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Walt Disney – “Rio Disney” ®
Magic Kingdom + epcot II Rio, Brazil 2010 DEMO Capital Budgeting Case 2015-CORP FINC Shanghai
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Key Assumptions This investment case is undertaken in 2010 and thus all the rates (Rf, spreads, Beta etc. are based on 2010 and earlier years!) If you are doing your iPhone Infinite Case you may assume the same! Cost of constructing Magic Kingdom $ 3 billion; $ 2 billion to be spent right now and $ 1 billion to be spent one year from now Disney has already spent $ 0.5 billion on this project, researching the proposal and getting the necessary Brazilian licenses for the park; none of this money can be recovered if the park is not built (sunk cost) The cost of constructing Epcot II will be $ 1.5 billion with $ 1 billion to be spent at the end of the second year and $ 0.5 billion at the end of the third year
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Key Revenue Assumptions- (Marketing base case)
REVENUES IN M USD YEAR Magic Kingdom Epcot II Resort Properties TOTAL 1 $0 2 $1,000 $250 $1,250 3 $1,400 $350 $1,750 4 $1,700 $300 $500 $2,500 5 $2,000 $625 $3,125 6 $2,200 $550 $688 $3,438 7 $2,420 $605 $756 $3,781 8 $2,662 $666 $832 $4,160 9 $2,928 $732 $915 $4,575 10 $2,987 $747 $933 $4,667
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Key Expenses Based on Segment Analysis of Walt Disney’s 10K and 10Q reports the operating expenses are assumed to be 60% of Revenues at the parks and 75% of Revenues at the Resort Properties Disney HQ will allocate Corporate G&A costs to this project based on Revenues: G&A will be 15% of Revenues each year Cost analysis has pointed out that one third of these expenses are variable (a function of Revenues) and two thirds are fixed cost
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Depreciation and Capital Maintenance
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Other assumptions… Disney will have to maintain non-cash working capital (primarily inventory netted against accounts payable) of 5% of Revenues with the investments being made at the end of each year… The income from the investment will be taxed at Disney’s marginal tax rate of 38% (35% corporate income tax US + 3% state tax)
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Starting to get the Picture: Book Capital, Working Capital and Depreciation…
Year $ Mln. 1 2 3 4 5 6 7 8 9 10 Book Value Pre Project $500 $450 $400 $350 $300 $250 $200 $150 $100 $50 $0 Depreciation Pre Project Magic Kingdom Rio $2,000 $1,000 Epcot II Rio Capital Maintenance $188 $252 $276 $258 $285 $314 $330 $347 Depreciation Fixed Assets $375 $419 $394 $322 $317 $316 $318 Book Value New Fixed Assets $3,000 $3,813 $4,146 $4,028 $3,964 $3,932 $3,948 $3,979 $4,011 Book Value Working Capital $63 $88 $125 $156 $172 $189 $208 $229 $233 Total Capital invested in Project $2,500 $3,450 $4,276 $4,584 $4,453 $4,370 $4,304 $4,271 $4,256 $4,258 $4,244 12.5% of book value at the end of prior year ( $3000)
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Estimate Accounting Earnings on Rio Disney:
Year 1 2 3 4 5 6 7 8 9 10 Magic Kingdom Revenues $0 $1,000 $1,400 $1,700 $2,000 $2,200 $2,420 $2,662 $2,928 $2,987 Epcot Rio Revenues $300 $500 $550 $605 $666 $732 $747 Resorts&Properties Revenues $250 $350 $625 $688 $756 $832 $915 $933 TOTAL REVENUES $1,250 $1,750 $2,500 $3,125 $3,438 $3,781 $4,160 $4,575 $4,667 Magic Kingdom Direct Expenses $600 $840 $1,020 $1,200 $1,320 $1,452 $1,597 $1,757 $1,792 Epcot Rio Direct Expenses $180 $330 $363 $399 $439 $448 Resort&Properties Direct Expenses $188 $263 $375 $469 $516 $567 $624 $686 $700 TOTAL DIRECT EXPENSES $788 $1,103 $1,575 $1,969 $2,166 $2,382 $2,620 $2,882 $2,940 Depreciation $50 $425 $444 $372 $367 $364 $366 $368 Allocated G&A costs OPERATING INCOME -$50 -$151 -$85 $106 $315 $389 $468 $552 $641 $659 Taxes 38% -$19 -$57 -$32 $40 $120 $148 $178 $210 $244 Operating Income after Tax -$31 -$94 -$53 $66 $195 $241 $290 $342 $397 $409
