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STRATEGIC FINANCIAL MANAGEMENT
Investment decision under risk and uncertainty
Techniques o Investment decision
Risk ad!usted discounted rate " Certain equiva#ent actors
Sensitivity ana#ysis and other methods o ca$ita# %ud&etin&
Com$arative ana#ysis o dierent methods o ca$ita# %ud&etin& 'ith risk and
uncertainty
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Investment decision under risk and uncertainty
Meaning(
)A determination made %y directors and*or mana&ement as to ho'+
'hen +'here and ho' much ca$ita# 'i## %e s$ent on investment o$$ortunities,
The decision oten o##o's research to determine costs and returns or each
o$tion,-
.ecision makin& is one o the ma!or mana&ement unctions, It invo#vescommitment to action 'hich requires qua#ity decisions to %e made or the
$ur$ose o the day to day runnin& o an or&ani/ation, To arrive at a qua#itydecision+ there must %e a $#an, 0#annin& reers to settin& attaina%#e &oa#s 'hichre#ates to the uture,1ICMA 23345, The environment in 'hich decisions are
%ein& made are #aced 'ith uncertainties and inherent risks thus+ e6tra cautionsare needed in takin& investment decisions, 7oont/ and 8eihrich 123935 deineddecision makin& as these#ection o a course o action rom amon& a#ternatives, :#o'e 1233;5+ deineddecision makin&+ as the $rocess o se#ectin& a #o&ica# choice rom avai#a%#eo$tions,
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e6$ect that the risk invo#ved is equa##y hi&h, Every investor e6$ects somereturns that 'ou#d cover the or&ani/ation>s inancia# commitments to servicesand $roduction as the case may %e,
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Investors common#y $erorm investment ana#ysis %y makin& use oundamenta# ana#ysis+ technica# ana#ysis and &ut ee#,
Investment decisions are oten su$$orted %y decision too#s, The investment decisions taken %y cor$orate are kno'n as ca$ita#
%ud&etin& decisions, The ca$ita# %ud&etin& decisions invo#ve eva#uation o s$eciic investment
$ro$osa#s,
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Techniques o Investment decision
:n economic %asis+ A num%er o Investment .ecision techniques are used in$ractice, They may %e &rou$ed in the o##o'in& t'o cate&ories(
I, Investment .ecision 1Ca$ita# %ud&etin&5 techniques under certaintyD andIi, Investment .ecision 1Ca$ita# %ud&etin&5 techniques under uncertainty
Capital budgeting techniques under certainty
Ca$ita# %ud&etin& techniques 1Investment a$$raisa# criteria5 under certainty cana#so %e divided into o##o'in& t'o &rou$s(
Non.iscounted Cash F#o' Criteria(
1a5 0ay ack 0eriod 10051%5 Accountin& Rate : Return 1ARR5
.iscounted Cash F#o' Criteria( 1a5 Net 0resent a#ue 1N051%5 Interna# Rate o Return 1IRR51c5 0roita%i#ity Inde6 10I5
Non-Discounted Cash Flow Criteria:
! "ay #ack "eriod
"ayback periodin ca$ita# %ud&etin&reers to the $eriod o time required
to recou$ the unds e6$ended in an investment+ or to reach the%reakeven$oint,
For e6am$#e+ a 9333 investment 'hich returned 33 $er year 'ou#d
have a t'oyear $ay%ack $eriod, The time va#ue o moneyis not takeninto account,
0ay%ack $eriod intuitive#y measures ho' #on& somethin& takes to H$ayor itse#,H A## e#se %ein& equa#+ shorter $ay%ack $eriods are $reera%#e to#on&er $ay%ack $eriods,
0ay%ack $eriod is $o$u#ar due to its ease o use des$ite the reco&ni/ed
#imitations descri%ed %e#o',$imitation0ay%ack $eriod doesnt take into consideration the time va#ue o money
and thereore may not $resent the true $icture 'hen it comes to
