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# Chap008

## by yuankwei on Nov 10, 2007

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## Chap008Presentation Transcript

• Risk Analysis, Real Options, and Capital Budgeting
• Chapter Outline
• 8.1 Sensitivity Analysis, Scenario Analysis, and Break-Even Analysis
• 8.2 Monte Carlo Simulation
• 8.3 Real Options
• 8.4 Decision Trees
• 8.1 Sensitivity, Scenario, and Break-Even
• Each allows us to look behind the NPV number to see how stable our estimates are.
• Sensitivity, Scenario, and Break-Even
• The projected cash flow often goes unmet in practice, and the firm ends up with a money loser.
• Sensitivity analysis examines how sensitive a particular NPV calculation is to changes in underlying assumptions .
• Revenues : Depends on three assumptions - market share , size of jet engine market , and price per engine.
• Costs: Total cost before taxes = Variable cost + Fixed cost
• Sensitivity Analysis and Scenario Analysis
• A table such as Table 8.3 can be used for a number of purposes :
• It can indicate whether NPV analysis should be trusted
• Sensitivity Analysis and Scenario Analysis
• The effect of incorrect estimates on revenues is so much greater than the effect of incorrect estimates on costs, more information on the factors determining revenues might be needed.
• Sensitivity Analysis and Scenario Analysis
• However, sensitivity analysis suffers from some drawbacks:
• It may unwittingly increase the false sense of security among managers; it treats each variable in isolation.
• Managers frequently perform scenario analysis to minimize this problem.
• Break-Even Analysis
• This approach determines the sales needed to break even .
• It is a useful complement to sensitivity analysis, because it also sheds light on the severity of incorrect forecasts .
• Break-Even Analysis
• Accounting Profit
• 　 (Fixed costs + Depreciation )* (1-T c ) 　 (Sales price-Variable costs)* (1-T c )
• 　 Contribution margin: It is the amount that 　 each additional engine contributes to pre-tax profit .
• Break-Even Analysis
• EAC = Initial Investment / 5-year annuity factor
• at 15%
• (Fixed costs + Depreciation )*(1-T c ) =
• Fixed costs *(1-T c ) + Depreciation )*( 1-T c ) =
• Fixed costs *(1-T c ) + 【 Depreciation - Depreciation*T c 】
• Fixed costs *(1-T c ) + 【 EAC - 　 Depreciation*T c 】
• Break-Even Analysis
• Present Value Break-Even Point:
• Fixed costs*(1-T c ) + 【 EAC -Depreciation*T c 】 (Sales price-Variable costs)*(1-T c )
• Break-Even Analysis
• The EAC of \$447.5 million is greater than the yearly depreciation of \$300 million , because we implicitly assume that the \$1,500 million investment could have been invested at 15%.
• Break-Even Analysis
• Depreciation understates the true costs of recovering the initial investment . Thus Companies that break even on an accounting basis are really losing money . They are losing the opportunity cost of the initial investment .
• 8.3 Real Options
• NPV analysis ignores the adjustments that a firm can make after a project is accepted. These adjustments are called real options . Thus, NPV underestimates the true value of a project.
• One of the fundamental insights of modern finance theory is that options have value .
• Because corporations make decisions in a dynamic environment , they have options that should be considered in project valuation .
• Options
• The Option to Expand
• Has value if demand turns out to be higher than expected.
• The Option to Abandon
• Managers also have the option to abandon existing projects. Abandonment can often save companies a great of money .Thus, the option to abandon increases the value of any potential project.
• Abandonment options are pervasive in the real world.
• Timing Options
• They have value if the underlying variables are changing with a favorable trend.
• Discounted CF and Options
• We can calculate the market value of a project as the sum of the NPV of the project without options and the value of the managerial options implicit in the project.
• M = NPV + Opt
A good example would be comparing the desirability of a specialized machine versus a more versatile machine. If they both cost about the same and last the same amount of time, the more versatile machine is more valuable because it comes with options.
• 8.4 Decision Trees
• Two decisions:
• Whether to develop and test the solar-powered jet engine.
• Whether to invest for full-scale production following the results of the test.
• A fundamental problem in NPV analysis is dealing with uncertain future outcomes.
• Warning : Perhaps a higher discount rate should have been used for the initial test-marketing decision.
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