Student Name: Firas Suhail

Student No.: 970562

Risk Analysis, Real

Options, and Capital
Budgeting
 Sensitivity Analysis and Scenario Analys

Estimated cash flows are expectations of



averages of possible cash flows, not

exact figures (although if an exact figure
were available, you would use it).
 Sensitivity analysis
What things are likely to be wrong and


what will be the effect if they are? Start

with a base case – the expected cash
flows – then ask “what if …?”
 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
 Scenario Analysis
Worst-case/Best-case scenarios: putting
lower and upper bounds on cash flows.
Common exercises include poor
revenues/high costs and high
revenues/low costs. Note that a thorough
scenario analysis starts with Base-
case/Worst-case/Best-case .
 Continue
vThe revenue estimate depend on three
assumption
1.Market share
2.Size of product in market
3.Price per product
 Costs
1. Variable cost
vChange as output change, and they are
zero when production is zero.
vIt is common to assume that a variable
cost is constant per unit of output.
For example:

Direct labor and raw materials are

usually variable
 continue
2. Fixed cost
vAre not dependent on the amount of
goods or services produced during
the period
vFixed cost are usually measured as cost
per unit of time
For example:

rent per month, salaries per year

 Example
The project cost= $720,000 Probably accurate to within ±10%
N= 4 year life
Price per unit= $21,000
Salvage value= 0

Scenario Unit sales per Variable cost Fixed costs per

year per unit year
Base 190 $15,000 $225,000

Worst 171 $16,500 $247,500

Best 209 $13,500 $202,500

 solution
Required return on the project= 15%
Tax= 35%
Depreciation is straight line to zero
1.Calculate operating cash flow

OCFbase = [($21,000 – 15,000)(190) – $225,000](0.65) + 0.35($720,000/4)

OCFbase = $657,750

OCFworst = [($21,000 – 16,500)(171) – $247,500](0.65) +0.35($720,000/4)

OCFworst = $402,300

OCFbest = [($21,000 – 13,500)(209) – $202,500](0.65) + 0.35($720,000/4)

OCFbest = $950,250
 Continue solution
 2. Calculate NPV for all scenarios


NPVbase = –$720,000 + $657,750(PVIFA15%,4)

NPVbase = $1,157,862.02

NPVworst = –$720,000 + $402,300(PVIFA15%,4)

NPVworst = $428,557.80

NPVbest = –$720,000 + $950,250(PVIFA15%,4)

NPVbest = $1,992,943.19
 Sensitivity analysis continue

 Calculate the sensitivity of the NPV to

changes in fixed costs, F cost =
$230,000
New OCF:
OCF = [($21,000 – 15,000)(190) – $230,000](0.65) +

0.35($720,000/4)
OCF = $654,500

And the NPV is:

NPV = –$720,000 + $654,500(PVIFA15%,4)

NPV = $1,148,583.34

The sensitivity of NPV to changes in fixed costs is:

ΔNPV/ΔFC = ($1,157,862.02 – 1,148,583.34)/($225,000 –

230,000)
ΔNPV/ΔFC = –$1.856
 Break-Even Analysis
Ø 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
 Break-Even Analysis
Ø There are three common break-even
measures
1.Accounting break-even: sales volume
at which net income = 0
2.Cash break-even: sales volume at
which operating cash flow = 0
3.Financial break-even: sales volume at
which net present value = 0

Accounting Break-Even
 Example
q Calculate the quantity (Q) necessary for
accounting break-even. Using the following
information:
q
q FC = $40,000; Depreciation = $4,000; Price
per unit = $3; VC per unit = $0.30
q
q Q = (FC + D) / (P – v)
 Q = ($40,000 + $4,000) / ($3 - $.3) =
16,296 units
Break even point using accounting
numbers

P t
fi
pro

lo
ss

16,296 Q
 Cash break-even point

 Cash break-even point =

(Fixed costs - depreciation) / CM
Unit
 The cash breakeven point indicates the minimum
amount of sales required to contribute to a positive
cash flow.
 Example 1

A small coal mine can produce a max of 100,000 tons per

month. The coal
sells for $30.00 per ton and the contribution is around 75%.
TFC per month is $1,850,000. How many tons of coal the mine
has to produce in order to break even?
Total revenue = n P = 100,000 x $30.00 = $3,000,000.
Total contribution = 0.75 x 3,000,000 = $2,250,000
B (% capacity) =FC / Contribution =
1850000 /2250000 = 82.22%
It requires 100,000 tons x 82.22% = 82,222 tons to break even.
 Example 2

