Chapter 11 Capital Budgeting and risk

# Single payback period cutoff fails to allow for this

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Single payback period cutoff fails to allow for this Some projects more risky than others during start up periods - PB criterion fails to recognize Approach may cause firm to reject some actually acceptable projects Helpful: Screening investment alternatives - politically unstable countries and investment in products characterized by rapid tech advances Firms that have difficulty raising external capital and therefore concerned about timing of internally generated cash flows often find PB useful See End-of-Chapter Problem #8

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NPV of Project A =-1,256; NPV of Project B = +18,455 Payback of Project A = 3 years; Payback of Project B = 4 years The firm desires +NPV projects with payback ≤ 3 years, 10% discount rate Sensitivity Analysis Calculates the change in NPV given a change in one of the cash flow elements - like product price Determine how sensitive a project's return is to change in particular variable Derived from simulation approach - req definition of all relevant variables that influence NPV of a project Allows the decision maker to use only the best estimate of each variable to compute the NPV Can be applied to any variable to determine the effect of cahnges in one or more of the inputs on a project’s NPV Provides possible consequences of various scenarios Involves systematically changing relevant variables to identify which variables are most important for the NPV (or IRR) Useful to make sensitivity curves to show the impact of changes in a variable on the project’s NPV NPV on vertical axis and variable of interest on horizontal axis Steep slope of priceNPV curve indicates NPV is very sensitive to changes in price for which the product can be oslfd This is a derivative (from calculus): Partial derivative (all else constant): Often the goal is to find the “break-even” outcome for important inputs/assumptions
Spreadsheets and financial modeling make sensitivity analysis easier to perform Recall our “blueberry” and “peppers” problems (#10-13 & 10-14) Scenario Analysis Considers the impact of simultaneous changes in key variables on the desirability of an investment project Unlike sensitivity analysis that looks at the impact of changes in key variables one at a time Estimate the expected NPV under (three) scenario assumptions: Optimistic Defined by the most optimistic values of each of the most input variables For ex. Low development costs, low production costs, high prices, strong demand Pessimistic Defined by low prices, product launch delay, soft demand, high dvlpmt costs, high production costs Most likely Estimate the probability of each scenario Compute the expected NPV Probability- weighted average of the NPVs under each scenario Compute the standard deviation of the NPV See HW problem 11-13 for both sensitivity and scenario analysis
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