Principles of

Corporate Finance
Chapter 10 Eighth Edition

A Project is Not A
Black Box
Slides by
Matthew Will

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 10- 2

Topics Covered
 Sensitivity Analysis
– Break Even Analysis
 Monte Carlo Simulation
 Real Options and Decision Trees

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 10- 3

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.

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 10- 4

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.

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 10- 5

Sensitivity Analysis
Example - continued
Year 0 Years 1 - 10
Investment - 15
Sales 37.5
Variable Costs 30
Fixed Costs 3
Depreciati on 1.5
Pretax profit 3
.Taxes @ 50% 1.5
Profit after tax 1.5
Operating cash flow 3.0
Net Cash Flow - 15 3
NPV= 3.43 billion Yen

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 10- 6

Sensitivity Analysis
Example - continued

Possible Outcomes
Range
Variable Pessimistic Expected Optimistic
Market Size .9 mil 1.0 mil 1.1 mil
Market Share .04 .1 .16
Unit price 350,000 375,000 380,000
Unit Var Cost 360,000 300,000 275,000
Fixed Cost 4 bil 3 bil 2 bil

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 10- 7

Sensitivity Analysis
Example - continued
NPV Calculations for Optimistic Market Size Scenario
Year 0 Years 1 - 10
Investment - 15
Sales 41.25
Variable Costs 33
Fixed Costs 3
Depreciation 1.5
Pretax profit 3.75
.Taxes @ 50% 1.88
Profit after tax 1.88
NPV= +5.7 bil yen
Operating cash flow 3.38
Net Cash Flow - 15  3.38

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 10- 8

Sensitivity Analysis
Example - continued

NPV Possibilities (Billions Yen)

Range
Variable Pessimistic Expected Optimistic
Market Size 1.1 3.4 5.7
Market Share - 10.4 3.4 17.3
Unit price - 4.2 3.4 5.0
Unit Var Cost - 15.0 3.4 11.1
Fixed Cost 0.4 3.4 6.5

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 10- 9

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.
PV Inflows

Break even
400 NPV=0
PV (Yen)
200 PV Outflows
Billions

19.6
Sales, 000’s
85 200
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 10- 10

Electric Scooter – NPV

Cash Flows, Years 1-10, Billions

High Oil Prices and
Base Case Recession Case
1 Revenue 37.5 44.9
2 Variable cost 30.0 35.9
3 Fixed cost 3.0 3.5
4 Depreciation 1.5 1.5
5 Pretax profit (1-2-3-4) 3.0 4.0
6 Tax 1.5 2.0
7 Net profit (5-6) 1.5 2.0
8 Net cash flow (4+7) 3.0 3.5

PV of cash flows 18.4 21.5

NPV 3.4 6.5

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 10- 11

Electric Scooter - Assumptions

Assumptions
High Oil Prices and
Base Case Recession Case
Market size 1 million .8 million
Market share 0.1 0.13
Unit Price 375000 431300
Unit variable cost 300000 345000
Fixed cost 3 billion 3.5 billion

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 10- 12

Electric Scooter - Scenarios

Inflows Outflows
Year 0 Years 1-10
Unit Sales, Revenue, Variable Fixed PV
Thousands Years 1-10 Investment Costs Costs Taxes PV Inflows Outflows NPV
0 0 15 0 3 -2.25 0 19.6 -19.6
100 37.5 15 30 3 1.5 230.4 227 3.4
200 75 15 60 3 5.25 460.8 434.4 26.4

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Electric Scooter – Accounting Profit

Unit Sales, Variable Fixed Total Profit

Thousands Revenue Costs Costs Depreciation Taxes Costs after Tax
0 0 0 3 1.5 -2.25 2.25 -2.25
100 37.5 30 3 1.5 1.5 36 1.5
200 75 60 3 1.5 5.25 69.75 5.25

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 10- 14

Electric Scooter – Cash Flows

Year 0 Year 1-10
Investment 15.00
1. Revenue 37.50
2. Variable cost 12.00
3. Fixed cost 19.00
4. Depreciation 1.50
5. Pretax profit (1-2-3-4) 5.00
6.Tax 2.50
7. Net profit (5-6) 2.50
8. Operating cash flow (4+7) 4.00

Net cash flow (15.00) 4.00

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 10- 15

Monte Carlo Simulation

Modeling Process

 Step 1: Modeling the Project

 Step 2: Specifying Probabilities
 Step 3: Simulate the Cash Flows

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 10- 16

Monte Carlo Simulation

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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.

