7.3 Project Analysis and Evaluation

Project analysis and evaluation are crucial steps in capital budgeting. They help managers assess the potential outcomes and risks of investment projects. These techniques provide a comprehensive view of a project's viability, allowing for more informed decision-making.

Sensitivity analysis, scenario analysis, and risk assessment are key tools in this process. They enable managers to understand how different variables impact project outcomes and prepare for various future scenarios. This knowledge is essential for making sound investment choices and maximizing shareholder value.

Sensitivity Analysis for Project Variables

Assessing Variable Impact on Project Outcomes

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• Sensitivity analysis determines how changes in independent variables affect dependent variables under given assumptions
• Process changes one input variable while holding others constant to observe impact on Net Present Value (NPV) or Internal Rate of Return (IRR)
• Identifies variables with most significant impact on project outcomes
  • Allows managers to focus on critical factors
• Key project variables typically include
  • Sales volume
  • Selling price
  • Variable costs
  • Fixed costs
  • Initial investment

Visualization and Advanced Techniques

• Results often presented in spider diagrams or tornado charts for visual representation
• Advanced sensitivity analysis incorporates probabilistic distributions for input variables
  • Provides more comprehensive view of potential outcomes
• Limitations of sensitivity analysis
  • Unable to consider interdependencies between variables
  • Assumes linear relationships between variables

Scenario Analysis for Project Evaluation

Analyzing Alternative Outcomes

• Scenario analysis evaluates future events by considering alternative possible outcomes
• Common scenarios in project evaluation
  • Best-case scenario
  • Worst-case scenario
  • Most likely or base-case scenario
• Each scenario involves consistent set of assumptions about key project variables
  • Differs from sensitivity analysis which changes one variable at a time
• Process typically involves
  • Defining scenarios
  • Estimating cash flows for each scenario
  • Calculating NPV or other financial metrics for each scenario
  • Comparing results

Probability-Weighted Analysis and Limitations

• Probability-weighted scenario analysis incorporates likelihood of each scenario occurring
  • Calculates expected NPV or other financial metric
• Helps understand range of potential outcomes and identify critical success factors
• Limitations of scenario analysis
  • Potential for overlooking important scenarios
  • Subjective nature of scenario definition and probability assignment

Project Risk Assessment Techniques

Break-Even and Simulation Analysis

• Break-even analysis determines point where total revenue equals total costs
  • Indicates sales volume required for project profitability
  • Can be calculated in units or dollars
  • Extended to find time required to reach profitability (payback period)
• Simulation (Monte Carlo) models probability of outcomes with random variables
  • Defines range of possible values for each input variable
  • Randomly samples from these ranges
  • Runs numerous iterations to generate probability distribution of possible outcomes
• Risk measures derived from simulation
  • Expected NPV
  • Standard deviation of NPV
  • Probability of negative NPV

Additional Risk Assessment Methods

• Decision trees for sequential decision-making under uncertainty
• Real options analysis for valuing managerial flexibility
• Choice of risk assessment technique depends on
  • Nature of project
  • Available data
  • Level of sophistication required in analysis

Capital Budgeting Decisions Based on Viability

Comprehensive Project Analysis

• Integrates results from various evaluation techniques
  • NPV
  • IRR
  • Payback period
  • Sensitivity analysis
  • Scenario analysis
  • Risk assessment
• Decision-makers consider both quantitative financial metrics and qualitative strategic factors
• Risk-adjusted return balances expected return with associated risk
  • Uses techniques like risk-adjusted discount rates or certainty equivalents
• Non-financial considerations in capital budgeting decisions
  • Strategic fit
  • Market positioning
  • Regulatory compliance
  • Environmental impact

Advanced Budgeting Techniques and Post-Audit

• Capital rationing problem arises when company has more acceptable investment opportunities than resources
  • Requires prioritization of projects
• Post-audit of capital budgeting decisions compares actual project outcomes with initial projections
  • Improves future decision-making processes
• Advanced capital budgeting techniques incorporate real options thinking
  • Values managerial flexibility and strategic growth opportunities embedded in projects