Name: Randrianantenaina Solohery Mampionona Aime

NIM: 041924353041

Chapter 7. Risk Analysis, Real Options, and Capital Budgeting

7.1 Sensitivity Analysis, Scenario Analysis, and Break–Even Analysis
Cash flows are projected down to the last thousand dollars (or even the last dollar) for each
year (or even each month). Opportunity costs and side effects are handled properly. Sunk
costs are ignored—also properly.
Table 7.1Cash Flow Forecasts for Solar Electronics Corporation’s Jet Engine: Base Case
(millions)
  Year 1 Years 2–6
Revenue   $6,000
Variable costs   3,000
Fixed costs   1,940
Depreciation   300
Pretax profit   $ 760
Tax (21%)   160
Net income   $ 600
Cash flow   $ 900
Initial investment costs $1,500

SENSITIVITY ANALYSIS AND SCENARIO ANALYSIS

Sensitivity analysis examines how sensitive a particular NPV calculation is to changes in
underlying assumptions.
The NPV at a discount rate of 15%:
5
NPV $ 900
=-$1,500 + ∑ t
t =1 1.15
$1,518 =-$1,500+$900×PVIFA15%,5
NPV>0, project accepted. But how about the revenue and costs?
Revenue: it depends on 1.Market share, 2.Size of jet engine market, 3.Price per engine.
Fixed costs: are not dependent on the amount of goods or services produced during the
period.
Now that we have got the firm’s expectations or best estimates, the firm’s analysts also
prepared both optimistic and pessimistic forecasts for each of the different variables.
Table 7.3NPV Calculations ($ in millions) for the Solar Jet Engine Using Sensitivity
Analysis.
NPV Calculations can be used for: (1) taken as a whole, the table can indicate whether NPV
analysis should be trusted. (2) sensitivity analysis shows where more information is needed.
BREAK-EVEN ANALYSIS
Name: Randrianantenaina Solohery Mampionona Aime
NIM: 041924353041

This is a financial tool which helps you to determine at what stage your company, or a new
service or a product, will be profitable.

Accounting Profit
Contribution margin: Sales price – variable cost
Costs incurred by the firm: Fixed cost + Depreciation
¿ costs+ Depreciation
So, Accounting Profit Break-Even Point:
Sales price−variable cost
Financial Break-Even:  is the level of earnings before interest and taxes that will result in
zero net income or zero earnings per share.
EAC+ Fixedcosts ×(1−Tc )−Depreciation× Tc
Financial Break-Even Point:
(Salesprice−Variablecosts)×(1−TC )
Where the top part of the formula is the aftertax costs
Initial investment
EAC=
PVIFA 15 % ,5

7.2Monte Carlo Simulation

What if? => sensitivity and scenario analysis. Sensitivity analysis allows only one variable to
change at a time while Scenario analysis follows specific scenarios, such as changes in
inflation, government regulation and so on.
Monte Carlo simulation is a computerized mathematical technique that allows people to
account for risk in quantitative analysis and decision making. There are 5 basic steps to do
the simulation (refer to the case of BBI in the books):
STEP 1: SPECIFY THE BASIC MODEL: break up cash money into three components:
Market share of
The revenue Number of grills sold Price per
= × BBI's hydrogen ×
in any year by entire industry hydrogen grill
grill (inpercent)

Fixed Variable
The cost in Marketing Selling
= manufacturing + manufacturing + +
any year costs costs
costs costs

The initial Cost of production

= Cost of patent + Test marketing costs +
investment facility
Name: Randrianantenaina Solohery Mampionona Aime
NIM: 041924353041

STEP 2: SPECIFY A DISTRIBUTION FOR EACH VARIABLE IN THE MODEL

Creates the following distribution for next year’s sales of grills by the entire industry:

Probability 20% 60% 20%

Next year’s industrywide unit sales 10 million 10.5 million 11 million

Determines the distribution of next year’s market share is:

Probability 10% 20% 30% 25% 10% 5%

Market share of BBI’s hydrogen grill next 1% 2% 3% 4% 5% 8%
year

These forecasts assume that unit sales for the overall industry are unrelated to the project’s
market share. The project’s market share is unlikely to be related to economic conditions.
Price per grill will be around $200:
Industry wide unit
Next year's price per
= $190 + $11 + sales (inmillions) +/
hydrogen grill
−$3
From now, we can proceed to the components of cost and investment by doing the same
computation as the component of revenue.
STEP 3: THE COMPUTER DRAWS ONE OUTCOME
Suppose that the industrywide unit sales is 10 million, a market share for BBI’s hydrogen
grill of 2 percent, and a +$3 random price variation. So,
-the next year’s price per hydrogen grill will be $203 = $190 + 10 + 3
-the next year’s revenue will be: $40.6 million= 10 million × .02 × $203
How likely is it that the specific outcome discussed would be drawn? To answer this question
we should refer to the distribution’s next year market share table, which give us: industry
sales of 10 million units has a 20 % probability, a market share of 2 % also has a 20 %
probability, and a random price variation of +$3 has a 50 % probability, so the the probability
of these three drawings together in the same outcome is: 0.02 = 0.20 × 0.20 × 0.50 . This step
generates the cash flow for each year from a single outcome.
STEP 4: REPEAT THE PROCEDURE: depending on the situation
STEP 5: CALCULATE NPV
Name: Randrianantenaina Solohery Mampionona Aime
NIM: 041924353041

Now that we already determine the expected cash flow, then we can also determine the
expected cash flow for each future year and then calculate the net present value of the project
by discounting these expected cash flows at an appropriate rate

7.3Real Options
Real options is all those adjustment that a firm can make after a project is accepted.
THE OPTION TO EXPAND
Supposed that, cash flows from a single ice hotel: $2 million; initial investment: $12 million;
appropriate discount rate: 20%,
So the NPV of the project is − $12,000,000 + $2,000,000/.20 = − $2,000,000
Obviously, most entrepreneurs would have rejected this venture bcause the NPV is negative.
But the entrepreneur here reasoned in another way, means that there was some uncertainty
concerning annual cash flows. He believes that there was a 50% probability that the annual
cash flows will be $3million and another 50% probability: $1million
So the NPV for those 2 forcasts are:
Optimistic forecast: −$12,000,000 + $3,000,000/.20 = $3,000,000
Pessimistic forecast: −$12,000,000 + $1,000,000/.20 = −$7,000,000
The average of the 2 forecasts yield an NPV for the project of:
0.50 × $3,000,000 + 0.50 × (− $7,000,000) = − $2,000,000, turns out to be the same as the
first calculation
However, if the optimistic forecast turns out to be correct, the entrepreneur want to expand
into another 10 location in the country, so the true NPV is:
0.50 × 10 × $3,000,000 + 0.50 × (− $7,000,000) = $11,500,000
THE OPTION TO ABANDON
Things change when we consider the abandonment option. If cash flows equal those under
the optimistic forecast, the entrepreneur will keep the project alive. If, however, cash flows
equal those under the pessimistic forecast, he will abandon the hotel.
The Abandonment Option in the Movie Industry
Name: Randrianantenaina Solohery Mampionona Aime
NIM: 041924353041

TIMING OPTIONS
A land that has been vacant for many years may have an NPV negative. However, if we
suppose that there will be an urbanization plan from the government in the area of the vacant
land, then automatically the vacant land in question will increase in terms of value as well.
7.4Decision Trees
A decision tree is a flowchart-like structure in which each internal node represents a "test" on
an attribute (e.g. whether a coin flip comes up heads or tails), each branch represents the
outcome of the test, and each leaf node represents a class label (decision taken after
computing all attributes).
Suppose the following example:
Decision Tree for SEC (in $ millions)
Name: Randrianantenaina Solohery Mampionona Aime
NIM: 041924353041

Assume tests have been successful (75 percent probability), refer to Table 7.1: if full-scale
production’s cost is $1,500million, it will generate annual cash flow of $900million for 5
years,
So the NPV is:
5
NPV $ 900
= -$1,500+∑
t =1 1.15t
=−$1,500+$900×PVIFA15%,5
=$1,518
NPV>0, lead to full-scale production
Assume tests have not been successful (25 percent probability), here, SEC’s $1,500 million
investment would produce an NPV of −$3,611 million, calculated as of Year 1. NPV<0, SEC
won’t need full-scale production.
Decision on marketing tests. We now want to figure out whether SEC should invest $100
million for the test marketing costs in the first place. The expected payoff evaluated at year 1:
Expected payeoff= (Probability of success × Payoff if successful) + (Probability of failure × Payoff if
failure)
=(0.75×$1,518)+(0.25×$0)= $1,139
And the NPV of testing computed at Year 0 (in millions) is:
NPV=−$100+($1,139/1.15)= $890
NPV>0, the firm should test the market for solar-powered jet engines.