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Decision Trees

Success
Test (Invest Pursue project
$200,000) NPV=$2million

Failure

Stop project

Don’t test NPV=0

NPV=0

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 10- 19

Real Options

1. Option to expand
2. Option to abandon
3. Timing option
4. Flexible production facilities

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 10- 20

Decision Trees
960 (.8)
+150(.6)
220(.2)
-550
930(.4)
NPV= ? +30(.4)
140(.6)
Turboprop
800(.8)
-150
100(.2)
+100(.6) or
410(.8)
0
180(.2)
-250
220(.4)
NPV= ? +50(.4)
100(.6)
Piston
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 10- 21

Decision Trees
960 (.8)
+150(.6) 812
220(.2)
-550
930(.4)
+30(.4) 456
NPV= ? 140(.6)
Turboprop
800(.8)
-150 660
100(.2)
+100(.6) or
410(.8)
0 364
180(.2)
-250
220(.4)
NPV= ? +50(.4) 148
100(.6)
Piston
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 10- 22

Decision Trees
960 (.8)
+150(.6) 812
220(.2)
-550
930(.4)
+30(.4) 456
NPV= ? 140(.6)
Turboprop
800(.8)
-150 660
100(.2)
+100(.6) or
410(.8)
0 364
180(.2)
-250
220(.4)
NPV= ?  960  .80+50(.4)
  220  .20  812
100(.6)
148
Piston
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 10- 23

Decision Trees
960 (.8)
660
660  150 812
 150  450
+150(.6)
450 220(.2)
-550 11..10
10 930(.4)
+30(.4) 456
NPV= ? 140(.6)
Turboprop
*450 800(.8)
-150 660
100(.2)
+100(.6) or
410(.8)
0 364
331 180(.2)
-250
220(.4)
NPV= ? +50(.4) 148
100(.6)
Piston
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 10- 24

Decision Trees
NPV=888.18 960 (.8)
+150(.6) 812
220(.2)
-550
930(.4)
+30(.4) 456
NPV= ? 140(.6)
NPV=444.55
Turboprop
*450 800(.8)
812
812  150 -150 660
 150  888
100(.2)
NPV=550.00
888 ..18
18
+100(.6) or
11..10
10 0
410(.8)
364
331 180(.2)
-250
220(.4)
NPV= ? +50(.4) 148
NPV=184.55 100(.6)
Piston
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 10- 25

Decision Trees
NPV=888.18 960 (.8)
+150(.6) 812
220(.2)
-550 710.73
930(.4)
+30(.4) 456
NPV= ? 140(.6)
NPV=444.55
Turboprop
*450 800(.8)
-150 660
NPV=550.00 100(.2)
+100(.6) or
410(.8)
 888   444 40
364
18..60 55..40
0
..18
888403.82 60
331 444 ..55
180(.2)
-250
220(.4)
NPV= ? +50(.4) 148
NPV=184.55 100(.6)
Piston
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 10- 26

Decision Trees
NPV=888.18 960 (.8)
+150(.6) 812
Turboprop 220(.2)
-550 710.73
930(.4)
+30(.4) 456
NPV=96.12 140(.6)
NPV=444.55
*450 800(.8)
-150 660
NPV=550.00 100(.2)
+100(.6) or
410(.8)
Piston 710 . 73 0
710.73  550331 96.12180(.2) 364

-250 403.82 550  96.12

11..10
10 220(.4)
NPV=117.00 +50(.4) 148
NPV=184.55 100(.6)

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 10- 27

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

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 10- 28

Web Resources
Click to access web sites
Internet connection required

www.jaxworks.com
www.decisioneering.com
www.kellogg.northwestern.edu/faculty/myerson

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