Lecture Three

Project Risk Analysis

Professor Paul Howe

Lecture Outline

• Uncertainty and Investment Analysis

– The Investment Process with Risky Cash Flows
• Example: The Earthilizer Proposal
• Sensitivity Analysis - Learning More about the
Project
– Scenario Analysis
– Breakeven Sensitivity Analysis
– Simulation Analysis
– Interpreting Simulation Results
– Reflections on the Use of Simulation
• Decision Trees—Valuing Project Flexibility
– Example—Decision Tree Analysis of the Abandonment
Option

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Introduction

• Investment decisions take place in a world of uncertain future

outcomes, where there are more things that can happen than will
happen, which makes investment analysis considerably more
complex.
• Project Risk Analysis Confronts Uncertainty
• Various approaches are used to analyze risk and deal with
uncertainty
– Scenario analysis, breakeven sensitivity analysis, and Monte Carlo
simulation
• Importance of Flexibility
– The role investment flexibility can have on expected cash flows
– The role that decision trees can play in organizing the analysis of
decision

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Evaluating new investment
opportunities: 2 Phases
Phase I
• Analyst tries to envision
the possible outcomes from
an investment
• Analyst prepares estimates
and forecast
– Analysis forms the basis
for estimating an expected
value for the investment
along with NPV, IRR, and
other measures of
investment worth
Phase II
• Analyst details underlying
sources of risk.
– Identify value drivers and
uncertainty
• Analyst seeks ways to
mitigate risks and monitors
throughout the life of the
project

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Uncertainty and Investment
Analysis
• Our focus is on project valuation
• Risk analysis tools apply to enterprise
valuation - the evaluation of acquisitions of
entire firms

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The Earthilizer Example

• CSM, Inc., is considering an investment in Earthilizer, a new

organic fertilizer made from dairy farm waste
• Developed by CSM’s ag-division over the past 3 years in response
to:
– growing demand from organic farmers
– More restrictions on the disposal of cattle manure
• Initial investment of $580K (250K WC + $330K PPE)
• Project will be “up and running” by the end of 2010, with first year
of revenues in 2011
• CSM financed from internally generated cash flows; project is all-
equity-financed
• Very promising investment opportunity
– Product has undergone extensive testing
– Product is wholly organic, and is cheaper than traditional applications

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Earthilizer FCFs “The Assumptions”
Cash flow calculations for 2011 to 2015 are based on:

• $580K initial investment at • Straight-line depreciation

the end of 2010 – PPE 10-year life
– $250K WC and $330 PPE – zero salvage value
• Sales $1million in 2011 • 30% tax rate
– growing 10% annually • 2011 - 2015 NWC
throughout the 5-year requirements = 25% of
planning period
Earthilizer’s sales
• COGS margin 67.4% • CAPEX $330K in 2010
• Operating expenses before – zero in all future years
depreciation are 10% of
• Project end = 2015
sales plus an annual fixed
$115K – Terminal cash flow:
$658,7701
1
Sum of NOPAT plus depreciation expense for 2015 ($128,020 + 33,000 = $161,020) plus the liquidating value (which is
expected to equal the book value) of the firm’s investment in net working capital ($366,030) and the book value of plant and
equipment at the end of 2012 ($165,000).

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Earthilizer Income Statement
Forecast

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Earthilizer Balance Sheet Forecast

Table 3.1 (cont)

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Earthilizer PFCF Forecast
Table 3.1 (cont)

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Earthilizer DCF Valuation
NPV and IRR Assessment
• Discounting the Cash Flows
– Discount rate for the Free Cash Flow forecast is 13.25%
– Present value of the expected project free cash flows to be
$623,070
• The Decision to Invest (or Not): Accept Project!
– NPV $623,070 exceeds the $580,000 initial cost
– IRR 15.36% exceeds the discount rate of 13.25%
• Since this is a risky project and things may not go exactly
as planned, CSM needs to learn more about the project to
get a better understanding of how confident we should be
about the NPV estimate

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Sensitivity Analysis - Learning More
about the Project
• Phase I is complete: We have an NPV estimate of
the Earthilizer investment
– How confident can we be that the project will unfold as
we expect?
– What are the key value drivers of the project that the
firm should monitor over the life of the investment to
ensure its success?
• In Phase II we use a variety of tools to address
these concerns
– scenario analysis, breakeven sensitivity analysis, and
simulation analysis

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Scenario Analysis
Sensitivity of an investment’s value under different situations:

• What would happen to • We could also analyze

the Earthilizer NPV if scenarios involving
we applied a multiple sets of
pessimistic estimate of changes in
the initial sales of assumptions and
$500,000? forecasts.
– DCF value drops to – Evaluate the project
$342,790 using optimistic and
– Negative-NPV pessimistic estimates
investment, for the value drivers

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Breakeven Sensitivity Analysis
What is the critical value of a particular value driver that pushes NPV to
zero?

• Variable (1): 6 key variables crucial to NPV were identified in the Earthilizer example
• Expected Value (2): Expected values for each of the value drivers that we used in our analysis of the
project’s expected NPV
• Critical Value (3): Critical or breakeven values for each of the value drivers that result in a zero NPV
for the project
• % Change (4): Compares the expected and critical values for these variables; it calculates the “%
Change” in each variable from its expected value required to produce a zero NPV

1
To perform this analysis we recommend use of the Goal Seek function in Excel under the tools menu (see technical insight box in the
text on page 61)
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Breakeven Sensitivity Analysis
What is the critical value of a particular value driver that pushes NPV to zero?”

