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1 Chaper Ouline CHAPTER 8 Sraegy and Analysis in Using Ne Presen Value 8.1 Decision Trees 8.2 Sensiiviy Analysis, Scenario Analysis, and Break-Even Analysis 8.3 Mone Carlo Simulaion 8. Opions 8.5 Summary and Conclusions Decision Trees Allow us o graphically represen he alernaives available o us in each period and he likely consequences of our acions. This graphical represenaion helps o idenify he bes course of acion. 8-3 Example of Decision Tree Squares represen decisions o be made. A Sudy finance sudy B C D Circles represen receip of informaion e.g. a es score. The lines leading away from he squares represen he alernaives. F 8- Sewar Pharmaceuicals The Sewar Pharmaceuicals Corporaion is considering invesing in developing a drug ha cures he common cold. A corporae planning group, including represenaives from producion, markeing, and engineering, has recommended ha he firm go ahead wih he es and developmen phase. This preliminary phase will las one year and cos $1 billion. Furhermore, he group believes ha here is a 60% chance ha ess will prove successful. If he iniial ess are successful, Sewar Pharmaceuicals can go ahead wih full-scale producion. This invesmen phase will cos $1.6 billion. Producion will occur over he nex years. 8-5 Sewar Pharmaceuicals NPV of Full-Scale Producion following Successful Tes Year 1 Years 2-5 $7,000 Variable Coss (3,000) Fixed Coss (1,800) Depreciaion (00) Preax profi $1,800 Tax (3%) (612) Ne Profi $1,188 Cash Flow -$1,600 $1,588 $1,588 NPV $1,600 + $3,33.75 () 1 Noe ha he NPV is calculaed as of dae 1, he dae a which he invesmen of $1,600 million is made. Laer we bring his number back o dae 0. 1

2 8-6 Sewar Pharmaceuicals NPV of Full-Scale Producion following Unsuccessful Tes Year 1 Years 2-5 $,050 Variable Coss (1,735) Fixed Coss (1,800) Depreciaion (00) Preax profi $115 Tax (3%) (39.10) Ne Profi $75.90 Cash Flow -$1,600 $75 Noe ha he NPV is calculaed as of dae 1, he dae a which he invesmen of $1,600 million is made. Laer we bring his number back o dae 0. $75.90 NPV $1,600 + $ () 8-7 Decision Tree for Sewar Pharmaceuical The firm has wo decisions o make: Inves To es or no o es. To inves or no o inves. NPV $3. b Success Tes es NPV $0 Failure inves NPV $0 NPV $91.6 m Inves 8-8 Sewar Pharmaceuical: Decision o Tes Le s move back o he firs sage, where he decision boils down o he simple quesion: should we inves? The expeced payoff evaluaed a dae 1 is: Prob. Prob. + payoff success given success failure given failure payoff (.60 $3,33.75) + (.0 $0) $2, The NPV evaluaed a dae 0 is: $2, NPV $ 1,000 + $ So we should es Sensiiviy Analysis, Scenario Analysis, and Break-Even Analysis Allows us o look he behind he NPV number o see firm our esimaes are. When working wih spreadshees, ry o build your model so ha you can jus adjus variables in one cell and have he NPV calculaions key o ha Sensiiviy Analysis: Sewar Pharmaceuicals 8-11 Scenario Analysis: Sewar Pharmaceuicals We can see ha NPV is very sensiive o changes in revenues. In he Sewar Pharmaceuicals example, a 1% drop in revenue leads o a 61% drop in NPV $6,000 $7,000 % Rev 1.29% $7,000 $1,31.6 $3,33.75 % NPV 60.93% $3,33.75 For every 1% drop in revenue we can expec roughly a.25% drop in NPV 60.93% % A variaion on sensiiviy analysis is scenario analysis. For example, he following hree scenarios could apply o Sewar Pharmaceuicals: 1. The nex years each have heavy cold seasons, and sales exceed expecaions, bu labor coss skyrocke. 2. The nex years are normal and sales mee expecaions. 3. The nex years each have ligher han normal cold seasons, so sales fail o mee expecaions. Oher scenarios could apply o FDA approval for heir drug. For each scenario, calculae he NPV. 2

