Chapter 10

Project
Analysis
 10-2

Topics Covered
 Sensitivity Analysis
 Scenario Analysis
 Monte Carlo Simulation
 Real Options and Decision Trees
 10-3

A positive NPV project = undertaking the project?

 Do you want to know the danger signals?

 Which actions you that you may take?
 Managers recognize the opportunities (such as to
expand the project if it is successful or to bail out
if it is not) when considering whether to invest 
real options.
 10-4

How To Handle Uncertainty

 Sensitivity Analysis - Analysis of the effects of
changes in sales, costs, etc. on a project.
 Scenario Analysis - Project analysis given a particular
combination of assumptions.
 Break-Even Analysis and Operating Leverage
 Simulation Analysis - Estimation of the probabilities
of different possible outcomes.
 Break Even Analysis - Analysis of the level of sales
(or other variable) at which the company breaks even.
 10-5

Sensitivity Analysis

Sensitivity analysis: determining what may

happen and the possible implications of these
surprise events.
Example: Considering a high-performance
electric scooter for city use. Table 10.1 is a
cash-flow forecast. NPV is positive at 10%
opportunity cost of capital.
 10-6

Sensitivity Analysis
Example
– Invest: $15 billion
– n = 10 (straight line)
– Market share: 1 million
– Market size: 0.1 million
– Price: $375,000
– Unit variable cost: $300,000
– Fixed cost: $3 billion
– Tax rate: 50%
– Coc: 10%
 10-7

Sensitivity Analysis
Example – continued
Expected outcome
Year 0 Years 1 - 10
Investment - 15
Sales 37.5
Variable Costs 30
Fixed Costs 3
Depreciation 1.5
Pretax profit 3
.Taxes @ 50% 1.5
Profit after tax 1.5
Operating cash flow 3.0
Net Cash Flow - 15 3
NPV= 3.43 billion Yen
 10-8

Sensitivity Analysis
 Before you decide, you need to scrutinize the forecasts and
identify key variables:
- Market share of the new products
- Size of the market of the company’s product.
- Price per unit ..
 Forecast from Marketing Dep:  Forecast from Production Dep:
- Market share of the new products - Variable cost
- Size of the market of the - Fixed costs
company’s product.
- Price per unit

 But the greatest dangers often lie in unidentified variables

- Patent problems
- Costs for service station that will recharge the scooter batteries.
 10-9

Sensitivity Analysis
To undertake a sensitivity analysis, each
variable is set at its most pessimistic or
optimistic value, then NPV of the project
recalculated
 10-10

Sensitivity Analysis
Conduct sensitivity analysis

Example - continued
Possible Outcomes
Range
Variable Pessimistic Expected Optimistic
Market Size .9 mil 1.0 mil 1.1 mil
Market Share .04 .1 .16
Unit price 350,000 375,000 380,000
Unit Var Cost 360,000 300,000 275,000
Fixed Cost 4 bil 3 bil 2 bil
 10-11

Sensitivity Analysis
Example - continued
NPV Calculations for Optimistic Market Size Scenario
Year 0 Years 1 - 10
Investment - 15
Sales 41.25
Variable Costs 33
Fixed Costs 3
Depreciation 1.5
Pretax profit 3.75
.Taxes @ 50% 1.88
Profit after tax 1.88
NPV= +5.7 bil yen
Operating cash flow 3.38
Net Cash Flow - 15  3.38
 10-12

Sensitivity Analysis
Example - continued
NPV Possibilities (Billions Yen)
Range
Variable Pessimistic Expected Optimistic
Market Size 1.1 3.4 5.7
Market Share - 10.4 3.4 17.3
Unit price - 4.2 3.4 5.0
Unit Var Cost - 15.0 3.4 11.1
Fixed Cost 0.4 3.4 6.5
The most dangerous variables are Market share and
unit variable costs
 10-13

Sensitivity Analysis
 10-14

Sensitivity analysis
Limits
 Each involved departments ( Marketing and
Production) may interpret “Pessimistic” and
“optimistic” in different ways
 Not easy to extract forecasters’ notion of true
probabilities of possible outcomes.
 Underlying variables are likely to be interrelated
(market size (+)  unit price (+); market size (+) 
unit variables costs (because inflation) unit price
(+), ect)
 10-15

