MIN 100

Investment Analysis
Roy Endr Dahl
University of Stavanger

E-mail: roy.e.dahl@uis.no
1
Early dialogue
We need to elect a student representative who will help
organize the early dialogue in this course.
The early dialogue will answer 5 questions:
1. Teaching and assesment methods
2. Curriculum
3. Use of its learning
4. Working conditions
5. Other conditions that could be improved
You will be given 10 minutes during this lecture to
discuss these questions, and the representative will fill
out a form reporting on the 5 questions.
2
0-3
MIN 100 Investment Analysis
Week / date Chapters / Topic Note
35 29.08.2012
1-3 / Introduction and basic
concepts.
Part 1: Overview
37 12.09.2012
4-5 / Net present value, bonds,
markets
Part 2: Valuation and Capital
budgeting
38 19.09.2012
6-7 / Stocks, NPV and other
investment rules
39 26.09.2012
8-9 / Cash flow and capital
budgeting, decision tree, sensitivity,
Monte Carlo
40 03.10.2012
10-11 / Return and Risk, expected
return, CAPM
Part 3: Risk and Return
41
Mandatory assignment
42 17.10.2012
11-12 / CAPM, Risk, Cost of Capital
43 24.10.2012
13-14 / Financing, capital structure,
Modigliani & Miller
Part 4: Capital Structure and Dividend
Policy
44 31.10.2012
15-16 / Use of debt, leverage,
dividends
45 07.11.2012
17 / Financial and Real Options. Part 5: Special topics
Making Capital Investment Decisions
Chapter 8
McGraw-
Hill/Irwin
Determine the relevant cash flows for
various types of capital investments
Compute depreciation expense for tax
purposes
Incorporate inflation into capital
budgeting
Employ the various methods for
computing operating cash flow
Apply the Equivalent Annual Cost
approach
Key Concepts and Skills
8.1 Incremental Cash Flows
8.2 The Baldwin Company: An Example
8.3 Inflation and Capital Budgeting
8.4 Alternative Definitions of Cash Flow
8.5 Investments of Unequal Lives: The
Equivalent Annual Cost Method

Chapter Outline
Opening Case
Las Vegas hotel its all about cash flows

7
Cash flows matternot accounting earnings.
Sunk costs dont matter.
Incremental cash flows matter.
Opportunity costs matter.
Side effects like synergy, cannibalism and
erosion matter.
Taxes matter: we want incremental after-tax
cash flows.
Inflation matters.
8.1 Incremental Cash Flows
When performing capital budgeting
analysis:

Always base calculations on cash flow, not
income
Earnings Cash
Need cash for capital spending
Need cash for rewarding shareholders
Therefore, capital expenditure analysis must be
based on cash

Cash Flow:
The Basis of Capital Budgeting Decisions
Much of the work in evaluating a project
lies in converting accounting income to
cash flow

Examples:
Depreciation (most common example)
You never write a check made out to
depreciation.
Amortization
Deferrals and Accruals

Cash Flows Accounting Income
Remember: Incremental cash flows arise
as a consequence of selecting a project

Seems like a simple task
Not so, there are many pitfalls in identifying
incremental cash flow
Incremental Cash Flows
Sunk costs are not relevant
Just because we have come this far does not mean
that we should continue to throw good money after
bad.

Opportunity costs do matter. Just because a
project has a positive NPV, that does not mean
that it should also have automatic acceptance.
Specifically, if another project with a higher NPV
would have to be passed up, then we should not
proceed.
Incremental Cash Flows
Side effects matter.
Erosion and cannibalism are both bad
things. If our new product causes
existing customers to demand less of
current products, we need to recognize
that.
If, however, synergies result that create
increased demand of existing products,
we also need to recognize that.
Incremental Cash Flows
Allocations
Overhead may be allocated to the new project
Allocations are only relevant if the project increases or
decreases the cash outlay of the entire firm
Salvage Value
Dont forget to treat salvage value (after tax, of course) as a
cash inflow at the end of the project
Changes in Net Working Capital
Many projects require an increase in NWC (inventory,
receivables, and other current assets) when initiated; this is a
cash outlay at the beginning of the project
Dont forget: To reduce NWC at the end of a project requiring
increased NWC; this is a cash inflow at the end of the project
Incremental Cash Flows
Later chapters will deal with the impact that the
amount of debt that a firm has in its capital
structure has on firm value.
For now, its enough to assume that the firms
level of debt (and, hence, interest expense) is
independent of the project at hand.

Interest Expense
Will invest in a new bowling ball machine.
Cost: $100,000 (depreciated according to
MACRS 5-year)
Costs of test marketing (already spent):
$250,000
Current market value of proposed factory site
(which we own): $150,000
Increase in net working capital: $10,000

8.2 The Baldwin Company
Production (in units) by year during 5-year life of
the machine: 5 000, 8 000, 12 000, 10 000, 6
000
Price during first year is $20; price increases 2%
per year thereafter.
Production costs during first year are $10 per
unit and increase 10% per year thereafter.
Annual inflation rate: 5%
Working Capital: initial $10 000 changes with
sales

The Baldwin Company
The Baldwin Company
($ thousands) (All cash flows occur at the end of the year.)
The Baldwin Company
At the end of the project, the warehouse is unencumbered, so we can sell it if we want to.
The Baldwin Company
Recall that production (in units) by year during the 5-year life of the machine is
given by:
(5 000, 8 000, 12 000, 10 000, 6 000).
Price during the first year is $20 and increases 2% per year thereafter.
Sales revenue in year 3 = 12 000[$20(1.02)
2
] = 12 000$20.81 = $249 720.
The Baldwin Company
Again, production (in units) by year during 5-year life of the machine is
given by:
(5 000, 8 000, 12 000, 10 000, 6 000).
Production costs during the first year (per unit) are $10, and they increase
10% per year thereafter.
Production costs in year 2 = 8 000[$10(1.10)
1
] = $88 000

The Baldwin Company
Depreciation is calculated using the Accelerated Cost
Recovery System (shown at right).
Our cost basis is $100,000.
Depreciation charge in year 4
= $100,000(.1152) = $11.52.

