Strategy and Analysis in Using NPV (Chapter 8)

1. Strategy and Analysis in Using NPV (Chapter 8) Financial Policy and Planning MB 29

2. Outline • Corporate Strategy and NPV • Sensitivity Analysis • Scenario Analysis • Breakeven Analysis • Decision Trees

3. Corporate Strategy and NPV • Until now our assumption was that managers are handed unbiased cash flow forecasts and their only task is to assess risks, choose the discount rates, and compute net present value. • Actual financial managers would not rest until they understand what makes the project tick and what could go wrong with it.

4. Even if the project’s risk is wholly diversified, we still need to understand why the venture could fail. • Once we know this, we can decide whether it is worth trying to resolve the uncertainty. If the project really has a negative NPV, the sooner you can identify it, the better.

5. And even if the manager decides that it is worth going ahead on the basis of present information, the manager does not want to be caught by surprise if things subsequently go wrong. • Managers want to know the danger signals and the actions they might take. • Solution—conduct project analysis

6. How to do project analysis? –use any or all of the following techniques • Sensitivity Analysis • Scenario Analysis • Break Even Analysis • Decision Trees

7. Sensitivity Analysis • The manager considers in turn each of the determinants of the project’s success and • estimates how far the present value of the project would be altered by taking a very optimistic and pessimistic view of that variable. • If a small change in one variable (holding all other variables constant) causes a big change in the NPV, then • the project is highly sensitive to that particular variable and must be analyzed carefully.

8. Sensitivity Analysis Contd… • Boils down to expressing cash flows in terms of unknown variables and then calculating the consequences of misestimating the variables. • However, sometimes gives ambiguous results. • Through pessimistic and optimistic outlook, subjectivity is introduced in decision-making. • Underlying variables are likely to be interrelated. • If the market size exceeds expectations, it is likely that demand will be stronger than you anticipated and unit prices will be higher. • If inflation pushes prices higher, costs will also go up.

9. Scenario Analysis • If the variables are interrelated, it may help to consider some alternative plausible combinations—different scenarios • In scenario analysis, interdependence among variables is recognized and more than one variables is allowed to change to construct a whole new different scenario.

10. For instance, suppose an electric car manufacturing company’s economist is worried about the possibility of another sharp increase in world oil prices. • The direct effect of this would be to encourage the use of electrically powered cars. • The popularity of compacts after the oil price increase in the 1970s leads you to estimate that an immediate 20 percent rise in oil prices would enable you to capture an extra 0.3 percent of the automobile market.

11. On the other hand, higher oil prices would prompt a world recession and at the same time stimulate inflation. This would cause the overall car market size to decline and both prices and costs would go up by 15%. • On the basis of this information, you can construct a whole different scenario and compute a new NPV.

12. Breakeven Analysis • When we undertake a sensitivity analysis of a project or when we look at alternative scenarios, we are asking how serious would it get before sales or costs turned out to be worse than we forecasted. • Another way of looking at the same problem is: How bad sales can get before the project begins to lose money. This exercise is known as breakeven analysis. • EAC +{Fixed Costs × ( 1- Tc)} – (Depreciation × Tc) BEP = --------------------------------------------------- (Sales Price – Variable Costs) ×(1 – Tc) Tc is the corporate tax rate

13. Decision Trees • Decision problems involving a reasonable number of alternative actions and states of nature can be analyzed using decision trees • Decision trees are more useful for analyzing projects that involve sequential decisions. • Example of Decision Trees: • The scientists at a company have come up with an electric mop and the firm is ready to go ahead with pilot production and test marketing. The preliminary phase will take a year and will cost $125,000. Management feels that there is only 50 percent chance that the pilot production and market tests will be successful. If they are, then the firm will build a $1 million plant, which will generate an expected annual cash flow in perpetuity of $250,000 a year after taxes. If they are not successful, the company will not continue with the project. The company could go ahead even if the tests fail. In that case, the $1 million investment would generate only $75,000 per year.

14. NPV = -1,000 + (250/0.10) = +$1,500 million Invest $1,000 million For full Scale Production Success 0.5 Do not Invest NPV = 0 Failure 0.5 Invest $1,000 million for full scale production NPV = -$250 million Test Invest $125 million Do not Invest NPV = 0 Do not Test Should we invest $125,000 now to obtain a 50% chance of Getting an NPV of $1,5 million and 50% chance of getting An NPV of -$250,000 a year later?