Strategy and Analysis in Using

NPV (Chapter 8)
Financial Policy and Planning MB 29

Outline
Corporate Strategy and NPV
Sensitivity Analysis
Scenario Analysis
Breakeven Analysis
Decision Trees

Corporate Strategy and NPV

Until now our assumption was that managers are

handed unbiased cash flow forecasts and their

only task is to assess risks, choose the discount
rates, and compute net present value.
Actual financial managers would not rest until
they understand what makes the project tick and
what could go wrong with it.

Even if the projects risk is wholly

diversified, we still need to understand

why the venture could fail.
Once we know this, we can decide whether
it is worth trying to resolve the uncertainty.
If the project really has a negative NPV,
the sooner you can identify it, the better.

 And even if the manager decides that it is worth

going ahead on the basis of present information,

the manager does not want to be caught by
surprise if things subsequently go wrong.
Managers want to know the danger signals and
the actions they might take.
Solutionconduct project analysis

 How to do project analysis? use any or all of the

following techniques
Sensitivity Analysis
Scenario Analysis
Break Even Analysis
Decision Trees

Sensitivity Analysis
The manager considers in turn each of the

determinants of the projects success and

estimates how far the present value of the project

would be altered by taking a very optimistic and
pessimistic view of that variable.

If a small change in one variable (holding all

other variables constant) causes a big change in

the NPV, then
the project is highly sensitive to that particular
variable and must be analyzed carefully.

Sensitivity Analysis Contd

Boils down to expressing cash flows in terms of unknown

variables and then calculating the consequences of

misestimating the variables.
However, sometimes gives ambiguous results.
Through pessimistic and optimistic outlook, subjectivity
is introduced in decision-making.
Underlying variables are likely to be interrelated.
If the market size exceeds expectations, it is likely that demand
will be stronger than you anticipated and unit prices will be
higher.
If inflation pushes prices higher, costs will also go up.

Scenario Analysis
If the variables are interrelated, it may help to

consider some alternative plausible combinations

different scenarios
In scenario analysis, interdependence among
variables is recognized and more than one
variables is allowed to change to construct a
whole new different scenario.

 For instance, suppose an electric car manufacturing

companys economist is worried about the possibility of

another sharp increase in world oil prices.
The direct effect of this would be to encourage the use of
electrically powered cars.
The popularity of compacts after the oil price increase in
the 1970s leads you to estimate that an immediate 20
percent rise in oil prices would enable you to capture an
extra 0.3 percent of the automobile market.

 On the other hand, higher oil prices would

prompt a world recession and at the same time

stimulate inflation. This would cause the overall
car market size to decline and both prices and
costs would go up by 15%.
On the basis of this information, you can
construct a whole different scenario and compute
a new NPV.

Breakeven Analysis
When we undertake a sensitivity analysis of a project or when we

look at alternative scenarios, we are asking how serious would it get

before sales or costs turned out to be worse than we forecasted.
Another way of looking at the same problem is: How bad sales can
get before the project begins to lose money.
This exercise is known as breakeven analysis.
EAC +{Fixed Costs ( 1- Tc)} (Depreciation Tc)

BEP = --------------------------------------------------(Sales Price Variable Costs) (1 Tc)

Tc is the corporate tax rate

Decision Trees
Decision problems involving a reasonable number

of alternative actions and states of nature can be

analyzed using decision trees
Decision trees are more useful for analyzing
projects that involve sequential decisions.
Example of Decision Trees:

The scientists at a company have come up with an electric mop and the firm is ready to
go ahead with pilot production and test marketing. The preliminary phase will take a
year and will cost $125,000. Management feels that there is only 50 percent chance that
the pilot production and market tests will be successful. If they are, then the firm will
build a $1 million plant, which will generate an expected annual cash flow in perpetuity
of $250,000 a year after taxes. If they are not successful, the company will not continue
with the project. The company could go ahead even if the tests fail. In that case, the $1
million investment would generate only $75,000 per year.

NPV = -1,000 + (250/0.10) = +$1,500 million

Invest $1,000 million
For full Scale Production

Success 0.5
Do not Invest
NPV = 0

Failure 0.5
Test
Invest $125 million

Invest $1,000 million for full scale production

NPV = -$250 million

Do not Invest
NPV = 0

Do not Test

Should we invest $125,000 now to obtain a 50% chance of

Getting an NPV of $1,5 million and 50% chance of getting
An NPV of -$250,000 a year later?