Decision Making

Financial Decision (Source of finance)

Investment Decision
(Concern about how much money require to invest)

Dividend Policy or Decision

Debt / Equity (WACC) Capital structure decision where minimise WACC to increase NPV and SHF Gearing decision

Investment Appraisal Question: Discuss factors that relevant to the decision making (NPV)? Ans: Quantifiable Taxation Accuracy of Forecast Competence of Forecast Not quantifiable Competitors re-action Change in IT Issues about Legislates environment. Extras

Cost of Capital Question (ABC): discuss the problem that may be encountered in using CAPM? Question: Explain briefly the order companies prefer to raise finance in? Portfolio theory Question: state the weakness of the evaluation technique about portfolio theory? Question: what further information might be useful in the evaluation of portfolio project? Question: Recommend and briefly describe an alternative investment evaluation technique that might be applied by the division?

Define and discuss the following terms: Sensitivity analysis Break-even analysis Base-case solution Optimistic and pessimistic forecasts Ex ante and ex post management decision making.

Pacific Products Inc. is considering the introduction of a new product, Alpha. The firm has gathered the following information relevant to the project: Initial fixed capital outlay: $120,000 Initial working capital outlay: $9,800 Life of the project: 5 years Capital recovery at project end: fixed $18,000; working $7,200 Sales units forecast: 50,000 units in year one, growing at 6.00 % per annum thereafter Unit selling price: $2.75 Unit production cost: $1.28 Annual fixed overhead cost: $35,000 Annual tax rate of depreciation claimable: 20%per annum Annual income tax rate: 38% Required rate of return: 9 %pa

For these data: (a) Calculate an NPV for the project under the given base-case scenario

(b) Perform sensitivity analyses on the following variables: initial fixed capital outlay, unit selling price, annual sales growth rate, unit production cost. (c) By the use of Data Tables and appropriate graphs, calculate the break-even points for unit production cost and the required rate of return.

(d) Advise management of the analyses regarding the new product Alpha, and make appropriate investment recommendations. (e) Compare and contrast sensitivity and break-even analyses with other risk analysis methods such as the risk adjusted discount rate and the certainty equivalent approach. Describe how each of these methods might influence management decision-making.

Answer Sensitivity analysis: This deals with the discovery of those variables which could cause significant impacts on a projects NPV. This analysis is usually done by stepping each variable through its pessimistic, most likely and optimistic values. This is a mechanical process of investigating the riskiness of a project, by allowing variables, which give rise to cash flows, to take on expected high and low extreme values. It is not based on any theoretical understanding of risk or on any theoretical framework of how risk and return are related. It is purely a mechanical method of measuring what-if impacts on a projects NPV. In that sense it gives management answers to direct intuitive questions, and can show various future scenarios. It is not a simultaneous analysis, because only one variable is stepped at a time, whilst others are held at their most likely values. The selection of variables is at best an experientially guided process, and not based on any theoretical or conceptual groundings. Therefore it cannot be guaranteed to capture or recognise important variables. Break-even analysis: This deals with the discovery of the particular value of a particular variable at which the projects NPV becomes zero. Break-even analysis is a special case of sensitivity analysis. It gives the lowest value to which any variable can fall independently before the project has to be abandoned. It is a useful figure when the firm may be engaged in a price war, a cost cutting exercise or a declining market. It presupposes a rather pessimistic outlook fore the firm, but it does give management a base line from which performance can only improve. The numerical value of the actual break-even point can be calculated by substituting various values by trial and error or using Excels Goal Seek function. Base-case solution: Base-case values are calculated by setting all forecast variables at their basic values which maybe their most likely values. When only a single NPV is calculated that value is normally taken as the base-case solution. Under the assumption of certainty, this is the only solution. However, when the project is analysed under uncertainty the base-case solution is used as a starting point for sensitivity analysis and break-even analysis. Alternative scenarios (e.g. optimistic and pessimistic values) are prepared by making adjustments to the basecase variable values. In our terminology, the base-case is used to describe the basic calculated outcome or solution. This may be different to the most-likely values defined in the discipline of statistics. Optimistic and pessimistic forecasts: These refer to the upper and lower extreme values of the forecasts. Optimistic and pessimistic values can be generated using ad hoc approach (i.e. making arbitrary adjustments to the base-case or most-likely values) or forecasting approach (i.e. making appropriate adjustments on the basis of estimation errors associated with the forecasting technique used or reasonable judgments by the management). If the ad hoc approach is used in sensitivity analysis, then the result will be difficult to interpret and will be unreliable.

