Chapter 10 Principles of Corporate Finance Eighth Edition A Project is Not A Black Box Slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Topics Covered  Sensitivity Analysis –Break Even Analysis  Monte Carlo Simulation  Real Options and Decision Trees

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin How To Handle Uncertainty Sensitivity Analysis - Analysis of the effects of changes in sales, costs, etc. on a project. Scenario Analysis - Project analysis given a particular combination of assumptions. Simulation Analysis - Estimation of the probabilities of different possible outcomes. Break Even Analysis - Analysis of the level of sales (or other variable) at which the company breaks even.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Sensitivity Analysis Example Given the expected cash flow forecasts for Otobai Company’s Motor Scooter project, listed on the next slide, determine the NPV of the project given changes in the cash flow components using a 10% cost of capital. Assume that all variables remain constant, except the one you are changing.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Sensitivity Analysis Example - continued NPV= 3.43 billion Yen

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Sensitivity Analysis Example - continued Possible Outcomes

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Sensitivity Analysis Example - continued NPV Calculations for Optimistic Market Size Scenario NPV= +5.7 bil yen

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Sensitivity Analysis Example - continued NPV Possibilities (Billions Yen)

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Break Even Analysis  Point at which the NPV=0 is the break even point  Otobai Motors has a breakeven point of 85,000 units sold. Sales, 000’s PV (Yen) Billions Break even NPV=0 PV Inflows PV Outflows

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Electric Scooter – NPV

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Electric Scooter - Assumptions

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Electric Scooter - Scenarios

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Electric Scooter – Accounting Profit

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Electric Scooter – Cash Flows

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Monte Carlo Simulation  Step 1: Modeling the Project  Step 2: Specifying Probabilities  Step 3: Simulate the Cash Flows Modeling Process

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Monte Carlo Simulation

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Flexibility & Real Options Decision Trees - Diagram of sequential decisions and possible outcomes.  Decision trees help companies determine their Options by showing the various choices and outcomes.  The Option to avoid a loss or produce extra profit has value.  The ability to create an Option thus has value that can be bought or sold.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Decision Trees NPV=0 Don’t test Test (Invest $200,000) Success Failure Pursue project NPV=$2million Stop project NPV=0

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Real Options 1.Option to expand 2.Option to abandon 3.Timing option 4.Flexible production facilities

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Decision Trees 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) +150(.6) +30(.4) +100(.6) +50(.4) -550 NPV= ? -250 NPV= ? or Turboprop Piston

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Decision Trees 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) +150(.6) +30(.4) +100(.6) +50(.4) -550 NPV= ? -250 NPV= ? or Turboprop Piston

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Decision Trees 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) +150(.6) +30(.4) +100(.6) +50(.4) -550 NPV= ? -250 NPV= ? or Turboprop Piston

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Decision Trees 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) -550 NPV= ? -250 NPV= ? or (.6) +30(.4) +100(.6) +50(.4) * Turboprop Piston

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Decision Trees 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) -550 NPV= ? -250 NPV= ? or (.6) +30(.4) +100(.6) +50(.4) NPV= NPV= NPV= NPV= * Turboprop Piston

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Decision Trees 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) (.6) (.4) +100(.6) (.4) * or NPV= NPV= NPV= NPV= NPV= ? -250 NPV= ? Turboprop Piston

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Decision Trees 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) (.6) (.4) +100(.6) (.4) -550 NPV= NPV= * or NPV= NPV= NPV= NPV= Turboprop Piston

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Decision Trees 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) (.6) (.4) +100(.6) (.4) -550 NPV= NPV= * or NPV= NPV= NPV= NPV= Turboprop Piston

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