1. Chapter 11 Principles PrinciplesofCorporateFinance Ninth Edition Project Analysis Slides by Matthew Will Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin

2. 11- 2 Topics Covered  The Capital Investment Process  Sensitivity Analysis –Break Even Analysis  Monte Carlo Simulation  Real Options and Decision Trees

3. 11- 3 Capital Investments  Items for consideration Capital Budget – A list of investment projects under consideration by a firm Do not add fudge factors to the cost of capital Post audits – A review of the project to see how closely it met forewcasts

4. 11- 4 How To Handle Uncertainty Sensitivity Analysis - Analysis of the effects of changes in sales, costs, etc. on a project. Scenario Analysis - Project analysis given a particular combination of assumptions. Simulation Analysis - Estimation of the probabilities of different possible outcomes. Break Even Analysis - Analysis of the level of sales (or other variable) at which the company breaks even.

5. 11- 5 Sensitivity Analysis Example Given the expected cash flow forecasts for Otobai Company’s Motor Scooter project, listed on the next slide, determine the NPV of the project given changes in the cash flow components using a 10% cost of capital. Assume that all variables remain constant, except the one you are changing.

6. 11- 6 Sensitivity Analysis Example - continued NPV= 3.43 billion Yen

7. 11- 7 Sensitivity Analysis Example - continued Possible Outcomes

8. 11- 8 Sensitivity Analysis Example - continued NPV Calculations for Optimistic Market Size Scenario NPV= +5.7 bil yen

9. 11- 9 Sensitivity Analysis Example - continued NPV Possibilities (Billions Yen)

10. 11- 10 Break Even Analysis  Point at which the NPV=0 is the break even point  Otobai Motors has a breakeven point of 85,000 units sold. Sales, 000’s PV (Yen) Billions 400 200 19.6 85 200 Break even NPV=0 PV Inflows PV Outflows

11. 11- 11 Break Even Analysis  Accounting break even is different, yet wrong. It does not consider the time value of money.  Otobai Motors has an accounting breakeven point of 60,000 units sold. Sales, 000’s Accounting revenue and costs (Yen) Billions 60 40 20 60 200 Break even Profit =0 Revenues Costs

12. 11- 12 Electric Scooter – NPV

13. 11- 13 Electric Scooter - Assumptions

14. 11- 14 Electric Scooter - Scenarios

15. 11- 15 Electric Scooter – Accounting Profit

16. 11- 16 Electric Scooter – Cash Flows

17. 11- 17 Monte Carlo Simulation  Step 1: Modeling the Project  Step 2: Specifying Probabilities  Step 3: Simulate the Cash Flows Modeling Process

18. 11- 18 Monte Carlo Simulation

19. 11- 19 Flexibility & Real Options Decision Trees - Diagram of sequential decisions and possible outcomes.  Decision trees help companies determine their Options by showing the various choices and outcomes.  The Option to avoid a loss or produce extra profit has value.  The ability to create an Option thus has value that can be bought or sold.

20. 11- 20 Decision Trees NPV=0 Don’t test Test (Invest $200,000) Success Failure Pursue project NPV=$2million Stop project NPV=0

21. 11- 21 Real Options 1.Option to expand 2.Option to abandon 3.Timing option 4.Flexible production facilities

22. 11- 22 Decision Trees 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) +150(.6) +30(.4) +100(.6) +50(.4) -550 NPV= ? -250 NPV= ? -150 0 or Turboprop Piston

23. 11- 23 Decision Trees 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) +150(.6) +30(.4) +100(.6) +50(.4) -550 NPV= ? -250 NPV= ? -150 0 or 812 456 660 364 148 Turboprop Piston

24. 11- 24 Decision Trees 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) +150(.6) +30(.4) +100(.6) +50(.4) -550 NPV= ? -250 NPV= ? -150 0 or 812 456 660 364 148 Turboprop Piston

25. 11- 25 Decision Trees 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) -550 NPV= ? -250 NPV= ? -150 0 or 812 456 660 364 148 +150(.6) +30(.4) +100(.6) +50(.4) *450 331 Turboprop Piston

26. 11- 26 Decision Trees 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) -550 NPV= ? -250 NPV= ? -150 0 or 812 456 660 364 148 +150(.6) +30(.4) +100(.6) +50(.4) NPV=444.55 NPV=888.18 NPV=550.00 NPV=184.55 *450 331 Turboprop Piston

27. 11- 27 Decision Trees 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) 812 456 660 364 148 +150(.6) 710.73 +30(.4) +100(.6) 403.82 +50(.4) -150 0 *450 331 or NPV=444.55 NPV=888.18 NPV=550.00 NPV=184.55 -550 NPV= ? -250 NPV= ? Turboprop Piston

28. 11- 28 Decision Trees 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) 812 456 660 364 148 +150(.6) 710.73 +30(.4) +100(.6) 403.82 +50(.4) -550 NPV=96.12 -250 NPV=117.00 -150 0 *450 331 or NPV=444.55 NPV=888.18 NPV=550.00 NPV=184.55 Turboprop Piston

29. 11- 29 Decision Trees 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) 812 456 660 364 148 +150(.6) 710.73 +30(.4) +100(.6) 403.82 +50(.4) -550 NPV=96.12 -250 NPV=117.00 -150 0 *450 331 or NPV=444.55 NPV=888.18 NPV=550.00 NPV=184.55 Turboprop Piston

30. 11- 30 Web Resources www.jaxworks.com www.decisioneering.com www.kellogg. northwestern.edu/ Click to access web sites Internet connection required