Year ACRS %
1 20.00%
2 32.00%
3 19.20%
4 11.52%
5 11.52%
6 5.76%
Total 100.00%
The Baldwin Company
What cash flows are relevant for an investment project?
Incremental After Tax Cash Flows
588 . 51 $
) 10 . 1 (
66 . 224 $
) 10 . 1 (
87 . 59 $
) 10 . 1 (
86 . 66 $
) 10 . 1 (
19 . 54 $
) 10 . 1 (
80 . 39 $
260 $
5 4 3 2
=
+ + + + + =
NPV
NPV
Inflation is an important fact of economic life and
might be considered in capital budgeting.

Consider the relationship between interest rates and
inflation, often referred to as the Fisher equation:

(1 + Nominal Rate) = (1 + Real Rate) (1 + Inflation Rate)

A nominal cash flow refers to the actual dollars to be
received (or paid out).
A real cash flow refers to the cash flows purchasing
power (thus equal to the nominal cash flow adjusted
by inflation)

8.3 Inflation and Capital Budgeting
For low rates of inflation, this is often approximated:
Real Rate ~ Nominal Rate Inflation Rate

While the nominal rate in the U.S. has fluctuated with
inflation, the real rate has generally exhibited far less
variance than the nominal rate.

In capital budgeting, one must compare real cash flows
discounted at real rates or nominal cash flows
discounted at nominal rates.
Inflation and Capital Budgeting
Example 8.6
A company selling books is considering publishing a new novel 4
years from now.
Todays price is $10.00 per book and the company assumes an
inflation of 6% over the next four years.
The company anticipates its books to outgrow this inflation by an
additional increase in price of 2% per year.
A new novel will therefore be sold at $13.60 four years from now
($10 * 1.08
4
), and sales are estimated at 100 000 copies.

Their nominal cash flow 4 years from now is:
$13.60 * 100 000 = $1.36 million

By deflating the nominal cash flow at 6% per year, we get the real
cash flow (or the actual purchasing power):
$1.36 / (1.06
4
) = $1.08 million
27
When discounting it is important to be consistent between
cash flows and discount rates:
Nominal cash flows must be discounted at the nominal
rate.
Real cash flows must be discounted at the real rate.

Net Present Value will be equal if you use the correct
discounting rate. Generally, if the cash flow is given in
nominal (real) rate, use nominal (real) discount rates.
Discounting: Nominal or Real ?
Cash Flow from Operations can be found as:
OCF = EBIT + Depreciation Taxes
(EBIT = Earnings before interest and taxes)

Bottom-Up Approach
Works only when there is no interest expense
OCF = Net Income + depreciation

Top-Down Approach
OCF = Sales Costs Taxes
Dont subtract non-cash deductions

Tax Shield Approach
OCF = (Sales Costs)(1 T) + Depreciation*T
8.4 Alternative Methods for Computing OCF
There are times when application of the NPV
rule can lead to the wrong decision.
Consider a factory that must have an air cleaner
that is mandated by law. There are two choices:
The Cadillac cleaner costs $4,000 today, has annual
operating costs of $100, and lasts 10 years.
The Cheapskate cleaner costs $1,000 today, has
annual operating costs of $500, and lasts 5 years.
Assuming a 10% discount rate, which one
should we choose?
8.5 Investments of Unequal Lives
Since the lifespan of these two investments are
unequal, we must compare them by looking at their
annual cost over an equal period.
There are two methods used to achieve this:
1. Using a Replacement Chain, where the projects are repeated
until they start and end at the same time. Then you can
compute the NPV for the repeated projects.
2. Calculate their Equivalent Annual Cost.
By repeating the purchase of the cheap air cleaner we
have 2 cash flows over 10 years:
8.5 Investments of Unequal Lives
Year 0 1 2 3 4 5 6 7 8 9 10
Cadillac 4000 100 100 100 100 100 100 100 100 100 100
Cheapskate 1000 500 500 500 500 1500 500 500 500 500 500
Net Present Value
(Replacement Chain)
32
-
1,000.00
2,000.00
3,000.00
4,000.00
5,000.00
6,000.00
7,000.00
8,000.00
0% 5.0 % 10.0 % 15.0 % 20.0 % 25.0 % 30.0 % 35.0 % 40.0 % 45.0 % 50.0 %
The Cadillac cleaner
The Cheapskate cleaner
Crossover rate = 10.60%
NPV Cheap > NPV Cadillac
NPV Cheap < NPV Cadillac
EAC is the annual annuity payment implied by a projects NPV:



This time we know NPV and need to find C, and by rearranging
we find:




The EAC for the Cadillac filter is $750.98
The EAC for the Cheapskate filter is $763.98
In general, select the EAC with the lower cost.
Suggests a decision to reject the Cheapskate filter.
(However, we are still dependent on discount rate.)
Equivalent Annual Cost (EAC)
Closing Case
Expansion at East Coast Yachts
East Coast Yachts are considering expanding their production with a new
manufacturing plant. A preliminary analysis has been conducted at a cost of 1.2
mill. for market research and investment costs.
Investments will be carried out over 2 years: 50 mill. in year 0 and 25 mill. in
year 1.
Income for the first years is as follows:


From year 6, income will grow indefinitely at 2% per year.
Variable costs = 60% of sales.
Fixed costs = 2 mill. per year.
Net working capital requirement = 8% of sales.
Tax rate = 40 %
Required return = 11 %
Depreciation rate = 1/20
Value of the land is disregarded, as it will go unused for ever if not used.
Consider the cash flows and calculate NPV, profitability index and IRR.
34
Year 2 Year 3 Year 4 Year 5 Year 6
Sales 15 000 000 27 000 000 35 000 000 40 000 000 42 000 000
Operating Cash Flow Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Revenue 15 000 000 27 000 000 35 000 000 40 000 000
Variable costs -9 000 000 -16 200 000 -21 000 000 -24 000 000
Fixed costs -2 000 000 -2 000 000 -2 000 000 -2 000 000
Depreciation -2 500 000 -3 875 000 -4 068 750 -4 272 188 -4 485 797
EBIT -2 500 000 125 000 4 731 250 7 727 813 9 514 203
Tax -1 000 000 50 000 1 892 500 3 091 125 3 805 681
Net income -1 500 000 75 000 2 838 750 4 636 688 5 708 522
OCF 1 000 000 3 950 000 6 907 500 8 908 875 10 194 319
Net working capital Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Beginning 1 200 000 2 160 000 2 800 000 3 200 000
Ending 1 200 000 2 160 000 2 800 000 3 200 000 3 360 000
NWC Cash Flow -1 200 000 -960 000 -640 000 -400 000 -160 000
Value of perpetuity after year 5 113 722 279
Cash flow Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Operating cash flow - 1 000 000 3 950 000 6 907 500 8 908 875 10 194 319
Capital Spending -50 000 000 -25 000 000 - - - -
Net working capital - -1 200 000 -960 000 -640 000 -400 000 -160 000
Terminal value - - - - - 113 722 279
Total Cash Flow -50 000 000 -25 200 000 2 990 000 6 267 500 8 508 875 123 756 598
Discounted Cash Flow -50 000 000 -22 702 703 2 426 751 4 582 742 5 605 060 73 443 517
NPV 13 355 367 > 0
Profitability Index 1,267 > 1
IRR 15 % > 11 %
35
First calculate operating cash flow.
Then calculate net working capital
Add perpetuity for indefinite cash flow.
Finally calculate total cash flow, and
discount it.
Should invest since NPV is positive,
and profitability index is greater
than 1 and the Internal Rate of
Return is higher than the required
rate of return.
Early dialogue
We need to elect a student representative who will help
organize the early dialogue in this course.
The early dialogue will answer 5 questions:
1. Teaching and assesment methods
2. Curriculum
3. Use of its learning
4. Working conditions
5. Other conditions that could be improved
You will be given 10 minutes during this lecture to
discuss these questions, and the representative will fill
out a form reporting on the 5 questions.
36
Risk Analysis, Real Options, and Capital
Budgeting
Chapter 9
McGraw-
Hill/Irwin
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
budgeting
Key Concepts and Skills
9.1 Decision Trees
9.2 Sensitivity Analysis, Scenario
Analysis, and Break-Even Analysis
9.3 Monte Carlo Simulation
9.4 Real Options
Chapter Outline
Opening Case
Oil fund real estate investments

40
Opening Case
Oil investments

41
Decisions are often made in several stages.
Decision tree analysis is a graphical representation of the
alternatives available in each period and the likely
consequences of our choices.
It estimates what is expected net present value when it is
conditional on decisions and outcomes of stochastic
variables during earlier stages of the project.
Decisions: E.g., investment level, technology choice
Stochastic variables: E.g., sales.


This graphical representation helps identify the best
course of action.
9.1 Decision Trees
Notation
Decision
node
Decision
branches
Decision tree:
Decision A
Decision B
The first decision node is called the root node
Chance
node
Chance
branches
Chance tree:
State of nature 1
State of nature 2
Study
Do not study
E
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.
D
B
C
A
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.
Stewart Pharmaceuticals
Note 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%.
NPV Following Successful Test
75 . 433 , 3 $
) 10 . 1 (
588 , 1 $
600 , 1 $
1
4
1
1
=
+ =

=
NPV
NPV
t
t
Investment Year 1 Years 2-5
Revenues $7,000
Variable Costs (3,000)
Fixed Costs (1,800)
Depreciation (400)
Pretax profit $1,800
Tax (34%) (612)
Net Profit $1,188
Cash Flow -$1,600 $1,588
Remember that Operating Cash Flow
can be calculated using bottom-up
approach when there is no interest:
OCF = Net income + depreciation
NPV Following Unsuccessful Test
461 . 91 $
) 10 . 1 (
90 . 475 $
600 , 1 $
1
4
1
1
=
+ =

=
NPV
NPV
t
t
Investment Year 1 Years 2-5
Revenues $4,050
Variable Costs (1,735)
Fixed Costs (1,800)
Depreciation (400)
Pretax profit $115
Tax (34%) (39.10)
Net Profit $75.90
Cash Flow -$1,600 $475.90
Note 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%.
Decision Tree for Stewart
Do not
test
Test
Failure
Success
Do not
invest
Invest
Invest
The firm has two decisions to make:
1. To test or not to test.
2. To invest or not to invest.
0 $ = NPV
NPV = $3.4 b
NPV = $0
NPV = $91.46 m
Lets 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:
Decision to Test
|
|
.
|

\
|
+
|
|
.
|

\
|
=
failure given
Payoff
failure
Prob.
success given
Payoff
sucess
Prob.
payoff
Expected
( ) ( ) 25 . 060 , 2 $ 0 $ 40 . 75 . 433 , 3 $ 60 .
payoff
Expected
= + =
95 . 872 $
10 . 1
25 . 060 , 2 $
000 , 1 $ = + = NPV
The NPV evaluated at date 0 is:
So, we should test.
Sensitivity Analysis:
Also called What if analysis
Allows the calculation of a range of NPV 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.
9.2 Sensitivity, Scenario, and Break-Even
Algorithm for sensitivity analysis

1. Specify the NPV equation, including cash flow equation

2. Specify base values for stochastic variables in the NPV equation (base
assumptions)

3. Calculate NPV using base values

4. For each stochastic variable:
1. Decide upon alternative outcomes for the variable
2. Calculate the NPV under alternative outcomes

5. Analyze the effect of alternative outcomes on NPV
Find which variables have the greatest effect, e.g. by using a spider (also
called star) diagram
Janus example
The company
The Janus plant was established in 1895 and is now one of
Europes leading manufacturers of underwear. The factory at
Espeland in Bergen has around 100 employees producing
underwear and socks for children and adults.