If VC is 60% of sales; with unit price at $10/each and

FC = $40,000. What is the cash break even point?
Sales @ BEP = a (Sales @ the BEP) + TFC
X = .60(X) + $40,000
X = $100,000
To find break-even in units:
$100,000/$10.00 = 10,000
 Financial break-even
qIn financial break even point it takes in
consideration the economic
opportunity costs
qFinancial break even point higher than
accounting break even point
qCompanies that break even on an
accounting basis are really losing
money. They are losing the
opportunity costs of the initial
investment
Continue financial break even point
 Example
The price is $3 per unit and the variable costs are $0.30 per unit. The
fixed costs are $40,000. The initial investment is $20,000. The project
lasts five years and has a discount rate of 15%. Assume no taxes, no
depreciation
Break even point using financial numbers

P t
fi
pro

lo
ss

17,025 Q
Monte Carlo Simulation
 Monte Carlo Simulation
q When the assumptions underlying the capital
budgeting are complex, it becomes difficult
to find the expected value of the NPV.
q
q
q For such a case, Monte Carlo Simulation can
help find the expected value of the project.

 Monte Carlo Simulation
qMoreover, you can visualize the
distribution of NPV easily by using
Monte Carlo Simulation.
q
q
qIn the following slides, we will use an
example to illustrate how a Monte
Carlo Simulation can be used.
 Monte Carlo Simulation
q Backyard Barbeque Inc (BBI) is considering
an project to produce a new grill that cooks
with compressed hydrogen.
q
q For simplicity, let us assume that the lifetime
of the project is 2 years. The discount rate
is 10%
q
q The company came up with the following
assumptions for the purpose of capital
budgeting.

 Monte Carlo Simulation Example
v Assumptions 1


The revenue from the new grill will be given by




Number of grill
market
sold share
by entire
of BBI
industry
hydrogen grill
price (per
in percent
hydrogen
) grill
x x
 Continue
v Assumption 2
The operating cost per year will be

Variable
Fixed manufacturing costs manufacturing costs
Marketing costs
+ + + Selling costs

Fixed cost is estimated to be $5 million per year. Variable

cost is estimated to be 40% of the revenue

vAssumption 3
The initial cost is estimated to be $50 million

Test marketingCost
costsof production facility
Cost of patent + +
 Continue
v Assumption 4
The probability distribution of the next year’s industry

wide unit sales of grills is given by


probability

Next years industry wide unit sales (in million)

 Continue
vAssumption 5
Distribution of the market share of BBI in each
year is given by
probability

The market share of BBI hydrogen

grill next year
 Continue
v Assumption 6
v The price of
the grill per 204 Positive random
unit for each drawing (50%
year is given probability)

by 201
Next years price per hydrogen grill
Expected

v 203
200.5
198
v Price= $190 + Negative random
$1×(Industr 200 drawing (50%
y wide unit probability)

sales in
million) + 197
(random
component)
v
Next years industry wide unit sales
v Where (in million)
(random
 Continue
v Assumption 7


Growth rate of industry wide unit sale is also assumed



to be a random number. The distribution of the growth

rate for each year is given by
 Monte Carlo Simulation
v Assumption 8: There is no tax.
Ø
 This is just an assumption to make the computation

easy.
Ø
 Continue
v Open “Monte Carlo example”


v Ex 1: Compute the NPV for the following condition.


Year 1market wide unit sale =10million
Year 1 market share =2%

Year 1 price error component is $3

Growth rate of the market unit sales is 3%

Year 2 market share =1%

Year 2 price error component =‒$3

 Monte Carlo Simulation
v Ex 2
Generate each variable 500 times (Monte

Carlo Simulation with 500 repetitions). Then

compute the expected net present value of the
project. Also make a histogram to show the
distribution of the net present value of the
project.
Ø
 Monte Carlo Simulation

The result of Monte Carlo simulation (500 random draws) shows that
the probability that the project will have negative net present value is
very small. The expected value of NPV is about $14.5 million dollars.
This would give the company confidence about the project.
 Real Options