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The Accounting View of Return:
YEAR After Tax Pre-Project Fixed Working TOTAL Average ROC Operating Income Investment Assets Capital CAPITAL Book Value average M USD of Capital $0 $500 $2,000 $2,500 NA 1 -$31 $450 $3,000 $3,450 $2,975 -1.04% -1.24% 2 -$93 $400 $3,813 $63 $4,276 $3,863 -2.41% -2.70% 3 -$52 $350 $4,145 $88 $4,583 $4,430 -1.17% -1.22% 4 $66 $300 $4,027 $125 $4,452 $4,518 1.46% 1.44% 5 $196 $250 $3,962 $156 $4,368 $4,410 4.44% 4.40% 6 $241 $200 $3,931 $172 $4,303 $4,336 5.56% 5.52% 7 $290 $150 $189 $4,270 $4,287 6.77% 6.74% 8 $341 $100 $3,946 $208 $4,254 $4,262 8.00% 7.99% 9 $397 $50 $3,978 $229 $4,257 $4,256 9.33% 10 $408 $4,010 $233 $4,243 $4,250 9.60% 9.58% AVERAGE 4.05% 3.99% ROC calculated over average capital in that year ROC calculated over Start Capital in that year
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How to judge this return? Compare with hurdle rate….
The computed return on Capital is about 4% ; to judge if this is sufficient we will need to compare this with a hurdle rate. But which hurdle rate is the right comparison? A) The risk free rate 3.5% (2010) B) The cost of equity of Disney (9%) C) The cost of equity of Disney Theme Parks (8.2%) D) The cost of capital of Disney as a company (7.5%) E) The cost of capital of Disney Theme Parks (6.6%) F) None of the above is right…..
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Should there be a risk premium for foreign projects?
Exchange rate in general should be diversifiable risk (and hence should not command a premium) if: The company has projects in a large number of countries (or) The investors in the company are globally diversified (For Disney this risk should not affect the cost of capital ; consequently one would not adjust the cost of capital for Disney investments in other mature markets like Germany, the UK and France) The same diversification argument we would use to justify no adjustment for the cost of capital because of political risk. However some aspects of political risk especially in emerging markets will be hard to diversify and may affect the cash flows by reducing the expected life of the project (For Disney we will incoprporate this risk in the cost of capital when it invests in Brazil or any other emerging market )
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Estimating a hurdle rate for Disney Rio…
If the country risk premium for Brazil is 2.5% (Moody’s based on bonds) And we scale this up to equity by taking the relative volatility of Brazilian equity (BOVESPA) to Brazilian Government bonds (STDEV(Bovespa)/STDEV(Gov Bond)= 34%/21.5% the additional risk premium for Brazil over the US is 34/21.5*2.5%=3.95% The cost of equity in the US is now: 3.5%+.78(beta)*(6% US spread+3.95% Brazil country risk)= 11.3% And the cost of capital US ($) : 65%* 11.3%+35%*3.7% (cost of debt after tax)=8.6%
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Would you conclude… Do not invest in this park (ROC 4% < cost of capital 8.6%) Or would you have second thoughts? We have calculated returns for 10 years but a theme park most likely will be operating longer and still have a value after it stops to operate? For existing investments in 2010 the data for Disney show: Company EBIT(1-t) BV Debt BV Equity Cash BV Capital ROC% Cost of Capital % ROC%- Cost of Capital% Disney $ 4395 M $ M $ M $ 3670 M $ M 9.91% 7.51% 2.4%
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Homework Assignment: Application test