Janus considering investment in a new brand of
underwear
Perform a sensitivity analysis on this investment




1. Specify the NPV equation, including
cash flow equation

Net present value (NPV):





Cash flow (CF):




Remember: depreciation cost should not be included in the cash
flow

( )

=
+
+ =
T
t
t
r
I NPV
1
t
1
flow Cash
cost Fixed - Sold Units cost unit Variabl. - Sold Units price Sales
Outflow - Inflow
=
=
CF
CF
2. Specify base values for stochastic variables in
the NPV equation
Sales price 200 NOK/unit
Variable unit cost 100 NOK/unit
Fixed cost 120 000 NOK/year
Depreciation cost 250 000 NOK/year
Units sold 5 000 units/year
Investment 1 250 000 NOK
Time horizon 5 Years
Discount rate 3 %
Janus example - Base assumptions:
The company does not incur taxes
No working capital
All amounts are in real NOK

3. Calculate NPV using base values
Positive NPV accept project
Or isnt this all that is to say about the venture?

(in 1000 real NOKs)
( )
490286 5797 . 4 380000 1250000
flow cash Annual
1
flow Cash
% 3 , 5
1
t
= + =
+ =
+
+ =

=
NPV
A I NPV
r
I NPV
year
T
t
t
r
0 1 2 3 4 5
Sales revenue 1000 1000 1000 1000 1000
- Variable costs 500 500 500 500 500
- Fixed cost 120 120 120 120 120
- Investment 1250
= Cash Flow -1250 380 380 380 380 380
56
The present value of a persistent cash-flow:



Multiply by (1+r) on both sides:



Subtraction of the first expression from the last now
yields

Recall: The present value of an annuity
n
r
C
r
C
r
C
r
C
PV
) 1 ( ) 1 ( ) 1 ( ) 1 (
3 2
+
+ +
+
+
+
+
+
=
1 2
) 1 ( ) 1 ( ) 1 (
) 1 (

+
+ +
+
+
+
+ = +
n
r
C
r
C
r
C
C PV r
n
r
C
C PV r
) 1 ( +
=
57
Division by r on both sides yields for the PV:



The fraction is called the annuity factor (a), and
represents the ratio between present value and annual
cash-flow in an annuity



Observe that the annuity factor depends only on interest
rate level and duration/maturity


Recall: The present value of an annuity
n
n
r r
r
C PV
) 1 (
1 ) 1 (
+
+
=
) ( ,
1
PV
a
PV
C aC PV
a
= = =
4.1 Decide upon alternative outcomes for each
stochastic variable
Change from base
value
-20,00% -10,00% 0,00% 10,00% 20,00%
Sales price 160 180 200 220 240
Variable unit cost 80 90 100 110 120
Fixed costs 96 000 108 000 120 000 132 000 144 000
Units sold 4 000 4 500 5 000 5 500 6 000
Investment 1 000 000 1 125 000 1 250 000 1 375 000 1 500 000
Life span 4 4,5 5 5,5 6
Risk free interest
rate
2,4 2,7 3 3,3 3,6
4.2 Sensitivity analysis on one variable
sales price
Sales price 160 180 200 220 240
Annual CF 180 000 280 000 380 000 480 000 580 000
NPV
-425 653 32 318 490 289 948 259 1 406 230
-1000
-500
0
500
1000
1500
160 180 200 220 240
N
P
V

(
1
0
0
0

N
O
K
)
Sales price
Under sensitivity analysis, one input is varied at a time while all other inputs are
assumed to meet their expectations (base assumption)
5. Spider diagram from Janus example
-1000000
-500000
0
500000
1000000
1500000
-20 % -10 % 0 % 10 % 20 %
N
P
V
Change from base
Sales price
Variable unit
cost
Fixed costs
Units sold
Investment
Life span
Risk free
interest rate
Note: The spider diagram does not say how likely these outcomes are!
Advantages of sensitivity analysis
Recognizes the uncertainty associated with the variables
Shows how significant any variable is in determining a
projects NPV
Help in anticipating and preparing for the what if
questions that are asked in presenting and defending a
project
Does not depend on probabilities associated with
outcomes of variables
Can be used when there is little information, resources
and time for more sophisticated techniques
Disadvantage of sensitivity analysis


Variables are often interrelated
Sensitivity analysis provides no explicit probabilistic
measure of risk exposure
How likely is a pessimistic or expected or optimistic
value and how likely is the corresponding outcome
value?
In other words, sensitivity analysis provides information
on the effects of different outcomes of variables on
project NPV, but not on the likelihood of these
outcomes, and the associated probability distribution of
NPV
Scenario analysis
Scenario analysis examine different scenarios, where
each scenario involves a confluence of factors
Scenario analysis allow us to look at different but
consistent combination of variables

What happened if Janus biggest competitor starts to
make a similar type of underwear?
Sales drop by 10%
Price drop by 10%
NPV: -151 872


