Things to Absorb, Read, Do

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1 McGraw-Hill/Irwin Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Things to Absorb, Read, Do Need to Absorb - There are three important areas in this chapter; decision trees, sensitivity/ scenario analysis, and real options. Decision trees, are a form of weighted average, that represents a method of viewing sequential decisions. Sensitivity/ Scenario analysis examines how sensitive a project s NPV is to changes in the underlying assumptions. You should learn to spot and describe real options such as the option to expand, the option to abandon, and the timing (a.k.a., wait and learn) option. Need to Read - Read the Chapter. Need to Do - Remember your Capital Budgeting Methods and Cash Flows from BA 530 Download my handout on real options. Make 100 on the quiz. Answer end-of-chapter Questions and Problems 1-14, and Project Analysis Capital Budget Chapters 8 and 9 develop a framework for project analysis. This chapter analyzes the robustness of a project s value by asking some What If Questions. Capital Budget A list of planned investment projects. If you cannot remember Capital Budgeting method and cash flows, go back and look at your BA 530 notes

2 What-if Testing Sensitivity Analysis - Analysis of the effects on project profitability of changes in sales, costs, etc. Scenario Analysis 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 at which the company breaks even. Option: Valued as a: wait & learn more before call investing (timing) default during construction a series of put options (staged investment) alter operating scale (expand, call restart, increase prices) alter operating scale (contract, put shut down, decrease prices) abandon put switch inputs or outputs call + put grow and build-on previous call investments Contact Information Professor: Charles Hodges Webpage: D2L Phone: (678) , (770) D2L and [email protected] Office: Not Applicable Office Hours:Not Applicable Capital Budgeting: The Decision Process 1. Stage 1: The Capital Budget 2. Stage 2: Project Authorization Outlays required by law or company policy Maintenance or cost reduction Capacity expansion in existing business Investment for new products

3 Potential Capital Budgeting Problems Ensuring forecasts are consistent Eliminating conflicts of interest Reducing forecast bias Proper selection criteria (NPV and others) What-if Testing Sensitivity Analysis - Analysis of the effects on project profitability of changes in sales, costs, etc. Scenario Analysis 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 at which the company breaks even Sensitivity Analysis Analysis of the effects on project profitability of changes in sales, costs, etc. Why is sensitivity analysis useful? Sensitivity Analysis - Example Base Case: Expected cash flows from a new project (with 8% Opportunity Cost of Capital; 40% average tax rate; variable costs are a constant 80% of sales; all numbers in $000s) Calculate: NPV = $1, IRR = 12.7% Payback Period = 6 years Profitability Index =

4 Sensitivity Analysis - Example Possible Range of Variables Sensitivity Analysis: Changing Sales (with 8% Opportunity Cost of Capital; 40% average tax rate; variable costs are a constant 80% of sales; all numbers in $000s) Pessimistic Case Sales = $14,000 Optimistic Case Sales = $18, NPV = -$426 NPV = $3, Sensitivity Analysis: Changing Fixed Costs (with 8% Opportunity Cost of Capital; 40% average tax rate; variable costs are a constant 80% of sales; all numbers in $000s) Pessimistic Case Fixed Costs = $2,500 Optimistic Case Fixed Costs = $1,500 Limits to Sensitivity Analysis Ambiguous How do you consistently define optimistic or pessimistic? Interrelatedness of variables NPV = -$878 NPV = $3,

5 Scenario Analysis Scenario Analysis Project analysis given a particular combination of assumptions. Why is it useful? Scenario Analysis: Introducing Competition Assume that it will take two years for competition to enter the market. At this time, sales drop 10% and variable costs increase to 82% (increased labor demand). What happens to NPV under this scenario? Base Case No Competition Scenario Introduce Competition 14,400 Simulation Analysis Estimation of the probabilities of different possible outcomes, e.g., from an investment project. Why is it useful? NPV = $1,382 NPV = -$ Contact Information Professor: Charles Hodges Webpage: D2L Phone: (678) , (770) D2L and [email protected] Office: Not Applicable Office Hours:Not Applicable Break-Even Analysis Break-Even Analysis - Analysis of the level of sales at which the project breaks even. Why is this useful?

