Chapter 9
RISK ANALYSIS, REAL OPTIONS, AND CAPITAL BUDGETING
Copyright 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
9-1
KEY CONCEPTS AND SKILLS
Grasp and execute decision trees
Apply scenario and sensitivity analysis
Comprehend and utilize the various forms of
break-even analysis
Conceptualize Monte Carlo simulation
Practically apply real options in capital budgeting
9-2
CHAPTER OUTLINE
9.1 Decision Trees
9.2 Sensitivity Analysis, Scenario
Analysis, and Break-Even
Analysis
9.3 Monte Carlo Simulation
9.4 Real Options
9-3
9.1 DECISION TREES
Graphical representation of the
alternatives available in each
period and the likely
consequences of our choices
This graphical representation
helps identify the best course of
action.
9-4
EXAMPLE OF A DECISION TREE
Squares represent decisions to be made.
A
Study
finance
Circles represent
receipt of information,
e.g., a test score.
B
C
Do not
study
The lines leading away
from the squares
D represent the alternatives.
F
9-5
STEWART PHARMACEUTICALS
Stewart Pharmaceuticals Corporation is considering
investing in the development of a drug that cures the
common cold.
A corporate planning group, including representatives
from production, marketing, and engineering, has
recommended that the firm go ahead with the test and
development phase.
This preliminary phase will last one year and cost $1
billion. Furthermore, the group believes that there is a
60% chance that tests will prove successful.
If the initial tests are successful, Stewart
Pharmaceuticals can go ahead with full-scale
production. This investment phase will cost $1.6
billion. Production will occur over the following 4 years.
9-6
,5
$
1
5
8
N
P
V
$314,60.7
(.0)
NPV FOLLOWING SUCCESSFUL TEST
Investment
Revenues
Variable Costs
Fixed Costs
Depreciation
Pretax profit
Tax (34%)
Net Profit
Cash Flow
Year 1
-$1,600
Years 2-5
$7,000
(3,000)
(1,800)
(400)
$1,800
(612)
$1,188
$1,588
4
1t
1t
Note that the NPV is
calculated as of date 1,
the date at which the
investment of $1,600
million is made. Later we
bring this number back to
date 0. Assume a cost of
capital of 10%.
9-7
.
$
4
7
5
9
0
N
P
V
$19,6.04
(1)
NPV FOLLOWING UNSUCCESSFUL
TEST
Investment
Revenues
Variable Costs
Fixed Costs
Depreciation
Pretax profit
Tax (34%)
Net Profit
Cash Flow
Year 1
-$1,600
Years 2-5
$4,050
(1,735)
(1,800)
(400)
$115
(39.10)
$75.90
$475.90
4
1t
1t
Note that the NPV is
calculated as of date
1, the date at which
the investment of
$1,600 million is
made. Later we
bring this number
back to date 0.
Assume a cost of
capital of 10%.
9-8
N
P
V
$0
DECISION TREE FOR STEWART
Invest
The firm has two decisions to make:
To test or not to test.
Success
To invest or not to invest.
Test
NPV = $3.4 b
Do not
invest
NPV = $0
Failure
Do not
test
Invest
NPV = $91.46 m
9-9
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DECISION TO TEST
Lets move back to the first stage, where the decision
boils down to the simple question: should we invest?
The expected payoff evaluated at date 1 is:
The NPV evaluated at date 0 is:
So, we should test.
9-10
9.2 SENSITIVITY, SCENARIO, AND
BREAK-EVEN
Sensitivity Analysis:
Also called What if analysis
Allows the calculation of a range of NPVs
based on the probability of changes in NPV
variables
TIP: When working with spreadsheets:
build the model so variables can be adjusted in
a single cell;
And the NPV calculations update automatically.
9-11
,V1038$.
$
6
$4,7,0
%
eN
R
vP
.34.18
1
4
2
9
%
75
7
1
5492.71%
SENSITIVITY ANALYSIS: STEWART
We can see that NPV is very sensitive to changes in
revenues. In the Stewart Pharmaceuticals example, a
14% drop in revenue leads to a 61% drop in NPV.
For every 1% drop in revenue, we can expect
roughly a 4.18% drop in NPV:
9-12
SCENARIO ANALYSIS: STEWART
A variation on sensitivity analysis is scenario
analysis.
For example, the following three scenarios
could apply to Stewart Pharmaceuticals:
1. The next years each have heavy cold seasons,
and sales exceed expectations, but labor costs
skyrocket.
2. The next years are normal, and sales meet
expectations.
3. The next years each have lighter than normal
cold seasons, so sales fail to meet expectations.
Other scenarios could apply to FDA approval.
For each scenario, calculate the NPV.
9-13
BREAK-EVEN ANALYSIS
Common tool for analyzing the relationship
between sales volume and profitability
There are three common break-even
measures
Accounting break-even: sales volume at which net
income = 0
Cash break-even: sales volume at which operating cash
flow = 0
Financial break-even: sales volume at which net present
value = 0
This discussion is most concerned with
financial break-even
9-14
BREAK-EVEN ANALYSIS: STEWART
In the Stewart Pharmaceuticals example,
there could be concern with break-even
revenue, break-even sales volume, or
break-even price.
To find any of these, we start with the
break-even operating cash flow.
9-15
BREAK-EVEN ANALYSIS: STEWART
The project requires an
investment of $1,600.
