1. © 2008 Pearson Addison Wesley. All rights reserved Chapter Three Project Risk Analysis

2. © 2008 Pearson Addison Wesley. All rights reserved 1-2 Chapter Outline Uncertainty and Investment Analysis –The Investment Process with Risky Cash Flows Example: The Earthilizer Proposal Sensitivity Analysis - Learning More about the Project –Scenario Analysis –Breakeven Sensitivity Analysis –Simulation Analysis –Interpreting Simulation Results –Reflections on the Use of Simulation Decision Trees—Valuing Project Flexibility –Example—Decision Tree Analysis of the Abandonment Option

3. © 2008 Pearson Addison Wesley. All rights reserved 1-3 Introduction Investment decisions take place in a world of uncertain future outcomes, where there are more things that can happen than will happen, which makes investment analysis considerably more complex. Project Risk Analysis Confronts Uncertainty Various approaches are used to analyze risk and deal with uncertainty –Scenario analysis, breakeven sensitivity analysis, and Monte Carlo simulation Importance of Flexibility –The role investment flexibility can have on expected cash flows –The role that decision trees can play in organizing the analysis of decision

4. © 2008 Pearson Addison Wesley. All rights reserved 1-4 Evaluating new investment opportunities: 2 Phases Phase I Analyst tries to envision the possible outcomes from an investment Analyst prepares estimates and forecast –Analysis forms the basis for estimating an expected value for the investment along with NPV, IRR, and other measures of investment worth Phase II Analyst details underlying sources of risk. –Identify value drivers and uncertainty Analyst seeks ways to mitigate risks and monitors throughout the life of the project

5. © 2008 Pearson Addison Wesley. All rights reserved 1-5 Uncertainty and Investment Analysis Our focus is on project valuation Risk analysis tools apply to enterprise valuation - the evaluation of acquisitions of entire firms

6. © 2008 Pearson Addison Wesley. All rights reserved 1-6 The Earthilizer Example CSM, Inc., is considering an investment in Earthilizer, a new organic fertilizer made from dairy farm waste Developed by CSM’s ag-division over the past 3 years in response to: –growing demand from organic farmers –More restrictions on the disposal of cattle manure Initial investment of $580K (250K WC + $330K PPE) Project will be “up and running” by the end of 2007, with first year of sales in 2008 CSM financed from internally generated cash flows; project is all- equity-financed Very promising investment opportunity –Product has undergone extensive testing –Product is wholly organic, and is cheaper than traditional applications

7. © 2008 Pearson Addison Wesley. All rights reserved 1-7 Earthilizer PFCFs “The Assumptions” $580K initial investment at the end of 2007 –$250K WC and $330 PPE Sales $1million in 2008 –growing 10% annually throughout the 5-year planning period COGS margin 67.40% Operating expenses before depreciation are 10% of sales plus an annual fixed $115K Straight-line depreciation –PPE 10-year life –zero salvage value 30% tax rate 2008 - 2012 NWC requirements = 25% of Earthilizer’s sales CAPEX $330K in 2007 –zero in all future years Project end = 2012 –Terminal cash flow: $692,050 1 Cash flow calculations for 2008 to 2012 are based on: 1 Sum of NOPAT plus depreciation expense for 2012 ($128,020 + 33,000 = $161,020) plus the liquidating value (which is expected to equal the book value) of the firm’s investment in net working capital ($366,030) and the book value of plant and equipment at the end of 2012 ($165,000).

