NPV Break Even Analysis
An investment has a positive net present value if its market value exceeds its cost. Such an investment is desirable because it creates value for its owner. The primary problem in identifying such opportunities is that most of the time we can’t actually observe the relevant market value.
The possibility that we will make a bad decision because of errors in the projected cash flows is called forecasting risk (or estimation risk). Because of forecasting risk, there is the danger that we will think a project has a positive NPV when it really does not. How is this possible? It happens if we are overly optimistic about the future, and, as a result, our projected cash flows don’t realistically reflect the possible future cash flows.
Break-even analysis is a popular and commonly used tool for analyzing the relationship between sales volume and profitability. There are a variety of different break-even measures, and we have already seen several types.
By definition, variable costs change as the quantity of output changes, and they are zero when production is zero. For example, direct labor costs and raw material costs are usually considered variable. This makes sense because if we shut down operations tomorrow, there will be no future costs for labor or raw materials.
Fixed costs, by definition, do not change during a specified time period. So, unlike variable costs, they do not depend on the amount of goods or services produced during a period (at least within some range of production). For example, the lease payment on a production facility and the company president’s salary are fixed costs, at least over some period.
Naturally, fixed costs are not fixed forever. They are fixed only during some particular time, say, a quarter or a year. Beyond that time, leases can be terminated and executives “retired.” More to the point, any fixed cost can be modified or eliminated given enough time; so, in the long run, all costs are variable.
The most widely used measure of break-even is accounting break-even. The accounting break-even point is simply the sales level that results in a zero project net income.
In this chapter, we looked at some ways of evaluating the results of a discounted cash flow analysis; we also touched on some of the problems that can come up in practice:
Net present value estimates depend on projected future cash flows. If there are -errors in those projections, then our estimated NPVs can be misleading. We called this -possibility forecasting risk.
Scenario and sensitivity analysis are useful tools for identifying which variables are critical to the success of a project and where forecasting problems can do the most damage.
Break-even analysis in its various forms is a particularly common type of scenario analysis that is useful for identifying critical levels of sales.
Operating leverage is a key determinant of break-even levels. It reflects the degree to which a project or a firm is committed to fixed costs. The degree of operating leverage tells us the sensitivity of operating cash flow to changes in sales volume.
Projects usually have future managerial options associated with them. These options may be important, but standard discounted cash flow analysis tends to ignore them.
Capital rationing occurs when apparently profitable projects cannot be funded. Standard discounted cash flow analysis is troublesome in this case because NPV is not necessarily the appropriate criterion.
The most important thing to carry away from reading this chapter is that estimated NPVs or returns should not be taken at face value. They depend critically on projected cash flows. If there is room for significant disagreement about those projected cash flows, the results from the analysis have to be taken with a grain of salt.
Despite the problems we have discussed, discounted cash flow analysis is still theway of attacking problems because it forces us to ask the right questions. What we have learned in this chapter is that knowing the questions to ask does not guarantee we will get all the answers.