Corporate Finance

Corporate Finance Class 04 Project Analysis Daniel Sungyeon Kim Peking University HSBC Business School

Class Outline • Project Analysis • Managerial options • Scenario & sensitivity analysis • Spreadsheet modeling

Dynamic Project Analysis: Real Options • “Real options” or “managerial options” • Manager’s right, not obligation, to modify the project as events occur • Capital investment projects can have embedded options • Option to expand: If project exceeds expectations, it may be expanded • Option to abandon: If project fails to take off, it may be abandoned • Option to wait: Project implementation could be postponed, until uncertainty is reduced • So far, our analysis has been ‘static’ • How to value the option embedded in a project?

Dynamic Project Analysis • Real / managerial options – Example • 2M Corp takes on a new product line of post-it notes • Suppose that 6 months after the start of the project, the company sees that: • Case 1: Sales are much worse than expected • Case 2: Sales are much better than expected • What could the company do in each case?

Types of Managerial Options • Option to expand • If a project exceeds expectations, it could be expanded • Option to abandon • If a project fails to meet expectations, it may be abandoned • Option to wait • Project implementation could be postponed till uncertainty is reduced or resolved • Designed-in options • Project with input flexibility, output flexibility, or expansion capabilities

Valuing Managerial Options • Managerial Options are priced using an option pricing technique called binomial pricing • Binomial pricing involves building a “tree” of contingencies • The value of the project depends on what may occur in the future and the probabilities • The valuation is similar to calculating an expected value based on scenarios and probabilities

Example: Abandonment Option • Nike considers developing a new line of product • The new product has 50/50 chance of success and failure • If successful, the new line of product generates a cash flow of $150M per year into perpetuity • If not, annual cash flows are $50M per year into perpetuity • The product line initially costs $550 million • The discount rate is 20% • Should Nike take this project?

Abandonment Option Cash flows if successful • Abandonment Option – Example – Continued • What is the expected NPV of the project? • Should Nike undertake it? Cash flows if not successful Initial capital spending

Abandonment Option • Let’s introduce an Abandonment Option • Basic idea: • You are not forced to run poorly-performing projects. They can be closed down early in order to get some salvage value • Sometimes, projects are worth more dead than alive • Having an abandonment option does not mean you must execute it → must determine when to abandon • Back to our example • Suppose 1 year later, we know better if the project is successful • Nike can terminate the project and sell the equipment for $400M

Example continued… • Now, there is a decision node at date 1: Continue or abandon • When should Nike terminate the project? • What is the NPV with the abandonment option? Cash flows if successful Initial capital spending Cash flows if not successful Liquidation value if abandon

Option to Expand • Basic idea: • Doing one project may allow you to do related projects in the future • We should include these follow-on projects in the analysis • Option to Expand – Example • Naturelle Cosmetics considers the production of an allergen-free lipstick but the management is concerned because it has negative expected NPV: • Development cost is $10M and the lipstick has 50% chance of success • If successful: the PV of all future cash flows is $10M • If failure: the PV of all future cash flows is $5M • Expected NPV= –10+(0.5(10)+0.5(5))= –$2.5M

Option to Expand • Option to Expand – Example – Continued • Suppose the expertise gained from developing the new lipstick can be used to develop an entire new line of allergen-free cosmetics • The first project gives the option of doing other related projects • Additional development costs are $50M • If the lipstick succeeds, the PV of all future cash flows from the related lines is $100M (big market for this type of cosmetics) • If the lipstick fails, the PV of all future cash flows from the related lines is –$10M (small market for this type of cosmetics)

Option to Expand • Does the ability to start the new line make the lipstick project more attractive? • Such embedded managerial / real options have value • How do we find the value of such options? • Option Value = NPV(with option) – NPV(without option) • What is the real option value in the cosmetics example?

Uncertainties to NPV approach • In Capital Budgeting, the investment decision is sensitive to the accuracy of the NPV • To calculate the NPV of a project we need to: • Forecast future financial statements • Compute the expected future CFs • However, all forecasts are inherently uncertain • The uncertainty of the forecasts leads to uncertainty in the NPV of the project • What if our assumptions and forecasts are wrong and things do not turn out to be as expected?

