Intermediate Finance

Session 5
Risk Analysis, Real
Options, and Capital
Budgeting
False Sense of Security
 Sensitivity Analysis
• Examines how sensitive a particular NPV
calculation is to changes in underlying
assumptions.
• Sensitivity analysis is also known as what-if
analysis and bop (best, optimistic, and
pessimistic) analysis.
 Sensitivity Analysis
• Solar Electronics Corporation (SEC) has
recently developed a solar-powered jet
engine and wants to go ahead with full-scale
production.
• The initial (Year 1) 1 investment is $1,500
million, followed by production and sales
over the next five years.
Sensitivity Analysis
 Sensitivity Analysis

• Should you go ahead?

Sensitivity Analysis
Assumptions : Revenue
Assumptions : Costs
Forecasts
What does this table
tell?
Forecasts
Any insights?
 Any insights?
• Error in the estimate of investment appears
to be relatively unimportant because, even
under the pessimistic scenario, the NPV of
$1,208 million is still highly positive.
• By contrast, the pessimistic forecast for
market share leads to a negative NPV of −
$696 million, and a pessimistic forecast for
market size leads to a substantially negative
NPV of −$1,802 million.
 ANY DRAWBACKS OF
SENSITIVITY ANALYSIS?
 You can have an optimistic
view of a pessimistic forecast
 Drawbacks of Sensitivity
Analysis
• Sensitivity analysis may unwittingly increase
the false sense of security among managers
• Sensitivity analysis treats each variable in
isolation when, in reality, the different
variables are likely to be related
 Scenario Analysis
• Examines a number of different likely
scenarios, where each scenario involves a
confluence of factors
 Scenario Analysis
• Consider the effect of a few airline crashes.
• Crashes  likely to reduce flying in total 
limiting the demand for any new engines
• Even if the crashes do not involve solar-
powered aircraft, the public could become
more averse to any innovative and
controversial technologies.
• SEC’s market share might fall as well
Scenario Analysis
 Break-Even Analysis
• Determines the sales needed to break even
• How far down sales can fall before the
project is losing money, either in an
accounting sense or an NPV sense.
 Break-Even Analysis
• Accounting Sense
Break-Even Analysis
Break-Even Analysis
Break-Even Analysis
 Break-Even Analysis
• NPV Sense
Break-Even Analysis
Break-Even Analysis
Notice anything?
Break-Even Analysis
 Why the difference?
• Why is the accounting break-even point
different from the financial break-even
point?
 Why the difference?
• In accounting profit as the basis for the break-even calculation,
we subtract depreciation. Depreciation for the solar jet engines
project is $300 million per year. If 2,091 solar jet engines are
sold per year, SEC will generate sufficient revenues to cover
the $300 million depreciation expense plus other costs.
• At this level of sales SEC will not cover the economic
opportunity costs of the $1,500 million laid out for the
investment.
• If we take into account that the $1,500 million could have been
invested at 15 percent, the true annual cost of the investment is
$447.5 million, not $300 million.
Monte Carlo Simulation
• Imagine that Backyard Barbeques, Inc. (BBI),
a manufacturer of both charcoal and 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.
Step 1
Step 1
 Step 2
• Specify a distribution for each variable in the
model
 Step 2
• Number of grills sold by the entire industry:
he trade publication Outdoor Food (OF)
reported that 10 million grills of all types were
sold in the continental United States last year,
and it forecasts sales of 10.5 million next year
Step 2
 Step 2
• Specify a distribution for each variable in the
model
Step 2
 Step 2
• Specify a distribution for each variable in the
model
Step 2
Step 2
 Step 3
• Computer draws one random outcome
• Imagine that the computer randomly picks
industry wide unit sales of 10 million, a
market share for BBI’s hydrogen grill of 2
percent, and a +$3 random price variation
 Step 3
• We would have to perform drawings for revenue in
each future year.
• We would perform drawings for costs in each future
year.
• We would have to perform drawing for initial
investment.
• In this way, a single outcome, made up of a drawing
for each variable in the model, would generate a
cash flow from the project in each future year
 Step 4
• Repeat the procedure
• Depending on the situation, the computer
may be called on to generate thousands or
even millions of outcomes.
• The result of all these drawings is a
distribution of cash flow for each future year.
This distribution is the basic output of Monte
Carlo simulation.
Step 4
 Step 5
• Calculate NPV
• Given the distribution of cash flow for the third
year one can determine the expected cash flow
for this year.
• In a similar manner, one can also determine the
expected cash flow for each future year and then
calculate the net present value of the project by
discounting these expected cash flows at an
appropriate rate.
 HANDS-ON PRACTICE OF
MONTE CARLO SIMULATIONS