3 Opions One of he fundamenal insighs of modern finance heory is ha opions have value. The phrase We are ou of opions is surely a sign of rouble. Because corporaions make decisions in a dynamic environmen, hey have opions ha should be considered in projec valuaion. Opions The Opion o Expand Has value if demand urns ou o be higher han expeced. The Opion o Abandon Has value if demand urns ou o be lower han expeced. The Opion o Delay Has value if he underlying variables are changing wih a favorable rend. 8-1 The Opion o Expand Imagine a sar-up firm, Campuseria, Inc. which plans o open privae (for-profi) dining clubs on college campuses. The es marke will be your campus, and if he concep proves successful, expansion will follow naionwide. Naionwide expansion, if i occurs, will occur in year four. The sar-up cos of he es dining club is only $30,000 (his covers leaseholder improvemens and oher expenses for a vacan resauran near campus) Campuseria pro forma Income Saemen Variable Coss Fixed Coss Depreciaion Preax profi Tax shield 3% Ne Profi Cash Flow Year 0 $30,000 Years 1- $60,000 ($2,000) ($18,000) ($7,500) ($7,500) $,950 NPV $30,000 + $21, () We plan o sell 25 meal plans a $200 per monh wih a 12-monh conrac. Variable coss are projeced o be $3,500 per monh. Fixed coss (he lease paymen) are projeced o be $1,500 per monh. We can depreciae our capialized leaseholder improvemens The Opion o Expand: Valuing a Sar-Up Noe ha while he Campuseria es sie has a negaive NPV, we are close o our break-even level of sales. If we expand, we projec opening 20 Campuserias in year four. The value of he projec is in he opion o expand. If we hi i big, we will be in a posiion o score large. We won know if we don ry Discouned Cash Flows and Opions We can calculae he marke value of a projec as he sum of he NPV of he projec wihou opions and he value of he managerial opions implici in he projec. M NPV + Op A good example would be comparing he desirabiliy of a specialized machine versus a more versaile machine. If hey boh cos abou he same and las he same amoun of ime he more versaile machine is more valuable because i comes wih opions. 3

4 8-18 Suppose ha we are drilling an oil well. The drilling rig coss $300 oday and in one year he well is eiher a success or a failure. The oucomes are equally likely. The discoun rae is 10%. The PV of he successful payoff a ime one is $575. The PV of he unsuccessful payoff a ime one is $ Tradiional NPV analysis would indicae rejecion of he projec. Prob. Success Successful + Prob. Failure Failure (0.50 $575) + (0.50 $0) $ $ NPV $300 + $ Tradiional NPV analysis overlooks he opion o abandon. Drill $500 drill NPV $0 Failure Success: PV $500 Si on rig; sare a empy hole: PV $0. Sell he rig; salvage value $250 The firm has wo decisions o make: drill or no, abandon or say When we include he value of he opion o abandon, he drilling projec should proceed: Prob. Success Successful + Prob. Failure Failure (0.50 $575) + (0.50 $250) $12.50 $12.50 NPV $300 + $ Valuaion of he Opion o Abandon Recall ha we can calculae he marke value of a projec as he sum of he NPV of he projec wihou opions and he value of he managerial opions implici in he projec. M NPV + Op $75.00 $ Op $ $38.61 Op Op $ The Opion o Delay: Example Year Cos PV NPV NPV 0 0 $ 20,000 $ 5,000 $ 5,000 1 $ 18,000 $ 7,000 $ 6,36 $7,900 $ 6, $ 17,100 $ 7,900 $ 6,529 () 3 $ 16,929 $ 8,071 $ 6,06 $ 16,760 $ 8,20 $ 5,628 Consider he above projec, which can be underaken in any of he nex years. The discoun rae is 10 percen. The presen value of he benefis a he ime he projec is launched remain consan a $25,000, bu since coss are declining he NPV a he ime of launch seadily rises. The bes ime o launch he projec is in year 2 his schedule yields he highes NPV when judged oday.

5 Summary and Conclusions This chaper discusses a number of pracical applicaions of capial budgeing. We ask abou he sources of posiive ne presen value and explain wha managers can do o creae posiive ne presen value. Sensiiviy analysis gives managers a beer feel for a projec s risks. Scenario analysis considers he join movemen of several differen facors o give a richer sense of a projec s risk. Break-even analysis, calculaed on a ne presen value basis, gives managers minimum arges. The hidden opions in capial budgeing, such as he opion o expand, he opion o abandon, and iming opions were discussed. 5