Corporate Finance

Lecture 5
Topics covered

 Decision trees
 Dealing with uncertainty
– Sensitivity analysis
– Senario analysis
 Decision Trees

 Graphically represent
the alternatives
available to us in each
period and the likely
consequences of our
actions.
 This graphical
representation helps to
identify the best course
of action.
Example of Decision Tree
“A”
Study
finance
“B”

“C”

“D”
Do not
study
“F”
Decision trees
 Example:
– The test marketing for a new project will take
one year and will cost $100 million.
– There is a 75% chance that the test will be
successful.
– If successful, the project will be taken and the
NPV is estimated to be $1,517 million at
year=1.
– If not successful, the project will have an NPV
of $-3,611 million at year=1.
– The discount rate is 15% for the firm.
 Decision trees
Now Year 1
Test marketing Investment
-$100 million Invest
75% NPV=1517
Success
test
No invest
Test
NPV=0
result
revealed
Invest
NPV=-3611
failure
25%
No invest
NPV=0
No test

1. Test or not 2. Invest or not

Decision trees

 How to solve the problem

– Make decisions in reverse order with
decision trees
 Decision trees
Now Year 1
Test marketing Investment
-$100 million Invest
75% NPV=1517
Success
test
No invest
Test
NPV=0
result
revealed
Invest
NPV=-3611
failure
25%
No invest
NPV=0
No test

1. Test or not 2. Invest or not

 Decision trees
Now Year 1
Test marketing Investment
-$100 million Invest
75% NPV=1517
Success
test
X No invest
Test
NPV=0
result
revealed
Invest
NPV=-3611
failure
25%
No invest
NPV=0
No test

1. Test or not 2. Invest or not

 Decision trees
Now Year 1
Test marketing Investment
-$100 million Invest
75% NPV=1517
Success
test

X
No invest
Test
NPV=0
result
revealed
Invest
NPV=-3611
failure
25%
No invest
NPV=0
No test

1. Test or not 2. Invest or not

 Decision trees
Now Year 1
Test marketing Investment
-$100 million Invest
75% NPV=1517
Success
test
X No invest
Test
NPV=0
result
revealed
X Invest
NPV=-3611
failure
25%
No invest
NPV=0
No test

1. Test or not 2. Invest or not

 Decision trees
Now Year 1

Test marketing Investment

-$100 million

test 75%
Success
Test Invest
result NPV=1517
revealed
failure No invest
25% NPV=0

E[Payoff]1=0.75*1517+0.25*0=1138
NPV=-100+1138/1.15=890>0
No test

1. Test or not 2. Invest or not

How to handle
uncertainty
 Sensitivity Analysis
– Analyze the effects of changes in one
variable (e.g. sales, cost, discount rate)
on a project.
 Scenario Analysis
– Project analysis given a particular
combination of assumptions.
 How to handle
uncertainty

Example
Given the expected cash
flow forecasts listed on the
next slide, determine the
NPV of the project given
changes in the cash flow
components using an 8%
cost of capital.
How to handle
uncertainty
Year 0 Years 1 - 12
Investment - 5,400
Sales 16,000
Variable Costs 13,000
Fixed Costs 2,000
Depreciati on 450
Pretax profit 550
.Taxes @ 40% 220
Profit after tax 330
Operating cash flow 780
Net Cash Flow - 5,400 780
NPV= $478
 How to handle
uncertainty
Possible Outcomes
Range
Variable Pessimisti c Expected Optimistic
Investment(000s) 6,200 5,400 5,000
Sales(000s ) 14,000 16,000 18,000
Var Cost (% of sales) 83% 81.25% 80%
Fixed Costs(000s ) 2,100 2,000 1,900
 Sensitivity Analysis
Assuming change in
Investment
Year 0 Years 1 - 12
Investment - 6,200
$1,000.00
Sales 16,000
$800.00
Variable Costs 13,000
Fixed Costs 2,000 $600.00

Depreciati on 450 $400.00

NPV
Pretax profit 550
$200.00
.Taxes @ 40% 220
$0.00
Profit after tax 330 -6200 -6000 -5800 -5600 -5400 -5200 -5000

Operating cash flow 780 ($200.00)

Net Cash Flow - 6,200 780 ($400.00)

investm ent
NPV= ($322)
 Scenario Analysis

Base Case. Competing Store Scenario.

1. Sales 16,000,000 13,600,000
2. Variable costs 13,000,000 11,152,000
3.Fixed costs 2,000,000 2,000,000
4. Depreciati on 450,000 450,000
5. Pretax profit (1 - 2 - 3 - 4) 550,000 - 2,000
6.Taxes 220,000 - 800
7. Profit after tax 330,000 - 1,200
8.Cash flow from operations (4  7) 780,000 448,000
Present va lue of cash flows 5,878,000 3,382,000
NPV 478,000 - 2,018,000