8. © 2008 Pearson Addison Wesley. All rights reserved 1-8 Earthilizer Income Statement Forecast

9. © 2008 Pearson Addison Wesley. All rights reserved 1-9 Earthilizer Balance Sheet Forecast

10. © 2008 Pearson Addison Wesley. All rights reserved 1-10 Earthilizer PFCF Forecast

11. © 2008 Pearson Addison Wesley. All rights reserved 1-11 Earthilizer DCF Valuation NPV and IRR Assessment Discounting the Cash Flows –Discount rate for the unlevered PFCFs is 13.25% –Present value of the expected project free cash flows to be $623,070 The Decision to Invest (or Not): Accept Project! –NPV $623,070 exceeds the $580,000 initial cost –IRR 15.36% exceeds the discount rate of 13,25% Since this is a risky project and things may not go exactly as planned, CSM needs to learn more about the project to get a better understanding of how confident we should be about the NPV estimate

12. © 2008 Pearson Addison Wesley. All rights reserved 1-12 Sensitivity Analysis - Learning More about the Project Phase I is complete: We have an NPV estimate of the Earthilizer investment –How confident can we be that the project will unfold as we expect? –What are the key value drivers of the project that the firm should monitor over the life of the investment to ensure its success? In Phase II we use a variety of tools to address these concerns –scenario analysis, breakeven sensitivity analysis, and simulation analysis

13. © 2008 Pearson Addison Wesley. All rights reserved 1-13 Scenario Analysis What would happen to the Earthilizer NPV if we applied a pessimistic estimate of the initial sales of $500,000? –DCF value drops to $342,790 –Negative-NPV investment, We could also analyze scenarios involving multiple sets of changes in assumptions and forecasts. –Evaluate the project using optimistic and pessimistic estimates for the value drivers Sensitivity of an investment’s value under different situations:

14. © 2008 Pearson Addison Wesley. All rights reserved 1-14 Breakeven Sensitivity Analysis Variable (1): 6 key variables crucial to NPV were identified in the Earthilizer example Expected Value (2): Expected values for each of the value drivers that we used in our analysis of the project’s expected NPV Critical Value (3): Critical or breakeven values for each of the value drivers that result in a zero NPV for the project % Change (4): Compares the expected and critical values for these variables; it calculates the “% Change” in each variable from its expected value required to produce a zero NPV What is the critical value of a particular value driver that pushes NPV to zero?” 1 To perform this analysis we recommend use of the Goal Seek function in Excel or Backsolver in Lotus 1-2-3.

15. © 2008 Pearson Addison Wesley. All rights reserved 1-15 Breakeven Sensitivity Analysis This analysis suggests that three variables are particularly critical to the outcome of the Earthilizer investment Very slight deviations from their expected value have a significant impact on project NPV: –gross profit margin (% ∆ for breakeven = -4.54%) –operating expenses as % of sales (% ∆ for breakeven = +14.80%) –base-year sales for 2008 (% ∆ for breakeven = - 7.68%). What is the critical value of a particular value driver that pushes NPV to zero?”

16. © 2008 Pearson Addison Wesley. All rights reserved 1-16 Breakeven Sensitivity Analysis NPV breakeven analysis shows the critical importance of gross profit margin to Earthilizer

17. © 2008 Pearson Addison Wesley. All rights reserved 1-17 Limitations to Breakeven Sensitivity Analysis Considers only one value driver at a time, while holding all others equal to their expected values. –This can produce misleading results if two or more of the critical value drivers are correlated with one another. We don’t have any idea about the probabilities associated with exceeding or dropping below the breakeven value drivers. No formal way of incorporating consideration for interrelationships among the variables.

18. © 2008 Pearson Addison Wesley. All rights reserved 1-18 Simulation Analysis Monte Carlo simulation can help the analyst evaluate what can happen to an investment’s future cash flows and summarize the possibilities in a probability 1 –Outcomes from large projects are often the result of the interaction of a number of interrelated factors (or value drivers) –Makes it difficult to determine the probability distribution of a project’s cash flows 1 The term “Monte Carlo” as a form of simulation comes from the famous gambling casinos in Monaco. Gambling, in its pure form, is of course based on the rules of chance or probability, as is simulation.

