slides18 - 18 Capital budgeting part 3 In the previous...

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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 down-side risk and up-side poten- tial? Are there any ways to minimize risk?
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Overview — continued We will examine several tools for thinking about uncertainty: scenario analysis sensitivity analysis break-even analysis real options Monte Carlo simulation 2
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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
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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 five-year life no salvage value No NWC needs Evaluate the project using Straight-line depreciation 34% tax rate 12% discount rate What is the range of possible outcomes? 4
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Example — continued First, compute the cash flows (the easiest way is using the tax-shield 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 IRR -14.40 15.10 40.88 What do you think of this investment? (Which is more useful, NPV or IRR?) 5
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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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