Compute the after tax ROC% for your company in FY 2010 use: ROC (after Tax)= EBIT(1-tax rate)/( BV of Debt + BV of Equity – Cash)previous year For Disney this was: 9.91% (see last slide) Now Calculate the Return Spread= After Tax ROC% - Cost of Capital% (Google for the cost of capital of your company later in the course you will learn how to calculate it) For Disney this was: 2.4% (see last slide)
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Now the Cash Flow of Rio Disney…
Year M USD 1 2 3 4 5 6 7 8 9 10 Operating Income -$50 -$150 -$84 $106 $315 $389 $467 $551 $641 $658 Taxes -$19 -$57 -$32 $40 $120 $148 $178 $209 $244 $250 Operating Income after Tax -$31 -$93 -$52 $66 $195 $241 $289 $342 $397 $408 + Depreciation $50 $425 $469 $444 $372 $367 $364 $366 $368 - Capital Expenditures $2,500 $1,000 $1,188 $752 $276 $258 $285 $314 $330 $347 $350 - Change in Working Capital $0 $63 $25 $38 $31 $16 $17 $19 $21 $5 CASH FLOW FIRM -$2,500 -$981 -$919 -$360 $196 $278 $307 $322 $357 $395 $421 To get from income to cash flow we: Added back all non cash charges such as depreciation Subtracted out the capital expenditures Subtracted out the change in non cash working capital
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The Depreciation Tax Benefit (tax shield)
While depreciation reduces taxable income and taxes, it does not reduce the cash flows ! The benefit of depreciation is therefore the Tax benefit. In general this Tax benefit can be written as: Tax Benefit= Depreciation* Tax rate For Disney with a tax rate of 38% the depreciation tax savings are: Year M USD 1 2 3 4 5 6 7 8 9 10 depreciation 50 425 469 444 372 367 364 366 368 Depreciation*tax rate 19 162 178 169 141 139 138 140 Note: The tax benefits from depreciation and other non-cash charges is greater the higher your company’s tax rate Note: Non cash charges that are not tax deductible (amortization of goodwill) have no tax benefits and thus have no effect on cash flows
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Depreciation methods You learned in Accounting:
Straight Line depreciation (SL) Accelerated depreciation (DDB, SYD etc.) SL= (P-R)/n DDB = 2*SL% SYD= Sum of year digits Questions: Which method will result in a higher net income this year (now) Which method will result in a higher cash flow this year (now) Assume; EBITDA=100 P=100 R= 20 n= 5 year tax=40% calculate SL and DDB this year compare income and cash flow for each method
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Answer.. So we conclude: SL income> DDB income
SL depreciation= (P-R)/n= (100-20)/5=16 DDB depreciation=2*SL%=1/n*2=40% Year 1 depreciation under DDB 40 EBITDA=100 SL income= =84 DDB income= =60 SL cash flow= (100 – 16)*(1-40%tax)=50.4 =66.4 DDB cash flow= ( )*(1-40%)=36 36+40=76 So we conclude: SL income> DDB income DDB cash flow> SL cash flow
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The Capital Expenditure Effects
Capital Expenditure (CAPEX) do cause cash outlows CAPEX can be categorized into two groups: Growth CAPEX designed tp create new assets Maintenance CAPEX designed to keep existing assets The need for Maintenance CAPEX increases with the life of the project; 25 year projects need more maintenance CAPEX than 5 year projects Clearly the Disney Rio Project is a long term project that requires Maintenance CAPEX
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To CAPEX or NOT TO CAPEX ? ANSWER: (assume Income before this expense=100 tax=40%) Expense it: Income : 100 – 90 Depreciate it: Income: 100 – 30 Depreciation/Capitalizing expenses results in higher income! Cash Flow: (100-90)(1-40%)+depreciation(=0) Cash Flow: (100-30)(1-40%)+depreciation(30) Assume you run a software business and you have an expense of $90 M from the production and distribution of promotion CD’s in Magazines Your Accountant tells you you can expense it or depreciate it over 3 years. Which will have a more positive effect on this years income? Which will have a more positive effect on this year’s cash flow?