Common tool for analyzing the relationship between
sales volume and profitability. The focus is on how far
sale could fall before the project begins to lose money

Is break-even analysis important?
o Very much so: All corporate executives fear losses. Break-even analysis
determines how far down sales can fall before the project is losing money

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
We will look at accounting break-even and financial
break-even.
Break-Even Analysis
Janus example base assumptions
Sales price 200 NOK/unit
Variable unit cost 100 NOK/unit
Fixed cost 120 000 NOK/year
Depreciation cost 250 000 NOK/year
Units sold 5 000 units/year
Investment 1 250 000 NOK
Time horizon 5 Years
Discount rate 3 %
The company does not incur taxes
No working capital
All amounts are in real NOK

Break-even analysis
Accounting Profit Break even Point
0
200000
400000
600000
800000
1000000
1200000
0
5
0
0
1
0
0
0
1
5
0
0
2
0
0
0
2
5
0
0
3
0
0
0
3
5
0
0
4
0
0
0
4
5
0
0
5
0
0
0
5
5
0
0
( )
3700
100 - 200
250000 120000

cost unit Var. - price Sales
on Depreciati cost Fixed
: Point even Break Accounting =
+
=
+
Accounting Profit
Break even Point
Revenue
= Sales price units sold
Total cost
= Var. unit cost units sold
+Fixed cost
+Depreciation
Unit sold
NOK
Is a project that breaks even in accounting term an
acceptable investment?
Would you be happy about investing in a stock that
after 5 years gave you a total rate of return of zero?
A zero return does not compensate you for the time value of
money or the risk you have taken.
A project that simply breaks even on accounting basis gives you
your money back, but does not cover the opportunity cost of
capital tied up in the project

A project that just breaks even in accounting terms will
surely have a negative NPV.
Have just seen that accounting break-even point is 3 700.
In order to include the time value and risk, the net present
value break-even must be higher than this.
A project that just breaks even in accounting terms will
surely have a negative NPV
Yearly sale: 3700 units
Yearly CF: NOK 250 000
Initial investment: NOK 1 250 000

Total cash flow from operations
= 5 years NOK 250 000 = NOK 1 250 000
= initial investment



Revenues are not sufficient to repay the opportunity cost of that NOK 1
250 000 investment


105075 5797 . 4 250000 1250000
flow cash Annual
% 3 , 5
= + =
+ =
NPV
A I NPV
year
Break-even analysis
Present Value Break-even Point
-1000000
-500000
0
500000
1000000
1500000
2000000
2500000
0
5
0
0
1
0
0
0
1
5
0
0
2
0
0
0
2
5
0
0
3
0
0
0
3
5
0
0
4
0
0
0
4
5
0
0
5
0
0
0
5
5
0
0
NPV of CF
Investment
Present Value
Break even Point
( )
3929
100 - 200
272943 120000

cost unit Var. - price Sales
EAC cost Fixed
: Point even Break PV =
+
=
+
Accounting Profit Break even Point vs
Present Value Break-even Point
( ) | |
( )
( )
( )
3929
100 - 200
272943 120000
Units

cost unit Var. - price Sales
/A Investment cost Fixed
Units
Investment Cost Fixed - Units Cost unit Var - price Sales
Investment flow) PV(cash
: Point even Break PV
5years,3%
% 3 , 5
=
+
=
+
=
=
=
year
A
( )
3700
100 - 200
250000 120000
Units

cost unit Var. - price Sales
on Depreciati cost Fixed
Units
Cost Total Revenue
: Point even Break Accounting
=
+
=
+
=
=
Investment /Time horizon
=1 250 000/5 = 250 000
EAC: Investment/A
5years,3%
=1 250 000/4.5797= 272 944
Monte Carlo simulation is a further attempt to
model real-world uncertainty.
Approach takes its name from the famous
European casino
analyzes projects the way one might analyze gambling
strategies.
9.3 Monte Carlo Simulation
Monte Carlo simulation of capital budgeting
projects
Highly probabilistic seen as a step beyond either
sensitivity analysis or scenario analysis.
Interactions between the variables are explicitly
specified in Monte Carlo simulation,
Theoretically provides a more complete analysis.
Pharmaceutical industry has pioneered
applications of this methodology
Use in other industries is far from widespread.
Monte Carlo Simulation
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.
Monte Carlo Simulation
Monte Carlo simulation
Sample Results (4 Decks)
Iterations BlackJack Bust 17 18 19 20 21
100 9,00 % 44,00 % 22,00 % 12,00 % 16,00 % 21,00 % 10,00 %
1 000 0,90 % 21,30 % 12,80 % 16,90 % 14,40 % 23,70 % 11,10 %
10 000 4,70 % 27,62 % 15,62 % 15,46 % 12,86 % 16,51 % 7,60 %
100 000 4,97 % 26,99 % 14,89 % 14,38 % 13,50 % 17,89 % 7,45 %
1 Million 4,98 % 27,68 % 14,48 % 14,11 % 13,53 % 18,00 % 7,23 %
10 Million 4,90 % 27,62 % 14,45 % 14,13 % 13,52 % 18,19 % 7,19 %
Win chance* 95,10 % - 27,62 % 42,07 % 56,20 % 69,72 % 87,91 %
74
Converges to appr.
12% chance for the
dealer to get either
blackjack or 21.
* Gives your chance of winning with a hand equal or better than the column header.
Monte Carlo simulation can provide us with even more information:
- Probability of winning with different dealers card showing.
- Probability of winning with a counted card deck
(equal to the plot in the movie 21).
Monte Carlo simulation
75
The dealer is more likely to bust if she gets 2 6 (average bust rate = 38 %).