eva#uatin& cash #o's o a $ro!ect,
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0ay%ack a#so i&nores the cash #o's %eyond the $ay%ack $eriod, Most
ma!or ca$ita# e6$enditures have a #on& #ie s$an and continue to $rovidecash #o's even ater the $ay%ack $eriod, Since the $ay%ack $eriodocuses on short term $roita%i#ity+ a va#ua%#e $ro!ect may %e over#ooked
i the $ay%ack $eriod is the on#y consideration,
Example:
Estimate the $ay%ack $eriod or(
%ear & ' ( ) *
CF 93+333 J+33 J+33 @+333 2+333
Solution:
To ind the $ay%ack $eriod+ 'e need to ind the cumu#ative cash #o's irst
%ear & ' ( ) *
CF 93+333 J+33 J+33 @+333 2+333
CCF 93333 33 9333 2333 J333
The $ay%ack $eriod occurs 'hen the cumu#ative cash #o's chan&es rom ne&ative to
$ositive, That is+ it occurs %et'een years 2 and @, ecause 'e sti## have to recover 9333 ater
second year+ the $ay%ack $eriod is( 2 K 9333*@333 2,@@ years
15 Accountin& Rate o Return 1ARR5Accountin& Rate o Return+ short#y reerred to as ARR+ is the $ercenta&e oavera&e accountin& $roit earned rom an investment in com$arison 'ith the
avera&e accountin& va#ue o investment over the $eriod,
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Accountin& Rate o Return is a#so kno'n as the Avera&e Accountin& Return1AAR5 and Return on Investment 1R:I5,
Computation Method:
9, Estimate the net incomes
2, Estimate the %ook va#ues
@, Estimate avera&e net incomes
J, Estimate avera&e %ook va#ue 1i,e, or strai&ht#ine de$reciation+ avera&e
%ook va#ue is historica# va#ue sa#va&e va#ueO*25
Decision Rule:
8e acce$t the $ro!ect i the AAR is &reater than a $reset rate,
Pros and Cons:
0ros Cons
9, Easy to ca#cu#ate,
2, Needed inormation 'i## usua##y%e avai#a%#e,
9, It is not a true rate o return,
2, Time va#ue o money is i&nored,
@, Pses an ar%itrary cuto $oint,
J, ased on accountin& net incomeand %ook va#ues+ not cash #o's and
market va#ues,
Example:
Assume a com$any invests J33+333 in $ro!ect de$reciated usin& strai&ht#ine method over J
years 'ith /ero sa#va&e va#ue, The o##o'in& ta%#e sho's the revenues and o$eratin&
e6$enses, Ca#cu#ate AAR usin& J3Q ta6 rate(
%ear ' ( ) *
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+evenue 233+333 23+333 @33+333 @23+333
,perating .penses ?3+333 933+333 923+333 ?3+333
Solution:
First+ 'e ind the net income 'here de$reciation 1%ook va#ue sa#va&e va#ue5* useu# #ie,
.e$recation is J33+333*J 933+333
%ear ' ( ) *
+evenue 233+333 23+333 @33+333 @23+333
,perating .penses ?3+333 933+333 923+333 ?3+333
Depreciation 933+333 933+333 933+333 933+333
/a.es 0 &!* 1+-,-D2 J+333 23+333 @2+333 2+333
Net Income 4+333 @3+333 J;+333 B;+333
Avera&e net income 14+333 K @3+333 K J;+333 K B;+3335*J J3+33
Avera&e %ook va#ue 1J33+33335*2 233+333
Discounted Cash Flow Criteria:
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12 Net "resent 3alue1N05The net $resent va#ue 1N05 is the $resent va#ue o uture aterta6 cash #o's
minus initia# investment, It re#ects the dierence %et'een the market va#ue o
the $ro!ect and its cost,
Computation Method:
9, Estimate the e6$ected uture cash #o's,
2, Estimate the required return or $ro!ects o this risk #eve#,
@, Find the $resent va#ue o the cash #o's and su%tract the initia#
investment,
8here CFtis the cash #o' at time t+ ris the discount rate or the investment
and out#ay is the investment cash #o' at time 3,
Decision Rule:
8e acce$t the $ro!ect i the N0 is &reater than /ero, A $ositive N0 means
