Because learning changes everything.

Corporate Finance Thirteenth Edition

Stephen A. Ross / Randolph W. Westerfield / Jeffrey F. Jaffe /
Bradford D. Jordan

Chapter 7

Risk Analysis, Real Options, and Capital Budgeting

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 Chapter Outline
7.1 Sensitivity Analysis, Scenario Analysis, and Break-
Even Analysis
7.2 Monte Carlo Simulation
7.3 Real Options
7.4 Decision Trees

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 7.1 Sensitivity Analysis, Scenario Analysis, and
Break-Even Analysis
• Each allows us to look behind the N PV number to
see how stable our estimates are.
• When working with spreadsheets, try to build your
model so that you can adjust variables in a single cell
and have the NPV calculations update accordingly.

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 Example: Stewart 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
percent 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.
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 NPV Following Successful Test

Investment Year 1 Years 2–5 Note that the NPV is

Revenues $7,000 calculated as of Date 1, the
Variable Costs 3,000
date at which the investment
Fixed Costs 1,800
of $1,600 million is made.
Depreciation 400
Later we bring this number
Pretax profit $1,800
back to Date 0. Assume a cost
Tax (21%) 378
of capital of 10 percent.
Net Profit $1,422
Cash Flow –$1,600 $1,822 4
$1,822
NPV1  –$1, 600   t
t 1 1.10

NPV1  $4,175.49

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 NPV Following Unsuccessful Test

Investment Year 1 Years 2–5 Note that the NPV is

Revenues $4,050 calculated as of Date 1, the
Variable Costs 1,735
date at which the investment
Fixed Costs 1,800
of $1,600 million is made.
Depreciation 400
Later we bring this number
Pretax profit $115
back to Date 0. Assume a cost
Tax (21%) 24.15
of capital of 10 percent.
Net Profit $90.85
Cash Flow –$1,600 $490.85 4
$490.85
NPV1  –$1, 600   t
t 1 1.10

NPV1  –$44.07

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 Decision 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:
Expected payoff  Prob. success  Payoff given success  Prob. failure  Payoff given failure

Expected payoff = (.6 × $4,175.49) + (.4 × −$44.07) =

$2,487.67
The NPV evaluated at Date 0 is:

$2, 487.67
NPV1  –$1, 000   $1, 261.52
1.10

So, we should test.

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 Sensitivity Analysis: Stewart
We can see that NPV is very sensitive to changes in
revenues. In the Stewart Pharmaceuticals example, a 14
percent drop in revenue leads to a 60 percent drop in NPV.
$6,000  7,000
%Rev   .1429, or  14.29%
$7,000

$1,671.30  4,175.49
%NPV   .5997, or  59.97%
$4,175.49

For every 1 percent drop in revenue, we can expect roughly

a 4.2 percent drop in NPV.

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 Scenario Analysis: Stewart
A variation on sensitivity analysis is scenario analysis.
For example, the following three scenarios could apply to
Stewart Pharmaceuticals:
1. The next few years each have heavy cold seasons, and
sales exceed expectations, but labor costs skyrocket.
2. The next few years are normal, and sales meet
expectations.
3. The next few 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.

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 Break-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.

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 Accounting Break-Even :Boing Input
• Sales price is $2 million per engine
• Variable cost is $1 million per engine
• The difference between sales price and variable cost per
engine is :
• Sales price - Variable cost = $2 million — 1 million = $1
million per engine is is called the pretax contribution
margin because each additional engine contributes this
amount to pretax profit.
• Total annual fixed costs are $1,940 million
• Annual depreciation expense is $300 million, implying that
the sum of these costs is: Fixed costs+ Depreciation =
$1,940 million+ 300 million = $2,240 million
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 Accounting Break-Even :Boing
Computations
• That is, the firm incurs fixed costs of $2,240 million per year,
regardless of the number of sales.
• Since each engine contributes $1 million, annual sales must reach the
following level to offset the costs:

• The break-even point required for an accounting profit is 2,240

engines.
• You might be wondering why taxes have been ignored in the
calculation of break-even accounting profit. The reason is that a firm
with a pretax profit of $0 also will have an after-tax profit of $0
because no taxes are paid if no pretax profit is reported. Thus, the
number of units needed to break even on a pretax basis must be
equal to the number of units needed on an aftertax basis
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 Using Accounting Break-Even
• Accounting break-even is often used as an early stage
screening number.

• If a project cannot break-even on an accounting basis,

then it is not going to be a worthwhile project. NPV will
generally be < 0.

• Accounting break-even gives managers an indication of

how a project will impact accounting profit.

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 Example/Accounting Break-even

Consider the following project:

 A new product requires an initial investment of $5 million
and will be depreciated to an expected salvage of zero
over 5 years.

 The price of the new product is expected to be $25,000,

and the variable cost per unit is $15,000.

 The fixed cost is $1 million.

 What is the accounting break-even point each year?

