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Unformatted text preview: 18. Capital budgeting, part 3 • In the previous chapters, we have learned to forecast cash flows and looked at different ways of evaluating a project based on those cash flows. • The problem is that cash flow projections are subject to a great deal of uncertainty . • In this chapter, we look at some ways to address this issue. Some of the questions we will want to examine include: – What is the range of possible outcomes? – How sensitive are our conclusions to changes in the underlying assumptions? – How can we evaluate downside risk and upside poten tial? – Are there any ways to minimize risk? Overview — continued We will examine several tools for thinking about uncertainty: • scenario analysis • sensitivity analysis • breakeven analysis • real options • Monte Carlo simulation 2 Scenario analysis • Construct several scenarios based on different sets of under lying assumptions. • A common framework is to look at – worst case – base case – best case • The “base case” represents out belief as to the most likely outcome. • The terms “best” and “worst” should not be taken too lit erally. Optimistic and pessimistic might be better. • Other kinds of scenarios might be of interest, e.g. – high energy prices – business cycle – election results – interest rates – geopolitical environment – etc... 3 Example • Suppose we are considering bringing out a new line of ex presso machines. Our market research suggests the following data: worst case base case best case Unit sales 5500 6000 6500 Unit price 75 80 85 Variable costs per unit 62 60 58 Fixed costs per year 55,000 50,000 45,000 • Suppose that the project has – initial costs of $200,000 – a fiveyear life – no salvage value – No NWC needs • Evaluate the project using – Straightline depreciation – 34% tax rate – 12% discount rate • What is the range of possible outcomes? 4 Example — continued • First, compute the cash flows (the easiest way is using the taxshield approach): worst case base case best case Sales 412500 480000 552500 Costs 396000 410000 422000 Depr 40000 40000 40000 OCF 24490 59800 99730 • Using these cash flows and an initial cost of $200,000, compute NPV and IRR: worst case base case best case NPV (R=12)111,719.03 15,565.62 159,504.33 IRR14.40 15.10 40.88 • What do you think of this investment? (Which is more useful, NPV or IRR?) 5 Discussion It is difficult to say much about this example without additional information. But issues one might think about if doing this analysis include: • How likely is each scenario?...
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This note was uploaded on 03/31/2008 for the course FNCE 3010 taught by Professor Donchez,ro during the Fall '07 term at Colorado.
 Fall '07
 DONCHEZ,RO
 Corporate Finance

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