Introduction to Corporate Finance

PART 3: CAPITAL BUDGETING

FIGURE 11.2B BREAKEVEN POINT FOR FIBERSPEED

The breakeven point (BEP) for Fiberspeed is 6,667 units, which occurs at the point where its total costs equal its total

revenue.

Costs and revenues

$2,000,000

6,667 units Units

Fiberspeed has low fixed costs ($2,000,000), and a low contribution

margin ($300/frame). It has a low breakeven point, but profits grow

slowly after fixed costs are covered.

Total revenue

Total costs

Fixed costs

Breakeven analysis is popular in part because it provides clear targets. From breakeven calculations,

managers can derive specific goals for different functional areas in the company (for example, produce at

least 10,000 units, gain at least a 5% market share, hold variable costs to no more than 65% of the selling

price). As always, we encourage managers to use breakeven analysis in the context of net present values

rather than earnings targets. A project that reaches the breakeven point in terms of net income would still

destroy shareholder value if it does not recover the company’s cost of capital. A company that exceeds the

NPV breakeven point will create shareholder value.

11-2b SENSITIVITY ANALYSIS

Most capital budgeting problems require analysts to make many different assumptions before arriving at a

final NPV. For instance, forecasting project cash flows may require assumptions about the selling price of

output, costs of raw materials, market share and many other unknown quantities. Managers use sensitivity

analysis to explore the importance of each individual assumption, holding all other assumptions fixed,

on the project’s NPV. A common way of conducting sensitivity analysis is first to establish a base case

set of assumptions for a particular project, and then to calculate its NPV based on those assumptions.

Next, managers allow one assumption to change while holding all others fixed, recalculating the NPV

based on that one change. By repeating this process for all the uncertain variables in an NPV calculation,

managers can see how sensitive the NPV is to changes in baseline assumptions. The following example

illustrates this procedure.

LO11.3

sensitivity analysis
Exploration of the impact of
individual assumptions on a
decision variable, such as a
project’s NPV, by determining
the effect of changing one
assumption while holding all
others fixed.