Corporate Finance

Lecture 04-1: Risk Analysis and Capital Budgeting

1 Decision Trees
A fundamental problem in NPV analysis is dealing with
uncertain future outcomes.

There is usually a sequence of decisions in NPV project

analysis.

Decision trees are used to identify the sequential decisions

in NPV analysis.

Decision trees allow us to graphically represent the

alternatives available to us in each period and the likely

consequences of our actions.

Example of Decision Tree

Open circles represent decisions to be made.
A
Study
finance

Filled circles represent receipt

of information e.g., a test
score in this class.

C
Do not
study

The lines leading away from the

circles represent the alternatives.

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% 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.

$(1.,508)$3,4.75
N
P
V
$1,60

NPV following Successful Test

Investment
Revenues

Variable Costs
Fixed Costs

Depreciation
Pretax profit
Tax (34%)
Net Profit

Cash Flow

Year 1

Years 2-5

$7,000

4t1t

(3,000)
(1,800)

(400)

$1,800

(612)

$1,188

-$1,600

$1,588

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.

$
4
7
5
.
9
0
NPV$1,60

$
9
1
.
4
6
(1)

NPV following Unsuccessful Test

Investment

Year 1

Years 2-5

Revenues

$4,050

Variable Costs

(1,735)

Fixed Costs

Depreciation
Pretax profit
Tax (34%)
Net Profit

Cash Flow

4
t1t
(1,800)

(400)

$115

(39.10)
$75.90

-$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.

N
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V$N
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N
P
V
$0NPV$91.46

Decision Tree for Stewart Pharmaceuticals

The firm has two decisions to make:
To test or not to test.

Invest

To invest or not to invest.

Success

Test

Do not
invest

Failure

Do not
test

Invest

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Decision to Test

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:

The NPV evaluated at date 0 is:

So we should test.

Discounted Cash Flows and 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.

NPVtoalNPVOpt

Discounted Cash Flows 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.

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The Option to Abandon

Suppose Stewart Pharmaceuticals have to make the

investment decision before the realization of the test result.

The NPV evaluated at date 0 is:

Thus the value of the option is $872.95-839.70 = 33.25

2 Sensitivity Analysis, Scenario Analysis,

and Break-Even Analysis

When a high NPV is calculated, ones temptation is

to accept the project immediately.

It is possible that the projected cash flow will go

unmet in practice.

These techniques allow the firm to check whether the

NPV remains positive under different assumptions.

They also allow us to look behind the NPV number to

see from where our estimates are.

$(1.9208)$1,34.6
N
P
V
$1,60
Sensitivity Analysis

Also known as what if analysis; we examine how sensitive a particular

NPV calculation is to changes in the underlying assumptions.
In the Stewart
Pharmaceuticals
example, revenues
were projected to be
$7,000,000 per year.

If they are only

$6,000,000 per year,
the NPV falls to
$1,341.64

Investment

Year 1

Revenues

Years 2-5

$6,000

4t1t

Variable Costs

(3,000)

Fixed Costs

(1,800)

Depreciation

(400)

Pretax profit

$800

Tax (34%)

(272)

Net Profit

$528

Cash Flow

-$1,600

$928

R
ev$6,0$7,0%
.4

1
4
2
9
%
,.25
.16402.93%
$
1
3
4
6$3,4.7560.93%
N
P
V

Sensitivity Analysis

We can see that NPV is very sensitive to changes in

revenues. For example, a 14% drop in revenue leads to a

61% drop in NPV

For every 1% drop in revenue we can expect roughly a

4.25% drop in NPV

Scenario Analysis

A variation on sensitivity analysis is scenario analysis.

For example, the following three scenarios could apply to
Stewart Pharmaceuticals:

1.

The next years each have heavy cold seasons, and sales exceed
expectations, but labor costs skyrocket.

2.
3.

The next years are normal and sales meet expectations.

The next years each have lighter than normal cold seasons, so sales
fail to meet expectations.

Other scenarios could apply to government approval for

their drug.

For each scenario, calculate the NPV.

$
O
C
F
N$OPCVF03.
$918,670

(
1
.
0
)
50475
Break-Even Analysis

4
B
E
t
t

1
BE

Another way to examine variability in our forecasts

even analysis.

is break-

In the Stewart Pharmaceuticals example, we could be

concerned with break-even revenue, break-even sales volume,

or break-even price.

We first compute the break-even OCF

BE

Break-Even Analysis
We can start with the break-even incremental after-tax cash
flow and work backwards through the income statement to
back out break-even revenue:
Investment
Revenues

calculation
= 158.72+VC+FC+D

Cash Flow
$5,358.72

Variable Costs

(3,000)

Fixed Costs

(1,800)

Depreciation
Pretax profit

(400)
= 104.75 (1-.34)

$158.72

= 504 - depreciation

$104.75

Tax (34%)
Net Profit
Cash Flow

$504.75

$
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reak-venpricem

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ilondse
Break-Even Analysis

Now that we have break-even revenue as $5,358.72 million

we can calculate break-even price and sales volume.

If the original plan was to generate revenues of $7,000

million by selling the cold cure at $10 per dose and selling
700 million doses per year, we can reach break-even revenue
with a price of only:

Practical Questions

Practical Questions

For question 13.c, replace accounting with financial.