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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,

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Presentation on theme: "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,"— Presentation transcript:

1 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

2 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 10- 2 McGraw-Hill/Irwin Topics Covered  Sensitivity Analysis –Break Even Analysis  Monte Carlo Simulation  Real Options and Decision Trees

3 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 10- 3 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.

4 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 10- 4 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.

5 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 10- 5 McGraw-Hill/Irwin Sensitivity Analysis Example - continued NPV= 3.43 billion Yen

6 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 10- 6 McGraw-Hill/Irwin Sensitivity Analysis Example - continued Possible Outcomes

7 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 10- 7 McGraw-Hill/Irwin Sensitivity Analysis Example - continued NPV Calculations for Optimistic Market Size Scenario NPV= +5.7 bil yen

8 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 10- 8 McGraw-Hill/Irwin Sensitivity Analysis Example - continued NPV Possibilities (Billions Yen)

9 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 10- 9 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 400 200 19.6 85 200 Break even NPV=0 PV Inflows PV Outflows

10 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 10- 10 McGraw-Hill/Irwin Electric Scooter – NPV

11 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 10- 11 McGraw-Hill/Irwin Electric Scooter - Assumptions

12 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 10- 12 McGraw-Hill/Irwin Electric Scooter - Scenarios

13 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 10- 13 McGraw-Hill/Irwin Electric Scooter – Accounting Profit

14 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 10- 14 McGraw-Hill/Irwin Electric Scooter – Cash Flows

15 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 10- 15 McGraw-Hill/Irwin Monte Carlo Simulation  Step 1: Modeling the Project  Step 2: Specifying Probabilities  Step 3: Simulate the Cash Flows Modeling Process

16 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 10- 16 McGraw-Hill/Irwin Monte Carlo Simulation

17 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 10- 17 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.

18 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 10- 18 McGraw-Hill/Irwin Decision Trees NPV=0 Don’t test Test (Invest $200,000) Success Failure Pursue project NPV=$2million Stop project NPV=0

19 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 10- 19 McGraw-Hill/Irwin Real Options 1.Option to expand 2.Option to abandon 3.Timing option 4.Flexible production facilities

20 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 10- 20 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= ? -150 0 or Turboprop Piston

21 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 10- 21 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= ? -150 0 or 812 456 660 364 148 Turboprop Piston

22 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 10- 22 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= ? -150 0 or 812 456 660 364 148 Turboprop Piston

23 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 10- 23 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= ? -150 0 or 812 456 660 364 148 +150(.6) +30(.4) +100(.6) +50(.4) *450 331 Turboprop Piston

24 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 10- 24 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= ? -150 0 or 812 456 660 364 148 +150(.6) +30(.4) +100(.6) +50(.4) NPV=444.55 NPV=888.18 NPV=550.00 NPV=184.55 *450 331 Turboprop Piston

25 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 10- 25 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) 812 456 660 364 148 +150(.6) 710.73 +30(.4) +100(.6) 403.82 +50(.4) -150 0 *450 331 or NPV=444.55 NPV=888.18 NPV=550.00 NPV=184.55 -550 NPV= ? -250 NPV= ? Turboprop Piston

26 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 10- 26 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) 812 456 660 364 148 +150(.6) 710.73 +30(.4) +100(.6) 403.82 +50(.4) -550 NPV=96.12 -250 NPV=117.00 -150 0 *450 331 or NPV=444.55 NPV=888.18 NPV=550.00 NPV=184.55 Turboprop Piston

27 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 10- 27 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) 812 456 660 364 148 +150(.6) 710.73 +30(.4) +100(.6) 403.82 +50(.4) -550 NPV=96.12 -250 NPV=117.00 -150 0 *450 331 or NPV=444.55 NPV=888.18 NPV=550.00 NPV=184.55 Turboprop Piston

28 Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 10- 28 McGraw-Hill/Irwin Web Resources www.jaxworks.com www.decisioneering.com www.kellogg.northwestern.edu/faculty/myerson Click to access web sites Internet connection required

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