Scenario Analysis: An Example • Nike is considering a new line of winter running clothes that adjust warmth protection based on body heat • After much analysis, the financial analysts at Nike determine that this project is expected to have an NPV of $34 million with a discount rate of 10% • The NPV calculation assumes that sales for Nike’s current sport clothes will decrease only 10%. Most of the sales for the new product will come from competitors’ customers • This NPV is the base case (most likely) outcome

More on Nike’s Example • The worst case • What if 25% of the sales come from Nike’s existing products, resulting in an NPV of -$190 million? • The best case • What if only 2% of the sales come from Nike’s existing products, resulting in an NPV of $150 million? • We examine how these outcomes affect your decision to take this project

Expected Value based on Scenarios • Suppose your marketing department tells you that • The best case scenario has a probability of 10% • The worse case scenario has a probability of 25% • The base case scenario has a probability of 65% • Will you accept this project? • Expected NPV = 10%×150+25%×(-190)+65%×34 = -10.4 (million) • NO!

What-if analyses • What-if analyses: (i) measuring forecast risk; (ii) understanding critical value drivers • Sensitivity analysis: Measures impact on NPV due to a change in one underlying parameter, holding all other parameters constant • Scenario analysis: Estimating NPV under alternative scenarios (i.e., let many parameters change simultaneously, but only let change by a few values) • Simulation Analysis: allows many parameters to change simultaneously in many ways (At-Risk software provides tools to do this)

Sensitivity Analysis • Consider the Nike example again • The staff has put together the following cash flow forecasts (in millions). Assume no working capital requirements and a discount rate of 10%.

Assumptions used to Obtain Cash Flows • Size of running clothing market: 5 million units • Nike’s market share: 20% • So Nike’s market share = 20%*5 million =1 million • Unit sales price: $375.00 • So Nike’s revenue = $375*1 million = $375 million • Unit variable costs: $300.00 • So Nike’s costs = $300*1 million = $300 million • Annual fixed costs: $30 million

Sensitivity Analysis • Alternative assumptions and the resulting NPVs. • To which assumption is NPV most sensitive?

Sensitivity Analysis • How sensitive is the NPV to changes in assumptions? • Purpose • Identifies the “value drivers” of a project • Determines where resources should be spent to reduce uncertainty • Limitations • Depends on the choice of optimistic/pessimistic assumptions • Interrelationships among the assumptions

Sensitivity Analysis in Excel • Link cells together!! • Example 1: Sales revenue per unit is forecast to be $9.70 in year 1, and then grow with inflation • This year’s Sales = Last year’s Sales × (1+This year’s inflation rate)

Two-Way Sensitivity Analysis: Excel • Two-way sensitivity: two assumptions changing simultaneously over a wide range of values • Tools for Sensitivity Analysis: Data Tables • In Excel 2007, select Data, then select What-If Analysis, then select Data Table • When prompted, complete “Row Input Cell” and “Column Input Cell” references • Tools for Sensitivity Analysis: Graphs

Dealing with Uncertainty • Sensitivity Analysis – Computer-based Example • A company considers a project which lasts for 12 years and requires an initial investment of $5,400,000 • In each of these 12 years: • Sales revenues are $16,000,000 • Variable costs are 81.25% of sales • Fixed costs, other than depreciation, are $2,000,000 • Assets are depreciated on a straight-line basis, the effective tax rate is 40% and the cost of capital is 8% • What’s the NPV for the project?

Dealing with Uncertainty • Sensitivity Analysis – Computer-based Example • Conduct a sensitivity analysis for each of the variables • Change only one variable at a time • Let’s try it out • Consider the following possible realizations for each variable

Dealing with Uncertainty • Sensitivity Analysis – Computer-based Example • Repeat the Sensitivity Analysis for all possible variables • Check that your NPV numbers (in thousands) match those in the table below

Dealing with Uncertainty • Break-Even Analysis • Analysis of the level of sales (dollar sales / sales volume) at which the project breaks-even • Accounting break-even: Sales level at which Net Income equals 0 • NPV break-even: Sales level at which NPV equals 0 • NPV break-even > Accounting break-even

Dealing with Uncertainty • Break-Even Analysis – Example • A project lasts for 10 years and requires an initial investment of $600,000 • The cost of capital is 10% and the tax rate is 40% • The level of sales will stay constant over the 10 years • The cost structure for the project is as follows: • Variable costs: 80% of sales • Fixed costs: $100,000 every year • Find the accounting break-even and NPV break-even level of sales.

Dealing with Uncertainty • Break-Even Analysis – Example • Outline of the solution approach • Let ‘Y’ denote the break-even volume of sales • Write the expression for project’s operating cash flow (OCF) in terms of ‘Y’ • Set NPV = 0 and solve for ‘Y’ • For accounting break-even, set NI = 0 • Questions: • What is the expression for OCF in terms of ‘Y’? • What is the expression for NPV in terms of ‘Y’?

Key Points • NPV approach will underestimate a project’s value if it ignores managerial options • Calculating the NPV of an investment requires many forecasts • Scenario, Sensitivity and Simulation Analysis help you evaluate your assumptions

Corporate Finance