Chapter 11 Principles PrinciplesofCorporateFinance Ninth Edition Project Analysis Slides by Matthew Will Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin

11- 2 Topics Covered  The Capital Investment Process  Sensitivity Analysis –Break Even Analysis  Monte Carlo Simulation  Real Options and Decision Trees

11- 3 Capital Investments  Items for consideration Capital Budget – A list of investment projects under consideration by a firm Do not add fudge factors to the cost of capital Post audits – A review of the project to see how closely it met forewcasts

11- 4 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.

11- 5 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.

11- 6 Sensitivity Analysis Example - continued NPV= 3.43 billion Yen

11- 7 Sensitivity Analysis Example - continued Possible Outcomes

11- 8 Sensitivity Analysis Example - continued NPV Calculations for Optimistic Market Size Scenario NPV= +5.7 bil yen

11- 9 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

Break Even Analysis  Accounting break even is different, yet wrong. It does not consider the time value of money.  Otobai Motors has an accounting breakeven point of 60,000 units sold. Sales, 000’s Accounting revenue and costs (Yen) Billions Break even Profit =0 Revenues Costs

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.

Decision Trees NPV=0 Don’t test Test (Invest $200,000) Success Failure Pursue project NPV=$2million Stop project NPV=0

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

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