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The McGraw-Hill Companies, Inc., 2000 Principles of Corporate Finance Brealey and Myers Sixth Edition A Project Is Not a Black Box Slides by Matthew Will Chapter 10 Irwin/McGraw Hill The McGraw-Hill Companies, Inc., 2000

Topics Covered Sensitivity Analysis Break Even Analysis Monte Carlo Simulation Decision Trees

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. 6

Sensitivity Analysis Example Given the expected cash flow forecasts for Otoban 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. 7

Sensitivity Analysis Example - continued NPV= 3.43 billion Yen 8

Sensitivity Analysis Example - continued Possible Outcomes 9

Sensitivity Analysis Example - continued NPV Calculations for Pessimistic Market Size Scenario NPV= +5.7 bil yen 10

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

Break Even Analysis Point at which the NPV=0 is the break even point. Otoban Motors has a breakeven point of 8,000 units sold. PV Inflows 400 200 19.6 Break even NPV=9 PV (Yen) Billions PV Outflows Sales, 000’s 85 200

Monte Carlo Simulation Modeling Process Step 1: Modeling the Project Step 2: Specifying Probabilities Step 3: Simulate the Cash Flows

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

Decision Trees Turboprop -550 NPV= ? or Piston -250 NPV= ? 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) +30(.4) Turboprop -550 NPV= ? -150 +100(.6) +50(.4) or Piston -250 NPV= ?

Decision Trees Turboprop -550 NPV= ? or Piston -250 NPV= ? 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) +30(.4) Turboprop -550 NPV= ? -150 +100(.6) +50(.4) or Piston -250 NPV= ?

Decision Trees Turboprop -550 NPV= ? or Piston -250 NPV= ? 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) +30(.4) Turboprop -550 NPV= ? *450 -150 +100(.6) +50(.4) or Piston 331 -250 NPV= ?

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

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

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

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