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Chap009(WW-FIN357)NT

Chap009(WW-FIN357)NT - Chapter 9 Risk Analysis Real Options...

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Chapter 9 Risk Analysis, Real Options, and  Capital Budgeting

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9-2 Chapter Outline 9.1 Decision Trees 9.2 Sensitivity, Scenario, and Simulation 9.3 Break-even analysis 9.4 Real Options
9-3 Key Concepts and Skills Understand decision trees Understand and apply scenario and sensitivity analysis Understand break-even analyses Understand Monte Carlo simulation Understand the importance of real options in capital budgeting

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9-4 9.1 Decision Trees Graphical representation of the investment alternatives available in each period Useful when: Uncertainties surrounding an investment can be reduced by initial information‑gathering Investment decisions are sequential Probabilities can be assigned to outcomes
9-5 Decision Tree Analysis United Robotics is considering the production of an industrial robot for the television manufacturing industry. The net investment for this project can be separated into 3 stages. Stage 1: At t = 0, conduct a \$500,000 study of the potential for robots on television assembly lines. There is an 80% chance the study will indicate potential and a 20% chance it will not.

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9-6 Decision Tree Analysis Stage 2: If it appears that a sizeable market share exists, invest \$1,000,000 at t = 1 to design and build a prototype robot. There is a 60% chance that the reaction will be good and a 40% chance that it will be poor. .
9-7 Decision Tree Analysis Stage 3: If reaction to the prototype is good, build a plant at a net cost of \$10,000,000. If Stage 3 is reached, the project will generate high (\$10,000,000), medium (\$4,000,000), or low (\$-2,000,000) net cash flows over the next four years. The probabilities of the high, medium, or low cash flows are 30%, 40%, and 30%.

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9-8 United Robotics Decision Tree (\$000) Stop (\$1000) Stop (\$10,000) (\$500) \$10,000 t = 0 t = 1 t = 2 t = 3-6 \$4,000 \$(2,000) 0.8 0.2 0.6 0.4 0.3 0.3 0.4
9-9 NPV (1 st  Scenario in \$000) NPV @ 11.5% = \$15,250 Calculate NPV for each alternative Calculate joint probabilities for each alternative Calculate E(NPV) = sum of the products of joint probability and NPV for each outcome 0 1 2 3 - 6 (500)* (1000) (10,000) 10,000

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9-10 Decision Tree Analysis (\$000) Joint Prob. NPV @ 11.5% Product (Prob. x NPV) 0.144 \$15,250 \$2,196 0.192 436 84 0.144 (14,379) (2,071) 0.320 (1,397) (447) 0.200 (500) (100) 1.000 (E)NPV = (\$338)
9-11 9.2 Sensitivity, Scenario, and Simulation

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Chap009(WW-FIN357)NT - Chapter 9 Risk Analysis Real Options...

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