Chapter 7

Risk Analysis, Real Options, and Capital

Budgeting

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
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Key Concepts and Skills
 Understand and be able to apply scenario and
sensitivity analysis
 Understand the various forms of break-even
analysis
 Understand Monte Carlo simulation
 Understand the importance of real options in
capital budgeting
 Understand decision trees

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Chapter Outline
7.1 Sensitivity Analysis, Scenario Analysis,
and Break-Even Analysis
7.2 Monte Carlo Simulation
7.3 Real Options
7.4 Decision Trees

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A positive NPV project = undertaking the project?

 Do you want to know the danger signals?

 Which actions you that you may take?
 Managers recognize the opportunities (such as
to expand the project if it is successful or to bail
out if it is not) when considering whether to
invest  real options.

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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.
 Break Even Analysis - Analysis of the level of sales
(or other variable) at which the company breaks
even.
 Simulation Analysis - Estimation of the probabilities
of different possible outcomes.

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7.1 Sensitivity, Scenario, and Break-Even
 Each allows us to look behind the NPV
number to see how stable our estimates
are.
 When working with spreadsheets, try to
build your model so that you can adjust
variables in a single cell and have the
NPV calculations update accordingly.

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7.1 Sensitivity
 Examine how is NPV sensitive to
changes in underlying assumptions.
 Provide Pessimistic and optimistic
forecasts for each variable
 Each time, only one variable changes
and others are expected.

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Sensitivity Analysis: Solar
Electronics Corp Jet Engine
 Expected case
Table of Parameters Unit: $1,000,000
Market share 30%
Market size 10,000 jet engines
Unit price 2 unit
Variable cost 1unit
Fixed cost per yeart $ 1,791 mill
Project life 5years
Required return 15%
Tax rate 34%
Initial cost of investment $ 1,500 mil
Depreciation $ 300 mil
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 7.1 Sensitivity
Expected
outcome 0 1 2 3 4 5
Revenue 6,000 6,000 6,000 6,000 6,000
Variable cost - 3,000 - 3,000 - 3,000 - 3,000 - 3,000
Fixed cost - 1,791 - 1,791 - 1,791 - 1,791 - 1,791
Depreciation - 300 - 300 - 300 - 300 - 300
EBIT 909 909 909 909 909
Tax @ 34% - 309 - 309 - 309 - 309 - 309
Income after tax 600 600 600 600 600
OCF 900 900 900 900 900
Investment -1,500
NCF -1,500 900 900 900 900 900
NPV 1,516.74
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Sensitivity Analysis
 Before you decide, you need to scrutinize the forecasts
and identify key variables:
- Market share of the new products
- Size of the market of the company’s product.
- Price per unit ..
 Forecast from Marketing Dep:  Forecast from Production Dep:
- Market share of the new products - Variable cost
- Size of the market of the - Fixed costs
company’s product.
- Price per unit

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 7.1 Sensitivity
Pessimistic Expected or Best Optimistic
Market size (per year) 5,000 10,000 20,000
Market share 20% 30% 50%
Units sold (per year) 1,000 3,000 10,000
Price $ 1,900,000 $ 2,000,000 $ 2,200,000
Variable cost (per plane) $ 1,200,000 $ 1,000,000 $ 800,000
Fixed cost (per year) $ 1,891,000,000 $ 1,791,000,000 $ 1,741,000,000
Investment $ 1,900,000,000 $ 1,500,000,000 $ 1,000,000,000

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Sensitivity Analysis
 To undertake a sensitivity analysis, each
variable is set at its most pessimistic or
optimistic value, then NPV of the project
recalculated

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7.1 Sensitivity
Possible outcome Pessimistic Expected Optimistic
Market size (per
year) $(1,802) $ 1,517 $ 8,154
Market share $ (7) $ 1,517 $ 5,942
Price $ 853 $ 1 ,517 $ 2,844
Variable cost (per
plane) $ 189 $ 1,517 $ 2,844

Fixed cost (per year) $ 1,295 $ 1,517 $ 1,628

Investment $ 1,208 $ 1 ,517 $ 1,903
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7.1 Sensitivity
Sensitivity analysis

Investment

Fixed cost (per plane)

Variable cost (per plane)

Price

Market share

Market size (per year)

$(4,000) $(2,000) $- $2,000 $4,000 $6,000 $8,000 $10,000

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7.1 Sensitivity
 Pessimistic and optimistic – (subjective)
 only one variable changes and fixed other
variables. In practice, several variables are
likely to be interrelated
 If demand of the sola engine increases, both market
share and price may go up together.