Scenario analysis
 If underlying variables are interrelated, scenario
analysis may help. It can be used to consider effect
of a limited number of combinations of variables
Example:
 If oil price increases leading to higher demand of scooters:
20% increase in oil price, market size will increase to 0.13
(from 0.1);
 If oil price increases leading to recession and higher
inflation that reduce market size to 0.8 mill and Unit price
and unit cost will be 15% higher expected
 NPV = $6.4 billion
 Assumptions 10-16

Electric Scooter - Assumptions Base Case

High Oil Prices and
Recession Case
Market size 1 million .8 million
Market share 0.1 0.13
Unit Price 375000 431300
Unit variable cost 300000 345000
Fixed cost 3 billion 3.5 billion
Cash Flows, Years 1-10, Billions
High Oil Prices and
Base Case Recession Case
1 Revenue 37.5 44.9
2 Variable cost 30.0 35.9
3 Fixed cost 3.0 3.5
4 Depreciation 1.5 1.5
5 Pretax profit (1-2-3-4) 3.0 4.0
6 Tax 1.5 2.0
7 Net profit (5-6) 1.5 2.0
8 Net cash flow (4+7) 3.0 3.5

PV of cash flows 18.4 21.4

NPV 3.4 6.4
 10-17

Break-Even Analysis

Asking how serious it would be if sales or costs

are worse than forecasted
Look at where NPV turns negative
Calculate break-even points for each variable
Defines break-even point at which NPV is zero
 10-18

Break-Even Analysis
 How bad sales can get before the project’s NPV
begin negative

Inflows Outflows
Year 0 Years 1-10
Unit Sales, Revenue, Variable Fixed PV
Thousands Years 1-10 Investment Costs Costs Taxes PV Inflows Outflows NPV
0 0 15 0 3 -2.25 0 19.6 -19.6
100 37.5 15 30 3 1.5 230.4 227 3.4
200 75 15 60 3 5.25 460.8 434.4 26.5

 Zero-NPV point occurs at a little under 100,000

scooters
 10-19

Break Even Analysis

 Point at which the NPV=0 is the break even point
 Otobai Motors has a breakeven point of 85,000
units sold.
PV Inflows

Break even
400 NPV=0
PV (Yen)
200 PV Outflows
Billions

19.6
Sales, 000’s
85 200
 Break-Even point in terms of 10-20

Accounting Profit

Unit Sales, Variable Fixed Total Profit

Thousands Revenue Costs Costs Depreciation Taxes Costs after Tax
0 0 0 3 1.5 -2.25 2.25 -2.25
100 37.5 30 3 1.5 1.5 36 1.5
200 75 60 3 1.5 5.25 69.75 5.25
 Break-Even point in terms of 10-21

Accounting Profit
 Accounting break even is different, yet wrong. It does not
consider the time value of money.
 Otobai Motors has an accounting breakeven point of
60,000 units sold.
60 Revenues

Break even

40 Profit =0
Accounting
revenue and costs
(Yen) Costs
Billions
20

Sales, 000’s
60 200
 10-22

Operating Leverage and Break-even point

Break-Even point depends on the operating cost

structure. (The degree to which costs are fixed)
 Variable costs
 Fixed costs

Suppose that entire costs were fixed at 33 billion yen/year,

only 3% shortfall in revenue (37,5 to 35,4 billion yen),
NPV turns to negative – NPV investment.

However, the firm whose costs are fixed fares poorly when
demand is low, but makes a killing during a boom.
 10-23

Operating Leverage

Operating leverage: The degree to which costs are fixed

Degree of operating leverage (DOL): Percentage change in

profits given a 1% change in sales

% change in profits
DOL =
% change in sales
or
fixed costs including depreciation
DOL = 1
profits
 10-24

Operating Leverage
Example – Use the data from the Otobai scooter project.What
is the DOL?

(3  1.5)
DOL = 1  = 2.5
3
 10-25

Monte Carlo Simulation

 Monte Carlo Simulation is a tool for
considering all possible combinations of
variables
 Modeling Process:
• Step 1: Modeling the Project
• Step 2: Specifying Probabilities
• Step 3: Simulate the Cash Flows
• Step 4: Calculate Present Value
 10-26

Monte Carlo Simulation

Step 1: Modeling the Project
– Give the computer a precise model of the project
– For example:

– How the variables are interrelated (for whole project)

 10-27

Monte Carlo Simulation

Step 1: Modeling the Project
– Give the computer a precise model of the project
– For example:

– Include sets of equations for each variable: Market

size, market share, price, variable cost, fixed cost.
 10-28

Monte Carlo Simulation

Step 2: Specifying Probabilities for forecasted
errors
– E.g:
• The forecast error (compared to expected value) of
market size is in the range [-15%, 15%], with expected
value = 0
• Do the same for other variables: specifying forecast
errors of each variable.
 10-29

