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Chapter 13 Risk Analysis and Project Evaluation

Chapter 13 Risk Analysis and Project Evaluation. Slide Contents. Principles Applied In This Chapter Learning Objectives The Importance of Risk Analysis Tools for Analyzing the Risk of Project Cash Flows Break-Even Analysis Real Options in Capital Budgeting Key Terms. Learning Objectives.

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Chapter 13 Risk Analysis and Project Evaluation

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  1. Chapter 13Risk Analysis and Project Evaluation

  2. Slide Contents • Principles Applied In This Chapter • Learning Objectives • The Importance of Risk Analysis • Tools for Analyzing the Risk of Project Cash Flows • Break-Even Analysis • Real Options in Capital Budgeting • Key Terms

  3. Learning Objectives • Explain the importance of risk analysis in the capital budgeting decision-making process. • Use sensitivity, scenario and simulation analyses to investigate the determinants of project cash flows. • Use break-even analysis to evaluate project risk. • Describe the types of real options.

  4. Principles Applied in This Chapter • Principle 1: Money has a Time Value • Principle 2: There Is a Risk-Return Tradeoff • Principle 3:Cash Flows are the Source of Value

  5. 13.1 THE IMPORTANCE OF RISK ANALYSIS

  6. The Importance of Risk Analysis There are two main reasons to perform a project risk analysis before making the final decision: • Project cash flows are risky and may not be equal to the estimates used to compute NPV. • Forecasts made by humans can be biased, either too optimistic or too pessimistic.

  7. 13.2 Tools for Analyzing the Risk of Project Cash Flows

  8. Tools for Analyzing the Risk of Project Cash Flows There are many possible cash flow outcomes for any risky project. The analyst uses tools such as Sensitivity analysis, Scenario analysis, and Simulation analysis to better understand the uncertainty of future cash flows.

  9. Key Concepts - Expected Values and Value Drivers Expected Values • The cash flows used to calculate a project’s NPV are expected values of the investment’s risky cash flows. The expected value of a future cash flow is a probability-weighted average of all the possible cash flows that might occur.

  10. Key Concepts - Expected Values and Value Drivers (cont.) Example What is the expected cash value if there are two possible cash flows, $100 and $400 and the probabilities of these cash flows are 25% and 75%. Expected cash value = .25 ( 100) + .75 (400) = $325

  11. Forecasting Revenues Using Expected Values CHECKPOINT 13.1: CHECK YOURSELF

  12. The Problem Consider your forecast of Marshall Home’s expected revenues for 2014 where the probability of entering a deep recession increases to 40%, the probability of mild recession drops to 50%, and the probability of a turn-around declines to only 10%. You may assume that the estimates of the number of units sold and the selling price of each remain unchanged.

  13. Step 1: Picture the Problem The following table lays out the number of units the firm’s manager estimate they will sell in each of three home categories for each of the three possible states of the economy:

  14. Step 1: Picture the Problem (cont.)

  15. Step 2: Decide on a Solution Strategy To compute the expected total revenue, we can proceed in three steps: • Estimate the probability of each state of the economy. • Calculate the total revenue from each category of homes for each of the three states of the economy. • Calculate a probability weighted average of the total revenues (step 2 times step 3).

  16. Step 3: Solve The expected total revenues declines from $156,000,000 to $118,0000.

  17. Step 4: Analyze The table in step 3 shows that there can be wide variation in revenue based on the future economic scenario. The table only shows the revenues. To get a more realistic picture, we should also consider the impact on expenses and consequently, profits and cash flows.

  18. Value Drivers Value drivers for investment cash flows consist of the fundamental determinants of project revenues (e.g., market share, market size, and price) and costs (e.g., variable costs and cash fixed costs, which are fixed costs other than depreciation).

  19. Value Drivers (cont.) Identification of value drivers allow the financial manager to: • Focus on refining forecasts of these key variables. • Monitor the key value drivers throughout the life of the project, so that timely corrective action can be taken.

  20. Sensitivity Analysis Sensitivity analysis occurs when a financial manager evaluates the effect of each value driver on the investment’s NPV. It helps identify the variable that has the most impact on NPV.

  21. Project Risk Analysis: Sensitivity Analysis CHECKPOINT 13.2: CHECK YOURSELF

  22. The Problem • After a careful cost analysis of the costs for making the silhouettes, Cranium’s management has determined that it will be possible to reduce the variable cost per unit down to $18 per unit by purchasing an additional option for the equipment that will raise its initial cost to $1.8 million (the residual or salvage value for this configuration is estimated to be $300,000). All other information remains the same as before. For this new machinery configuration, analyze the sensitivity of the project NPV to the same percent changes analyzed above.

  23. Step 1: Picture the Problem To evaluate the sensitivity of the project’s NPV and IRR to uncertainty surrounding the project’s value drivers, we need to analyze the effects of the changes in the value drivers (unit sales, price per unit, variable cost per unit, and annual fixed operating cost other than depreciation).