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7.1 Scenario Analysis
 A variation on sensitivity analysis is scenario
analysis.
 Each scenario involves a confluence of
factors.
 For each scenario, calculate the NPV.
 Example (Excel sheet)

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Senario Analysis
Expected case Inflation & cost & market size
Table of Parameters Unit: $1,000,000
Market share 30%
Market size 10,000 7,000
Unit price 2 2
Variable cost 1 1.1
Fixed cost per year $ 1,791 $ 1,791
Project life 5 5
Required return 15% 15%
Tax rate 34% 34%
Initial cost of investment $ 1,500 $ 1,500
Depreciation $ 300 $ 300
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 7.1 Break-Even Analysis
 Common tool for analyzing the relationship
between sales volume and profitability
 There are two common break-even measures
 Accounting break-even: sales volume at which
income = 0 (EBIT = 0)
 Financial break-even: sales volume at which NPV = 0

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Break-Even Analysis: Accounting BE

 How bad sales can

get before the
project’s NPV begin
negative

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 Revenue PV Inflows

Break even Break even

Profit =0 NPV=0

Costs PV Outflows

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Break-Even Analysis: Accounting BE

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Break-Even Analysis: Financial BE

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Break-Even Analysis: Financial BE

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7.2 Monte Carlo Simulation
 Monte Carlo simulation is a further
attempt to model real-world uncertainty.
 This approach takes its name from the
famous European casino, because it
analyzes projects the way one might
evaluate gambling strategies.

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Monte Carlo Simulation
 Imagine a serious blackjack player who wants to
know if she should take the third card whenever her
first two cards total 16.
 She could play thousands of hands for real money to
find out. This could be hazardous to her wealth.
 Or, she could play thousands of practice hands.
 Monte Carlo simulation of capital budgeting projects
is in this spirit.

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Monte Carlo Simulation
 Monte Carlo simulation of capital budgeting projects
is often viewed as a step beyond either sensitivity
analysis or scenario analysis.
 Interactions between the variables are explicitly
specified in Monte Carlo simulation; so, at least
theoretically, this methodology provides a more
complete analysis.
 While the pharmaceutical industry has pioneered
applications of this methodology, its use in other
industries is far from widespread.
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 Monte Carlo Simulation
 Monte Carlo Simulation is a tool for considering
all possible combinations of variables
 Modeling Process
 Step 1: Specify the Basic Model
 Step 2: Specify a Distribution for Each Variable in the
Model
 Step 3: The Computer Draws One Outcome
 Step 4: Repeat the Procedure
 Step 5: Calculate NPV

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Monte Carlo Simulation
 Imagine that Backyard Barbeques, Inc. (BBI),
a manufacturer of gas grills, has a blueprint
for a new grill that cooks with compressed
hydrogen.
 The CFO, Edward H. Comiskey, dissatisfied
with simpler capital budgeting techniques,
wants a Monte Carlo simulation for this new
grill. A consultant specializing in the Monte
Carlo approach, Lester Mauney, takes him
through the five basic steps of the method. 7-27
Monte Carlo Simulation
 Step 1: Specify the Basic Model
Revenue of any year =

The cost of any year =

Initial investment =

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 Monte Carlo Simulation
 Step 2: Specify a Distribution for Each Variable in the Model
 The distribution for next year’s sales of grills by the entire industry:

 The distribution of next year’s market share:

 Next year’s price per hydrogen grill

 The distribution of growth rates for the entire industry over the second year:

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 Monte Carlo Simulation
 Step 2: Specify a Distribution for Each Variable in the Model

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 Monte Carlo Simulation
 Step 3: The Computer Draws One Outcome
 Next year’s revenue is the product of 3 components
 Suppose the computer pick: unit sales of 10 million, market
share for grill of 2 percent and a + 3 random price variation 
next year price = $190 + $10 + $3 = $203

 So, next year’s revenue = 10 mil. X 0.02 x $203 = $40.6 mil

Probability of these three drawing together in the same outcome:
0.02 (size) x 0,02 (share) x 0.5 (Price)

Similar process is applied for cost, and other variables.

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Monte Carlo Simulation
 Step 4: Repeat the Procedure

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Monte Carlo Simulation
 Step 5: Calculate NPV
 Expected cash flows of each year is determined
given the distribution of the year’s cash flows in
Step 4.

 Calculate NPV at an appropriate rate.

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7.3 Real Options
 One of the fundamental insights of modern
finance theory is that options have value.
 Because corporations make decisions in a
dynamic environment, they have options that
should be considered in project valuation.
 Real option is the adjustment that a firm can
make after the project is accepted.

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Real Options
 The Option to Expand
 Has value if demand turns out to be higher than
expected
 The Option to Abandon
 Has value if demand turns out to be lower than
expected
 The Option to Delay
 Has value if the underlying variables are
changing with a favorable trend
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The Option to Expand: Example
 The project of the hotel made of ice
 A single ice hotel cash flows
0 1…. NPV (20%)
CF -12,000,000 2,000,000 -2,000

 Because the future annula cash flows is uncertain:

$3,000,000 (with 50%) and $1,000,000 with 50%).
NPV (op) = $3mil, and NPV (pe) = -$7 mil.
Expected NPV = -$2 mil
 If optimistic forecast turns out to be correct, the firm
want to expand with more 9 new hotels.
 The true NPV = $9.25 mil
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Discounted CF and Options
 We can calculate the market value of a project as the
sum of the NPV of the project without options and
the value of the managerial options implicit in the
project.
M = NPV + Opt

Opt = $9.25 mil – ($2mil) = $11,25 mil

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The Option to Abandon: Example
 Suppose we are drilling an oil well. The
drilling rig costs $300 today, and in one year
the well is either a success or a failure.
 The outcomes are equally likely. The
discount rate is 10%.
 The PV of the successful payoff at time one
is $575.
 The PV of the unsuccessful payoff at time
one is $0.
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The Option to Abandon: Example
Traditional NPV analysis would indicate rejection of the project.

Expected = Prob. × Successful + Prob. × Failure

Payoff Success Payoff Failure Payoff

Expected
= (0.50×$575) + (0.50×$0) = $287.50
Payoff

$287.50
NPV = –$300 + = –$38.64
1.10
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 The Option to Abandon: Example
However, traditional NPV analysis overlooks the option to abandon.
Success: PV = $500

Drill Sit on rig; stare

at empty hole:
 $500 PV = $0.
Failure

Do not Sell the rig;

NPV  $0 salvage value
drill
= $250
The firm has two decisions to make: drill or not, abandon or stay.
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The Option to Abandon: Example
 When we include the value of the option to abandon, the
drilling project should proceed:

Expected = Prob. × Successful + Prob. × Failure

Payoff Success Payoff Failure Payoff

Expected
= (0.50×$575) + (0.50×$250) = $412.50
Payoff

$412.50
NPV = –$300 + = $75.00
1.10
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Valuing the Option to Abandon
 Recall that we can calculate the market value of
a project as the sum of the NPV of the project
without options and the value of the managerial
options implicit in the project.

