Chapter 9 Risk Analysis, Real Options and Capital Budgeting

# Chapter 9 Risk Analysis, Real Options and Capital Budgeting...

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Risk Analysis, Real Options and Capital Budgeting Chapter 9 Finance 357

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Cash Flow Uncertainty In the problems to this point, cash flows have been certain. Tables of cash flows told you when the cash flow would come and how much it would be. Not very similar to life in the real world. In the real world, cash flows aren’t always certain and decision makes much take the uncertainty into account. We must have some tools to deal with the uncertainty. 2
Decision Trees Decision Trees are used to sort through the variety of decisions that are usually involved with NPV project analysis. 3

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Decision Trees Should the firm invest \$100 million in this project with a 15% discount rate? Expected Payoff = (.75 x 1517) + (.25 x \$0) = \$1,138 at T 1 NPV = -\$100 + \$1,138/1.15 = \$890 4
Sensitivity Analysis Many times during project planning, NPV values are calculated down to the dollar for each year, but in reality, projects rarely reach the planned numbers. A tool is needed to give managers a way to determine how closely actual numbers will be to the planned numbers. Sensitivity Analysis examines how sensitive a particular NPV calculation is to changes in the underlying assumptions of the project. 5

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Using Sensitivity Analysis We work for a jet engine manufacturer who is projecting that it will sell 3,000 plane engines next year. We must decide if this is a reasonable sales estimate. Based on this breakdown, we see that market share, size of the jet engine market and the price per engine are the key variables. 6
Costs – Fixed vs. Variable Variable costs change as output changes. Fixed costs are not dependent on the amount of goods or services produced in the period. Variable Pessimistic Expect or Best Optimistic Market Size 5,000 10,000 20,000 Market Share 20% 30% 50% Price \$1.9 million \$2 million \$2.2 million Variable Cost (per engine) \$1.2 million \$1 million \$2.2 million Fixed Cost (per year) \$1,891 million \$1,791 million \$1,741 million Investment \$1,900 million \$1,500 million \$1,000 million 7

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NPV The table on the next slide is the NPV for the project for the specified variable set as indicated and all other variables set as expected. In Sensitivity Analysis, all the variables are calculated as the expected case, and the only variable that changes is the specific variable being tested. 8
NPV (Only 1 variable changes) Variable Pessimistic Expect or Best Optimistic Market Size -\$1,802 \$1,517 \$8,154 Market Share -\$696 \$1,517 \$5,942 Price \$853 \$1,517 \$2,844 Variable Cost (per engine) \$189 \$1,517 \$2,844 Fixed Cost (per year) \$1,295 \$1,517 \$1,628 Investment \$1,208 \$1,517 \$1,903 Variable Pessimistic Expect or Best Optimistic Market Size 5,000 10,000 20,000 Market Share 20% 30% 50% Price \$1.9 million \$2 million \$2.2 million

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