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Unformatted text preview: Chapter 8 presents Sensitivity Analysis, Scenario Analysis, Decision Tree, and Break-Even Analysis; Real Option Perhaps the single largest source of positive NPVs is the economic concept of monopoly rents positive profits that occur from being the only one able or allowed to do something. Monopoly rents are often associated with patent rights and technological edges, and they quickly disappear in a competitive market. Introducing this notion in class provides a springboard for discussions of both business and financial strategy as well as for discussion of the application of economic theory to the real world. The following are project characteristics associated with positive NPVs: 1) Economies of scale 2) Product differentiation 3) Cost advantages 4) Access to distribution channels 5) Favorable government policy Sensitivity Analysis To conduct a sensitivity analysis, hold all projections constant except one; alter that one, and see how sensitive cash flows (and NPV) are to the change the point is to get a fix on where forecasting risk may be especially severe. You may want to use the Worst-case/Best-case idea for the item being varied. Common exercises include varying sales, variable costs, and fixed costs. A major misconception about a projects estimated NPV at this point is that it depends upon how the cash flows actually turn out. This thinking misses the point that NPV is an ex ante valuation of an uncertain future. The distinction between the valuation of what is expected versus the ex post value of what transpired is often difficult for students to appreciate. A useful analogy is the market value of a new car. The potential to be a lemon is in every car, as is the possibility of being a cream puff. The greater the likelihood that a car will have problems, the lower the price will be. The point, however, is that a new car does not have many different prices right now one for each conceivable repair record. Rather, there is one price embodying the different potential outcomes and their expected value. So it is with NPV the potential for good and bad cash flows is reflected in a single market value. Break-Even Analysis Break-even analysis is a widely used technique for analyzing sales volume and profitability. More to the point, it determines the sales volume necessary to cover costs and implicitly asks, Are things likely to go that well? As quantity increases, total fixed costs remain constant, but, on a per unit basis, they decrease with increasing volume. And, as quantity increases, total cost per unit approaches variable cost per unit. If a company expects a high unit sales volume, the company may desire to exploit the possible economies of scale by investing more in fixed costs in an effort to lower variable cost per unit. However, this could create future financial problems if sales expectations fail to materialize. This relation is a reflection of the degree of operating leverage. Accounting Break-Even...
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- Spring '09
- Corporate Finance