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Chapter 2 (b)
Risk Analysis and Project Evaluation
Learning Objectives
1. Explain the importance of risk analysis in the
capital-budgeting decision-making process.
2. Use sensitivity, scenario and simulation analyses
to investigate the determinants of project cash
flows.
3. Use break-even analysis to evaluate project risk.
4. Describe the types of real options.
Principles Applied in This Chapter
• Principle 1: Money has a Time Value
• Principle 2: There Is a Risk-Return Tradeoff
• Principle 3:Cash Flows are the Source of Value
2.1 THE IMPORTANCE OF RISK ANALYSIS
The Importance of Risk Analysis
There are two fundamental reasons to perform a
project risk analysis before making the final
accept/reject decision:
– Project cash flows are risky and may not be equal to
the estimates of future cash flows used to compute
NPV.
– Forecasts are made by humans who can be either too
optimistic or too pessimistic when making their cash
flow forecasts.
2.2 TOOLS FOR ANALYZING THE RISK
OF PROJECT CASH FLOWS
Tools for Analyzing the Risk of Project
Cash Flows
The actual cash flows an investment produces will
almost never exactly equal the expected cash flows
used to estimate the investment’s NPV. There are
many possible cash flow outcomes for any risky
project. The analyst uses tools such as Sensitivity
analysis, Scenario analysis, and Simulation analysis
to examine the uncertainty of future cash flows and
better understand the reliability of the NPV
estimate.
Key Concepts—Expected Values and
Value Drivers (1 of 3)
The cash flows used in the calculation of a project’s
NPV are actually the expected values of the
investment’s risky cash flows. The expected value
of a future cash flow is simply a probability-weighted
average of all the possible cash flows that might
occur.
Key Concepts—Expected Values and
Value Drivers (2 of 3)
Example What is the expected cash value if there
are two possible cash flows, $100 and $400 and the
probabilities of these cash flows are 25% and 75%.
Expected cash value = .25 (100) + .75 (400)
= $325
Key Concepts—Expected Values and
Value Drivers (3 of 3)
• Financial managers sometimes refer to the basic
determinants of an investment’s cash flows – and
consequently, its performance – as value drivers.
• Value drivers for investment cash flows consist of
fundamental determinants of project revenues
(e.g., market size, market share, and unit price)
and costs (e.g., variable costs and cash fixed
costs, which exclude depreciation expense)
CHECKPOINT 2.1: CHECK YOURSELF
Forecasting Revenues Using Expected Values
The Problem
Consider your forecast of Marshall Home’s
expected revenues for 2014 where the probability of
entering a deep recession increases to 40%, the
probability of mild recession drops to 50%, and the
probability of a turn-around declines to only 10%.
You may assume that the estimates of the number
of units sold and the selling price of each remain
unchanged.
Step 1: Picture the Problem (1 of 2)
The following table lays out the number of units the
firm’s manager estimate they will sell in each of
three home categories for each of the three
possible states of the economy:
Step 1: Picture the Problem (2 of 2)
Blank Deep Recession Mild Recession Turn-Around
NPV ($326,276.10)
IRR 6.29%
Step 3: Solve (2 of 2)
Scenario 2 cash flow and NPV/IRR estimates
Blank Year 0 Years 1-4 Year-5
Revenues Blank $ 3,500,000.00 $ 3,500,000.00
Less: Variable cost Blank $ (2,000,000.00) $ (2,000,000.00)
Less: Depreciation expense Blank $ (250,000.00) $ (250,000.00)
NPV = $1,471,606
IRR = 36%
Step 4: Analyze
Examination of the two scenarios reveals that this is
a risky opportunity as there is a wide divergence in
the NPV estimates. The NPV could be as high as
$1,491,606 or as low as a negative $326,276.
Simulation Analysis (1 of 3)
Scenario analysis provides the analyst with a
discrete number of project NPV estimates for a
limited number of cases or scenarios. Simulation
analysis generates thousands of NPV estimates
that are built on thousands of values for each of the
investment’s value drivers. These different values
arise out of each value driver’s individual probability
distribution.
Simulation Analysis (2 of 3)
• Simulation process involves the following five steps:
1. Select appropriate probability distribution for each
of the investment’s key value drivers.
2. Randomly select one value for each of the value
drivers from its respective probability distributions.
3. Combine the values selected for each of the
values drivers to estimate project cash flows for
each year of the project’s life, and calculate the
project’s NPV.
Simulation Analysis (3 of 3)
4. Store or save the calculated value of the NPV,
and repeat Steps 2 and 3. Computer softwares
allows one to easily repeat Steps 2 and 3
thousands of times.
5. Use the stored values of the project NPV to
construct a histogram or probability distribution of
NPV.