that the $ro!ect is e6$ected to add va#ue to the irm and 'i## thereore increasethe 'ea#th o the o'ners, Since our &oa# is to increase o'ner 'ea#th+ N0 is a
direct measure o ho' 'e## this $ro!ect 'i## meet our &oa#,
Pros and Cons:
0ros Cons
9, N0 &ives im$ortance to the timeva#ue o money,
2, In the ca#cu#ation o N0+ %oth atercash #o' and %eore cash #o' over the#ie s$an o the $ro!ect are considered,
@, 0roita%i#ity and risk o the $ro!ectsare &iven hi&h $riority,
J, N0 he#$s in ma6imi/in& the irm>s
va#ue,
9, N0 is diicu#t to use,
2, N0 can>t &ive accurate decision ithe amount o investment omutua##y e6c#usive $ro!ects is notequa#,
@, It is diicu#t to ca#cu#ate thea$$ro$riate discount rate,
J, N0 may not &ive correct decision
'hen the $ro!ects are o unequa# #ie,
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Example:
Estimate the N0 at 93Q discount rate or(
%ear & ' ( ) *
CF 93+333 J+33 J+33 @+333 2+333
Solution:
15 Interna# Rate o Return 1IRR5
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This is the most im$ortant a#ternative to N0D it is oten used in $ractice and is
intuitive#y a$$ea#in&, It is %ased entire#y on the estimated cash #o's and is
inde$endent o interest rates ound e#se'here,
Computation Method:
9, Estimate the e6$ected uture cash #o's,
2, Estimate usin& tria# and error the discount rate that makes N0 3
8ritten out in an equation orm+
Decision Rule:
Acce$t the $ro!ect i the IRR i it is &reater than the required return,
Pros and Cons:
0ros Cons
9, 7no'in& a return is intuitive#y a$$ea#in& mana&ers #ike to hear returns,
2, It is a sim$#e 'ay to communicate the va#ueo a $ro!ect to someone 'ho does not kno'a## the estimation detai#s,
@, I the IRR is hi&h enou&h+ you may not needto estimate a required return+ 'hich oten is adiicu#t task,
9, Pnrea#istic assum$tion o reinvestmentat IRR un#ike N0 'hich assumesreinvestment at 8ACC 'hich is a rea#isticassum$tion,
2, IRR is not &ood or com$arin& t'omutua##y e6c#usive investments,
Example:
Estimate the IRR at 93Q discount rate or(
%ear & ' ( ) *
CF 93+333 J+33 J+33 @+333 2+333
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Solution:
Psin& tria# and error+ i 'e start 'ith discount rate o 9BQ
8e ind(
So 'e use a hi&her discount rateD #et>s say 'e a$$#y a discount rate o9;Q+ 'e ind(
Thereore+ the discount rate that makes N0 3 is %et'een 9BQ and 9;Q, 7ee$in& tria# and
error+ then IRR 9B,J@Q
1C5 0roita%i#ity Inde6 10I5The $roita%i#ity inde6 10I5 is very c#ose#y re#ated to net $resent va#ue 1N05, It
is the $resent va#ue o cash #o's dividend %y the initia# investments,
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Computation Method:
9, Estimate the e6$ected uture cash #o's,
2, Estimate the required return or $ro!ects o this risk #eve#,
@, Find the $resent va#ue o the cash #o's and divide %y the initia#
investment,
8here CFtis the cash #o' at time t+ ris the discount rate or the investment
and out#ay is the investment cash #o' at time 3,
Decision Rule:
8e acce$t the $ro!ect i the 0I is &reater than one, 0I &reater than one means
that the $ro!ect is e6$ected to add va#ue to the irm and 'i## thereore increase
the 'ea#th o the o'ners,
Pros and Cons:
0ros Cons
9, 0I he#$s in ma6imi/in& the irm>s va#ue,
2, 0I is useu# in cases o ca$ita# rationin&,
9, 0I can>t &ive accurate decision i theamount o investment o mutua##ye6c#usive $ro!ects is not equa#,
2, It may not %e easy to understand,
Example:
Estimate the 0I at 93Q discount rate or(
%ear & ' ( ) *
CF 93+333 J+33 J+33 @+333 2+333
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Solution:
+isk d4usted Discounted +ate 1+D+2
Accordin& to $andy 1233?5+ risk is the varia%i#ity that is #ike#y to occur in
the uture returns o a $ro!ect,
The %asic $rinci$#e o RA.R is that there shou#d %e adequate re'ard in
the orm o return to the irms 'hich decide to e6ecute risky %usiness
$ro!ects
Man %y nature is riskaverse and tries to avoid risk
To motivate irms to take u$ risky $ro!ects+ returns e6$ected rom the
$ro!ect sha## have to %e adequate+ kee$in& in vie' the e6$ectations o the
investors, Thereore risk $remium needs to %e incor$orated in discount
rate durin& the eva#uation o risky $ro!ect $ro$osa#s,
This method o risk ana#ysis ad!usts the cost o ca$ita# u$'ards as
$ro!ects %ecome more risky, Greater the risk+ hi&her the ad!usted discount
rate+ and thereore #o'er the $ro!ect>s riskad!usted N0
RA.R is more %rie#y descri%ed as (
RA.R Risk ree rate K risk $remium
Risk ree rate is com$uted %ased on the returns on &ovt, securities,
Risk $remium is the additiona# returns that the investors require or
assumin& the additiona# risk associated 'ith the $ro!ect to %e taken u$ or
e6ecution,
Thus+ $ro!ects are eva#uated on the %asis o uture cash #o' $ro!ections and
an
a$$ro$riate discount rate,Decision +ule:
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The risk ad!usted a$$roach can %e used or %oth N0 " IRR,
I N0 method is used or eva#uation+ the N0 'ou#d %e ca#cu#ated usin& risk ad!usted
rate, I N0 is $ositive+ the $ro$osa# 'ou#d qua#iy or acce$tance+ i it is ne&ative+ the
$ro$osa# 'ou#d %e re!ected,
In case o IRR+ the IRR 'ou#d %e com$ared 'ith the risk ad!usted required rate o
return, I the =r> e6ceeds risk ad!usted rate+ the $ro$osa# 'ou#d %e acce$ted+ other'ise not,
For e6am$#e+ i an investment $ro!ect has o##o'in& cash #o's+ its N0 usin& RA.R
'i## %e as o##o's(
Risk ree rate is 4Q and Risk ad!usted rate is 93Q,
%ear CF/
1+s!2
"3 5 '&6 "3 1+s!2
9 3333 3,?3? JJ3
2 J3333 3,;24 @@3J3
@ J333 3,B9 @@B?
PV 112285
Less( Investment 93333
N0 1@BB95
Merits:
It is sim$#e to ca#cu#ate and easy to understand,
It has a &reat dea# o intuitive a$$ea# or riskaverse %usinessman,
It incor$orates an attitude to'ards uncertainty,
Demerits:
The determination o a$$ro$riate discount rates kee$in& in vie' the dierin& de&rees o risk
is ar%itrary and does not &ive o%!ective resu#ts,
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Conce$tua##y this method is incorrect since it ad!usts the required rate o return, As a matter
act it is the uture cash #o's 'hich are su%!ect to risk,
This method resu#ts in com$oundin& o risk over time+ thus it assumes that risk necessari#y
increases 'ith time 'hich may not %e correct in a## cases,
The method $resumes that investors are averse to risk+ 'hich is true in most cases,
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%ear NCF
1+s!2
C
Coe77icient
d4usted
NCF
1+s!2
"3 5 86 "3
1+s!2
9 43+333 3,; J;+333 3,?2 J4?4
2 B3+333 3,4 J2+333 3,?3B @;3?J
@ J3+333 3,B 2;+333 3,;4J 2J9?2
PV 107982
Less( Investment 933333
N0 B?;2
Decision +ule:
I N0 method is used+ the $ro$osa# 'ou#d %e acce$ted i N0 o CE cash
#o's is $ositive+ other'ise it is re!ected,
I IRR is used+ the interna# rate o return 'hich equates the $resent va#ue o
CE cash in#o's 'ith the $resent va#ue o the cash out#o's+ 'ou#d %e
com$ared 'ith risk ree discount rate, I IRR is &reater than the risk ree rate+
the investment $ro!ect 'ou#d %e acce$ted other'ise it 'ou#d %e re!ected
Merits:
It is sim$#e to ca#cu#ate,
It is conce$tua##y su$erior to timead!usted discount rate a$$roach %ecause it
