CB and Risk Analysis

8/7/2019 CB and Risk Analysis

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Risk Analysis and CapitalBudgeting

Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin


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7-1

Sequential DecisionAn approach to reduce risk in capital

budgeting

Decisions are made stage by stageEg: develop a prototype, test the market, thenconsider bigger investment

Overcome large losses


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7-2

7.4 Decision TreesAllow us to graphically represent thealternatives available to us in each period and

the likely consequences of our actionsThis graphical representation helps to identifythe best course of action .

Helpful to evaluate sequential decision andreal options


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7-3

Example of a Decision Tree

Do notstudy

Studyfinance

Squares represent decisions to be made . Circles representreceipt of information,e.g ., a test score .

The lines leading awayfrom the squaresrepresent the alternatives .

C

A

B

F

D


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7-4

7.1 S ensitivity and Scenario AnalysisAllow us to look behind the NPVnumber to see how stable our estimatesare .Enable us to assess the risk of the project

Improve our estimate of expected NPV


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7-6

Decision Tree for Stewart

Do nottest

Test

Failure

Success

Do notinvest

Invest

Invest

The firm has two decisions to make:

To test or not to test .

To invest or not to invest .

0$! NPV

NPV = $3.4 b

NPV = $0

NPV = $91.4 6 m


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7-7

NPV Following Successful Test Note that the NPV iscalculated as of date 1, thedate at which the

investment of $ 1,600million is made . Later we bring this number back todate 0 . Assume a cost of capital of 10% .

Investment Year 1 Years 2-5Revenues $ 7,000

Variable Costs ( 3,000)Fixed Costs ( 1,800)Depreciation ( 400)

Pretax profit $ 1,800Tax ( 34 %) (6 12 )

Net Profit $ 1,188

Cash Flow -$1,600 $ 1,588

75.433,3$)10.1(

588,1$600,1$

1

4

1

1

!

! !

NPV

NPV t

t


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7-8

NPV Following Unsuccessful Test Note that the NPV iscalculated as of date 1,the date at which theinvestment of $ 1,600million is made . Later we bring this number

back to date 0 . Assume acost of capital of 10% .

Investment Year 1 Years 2-5Revenues $ 4,050

Variable Costs ( 1,735 )Fixed Costs ( 1,800)Depreciation ( 400)

Pretax profit $ 115Tax ( 34 %) (39.10)

Net Profit $ 75. 90Cash Flow -$1,600 $ 475. 90

461.91$)10.1(90.475$

600,1$

1

4

1

1

NPV

NPV t

t


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7-9

Decision to TestLets move back to the first stage, where the decision boilsdown to the simple question: should we invest?The expected payoff evaluated at date 1 is:

v

v!

failuregivenPayoff

failureProb.

successgivenPayoff

sucessProb.

payoff Expected

25.060,2$0$40.75.433,3$60. payoff

Expected !vv!

95.872$10.1

25.060,2$000,1$ !! NPV

The NPV evaluated at date 0 is:

So, we should test .


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7-1 0

Sensitivity Analysiswhat-if -analysisExamine how sensitive a particular NPV calculation tochanges in underlying factors (such as market share, variablecosts, discount rate)Underlying factors for revenue- market share- market size- priceUnderlying factor for cost- variable costs- fixed cost


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7-11

Sensitivity Analysis: Stewart

2.1,7

,7,6R ev !!(

W e can see that NPV is very sensitive to changes in revenues . In the Stewart Pharmaceuticals example, a 14 % drop inrevenue leads to a 6 1% drop in NPV .

%3.675.433,3

75.433,364.341,1% !! NPV

For every 1% drop in revenue, we can expect roughly a4.2 6% drop in NPV:

%29.14%9.6

26.4 !


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7-12

Scenario Analysis: StewartA variation on sensitivity analysis is scenario analysis .For example, the following three scenarios could apply

to Stewart Pharmaceuticals:1. The next few years each have heavy cold seasons, and

sales exceed expectations, but labor costs skyrocket .2. The next few years are normal, and sales meet

expectations .3. The next few 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 .


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7-13

7.2 Monte Carlo SimulationMonte Carlo simulation is a further attempt to model real -world uncertainty .This approach takes its name from thefamous European casino, because itanalyzes projects the way one mightevaluate gambling strategies .


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7-14

Monte Carlo SimulationMonte Carlo simulation of capital budgeting projectsis often viewed as a step beyond either sensitivity

analysis or scenario analysis .Interactions between the variables are explicitlyspecified in Monte Carlo simulation; so, at leasttheoretically, this methodology provides a more

complete analysis .W hile the pharmaceutical industry has pioneeredapplications of this methodology, its use in other industries is far from widespread .


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7-15

Monte Carlo SimulationStep 1: S pecify the Basic ModelStep 2: S pecify a Distribution for EachVariable in the ModelStep 3: The Computer Draws One OutcomeStep 4: Repeat the ProcedureStep 5: Calculate NPV


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7-1 6

Break -Even AnalysisCommon tool for analyzing the relationship

between sales volume and profitability

There are two common break -even measuresAccounting break -even: sales volume at whichnet income = 0

Financial break -even: sales volume at which net present value = 0


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7-17

Accounting Break -Even AnalysisCosts are classified into fixed cost ( FC)(which include depreciation) and variable cost

per unit (VC)Operating profit = 0[Q*(P VC) FC] (1- T) = 0

Q*(P - VC) = FCTotal contribution margin = total fixed cost


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7-1 8

Financial Break -even NPV = OAnnual Net Cash flow = 0Total contribution margin after tax = totalfixed cash outflowQ(P -VC)( 1-T) = FC (1- T) T (D) + EACW here EAC = equivalent annual cost of theinvestmentEAC = IO/PVI FAr,n


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7-1 9

Financial Break -even NPV = 0ACF * PVI FAr,n = IO[Q(P - VC)( 1-T) FC (T) + D (T)] PVI FAr,n = IOQ(P -VC)( 1-T) = FC (1- T) T (D) + EAC


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7-2 0

Break -Even Analysis: ExampleSigma has purchased a new machine for RM2,000,000 to produce a new type of mixer . The

machine has an economic life of five years over which it will be depreciated based on the straightline method . The sale price per unit of mixer isRM400, the variable cost is RM60 and the fix cost is

RM750,000 . Assume a tax rate of 28% and adiscount rate of 10%, calculate the present value breakeven point .

Answer: 3904 unit

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