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Get Full Access to UGA - FINA 3000 - Class Notes - Week 9
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UGA / Finance / FINA 3000 / How long should we run a project before terminating it?

# How long should we run a project before terminating it? Description

##### Description: Lecture IV for test 3, based off of his notes given. Includes current events.
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FINA 3000:  TEST 3, LECTURE 4 OBJECTIVES: 1. Describe and calculate the optimal cycle length for a project. 2. Describe project risk.   3. Describe sensitivity analysis, scenario analysis, and Monte Carlo Simulation. 4. Define a real option and work a real option example. SPECIAL TOPIC: OPTIMAL CYCLE LENGTH. How long should we run a project before terminating it? ­we quit a project when present value of quitting > present value of continuing Employed by a local consulting firm, you are sent to Classy Rentals, a car rental agency.   Classy Rentals buys new cars and then salvages them after 8 years of use.  This is the  physical life of the cars.  Classy’s CFO provides you with the following table.  The year  zero cash flow represents the purchase price of a new Buick Regal and the later flows  represent net cash flows gained over the next 8 years.  Terminal cash flows are also  projected for each year based on the net salvage values.  Classy uses a 10% cost of  capital. *Goal: run project for length that maximizes value Year 0 1 2 3 4 5 6 7 8 ICO/OCF =FCF ­ 35.7 15.4 12.3 10.3 8.6 5.8 3.4 2.1 0.6 TCF = NSV 31.2 27.4 25 21 14 8.3 4.8 2.7 1.4

## How long should we run a project before terminating it? *maximize NPV a. Given Classy’s current 8 year lifecycle for their cars, calculate: ­ The NPV for each Regal ­ The IRR for each Regal ­ The Payback Period for each Regal b. If each car represents a non­repeatable or one­time project, what would the  optimal time to abandon each Regal?  In other words, what is the economic life of the Regal? What is the NPV for this economic life? c. If each car represents a repeatable project (for as many cycles as you want), what  would the optimal time to abandon each Regal?  What would the NPV be if the  project were repeated 4 times? One year project: Yr. 0: ­ 35.7Yr.1 : 15.4 + NSV of 27.4 R = 10% NPV = [(15.4 + 27.4) / 1.10] – 35.7 = 3.21 Two year project: Yr. 0 = ­35.7 Yr. 1 = 15.4 Yr. 2 = 12.3 + NSV of 25 Use CF to solve: CF0 = ­35.7 C01 = 15.4 C02 = 12.3 +25 = 37.3 I = 10 NPV = 9.13 Three year project: CF0 = ­35.7 C01 = 15.4 C02 = 12.3 C03 = 10.3 + 21 = 31.3 I = 10 NPV = 11.98 Four year project: CF0 = ­35.7 C01 = 15.4 C03 = 10.3 C04 = 8.6 + 14 = 22.6 I = 10 NPV = 11.64 ­here, 3 years gives the highest NPV Why? PV of quitting > PV of continuing End of year 3: Quit = NSV = 21 Continue one more year = 8.6 + 14 = 22.6 Compare at year 3 = 22.6/1.10 = 20.55 < 21 PROJECT RISK: 3/28So far, we have assumed that the cash flows for our projects are known with certainty.   This is seldom the case in practice, so we need to account for uncertainty in our projects.   There are a few ways to measure this uncertainty in cash flows. ­ there’s uncertainty in forecasting project cash flows 3 ways to measure project uncertainty: 1. Sensitivity analysis a. Change value of one variable at a time i. Sales, growth, pricing, inventory b. Observe the impact on NPV c. See the range where NPV is still positive 2. Scenario Analysis a. Consider two or three project outcomes or cases i. Cases: bad, average, good 1. Calculate the NPV for each case 2. Range for NPV 3. Assign probabilities for each case and calculate the  expected NPV 3. Monte Carlo Simulation a. Assign a distribution of possible values for each variable i. Sales yr. 1: normally distributed ii. COGS yr. 1: normally distributed b. At random, we pick a value from each distribution c. Calculate NPV d. 500­1,000 trials e. Take trials and calculate the following: i. Average or expected NPV ii. Standard deviation for NPV iii. Probability of NPV > 0 EXAMPLE: Suppose that the Green Bay Packers are trying to weight an investment  decision in a new stadium expansion. The analyst wants to consider two  scenarios, GOOD and BAD, to evaluate the opportunity. In the GOOD case,  the team continues to perform well and all new seats are sold every season.  In the BAD case, the team does not play well on the field and fan support  declines. The probability of the GOOD case is estimated to be 80%, while the probability of the BAD case is estimated at 20%. Management will value this  opportunity in perpetuity. The Packers have a discount rate of 6%, and cash  flows are expected to grow at 3% per year going forward. The cash flows are  shown below: YEAR 0 1 BAD Case -\$150,000,000 \$2,000,000 GOOD Case -\$150,000,000 \$6,000,000

## In other words, what is the economic life of the Regal? ## If each car represents a non­repeatable or one­time project, what would the optimal time to abandon each Regal? We also discuss several other topics like What does a mercury represents?
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A. What is the NPV of the BAD case? B. What is the NPV of the GOOD case? C. What is the expected NPV of the project? D. Suppose that management is not sure of the probability of success for  the team. What probability of the GOOD case allows the project to break  even?
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