With this table you can calculate more accurate odds since you know your
hand and see the dealers top card. E.g.:
If you have 18 and the dealer is dealt:
a 4, you will win by a likelihood of 54 %.
an 8, you will win by a likelihood of 36 %.
a 10 or face, win by a likelihood of 28 %.
If you have 20, and the dealer is dealt:
a 4, you will win by a likelihood of 81 %.
an 8, you will win by a likelihood of 92 %.
a 10 or face, win by a likelihood of 53 %.
Simulation Results (percent of hands with dealer card showing)
Dealer Up Card BlackJack Bust 17 18 19 20 21
Ace 28 % 13 % 14 % 15 % 16 % 10 % 5 %
2 0 % 32 % 15 % 17 % 10 % 13 % 13 %
3 0 % 40 % 11 % 13 % 12 % 11 % 13 %
4 0 % 34 % 18 % 13 % 15 % 10 % 9 %
5 0 % 37 % 12 % 12 % 12 % 13 % 14 %
6 0 % 47 % 16 % 10 % 8 % 9 % 10 %
7 0 % 25 % 40 % 13 % 6 % 8 % 7 %
8 0 % 24 % 15 % 40 % 13 % 3 % 5 %
9 0 % 17 % 12 % 11 % 43 % 12 % 4 %
10 or Face 8 % 23 % 9 % 10 % 10 % 36 % 3 %
Algorithm for simulation
analysis
1. Specify the basic model
2. Estimate or assume a probability distribution of stochastic
variables, e.g. a normal, uniform, lognormal
3. Draw a number from each probability distribution
4. Calculate NPV (or other measures) using the values from step 3
5. Replicate step 3 and 4 many times, e.g. 10000 times.
6. Sort the estimated NPVs and construct the simulated probability
distribution.
If there are 10000 draws, then each value will represent 1/10000 =
0.0001 of the simulated probability distribution
Simulation analysis - Janus case

What is the mean value of NPV?
What is the 50% (median) value of the distribution?
What are the 10% and 90% percentile values?
What is the probability that the project will have a
negative NPV?

Can do more sophisticated analyses using more
dedicated software, e.g. @risk, Crystal Ball



1. Base assumptions:
Sales price 200 NOK/unit
Variable unit cost 100 NOK/unit
Fixed cost 120 000 NOK/year
Units sold 5000 units/year
Investment 1 250 000 NOK
Time horizon 5 Years
Discount rate 3 %
289 490 4,5797 000 380 000 250 1 - NPV
flow Cash
% 3 , 5
= + =
+ =
year
A I NPV
000 380 kr 000 kr120 - 5000 kr100 - 5000 200 kr CF
cost Fixed - sold units cost unit Variabl - Sold Units price Sales
= =
= CF
2. Estimate or assume a probability
distribution of stochastic variables
Probability distribution
2. Estimate or assume a probability distribution of stochastic
variables
Probability 20% 20% 20% 20% 20%
Sales price 180 190 200 210 220
Variable unit cost 90 95 100 105 110
Fixed costs 100000 110000 120000 130000 140000
Units sold 4000 4500 5000 5500 6000
We assume a discrete uniform distribution
The variable values all have the same probability of
occurring (20%)
Probability distribution for sales
price
0%
5%
10%
15%
20%
25%
180 190 200 210 220
Sales price
Probability
3. Draw a number from each probability distribution
4. Calculate NPV using the values from step 3
My random numbers: 3, 4, 3, 5
Number 1 2 3 4 5
Probability 20% 20% 20% 20% 20%
Sales price 180 190 200 210 220
Variable unit
cost 90 95 100 105 110
Fixed costs 100000 110000 120000 130000 140000
Units sold 4000 4500 5000 5500 6000
000 450 kr 000 kr120 - units 6000 105 kr - units 6000 200 kr CF
cost Fixed - sold Units cost unit Variabl - Sold Units price Sales
= =
= CF
868 810 4,5797 000 450 000 250 1 - NPV
flow Cash
% 3 , 5
= + =
+ =
year
A I NPV
Draw you own random numbers:






Probability 20% 20% 20% 20% 20%
Sales price 180 190 200 210 220
Variable unit cost 90 95 100 105 110
Fixed costs 100000 110000 120000 130000 140000
Units sold 4000 4500 5000 5500 6000
cost Fixed - sold Units cost unit Variabl - Sold Units price Sales = CF
% 3 , 5
flow Cash
year
A I NPV + =
5. Replicate step 2 and 3 many times,
e.g. 10000 times
Generate random numbers in Excel

If you want to generate random numbers in Excel, use the
RANDBETWEEN (TILFELDIGMELLOM) function. This function allows
you to specify the range of numbers it is to pick from.
RANDBETWEEN returns only integers.


The syntax for the RANDBETWEEN function is:
= RANDBETWEEN(Bottom;Top)
Bottom - the lowest number the function is to use.
Top - the highest number the function is to use.


http://spreadsheets.about.com/od/excelfunctions/qt/080218_randbetw.htm
Random variables for sales price




A random integer between 180 and 220, where all values have the
same probability of occurring:
=RANDBETWEEN(180;220)

A discrete uniform distribution of the values 180, 190, 200, 220,
220, where each value has equal probability of occurring:
=180+RANDBETWEEN(0;4)*10

Probability 20% 20% 20% 20% 20%
Sales price 180 190 200 210 220
Can you answer the questions?

What is the mean value of NPV?
What is the 50% (median) value of the
distribution?
What are the 10% and 90% percentile
values?
What is the probability that the project
will have a negative NPV?

