Strategy and Analysis in Using Net Present Value

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McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

Corporate Finance Ross Westerfield Jaffe Sixth Edition

8Chapter Eight

Strategy and Analysis in Using Net Present Value

Prepared by

Gady JacobyUniversity of Manitobaand Sebouh AintablianAmerican University of Beirut

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Chapter Outline

8.1 Corporate Strategy and Positive NPV

8.2 Decision Trees

8.3 Sensitivity Analysis, Scenario Analysis, and

Break-Even Analysis

8.4 Options

8.5 Summary and Conclusions

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• Introduce new products– McDonald Canada’s introduction of its fast foods into Russia

• Develop core technology– The TSE’s development of CATS

• Create barrier to entry– Qualcomm’s patents on proprietary technology

• Introduce variations on existing products– Corel’s introduction of Corel Draw

• Create product differentiation– Coca-Cola—it’s the real thing

• Utilize organizational innovation– Motorola just-in-time inventory management

• Exploit a new technology– Yahoo!’s use of banner advertisements on the Web

Corporate Strategy and Positive NPV

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Corporate Strategy and the Stock Market

• There should be a connection between the stock market and capital budgeting.

• If the firm invests in a positive NPV project, the firm’s stock price should go up.

• Sometimes the stock market provides negative clues as to a new project’s NPV.

• Consider Seagram’s decision to acquire a stake in Time Warner.

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8.2 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.

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Example of Decision Tree

Do not study

Study finance

Open circles represent decisions to be made.

Filled circles represent receipt of information

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

The lines leading away from the circles represent

the alternatives.

“C”

“A”

“B”

“F”

“D”

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Stewart Pharmaceuticals

• The Stewart Pharmaceuticals Corporation is considering investing in developing 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 $1,600 million. Production will occur over the next four years.

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Stewart Pharmaceuticals NPV of Full-Scale Production following Successful Test

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.

Investment Year 1 Years 2-5Revenues $7,000

Variable Costs (3,000)

Fixed Costs (1,800)

Depreciation (400)

Pretax profit $1,800

Tax (34%) (612)

Net Profit $1,188

Cash Flow -$1,600 $1,588

75.433,3$)10.1(

588,1$600,1$4

1

t

tNPV

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Decision Tree for Stewart Pharmaceuticals

Do not test

Test

Failure

Success

Do not invest

Invest

Invest

611,3$NPV

0$NPV

The firm has two decisions to make:To test or not to test.To invest or not to invest. mNPV 75.433,3$

0$NPV

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Stewart Pharmaceuticals: Decision to Test

• Let’s 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:

failuregiven Payoff

failureProb.

successgiven Payoff

sucessProb.

payoffExpected

25.060,2$0$40.75.433,3$60.payoff

Expected

95.872$10.1

25.060,2$000,1$ NPV

• The NPV evaluated at date 0 is:

So we should test.

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8.3 Sensitivity Analysis, Scenario Analysis, and Break-Even Analysis• When a high NPV is calculated, one’s 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 get the NPV

technique to live up to its potential.• They also allow us to look behind the NPV number

to see from where our estimates are.

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Sensitivity Analysis and Scenario Analysis

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

Also known as “what if” analysis; we examine how sensitive a particular NPV calculation is to changes in the underlying assumptions.

64.341,1$)10.1(

928$600,1$4

1

t

tNPV

Investment Year 1 Years 2-5Revenues $6,000Variable Costs

Fixed Costs

Depreciation

Pretax profit

Tax (34%)

Net Profit

Cash Flow -$1,600

Investment Year 1 Years 2-5Revenues $6,000Variable Costs (3,000)

Fixed Costs

Depreciation

Pretax profit

Tax (34%)

Net Profit

Cash Flow -$1,600


Fixed Costs (1,800)

Depreciation

Pretax profit

Tax (34%)

Net Profit

Cash Flow -$1,600


Fixed Costs (1,800)

Depreciation (400)

Pretax profit

Tax (34%)

Net Profit

Cash Flow -$1,600


Fixed Costs (1,800)

Depreciation (400)

Pretax profit $800

Tax (34%)

Net Profit

Cash Flow -$1,600


Fixed Costs (1,800)

Depreciation (400)

Pretax profit $800

Tax (34%) (272)

Net Profit

Cash Flow -$1,600


Fixed Costs (1,800)

Depreciation (400)

Pretax profit $800

Tax (34%) (272)

Net Profit $528

Cash Flow -$1,600


Fixed Costs (1,800)

Depreciation (400)

Pretax profit $800

Tax (34%) (272)

Net Profit $528

Cash Flow -$1,600 $928

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Sensitivity Analysis

%29.14000,7$

000,7$000,6$Rev%

• 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

%93.6075.433,3$

75.433,3$64.341,1$%

NPV

• For every 1% drop in revenue we can expect roughly a 4.25% drop in NPV

%29.14%93.6025.4

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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 labour costs skyrocket.2. The next years are normal and sales meet expectations.3. 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.