incor$orates risk %y modiyin& the cash #o's 'hich are su%!ect to risk,
Demerits:
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This method e6$#icit#y reco&ni/es risk+ %ut the $rocedure or reducin& the
orecast o cash #o's is im$#icit and #ike#y to %e inconsistent rom one
investment to another,
The orecaster e6$ectin& reduction that 'i## %e made in his orecast+ may
in#ate them in antici$ation, This 'i## no #on&er &ive orecasts accordin& to
)%est estimate-,
I orecast have to $ass throu&h severa# #ayers o mana&ement+ the eect may
%e to &reat#y e6a&&erate the ori&ina# orecast or to make it u#tra conservative,
y ocusin& e6$#icit attention on#y on the oomy outcomes+ chances are
increased or $assin& %y some &ood investments,
9ensitivity nalysis nd ,ther Methods ,7 Capital #udgeting
9ensitivity nalysis
8hi#e eva#uatin& any ca$ita# %ud&etin& $ro!ect+ there is a need to orecast
cash #o's, The orecastin& o cash #o's de$ends on sa#es orecast and
costs, The Sa#es revenue is a unction o sa#es vo#ume and unit se##in& $rice,
Sa#es vo#ume 'i## de$end on the market si/e and the irm>s market share,
The N0 and IRR o a $ro!ect are determined %y ana#y/in& the aterta6
cash #o's arrived at %y com%inin& various varia%#es o $ro!ect cash #o's+
$ro!ect #ie and discount rate, The %ehavior o a## these varia%#es are very
much uncertain,
The sensitivity ana#ysis he#$s in identiyin& ho' sensitive are the
various estimated varia%#es o the $ro!ect, It sho's ho' sensitive is a
$ro!ect>s N0 or IRR or a &iven chan&e in $articu#ar varia%#es,
The more sensitive the N0+ the more critica# is the varia%#es,
9teps:
The o##o'in& three ste$s are invo#ved in the use o sensitivity ana#ysis,
9, Identiy the varia%#es 'hich can in#uence the $ro!ect>s N0 or IRR,
2, .eine the under#yin& re#ationshi$ %et'een the varia%#es,
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@, Ana#y/e the im$act o the chan&e in each o the varia%#es on the $ro!ect>s
N0 or IRR,
The 0ro!ect>s N0 or IRR can %e com$uted under o##o'in& three
assum$tions in
sensitivity ana#ysis,
9, 0essimistic 1i,e, the 'orst5+
2, E6$ected 1i,e, the most #ike#y5
@, :$timistic 1i,e, the %est5
Merits:
The sensitivity ana#ysis has the o##o'in& advanta&es(
It com$e#s the decision maker to identiy the varia%#es aectin& the cash
#o'
orecasts 'hich he#$s in understandin& the investment $ro!ect in tota#ity,
It identiies the critica# varia%#es or 'hich s$ecia# actions can %e taken,
It &uides the decision maker to concentrate on re#evant varia%#es or the
$ro!ect,
Demerits:
The sensitivity ana#ysis suers rom o##o'in& #imitations(
The ran&e o va#ues su&&ested %y the technique may not %e consistent, The
terms
=o$timistic> and =$essimistic> cou#d mean dierent thin&s to dierent $eo$#e,
It ai#s to ocus on the interre#ationshi$ %et'een varia%#es, The study o
varia%i#ity o one actor at a time+ kee$in& other varia%#es constant may not
much sense, For e6am$#e+ sa#es vo#ume may %e re#ated to $rice and cost,
:ne
can not study the eect o chan&e in $rice kee$in& quantity constant,
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9cenario nalysis:
In sensitivity ana#ysis+ ty$ica##y one varia%#e is varied at a time, I varia%#es
are interre#ated+ as they are most #ike#y to %e+ it is he#$u# to #ook at some
$#ausi%#e scenarios+ each scenario re$resentin& a consistent com%ination o
varia%#es,
"rocedure:
The ste$s invo#ved in scenario ana#ysis are as o##o's (
9, Se#ect the actor around 'hich scenarios 'i## %e %ui#t, The actor chosen
