McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
Things to Absorb, Read, Do
Need to Absorb - There are three important areas in this chapter; decision trees, sensitivity/ scenario analysis, and real options. Decision trees, are a form of weighted average, that represents a method of viewing sequential decisions. Sensitivity/ Scenario analysis examines how sensitive a project’s NPV is to changes in the underlying
assumptions. You should learn to spot and describe real options such as the option to expand, the option to abandon, and the timing (a.k.a., wait and learn) option.
Need to Read - Read the Chapter.
Need to Do - Remember your Capital Budgeting Methods and Cash Flows from BA 530 Download my handout on real options. Make 100 on the quiz. Answer end-of-chapter Questions and Problems 1-14, and 19-26..
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Project Analysis
Chapters 8 and 9 develop a framework for project
analysis.
This chapter analyzes the robustness of a project’s
value by asking some “What If” Questions.
If you cannot remember Capital Budgeting method and
cash flows, go back and look at your BA 530 notes.
Capital Budget
Capital Budget – A list of planned investment
projects.
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What-if Testing
Sensitivity Analysis -
Analysis of the effects on project profitability of changes in sales, costs, etc.
Scenario Analysis –
Analysis given a particularcombination of assumptions.
Simulation Analysis -
Estimation of the probabilities of different possible outcomes.
Break-Even Analysis -
Analysis of the level ofsales at which the company breaks even.
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Option: Valued as a: wait & learn more before
investing (timing)
call default during construction (staged investment)
a series of put options alter operating scale (expand,
restart, increase prices)
call alter operating scale (contract, shut down, decrease prices)
put
abandon put
switch inputs or outputs call + put grow and build-on previous
investments
call
Contact Information
Professor:
Charles Hodges
Webpage: D2L
Phone:
(678) 839-4816, (770)301-8648
Email:
D2L and [email protected]
Office:
Not Applicable
Office Hours:
Not Applicable
3-7 10-8
Capital Budgeting:
The Decision Process
1. Stage 1: The Capital Budget
2. Stage 2: Project Authorization
• Outlays required by law or company policy • Maintenance or cost reduction
• Capacity expansion in existing business • Investment for new products
10-9
Potential Capital Budgeting
Problems
Ensuring forecasts are consistent
Eliminating conflicts of interest
Reducing forecast bias
Proper selection criteria (NPV and others)
10-10
What-if Testing
Sensitivity Analysis -
Analysis of the effects on project profitability of changes in sales, costs, etc.
Scenario Analysis –
Analysis given a particularcombination of assumptions.
Simulation Analysis -
Estimation of the probabilities of different possible outcomes.
Break-Even Analysis -
Analysis of the level ofsales at which the company breaks even.
Sensitivity Analysis
Analysis of the effects on project profitability of
changes in sales, costs, etc.
Why is sensitivity analysis useful?
Sensitivity Analysis - Example
Base Case: Expected cash flows from a new project (with 8% Opportunity Cost of Capital; 40% average tax rate; variable costs are a constant 80% of sales; all numbers in $000s)
NPV = $1,382.47 IRR = 12.7% Payback Period = 6 years Profitability Index = .256 NPV = IRR = Payback Period = Profitability Index = Calculate:
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Sensitivity Analysis - Example
Possible Range of Variables
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Sensitivity Analysis: Changing Sales
(with 8% Opportunity Cost of Capital; 40% average tax rate; variable costs are aconstant 80% of sales; all numbers in $000s)
Pessimistic Case—Sales = $14,000 Optimistic Case—Sales = $18,000
NPV = -$426 NPV = $3,191
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Sensitivity Analysis: Changing Fixed Costs
(with 8% Opportunity Cost of Capital; 40% average tax rate; variable costs are a constant 80% of sales; all numbers in $000s)
Pessimistic Case—Fixed Costs = $2,500 Optimistic Case—Fixed Costs = $1,500
NPV = -$878 NPV = $3,643
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Limits to Sensitivity Analysis
•
Ambiguous
• How do you consistently define “optimistic” or “pessimistic”?
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Scenario Analysis
Scenario Analysis –
Project analysis given a particular combination of assumptions.Why is it useful?
Simulation Analysis –
Estimation of the probabilities of different possible outcomes, e.g., from an investment project.Why is it useful?
