Chapter 2 Risk Analysis, Real Options, and Capital Budgeting

Key Concepts and Skills

Understand forecasting risk and sources of value Understand and be able to conduct scenario and sensitivity analysis Understand the various forms of break-even analysis Understand decision tree

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Chapter Outline
Evaluating NPV Estimates Scenario and Other What-If Analyses Break-Even Analysis Operating Cash Flow, Sales Volume, and Break-Even Decision tree

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Evaluating NPV Estimates

NPV estimates are just that estimates A positive NPV is a good start now we need to take a closer look
Forecasting risk how sensitive is our NPV to changes in the cash flow estimates; the more sensitive, the greater the forecasting risk Sources of value why does this project create value?

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Scenario Analysis
What happens to the NPV under different cash flow scenarios? At the very least, look at:
Best case high revenues, low costs Worst case low revenues, high costs Measure of the range of possible outcomes

Best case and worst case are not necessarily probable, but they can still be possible

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New Project Example

Consider the project discussed in the text The initial cost is $200,000, and the project has a 5year life. There is no salvage. Depreciation is straightline, the required return is 12%, and the tax rate is 34%. The base case NPV is 15,567

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Summary of Scenario Analysis

Scenario Net Income Cash Flow NPV IRR

Base case

19,800

59,800

15,567

15.1%

Worst Case

-15,510

24,490

-111,719

-14.4%

Best Case

59,730

99,730

159,504

40.9%

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Sensitivity Analysis
What happens to NPV when we change one variable at a time This is a subset of scenario analysis where we are looking at the effect of specific variables on NPV The greater the volatility in NPV in relation to a specific variable, the larger the forecasting risk associated with that variable, and the more attention we want to pay to its estimation

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Summary of Sensitivity Analysis for New Project

Scenario Unit Sales Cash Flow NPV IRR

Base case

6,000

59,800

15,567

15.1%

Worst case

5,500

53,200

-8,226

10.3%

Best case

6,500

66,400

39,357

19.7%

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Simulation Analysis
Simulation is really just an expanded sensitivity and scenario analysis Monte Carlo simulation can estimate thousands of possible outcomes based on conditional probability distributions and constraints for each of the variables The output is a probability distribution for NPV with an estimate of the probability of obtaining a positive net present value The simulation only works as well as the information that is entered, and very bad decisions can be made if care is not taken to analyze the interaction between variables

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Making a Decision
Beware Paralysis of Analysis At some point you have to make a decision If the majority of your scenarios have positive NPVs, then you can feel reasonably comfortable about accepting the project If you have a crucial variable that leads to a negative NPV with a small change in the estimates, then you may want to forego the project

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Break-Even Analysis
Common tool for analyzing the relationship between sales volume and profitability There are three common break-even measures
Accounting break-even sales volume at which NI = 0 Cash break-even sales volume at which OCF = 0 Financial break-even sales volume at which NPV = 0

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Example: Costs
There are two types of costs that are important in breakeven analysis: variable and fixed
Total variable costs = quantity * cost per unit Fixed costs are constant, regardless of output, over some time period Total costs = fixed + variable = FC + vQ

Example:
Your firm pays $3,000 per month in fixed costs. You also pay $15 per unit to produce your product. What is your total cost if you produce 1,000 units? What if you produce 5,000 units?

Produce 1000 units: TC = 3000 + 15*1000 = 18,000 Produce 5000 units: TC = 3000 + 15*5000 = 78,000
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Average vs. Marginal Cost

Average Cost
TC / # of units Will decrease as # of units increases

Marginal Cost
The cost to produce one more unit Same as variable cost per unit

Example: What is the average cost and marginal cost under each situation in the previous example
Produce 1,000 units: Average = 18,000 / 1000 = $18 Produce 5,000 units: Average = 78,000 / 5000 = $15.60

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Accounting Break-Even
The quantity that leads to a zero net income NI = (Sales VC FC D)(1 T) = 0 QP vQ FC D = 0 Q(P v) = FC + D Q = (FC + D) / (P v)

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Using Accounting Break-Even

Accounting break-even is often used as an early stage screening number If a project cannot break-even on an accounting basis, then it is not going to be a worthwhile project Accounting break-even gives managers an indication of how a project will impact accounting profit
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Accounting Break-Even and Cash Flow

We are more interested in cash flow than we are in accounting numbers As long as a firm has non-cash deductions, there will be a positive cash flow If a firm just breaks even on an accounting basis, cash flow = depreciation If a firm just breaks even on an accounting basis, NPV will generally be < 0

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Example
Consider the following project
A new product requires an initial investment of $5 million and will be depreciated to an expected salvage of zero over 5 years The price of the new product is expected to be $25,000, and the variable cost per unit is $15,000 The fixed cost is $1 million What is the accounting break-even point each year? Depreciation = 5,000,000 / 5 = 1,000,000 Q = (1,000,000 + 1,000,000)/(25,000 15,000) = 200 units

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Sales Volume and Operating Cash Flow

What is the operating cash flow at the accounting breakeven point (ignoring taxes)?
OCF = (S VC FC - D) + D OCF = (200*25,000 200*15,000 1,000,000 -1,000,000) + 1,000,000 = 1,000,000

What is the cash break-even quantity?

OCF = [(P-v)Q FC D] + D = (P-v)Q FC Q = (OCF + FC) / (P v) Q = (0 + 1,000,000) / (25,000 15,000) = 100 units (Cash break-even occurs where operating cash flow = 0).

