ChapterOutline 8 1CorporateStrategyandPositiveNPV8 2DecisionTrees8 3SensitivityAnalysis ScenarioAnalysis andBreak EvenAnalysis8 4Options8 5SummaryandConclusions IntroducenewproductsAppleCorporationandthemouseDevelopcoretechnologyHondaandsmallenginesCreatebarriertoentryQualcomm spatentsonproprietarytechnologyIntroducevariationsonexistingproductsChrysler sPTCruiserCreateproductdifferentiationCoca Cola it stherealthingUtilizeorganizationalinnovationMotorolajust in timeinventorymanagementExploitanewtechnologyYahoo suseofbanneradvertisementsontheweb CorporateStrategyandPositiveNPV CorporateStrategyandtheStockMarket Thereshouldbeaconnectionbetweenthestockmarketandcapitalbudgeting IfthefirminvestsinapositiveNPVprojects thefirm sstockpriceshouldgoup Sometimesthestockmarketprovidesnegativecluesastoanewproject sNPV ConsiderAT T srepeatedattemptstopenetratethecomputer manufacturingindustry 8 2DecisionTrees Allowustographicallyrepresentthealternativesavailabletousineachperiodandthelikelyconsequencesofouractions ExampleofDecisionTree Donotstudy Studyfinance Opencirclesrepresentdecisionstobemade Filledcirclesrepresentreceiptofinformatione g atestscoreinthisclass Thelinesleadingawayfromthecirclesrepresentthealternatives StewartPharmaceuticals TheStewartPharmaceuticalsCorporationisconsideringinvestingindevelopingadrugthatcuresthecommoncold Acorporateplanninggroup includingrepresentativesfromproduction marketing andengineering hasrecommendedthatthefirmgoaheadwiththetestanddevelopmentphase Thispreliminaryphasewilllastoneyearandcost 1billion Furthermore thegroupbelievesthatthereisa60 chancethattestswillprovesuccessful Iftheinitialtestsaresuccessful StewartPharmaceuticalscangoaheadwithfull scaleproduction Thisinvestmentphasewillcost 1 600million Productionwilloccuroverthenext4years StewartPharmaceuticalsNPVofFull ScaleProductionfollowingSuccessfulTest NotethattheNPViscalculatedasofdate1 thedateatwhichtheinvestmentof 1 600millionismade Laterwebringthisnumberbacktodate0 DecisionTreeforStewartPharmaceutical Donottest Test Failure Success Donotinvest Invest Thefirmhastwodecisionstomake Totestornottotest Toinvestornottoinvest StewartPharmaceutical DecisiontoTest Let smovebacktothefirststage wherethedecisionboilsdowntothesimplequestion shouldweinvest Theexpectedpayoffevaluatedatdate1is TheNPVevaluatedatdate0is Soweshouldtest 8 3SensitivityAnalysis ScenarioAnalysis andBreak EvenAnalysis AllowsustolookthebehindtheNPVnumbertoseefirmourestimatesare Whenworkingwithspreadsheets trytobuildyourmodelsothatyoucanjustadjustvariablesinonecellandhavetheNPVcalculationskeytothat SensitivityAnalysisandScenarioAnalysis IntheStewartPharmaceuticalexample revenueswereprojectedtobe 7 000 000peryear Iftheyareonly 6 000 000peryear theNPVfallsto 1 341 64 Alsoknownas whatif analysis weexaminehowsensitiveaparticularNPVcalculationistochangesintheunderlyingassumptions SensitivityAnalysis WecanseethatNPVisverysensitivetochangesinrevenues Forexample a14 dropinrevenueleadstoa61 dropinNPV Forevery1 dropinrevenuewecanexpectroughlya4 25 dropinNPV ScenarioAnalysis Avariationonsensitivityanalysisisscenarioanalysis Forexample thefollowingthreescenarioscouldapplytoStewartPharmaceuticals Thenextyearseachhaveheavycoldseasons andsalesexceedexpectations butlaborcostsskyrocket Thenextyearsarenormalandsalesmeetexpectations Thenextyearseachhavelighterthannormalcoldseasons sosalesfailtomeetexpectations OtherscenarioscouldapplytoFDAapprovalfortheirdrug Foreachscenario calculatetheNPV Break EvenAnalysis Anotherwaytoexaminevariabilityinourforecastsisbreak evenanalysis IntheStewartPharmaceuticalsexample wecouldbeconcernedwithbreak evenrevenue break evensalesvolumeorbreak evenprice Thebreak evenIATCFisgivenby Break EvenAnalysis Wecanstartwiththebreak evenincrementalafter taxcashflowandworkbackwardsthroughtheincomestatementtobackoutbreak evenrevenue Break EvenAnalysis Nowthatwehavebreak evenrevenueas 5 358 72millionwecancalculatebreak evenpriceandsalesvolume Iftheoriginalplanwastogeneraterevenuesof 7 000millionbysellingthecoldcureat 10perdoseandselling700milliondosesperyear wecanreachbreak evenrevenuewithasalesvolumeofonly Wecanreachbreak evenrevenuewithapriceofonly 8 4Options Oneofthefundamentalinsightsofmodernfinancetheoryisthatoptionshavevalue Thephrase Weareoutofoptions issurelyasignoftrouble Options Becausecorporationsmakedecisionsinadynamicenvironment theyhaveoptionsthatshouldbeconsideredinprojectvaluation TheOptiontoExpandHasvalueifdemandturnsouttobehigherthanexpected TheOptiontoAbandonHasvalueifdemandturnsouttobelowerthanexpected TheOptiontoDelayHasvalueiftheunderlyingvariablesarechangingwithafavorabletrend TheOptiontoDelay Example Considertheaboveproject whichcanbeundertakeninanyofthenext4years Thediscountrateis10percent Thepresentvalueofthebenefitsatthetimetheprojectislaunchedremainconstantat 25 000 butsincecostsaredecliningtheNPVatthetimeoflaunchsteadilyrises Thebesttimetolaunchtheprojectisinyear2 thisscheduleyieldsthehighestNPVwhenjudgedtoday DiscountedCashFlowsandOptions