Monte Carlo Simulation

Step 3: Simulate the cash flows
– The computer samples from the distribution of the
forecast errors, calculating resulting cash flows for
each period and records them.
– After many iterations you begin to get accurate
estimates of the probability distributions of the
project cash flows.
– Remember: “Garbage in, garbage out”
– Figure 10.3: Possible values for cash flows
 10-30

Monte Carlo Simulation

Step 4: Calculate Present value
– The distribution of cash flows in step 3 should
allow us to estimate E(CF) more accurately.
– Discount the E(CF) to find present value
 10-31

Monte Carlo Simulation

 10-32

Real Options & Decision trees

 Real Option is Option to modify Project.
 Why real option exists?
 After company invests in a project, it may be
modified:
 Expanded
 Abandoned
 Cut back
 The flexibility
 E.g. If Market share decreases, firm may
choose to stop the project.
 10-33

Real Options & Decision trees

Decision Trees - Diagram of sequential decisions
and possible outcomes.
 Decision trees help companies determine their
Options by showing the various choices and
outcomes.
 The Option to avoid a loss or produce extra profit
has value.
 The ability to create an Option thus has value that
can be bought or sold.
 10-34

Real Options

1. Option to expand
2. Option to abandon
3. Timing option
4. Flexible production facilities
 10-35

Decision Trees
Example - FedEx Expansion Option
(buy call option to buy more 14
Boeings) Exercise
High delivery
Demand option
Observe growth
in demand for
airfreight

Acquire option on Don’t

Low
future delivery take
Demand
delivery
 10-36

Decision tree for Pharmaceutical R&D

 10-37

Decision Trees
$700 (.80)
- $130

.25
$ 0 (.20)
$ 300 (.80)
- $18 .44 .50 - $130

Invest .56
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV= ? - $130

$ 0 (.20)
 10-38

Decision Trees
$700 (.80)
- $130
560
.25
$ 0 (.20)
$ 300 (.80)
- $18 .44 .50 - $130
240
Invest .56
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV= ? - $130
80

$ 0 (.20)
 10-39

Decision Trees
$700 (.80)
- $130
560
.25
$ 0 (.20)
$ 300 (.80)
- $18 .44 .50 - $130
240
Invest .56
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV= ? - $130

700  .80  0  .20 = 560 80

$ 0 (.20)
 10-40

Decision Trees
$700 (.80)
NPV = $295
- $130
560
.25
$ 0 (.20)
$ 300 (.80)
560
- $18 .50 = 130
NPV (upside)
.44 
- $130 = 295
1.0963
240
Invest .56
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV= ? - $130
80

$ 0 (.20)
 10-41

Decision Trees
$700 (.80)
NPV = $295
- $130
560
.25
$ 0 (.20)
$ 300 (.80)
- $18 .44 .50 - $130
240
NPV = $52
Invest .56
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV= ? - $130
80
NPV = - $69
(do not invest, so NPV = 0)
$ 0 (.20)
 10-42

Decision Trees
$700 (.80)
NPV = $295
- $130
560
.25
$ 0 (.20)
NPV = $83 $ 300 (.80)
- $18 .44 .50 - $130
240
NPV = $52
Invest .56
Yes / No $0 $ 0 (.20)
.25 (0  .25)  (52  .5)  (295  .25)
NPV = $2 100 (.80)
NPV= ? - $130 1.096 
80
NPV = - $69 = $83
(do not invest, so NPV = 0)
$ 0 (.20)
 10-43

Decision Trees
$700 (.80)
NPV = $295
- $130
560
.25
$ 0 (.20)
NPV = $83 $ 300 (.80)
- $18 .44 .50 - $130
240
NPV = $52
Invest .56
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV = 18  (.-44  83)  (.56  0)
$130
NPV= $19
= $19
NPV = - $69
80
(do not invest, so NPV = 0)
$ 0 (.20)
 10-44

Decision Trees
$700 (.80)
NPV = $295
- $130
560
.25
$ 0 (.20)
NPV = $83 $ 300 (.80)
- $18 .44 .50 - $130
240
NPV = $52
Invest .56
Yes / No $0 $ 0 (.20)
.25
$ 100 (.80)
NPV= $19 - $130
80
NPV = - $69
(do not invest, so NPV = 0)
$ 0 (.20)