CORPORATE FINANCE III ESCP-EAP - European Executive MBA 24 Nov a.m. London Project Appraisal-Dealing with uncertainty I. Ertürk Senior Fellow in Banking

INNOVATION LTD Project Appraisal

Identifying Relevant Cash flows  Use cash flows only not accounting figures  Depreciation is not a cash flow but capital expenditure is  Construct “Project Appraisal Table”  Use incremental cash flows only  Separate investment and financing decisions  Include all incidental effects.  Do not forget working capital requirements.  Forget sunk costs.  Include opportunity costs.  Beware of allocated overhead costs  Use after-tax cash flows only

(DISCOUNTED) PAYBACK INTERNAL RATE OF RETURN PROFITABILITY INDEX ALTERNATIVES TO THE NPV RULE

IF FIRM USES 1 YEAR CUTOFF PERIOD, ACCEPT PROJECT A IF FIRM USES 2 YEAR CUTOFF PERIOD, ACCEPT PROJECTS A & B REGARDLESS OF CUTOFF PERIOD, PAYBACK RULE MAY GIVE DIFFERENT ANSWER THAN NPV PAYBACK GIVES EQUAL WEIGHT TO ALL CASH FLOWS BEFORE PAYBACK DATE AND NO WEIGHT TO LATER CASH FLOWS NO DISCOUNTING - IGNORES TIME VALUE OF MONEY NO GOOD RATIONALE FOR CUTOFF PAY BACK RULE

CASH FLOWS (€000) NPV Year: Payback At 10% B C D PAY BACK RULE

CALCULATE LENGTH OF TIME UNTIL THE SUM OF THE DISCOUNTED CASH FLOWS IS EQUAL TO THE INITIAL INVESTMENT ACCEPT PROJECT IF IT IS LESS THAN SOME CUTOFF VALUE DISCOUNTED-PAYBACK RULE ASKS HOW LONG WILL IT BE UNTIL THE PROJECT HAS A POSITIVE NPV NO LONGER GIVES EQUAL WEIGHT TO ALL CASH FLOWS BEFORE PAYBACK DATE BUT STILL IGNORES CASH FLOWS AFTER CUTOFF DATE CANNOT BE USED FOR RANKING PROJECTS DISCOUNTED PAY BACK RULE

INITIAL INVESTMENT PROFITABILITY INDEX = NET PRESENT VALUE PROJECT INVESTMENT NPV PROFITABILITY INDEX A B C  RANK PROJECTS IN TERMS OF DECLINING PI  CONTINUE MAKING INVESTMENTS UNTIL CAPITAL EXHAUSTED  ACCEPT PROJECTS B AND C CAPITAL RATIONING

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.

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.

Sensitivity Analysis Example - continued NPV= 3.43 billion Yen

Sensitivity Analysis Example - continued Possible Outcomes

Sensitivity Analysis Example - continued NPV Calculations for Optimistic Market Size Scenario NPV= +5.7 bil yen

Sensitivity Analysis Example - continued NPV Possibilities (Billions Yen)

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

Electric Scooter – NPV

Electric Scooter - Assumptions

Electric Scooter - Scenarios

Electric Scooter – Accounting Profit

Electric Scooter – Cash Flows

Monte Carlo Simulation Step 1: Modeling the Project Step 2: Specifying Probabilities Step 3: Simulate the Cash Flows Modeling Process

Monte Carlo Simulation

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.

Real Options 1. Option to expand 2. Option to abandon 3. Timing option 4. Flexible production facilities

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

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

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

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

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

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

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

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

Decision Trees NPV of piston-engine plane when option to expand is ignored:

Decision Trees =+52, or €52,000 The value of the option to expand is, therefore: =+65, or €65,000

Decision Trees NPV of piston-engine plane when option to expand is ignored: =+52, or €52,000 The value of the option to expand is, therefore: =+65, or €65,000