In order to cover our
cost of capital (financial
break even), the project
needs to generate a
cash flow of $504.75
each year for four years.
This is the projects
break-even operating
cash flow, OCFBE.
I/Y
10
PV
1,600
PMT
FV
504.75
9-16
BREAK-EVEN REVENUE: STEWART
Work backwards from OCFBE to Break-Even Revenue
Revenue
Variable cost
Fixed cost
Depreciation
EBIT
$104.75
Tax (34%)
0.66
Net Income
OCF = $104.75 + $400
+ VC
+D
+FC
$5,358.71
$3,000
$1,800
$400
$158.71
$53.96
$104.75
$504.75
9-17
BREAK-EVEN ANALYSIS: PBE
Now that we have break-even revenue of
$5,358.71 million, we can calculate breakeven price.
The original plan was to generate revenues of
$7 billion by selling the cold cure at $10 per
dose and selling 700 million doses per year,
We can reach break-even revenue with a
price of only:
$5,358.71 million = 700 million PBE
PBE =
$5,358.71
700
= $7.66 / dose
9-18
9.3 MONTE CARLO SIMULATION
Monte Carlo simulation is a
further attempt to model realworld uncertainty.
Approach takes its name from
the famous European casino
Analyzes projects the way one might analyze
gambling strategies.
9-19
MONTE CARLO SIMULATION
Imagine a serious blackjack player who
wants to know if she should take the third
card whenever her first two cards total
sixteen.
She could play thousands of hands for real
money to find out.
This could be hazardous to her wealth.
Or, she could play thousands of practice
hands.
Monte Carlo simulation of capital
budgeting projects is in this spirit.
9-20
MONTE CARLO SIMULATION
Monte Carlo simulation of capital budgeting
projects
Highly probabilistic; seen as a step beyond either
sensitivity analysis or scenario analysis.
Interactions between the variables are
explicitly specified in Monte Carlo simulation.
Theoretically provides a more complete analysis.
Pharmaceutical industry has pioneered
applications of this methodology
Use in other industries is far from widespread.
9-21
9.4 REAL OPTIONS
One of the fundamental insights of modern
finance theory is that options have value.
The phrase We are out of options is surely a
sign of trouble.
Corporations make decisions in a dynamic
environment
Choice of options should be considered in project
valuation.
9-22
REAL OPTIONS
The Option to Expand
Has value if demand turns out to be higher than
expected
The Option to Abandon
Has value if demand turns out to be lower than expected
The Option to Delay
Has value if the underlying variables are changing with a
favorable trend
9-23
DISCOUNTED CF AND OPTIONS
We can calculate the market value of a project as the
sum of the NPV of the project without options and the
value of the managerial options implicit in the project.
M = NPV + Opt
A good example would be comparing the
desirability of a specialized machine versus a
more versatile machine. If they both cost about
the same and last the same amount of time, the
more versatile machine is more valuable because
it comes with options.
9-24
THE OPTION TO ABANDON: EXAMPLE
Suppose we are drilling an oil well. The drilling
rig costs $300 today, and in one year the well is
either a success or a failure.
The outcomes are equally likely. The discount
rate is 10%.
The PV of the successful payoff at time one is
$575.
The PV of the unsuccessful payoff at time one is
$0.
9-25
THE OPTION TO ABANDON: EXAMPLE
Traditional NPV analysis would indicate rejection of the project.
Expected = Prob. Successful + Prob. Failure
Payoff
Success Payoff
Failure Payoff
Expected
= (0.50$575) + (0.50$0) = $287.50
Payoff
NPV = $300 +
$287.50
= $38.64
1.10
9-26
$30N
P
V
$0
THE OPTION TO ABANDON: EXAMPLE
Traditional NPV analysis overlooks the option to abandon.
Success: PV = $575
Sit on rig; stare
at empty hole:
PV = $0.
Drill
Failure
Do not
drill
Sell the rig;
salvage value
= $250
The firm has two decisions to make: drill or not, abandon or stay.
9-27
THE OPTION TO ABANDON: EXAMPLE
When we include the value of the option to abandon,
the drilling project should proceed:
Expected = Prob. Successful + Prob. Failure
Payoff
Success Payoff
Failure Payoff
Expected
= (0.50$575) + (0.50$250) = $412.50
Payoff
NPV = $300 +
$412.50
= $75.00
1.10
9-28
VALUING THE OPTION TO ABANDON
Recall that we can calculate the market
value of a project as the sum of the NPV of
the project without options and the value
of the managerial options implicit in the
project.
M = NPV + Opt
$75.00 = $38.64 + Opt
$75.00 + $38.64 = Opt
Opt = $113.64
9-29
$6,529($17.,90)2
THE OPTION TO DELAY: EXAMPLE
Consider the above project, which can be undertaken in
any of the next 4 years. The discount rate is 10 percent.
The present value of the benefits at the time the project
is launched remains constant at $25,000, but since costs
are declining, the NPV at the time of launch steadily
rises.
The best time to launch the project is in year 2this
schedule yields the highest NPV when judged today.
9-30
QUICK QUIZ
What information does a decision tree provide?
What are sensitivity analysis, scenario analysis,
break-even analysis, and simulation?
Why are these analyses important, and how
should they be used?
How do real options affect the value of capital
projects?
9-31
