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Risk analysis:
Real options
2
CF
NPV =
(1 1+ r )1
Initial cost
Market
interest rates
Market
risk aversion
CF
+
(1 2+ r)2
CF
+ + N
(1 + r)N
Projects risk-adjusted
Projects risk-adjusted
cost of capital
cost of capital
(r)
(r)
Projects
debt/equity capacity
Projects
Projects
business
business risk
risk
Continued
4
Project Data
(Continued)
NWCt = 12%(Salest+1)
Treatment of Financing
Costs
NO.
Sunk Costs
Incremental Costs
Externalities
What is an assets
depreciable basis?
Basis = Cost
+ Shipping
+ Installation
$240,000
11
Annual Depreciation
Expense (000s)
Year
(Initial
Basis)
$240
=
Deprec.
$79.2
0.33
0.45
108.0
0.15
36.0
0.07
16.8
12
Year 1
Year 2
Year 3
Year 4
1,250
1,250
1,250
1,250
$200
$100
$250,00
0
$125,00
0
13
Inflation
(Continued)
15
Year 2
Sales
$250,000
$257,500
Costs
125,000
128,750
79,200
108,000
$ 45,800
$ 20,750
18,320
8,300
$ 27,480
$ 12,450
79,200
108,000
$106,680
$120,450
Deprec.
EBIT
Taxes (40%)
EBIT(1 T)
+ Deprec.
Net Op. CF
16
Year 4
Sales
$265,225
$273,188
Costs
132,613
136,588
36,000
16,800
$ 96,612
$119,800
38,645
47,920
$ 57,967
$ 71,880
36,000
16,800
$ 93,967
$ 88,680
Deprec.
EBIT
Taxes (40%)
EBIT(1 T)
+ Deprec.
Net Op. CF
17
Sales
Year
Year
Year
Year
Year
0
1 $250,000
2 257,500
3 265,225
4 273,188
CF Due to
NWC
Investment
(% of sales)
in NWC
$30,000
30,900
31,827
32,783
0
-$30,000
-900
-927
-956
32,783
18
$25
0
$25
10
$15
19
Cash flow
from sale
Sale
proceed
s
Taxe
s
paid
20
Year 0
Year 1
Year 2
0
0
$240,000
0 $106,680 $120,450
-$30,000
-$900
-$927
0
- $105,780 $119,523
23
$270,000
Year 3
Year 4
$93,967
$88,680
-$956
$32,783
$15,000
$93,011
$136,463
24
(270,000)105,780 119,523
93,011
136,463
10%
(270,000)105,780 119,523
3
93,011
4
136,463
102,312
144,623
140,793
(270,000)
MIRR = ?
524,191
26
Calculator Solution
MIRR = 18.0%.
27
(270)
106
120
93
136
(44)
49
185
Cumulative:
(270)
(164)
29
30
Stand-alone risk
Corporate risk
Market (or beta) risk
31
Stand-Alone Risk
Probability Density
Flatter distribution,
larger , larger
stand-alone risk.
E(NPV)
NPV
33
Corporate Risk
Project X is negatively
correlated to firms other assets,
so has big diversification
benefits
Profitability
If r = 1.0, no diversification
benefits. If r < 1.0, some
diversification benefits.
Project X
Total Firm
Rest of Firm
Years
35
Market Risk
What is sensitivity
analysis?
Sensitivity Analysis
Change From
Base level
-30%
-15%
0%
15%
30%
r
$113
$100
$88
$76
$65
Resulting NPV
(000s)
Unit Salvage
sales
$17
$85
$52
$86
$88
$88
$124
$90
$159
$91
40
Sensitivity Graph
NPV
($ 000s)
Unit Sales
Salvage
88
r
-30
(%)
-20
-10 Base 10
20
30
41
Results of Sensitivity
Analysis
42
44
45
0.25
$279
0.50
88
0.25
-49
E(NPV) = $101.6
(NPV) = 116.6
CV(NPV) = (NPV)/E(NPV) =
1.15
46
What is a simulation
analysis?
Simulation Example
Assumptions
Mean = 1,250
Mean = $200
50
Simulation Process
Price
NPV
1,252
$200
$88,808
199
30
$82,519
Maximum
1,927
294
$475,145
Minimum
454
Mean
Std deviation
Median
Prob NPV > 0
CV
685
94 -$166,208
$163
$84,551
86.9%
0.93
52
Histogram of Results
54
55
(More...)
56
59
New products
62
Abandonment options
Contraction
Temporary suspension
Flexibility options
63