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Working Capital (WC) Effects
Money invested in inventory and Accounts Receivable can not be used elsewhere…thus is a drain on cash flow This drain is reduced to the degree suppliers credit is provided Investments in WC are Cash Out flows any reduction in WC is a Cash inflow At the end of the project life WC investments need to be salvaged WC requirements need to be estimated and brought into the Project cash flows
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Incremental cash flows of disney rio:
Year M USD tax rate=38% 1 2 3 4 5 6 7 8 9 10 Operating Income -$50 -$150 -$84 $106 $315 $389 $467 $551 $641 $658 Taxes -$19 -$57 -$32 $40 $120 $148 $178 $209 $244 $250 Operating Income after Tax -$31 -$93 -$52 $66 $196 $241 $290 $341 $397 $408 + Depreciation $50 $425 $469 $444 $372 $367 $364 $366 $368 - CAPEX $2,500 $1,000 $1,188 $752 $276 $258 $285 $314 $330 $347 $350 - Change in WC $0 $63 $25 $38 $31 $16 $17 $19 $21 $5 Cash Flow Firm -$2,500 -$981 -$918 -$360 $279 $307 $323 $357 $395 $422 + Pre project investment $500 - Pre project depreciation*tax rate + Fixed SG&A *(1-tax rate) $78 $109 $155 $194 $213 $234 $284 $289 Incremental Cash Flow -$2,000 -$1,000 -$859 -$270 $332 $454 $501 $538 $596 $660 $692 Note: $500M has been spent and the $50M in depreciation will thus exist anyway no matter the project will be done… The pre-project depreciation tax advantage is thus added back as a cash outflow ($19) Note: two thirds of the SG&A is fixed; this cost will still be there if the project will not be done and is thus not an incremental cash flow of this project (add back this amount *( 1-38%))
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Sunk costs Any cost/expenditure that has been incurred and can not be recovered (even if a project is rejected) is a Sunk Cost Examples; test market for a consumer product R&D expenses for a drug Behavioral research: Managers find it impossible to ignore Sunk Costs… CASE: A Consumer Product Company has spent $100M on test Marketing; the project (excluding the cost of test marketing) will generate $25M in value for the company…Should the company take the investment? Now assume that every investment that this company shares has the same characteristics (Sunk Cost>Added Value) The company is clearly not able to survive?
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Allocated Costs Firms allocate costs to individual projects from a central pool (SG&A-Corporate Overheads) based on the Characteristics of the project based on Sales Revenues or Earnings… For large companies this could be a significant cost and result in Rejection of the project The part of the cost that are not incremental should be added back to the project if the total allocated costs are already subtracted from income like in the Disney example (they would exist anyway) this would make the project for the firm look unnecessarily worse. Thus only the incremental (variable) component of allocated costs should show up in the project analysis!
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How to break out SG&A in fixed and variable costs ?
