INTERMEDIATE FINANCE

FINN-200
Instructor:
Bushra Naqvi PhD, FRM
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Bushra Naqvi PhD, FRM
RISK ANALYSIS OF CAPITAL
INVESTMENT
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B.1: STAND-ALONE METHODS
B.1.1: SCENARIO ANALYSIS

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 What happens to the NPV under different cash flow
scenarios?

Bushra Naqvi PhD, FRM

 At the very least look at:
 Best case – high revenues, low costs
 Worst case – low revenues, high costs
 Measure of the range of possible outcomes
 Best case and worst case are not necessarily probable,
but they can still be possible

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NEW PROJECT EXAMPLE

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 Consider the project discussed in the text
 The initial cost is $200,000 and the project has a 5-year

Bushra Naqvi PhD, FRM

life. There is no salvage. Depreciation is straight-line, the
required return is 12%, and the tax rate is 34%
 The base case NPV is 15,567

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SUMMARY OF SCENARIO ANALYSIS
Scenario Net Cash NPV IRR
Income Flow

Base case 19,800 59,800 15,567 15.1%

Worst -15,510 24,490 -111,719 -14.4%

Case

Best Case 59,730 99,730 159,504 40.9%

B.1.2: SENSITIVITY ANALYSIS

01/10/2014
 What happens to NPV when we vary one variable at a time

Bushra Naqvi PhD, FRM

 This is a subset of scenario analysis where we are looking at
the effect of specific variables on NPV

 The greater the volatility in NPV in relation to a specific

variable, the larger the forecasting risk associated with that
variable, and the more attention we want to pay to its
estimation

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SUMMARY OF SENSITIVITY ANALYSIS FOR
NEW PROJECT

Scenario Unit Sales Cash NPV IRR

Flow

Base case 6000 59,800 15,567 15.1%

Worst 5500 53,200 -8,226 10.3%

case

Best case 6500 66,400 39,357 19.7%

B.1.3: SIMULATION (MONTE CARLO)
ANALYSIS
B.1.3: SIMULATION (MONTE CARLO)
ANALYSIS
SOLUTION 1: NPV, IRR BASED ON EV

Expected Cash Flows for Simulation Exercise

Time 0 1 2 3 4 5
Fixed Capital (20,000)
After tax Salvage Value 1,200

Price 5 5 5 5 5
Output 2,000 2,120 2,247 2,382 2,525
Revenues 10,000 10,600 11,236 11,910 12,625
Cash Operating Expenses 3,000 3,180 3,371 3,573 3,787
Depreciation 4,000 4,000 4,000 4,000 4,000
Operating income before taxes 3,000 3,420 3,865 4,337 4,837
Taxes 1,200 1,368 1,546 1,735 1,935
Operating income after taxes 1,800 2,052 2,319 2,602 2,902
Add: Depreciation 4,000 4,000 4,000 4,000 4,000

After Tax Cash Flows (20,000) 5,800 6,052 6,319 6,602 8,102

NPV @ 12% 3,294

IRR 18.11%
SOLUTION 2: SIMULATION ANALYSIS
SOLUTION 2: SIMULATION ANALYSIS
(CONT.)
SOLUTION 2: SIMULATION ANALYSIS
(CONT.)
01/10/2014 Bushra Naqvi PhD, FRM
REAL OPTIONS
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REAL OPTIONS

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 Real options are capital budgeting options / opportunities that
are embedded in capital projects that enable managers to alter
their cash flows and risk in a way that affects project

Bushra Naqvi PhD, FRM

acceptability (NPV).

 Instead of making all decisions now, at time zero, managers

can wait and make additional decisions at future dates when
these future decisions are contingent upon future economic
events or information

 Real options are also sometimes referred to as strategic

options.
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REAL OPTIONS

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 Some of the more common types of real options are:
 Sizing Option

Bushra Naqvi PhD, FRM

 Abandonment Option
 Growth Option
 Flexibility Option
 Price-Setting Option
 Production Flexibility
 Timing Option

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REAL OPTIONS
EVALUATING PROJECTS WITH
OPTIONS

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 There are several approaches to evaluating capital budgeting
projects with real options.

Bushra Naqvi PhD, FRM

 Four common sense approaches to real options analysis are:

1. Consider the project NPV = NPV (based on DCF alone) –

Cost of options + Value of Options
2. Using Decision Trees
3. Using Option Pricing Models

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ABANDONMENT OPTIONS
Example:
ABANDONMENT OPTIONS
Solution: NPV without Option

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ABANDONMENT OPTIONS
Solution: NPV with Option

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ABANDONMENT OPTIONS
Solution: NPV with Option (cont.)

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FLEXIBILITY OPTIONS
Example:
OPTION TO WAIT
Hickock Mining is evaluating when to open a gold mine.

01/10/2014
The mine has 48,000 ounces of gold left that can be mined,
and mining operations will produce 6,000 ounces per year.
The required return on the gold mine is 12 percent, and it

Bushra Naqvi PhD, FRM

will cost $34 million to open the mine. When the mine is
opened, the company will sign a contract that will guarantee
the price of gold for the remaining life of the mine.
If the mine is opened today, each ounce of gold will generate
an after-tax cash flow of $1,400 per ounce. If the company
waits one year, there is a 60 percent probability that the
contract price will generate an after-tax cash flow of $1,600
per ounce and a 40 percent probability that the after-tax cash
flow will be $1,300 per ounce. What is the value of the
option to wait? 25
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