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Break-Even Analysis

• Another way to examine variability in our forecasts is break-even analysis.

• In the Stewart Pharmaceuticals example, we could be concerned with break-even revenue, break-even sales volume, or break-even price.

• The break-even IATCF is given by:

75.504$16987.3

600,1$$

)10.1($600,1$0

4

1

IATCF

IATCFNPVt

t

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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 calculation Cash Flow RevenuesVariable Costs

Fixed Costs

Depreciation

Pretax profit

Tax (34%)

Net Profit

Cash Flow $504.75


Fixed Costs

Depreciation

Pretax profit

Tax (34%)

Net Profit = 504 - depreciation $104.75

Cash Flow $504.75


Fixed Costs

Depreciation

Pretax profit = 104.75 ÷ (1-.34) $158.72

Tax (34%)


Cash Flow $504.75

Investment calculation Cash Flow Revenues = 158.72+VC+FC+D $5,358.72Variable Costs (3,000)

Fixed Costs (1,800)

Depreciation (400)

Pretax profit = 104.75 ÷ (1-.34) $158.72

Tax (34%)


Cash Flow $504.75

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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 sales volume of only:

yearper million 87.535$10$

72.358,5$ volumesaleseven -Break

volume)sales(price72.358,5$

We can reach break-even revenue with a price of only:

doseper 65.7$dosesmillion 7million72.358,5$priceeven -Break

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8.4 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.

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Options

The Option to Expand• Static analysis implicitly assumes that the scale of the

project is fixed.• If we find a positive NPV project, we should consider the

possibility of expanding the project to get a larger NPV.• For example,the option to expand has value if demand turns

out to be higher than expected.• All other things being equal, we underestimate NPV if we

ignore the option to expand.The Option to Delay• Has value if the underlying variables are changing with a favourable trend.

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The Option to Delay: Example

• Consider the above project, which can be undertaken in any of the next four years. The discount rate is 10-percent. The present value of the benefits at the time the project is launched remain constant at $25,000, but since costs are declining the NPV at the time of launch steadily rises.

• The best time to launch the project is in year 2—this schedule yields the highest NPV when judged today.

Year Cost PV NPV t NPV 0

0 20,000$ 25,000$ 5,000$ 5,000$ 1 18,000$ 25,000$ 7,000$ 6,364$ 2 17,100$ 25,000$ 7,900$ 6,529$ 3 16,929$ 25,000$ 8,071$ 6,064$ 4 16,760$ 25,000$ 8,240$ 5,628$

2)10.1(900,7$529,6$

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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.

OptNPVM

A good example would be comparing the desirability of a specialized machine versus a more versatile machine. If they both cost about the same and last the same amount of time the more versatile machine is more valuable because it comes with options.

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The Option to Abandon:• The option to abandon a project has value if demand turns

out to be lower than expected.

EXAMPLE• Suppose that we are drilling an oil well. The drilling rig

costs $300 today and in one year the well is either a success or a failure.

• The outcomes are equally likely. The discount rate is 10%.• The PV of the successful payoff at time one is $575.• The PV of the unsuccessful payoff at time one is $0.

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The Option to Abandon: Example

failuregiven Payoff

failureProb.

successgiven Payoff

sucessProb.

payoffExpected

5.287$05.0575$5.0payoff

Expected

64.38$)10.1(50.287$300$ tNPV

Traditional NPV analysis would indicate rejection of the project.

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The firm has two decisions to make: drill or not, abandon or stay.

Do not drill

Drill

0$NPV

500$

Failure

Success: PV = $500

Sell the rig; salvage value

= $250

Sit on rig; stare at empty hole:

PV = $0.

Traditional NPV analysis overlooks the option to abandon.

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failuregiven Payoff

failureProb.

successgiven Payoff

sucessProb.

payoffExpected

50.412$0255.0575$5.0payoff

Expected

00.75$)10.1(50.412$300$ tNPV

• When we include the value of the option to abandon, the drilling project should proceed:

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Valuation of the Option to Abandon

• Recall that 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.

OptNPVM

Opt 64.3800.75$

Opt 64.3800.75$

64.113$Opt

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8.5 Summary and Conclusions

• This chapter discusses a number of practical applications of capital budgeting.

• We ask about the sources of positive net present value and explain what managers can do to create positive net present value.

• Sensitivity analysis gives managers a better feel for a project’s risks.

• Scenario analysis considers the joint movement of several different factors to give a richer sense of a project’s risk.

• Break-even analysis, calculated on a net present value basis, gives managers minimum targets.

• The hidden options in capital budgeting, such as the option to expand, the option to abandon, and timing options were discussed.

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Strategy and Analysis in Using Net Present Value