Making Capital Investment

Decisions

Session Three
 The Capital Investment Process

• Capital Budget
• List of investment projects under consideration by a firm
• Do not add fudge factors to cost of capital
• Postaudit
• Review of project to see if met forecasts
Types of Analysis

• Sensitivity
• Analyzes effects of changes in sales, costs, etc., on project
• Scenario
• Project analysis given particular combination of assumptions
• Break Even
• Level of sales (or other variable) at which project breaks even
• Real Options
• Choice is valuable, the value of an option
• Decision Trees
• Sequential decisions and possible outcomes
Establish the Base Case

Otobai Company plans to introduce an electric scooter for city use.

The sales team estimate that they could sell 100,000 units of the scooter
each year for 10 years, at the price of 375,000¥.
The staff members of Otobai have prepared the cashflow forecast of the
project.
Given expected cash-flow forecasts, determine the NPV of project given
changes in cash-flow components using 10% cost of capital.
Cashflow of Otobai (in ¥ billions)
Net Present Value

6
 Annuity Equation for NPV calculations

Annuity : regular cashflows for a fixed

duration
Present value of annuity

NPV = PV(annuity) – investment

= 18.43 – 15
= 3.43
 Sensitivity Analysis

• How is the NPV sensitive to sales forecast?

Forecast Pessimistic Normal Optimistic

90% of 110% of
N° units sale 100,000
100,000 100,000
Sales revenue 0.9*37.5 37.5 1.1*37.5
Cost of production 0.9*30 30 1.1*30
NPV 1.13 3.43 5.74

8
Sensitivity Analysis: Optimistic

NPV calculations—
Optimistic scenario of
market size:
Sales = 1.1*37.5 = 41.25
Variable costs = 1.1*30 = 33

c
Sensitivity Analysis: Pessimistic

NPV calculations—
Pessimistic scenario of
market size: ?
?
Sales = 0.9*37.5 = ?
Variable costs = 0.9*30 = ?

?
 Sensitivity Analysis

• How is the NPV sensitive to sales forecast?

Forecast Pessimistic Normal Optimistic

90% of 110% of
N° units sale 100,000
100,000 100,000
Sales revenue 0.9*37.5 37.5 1.1*37.5
Cost of production 0.9*30 30 1.1*30
NPV 1.13 3.43 5.74

11
 Sensitivity Analysis

Change variables one at a time: market size

 Sensitivity Analysis

Resulting NPV due to changes in variables

 Sensitivity Analysis

• Decrease in 10% unit sales

• Decrease in NPV =
OR
• Increase in 10% unit sales
• Increase in NPV =

14
 Scenario Analysis

• If the oil prices increase by 20% and inflation increases by 15%

• Revise sales and expenses forecast
• Unit sales increase by 4%
• Unit price increase by 15%
• Cost of production increase by 15%

15
Scenario Analysis

Revise estimated sales and costs for high oil prices and recession
Base Case High Oil Prices and Recession
Unit sales 100,000 100,000*1.04 = 104,000
Unit price 375,000 375,000*1.15 = 431,250
Sales revenue 37.5 billion 104,000*431.250 = 44.85 billion
Unit variable cost 300,000 300,000*1.15 = 345,000
Variable cost 30 billion 104,000*345,000 = 35.88 billion
Fixed cost 3 billion 3 * 1.15 = 3.45 billion

16
Scenario Analysis
 Breakeven Analysis

• NPV of electric scooter project by varying the number of scooters sold

 Break-even chart

• Point at which NPV=0 is break-even point

• Otobai Motors has a break-even point of 85,000 units sold
PV inflows
PV (Yen)
Billions Break-even
400 NPV = 0

200 PV Outflows

19.6

85 200 Sales,
thousands
 Breakeven Analysis

• Accounting profit of the electric scooter project by varying the number

of scooters sold
 Accounting break-even

• Accounting break-even does not consider time value of money

• Otobai Motors has accounting break-even point of 60,000 units sold

60 Revenues

Accounting Break -even

Profit =0
revenue and 40
costs (Yen)
Billions Costs
20

Sales, thousands
60 200
Real Options

• Option to expand
• Option to abandon
• Timing option
• Flexible production facilities
 Option to Abandon

• Cashflows (in millions) generated from producing outboard using

technology A and B
Technology A Technology B
Buoyant demand $24 $22.5
Sluggish demand 16 15

• Machinery used in technology A has no resale value, while machines in

technology B can be sold for $18.5 million

23
Option to Abandon
Buoyant
$24 million
Technology A

Sluggish
$16 million Continue
$22.5 million
Buoyant
Abandon
$18.5 million
Continue $15 million
Technology B
Sluggish
Abandon
$18.5 million
24
 Option to Abandon

• Cashflows (in millions) generated from producing outboard using

technology A and B
Technology A Technology B
Buoyant demand $24 $22.5
Sluggish demand 16 18.5

• Technology B with a different valuation given the option to abandon

25
 Decision Trees

• Diagram of sequential decisions and possible outcomes

• Help companies analyze options by showing various choices and
outcomes
• Option to avoid a loss or produce extra profit has value
• Ability to create option has value that can be bought or sold
 Decision Tree: Example

Stages for pharmaceutical R&D

• Phase 1-3 clinical trials
• FDA approval
• Commercial launch
• 10 years of patent
• Post patent (competitors with generic)

27
 Decision Tree: Example

• Drug pass phase 1 trial

• Enter phase 2
• $18 million investment
• 2 years trial period
• Enter phase 3 with FDA decision
• $130 million investment
• 3 years trial period
• Product launch

28
Decision Tree: Example
Invest $130? FDA approval for widely use
Phase 2 (2 years) Phase 3 (3 years)
PV = 700
FDA disapproves
PV = 0

Invest $130? FDA approval for limited use

PV = 300
Trial succeed
FDA disapproves
PV = 0
Invest $18?

Invest $130? FDA approval for restricted use

Fail PV=0
PV = 100
FDA disapproves
PV = 0

29
 Decision Tree

Probabilities
• Phase two
• Trail successful : 44%
• Trail fail : 56%
• Phase three
• FDA approval : 80%
• Wide use (over the counter) : 25%
• Limited use (prescription) : 50%
• Restricted use (with medical supervision) : 25%
• FDA reject : 20%

30
Decision tree
$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)
Decision tree
$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)
Decision tree
$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)
Decision tree
$700 (.80)
NPV = $295
- $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)
Decision tree
$700 (.80)
NPV = $295
- $130
560
.25
$ 0 (.20)
$ 300 (.80)
- $18 .44 .50 - $130
240
Invest .56 NPV = $52
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV= ? - $130
NPV = - $69 80
(do not invest, so NPV = 0)
$ 0 (.20)
Decision tree
$700 (.80)
NPV = $295
- $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= ? - $130
80
NPV = - $69
(do not invest, so NPV = 0)
$ 0 (.20)
Decision tree
$700 (.80)
NPV = $295
- $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)
Decision tree
$700 (.80)
NPV = $295
- $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)