Risk Analysis, Real Options, and Capital
Answers to Concept Questions
Forecasting risk is the risk that a poor decision is made because of errors in projected cash
flows. The danger is greatest with a new product because the cash flows are probably harder
With a sensitivity analysis, one variable is examined over a broad range of values. With a
scenario analysis, all variables are examined for a limited range of values.
It is true that if average revenue is less than average cost, the firm is losing money. This
much of the statement is therefore correct. At the margin, however, accepting a project with
marginal revenue in excess of its marginal cost clearly acts to increase operating cash flow.
From the shareholder perspective, the financial break-even point is the most important. A
project can exceed the accounting and cash break-even points but still be below the financial
break-even point. This causes a reduction in shareholder (your) wealth.
The project will reach the cash break-even first, the accounting break-even next and finally
the financial break-even. For a project with an initial investment and sales after, this
ordering will always apply. The cash break-even is achieved first since it excludes
depreciation. The accounting break-even is next since it includes depreciation. Finally, the
financial break-even, which includes the time value of money, is achieved.
Traditional NPV analysis is often too conservative because it ignores profitable options such
as the ability to expand the project if it is profitable, or abandon the project if it is
unprofitable. The option to alter a project when it has already been accepted has a value,
which increases the NPV of the project.
The type of option most likely to affect the decision is the option to expand. If the country
just liberalized its markets, there is likely the potential for growth. First entry into a market,
whether an entirely new market, or with a new product, can give a company name
recognition and market share. This may make it more difficult for competitors entering the
Sensitivity analysis can determine how the financial break-even point changes when some
factors (such as fixed costs, variable costs, or revenue) change.
There are two sources of value with this decision to wait. Potentially, the price of the timber
can increase, and the amount of timber will almost definitely increase, barring a natural
catastrophe or forest fire. The option to wait for a logging company is quite valuable, and
companies in the industry have models to estimate the future growth of a forest depending
on its age.