Uncertainty with A Project Analysis

1. Since the cost behaviors differently occur in two manufacturing systems, new costing systems need to be developed.

2. Since firms invest in AMS to obtain such intangible(strategic or noneconomic) benefits as quality, flexibility, and etc., the investment justification techniques need to be developed to reflect them in the process.

3. Since an AMS requires a huge initial investment, coupled with irreversibility of investment, in a very dynamic economic environment, the investment evaluator must be capable of dealing with uncertainty inherent in the project.

4. Since a real investment infrequently occurs, it is so difficult to collect relevant data.

Four Problems inherent in Investment Justification

$125

0

1 2

$100

Project (A):

NPV(10%)=$3.30

Project (B):0

1 2

$100 NPV(10%)=$3.30

$70$50

$45

$90

Project (C): Uncertainty: Future Investment Opportunity in Year 1

Ignores future investment opportunity

Fails to capture investment flexibility

$115

$100

0

1 E(C)=$115

=0

Deterministic Cash Flows:

NPV(10%)=$4.55

$115

$100

0

1 E(C)=$115

=147

E(NPV)=$4.55

Uncertain Cash Flows:

P(G)=0.75

P(B)=0.25

C=$200

C= -$140

E(C)=$115 =147

Units SalesForecast 47,500 $475,000Break-Even Point 30,000 300,000Margin of Safety 17,500 175,000(Difference between Forecast and Break-Even Point)

Product A Product BForecast Sales $400,000 $600,000Break-Even Point 200,000 450,000Producing Product A is more preferred to Product B because of the higher margin of safety.

Margin of SafetyBreak-Even Point = Fixed Cost/Contribution per UnitMargin of Safety = 1 - BEP/Forecast Example]

Break-Even Point Analysis

Three Main Assumptions(1). Fixed cost will remain the same throughout all levels of activity.(2). Variable cost per unit is the same ".(3). Selling prices will remain the same ".

The above assumptions are unrealistic for the following reasons(1). Fixed costs are likely to show a stepped increase as business activity

increases.(2). At he high levels of activity, variable costs per unit are likely to decrease

because of factors such as higher discounts for bulk buying.(3). In order to achieve the higher level of sales it might be necessary to

reduce selling prices by offering special trade discounts.

Limitations of BEP Analysis