PowerPoint PresentationKey Concepts and SkillsChapter Outline9.1 Decision TreesExample of a Decision TreeStewart PharmaceuticalsNPV Following Successful TestNPV Following Unsuccessful TestDecision Tree for StewartDecision to Test9.2 Sensitivity, Scenario, and Break-EvenSensitivity Analysis: StewartScenario Analysis: StewartBreak-Even AnalysisBreak-Even Analysis: StewartSlide 16Break-Even Revenue: StewartBreak-Even Analysis: PBE9.3 Monte Carlo SimulationMonte Carlo SimulationSlide 219.4 Real OptionsReal OptionsDiscounted CF and OptionsThe Option to Abandon: ExampleThe Option to Abandon: ExampleSlide 27Slide 28Valuing the Option to AbandonThe Option to Delay: ExampleQuick Quiz9-1RISK ANALYSIS, REAL OPTIONS, AND CAPITAL BUDGETINGChapter 9Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.9-2KEY CONCEPTS AND SKILLS•Grasp and execute decision trees•Apply scenario and sensitivity analysis•Comprehend and utilize the various forms of break-even analysis•Conceptualize Monte Carlo simulation•Practically apply real options in capital budgeting9-3CHAPTER OUTLINE9.1 Decision Trees9.2 Sensitivity Analysis, Scenario Analysis, and Break-Even Analysis9.3 Monte Carlo Simulation9.4 Real Options9-49.1 DECISION TREES•Graphical representation of the alternatives available in each period and the likely consequences of our choices•This graphical representation helps identify the best course of action.9-5EXAMPLE OF A DECISION TREEDo not studyStudy financeSquares represent decisions to be made.Circles represent receipt of information, e.g., a test score.The lines leading away from the squares represent the alternatives.“C”“A”“B”“F”“D”9-6STEWART PHARMACEUTICALS •Stewart Pharmaceuticals Corporation is considering investing in the development of a drug that cures the common cold.•A corporate planning group, including representatives from production, marketing, and engineering, has recommended that the firm go ahead with the test and development phase.•This preliminary phase will last one year and cost $1 billion. Furthermore, the group believes that there is a 60% chance that tests will prove successful.•If the initial tests are successful, Stewart Pharmaceuticals can go ahead with full-scale production. This investment phase will cost $1.6 billion. Production will occur over the following 4 years.9-7NPV FOLLOWING SUCCESSFUL TESTNote that the NPV is calculated as of date 1, the date at which the investment of $1,600 million is made. Later we bring this number back to date 0. Assume a cost of capital of 10%.Investment Year 1 Years 2-5Revenues $7,000Variable Costs (3,000)Fixed Costs (1,800)Depreciation (400)Pretax profit $1,800Tax (34%) (612)Net Profit $1,188Cash Flow -$1,600 $1,58875.433,3$)10.1(588,1$600,1$1411NPVNPVtt9-8NPV FOLLOWING UNSUCCESSFUL TESTNote that the NPV is calculated as of date 1, the date at which the investment of $1,600 million is made. Later we bring this number back to date 0. Assume a cost of capital of 10%.Investment Year 1 Years 2-5Revenues $4,050Variable Costs (1,735)Fixed Costs (1,800)Depreciation (400)Pretax profit $115Tax (34%) (39.10)Net Profit $75.90Cash Flow -$1,600 $475.90461.91$)10.1(90.475$600,1$1411NPVNPVtt9-99-9DECISION TREE FOR STEWARTDo not testTestFailureSuccessDo not investInvestInvestThe firm has two decisions to make:To test or not to test.To invest or not to invest.0$NPVNPV = $3.4 bNPV = $0NPV = –$91.46 m9-10DECISION TO TEST•Let’s move back to the first stage, where the decision boils down to the simple question: should we invest?•The expected payoff evaluated at date 1 is:failuregiven PayofffailureProb.successgiven PayoffsucessProb.payoffExpected   25.060,2$0$40.75.433,3$60.payoffExpected95.872$10.125.060,2$000,1$ NPVThe NPV evaluated at date 0 is:So, we should test.9-119.2 SENSITIVITY, SCENARIO, AND BREAK-EVEN•Sensitivity Analysis:•Also called “What if” analysis •Allows the calculation of a range of NPVs based on the probability of changes in NPV variables•TIP: When working with spreadsheets:•build the model so variables can be adjusted in a single cell;•And the NPV calculations update automatically.9-12SENSITIVITY ANALYSIS: STEWART•We can see that NPV is very sensitive to changes in revenues. In the Stewart Pharmaceuticals example, a 14% drop in revenue leads to a 61% drop in NPV.%29.14000,7$000,7$000,6$Rev% %71.5975.433,3$75.433,3$48.383,1$% NPVFor every 1% drop in revenue, we can expect roughly a 4.18% drop in NPV:%29.14%71.5918.49-13SCENARIO ANALYSIS: STEWART•A variation on sensitivity analysis is scenario analysis.•For example, the following three scenarios could apply to Stewart Pharmaceuticals:1. The next years each have heavy cold seasons, and sales exceed expectations, but labor costs skyrocket.2. The next years are normal, and sales meet expectations.3. The next years each have lighter than normal cold seasons, so sales fail to meet expectations.•Other scenarios could apply to FDA approval.•For each scenario, calculate the NPV.9-14BREAK-EVEN ANALYSIS•Common tool for analyzing the relationship between sales volume and profitability•There are three common break-even measures•Accounting break-even: sales volume at which net income = 0•Cash break-even: sales volume at which operating cash flow = 0•Financial break-even: sales volume at which net present value = 0•This discussion is most concerned with financial break-even9-15BREAK-EVEN ANALYSIS: STEWART•In the Stewart Pharmaceuticals example, there could be concern with break-even revenue, break-even sales volume, or break-even price.•To find any of these, we start with the break-even operating cash flow.9-16BREAK-EVEN ANALYSIS: STEWART•The project requires an investment of $1,600. •In order to cover our cost of capital (financial break even), the project needs to generate a cash flow of $504.75 each year for four years.•This is the project’s break-even operating cash flow, OCFBE.PMTI/YFVN− 504.751001,6004PV9-179-17BREAK-EVEN REVENUE: STEWARTWork backwards from OCFBE to Break-Even RevenueRevenue $5,358.71Variable cost $3,000Fixed cost $1,800Depreciation $400EBIT $158.71Tax (34%) $53.96Net Income $104.75 OCF = $104.75 +