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Slide Contents
Learning Objectives
Principles Used in This Chapter
1.The Importance of Risk Analysis
2.Tools for Analyzing the Risk of Project Cash Flows
3.Break-Even Analysis
4.Real Options in Capital Budgeting
Key Terms
13-2
Learning Objectives
1. Explain the importance of risk analysis in the
capital budgeting decision-making process.
2. Understand the use of sensitivity and scenario
analysis as well as simulation analysis to
investigate the determinants of project cash
flows.
3. Use break-even analysis to evaluate project risk.
4. Explain the types of real options.
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13.1 The
Importance of
Risk Analysis
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Checkpoint 13.1
Forecasting Revenues Using Expected Values
Marshall Homes is a Texas homebuilder that specializes in the
construction of high-end homes costing $1.5 million to $10 million
each. To estimate its revenues for 2011 following the economic
downturn of 200709, it divided its home sales into three categories
based on selling price (high, medium, and low) and estimated the
number of units it expects to sell under three different economic
scenarios for 2011. These scenarios include a deep recession
(Scenario I), a continuation of current conditions in which the
economy is in a mild recession (Scenario II), and finally a turnaround
in the economy and return to the economic conditions of 20042006
(Scenario III). What are Marshalls expected revenues for 2011?
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Checkpoint 13.1
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Checkpoint 13.1
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Checkpoint 13.1
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Mild Recession
Turn-Around
Probability
40%
50%
10%
$0
$40,000,000
$80,000,000
Medium Priced
Home:
Total Revenues
$20,000,000
$60,000,000
$120,000,000
Low-Priced Home:
Total Revenues
$20,000,000
$40,000,000
$120,000,000
$40,000,000
$140,000,000
$320,000,000
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Step 3: Solve
Deep
Recession
Mild
Recession
40%
50%
Step 1
Probability
Step 2
Total Revenues
for each
Scenario
$40,000,000
Step 3
Probability
Total Revenue
$16,000,000
Turn-around
10%
$140,000,000 $320,000,000
$70,000,000
$32,000,000
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Step 4: Analyze
The table in step 3 shows that there can
be wide variation in revenue based on the
future economic scenario. The table only
shows the revenues. To get a more
realistic picture, we should also consider
the impact on expenses and consequently,
profits and cash flows.
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Value Drivers
Value drivers are the basic determinants
of an investments cash flows and
consequently its performance.
Value drivers may consist of determinants
of project revenues (e.g., market share,
market size, and price) and costs (e.g.,
variable and cash fixed costs)
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Sensitivity Analysis
Sensitivity analysis occurs when a
financial manager evaluates the effect of
each value driver on the investments NPV.
It helps identify the variable that has the
most impact on NPV.
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Checkpoint 13.2
Project Risk Analysis: Sensitivity Analysis
Crainium, Inc. is considering an investment in a new plasma cutting tool to be
used in cutting out steel silhouettes that will be sold through the firms catalog
sales operations. The silhouettes can be cut into any two-dimensional shape such
as a state, university mascot or logo, etc. The products are expected to sell for
an average price of $25 per unit, and the company analysts expect the firm can
sell 200,000 units per year at this price for a period of five years. Launching this
service will require the purchase of a $1.5 million plasma cutter and materials
handling system that has a residual or salvage value in five years of $250,000.
In addition, the firm expects to have to invest an additional $500,000 in working
capital to support the new business. Other pertinent information concerning the
business venture is provided below:
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Checkpoint 13.2
Crainiums analysts have estimated the projects expected or base-case cash
flows as well as the NPV and IRR to be the following:
Although the project is expected to have a $209,934 NPV and a 15.59% IRR
(which exceeds the projects 10% discount rate), it is risky, so the firms
analysts want to explore the importance of uncertainty in the project cash
flows. Perform a sensitivity analysis on this proposed investment.
Copyright 2011 Pearson Prentice Hall. All rights reserved.
