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 project’s 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.
 Solution—conduct project analysis
 How to do project analysis? –use any or all of the
following techniques
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–
–
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Sensitivity Analysis
Scenario Analysis
Break Even Analysis
Decision Trees
Sensitivity Analysis
 The manager considers in turn each of the
determinants of the project’s 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
company’s 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?