A Project Is Not a Black Box

1

• A Project Is Not a Black Box

Chapter 10
2
Topics Covered

• Sensitivity Analysis
• Break Even Analysis
• Monte Carlo Simulation
• Decision Trees

3
How To Handle Uncertainty

• Sensitivity Analysis - Analysis of the effects of
  changes in sales, costs, etc. on a project.
• Scenario Analysis - Project analysis given a
  particular combination of assumptions.
• Simulation Analysis - Estimation of the
  probabilities of different possible outcomes.
• Break Even Analysis - Analysis of the level of
  sales (or other variable) at which the company
  breaks even.

4
Sensitivity Analysis

• Example
• Given the expected cash flow forecasts for
  Otoban 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.

5
Sensitivity Analysis

• Example - continued

NPV 3.43 billion Yen
6
Sensitivity Analysis

• Example - continued
• Possible Outcomes

7
Sensitivity Analysis

• Example - continued
• NPV Calculations for Pessimistic Market Size
  Scenario

NPV 5.7 bil yen
8
Sensitivity Analysis

• Example - continued
• NPV Possibilities (Billions Yen)

9
Break Even Analysis

• Point at which the NPV0 is the break even point.
• Otoban Motors has a breakeven point of 8,000
  units sold.

PV Inflows
400 200 19.6
Break even NPV9
PV (Yen) Billions
PV Outflows
Sales, 000s
85 200
10
Monte Carlo Simulation
Modeling Process

• Step 1 Modeling the Project
• Step 2 Specifying Probabilities
• Step 3 Simulate the Cash Flows

11
Decision Trees
960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 4
10(.8) 180(.2) 220(.4) 100(.6)
150(.6) 30(.4)
Turboprop
-550 NPV ?
-150
100(.6) 50(.4)
or
0
Piston
-250 NPV ?
12
Decision Trees
960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 4
10(.8) 180(.2) 220(.4) 100(.6)
812 456 660 364 148
150(.6) 30(.4)
Turboprop
-550 NPV ?
-150
100(.6) 50(.4)
or
0
Piston
-250 NPV ?
13
Decision Trees
960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 4
10(.8) 180(.2) 220(.4) 100(.6)
812 456 660 364 148
150(.6) 30(.4)
Turboprop
-550 NPV ?
-150
100(.6) 50(.4)
or
0
Piston
-250 NPV ?
14
Decision Trees
960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 4
10(.8) 180(.2) 220(.4) 100(.6)
812 456 660 364 148
150(.6) 30(.4)
Turboprop
-550 NPV ?
450
-150
or
100(.6) 50(.4)
0
Piston
331
-250 NPV ?
15
Decision Trees
960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 4
10(.8) 180(.2) 220(.4) 100(.6)
NPV888.18
812 456 660 364 148
150(.6) 30(.4)
Turboprop
-550 NPV ?
NPV444.55
450
-150
NPV550.00
or
100(.6) 50(.4)
0
Piston
331
-250 NPV ?
NPV184.55
16
Decision Trees
960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 4
10(.8) 180(.2) 220(.4) 100(.6)
NPV888.18
812 456 660 364 148
150(.6) 710.73 30(.4)
Turboprop
-550 NPV ?
NPV444.55
450
-150
NPV550.00
100(.6) 403.82 50(.4)
or
0
Piston
331
-250 NPV ?
NPV184.55
17
Decision Trees
960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 4
10(.8) 180(.2) 220(.4) 100(.6)
NPV888.18
812 456 660 364 148
150(.6) 710.73 30(.4)
Turboprop
-550 NPV96.12
NPV444.55
450
-150
NPV550.00
100(.6) 403.82 50(.4)
or
0
Piston
331
-250 NPV117.00
NPV184.55
18
Decision Trees
960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 4
10(.8) 180(.2) 220(.4) 100(.6)
NPV888.18
812 456 660 364 148
150(.6) 710.73 30(.4)
Turboprop
-550 NPV96.12
NPV444.55
450
-150
NPV550.00
100(.6) 403.82 50(.4)
or
0
Piston
331
-250 NPV117.00
NPV184.55