• Depreciation = 5,000,000 / 5 = 1,000,000
• Q = (1,000,000 + 1,000,000)/(25,000 – 15,000) = 200 units

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 Sales Volume and Operating Cash
Flow Break-Even Analysis
• Cash break-even occurs where operating cash flow = 0.
• What is the cash break-even quantity (ignoring taxes) in
the previous example ? (P=Price;v=variable
costs;FC=fixed costs;D=depreciation)
 OCF = [(P-v)Q – FC – D] + D = (P-v)Q – FC
 Q = (OCF + FC) / (P – v)
 Q = (0 + 1,000,000) / (25,000 – 15,000) = 100 units
• With taxes:
 OCF = [(P − v)Q − FC − D](1 − T) + D

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 Financial Break-Even: NPV=0

Similar to the minimum bid price example in the special

cases of capital budgeting

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 Summary: Three Types of Break-Even
Analysis
Accounting Break-even
 Where NI = 0
 Q = (FC + D)/(P – v)

Cash Break-even
 Where OCF = 0
 Q = (FC + OCF)/(P – v); (ignoring taxes)

Financial Break-even
 Where NPV = 0

Cash BE < Accounting BE < Financial BE

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 7.2 Monte Carlo Simulation – I
Monte Carlo simulation is a further attempt to model
real-world uncertainty.
This approach takes its name from the famous
European casino because it analyzes projects the way
one might evaluate gambling strategies.

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 Monte Carlo Simulation – II
Imagine a serious blackjack player who wants to know if
she should take the third card whenever her first two
cards total sixteen.
• She could play thousands of hands for real money to
find out.
• This could be hazardous to her wealth.
• Or, she could play thousands of practice hands.

Monte Carlo simulation of capital budgeting projects is

in this spirit.

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 Monte Carlo Simulation – III
Monte Carlo simulation of capital budgeting projects is
often viewed as a step beyond either sensitivity analysis
or scenario analysis.
Interactions among the variables are explicitly specified
in Monte Carlo simulation; so, at least theoretically, this
methodology provides a more complete analysis.
While the pharmaceutical industry has pioneered
applications of this methodology, its use in other
industries is far from widespread.

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 Monte Carlo Simulation – IV
Step 1: Specify the Basic Model
Step 2: Specify a Distribution for Each Variable in the
Model
Step 3: The Computer Draws One Outcome
Step 4: Repeat the Procedure
Step 5: Calculate NPV

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 7.3 Real Options
One of the fundamental insights of modern finance
theory is that options have value.
The phrase “We are out of options” is surely a sign of
trouble.
Because corporations make decisions in a dynamic
environment, they have options that should be
considered in project valuation.

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 Real Options
The Option to Expand.
• Has value if demand turns out to be higher than expected.

The Option to Abandon.

• Has value if demand turns out to be lower than expected.

The Option to Delay.

• Has value if the underlying variables are changing with a
favorable trend.

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 Discounted CF and Options
We can calculate the market value of a project as the sum of
the NPV of the project without options and the value of the
managerial options implicit in the project.

M  NPV  Opt

A good example would be comparing the desirability of a

specialized machine versus a more versatile machine. If they
both cost about the same and last the same amount of time,
the more versatile machine is more valuable because it
comes with options.

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 The Option to Abandon: Example – I
• Suppose we are drilling an oil well. The drilling rig
costs $300 today, and in one year the well is either a
success or a failure.
• The outcomes are equally likely. The discount rate is
10 percent.
• The PV of the successful payoff at time one is $575.
• The PV of the unsuccessful payoff at time one is $0.

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 The Option to Abandon: Example - II
Traditional NPV analysis would indicate rejection of the
project.
Expected Payoff  Prob. Success  Successful Payoff  Prob. Failure  Failure Payoff

Expected Payoff  .50  $575   .50  $0   $287.50

$287.50
NPV  –$300   $38.64
1.10

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 The Option to Abandon: Example – III
However, traditional NPV analysis overlooks the option to
abandon.

The firm has two decisions to make: drill or not, abandon or

stay.
Access the text alternative for slide images
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 The Option to Abandon: Example - IV
When we include the value of the option to abandon, the
drilling project should proceed:
Expected Payoff  Prob. Success  Successful Payoff  Prob. Failure  Failure Payoff

Expected Payoff  .50  $575   .50  $250   $412.50

$412.50
NPV  –$300   $75.00
1.10

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 Valuing the Option to Abandon
Recall that we can calculate the market value of a
project as the sum of the NPV of the project without
options and the value of the managerial options implicit
in the project.

M  NPV  Opt
$75.00  $38.64 Opt
$75.00  $38.64  Opt
Opt  $113.64

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 The Option to Delay: Example

Year Cost PV
In the following table, read ‘N P V t’ as N P N sub t; ‘N P V t’ as N P V sub 0.
NPVt NPV0
0 $20,000 $25,000 $5,000 $5,000
1 18,000 25,000 7,000 6,364 $7,900
$6,529 
2 17,100 25,000 7,900 6,529 1.102
3 16,929 25,000 8,071 6,064
4 16,760 25,000 8,240 5,628

• Consider the above project, which can be undertaken in any of the

next 4 years. The discount rate is 10 percent. The present value of the
benefits at the time the project is launched remains constant at
$25,000, but since costs are declining, the N PV at the time of launch
steadily rises.
• The best time to launch the project is in Year 2—this schedule yields
the highest NPV when judged today with an option to wait worth
$1529 (i.e. $6,529-$5,000) in today’s dollar if we wait two years.
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 7.4 Decision Trees
Allow us to graphically represent the alternatives
available to us in each period and the likely
consequences of our actions
This graphical representation helps to identify the best
course of action.

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 Example of a Decision Tree
Squares 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.

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 Decision Tree for Stewart
The firm has two decisions to make:
To test or not to test.
To invest or not to invest.

Access the text alternative for slide images

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 Quick Quiz
What are sensitivity analysis, scenario analysis, break-
even analysis, and simulation?
Why are these analyses important, and how should they
be used?
How do real options affect the value of capital projects?
What information does a decision tree provide?

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