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Three Types of Break-Even Analysis

Accounting Break-even Where NI = 0 Q = (FC + D)/(P v) Cash Break-even Where OCF = 0 Q = (FC + OCF)/(P v) (ignoring taxes) Financial Break-even Where NPV = 0 Cash BE < Accounting BE < Financial BE With taxes included. The equations change as follows: OCF = [(P v)Q FC D](1 T) + D Use a tax rate = 40% and rework the Wettways example from the book:Need 1170 in OCF to break-even on a financial basis OCF = [(40 20)(Q) 500 700](1 - .4) + 700 = 1170; Q = 99.2 You end up with a new quantity of 100 units. The firm must sell an additional 16 units to offset the effects of taxes.
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Example: Break-Even Analysis

Consider the previous example
Assume a required return of 18% Accounting break-even = 200 Cash break-even = 100 What is the financial break-even point?
Similar process to that of finding the bid price What OCF (or payment) makes NPV = 0?
N = 5; PV = 5,000,000; I/Y = 18; CPT PMT = 1,598,889 = OCF

Q = (1,000,000 + 1,598,889) / (25,000 15,000) = 260 units

The question now becomes: Can we sell at least 260 units per year?
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Real Options
One of the fundamental insights of modern finance theory is that options have value. The phrase We are out of options is surely a sign of trouble. Because corporations make decisions in a dynamic environment, they have options that should be considered in project valuation.

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Real Options (cont)

The Option to Expand
Has value if demand turns out to be higher than expected

The Option to Abandon

Has value if demand turns out to be lower than expected

The Option to Delay

Has value if the underlying variables are changing with a favorable trend
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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.

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The Option to Abandon: Example

Suppose we are drilling an oil well. The drilling rig costs $300 today, and in one year the well is either a success or a failure. The outcomes are equally likely. The discount rate is 10%. The PV of the successful payoff at time one is $575. The PV of the unsuccessful payoff at time one is $0.

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The Option to Abandon: Example

Traditional NPV analysis would indicate rejection of the project.
Expected = Payoff Prob. Successful Success Payoff + Prob. Failure Failure Payoff

Expected = (0.50$575) + (0.50$0) = $287.50 Payoff

$287.50 1.10

NPV =

$300 +

= $38.64

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The Option to Abandon: Example

However, traditional NPV analysis overlooks the option to abandon.
Success: PV = $575 Sit on rig; stare at empty hole: PV = $0. Failure

Drill

Do not drill

NPV $0

Sell the rig; salvage value = $250

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The firm has two decisions to make: drill or not, abandon or stay.

The Option to Abandon: Example

When we include the value of the option to abandon, the drilling project should proceed:
Prob. Successful Success Payoff

Expected = Payoff

Prob. Failure Failure Payoff

Expected = (0.50$575) + (0.50$250) = $412.50 Payoff

NPV = $300 +

$412.50 1.10

= $75.00
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Valuing the Option to Abandon

Recall that 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 $75.00 = $38.64 + Opt $75.00 + $38.64 = Opt Opt = $113.64
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The Option to Delay: Example

Year 0 1 2 3 4 Cost $ 20,000 $ 18,000 $ 17,100 $ 16,929 $ 16,760 PV $ 25,000 $ 25,000 $ 25,000 $ 25,000 $ 25,000 NPV t $ 5,000 $ 7,000 $ 7,900 $ 8,071 $ 8,240 NPV 0 $ 5,000 $7,900 $ 6 , 529 $ 6,364 (1.10) 2 $ 6,529 $ 6,064 $ 5,628

Consider the above project, which can be undertaken in any of the next 4 years. The discount rate is 10 percent. The present value of the benefits at the time the project is launched remains constant at $25,000, but since costs are declining, the NPV at the time of launch steadily rises. The best time to launch the project is in year 2this schedule yields the highest NPV when judged today.
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Decision Trees
Allow us to graphically represent the alternatives available to us in each period and the likely consequences of our actions This graphical representation helps to identify the best course of action.

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Example of a Decision Tree

Squares represent decisions to be made.
A Circles represent receipt of information, e.g., a test score.

Study finance

C The lines leading away from the squares represent the alternatives.

Do not study

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Decision Tree for Stewart

The firm has two decisions to make: To test or not to test. Success Do not invest Invest NPV = $3.4 b

To invest or not to invest.

Test

NPV = $0

Failure Do not test

NPV $0

Invest
NPV = $91.46 m

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Decision Tree for Stewart

If you dont invest, the NPV = 0, even if you test first, because the cost of testing becomes a sunk cost. If you are so unwise as to invest in the face of a failed test, you incur lots of additional costs, but not much in the way of revenue, so you have a negative NPV as of date 1. Referring back to previous slide (Decision to Test) may help to clarify the application of decision trees.

Comprehensive Problem
A project requires an initial investment of $1,000,000 and is depreciated straight-line to zero salvage over its 10-year life. The project produces items that sell for $1,000 each, with variable costs of $700 per unit. Fixed costs are $350,000 per year. What is the accounting break-even quantity, operating cash flow at accounting break-even at that output level?

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Quick Quiz
What are sensitivity analysis, scenario analysis, break-even analysis, and simulation? Why are these analyses important, and how should they be used? How do real options affect the value of capital projects? What information does a decision tree provide?

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