6. Cumulative probability distribution from
Janus example
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
-600000 -400000 -200000 0 200000 400000 600000 800000 1000000 1200000 1400000 1600000 1800000
NPV
C
u
m
u
l
a
t
i
v
e

p
r
o
b
a
b
i
l
i
t
y

d
i
s
t
r
i
b
u
t
i
o
n
Median
10% percentile
90% percentile
Probability of negative
NPV = 0.145
Mean NPV = 482160 (must
be calculated)
Pros and Cons Simulation analysis
A simulation model that attempts to be realistic will also be
complex
Difficult to model the underlying probability distribution of each
variable
Difficult to model the interactions between variables
Simulation analysis is sensitive to assumption affecting the input
parameters

GIGO principle: Garbage in, garbage out

Simulation can provide useful information that sensitivity- or
scenario analysis cannot give us

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.
Corporations make decisions in a dynamic
environment
Choice of options should be considered in
project valuation.

9.4 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
Real Options
Real Option = Flexibility
The investment flexibility is equal to a call/put
option on a stock

It gives the right, but not the obligation, to make
an investment expenditure/abandon the
investment

What is this option worth?
First we study an example without flexibility
Afterwards with flexibility




Example: Buying jet or propeller
Standard investment problem:
Buy large capacity jet or smaller or cheaper propeller?

The opportunity cost of capital for this venture is 10%

Price jet: 400
Price propeller: 200

The demand is uncertain:
The probability for high demand the first year is 0.6, and for low demand
0.4.
The probabilities for the second year depend on the first period
outcomes




Payoff and probability matrix
Decision State of nature
Year 1
Outcome
(probability)
State of nature
Year 2
Outcome
1

(probability)
Jet
-400
High demand 200 (0.6) High demand
Low demand
1000 (0.8)
50 (0.2)
Low demand -100(0.4) High demand
Low demand
500 (0.3)
-500 (0.7)
Propeller
-200
High demand 100 (0.6) High demand
Low demand
400 (0.8)
200 (0.2)
Low demand 0 (0.4) High demand
Low demand
300 (0.3)
0 (0.7)
The demand is uncertain
The probabilities for the second year depend on the first period
outcomes

1
You can interpret the outcome in year 2 as the present value at the end of year 2 of the cash flow for that and all
the subsequent years
Example: Buying jet or propeller

Which plane should be bought?

What is the optimal investment level
without flexibility for the risk neutral
firm?

Standard investment problem
Buy jet or propeller?
Jet
-400
Propeller
-200
High demand
(p=0.6) 200
Low demand
(p=0.4) -100
High demand
(p=0.6) 100
Low demand
(p=0.4) 0
High demand
(p=0.8) 1000
High demand
(p=0.3) 500
High demand
(p=0.8) 400
High demand
(p=0.3) 300
Low demand
(p=0.7) 0
Low demand
(p=0.2) 200
Low demand
(p=0.7) -500
Low demand
(p=0.2) 50
Year 0 Year 1 Year 2
Expected NPV as decision criterion leads us to invest in a
propeller

E(NPV) if buying a jet:




E(NPV) if buying a propeller:





( )
( ) ( )
26 . 8
1 . 1
-500 0.7 + 500 0.3 0.4 + 50 0.2 + 1000 0.8 0.6
1.1
-100 0.4 + 200 0.6
+ 400 - = NPV E
2
Jet
= +
( )
( ) ( )
81 . 62
1 . 1
0 0.7 + 300 0.3 0.4 + 200 0.2 + 400 0.8 0.6
1.1
0 0.4 + 100 0.6
+ 200 - = NPV E
2
Propeller
= +
Flexibility
1. Investment problem with call option on a used
propeller two years from now

2. Investment problem with call option on a used
propeller two years from now, and a put option on the
first propeller two years from now

3. Investment problem with call- and put option on both
propeller and jet in two years.


Flexibility: The option to expand

Start out with one propeller

High demand - buy another one
Price secondhand propeller: 100

Low demand - sit tight with one smal
relative inexpensive aircraft


What is the optimal investment choice if
we have this flexibility?

Call option on a used propeller
Jet
-400
Propeller
-200
High demand
(p=0.6) 200
Low demand
(p=0.4) -100
High demand
(p=0.6) 100
Low demand
(p=0.4) 0
High demand
(p=0.8) 1000
High demand
(p=0.3) 500
High demand
(p=0.8) 800
High demand
(p=0.3) 300
Low demand
(p=0.7) 0
Low demand
(p=0.2) 100
Low demand
(p=0.7) -500
Low demand
(p=0.2) 50
High demand
(p=0.8) 400
Low demand
(p=0.2) 200
Expand
-100
Do not exp
0
What are we willing to pay for a
used propeller in year 1?
Flexibility: The option to
Abandon
If we can buy a used propeller for 100,
there should be possible to also sell it for
100

When do we want to sell?
When demand is low.
Allow for the possiblity of selling the propeller
Jet
-400
Propeller
-200
High demand
(p=0.6) 200
Low demand
(p=0.4) -100
High demand
(p=0.6) 100
Low demand
(p=0.4) 0
High demand
(p=0.8) 1000
High demand
(p=0.3) 500
High demand
(p=0.8) 800
High demand
(p=0.3) 300
Low demand
(p=0.7) 0
Low demand
(p=0.2) 100
Low demand
(p=0.7) -500
Low demand
(p=0.2) 50
Expand
-100
Sell propeller
100
Do not sell
propeller
Flexibility: The option to
Abandon
If the business in the first year is poor, it may pay to sell
the jet and abandon the venture

Assume that the used jet could be sold next year for 300

Should we sell the jet if the demand is low the first year?
What is the value of this option to abandon?
What is the optimal investment choice if we have this
flexibility?


