ACF213214 Finance I Finance II Lecture 6 Learning

ACF-213/214 Finance I / Finance II Lecture 6

Learning Outcome Apply techniques for financial valuation and rules for capital investment

Topics Covered Sensitivity and Scenario Analysis Break-Even Analysis and Operating Leverage Monte Carlo Simulation Real Options and Decision Trees

Example: Otobai Sensitivity Analysis Sensitivity analysis: determining what may happen and the possible implications of these surprise events. Example: Considering a high-performance electric scooter for city use. Table 10. 1 is a cash-flow forecast. NPV is positive at 20% opportunity cost of capital.

Table 10. 1 Preliminary Cash-Flow Forecasts for Otobai’s Electric Scooter Project

Example: Otobai Sensitivity Analysis Continued Project requires initial investment of ¥ 15 billion in plant and machinery. After year 6, company expects sales to tail off as competition enters market. Cost of goods sold is forecast to be 50% of sales. Taxes at 40% rate computed after deducting straight-line depreciation.

Example: Otobai Sensitivity Analysis Concluded To undertake a sensitivity analysis, each variable is set at its most pessimistic or optimistic value, then NPV of the project recalculated See Table 10. 2

Table 10. 2 Sensitivity Analysis—Otobai

Figure 10. 1 Tornado Diagram for Electric Scooter Project

Limits to Sensitivity Analysis Expressing cash flows in terms of key project variables, then calculating the consequences of misestimation. Forces managers to identify determinants for success and areas where more information is needed. Results may be ambiguous. Underlying variables are likely to be interrelated.

Table 10. 3 How the NPV of the Electric Scooter Project Would Be Affected by Higher Oil Prices and Increased Inflation

Break-Even Analysis Asking how serious it would be if sales or costs are worse than forecasted Look at where NPV turns negative Table 10. 4 looks at break-even points for each variable Defines break-even point at which NPV is zero

Table 10. 4 Change in Estimated Value The percentage change in the estimated value of each variable that produces NPV of zero for the electric scooter project.

Table 10. 5 Cash Flows in Year A project’s accounting break-even point is the minimum level of sales required to avoid an accounting loss.

Operating Leverage Operating leverage: The degree to which costs are fixed Degree of operating leverage (DOL): Percentage change in profits given a 1% change in sales

Operating Leverage Example Use the data from year 2 of the Otobai scooter project. What is the DOL?

Monte Carlo Simulation Modeling Process Step 1: Modeling the project Step 2: Specifying probabilities Step 3: Simulate the cash flows Step 4: Calculate present value

Monte Carlo Simulation Continued

Real Options and Decision Trees 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

Figure 10. 2 UPS’s Expansion Option

Real Options and Decision Trees Continued 1. Option to expand 2. Option to abandon 3. Production options 4. Timing options

Figure 10. 3 Decision Tree for Wankel Outboard Motor Project

Figure 10. 4 Decision Tree for Pharmaceutical R&D

Pro and Con Decision Trees Decision trees can get complicated quickly Point is to allow explicit analysis of possible future events and decisions Should show links between today’s and tomorrow’s decisions