M = NPV + Opt
$75.00 = –$38.64 + Opt
$75.00 + $38.64 = Opt

Opt = $113.64
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The Option to Delay: Example
Year
Year CostCost PVPV NPV NPVt t
NPV 0
0 0 $ 20,000
$ 20,000$ 25,000
$ 25,000$ 5,000
$ 5,000$ 5,000 $7,900
1 1 $ 18,000
$ 18,000$ 25,000
$ 25,000$ 7,000
$ 7,000$ 6,364 $ 6,529 
(1.10) 2
2 2 $ 17,100
$ 17,100$ 25,000
$ 25,000$ 7,900
$ 7,900$ 6,529
3 3 $ 16,929
$ 16,929$ 25,000
$ 25,000$ 8,071
$ 8,071$ 6,064
4 4 $ 16,760
$ 16,760$ 25,000
$ 25,000$ 8,240
$ 8,240$ 5,628
 Consider the above project, which can be undertaken in any of
the next 4 years. The discount rate is 10 percent. The present
value of the benefits at the time the project is launched remains
constant at $25,000, but since costs are declining, the NPV at
the time of launch steadily rises.
 The best time to launch the project is in year 2—this schedule
yields the highest NPV when judged today. 7-43
7.4 Decision Trees
 Allow us to graphically represent the
alternatives available to us in each period
and the likely consequences of our
actions
 This graphical representation helps to
identify the best course of action.

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Decision tree for Pharmaceutical R&D

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Decision Trees $700 (.80)
- $130

.25
$ 0 (.20)
$ 300 (.80)
- $18 .44 .50 - $130

Invest .56
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV= ? - $130

$ 0 (.20)

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Decision Trees $700 (.80)
- $130
560
.25
$ 0 (.20)
$ 300 (.80)
- $18 .44 .50 - $130
240
Invest .56
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV= ? - $130
80

$ 0 (.20)

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Decision Trees $700 (.80)
- $130
560
.25
$ 0 (.20)
$ 300 (.80)
- $18 .44 .50 - $130
240
Invest .56
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV= ? - $130
80
700  .80   0  .20  560
$ 0 (.20)

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Decision Trees
NPV = $295
$700 (.80)
- $130
560
.25
$ 0 (.20)
$ 300 (.80)
560
- $18 NPV (upside)
.44 .50  130 
- $130 3
 295
1.096 240
Invest .56
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV= ? - $130
80

$ 0 (.20)

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Decision Trees
NPV = $295
$700 (.80)
- $130
560
.25
$ 0 (.20)
$ 300 (.80)
- $18 .44 .50 - $130
240
NPV = $52
Invest .56
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV= ? - $130
80
NPV = - $69
(do not invest, so NPV = 0)
$ 0 (.20)

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Decision Trees
NPV = $295
$700 (.80)
- $130
560
.25
$ 0 (.20)
NPV = $83 $ 300 (.80)
- $18 .44 .50 - $130
240
NPV = $52
Invest .56
Yes / No $0 $ 0 (.20)
.25 (0  .25)  (52  .5)  (295  .25)
NPV  $2 100 (.80)
NPV= ? - $130 1.096 
80
NPV = - $69  $83
(do not invest, so NPV = 0)
$ 0 (.20)

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Decision Trees
NPV = $295
$700 (.80)
- $130
560
.25
$ 0 (.20)
NPV = $83 $ 300 (.80)
- $18 .44 .50 - $130
240
NPV = $52
Invest .56
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV  18  (.-44  83)  (.56  0)
$130
NPV= $19
 $19
NPV = - $69
80
(do not invest, so NPV = 0)
$ 0 (.20)

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Decision Trees
NPV = $295
$700 (.80)
- $130
560
.25
$ 0 (.20)
NPV = $83 $ 300 (.80)
- $18 .44 .50 - $130
240
NPV = $52
Invest .56
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV= $19 - $130
80
NPV = - $69
(do not invest, so NPV = 0)
$ 0 (.20)

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Quick Quiz
 What are sensitivity analysis, scenario
analysis, break-even analysis, and simulation?
 Why are these analyses important, and how
should they be used?
 How do real options affect the value of capital
projects?
 What information does a decision tree
provide?
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 Quiz
Click the Quiz button to edit this object

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