Assume you gathered the following data for your company: Question: what % of SG&A cost is variable? YEAR Sales $M SG&A $M 1 1,000 250 2 1,200 270 3 1,500 300 Answer: Variable cost vary with Sales, Fixed cost do not vary with sales and thus if Sales increase with $500M between year 1 and year 3 the SG&A increases with $50M i.e. every extra $ in sales triggers $0.10 in additional SG&A cost (10% of sales) So if the sales is $1,000 approximately $ 100M of the SG&A is Variable and thus the remainder $ 150M must be Fixed! The Total Cost function would be: TC= $150M + $0.10*Sales Revenues
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Time weighted cash flows
Incremental cash flows in early years are worth more than cash flows later Cash flows across time can not be added up ; they have to be brought back to the same point in time before aggregation You have learned in week 2 (Time Value of Money) that we need to take the Present Values of future cash flows REMINDER: (note: i>g) $C=cash flow in $; i=hurdle rate;g=growth rate; n= number of years Annuity: $C(1-(1/(1+i)n)/i Growing Annuity: $C(1+g)(1-((1+g)n/(1+i)n))/(i-g) Perpetuity: $C/i Growing Perpetuity: $C/(i-g)
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Measures of return NPV (Net Present Value)
Sum of present values of all cash flows on the project including the initial investment, with all cash flows being discounted at the appropriate hurdle rate (cost of capital) Decision Rule: If NPV>0 Accept the project IRR (Internal Rate of Return) The IRR is the discount rate that sets the NPV of the Project’s cash flows to zero. The IRR is calculated on the incremental cash flows of the project! Decision Rule: If IRR> Hurdle rate Accept the project
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Closure on cash flows Salvage Value finite project: Book Value Fixed Assets + Book Value WC (you will need to make projected Balance sheets) Salvage Value=Terminal Value (TV): In Disney Rio case: TV in year 10= Cash Flow year 11/(cost of capital –growth rate) Cash Flow year 10 is calculated as $692M Assuming a perpetual growth of 2% and a cost of capital of 8.6% TV= $692M(1+2%)/(8.6% - 2%)= $ 10,669M If Disney exits the project after 10 years the future cash flows after that indicate a remaining value of $ 10,669M! In a project with a finite life you need to compute a salvage value usually equal to the book value if fixed assets and WC at the end of the project’s life… In a project with an infinite life we compute cash flows for a reasonable period of time and then compute a Terminal Value (TV) which is the Present Value of all cash flows after the estimation period ends… This is in effect a Growing Perpetuity for a project like Disney Rio ….
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The project Disney rio including tv yields a NPV of:
Year Annual Cash Flow Terminal Value Present Value in M USD -$2,000 1 -$1,000 -$921 2 -$860 -$729 3 -$270 -$211 4 $332 $239 5 $453 $300 6 $502 $305 7 $538 $302 8 $596 $307 9 $660 $313 10 $692 $10,669 $4,970 NPV $2,877 Discounted at the Cost of Capital of Rio Disney of 8.6%
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This makes the argument that….
Project Disney Rio should be accepted: The positive NPV of $ 2,877 M suggests that this project will add value to the firm and earn a return in excess of the cost of capital By taking this project (under the assumptions) Disney will increase its value by $ 2,877 M
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IRR%= 16.2% M USD NPV hurdle rate 8% 9% 10% 11% 12% 13% 14% 15% 16%
18% 20% NPV M USD $3,220 $2,675 $2,183 $1,737 $1,332 $964 $631 $328 $52 -$427 -$825
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IRR%= 16.2% M USD NPV hurdle rate 8% 9% 10% 11% 12% 13% 14% 15% 16%
18% 20% NPV M USD $3,220 $2,675 $2,183 $1,737 $1,332 $964 $631 $328 $52 -$427 -$825
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The IRR% suggests: The project Disney Rio is a good project! This project provide a return of 16.2% and this is significant higher than the Cost of Capital (8.6%) IRR% and NPV will yield similar results most of the time… The analysis was done in USD; since this is a project in Brazil would the conclusion be different if we had done the analysis in Brazilian Reals?
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USD versus BRL and USD versus CNY (5 years)
USD lost 20% over the past 5 years against the BRL and against the CNY Imagine how this would effect your investment Projects ….?
