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Chapter 10

Chapter 10. Principles of Corporate Finance, 8/e (Special Indian Edition). A project Is Not a Black Box. Topics Covered. Sensitivity Analysis Break Even Analysis Monte Carlo Simulation Real Options and Decision Trees. How To Handle Uncertainty.

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Chapter 10

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  1. Chapter 10 Principles of Corporate Finance, 8/e (Special Indian Edition) A project Is Not a Black Box

  2. Topics Covered • Sensitivity Analysis • Break Even Analysis • Monte Carlo Simulation • Real Options and Decision Trees

  3. How To Handle Uncertainty Sensitivity Analysis - Analysis of the effects of changes in sales, costs, etc. on a project. Scenario Analysis - Project analysis given a particular combination of assumptions. Simulation Analysis - Estimation of the probabilities of different possible outcomes. Break Even Analysis - Analysis of the level of sales (or other variable) at which the company breaks even.

  4. Sensitivity Analysis Example Given the expected cash flow forecasts for Otobai Company’s Motor Scooter project, listed on the next slide, determine the NPV of the project given changes in the cash flow components using a 10% cost of capital. Assume that all variables remain constant, except the one you are changing.

  5. Sensitivity Analysis Example - continued NPV= 3.43 billion Yen

  6. Sensitivity Analysis Example - continued Possible Outcomes

  7. Sensitivity Analysis Example - continued NPV Calculations for Optimistic Market Size Scenario NPV= +5.7 bil yen

  8. Sensitivity Analysis Example - continued NPV Possibilities (Billions Yen)

  9. Break Even Analysis • Point at which the NPV=0 is the break even point • Otobai Motors has a breakeven point of 85,000 units sold. PV Inflows 400 200 19.6 Break even NPV=0 PV (Yen) Billions PV Outflows Sales, 000’s 85 200

  10. Electric Scooter – NPV

  11. Electric Scooter - Assumptions

  12. Electric Scooter - Scenarios

  13. Electric Scooter – Accounting Profit

  14. Electric Scooter – Cash Flows

  15. Monte Carlo Simulation • Step 1: Modeling the Project • Step 2: Specifying Probabilities • Step 3: Simulate the Cash Flows Modeling Process

  16. Monte Carlo Simulation

  17. Flexibility & Real Options Decision Trees - Diagram of sequential decisions and possible outcomes. • Decision trees help companies determine their Options by showing the various choices and outcomes. • The Option to avoid a loss or produce extra profit has value. • The ability to create an Option thus has value that can be bought or sold.

  18. Decision Trees Success Test (Invest Rs.200,000) Pursue project NPV=Rs.2million Failure Stop project NPV=0 Don’t test NPV=0

  19. Real Options • Option to expand • Option to abandon • Timing option • Flexible production facilities

  20. Decision Trees 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) +150(.6) +30(.4) -550 NPV= ? Turboprop -150 +100(.6) +50(.4) or 0 -250 NPV= ? Piston

  21. Decision Trees 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) 812 456 660 364 148 +150(.6) +30(.4) -550 NPV= ? Turboprop -150 +100(.6) +50(.4) or 0 -250 NPV= ? Piston

  22. Decision Trees 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) 812 456 660 364 148 +150(.6) +30(.4) -550 NPV= ? Turboprop -150 +100(.6) +50(.4) or 0 -250 NPV= ? Piston

  23. Decision Trees 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) 812 456 660 364 148 +150(.6) +30(.4) -550 NPV= ? Turboprop *450 -150 +100(.6) +50(.4) or 0 331 -250 NPV= ? Piston

  24. Decision Trees 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) NPV=888.18 812 456 660 364 148 +150(.6) +30(.4) -550 NPV= ? NPV=444.55 Turboprop *450 -150 NPV=550.00 +100(.6) +50(.4) or 0 331 -250 NPV= ? NPV=184.55 Piston

  25. Decision Trees 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) NPV=888.18 812 456 660 364 148 +150(.6) 710.73 +30(.4) -550 NPV= ? NPV=444.55 Turboprop *450 -150 NPV=550.00 +100(.6) 403.82 +50(.4) or 0 331 -250 NPV= ? NPV=184.55 Piston

  26. Decision Trees 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) NPV=888.18 812 456 660 364 148 +150(.6) 710.73 +30(.4) Turboprop -550 NPV=96.12 NPV=444.55 *450 -150 NPV=550.00 +100(.6) 403.82 +50(.4) or Piston 0 331 -250 NPV=117.00 NPV=184.55

  27. Decision Trees 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) NPV=888.18 812 456 660 364 148 +150(.6) 710.73 +30(.4) Turboprop -550 NPV=96.12 NPV=444.55 *450 -150 NPV=550.00 +100(.6) 403.82 +50(.4) or Piston 0 331 -250 NPV=117.00 NPV=184.55

  28. Web Resources Web Links Click to access web sites Internet connection required www.jaxworks.com www.decisioneering.com www.kellogg.northwestern.edu/faculty/myerson

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