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Checkpoint 13.2
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Checkpoint 13.2
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Step 3: Solve
Following are the projected cash flows for years 0-5:
Year-0
Revenues
Years 1-4
Year-5
5,000,000
5,000,000
$(3,600,000.00)
$(3,600,000.00)
$(300,000.00)
$(300,000.00)
$(400,000.00)
$(400,000.00)
$700,000.00
$700,000.00
$(210,000.00)
$(210,000.00)
$490,000.00
$490,000.00
$300,000.00
$300,000.00
Less: CAPEX
Less: Change in Working Capital
Free Cash Flow
$(1,800,000.00)
$300,000.00
$(500,000.00)
$500,000.00
$(2,300,000.00)
$790,000.00
$1,590,000.00
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$(2,300,000.00)
$790,000.00
$790,000.00
$790,000.00
$790,000.00
$1,590,000.00
NPV
$1,001,714.68
IRR
26.65%
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Years 1-4
Revenues
Year-5
4,500,000
4,500,000
$(3,240,000.00)
$(3,240,000.00)
$(300,000.00)
$(300,000.00)
$(400,000.00)
$(400,000.00)
$560,000.00
$560,000.00
$(168,000.00)
$(168,000.00)
$392,000.00
$392,000.00
$300,000.00
$300,000.00
Less: CAPEX
Less: Change in Working Capital
Free Cash Flow
$(1,800,000.00)
$300,000.00
$(500,000.00)
$500,000.00
$(2,300,000.00)
$692,000.00
NPV
$648,446.62
IRR
21.59%
$1,492,000.00
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Years 1-4
Revenues
Year-5
5,000,000
5,000,000
$(3,960,000.00)
$(3,960,000.00)
$(300,000.00)
$(300,000.00)
$(400,000.00)
$(400,000.00)
$340,000.00
$340,000.00
$(102,000.00)
$(102,000.00)
$238,000.00
$238,000.00
$300,000.00
$300,000.00
Less: CAPEX
Less: Change in Working Capital
Free Cash Flow
$(1,800,000.00)
$300,000.00
$(500,000.00)
$500,000.00
$(2,300,000.00)
$538,000.00
NPV
$220,414.70
IRR
15.19%
$1,338,000.00
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Years 1-4
Revenues
Year-5
4,500,000
4,500,000
$(3,600,000.00)
$(3,600,000.00)
$(300,000.00)
$(300,000.00)
$(400,000.00)
$(400,000.00)
$200,000.00
$200,000.00
Les: Taxes
$(60,000.00)
$(60,000.00)
$140,000.00
$140,000.00
$300,000.00
$300,000.00
Less: CAPEX
Less: Change in Working Capital
Free Cash Flow
$(1,800,000.00)
$300,000.00
$(500,000.00)
$500,000.00
$(2,300,000.00)
$440,000.00
NPV
($259,956.99)
IRR
8.02%
$1,240,000.00
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Years 1-4
Revenues
Year-5
5,000,000
5,000,000
$(3,600,000.00)
$(3,600,000.00)
$(300,000.00)
$(300,000.00)
$(440,000.00)
$(440,000.00)
$660,000.00
$660,000.00
$(198,000.00)
$(198,000.00)
$462,000.00
$462,000.00
$300,000.00
$300,000.00
Less: CAPEX
Less: Change in Working Capital
Free Cash Flow
$(1,800,000.00)
$300,000.00
$(500,000.00)
$500,000.00
$(2,300,000.00)
$762,000.00
NPV
$900,780.95
IRR
25.22%
$1,562,000.00
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Expected NPV
$1,001,714.68
$648,446.62
-35%
$1,001,714.68
$(259,956.99)
-126%
$1,001,714.68
$220,414.70
-78%
$1,001,714.68
$900,780.95
-10%
Revised NPV
% Change
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Step 4: Analyze
Here we observe that a 10% adverse
change in value drivers has a significant
impact on NPV. If the price per unit drops
by 10%, the project turns negative with
the value of NPV declining by 126%.
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Scenario Analysis
Sensitivity analysis involves changing one
value driver at a time and analyzing its
effect on the investment NPV.
Scenario analysis considers the effect of
multiple changes in value drivers on the
NPV. For example, the scenarios could be
Expected or base-case, Worst-case and
Best-case.
Copyright 2011 Pearson Prentice Hall. All rights reserved.
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Checkpoint 13.3
Project Risk Analysis: Scenario Analysis
The analysts performing the risk analysis on the plasma cutting tool
being considered by Crainium, Inc. (described in Checkpoint 13.2)
now want to evaluate the project risk using scenario analysis.
Specifically, they now want to evaluate thE projects risk using
scenario analysis aimed at evaluating the projects NPV under worstand best-case scenarios for the projects value drivers.
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Checkpoint 13.3
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Checkpoint 13.3
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Scenario 2
$175,000.00
$100,000.00
$24.50
$35
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Step 3: Solve
Scenario 1 cash flow and NPV/IRR estimates
Year-0
Years 1-4
Revenues
Year-5
$4,287,500.00
$4,287,500.00
$(3,500,000.00)
$(3,500,000.00)
$(250,000.00)
$(250,000.00)
$(400,000.00)
$(400,000.00)
$137,500.00
$137,500.00
Les: Taxes
$(41,250.00)
$(41,250.00)
$96,250.00
$96,250.00
$250,000.00
$250,000.00
$(1,500,000.00)
$250,000.00
$(500,000.00)
$500,000.00
$(2,000,000.00)
$346,250.00
NPV
$326,276.10
IRR
6.29%
$1,096,250.00
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Years 1-4
Revenues
Year-5
$3,500,000.00
$3,500,000.00
$(2,000,000.00)
$(2,000,000.00)
$(250,000.00)
$(250,000.00)
$(400,000.00)
$(400,000.00)
$850,000.00
$850,000.00
$(255,000.00)
$(255,000.00)
$595,000.00
$595,000.00
$250,000.00
$250,000.00
Less: CAPEX
Less: Change in Working Capital
Free Cash Flow
$(1,500,000.00)
$250,000.00
$(500,000.00)
$500,000.00
$(2,000,000.00)
$845,000.00
NPV
$1,471,606.03
IRR
36.10%
$1,595,000.00
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Step 4: Analyze
Examination of the two scenarios reveals
that this is a risky opportunity as there is a
wide divergence in the two NPV estimates.