10-18
Scenario Analysis: Introducing Competition
Base Case – No Competition Scenario – Introduce Competition
NPV = $1,382 NPV = -$717
Assume that it will take two years for competition to enter the market. At this time, sales drop 10% and variable costs increase to 82% (increased labor demand). What happens to NPV under this scenario?
14,400
Contact Information
Professor:
Charles Hodges
Webpage: D2L
Phone:
(678) 839-4816, (770)301-8648
Email:
D2L and [email protected]
Office:
Not Applicable
Office Hours:
Not Applicable
Break-Even Analysis
Break-Even Analysis -
Analysis of the level of sales
at which the project breaks even.
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Break-Even Analysis – Example
(with 8% Opportunity Cost of Capital; 40% average tax rate; variablecosts are a constant 80% of sales; all numbers in $000s)
-Determine the number of units that must be sold in order to break even, on an NPV basis. -Suppose each unit has a price point of $45,000
-All other variables are at their base case levels
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Break-Even Point: Accounting
Break-Even Point (Accounting) - The break-even point is the number of units sold where net profits = $0.
What does the accounting break-even point not account for?
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Break-Even Point: Finance
NPV Break-Even Point (Finance):
How can we find the present value of future cash flows? As long as cash flows are equal each year, we can use the Annuity Factor (=Compute PV where FV=0, N=number of years, I=Interest rate, PMT=1)Solve for the annuity factor, FV=0, N=12, I=8, PMT=1, compute PV=PV Cash Flows = 7.536. Therefore PV (Cash Flows) = 7.536*(5.4*X-1020)
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Break-Even Analysis
Step 2, Recall: the break-even point is the number of units sold where NPV = $0, or where $5,400 in initial costs are recovered. Therefore 5,400 = 7.536*(5.4X-1020)
=>5400 = 40.694X – 7686.72 => 13086.72=40.694X => 321.59 Units
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Operating Leverage
Operating Leverage -
Degree to which costs are fixed.Degree of Operating Leverage (DOL) -
Percentage change in profits given a 1% change in sales.10-26
Operating Leverage:
Why is it useful?
Degree of Operating Leverage:
Example
Real Options
1. Option to expand
2. Option to abandon
3. Timing option
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Option: Valued as a: wait & learn more before
investing
call default during construction (staged investment)
a series of put options alter operating scale
(expand, restart)
call alter operating scale
(contract, shut down)
put
abandon put
switch inputs or outputs call + put grow and build-on previous
investments
call
Identifying Real Options
Type of option? Who is long? Who is short? UnderlyingAsset? Exercise Price?
The number of people applying for Social Security at age 62 instead of waiting until age 65 is up by 25%. A person getting Social Security at age 62 draws about 30% less money than if one waits until age 65. The government is obligated to pay Social Security to anyone who is over 62 and has worked for at least 10 years in their lifetime.
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Identifying Real Options
The Federal Deposit Insurance Corporation insures deposits, up to $250,000 in banks. In 2008, many banks failed. No depositor has lost any money and no depositor has had to wait more than one week to get their money from a failed bank. However without insurance, the average depositor would have lost about 40% of their money and would have waited about one year. Describe the depositor’s real option.
A famous football coach, Bobby Bowden, did not have his contract renewed by Florida State University and was forced into retirement. Instead of receiving a $2.5 million dollar salary, Bobby Bowden received an immediate severance payment of $1 million.
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Identifying Real Options
In Florida, there is a minimum mandatory prison sentence of 5 years for anyone using a gun in a robbery. Because of prison overcrowding, almost no one gets more than the minimum sentence. Danny, a Florida resident, was laid off from work after 30 years at age 59. Danny is now unemployed, hungry, has no insurance, and has lost his house to foreclosure. Danny finds a gun lying outside a convenience store.
Same scenario as part B, with one extra fact. Robbing a Bank with a gun is a Federal (United States) crime that almost always produces a three-year sentence. Robbing a store is a Florida state crime. Federal prisons are of higher quality and have nicer locations than Florida state prisons. Danny must decide between robbing a convenience store or a Bank.
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Real Options & the Value of
Flexibility
Decision Trees
– Diagram of sequential decisions and possible outcomes. Decision trees help companies determine their options by showing various choices and outcomes.
The option to avoid a loss or produce extra profit has value.
The ability to create an option has value that can be bought or sold.
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Decision Trees: Example
NPV=0 Don’t Test New
Product
Test New Product (Invest $200,000) Success Failure Pursue project NPV=$2million Stop project NPV=0
