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MANAGING PROJECTS

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Projects represent nonroutine business activities that often have long-term strategic ramifications for a firm. In this chapter, we examined how projects differ from routine business activities and discussed the major phases of projects. We noted how environmental changes have resulted in increased attention being paid to projects and project management over the past decade. In the second half of the chapter, we introduced some basic tools that businesses can use when planning for and controlling projects. Both Gantt charts and network diagrams give managers a visual picture of how a project is going. Network diagrams have the added advantage of showing the precedence between activities, as well as the critical path(s). We wrapped up the chapter by showing how these concepts are embedded in inexpensive yet powerful software packages such as Microsoft Project. If you want to learn more about project management, we encourage you to take a look at the Web site for the Proj...
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Cash Flow Estimation and Risk Analysis

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This chapter focused on estimating the cash flows that are used in a capital budgeting analysis, appraising the riskiness of those flows, finding NPVs when risk is present, and calculating the NPVs of mutually exclusive projects having unequal lives. Here is a summary of our primary conclusions:
Some cash flows are relevant (hence, should be included in a capital budgeting analysis), while others should not be included. The key question is this: Is the cash flow incremental in the sense that it will occur if and only if the project is accepted?
Sunk costs are not incremental costs—they are not affected by accepting or rejecting the project. Cannibalization and other externalities, on the other hand, are incremental—they will occur if and only if the project is accepted.
The cash flows used to analyze a project are different from a project’s net income. One important factor is that depreciation is deducted when accountants calculate net income; but because it is a noncash charge, it must be added back to find cash flows.
Many projects require additional net working capital. Net working capital is a negative flow when the project is started but a positive flow at the end of the project’s life, when the capital is recovered.
We considered two types of projects—expansion and replacement. For a replacement project, we find the difference in the cash flows when the firm continues to use the old asset versus the new asset. If the NPV of the differential flows is positive, the replacement should be made.
The forecasted cash flows (and hence NPV and other outputs) are only estimates—they may turn out to be incorrect, and this means risk.
There are three types of risk: stand-alone, within-firm, and market (or beta) risk. In theory, market risk is most relevant; but since it cannot be measured for most projects, stand-alone risk is the one on which we generally focus. However, firms subjectively consider within-firm and market risk, which they definitely should not ignore. Note, though, that since the three types of risk are generally positively correlated, stand-alone risk is often a good proxy for the other risks.
Stand-alone risk can be analyzed using sensitivity analysis, scenario analysis, and/or Monte Carlo simulation.
Once a decision has been made about a project’s relative risk, we determine a risk-adjusted WACC for evaluating it.
If mutually exclusive projects have unequal lives and are repeatable, a traditional NPV analysis may lead to incorrect results. In this case, we should use replacement chain or equivalent annual annuity (EAA) analysis.

 

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