The NPV could be as high as $1,491,606 or
as low as a negative $326,276.
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Simulation Analysis
Scenario analysis provides the analyst with
a discrete number of estimates of project
NPVs for a limited number of cases or
scenarios.
Simulation analysis generates thousands
of estimates of NPV that are built upon
thousands of values for each of the
investments value drivers. These different
values arise out of each value drivers
individual probability distribution.
Copyright 2011 Pearson Prentice Hall. All rights reserved.
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13.3 Break-Even
Analysis
Break-Even Analysis
Break-even analysis determines the
minimum level of output or sales that the
firm must achieve in order to avoid losing
money i.e. to break even.
In most cases, break-even sales is defined
as the level of sales for which net
operating income equals zero.
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Checkpoint 13.4
Project Risk Analysis: Accounting Break-Even Analysis
The new plasma cutting tool that Crainium, Inc. is considering
investing in as described in Checkpoint 13.2 has the following
value driver estimates of fixed and variable costs:
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Checkpoint 13.4
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Checkpoint 13.4
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Checkpoint 13.4
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Checkpoint 13.4
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Variable Costs
Fixed Costs
Total Costs
50,000.00
$1,050,000.00
$700,000.00
$1,750,000.00
100,000.00
$2,100,000.00
$700,000.00
$2,800,000.00
150,000.00
$3,150,000.00
$700,000.00
$3,850,000.00
200,000.00
$4,200,000.00
$700,000.00
$4,900,000.00
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Step 3: Solve
QBreak-even = F (P-V)
= $700,000 ($23-$21)
= $700,000 $2
= 350,000 units
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Variable Costs
Fixed Costs
Total Costs
Revenue
Profit
50,000.00
$1,050,000.00
$700,000.00
$1,750,000.00
1,150,000.00
(600,000.00)
100,000.00
$2,100,000.00
$700,000.00
$2,800,000.00
2,300,000.00
(500,000.00)
150,000.00
$3,150,000.00
$700,000.00
$3,850,000.00
3,450,000.00
(400,000.00)
200,000.00
$4,200,000.00
$700,000.00
$4,900,000.00
4,600,000.00
(300,000.00)
350,000.00
$7,350,000.00
$700,000.00
$8,050,000.00
8,050,000.00
$0
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Step 4: Analyze
Break-even analysis indicates the number
of units the firm must sell in order to
cover total fixed and variable costs
resulting in net operating income of zero.
Break-even point sets the lower limit on
the level of sales, from an accounting
perspective. Note projects that merely
break even in an accounting sense have
negative NPVs and results in a loss of
shareholder value.
Copyright 2011 Pearson Prentice Hall. All rights reserved.
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Checkpoint 13.5
Analyzing Real Options: Option to Expand
You are considering introducing a new drive-in restaurant called Smooth-Thru
featuring high protein and vitamin-laced smoothies along with other organic
foods. The initial outlay on this new restaurant is $2.4 million and the present
value of the free cash flows (excluding the initial outlay) is $2 million, such that
the project has a negative expected NPV of$400,000. Looking closer, you find
that there is a 50% chance that this new restaurant will be well received and
will produce annual cash flows of $320,000 per year forever (a perpetuity),
while there is a 50% chance of it producing a cash flow of only $80,000 per
year forever (a perpetuity) if it isnt received well. The required rate of return
you use to discount the project cash flows is 10%. However, if the new
restaurant is successful, you will be able to build 4 more of them and they will
have costs and cash flows similar to the successful restaurants cash flows. If
your new restaurant is not received favorably, you will not expand. Ignoring the
fact that there would be a time delay in building additional new restaurants if
the project is favorably received, determine the projects NPV.
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Checkpoint 13.5
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Checkpoint 13.5
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P(Unfavorable)
=.6
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Step 3: Solve
We are given the following information
(per Restaurant):
Perpetual annual cash flow (if favorably received)
= $320,000
Perpetual annual cash flow (if not favorably
received) = $80,000
Probability of being favorably received = 40%
Discount rate = 10%
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Step 4: Analyze
Without the option to expand, this project
would have had a NPV of -$640,000.
NPV = $800,000(.4) + (-$1,600,000)(.6)
= -$640,000
However, by considering the option to
expand, the project has a positive NPV.
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Key Terms
13-100
Fixed cost
Indirect cost
NPV break-even analysis
Operating leverage
Real options
Scenario analysis
Sensitivity analysis
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