Corporate Finance Lecture 5. Topics covered Decision trees Decision trees Dealing with uncertainty Dealing with uncertainty –Sensitivity analysis –Senario.

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Corporate Finance Lecture 5

Topics covered Decision trees Decision trees Dealing with uncertainty Dealing with uncertainty –Sensitivity analysis –Senario analysis

Decision Trees Graphically represent the alternatives available to us in each period and the likely consequences of our actions. Graphically represent the alternatives available to us in each period and the likely consequences of our actions. This graphical representation helps to identify the best course of action. This graphical representation helps to identify the best course of action.

Example of Decision Tree Do not study Study finance “C” “A” “B” “F” “D”

Decision trees Example: Example: –The test marketing for a new project will take one year and will cost $100 million. –There is a 75% chance that the test will be successful. –If successful, the project will be taken and the NPV is estimated to be $1,517 million at year=1. –If not successful, the project will have an NPV of $-3,611 million at year=1. –The discount rate is 15% for the firm.

Decision trees Test result revealed Success failure Invest NPV=1517 No invest NPV=0 Invest NPV=-3611 No invest NPV=0 Now Test marketing -$100 million Year 1 Investment test No test 75% 25% 1. Test or not 2. Invest or not

Decision trees How to solve the problem How to solve the problem –Make decisions in reverse order with decision trees

Decision trees Test result revealed Success failure Invest NPV=1517 No invest NPV=0 Invest NPV=-3611 No invest NPV=0 Now Test marketing -$100 million Year 1 Investment test No test 75% 25% 1. Test or not2. Invest or not

Decision trees Test result revealed Success failure Invest NPV=1517 No invest NPV=0 Invest NPV=-3611 No invest NPV=0 Now Test marketing -$100 million Year 1 Investment test No test 75% 25% 1. Test or not2. Invest or not X

Decision trees Test result revealed Success failure Invest NPV=1517 No invest NPV=0 Invest NPV=-3611 No invest NPV=0 Now Test marketing -$100 million Year 1 Investment test No test 75% 25% 1. Test or not2. Invest or not X

Decision trees Test result revealed Success failure Invest NPV=1517 No invest NPV=0 Invest NPV=-3611 No invest NPV=0 Now Test marketing -$100 million Year 1 Investment test No test 75% 25% 1. Test or not2. Invest or not X X

Decision trees Test result revealed Success failure Invest NPV=1517 No invest NPV=0 Now Test marketing -$100 million Year 1 Investment test No test 75% 25% 1. Test or not2. Invest or not E[Payoff] 1 =0.75* *0=1138 NPV= /1.15=890>0

How to handle uncertainty Sensitivity Analysis Sensitivity Analysis –Analyze the effects of changes in one variable (e.g. sales, cost, discount rate) on a project. Scenario Analysis Scenario Analysis –Project analysis given a particular combination of assumptions.

How to handle uncertainty Example Given the expected cash flow forecasts listed on the next slide, determine the NPV of the project given changes in the cash flow components using an 8% cost of capital.

How to handle uncertainty NPV= $478

How to handle uncertainty Possible Outcomes

Sensitivity Analysis Assuming change in Investment NPV= ($322)

Scenario Analysis