6 Break-Even Analysis Example (with 8% Opportunity Cost of Capital; 40% average tax rate; variable costs are a constant 80% of sales; all numbers in $000s) Break-Even Point: Accounting Break-Even Point (Accounting) - The break-even point is the number of units sold where net profits = $0. -Determine the number of units that must be sold in order to break even, on an NPV basis. -Suppose each unit has a price point of $45,000 -All other variables are at their base case levels What does the accounting break-even point not account for? Break-Even Point: Finance NPV Break-Even Point (Finance): How can we find the present value of future cash flows? As long as cash flows are equal each year, we can use the Annuity Factor (=Compute PV where FV=0, N=number of years, I=Interest rate, PMT=1) Break-Even Analysis Step 2, Recall: the break-even point is the number of units sold where NPV = $0, or where $5,400 in initial costs are recovered. Therefore 5,400 = 7.536*(5.4X-1020) =>5400 = X => =40.694X => Units. Solve for the annuity factor, FV=0, N=12, I=8, PMT=1, compute PV=PV Cash Flows = Therefore PV (Cash Flows) = 7.536*(5.4*X-1020)

7 Operating Leverage Operating Leverage - Degree to which costs are fixed. Degree of Operating Leverage (DOL) - Percentage change in profits given a 1% change in sales. Operating Leverage: Why is it useful? Degree of Operating Leverage: Example Real Options 1. Option to expand 2. Option to abandon 3. Timing option 4. Flexible production facilities

8 Option: Valued as a: wait & learn more before call investing default during construction a series of put options (staged investment) alter operating scale call (expand, restart) alter operating scale put (contract, shut down) abandon put switch inputs or outputs call + put grow and build-on previous call investments Identifying Real Options Type of option? Who is long? Who is short? Underlying Asset? Exercise Price? The number of people applying for Social Security at age 62 instead of waiting until age 65 is up by 25%. A person getting Social Security at age 62 draws about 30% less money than if one waits until age 65. The government is obligated to pay Social Security to anyone who is over 62 and has worked for at least 10 years in their lifetime Identifying Real Options The Federal Deposit Insurance Corporation insures deposits, up to $250,000 in banks. In 2008, many banks failed. No depositor has lost any money and no depositor has had to wait more than one week to get their money from a failed bank. However without insurance, the average depositor would have lost about 40% of their money and would have waited about one year. Describe the depositor s real option. A famous football coach, Bobby Bowden, did not have his contract renewed by Florida State University and was forced into retirement. Instead of receiving a $2.5 million dollar salary, Bobby Bowden received an immediate severance payment of $1 million. Identifying Real Options In Florida, there is a minimum mandatory prison sentence of 5 years for anyone using a gun in a robbery. Because of prison overcrowding, almost no one gets more than the minimum sentence. Danny, a Florida resident, was laid off from work after 30 years at age 59. Danny is now unemployed, hungry, has no insurance, and has lost his house to foreclosure. Danny finds a gun lying outside a convenience store. Same scenario as part B, with one extra fact. Robbing a Bank with a gun is a Federal (United States) crime that almost always produces a three-year sentence. Robbing a store is a Florida state crime. Federal prisons are of higher quality and have nicer locations than Florida state prisons. Danny must decide between robbing a convenience store or a Bank

9 Real Options & the Value of Flexibility Decision Trees Diagram of sequential decisions and possible outcomes. Decision Trees: Example Test New Product (Invest $200,000) Success Pursue project NPV=$2million Decision trees help companies determine their options by showing various choices and outcomes. The option to avoid a loss or produce extra profit has value. The ability to create an option has value that can be bought or sold. Don t Test New Product NPV=0 Failure Stop project NPV= Contact Information Professor: Charles Hodges Webpage: D2L Phone: (678) , (770) D2L and [email protected] Office: Not Applicable Office Hours:Not Applicable