Allow for the possiblity of selling the jet

Jet
-400
Propeller
-200
High demand
(p=0.6) 200
Low demand
(p=0.4) -100
High demand
(p=0.6) 100
Low demand
(p=0.4) 0
High demand
(p=0.8) 1000
High demand
(p=0.8) 800
Low demand
(p=0.2) 100
Low demand
(p=0.2) 50
Expand
-200
Sell Jet
300
Sell Propeller
100
Do not
sell Jet
High demand
(p=0.3) 500
Low demand
(p=0.7) -500
Expected NPV as decision criterion leads us to invest in a
propeller
Without real options the expected NPV for buying a propeller was higher than when
buying a jet (62.81 > 8.26).
E(NPV) if buying a jet w/real options:




(Real option value = 173.55 8.26 = 165.29)

E(NPV) if buying a propeller w/real options:





(Real option value = 115.71 62.81 = 52.90)
With real options accounted for, you should choose to buy the jet.

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 NPV at the time of launch steadily rises.
The best time to launch the project is in year 2this schedule yields the
highest NPV when judged today.
The Option to Delay: Example
Year Cost PV NPV
t
NPV
0
0 20,000 $ 25,000 $ 5,000 $ 5,000 $
1 18,000 $ 25,000 $ 7,000 $ 6,364 $
2 17,100 $ 25,000 $ 7,900 $ 6,529 $
3 16,929 $ 25,000 $ 8,071 $ 6,064 $
4 16,760 $ 25,000 $ 8,240 $ 5,628 $
What is the value of flexibility?
The value of flexibility is equal to the increase in expected NPV
(cash flow) compared to the alternative without flexibility

Expected NPV with flexibility
Expected NPV without flexibility
= Value of flexibility

Expansion value = value of option to make an investment
expenditure
Abandonment value = value of option to bail out
Delay value = value of option to delay investment

Simple idea with broad implications

Real Options
Land sites with resources have often a
real option concerning the timing of the
extraction.
Tar sand in Canada and gold at
Finnmarksvidda in Norway are both highly
dependent on high prices for the resource
to make production profitable.
108
Opening case revisited
Oil field investment
109
Revenues Investment Operational cost Tariffs Exploration cost
Reduced
exploration costs
Reduced
investments
Reduced tariffs
Reduced operational costs
Swift decision-making
Fast-track developments
Accelerated ramp-up
of production
Improved regularity and capacity utilisation
Extension of plateau production
Higher prices
Increased recovery
Extended tailend production
Opening case revisited
Oil Field Investment
Statoil is considering exploring a new oil field at the Loki field in the
North Sea. The initial exploration at 10 mill. NOK has indicated
findings of 250 (p = ), 600 (p = ) and 1250 (p = ) mill. barrels of
oil equivalents (mboe). Further explorations can make the
estimates more accurate but will cost another 10 mill. over 3 years
and will delay production by 3 years. You need to evaluate if this is
necessary before concluding on the size of the investment.

There are several uncertain factors in this project:
Size of oil field (deciding lifespan in years and barrels per year)
Oil price
Operating cost
Technical progress increasing recovery
Discount rate
110
Opening case revisited
Oil Field Investment
The following base assumptions are used:
Field size
Large = 1 200 mboe
Medium = 600 mboe
Small = 250 mboe
Oil rig investment
Large 50 mboe per year, cost = 25 000 mill. NOK, operating cost = 1 800 MNOK
Medium 35 mboe per year, cost = 14 000 mill. NOK , operating cost = 850 MNOK
Small 25 mboe per year, cost = 8 000 mill. NOK , operating cost = 500 MNOK
Oil price = 100 USD / bbl = 550 NOK / bbl
Discount rate = 22 % (remember Statoils implied required rate of
return = 25.3 %)
Tax rate = 78 %
Depreciation rate = 1/40 per year
Calculate NPV and IRR for the options.
111
Oil field decision tree
112
Further
Exploreation
Results
Small
Medium
Large
Investment
Large
inv.
Large
field
Medium
field
Small
field
Mediu
m inv.
Large
field
Medium
field
Smalle
field
Small
inv.
Large field
Medium
field
Small field
Yes
No
NPV = 3 691.97
NPV = 3 233.49
NPV =2 215.81 NPV = 11 272.80
NPV = 9 860.02
NPV = 5 157.04
NPV = 8 847.84
NPV = 8 465.92
NPV = 5 975.67
NPV = 6 698.49
NPV = 6 627.53
NPV = 5 541.05
NPV (Yes) = 0.25 * 3 691.97 + 0.25 *
3 233.49 + 0.5 * 2 215.81 = 2 839.27
NPV (No) = MAX(NPV Large, NPV
Medium, NPV Small)
= 7 861.72
= NPV Large
Since NPV (No) > NPV (Yes), we should not do any
further exploration. The best option is to do a
large investment with no exploration.
Opening case revisited
Oil Field Investment
Real option: The Loki field is close to existing findings at the Laufey
field, and if investments at Loki is set to large, the findings of 150
mboe can be connected through an extra investment of 400 mill.
NOK.
This investment would produce 10 mboe per year at an operating
cost of only 200 mill NOK per year.
The investment is depreciated at 1/40 per year.

Calculate the value of this real option.
113
Opening case revisited
Oil Field Investment
NPV of real option
= NPV investment with option NPV investment without option

NPV investment with option can easily be calculated by adding the
extra production, investment and operating cost to alternative
Large, since there are no uncertainty to this real option.

Provides us with an NPV of 9 341.91, and the real option is worth:

NPV of real option = 9 341.91 - 7 861.72 = 1 480.19 MNOK
114
Lecture summary
Chapter 8 Making Capital Investment
Decisions
Incremental Cash Flows
Inflation and Capital Budgeting
Investments of Unequal Lives
Chapter 9 Risk Analysis, Real Options, and
Capital Budgeting
Decision trees
Sensitivity, scenario and break-even analysis
Monte Carlo simulation
Real options
115