Chapter 10 Principles of Corporate Finance Tenth Edition

Chapter 10 Principles of Corporate Finance Tenth Edition Project Analysis Slides by Matthew Will Mc. Graw-Hill/Irwin Copyright © 2011 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

Topics Covered Ø The Capital Investment Process Ø Sensitivity Analysis Ø Monte Carlo Simulation Ø Real Options and Decision Trees 10 -2

Capital Investments Ø Items for consideration Capital Budget – A list of investment projects under consideration by a firm Do not add fudge factors to the cost of capital Post audits – A review of the project to see how closely it met forewcasts 10 -3

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. 10 -4

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. 10 -5

Sensitivity Analysis Example - continued NPV= 3. 43 billion Yen 10 -6

Sensitivity Analysis Example - continued Possible Outcomes 10 -7

Sensitivity Analysis 10 -8 Example - continued NPV Calculations for Optimistic Market Size Scenario NPV= +5. 7 bil yen

Sensitivity Analysis Example - continued NPV Possibilities (Billions Yen) 10 -9

Electric Scooter – NPV 10 -10

Electric Scooter - Assumptions 10 -11

Electric Scooter - Scenarios 10 -12

Electric Scooter – Accounting Profit 10 -13

Electric Scooter – Cash Flows 10 -14

10 -15 Break Even Analysis Ø Point at which the NPV=0 is the break even point Ø Otobai Motors has a breakeven point of 85, 000 units sold. PV Inflows Break even 400 NPV=0 PV (Yen) Billions PV Outflows 200 19. 6 85 200 Sales, 000’s

10 -16 Break Even Analysis Ø Accounting break even is different, yet wrong. It does not consider the time value of money. Ø Otobai Motors has an accounting breakeven point of 60, 000 units sold. Revenues 60 Break even Accounting revenue and costs (Yen) 40 Profit =0 Costs 20 Billions 60 200 Sales, 000’s

Operating Leverage- The degree to which costs are fixed. Degree of Operating Leverage (DOL) - Percentage change in profits given a 1 percent change in sales. 10 -17

Operating Leverage Example – Use the data from the Otobai scooter project. What is the DOL? 10 -18

Monte Carlo Simulation Modeling Process Ø Step 1: Modeling the Project Ø Step 2: Specifying Probabilities Ø Step 3: Simulate the Cash Flows Ø Step 4: Calculate Present Value 10 -19

Monte Carlo Simulation 10 -20

Flexibility & Real Options Decision Trees - Diagram of sequential decisions and possible outcomes. Ø Decision trees help companies determine their Options by showing the various choices and outcomes. Ø The Option to avoid a loss or produce extra profit has value. Ø The ability to create an Option thus has value that can be bought or sold. 10 -21

Decision Trees 10 -22 Example - Fed. Ex Expansion Option Observe growth in demand for airfreight Acquire option on future delivery High Demand Exercise delivery option Low Demand Don’t take delivery

Real Options 1. 2. 3. 4. Option to expand Option to abandon Timing option Flexible production facilities 10 -23

10 -24 Decision Trees $700 (. 80) - $130. 25 $ 0 (. 20) $ 300 (. 80) - $18 Invest Yes / No . 44. 56 . 50 - $130 $ 0 (. 20) $0. 25 NPV= ? $ 100 (. 80) - $130 $ 0 (. 20)

10 -25 Decision Trees $700 (. 80) - $130. 25 560 $ 0 (. 20) $ 300 (. 80) - $18 Invest Yes / No . 44. 56 . 50 - $130 $ 0 (. 20) $0. 25 NPV= ? 240 $ 100 (. 80) - $130 80 $ 0 (. 20)

10 -26 Decision Trees $700 (. 80) - $130. 25 560 $ 0 (. 20) $ 300 (. 80) - $18 Invest Yes / No . 44. 56 . 50 - $130 $ 0 (. 20) $0. 25 NPV= ? 240 $ 100 (. 80) - $130 80 $ 0 (. 20)

10 -27 Decision Trees NPV = $295 $700 (. 80) - $130 . 25 560 $ 0 (. 20) $ 300 (. 80) - $18 Invest Yes / No . 44. 56 . 50 - $130 $ 0 (. 20) $0. 25 NPV= ? 240 $ 100 (. 80) - $130 80 $ 0 (. 20)

10 -28 Decision Trees NPV = $295 $700 (. 80) - $130 . 25 560 $ 0 (. 20) $ 300 (. 80) - $18 Invest Yes / No . 44. 56 . 50 - $130 NPV = $52 $ 0 (. 20) $0. 25 NPV= ? 240 $ 100 (. 80) - $130 NPV = - $69 (do not invest, so NPV = 0) 80 $ 0 (. 20)

10 -29 Decision Trees NPV = $295 $700 (. 80) - $130 . 25 - $18 Invest Yes / No NPV = $83. 44. 50. 56 $ 0 (. 20) $ 300 (. 80) - $130 NPV = $52 ? 240 $ 0 (. 20) $0. 25 NPV= 560 $ 100 (. 80) - $130 NPV = - $69 (do not invest, so NPV = 0) 80 $ 0 (. 20)

10 -30 Decision Trees NPV = $295 $700 (. 80) - $130 . 25 - $18 Invest Yes / No NPV = $83. 44. 50. 56 $ 0 (. 20) $ 300 (. 80) - $130 NPV = $52 240 $ 0 (. 20) $0. 25 NPV= $19 560 $ 100 (. 80) - $130 NPV = - $69 (do not invest, so NPV = 0) 80 $ 0 (. 20)

10 -31 Decision Trees NPV = $295 $700 (. 80) - $130 . 25 - $18 Invest Yes / No NPV = $83. 44. 50. 56 $ 0 (. 20) $ 300 (. 80) - $130 NPV = $52 240 $ 0 (. 20) $0. 25 NPV= $19 560 $ 100 (. 80) - $130 NPV = - $69 (do not invest, so NPV = 0) 80 $ 0 (. 20)

Web Resources Click to access web sites Internet connection required www. jaxworks. com www. decisioneering. com 10 -32