Risk Analysis and Capital

Budgeting

McGraw-Hill/Irwin Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
Sequential Decision
 An approach to reduce risk in capital
budgeting
 Decisions are made stage by stage
 Eg: develop a prototype, test the market, then
consider bigger investment
 Overcome large losses

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7.4 Decision Trees
 Allow us to graphically represent the
alternatives available to us in each period and
the likely consequences of our actions
 This graphical representation helps to identify
the best course of action.
 Helpful to evaluate sequential decision and
real options

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 Example of a Decision Tree
Squares represent decisions to be made. Circles represent
“A” receipt of information,
e.g., a test score.
Study “B”
finance

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

“F” 7-4
7.1 Sensitivity and Scenario Analysis
 Allow us to look behind the NPV
number to see how stable our estimates
are.
 Enable us to assess the risk of the project
 Improve our estimate of expected NPV

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Example: Stewart Pharmaceuticals
 Stewart Pharmaceuticals Corporation is considering investing in
the development of a drug that cures the common cold.
 A corporate planning group, including representatives from
production, marketing, and engineering, has recommended that
the firm go ahead with the test and development phase.
 This preliminary phase will last one year and cost $1 billion.
Furthermore, the group believes that there is a 60% chance that
tests will prove successful.
 If the initial tests are successful, Stewart Pharmaceuticals can go
ahead with full-scale production. This investment phase will cost
$1.6 billion. Production will occur over the following 4 years.

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 Decision Tree for Stewart
Invest
The firm has two decisions to make:
NPV = $3.4 b
To test or not to test.
Success
To invest or not to invest.
Do not
Test invest
NPV = $0

Failure

Do not
test
NPV  $ 0 Invest
NPV = –$91.46 m 7-7
 NPV Following Successful Test
Investment Year 1 Years 2-5 Note that the NPV is calculated
as of date 1, the date at which
Revenues $7,000 the investment of $1,600 million
is made. Later we bring this
Variable Costs (3,000) number back to date 0. Assume
a cost of capital of 10%.
Fixed Costs (1,800)
Depreciation (400)
Pretax profit $1,800
4
Tax (34%) (612) $1,588
NPV 1  $1,600  
t 1 (1.10) t
Net Profit $1,188 NPV 1  $3,433.75
Cash Flow -$1,600 $1,588
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 NPV Following Unsuccessful Test
Investment Year 1 Years 2-5 Note that the NPV is
calculated as of date 1,
Revenues $4,050 the date at which the
investment of $1,600
Variable Costs (1,735) million is made. Later
we bring this number
Fixed Costs (1,800) back to date 0. Assume
a cost of capital of 10%.
Depreciation (400)
Pretax profit $115 4
$475.90
NPV 1  $1,600  
Tax (34%) (39.10) t 1 (1.10) t
Net Profit $75.90 NPV 1  $91.461

Cash Flow -$1,600 $475.90

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Decision to Test
 Let’s move back to the first stage, where the decision boils down to
the simple question: should we invest?
 The expected payoff evaluated at date 1 is:

Expected  Prob. Payoff   Prob. Payoff 

       
payoff  sucess given success   failure given failure 
Expected
  .60  $3,433.75    .40  $0   $2,060.25
payoff
The NPV evaluated at date 0 is:
$2,060.25
NPV  $1,000   $872.95
1.10
So, we should test.
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Sensitivity Analysis
 ‘what-if-analysis’
 Examine how sensitive a particular NPV calculation to
changes in underlying factors (such as market share, variable
costs, discount rate)
 Underlying factors for revenue
- market share
- market size
- price
 Underlying factor for cost
- variable costs
- fixed cost

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Sensitivity Analysis: Stewart
 We can see that NPV is very sensitive to changes in revenues.
In the Stewart Pharmaceuticals example, a 14% drop in
revenue leads to a 61% drop in NPV.
$6,000  $7,000
% Rev   14.29%
$7,000
$1,341.64  $3,433.75
% NPV   60.93%
$3,433.75
For every 1% drop in revenue, we can expect roughly a
4.26% drop in NPV:
 60.93%
 4.26 
14.29%

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Scenario Analysis: Stewart
 A variation on sensitivity analysis is scenario analysis.
 For example, the following three scenarios could apply
to Stewart Pharmaceuticals:
1. The next few years each have heavy cold seasons, and
sales exceed expectations, but labor costs skyrocket.
2. The next few years are normal, and sales meet
expectations.
3. The next few years each have lighter than normal cold
seasons, so sales fail to meet expectations.
 Other scenarios could apply to FDA approval.
 For each scenario, calculate the NPV.
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7.2 Monte Carlo Simulation
 Monte Carlo simulation is a further
attempt to model real-world uncertainty.
 This approach takes its name from the
famous European casino, because it
analyzes projects the way one might
evaluate gambling strategies.

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Monte Carlo Simulation
 Monte Carlo simulation of capital budgeting projects is
often viewed as a step beyond either sensitivity analysis
or scenario analysis.
 Interactions between the variables are explicitly
specified in Monte Carlo simulation; so, at least
theoretically, this methodology provides a more
complete analysis.
 While the pharmaceutical industry has pioneered
applications of this methodology, its use in other
industries is far from widespread.

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Monte Carlo Simulation
 Step 1: Specify the Basic Model
 Step 2: Specify a Distribution for Each
Variable in the Model
 Step 3: The Computer Draws One Outcome
 Step 4: Repeat the Procedure
 Step 5: Calculate NPV

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Break-Even Analysis
 Common tool for analyzing the relationship
between sales volume and profitability
 There are two common break-even measures
 Accounting break-even: sales volume at which
net income = 0
 Financial break-even: sales volume at which net
present value = 0

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Accounting Break-Even Analysis
 Costs are classified into fixed cost (FC)
(which include depreciation) and variable cost
per unit (VC)
 Operating profit = 0
 [Q*(P – VC) – FC] (1- T) = 0
 Q*(P - VC) = FC
 Total contribution margin = total fixed cost

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Financial Break-even
 NPV = O
 Annual Net Cash flow = 0
 Total contribution margin after tax = total
fixed cash outflow
 Q(P-VC)(1-T) = FC (1- T) – T (D) + EAC
 Where EAC = equivalent annual cost of the
investment
 EAC = IO/PVIFAr,n
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Financial Break-even
 NPV = 0
 ACF * PVIFAr,n = IO
 [Q(P - VC)(1-T) – FC (T) + D (T)] PVIFAr,n =
IO
 Q(P-VC)(1-T) = FC (1- T) – T (D) + EAC

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Break-Even Analysis: Example
 Sigma has purchased a new machine for RM2,000,000
to produce a new type of mixer. The machine has an
economic life of five years over which it will be
depreciated based on the straight line method. The sale
price per unit of mixer is RM400, the variable cost is
RM60 and the fix cost is RM750,000. Assume a tax
rate of 28% and a discount rate of 10%, calculate the
present value breakeven point.
 Answer: 3904 unit

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