Figure 2-1 Probability Distribution of NPVs for the Marketing
of Longhorn’s Brake Lights
2.3 BREAK—EVEN ANALYSIS
Break—Even Analysis
Break-even analysis determines the minimum level
of output or sales that the firm must achieve in order
to avoid losing money – that is, to break even. In
most cases, break-even sales is defined as the
level of sales for which net operating income (NOI)
equals zero.
Accounting Break—Even Analysis
• Accounting break-even analysis involves
determining the level of sales necessary to cover
total fixed costs – that is, both cash fixed costs
and depreciation.
• We decompose production costs into two
components: fixed costs and variable costs.
Fixed Costs
• Fixed costs (or indirect costs) do not vary
directly with sales revenue but instead remain
constant despite any change to the business; they
can be divided into fixed operating costs before
depreciation and depreciation itself.
• As the number of units sold increases, fixed cost
per unit decreases, because the fixed costs are
spread over larger quantities of output.
Variable Costs
• Variable costs (or direct costs) are those costs
that vary with firm sales. For example, hourly
wages, cost of materials used, sales commission.
• Variable costs per unit remain the same
regardless of the level of output. If zero units are
produced, total variable costs will be equal to
zero.
Calculating the Accounting Break—Even
Point
The accounting break-even point is the level of
sales that is necessary to cover both variable and
total fixed costs, such that the net operating income
is equal to zero.
Total Fixed Costs (F ) Total Fixed Costs (F )
QAccounting break-even = =
Price per Variable Cost Contribution Margin
−
Unit (P ) per Unit (V ) per Unit
Figure 2-2 Accounting Break—Even Analysis (1 of 2)
Figure 2-2 Accounting Break—Even Analysis (2 of 2)
CHECKPOINT 2.4: CHECK YOURSELF
Project Risk Analysis:
Accounting Break-Even Analysis
The Problem
Crainium, Inc.’s analysts have estimated the
accounting break-even for the project to be 130,000
units and now want to consider how the values for
the worst-case scenario affect the accounting
break-even. Specifically, consider a unit price of
$23, variable cost per unit of $21, and total fixed
costs of $700,000.
Step 1: Picture the Problem (1 of 3)
The new investment that Crainium, Inc. is planning
to invest is described in Checkpoint 2.2 with the
following revised estimates:
– Price per unit = $25
– Variable cost per unit = $23
– Total fixed cost per year = $700,000
Step 1: Picture the Problem (2 of 3)
The annual costs consists of total fixed costs and
variable costs that vary by the level of output.
Total costs
= Variable cost (# of units) + Total fixed costs
Step 1: Picture the Problem (3 of 3)
The following table shows the break-up of total costs for four units of
output.
Units of Output Variable Costs Fixed Costs Total Costs Revenue Profit
Blank Base Sales Level for Forecast Sales Percentage Change in Sales
Year t Level for Year t and NOI
+1
P(favorable)
= .4
Build 10 more
restaurants
NPV = 10 × $800,000
Build 1 smooth-Thru
at a cost of $2.4
million
Don’t build any more
restaurants
P(Unfavorable)
= .6 NPV = −$1,600,000
Step 2: Decide on a Solution Strategy
We need to determine the NPV of this project
assuming we will build 10 restaurants if the project
is favorably received and will not build any
additional restaurants if it is not favorably received.
Step 3: Solve (1 of 3)
We are given the following information (per
Restaurant):
• Perpetual annual cash flow:
– if favorably received = $320,000
– if not favorably received = $80,000
• Probability of being favorably received = 40%
• Discount rate = 10%
Step 3: Solve (2 of 3)
We use the PV of perpetuity equation (given by
CF/i) to determine the present value of cash flows.
• NPV (if favorably received)
– = ($320,000 ÷.10) − $2,400,000 = $800,000
• NPV (if not favorably received)
– = ($80,000 ÷.10) − $2,400,000 = −$1,600,000
Step 3: Solve (3 of 3)
• Assuming we will open 10 restaurants if it is
favorably received and only one if it is unfavorably
received, we can determine the expected NPV as
follows:
• Expected NPV
= 10 (.4)($800,000) + 1(.60)(−1,600,000)
= $2,240,000
Step 4: Analyze
Without the option to expand, this project would
have had a NPV of −$640,000.
NPV = $800,000(.4) + (−$1,600,000)(.6)
= −$640,000
However, by considering the option to expand, the
project has a positive NPV.
Key Terms (1 of 3)
• Accounting break-even analysis
• Break-even analysis
• Cash break-even point
• Contribution margin
• Degree of operating leverage (DOL)
• Direct cost
• Expected value
Key Terms (2 of 3)
• Fixed cost
• Indirect cost
• NPV break-even analysis
• Operating leverage
• Real options
• Scenario analysis
• Sensitivity analysis
Key Terms (3 of 3)
• Simulation analysis
• Value drivers
• Variable costs