must %e the #ar&est source o uncertainty or the success o the $ro!ect, Itmay %e the state o the economy or interest rate or techno#o&ica#
deve#o$ment or res$onse o the market,
2, Estimate the va#ues o each o the varia%#es in investment ana#ysis
1investment out#ay+ revenues+ costs+ $ro!ect #ie+ and so on5 or each scenario,
@, Ca#cu#ate the net $resent va#ue and*or interna# rate o return under each
scenario,
Illustration:
A com$any is eva#uatin& a $ro!ect or introducin& a ne' $roduct, .e$endin& on
the res$onse o the market the actor 'hich is the #ar&est source o uncertainty
or the success o the $ro!ect the mana&ement o the irm has identiied three
scenarios (
Scenario 9 ( The $roduct 'i## have a moderate a$$ea# to customers across the
%oard at a modest $rice,Scenario 2 ( The $roduct 'i## strony a$$ea# to a #ar&e se&ment o the
market 'hich is hi&h#y $ricesensitive,
Scenario @ ( The $roduct 'i## a$$ea# to a sma## se&ment o the market
'hich 'i## %e 'i##in& to $ay a hi&h $rice
#est and orst case analysis:
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In the a%ove i##ustration+ an attem$t 'as made to deve#o$ scenarios in 'hich the
va#ues o varia%#es 'ere interna##y consistent, For e6am$#e+ hi&h se##in& $rice
and #o' demand ty$ica##y &o hand in hand, Firms oten do another kind o
scenario ana#ysis are considered, est case and 'orst case ana#ysis, In this kind
o ana#ysis the o##o'in& scenarios are considered(
#est scenario (
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Simu#ation ana#ysis is an e6tension o scenario Ana#ysis, Instead o ar%itrari#y
s$eciyin& a re#ative#y sma## num%er o scenarios+ a com$uter &enerates severa#
thousand $ossi%#e com%inations o varia%#es via $ro%a%i#ity distri%utions
accordin& to the historica# data, The entire $ro%a%i#ity distri%ution o outcomes
can %e constructed rom the simu#ation resu#ts,
Merits:
An increasiny $o$u#ar too# o risk ana#ysis+ simu#ation oers certain
advanta&es(
It aci#itates the ana#ysis and a$$raisa# o hi&h#y com$#e6+ mu#tivariate
investment $ro$osa#s 'ith the he#$ o so$histicated com$uter $acka&es,
It can co$e u$ 'ith %oth inde$endence and de$endence amon&st varia%#es, It
orces decisionmakers to e6amine the re#ationshi$ %et'een varia%#es,
Demerits:
Simu#ation is not a#'ays a$$ro$riate or easi%#e or risk eva#uation,
The mode# requires accurate $ro%a%i#ity assessments o the key varia%#es, For
E6am$#e+ it may %e kno'n that there is a corre#ation %et'een sa#es $rice and
o#ume so#d+ %ut s$eciyin& 'ith mathematica# accuracy the nature o the
Re#ationshi$ or mode# $ur$oses may %e diicu#t,
Constructin& simu#ated inancia# mode#s can %e timeconsumin&+ cost#y and
Requires s$ecia#i/ed ski##s+ thereore, It is #ike#y to %e used to ana#y/e very
Im$ortant+ com$#e6+ and #ar&esca#e $ro!ects,
It ocuses on a $ro!ect>s standa#one risk, It i&nores the im$act o
.iversiication+ i,e,+ s overa## cor$orate risk,
Simu#ation is inherent#y im$recise, It $rovides a rou&h a$$ro6imation o the
0ro%a%i#ity distri%ution o net $resent va#ue 1or any other criterion o merit5,
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#reak ven nalysis
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)%reakeven-(
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your investment %ack, It does not cover the o$$ortunity cost o the ca$ita#
1initia# investment5
2, N0ased 1or Economic5 reakEven Ana#ysis+ It is more $ro$er#y %ecause
the o$$ortunity cost o the ca$ita# is taken into consideration, The N0 at the
economic %reakeven $oint is /ero,