Real options provide the right to buy or



sell real assets. These options often

apply in capital budgeting situations and
can be very valuable.
Real Options
 The Option to Expand Example
v Mr. willing liked the idea of hotel made of ice
more than anything else. Conrad estimate
the annual cash flow from a single ice hotel
to be $2 million, based on an initial
investment of $12 million. He felt that 20%
was appropriate discount rate, giving the
risk of this new venture. Believing that the
cash flows would be perpetual, Mr. willing
determined the NPV of the project to be:
-$12x10^6+$2x10^6/0.2= -$2 million
 Continue The Option to Expand
Example
v Most entrepreneurs would have rejected this
venture, given it negative NPV. But Conrad he was
pretty sure that initial investment would cost $12
million per year actually reflected his belief that
there was a 50% probability that annual cash flow
will be $3 million and 50% probability that annual
cash flows will be $1 million
The NPV calculation for the two forecast are given

here:


Optimistic forecast: -$12x10^6+$3x10^6/0.2=$3

million
Pessimistic forecast: -$12x10^6+$1x10^6/0.2= -

$7 million
 Continue The Option to Expand
Example
However, if the optimistic forecast turns out to be


correct, Mr. Willing would want to expand. An average

of two forecast yield an NPV for the project of:

If h e b e lie ve s th a t th e re a re 1 0 lo ca tio n in th e co u n try

th a t ca n su p p o rt a n ice h o te l, th e tu rn N P V o f th e
ve n tu re w o u ld b e :
 The Option to Abandon Example
v The same example of the ice hotel, which illustrated
the option to expand, can also illustrate the option
to abandon.
Imagine that Mr. willing now believes that there is a

50% probability that annual cash flows will be $6

million, and a 50% probability ability that annual
cash flows will be -$2 million. The NPV calculation
under the two forecast become:


 Optimistic forecast: -$12x10^6+$6x10^6/0.2= $18

million
 Pessimistic forecast: -$12x10^6 - $2x10^6/0.2= -$22
million

Continue The Option to Abandon
Example
 The Option to Delay: Example
Year Cost
Year PV
Cost NPVPVt NPV NPV
0 t
0 $ 20,000
0 $ $20,000
25,000 $$ 5,000
25,000 $ 5,000
$ 5,000
1 $ 18,000
1 $ $18,000
25,000 $$ 7,000
25,000 $ 6,364
$ 7,000
2 $ 17,100
2 $ $17,100
25,000 $$ 7,900
25,000 $ 6,529
$ 7,900 $7,900
3 $ 16,929 $ 25,000
3 $ 16,929
$ 8,071 $ 6,064
$ 25,000 $ 8,071
$6,529 =
4 $ 16,760 $ 25,000 $ 8,240 $ 5,628 (1.10) 2
4 $ 16,760 $ 25,000 $ 8,240

 Consider the above project, which can be undertaken

in any of the next 4 years. The discount rate is 10
percent. The present value of the benefits at the
time the project is launched remains constant at
$25,000, but since costs are declining, the NPV at
the time of launch steadily rises.
 The best time to launch the project is in year 2—this
schedule yields the highest NPV when judged today.
Decision Tree
 Decision Trees
vDecision trees are a convenient way to
represent sequential decisions over
time. Such decisions often arise when
the uncertainty surrounding an
investment can be reduced by some
initial information-gathering such as
test marketing a new product or
preparing a feasibility study .
 Example of a Decision Tree
Squares represent decisions to be made.
“A” Circles represent
receipt of information,
e.g., a test score.
Study finance “B”

“C”
The lines leading away
from the squares
Do not study “D” represent the options

“F”
 Decision Trees
Example

B&B has new baby powder ready to market, if the firm goes directly
to the market with the product, there is only a 55% percent chance
of success, however, the firm can conduct customer segment
research which will take a year and cost $1 million by going
through research, B&B will be able to better target potential
customer and will increase the probability 70 percent. If successful,
the present value payoff is only profit(at time of initial selling) of $30
million. If unsuccessful, the present payoff is only $3 million. Should
the firm conduct customer segment research or go directly to
market? The appropriate discount rate is 15 percent
 Decision Trees
Make the research

NPV= C0 + {[CSuccess (Prob. of Success)] + [CFailure (Prob. of Failure)]} / (1 + R)^t

NPV = –$1,000,000 + {[$30,000,000 (0.70)] + [$3,000,000 (0.30)]} / 1.15
NPV = $18,043,478.26

Don’t Make the research

NPV = CSuccess (Prob. of Success) + CFailure (Prob. of Failure)

NPV = $30,000,000(.55) + $3,000,000(.45)
NPV = $17,850,000.00
Decision Trees
Success

Research
$18.0435 million at t = 0 Failure

Success
No Research

$17.85 million at t = 0
Failure
Thank you
