Risk Analysis, Real Options, and Capital Budgeting Ch.8 Risk Analysis, Real Options, and Capital Budgeting

Financial Management Ch.8 Real-world practitioners often wonder how much confidence they should place in NPV calculations. NCUMBA Financial Management Ch.8

Financial Management Ch.8 Chapter Outline 8.1 Decision Trees 8.2 Sensitivity Analysis, Scenario Analysis, and Break-Even Analysis 8.3 Monte Carlo Simulation 8.4 Real Options NCUMBA Financial Management Ch.8

8.1 Decision Trees

Financial Management Ch.8 A fundamental problem in NPV analysis is dealing with uncertain future outcomes. Warning 1: Perhaps a higher discount rate should have been used for the initial test-marketing decision. Warning 2: It is hard for decision trees to capture all of the managerial options in changing environments. NCUMBA Financial Management Ch.8

Sensitivity Analysis, Scenario Analysis, and Break-Even Analysis 8.2 Sensitivity Analysis, Scenario Analysis, and Break-Even Analysis

Financial Management Ch.8 The projected cash flow often goes unmet in practice, and the firm ends up with a money loser. NCUMBA Financial Management Ch.8

Sensitivity Analysis and Scenario Analysis Sensitivity analysis examines how sensitive a particular NPV calculation is to changes in underlying assumptions. Revenue: Depends on three assumptions - market share, size of jet engine market, and price per engine. Cost: Total cost before taxes =Variable cost + Fixed cost NCUMBA Financial Management Ch.8

Sensitivity Analysis and Scenario Analysis A table such as Table 8.3 can be used for a number of purposes: It can indicate whether NPV analysis should be trusted It shows where more information is needed NCUMBA Financial Management Ch.8

Sensitivity Analysis and Scenario Analysis The effect of incorrect estimates on revenues is so much greater than the effect of incorrect estimates on costs, more information on the factors determining revenues might be needed. NCUMBA Financial Management Ch.8

Sensitivity Analysis and Scenario Analysis However, sensitivity analysis suffers from some drawbacks: It may unwittingly increase the false sense of security among managers; it treats each variable in isolation. Managers frequently perform scenario analysis to minimize this problem. NCUMBA Financial Management Ch.8

Financial Management Ch.8 Break-Even Analysis This approach determines the sales needed to break even. It is a useful complement to sensitivity analysis, because it also sheds light on the severity of incorrect forecasts. NCUMBA Financial Management Ch.8

Financial Management Ch.8 Break-Even Analysis Accounting Profit (Fixed costs + Depreciation)*(1-Tc) (Sales price-Variable costs)*(1-Tc) Contribution margin: It is the amount that each additional engine contributes to after-tax profit. NCUMBA Financial Management Ch.8

Financial Management Ch.8 Break-Even Analysis EAC = Initial Investment / 5-year annuity factor at 15% (Fixed costs + Depreciation)*(1-Tc) = Fixed costs *(1-Tc) + Depreciation)*(1-Tc) = Fixed costs *(1-Tc) +【Depreciation - Depreciation*Tc】 Fixed costs *(1-Tc) + 【 EAC - Depreciation*Tc 】 NCUMBA Financial Management Ch.8

Financial Management Ch.8 Break-Even Analysis Present Value Break-Even Point: Fixed costs*(1-Tc) +【 EAC -Depreciation*Tc 】 (Sales price-Variable costs)*(1-Tc) NCUMBA Financial Management Ch.8

Financial Management Ch.8 Break-Even Analysis The EAC of $447.5 million is greater than the yearly depreciation of $300 million, because we implicitly assume that the $1,500 million investment could have been invested at 15%. NCUMBA Financial Management Ch.8

Financial Management Ch.8 Break-Even Analysis Depreciation understates the true costs of recovering the initial investment. Thus Companies that break even on an accounting basis are really losing money. They are losing the opportunity cost of the initial investment. NCUMBA Financial Management Ch.8

8.4 Real Options

Financial Management Ch.8 NPV analysis ignores the adjustments that a firm can make after a project is accepted. These adjustments are called real options. Thus, NPV underestimates the true value of a project. NCUMBA Financial Management Ch.8

Financial Management Ch.8 One of the fundamental insights of modern finance theory is that options have value. Because corporations make decisions in a dynamic environment, they have options that should be considered in project valuation. NCUMBA Financial Management Ch.8

Financial Management Ch.8 Options The Option to Expand Has value if demand turns out to be higher than expected. NCUMBA Financial Management Ch.8

Financial Management Ch.8 The Option to Abandon Managers also have the option to abandon existing projects. Abandonment can often save companies a great of money.Thus, the option to abandon increases the value of any potential project. NCUMBA Financial Management Ch.8

Financial Management Ch.8 Timing Options They have value if the underlying variables are changing with a favorable trend. NCUMBA Financial Management Ch.8

Financial Management Ch.8 NCUMBA Financial Management Ch.8

Financial Management Ch.8 NCUMBA Financial Management Ch.8