Advanced Topics in Capital Budgeting

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Advanced Topics in Capital Budgeting
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Teaching Notes This material reflects a very
different style from how I taught in 2002 and
2003, my first years at the University of
Colorado. The formal lecture itself is now a
small part of the class meeting. Rather than
talking about sensitivity analysis in principle,
I take an example from textbook (see slide 7) and
make an Excel spreadsheet out of it. I modify
this spreadsheet in real-time to show sensitivity
analysis at work, and demonstrate goal seek (a
powerful Excel feature). Homework reinforces
these skills and uses the same spreadsheet in
complementary ways. For the operating leverage
concept, I located a java applet that illustrates
the intuition visually. A screenshot of that
applet follows.
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Overview

• Sensitivity Analysis and Break-Even Points
• Operating Leverage
• The usage of Excels Goal Seek
• Monte Carlo Simulations

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Operating Leverage

• Costs of goods sold has two components
• Fixed costs and variable costs
• On the real side
• Fixed costs must be paid no matter what
• On the financial side
• Bondholders must be paid no matter what
• Fixed costs act a lot like interest payments on
  debt!

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Capital Intensive Projects

• defined as projects for which fixed costs
  constitute a large portion of total costs
• Fixed costs tend to increase the variance of the
  EBIT of projects
• EBIT Sales Fixed Costs Variable Costs
• Q All else equal, do capital intensive projects
  have higher asset betas than other projects?
• Q2 What is the effect of outsourcing on beta?
• Know the this intuition

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Sensitivity Analysis

• Example
• Given the expected cash flow forecasts for
  Otobai Companys Motor Scooter project, listed on
  the next slide, determine the NPV of the project
  given changes in the cash flow components using a
  10 cost of capital. Assume that all variables
  remain constant, except the one you are changing.

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Sensitivity Analysis

• Example cash flow statement if 100,000 units
  sold

NPV 3.43 billion Yen
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Break Even Analysis

• Point at which the NPV0 is the break even point
• Otobai Motors has a breakeven point of 85,000
  units sold.

PV Inflows
400 200 19.6
Break even NPV0
PV (Yen) Billions
PV Outflows
Sales, 000s
85 200
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Monte Carlo Simulation

• A more complete analysis would involve specifying
  a probability distribution for each random
  variable that enters your forecast.
• Excel has some simple capabilities to do this.
• Heavy-use professionals use forecasting software
• www.decisioneering.com