NPV Breakeven Analysis

Definition
• The NPV break-even analysis identifies the
level of sales necessary to produce a zero level
of NPV.
• It differs from accounting break-even analysis
in that NPV break-even focuses on cash flows,
not accounting profits.
• Principle 1: Money Has a Time Value
 Sample Scenario:
Cash Flow Forecasts: Year 0 Years 1-12
Investment ($5,400)
Sales $16,000
Variable Costs (81.25% of Sales) 13,000
Fixed Costs 2,000
Depreciation (Straight Line) 450
Pretax Profit 550
Taxes @ 40% 220
Profit after Tax 330
Cash Flow from Operations 780
Net Cash Flow ($5,400) $780
 Accounting Break-Even
– Accounting break-even is calculated as:

Break-Even Revenues = Fixed Costs + Depreciation

Profit per $1 of Sales
= $2,000 + $450
$1 - $0.8125
= $2,450
$0.1875
= $13.067 million
 Accounting Break-Even
– Creating an income statement at $13.067
million of sales shows profit equals zero:

Revenues $13,067
Variable Costs 10,067
Fixed Costs + Depreciation 2,450
Pretax Profit 0
Taxes 0
Profit after Tax 0
 Why NPV Analysis?
• Accounting Break-Even
– If a project breaks even in accounting terms is it
an acceptable investment?

Would you be happy with an investment

which after 12 years gave you a zero total rate
of return?
 NPV Break-Even Analysis
• NPV Break-Even
– Going back to our example:
Variable Costs 81.25% of Sales
+ Fixed Costs + Depreciation $2.45 m
Pretax Profit (0.1875 Sales) - 2.45 m
- Tax @ 40% 0.40 x [(0.1875 Sales) - 2.45 m]
After Tax Profit 0.60 x [(0.1875 Sales) - 2.45 m]
Cash flow $0.45 m + 0.60 x [(0.1875 Sales) - 2.45 m]
= 0.1125 * Sales - $1.02 m
Note: Cash flow = Depreciation + After Tax Profit
8-7
 NPV Break-Even Analysis
 This cash flow will last for 12 years.

PV(cash flows) = Cash Flows x Annuity Factor

= (0.1125 x Sales - 1.02 m) x 12 year
Annuity Factor
= (0.1125 x Sales - 1.02 m) x 7.536

But: NPV = 0 if PV (cash flows) = C0

NPV = 0 if (0.1125 x Sales – 1.02 m) x 7.536 = 5.4 m
Sales = $15.4 m

8-8
 Break-Even Analysis
– Using the accounting break-even, the project
had to generate sales of $13.067 million to have
zero profit.
– Using the NPV break-even, we find that the
project needs sales of $15.4 million to have a
zero NPV.
• The project needs to be 18% more successful to break-
even on a NPV basis!
Longhorn Enterprises
is considering an
investment that
involves producing
novelty brake
lights for
automobiles. The
analysis of NPV
breakeven
presented here
corresponds to the
assumptions
underlying the
worst case
scenario for the
investment.
 Operating Leverage and the
Volatility of Project Cash Flows
 Definition
• Operating leverage results from the use of
fixed costs in the operations of the firm and
measures the sensitivity of changes in
operating income to changes in sales.
 Basic Idea of Operating Leverage
• Operating leverage is the degree to which a
project or firm is committed to fixed production
costs.
• A firm with low operating leverage will have low
fixed costs compared to a firm with high
operating leverage.
• Generally speaking, projects with a relatively
heavy investment in plant and equipment will
have a relatively high degree of operating
leverage. Such projects are said to be capital
intensive.
 Degree of Operating Leverage
• Degree of operating leverage (DOL) tells us
when there is a percent change in sales, how
that is reflected in a percent change in Net
Operating Income (NOI).
 DOL Equation

• If DOL = 1, then a 1% change in sales will produce a

1% change in profits.
• If DOL = 50, then a 1% change in sales will produce a
50% change in profits.
 Application
• The risk of a project is affected by its DOL.
• If a large proportion of the project’s costs are
fixed, then DOL will be high.
• If DOL is high, then any shortfall in sales will
have a magnified effect on profits.
• In other words, high DOL means high risk if
sales do not work out as forecasted!
Table 13-1 How Operating Leverage Affects NOI for a 20%
Increase in Longhorn’s Sales

Table 13-2 How Operating Leverage Affects NOI for a 20%

Decrease in Longhorn’s Sales
 DOL in a nutshell
• Operating leverage results from substitution of
fixed operating costs for variable operating
costs.
• The effect of operating leverage is to increase the
effect of changes in sales on operating income.
• The degree of operating leverage (DOL) is an
indication of the firm’s use of operating leverage.
The DOL decreases as the level of sales increases
beyond the break-even point.
• Operating leverage is a double-edged sword,
magnifying both profits and losses, helping in the
good times and causing pain in the bad times
 Summary
– Successful managers know that the
forecasts behind NPV calculations are
imperfect.
– Thus, they explore the consequences to the
firm of a poor forecast.
– They check whether the project is really
worth pursuing by doing some additional
homework.
• This consists of asking a series of “what-if”
questions to determine the feasibility of the
project and its risk profile.
 Summary
– The principal tools used by managers in
“what-if” questions are:
• Sensitivity Analysis
• Scenario Analysis
• Simulation Analysis
• Break-Even Analysis
• Operating Leverage
– A desirable characteristic in a project is
flexibility.
copyright © 2003 McGraw Hill
8-20
Ryerson Limited