Ex-ante and ex-post management decision-making: Ex-ante decisions are made before a commitment is made to a project. Ex-post decisions are made after the project is commenced and are concerned with the day-to-day monitoring of the project. Sensitivity analysis can identify, ex-ante, the critical variables which would require ex-ante decisions or ex-post decisions. For example, ex-ante decisions would be to get better forecasts for some critical variables, to call new tenders for the capital expenditures, adoption of cost reduction strategies or changing the scale of production to reduce the cost. All of these decisions are taken before the project is commenced. Once the project has begun operating, managers make ex-post decisions to ensure that important (or sensitive) variables are properly monitored to keep the project viable. Answer to The base-case solution for new product Alpha is held in Excel file titled Q 8.2 Excel Solutions.xls. (a) The NPV result for the base-case is $27,715.

(b) There is no guidance in the question on how set up the optimistic and pessimistic variations around the given base-case values. For demonstration purposes the following set of forecasts has been assumed for the analysis. Table Q 8.2: Pessimistic, base-case, and optimistic forecasts for variables to be analysed. Pessimistic Base-case Optimistic Initial Outlay $150,000 $120,000 $100,000 Unit Selling Price $2.00 $2.75 $3.10 Annual Sales Growth Rate 2.00% 6.00% 9.00% Unit Production Cost $1.92 $1.28 $0.64 The outcomes of this analysis are given below: Table Q 8.2: Results of sensitivity analysis Variable Sheet Number Pessimistic NPV Optimistic NPV Range Initial Outlay 1(2),1(3) $6,583 $41, 803 $35,220 Forecast Unit Selling Prices 1(4),1(5) $(99,406) $72,969 $172,375 Annual Sales Growth Rate 1(6),1(7) $19,062 $34,493 $15,431 Forecast Unit Production Cost 1(8),1(9) $(76,466) $110,465 $186,931 A rank ordering of the critical variables is: 1 Forecast Production Cost per Unit 2 Forecast Selling Price per Unit 3 Initial Outlay.

The impact of changes in these variables is quite significant on the projects NPV. Management would be well advised to investigate the possible behavior of these variables before proceeding with the project, perhaps by simulating them. (c) From worksheet 1(10) the break-even production cost is between $1.74 and $1.75 per unit. From worksheet 1(11) the break-even required rate of return is 16.2%. This figure is accurately calculated from the IRR within this worksheet, and it can be read off the graph within the worksheet. (d) Under the most likely scenario, the new product would be a sound investment. It is possible that the internal aspects of production cost control could be reviewed ex-ante, and controlled ex-post, so this variable would not cause a negative NPV. Fortunately however the cost has to increase about 36% before the project becomes untenable. Variations in selling price may be more damaging to the project. The quoted price range shows a plus variation of 12.7% and a minus variation of 27%. This relatively low range has a large impact on the projects NPV. The break-even price is calculated, as an extra piece of decision-making information, at $2.54. This is only 7.6% below the forecast price of $2.75. A price fall of this size is easily possible, so management needs to develop better forecasts of this variable, or to ensure that it is controllable in the market place. With pessimistic forecasts, both of these variables result in a negative NPV for the project, so careful management control will be needed. The initial outlay size is also a significant variable, but even under a worst-case forecast it still returns a positive NPV. (e) Risk analysis methods compared The capital budgeting decision inherently includes risk. Since investment decisions represent long-term fund commitments, require long-term forecasts, and often deal with unknown or un-proven products, they intrinsically require an appreciation of variation in future values and a conversion of those future variations to todays decision variable, the NPV. There are several methods by which the risk associated with unexpected variations to the cash flows can be analysed. Two such methods are risk-adjusted discount rate and certainty equivalent. The risk-adjusted discount rate attempts to incorporate the risk by making adjustments to the denominator of the NPV formula, namely, by adjusting the discount rate. Certainty equivalent method attempts to incorporate the risk by making adjustments to the numerator of the NPV formula, namely, by directly adjusting the values of the cash flows. Both these methods eventually produce a single NPV. Sensitivity analysis produce a range of NPVs. Break-even analysis produce the critical values at which the NPV will be zero for a set of selected variables. The Sensitivity and break-even approaches give management a better feel for the behavior of individual variables and can identify which variables have to carefully forecast and/or monitored by management. However, both these methods analyse the behavior of only one variable at a time and may not capture all the risks of

future economic scenarios. More dynamic models such as simulations which capture the behavior of all variables within the one analysis are examined in chapters nine and ten. All these methods can be used by the management for their decision support.

Advantages of Sensitivity analysis? Disadvantages of sensitivity analysis?

Exe 6: Forward contacts A UK importer knows on 1 April that he must pay a foreign seller 26,500 Swiss francs in one months time, on 1 May. He can arrange a forward exchange contract with his bank on 1 April, whereby the bank undertakes to sell the importer 26,500 Swiss francs on 1 May, at a fixed rate of 2.6400 to the . What will happen if the spot rate on 1 May is: - SFr 2.6200/1 - SFr 2.6600/1