L5: Capital Budgeting - Project Staging, Risk Analysis

Question 1

What is sensitivity analysis?

Answer 1

Breaks the NPV calculation into its component assumptions and shows how the NPV varies as the underlying assumptions change. Change one variable at a time, while holding others at the expected value. Can learn which assumptions are the most important → can invest resources and effort to refine these assumptions.

Question 2

What is scenario analysis?

Answer 2

Considers the effect on the NPV of changing multiple project parameters simultaneously.
- Grouped by economic scenarios: Base/best/worst case
- Attaches probabilities to analysed scenarios (weigh relative importance)
- The implied values given by these probabilities should match the expectation in the standard analysis. (if scenarios & probabilities are estimated independently –> internal validation on consistency of estimates)

Question 3

What does Weitzman, M. L. (1979) suggest about optimal search for the best alternative and real option value?

Answer 3

• Riskier projects provide more real option value.
• The real option value comes from being able to stop the search given a “good enough” outcome.

Question 4

What are some limitations of real options?

Answer 4

• Unlike with financial options, there are no historical prices with which to estimate volatility.
• Requires projections about how future decision makers will proceed.
• The value of a real option is often sensitive to the estimates about the likelihood of scenarios (e.g. probability that the first movie is successful).

Question 5

What are the advantages of sensitivity analysis?

Answer 5

• Shows whether the investment decision is robust. Is the result still NPV positive for all changes?
• Identifies where more information is needed. May want to learn more about particular areas.
• Identifies the areas that deserve the most managerial attention.

Question 6

What are the limitations of sensitivity analysis?

Answer 6

• Even the best-case and worst-case estimates are wrong
• Variables are examined in isolation when they are related
• Best- and worst-case estimates are not associated with likelihood

Question 7

What are some scenarios that impact how a company performs?

Answer 7

• Production management effectiveness (market share, price, costs)
• Trade restrictions (cost, market size, market share, price)
• Competition (cost, market share, price)
• Recession (discount rate, market size, price)
• Government incentives (market size, price, taxes)
• Etc.

Question 8

What are the limitations of scenario analysis?

Answer 8

• Selecting likely scenarios is not an exact science. (countless options, no rule for deciding with are more relevant, business judgment)
• Important economic connections between sets of parameters may be overlooked. (since not all possible scenarios are feasible to exhaust)
• Analyzing the many combinations of different parameter values is cumbersome (–> monte carlo beneficial)

Question 9

What is Monte Carlo estimation and what are the 5 steps of the general procedure?

Answer 9

A technique that relies on repeated random samplings to model uncertainty in complex economic interactions.

1. Specify the model
2. Specify a distribution for each variable
3. Computer draws a sample
4. Repeat step 3 N times
5. Calculate relevant outcome (e.g. NPV)

Question 10

What are 3 risk analysis techniques?

Answer 10

• Sensitivity analysis
• Scenario analysis
• Monte Carlo simulations

Question 11

What are the advantages of Monte Carlo Estimation?

Answer 11

• Can explicitly specify the relationship between different parameters (e.g. correlations and other relationships)
• Does not require an exact model of how outcome variables depend on the input parameters (no exact mathematical formula needed. Instead simulation of if-then statements)
• Simulations can deepen a forecaster’s understanding of complicated economic scenarios (e.g. what it depends on)

Question 12

What are the limitations of Monte Carlo Estimation?

Answer 12

• Not exactly “model-free”; it requires assumptions about how decisions in the economic interactions are made.
• Computer outputs are devoid of economic intuition (requires outside judgment from the analyst, human action needed to interpret the results)
• The distribution of each variable and the interactions between them are difficult to model (not clear which best describes reality)
• At some point, even the Monte Carlo method requires input of information from experts.

Question 13

What is unlevered net income?

Answer 13

= EBIT * (1-t)
= (Revenues - Costs - Depreciation) * (1-t)

Question 14

What are indirect effects that can affect earnings?

Answer 14

• Opportunity costs
• Project externalities: cannibalization/cross-selling

Question 15

What are some common sunk costs?

Answer 15

• Fixed overhead expenses
• Past R&D expenditures
• Unavoidable competitive effects

Question 16

What are free cash flows?

Answer 16

The incremental effect of a project on the firm’s available cash, separate from any financing decision.

Question 17

What is the formula for net working capital?

Answer 17

= Current assets - Current liabilities

= Cash + Inventory + Receivables - Payables

Question 18

What is the formula for free cash flows?

Answer 18

= Unlevered net income + Depreciation - CapEx - ∆NWC

= ((Revenues - Costs - Depreciation) * (1-t)) + Depreciation - CapEx - ∆NWC

= (Revenues - Costs)*(1-t) - CapEx - ∆NWC + (t * Depreciation)

Where:
t*Depreciation = depreciation tax shield

Question 19

What are two situations where we have applied project staging?

Answer 19

Under:
- extreme complementarity (e.g. Eclectic Motors)
- extreme substitutability (e.g. Commodity Inc.)

Question 20

What are the costs of real options?

Answer 20

• Direct costs. The real option is something that the firm has to pay for (increase bids).
• Lost profits in the interim. The real option to delay has a cost because it pushes back payoff, which results in a lower NPV due to time value.
• Costs may rise. Could save some production costs due to economies of scale. Waiting results in an additional production cost.
• Competitors get a head start. Often time firms are racing to bring a product to market. To the extent that there is a first-mover advantage, waiting to act until more information is known may be costly.
• May exacerbate agency problems.

Question 21

What does Graham, J.R., & Harvey, C. R. (2001) suggest about the use of sensitivity/scenario analysis and simulations?

Answer 21

Responses from 392 CFOs

51,54% of companies use sensitivity/scenario analysis in their capital budgeting
- Larger companies are more likely to use them
- Highly leveraged companies are more likely to use them

13,66% simulations
- Larger companies are more likely to use them
- Highly leveraged companies are more likely to use them

Question 22

What are some aspects to consider when choosing which factors from a sensitivity analysis to look into more?

Answer 22

• Does any factor make the project NPV negative?
• Which factor has the largest spread between good and bad (more uncertainty is resolved by learning about the factor)?
• Do we have control over the factor?

Question 23

What is an alternative formula for free cash flows considering the market?

Answer 23

FCF = Market size * Market share * (Price-VC) - FC

Question 24

Are multiplicative or additive errors worse?

Answer 24

Errors in estimates that factor into a calculation in a multiplicative way is worse relative to when it is in an additive way

Question 25

What is a mortgage-backed security?

Answer 25

A (structured) financial asset secured by a collection of mortgages

Question 26

What is the pseudo-code (monte carlo?

Answer 26

Lays out the formal and structure of the main steps of a given simulations. Purpose is to guide the analyst through the steps involved in the simulation before actually coding it.

1. Draw the factors from a joint distribution F(0,p,y) for each borrower.
2. Calculate repayment for each mortgage.
3. Aggregate repayments to figure out the payoff of the security based on the whole portfolio
4. Repeat steps 1-3 (N times)

Question 27

What are some reasons to the financial crisis?

Answer 27

• CDOs did not factor in correctly the possibility of a general housing bust. The reduction of risk in a pool of mortgages depends on the extent to which default probabilities within the pool are not correlation.
• Even securities rates AAA could default with reasonable likelihood