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The consistency rule of cash flow
The Cash Flow on a project and the discount rate used should ne defined in the same terms So if the cash flow is in BRL then the discount rate also has to be in BRL If the Cash Flow is nominal (uncorrected for inflation) then the discount rate should also be nominal If consistency is maintained this way then the project conclusions should be the same no matter what currency is used… Case: Assume the inflation in Brazil is 7% and in the US 2% In 2010 when this analysis was done 2.04 BRL/USD (now already 1.73 BRL/USD)…. Assuming PPP the expected exchange rate going forward should be: Future Exchange rate in period t=(1+inflation Brazil)/(1+inflation US)* Exchange rate today Thus Exchange rate in 2011 was predicted to be: (1.07)/(1.02)* 2.04BRL= 2.14 BRL/USD we now know that was wrong… Similarly the cost of capital in BRL would be : (1+cost of capital US)*((1+inflation Brazil)/(1+inflation US))= (1.086)* (1.07/1.02)= 13.94% Nominator* (1.07/1.02) Denominator* (1.07/1.02) NPV in BRL=NPV in USD
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Disney RIO in BRL (NPV calculation)
Year Cash Flow in M USD USDBRL=X Cash Flow in M BRL Present Value at 13.94% discount rate (201)0 -$2,000 2.04 -4,080.00 -4080 M BRL 1 -$1,000 2.14 -2,140.00 2 -$860 2.24 -1,929.49 3 -$270 2.35 4 $333 2.47 821.40 487.32 5 $453 2.59 1,175.13 611.87 6 $502 2.72 1,363.47 623.06 7 $538 2.85 1,534.43 615.39 8 $596 2.99 1,781.90 627.19 9 $660 3.14 2,070.09 639.48 10 $11,361 3.29 37,400.50 TOTAL NPV (BRL)= BRL 5870/2.04 (today is 2010)= $ 2,877 M
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Uncertainty in Project analysis:
Based on both the NPV and IRR% the Disney Rio project seems to be a good project, however we have made many assumptions; which of the following may effect your assessment of the value? The revenues may be over-estimated by the Marketing department The actual costs of operating the park may be higher than estimated Tax rates may go up The exchange rate USD/BRL may turn unfavorably Interest rates may cause the cost of capital to rise Risk premiums and default spreads may increase Estimated Maintenance CAPEX proofs to be higher than estimated The FIFA 2014 Finals, and the Olympics will take visitors away Heavy Monsoon rains (December-March) cause flooding in Disney Rio All of the above… How would you respond to these uncertainties? Will you wait, walk away from the project, ignore uncertainties, or…?
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One solution: how quickly can you get your money back?
Year Cash Flow Cum Cash Flow PV Cash Flow Cum PV Cash Flow -$2,000 1 -$1,000 -$3,000 -$921 -$2,921 2 -$860 -$3,860 -$729 -$3,650 3 -$270 -$4,130 -$211 -$3,861 4 $332 -$3,798 $239 -$3,622 5 $453 -$3,345 $300 -$3,322 6 $502 -$2,843 $305 -$3,017 7 $538 -$2,305 $302 -$2,715 8 $596 -$1,709 $307 -$2,408 9 $660 -$1,049 $313 -$2,095 10 $692 -$357 $303 -$1,792 11 $706 $349 $284 -$1,508 12 $720 $1,069 $267 -$1,241 13 $735 $1,804 $251 -$990 14 $749 $2,553 $236 -$754 15 $764 $3,317 $221 -$533 16 $780 $4,097 $208 -$325 17 $795 $4,892 $195 -$130 18 $811 $5,703 $183 $53 10.5 YEAR 17.7 YEAR
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A more sophisticated approach: Sensitivity Analysis…
BASE CASE NPV IRR (Cost of Capital 8.6%) $ M % 2,877 16.2 How to Manage this risk: Main Risks/ Sensitivity: Assumed NPV MUSD Impact in M USD IRR% Impact in IRR% Number of visitors -10% 1,211 -1,666 11.9 -4.3 1) Marketing Promotion Ticket Price -20% 231 -2,646 9.5 -6.7 2) Price packages Operational Cost plus 5% 1876 -1,001 14.2 -2 Accident +1/5YR 1988 -889 15.1 -1.1 Monsoon 2314 -563 15.8 -0.4 BRL/USD -30% -1672 -4,549 5.2 -11 3) Hedging/Derivatives WACC plus 3% 1456 -1,421 12.8 -3.4 4) Local project financing Tax Rate US 933 -1,944 10.8 -5.4 5) Set up SPE's
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Caveats in sensitivity analysis…
Analyzing the effects of changing assumptions we often hold all other factors constant (The ceteris paribus condition); in the real world variables move together The objective of a sensitivity analysis is that we make better decisions not to churn out more tables and numbers Not every thing is worth varying; sometimes less is more… A picture is worth a thousand words and tables…
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