McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Risk Analysis and Capital Budgeting Module 3.3

Sensitivity, Scenario, and Break-Even  We often want to look behind the NPV number to see how stable our estimates are.  When working with spreadsheets, try to build your model so that you can adjust variables in a single cell and have the NPV calculations update accordingly.

7-2 Nike ballet 9-2

7-3 Nike ballet – base case  Nike is considering a $150 million investment to refurbish a factory for pointe shoe production. Nike already paid an expert marketing consulting firm $4 million for an analysis of the ballet market for pointe shoes. The marketing team assures Nike that they will sell approximately ½ million pairs each year at an average retail price of $155. The marketing team also believes that it will increase other sales of other Nike products by 10% of total pointe shoe revenue. The production line will last 12 years at which point it will be worth $6 million in scrap value – but will be depreciated to zero using straight-line over 12 years. The cost to produce each pair is $45, an initial $10 million increase in NWC will be recovered in 12 years, and Nike faces a 38% tax rate and 15% required rate of return on investment. What is the NPV of this investment? 9-3

7-4 Calculating simple NPV  Initial Investments Factory refurbish = -$150m PV Salvage Value = $6/(1.15) 12 = m NWC investment = /(1.15) 12 = m  OCFs ignore prior consulting costs. OCF=(77.5*1.1m – 22.5m)(0.62) (.38) OCF = OCF = $ million/year for 12 years

7-5 Nike ballet base case NPV  PV Invest = = m  PV OCFs = /.15(1-1/(1.15) 12 ) =  NPV = – = $79.63m  NPV > 0, implies that we should invest.

7-6 Spreadsheet of base case

7-7 Risk Assessments  Sensitivity Analysis  Change just 1 input by x%, to measure the % change in NPV  Scenario Analysis  Input the “best case sales/costs, etc” and calculate NPV  Input the “worst case sales/costs, etc” and calculate NPV  Break-even analysis  Find the input (cost, revenue, etc) that gives NPV=0.

7-8 Extend Nike example  1. Sensitivity analysis  How does a 5% increase in costs greater than expected change NPV?  2. Scenario analysis  Suppose before launch, marketing team tells us we can only expect to sell 450,000 units at $120 per pair AND engineers tell us the cost is $65/unit maximum. What is this worst case scenario NPV?  3. Breakeven analysis  Exactly how many units could we sell at $155 and still break-even?

Sensitivity Analysis  How does a 5% increase in cost/unit change NPV? I multiply cost cell by 1.05 and see that NPV falls 4.7%:

Scenario Analysis  Suppose before launch, marketing team tells us we can only expect to sell 450,000 units at $120 AND engineers tell us the cost is $65/unit maximum. What is this worst case scenario NPV? NPV falls to -$30 million.

7-11 Break-even analysis Exactly how many units could we sell at $155 and still break-even? Use goal-seek on Excel, answer=311,210 units

7-12 Coming soon? 9-12 Apparently not – these graphics are not the property of Nike.