Corporate Finance

Chapter 8

Risk Analysis, Real Options and

Capital Budgeting
Overview of Lecture
Real Options in the News

[Optional slide for inserting your own topical

news story]
Sensitivity Analysis

Solar Electronics (SE) has recently developed a solar-

powered jet engine and wants to go ahead with full-scale
production. The initial (year 1) investment is £1,500 million,
followed by production and sales over the next five years.
The projected cash flows are on the next slide.
 Sensitivity Analysis

Year 1 Years 2–6

Revenues £6,000
Variable costs 3,000
Fixed costs 1,791
Depreciation 300
Pretax profit 909
Tax (tc = 0.28) 255
Net profit £ 654
Cash flow £ 954
Initial investment costs £1,500
Sensitivity Analysis

Revenues:

Number of jet engines = Market share  Size of jet engine

sold per year market per year

3,000 0.30  10,000

=
Annual sales = Number of jet  Price per
revenues engines sold engine
£6,000 million = 3,000  £2 million
Sensitivity Analysis
Sensitivity Analysis

Costs:
Variable Variable cost Number of jet engines
 
cost per year per unit sold per year
£3,000 million  £1 million  3,000
Total cost before Variable cost
  Fixed cost per year
taxes per year per unit
£
£4,791 million  £3,000 million  1,791 million
Sensitivity Analysis
Scenarios:
Variable Pessimistic Expected or Best Optimistic

Market size (per year) 5,000 10,000 20,000

Market share 20% 30% 50%

Price £1.9 million £2 million £2.2 million

Variable cost (per engine) £1.2 million £1 million £0.8 million

Fixed cost (per year) £1,891 million £1,791 million £1,741 million

Investment £1,900 million £1,500 million £1,000 million

Sensitivity Analysis

NPV Calculations:
Pessimistic Expected or Best Optimistic
Market size -£1,921* £1,700 £8,940
Market share  714* 1,700 6,527
Price 975 1,700 3,148
Variable cost 251 1,700 3,148
Fixed cost 1,458 1,700 1,820
Investment 1,300 1,700 2,200
Under sensitivity analysis, one input is varied while all other inputs are assumed to
meet their expectation. For example, an NPV of  £1,921 occurs when the
pessimistic forecast of 5,000 is used for market size, while all other variables are
set at their expected forecasts from Table 8.2.
What Does Sensitivity Analysis Tell Us?
Weaknesses of Sensitivity Analysis
Scenario Analysis
 Example of a Scenario Analysis:
A Plane Crash
 Example of a Scenario Analysis: A
Plane Crash

Year 1 Years 2–5

Revenues £2,800
Variable costs 1,400
Fixed costs 1,791
Depreciation 300
Pretax profit 691
193
=
Tax (tc 0.28)†
Net profit £498
Cash flow £198
Initial investment cost £1,500
 Example of a Scenario Analysis:
A Plane Crash

NPV:

5
£2,162  £1,500  £198  A 0.15
Break Even Analysis
Break Even Analysis: Accounting Profit

Year 1 Years 2-6

Initial Annual
Invest- Unit Variable Fixed
ment Sales Revenues Costs Costs
£1,500 0 £   0 £    0 £1,791
1,500 1,000 2,000 1,000 1,791
1,500 3,000 6,000 3,000 1,791
1,500 10,000 20,000 10,000 1,791

Years 2–6
Operating NPV
Depreci- Taxes* Net Cash (evaluated
ation (tc = 0.28) Profit Flows date 1)
£300 £ 585 £1,506 £1,206 £ 5,541
300 305 786 486 3,128
300 255 654 954 1,700
300 2,215 5,694 5,994 18,594
Break Even Analysis: Accounting Profit
Calculating the Accounting Break Even Point

Fixed costs + Depreciation £2, 091 million

  2, 091
Sales price  Variable costs £1 million
Break Even Analysis: Present Value
Calculating the Present Value Break Even Point

EAC + Fixed costs  (1  tc )  Depreciation  tc

(Sales price  Variable costs)  (1  tc )
£1,653 million
  2,296
£.72 million
Break Even Analysis Overview
Monte Carlo Simulation
Monte Carlo Simulation
Monte Carlo Simulation Example

Backyard Barbeques (BB), a manufacturer of

both charcoal and gas grills, has a blueprint
for a new grill that cooks with compressed
hydrogen. The CFO, Edward H. Comiskey,
being dissatisfied with simpler capital
budgeting techniques, wants a Monte Carlo
simulation for this new grill.
Monte Carlo Simulation Example

Step 1: Specify the Basic Model

Number of grills sold Market share of BB's Price per
Revenue =  
by entire industry hydrogen grill (in percent) hydrogen grill

Costs = Fixed manufacturing costs  Variable manufacturing costs

 Marketing costs  Selling costs
Initial investment =
Cost of patent + Test marketing costs + Cost of production
facility
Monte Carlo Simulation Example

Step 2: Specify a distribution for each variable

Monte Carlo Simulation Example

Step 2: Specify a distribution for each variable

Monte Carlo Simulation Example

Step 2: Specify a distribution for each variable

Monte Carlo Simulation Example

Step 3: The computer draws one outcome

Imagine that the computer randomly picks industry-wide unit
sales of 10 million, a market share for BBI’s hydrogen grill
of 2 percent, and a +€3 random price variation.
Grill price is €190 + €10 + €3 = €203
Next year’s revenue for BB’s hydrogen grill will be:
10 million  0.02  €203 = €40.6 million
Do the same for all future cash flows
Monte Carlo Simulation Example

Step 4: Repeat the Procedure

Monte Carlo Simulation Example

Step 5: Calculate NPV

For all generated cash flow combinations, calculate NPV and
determine the NPV distribution
Real Options
Real Options: The Option to Expand

Conrad Willig, an entrepreneur, recently learned of a chemical

treatment causing water to freeze at 20 degrees Celsius rather
than 0 degrees.
Mr. Willig liked the idea of hotels made of ice more than anything
else.
Annual cash flows from 1 ice hotel = £2 million, based on an
initial investment of £12 million.
Discount rate = 20 percent and cash flows are perpetual.
What is the NPV?
£12,000,000 + £2,000,000/0.20 = £2 million
Real Options: The Option to Expand

While Conrad was pretty sure that the initial investment would cost
£12 million, there was some uncertainty concerning annual cash
flows.
His cash flow estimate of £2 million per year actually reflected his
belief that there was a 50 percent probability that annual cash
flows will be £3 million and a 50 percent probability that annual
cash flows will be £1 million.
Optimistic forecast:
£12 million + £3 million/0.20 = £3 million
Pessimistic forecast:
£12 million + £1 million/0.20 =  £7 million
Real Options: The Option to Expand
Real Options: The Option to Expand
Real Options: The Option to Abandon

Imagine that Mr. Willig now believes that there is a 50 percent

probability that annual cash flows will be £6 million and a 50
percent probability that annual cash flows will be £2 million.
NPV:
Optimistic forecast:
£12 million + £6 million/0.2 = £18 million
Pessimistic forecast:
£12 million  £2 million/0.2 =  £22 million
50%  £18 million + 50%  (£22 million) =  £2 million
Real Options: The Option to Abandon
 Real Options: The Option to
Abandon in the Movie Industry
Real Options: Timing
Decision Trees
Overview of Lecture
Activities for This Lecture
Thank You