  24. Step 1: Picture the Problem (cont.) We consider the following changes: • Unit sales (-10%) • Price per unit (-10%) • Variable cost per unit (+10%) • Cash fixed costs per year (+10%)

  25. Step 2: Decide on a Solution Strategy • The objective of this analysis is to explore the effects of the prescribed changes in the value drivers on the project’s NPV. • We will need to estimate the base-case NPV based on given information and then compute the NPV based on assumed changes to the value drivers.

  26. Step 3: Solve • Following are the projected cash flows for years 0-5:

  27. Step 3: Solve (cont.) Given the free cash flows for years 0-5, we can compute the NPV and IRR on Excel spreadsheet, which gives us the following results:

  28. Step 3: Solve (cont.) The following table shows the impact on NPV of changes in the value drivers.

  29. Step 4: Analyze Here we observe that a 10% adverse change in value drivers has a significant impact on NPV. If the price per unit drops by 10%, the project turns negative with the value of NPV declining by 126%.

  30. Step 4: Analyze (cont.) The results also show that NPV is most sensitive to changes in the selling price and variable cost. Thus management must be doubly sure that the estimates on these value drivers are accurate and that these two value drivers are closely monitored.

  31. Scenario Analysis Sensitivity analysis involves changing one value driver at a time and analyzing its effect on the investment NPV. Scenario analysis allows the financial manager to simultaneously consider the effects of changes in the estimates of multiple value drivers on the investment opportunity’s NPV.

  32. Project Risk Analysis: Scenario Analysis CHECKPOINT 13.3: CHECK YOURSELF

  33. The Problem The deepening recession that characterized the economy caused Cranium’s management to reconsider the base-case scenario for the project by lowering their unit sales estimates to 175,000 at revised price per unit of $24.50. Based on these projections, is the project still viable? What if Longhorn followed a higher price strategy of $35 per unit but only sold 100,000 units? What would you recommend Longhorn do?

  34. Step 1: Picture the Problem • We are given the following revised estimates for two scenarios: • Rest of the information is the same as Checkpoint 13.2

  35. Step 2: Decide on a Solution Strategy Our objective is to determine the sensitivity of NPV to the two scenarios. We can estimate the free cash flows as before and then compute the NPVs for the two scenarios and compare.

  36. Step 3: Solve Scenario 1 cash flow and NPV/IRR estimates

  37. Step 3: Solve (cont.) Scenario 2 cash flow and NPV/IRR estimates

  38. Step 4: Analyze Examination of the two scenarios reveals that this is a risky opportunity as there is a wide divergence in the NPV estimates. The NPV could be as high as $1,491,606 or as low as a negative $326,276.

  39. Simulation Analysis Simulation analysis generates thousands of estimates of NPV that are built upon thousands of values for each of the investment’s value drivers. These different values arise out of each value driver’s individual probability distribution.

  40. Simulation Analysis (cont.) • Simulation process involves the following steps: • Estimate the probability distributions for each of the key value drivers. • Randomly select one value for each of the value drivers from their probability distributions. • Combine the values selected for each of the values drivers to estimate project cash flows for each year of the project’s life and calculate the project’s NPV.

  41. Simulation Analysis (cont.) • Store or save the calculated value of the NPV and repeat Steps 2 and 3. Computer softwares allows one to easily repeat Steps 2 and 3 thousands of times. • Use the stored values of the project NPV to construct a histogram or probability distribution of NPV.

  42. Figure 13-1 Probability Distribution of NPVs for the Marketing of Longhorn’s Brake Lights

  43. 13.3 Break-Even Analysis

  44. Break-Even Analysis • Break-even analysis determines the minimum level of output or sales that the firm must achieve in order to avoid losing money – that is, to break even. • In most cases, break-even sales is defined as the level of sales for which net operating income equals zero.

  45. Accounting Break-Even Analysis • Accounting break-even analysis involves determining the level of sales necessary to cover total fixed costs – that is, both cash fixed costs and depreciation. • We decompose production costs into: fixed costs and variable costs.

  46. Accounting Break-Even Analysis (cont.) • Fixed costs (or indirect costs) do not vary directly with sales revenue. For example, insurance premiums, administrative salaries. • As the number of units sold increases, fixed cost per unit decreases, because the fixed costs are spread over larger quantities of output.

  47. Accounting Break-Even Analysis (cont.) • Variable costs (or direct costs) are costs that vary with firm sales. For example, hourly wages, cost of materials used, sales commission. • Variable costs per unit remain the same regardless of the level of output.

  48. Figure 13-2 Accounting Break-Even Analysis

  49. Figure 13-2 Accounting Break-Even Analysis (cont.)

  50. Accounting Break-Even Analysis (cont.) • The accounting break-even point is the level of sales that is necessary to cover both variable and total fixed costs, such that the net operating income is equal to zero.

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