19. © 2008 Pearson Addison Wesley. All rights reserved 1-19 Simulation Analysis Two principal tools for adding simulation capabilities to your spreadsheet program: –@Risk from the Palisade Corporation –Crystal Ball Professional Edition from Decisioneering, Inc. http://www.palisade.com/ http://www.crystalball.com/

20. © 2008 Pearson Addison Wesley. All rights reserved 1-20 Interpreting Simulation Results The simulation uses 10,000 iterations to produce estimates of PFCFs distributions for 2008–2012

21. © 2008 Pearson Addison Wesley. All rights reserved 1-21 Reflections on the Use of Simulation Simulation models require deep consideration about the underlying sources of uncertainty that affect an investment’s profits –Requires explicit assumptions –Benefits arise from the process and from the actual output of the simulation

22. © 2008 Pearson Addison Wesley. All rights reserved 1-22 Decision Trees—Valuing Project Flexibility Most investment projects offer the firm some flexibility on the inputs used and final product produced –Generate greater cash flows when market demand is high; cut back on capacity when market demand is low Options associated with investments

23. © 2008 Pearson Addison Wesley. All rights reserved 1-23 Decision Trees—Valuing Project Flexibility Decision trees are useful tools that illustrate the degree of flexibility in a project’s implementation, and how future decisions can affect values. They contains a number of nodes identified by vertical lines, circles, and boxes. –The vertical lines denote a terminal node that signals the end of the decision process. –The circles signify an event node that represents a point where nature intervenes and something happens that is subject to chance.

24. © 2008 Pearson Addison Wesley. All rights reserved 1-24 Decision Trees—Valuing Project Flexibility

25. © 2008 Pearson Addison Wesley. All rights reserved 1-25 Example—Decision Tree Analysis of the Abandonment Option Modification of Earthilizer example: Assume CSM faces an EPA test of the runoff effects of Earthilizer on groundwater. –Scenario 1: At end of year 1: EPA determines that the project poses no hazard; grants approval, no effect on project expected cash flows –Scenario 2: EPA rules product detrimental; processing costs to CSM of $80K per year (after taxes) –CSM’s management “guesstimates” 20% chance for scenario 2 Expected PFCFs are equal to a weighted average of the original cash flows and the revised cash flows –Revised PFCF 2008 =.8 x $87,600 + (1 -.8)($87,600 - 80,000) = $71,600

26. © 2008 Pearson Addison Wesley. All rights reserved 1-26 Example—Decision Tree Analysis of the Abandonment Option The risk of having to incur $80,000 in added costs results in negative project NPV

27. © 2008 Pearson Addison Wesley. All rights reserved 1-27 Example—Decision Tree Analysis of the Abandonment Option If the EPA ruling is favorable, CSM will want to operate the project. –This alternative is highlighted and the inferior alternative (abandoning) is struck out. If the EPA ruling is unfavorable, the expected NPV of continuing operations is ($236,608). –The NPV of abandoning the project is only ($167,108).

28. © 2008 Pearson Addison Wesley. All rights reserved 1-28 Example—Decision Tree Analysis of the Abandonment Option

29. © 2008 Pearson Addison Wesley. All rights reserved 1-29 Example—Decision Tree Analysis of the Abandonment Option

30. © 2008 Pearson Addison Wesley. All rights reserved 1-30 Summary of the Risk Analysis Process Determining the value of an investment opportunity is straightforward when future cash flows are known Uncertainty complicates the valuation process Analysts can utilize three basic tools to assess the impact of uncertainty on a project –Scenario analysis, breakeven sensitivity analysis, and simulation analysis –All three tools provide information that the analyst can use to understand the key factors that drive a project’s success or failure Project flexibility allows firms to modify investments in response to changing circumstances –More on real options later!

31. © 2008 Pearson Addison Wesley. All rights reserved 1-31 Additional Equations and Art

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33. © 2008 Pearson Addison Wesley. All rights reserved 1-33 Exhibit P3-9.1Analysis of the ConocoPhillips Gas Purchase Project (cont.)

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37. © 2008 Pearson Addison Wesley. All rights reserved 1-37 Figure 3-3 Simulation Analysis of the Earthilizer Investment (cont.)

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