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Corporate Finance

Corporate Finance. Lecture 5. Topics covered. Decision trees Dealing with uncertainty Sensitivity analysis Senario analysis. Decision Trees. Graphically represent the alternatives available to us in each period and the likely consequences of our actions.

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Corporate Finance

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  1. Corporate Finance Lecture 5

  2. Topics covered • Decision trees • Dealing with uncertainty • Sensitivity analysis • Senario analysis

  3. Decision Trees • Graphically represent the alternatives available to us in each period and the likely consequences of our actions. • This graphical representation helps to identify the best course of action.

  4. “A” “B” “C” “D” “F” Example of Decision Tree Study finance Do not study

  5. Decision trees • Example: • The test marketing for a new project will take one year and will cost $100 million. • There is a 75% chance that the test will be successful. • If successful, the project will be taken and the NPV is estimated to be $1,517 million at year=1. • If not successful, the project will have an NPV of $-3,611 million at year=1. • The discount rate is 15% for the firm.

  6. Decision trees Now Test marketing -$100 million Year 1 Investment Invest NPV=1517 75% Success test No invest NPV=0 Test result revealed Invest NPV=-3611 failure 25% No invest NPV=0 No test 2. Invest or not 1. Test or not

  7. Decision trees • How to solve the problem • Make decisions in reverse order with decision trees

  8. Decision trees Now Test marketing -$100 million Year 1 Investment Invest NPV=1517 75% Success test No invest NPV=0 Test result revealed Invest NPV=-3611 failure 25% No invest NPV=0 No test 1. Test or not 2. Invest or not

  9. Decision trees Now Test marketing -$100 million Year 1 Investment Invest NPV=1517 75% Success test X No invest NPV=0 Test result revealed Invest NPV=-3611 failure 25% No invest NPV=0 No test 1. Test or not 2. Invest or not

  10. Decision trees Now Test marketing -$100 million Year 1 Investment Invest NPV=1517 75% Success test X No invest NPV=0 Test result revealed Invest NPV=-3611 failure 25% No invest NPV=0 No test 1. Test or not 2. Invest or not

  11. Decision trees Now Test marketing -$100 million Year 1 Investment Invest NPV=1517 75% Success test X No invest NPV=0 Test result revealed X Invest NPV=-3611 failure 25% No invest NPV=0 No test 1. Test or not 2. Invest or not

  12. Decision trees Year 1 Investment Now Test marketing -$100 million 75% test Success Test result revealed Invest NPV=1517 failure No invest NPV=0 25% E[Payoff]1=0.75*1517+0.25*0=1138 NPV=-100+1138/1.15=890>0 No test 1. Test or not 2. Invest or not

  13. How to handle uncertainty • Sensitivity Analysis • Analyze the effects of changes in one variable (e.g. sales, cost, discount rate) on a project. • Scenario Analysis • Project analysis given a particular combination of assumptions.

  14. How to handle uncertainty Example Given the expected cash flow forecasts listed on the next slide, determine the NPV of the project given changes in the cash flow components using an 8% cost of capital.

  15. How to handle uncertainty NPV= $478

  16. How to handle uncertainty Possible Outcomes

  17. Sensitivity Analysis Assuming change in Investment NPV= ($322)

  18. Scenario Analysis

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