• This analysis suggests that three variables are

particularly critical to the outcome of the
Earthilizer investment
• Very slight deviations from their expected value
have a significant impact on project NPV:
– gross profit margin (% ∆ for breakeven = -4.54%)
– operating expenses as % of sales (% ∆ for breakeven =
+14.80%)
– base-year sales for 2008 (% ∆ for breakeven = -7.68%).

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Breakeven Sensitivity Analysis
NPV breakeven analysis shows the critical importance of gross profit margin to
Earthilizer

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Limitations to Breakeven Sensitivity
Analysis
• Considers only one value driver at a time, while
holding all others equal to their expected values.
– This can produce misleading results if two or more of the
critical value drivers are correlated with one another.
• We don’t have any idea about the probabilities
associated with exceeding or dropping below the
breakeven value drivers.
• No formal way of incorporating consideration for
interrelationships among the variables.

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Simulation Analysis

• Monte Carlo simulation can help the

analyst evaluate what can happen to an
investment’s future cash flows and
summarize the possibilities in a probability1
– Outcomes from large projects are often the
result of the interaction of a number of
interrelated factors (or value drivers)
– Makes it difficult to determine the probability
distribution of a project’s cash flows

1
The term “Monte Carlo” as a form of simulation comes from the famous gambling casinos in Monaco. Gambling, in its pure
form, is of course based on the rules of chance or probability, as is simulation.
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Simulation Analysis

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Simulation Analysis

• Two principal tools for

adding simulation
capabilities to your
spreadsheet program:
– @Risk from the Palisade http://www.palisade.com/
Corporation
– Crystal Ball Professional http://www.crystalball.com/
Edition from Oracle

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Interpreting Simulation Results
The simulation uses 10,000 iterations to produce estimates of FCFs
distributions for 2010–2015
• The simulated distribution of FCFs for 2011 provides some interesting
insights into the prospects of the investment.
– There is substantial dispersion in the simulated cash flows for 2011, ranging from a
minimum of $29,140 up to a maximum of $161,760, with a mean value of $87,680. The
“Certainty” cell found at the bottom of the graph indicates that 99.47% of the total area
under the frequency distribution of FCFs lies above $0.00 (i.e., the simulated FCFs are
positive 99.47% of the time). Although we do not display them here, the FCF distributions
for the remaining years of the project exhibit similar characteristics to those described
above for 2011.
– From the simulated cash flows in each year, we calculate the mean or average cash flow
for each year from 2010 to 2015.

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Interpreting Simulation Results

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Interpreting Simulation Results

Figure 3.3 (cont)

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Interpreting Simulation Results

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Interpreting Simulation Results–
Tornado Diagram

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Reflections on the Use of Simulation

• Simulation models require deep

consideration about the underlying sources
of uncertainty that affect an investment’s
profits
– Requires explicit assumptions
– Benefits arise from the process and from the
actual output of the simulation

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Decision Trees—Valuing Project
Flexibility
• Most investment projects offer the firm
some flexibility on the inputs used and
final product produced
– Generate greater cash flows when market
demand is high; cut back on capacity when
market demand is low
• Options associated with investments

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Decision Trees—Valuing Project
Flexibility
• Decision trees are useful tools that illustrate the
degree of flexibility in a project’s implementation,
and how future decisions can affect values.
• They contains a number of nodes identified by
vertical lines, circles, and boxes.
– The vertical lines denote a terminal node that signals the
end of the decision process.
– The circles signify an event node that represents a point
where nature intervenes and something happens that is
subject to chance.

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Decision Trees—Valuing Project
Flexibility

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Example—Decision Tree Analysis of the
Abandonment Option

Modification of Earthilizer example:

• Assume CSM faces an EPA test of the runoff effects of
Earthilizer on groundwater.
– Scenario 1: At end of year 1 the EPA determines that the
project poses no hazard; grants approval, no effect on project
expected cash flows
– Scenario 2: EPA rules product detrimental; processing costs to
CSM of $80K per year (after taxes)
– CSM’s management “guesstimates” 20% chance for scenario 2
• Expected FCFs are equal to a weighted average of the
original cash flows and the revised cash flows
– Revised FCF2010 = .8 x $87,600 + (1 - .8)($87,600 - 80,000) = $71,600

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Example—Decision Tree Analysis of the
Abandonment Option
The risk of having to incur $80,000 in added costs results in negative
project NPV

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Example—Decision Tree Analysis of the
Abandonment Option

• If the EPA ruling is favorable, CSM will

want to operate the project.
– This alternative is highlighted and the inferior
alternative (abandoning) is struck out.
• If the EPA ruling is unfavorable, the
expected NPV of continuing operations is
($236,608).
– The NPV of abandoning the project is only
($167,108).

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Example—Decision Tree Analysis of the
Abandonment Option

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Example—Decision Tree Analysis of the
Abandonment Option
Table 3.4 (cont.)

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Summary of the Risk Analysis Process

• Determining the value of an investment opportunity is

straightforward when future cash flows are known
• Uncertainty complicates the valuation process
• Analysts can utilize three basic tools to assess the impact of
uncertainty on a project
– Scenario analysis, breakeven sensitivity analysis, and
simulation analysis
– All three tools provide information that the analyst can use to
understand the key factors that drive a project’s success or
failure
• Project flexibility allows firms to modify investments in
response to changing circumstances
– More on real options later!

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 Exhibit P3-4.1 (cont.)

Need updated 2/e

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