TKM CH 13

Chapter 13
Risk Analysis and

Project Evaluation
Copyright 2011 Pearson Prentice Hall. All rights reserved.
Slide Contents
Learning Objectives
Principles Used in This Chapter
1.The Importance of Risk Analysis
2.Tools for Analyzing the Risk of Project Cash Flows
3.Break-Even Analysis
4.Real Options in Capital Budgeting
Key Terms
13-2
Learning Objectives
1. Explain the importance of risk analysis in the
capital budgeting decision-making process.
2. Understand the use of sensitivity and scenario
analysis as well as simulation analysis to
investigate the determinants of project cash
flows.
3. Use break-even analysis to evaluate project risk.
4. Explain the types of real options.
13-3
Principles Used in This Chapter

Principle #2: There Is a Risk-Return
Tradeoff
13-4
13.1 The
Importance of
Risk Analysis
The Importance of Risk Analysis

There are two fundamental reasons to
perform a project risk analysis before
making a final accept/reject decision:
Project cash flows are risky and may not be
equal to the estimates used to compute NPV.
Forecasts are made by humans who can be
either too optimistic or too pessimistic when
making their cash flow forecasts. Risk analysis
will help guard against such biases.
13-6
13.2 Tools for

Analyzing the
Risk of Project
Cash Flows
Tools for Analyzing the Risk of

Project Cash Flows
It is reasonable to assume that the actual
cash flows an investment produces will
never equal the expected cash flows used
to estimate the investments NPV as there
are many possible cash flow outcomes for
any project.
13-8
Tools for Analyzing the Risk of

Project Cash Flows (cont.)
Tools such as Sensitivity analysis, Scenario
analysis, and Simulation analysis provide
better understanding of the uncertainty of
future cash flows and, consequently, the
reliability of the NPV estimate.
13-9
Key Concepts - Expected Values and

Value Drivers
Expected Values
The expected value of a future cash flow is
given by the probability weighted average of all
the possible cash flows that might occur.
The cash flows used to calculate a projects NPV
are expected values.
13-10
Key Concepts - Expected Values and

Value Drivers (cont.)
Example 13.1
What is the expected cash value if there are two
possible cash flows, $100 and $400 and the
probabilities of these cash flows are 25% and
75%.
Expected cash value
= .25 ( 100) + .75 (400)

= $325
13-11
Checkpoint 13.1
Forecasting Revenues Using Expected Values
Marshall Homes is a Texas homebuilder that specializes in the
construction of high-end homes costing $1.5 million to $10 million
each. To estimate its revenues for 2011 following the economic
downturn of 200709, it divided its home sales into three categories
based on selling price (high, medium, and low) and estimated the
number of units it expects to sell under three different economic
scenarios for 2011. These scenarios include a deep recession
(Scenario I), a continuation of current conditions in which the
economy is in a mild recession (Scenario II), and finally a turnaround
in the economy and return to the economic conditions of 20042006
(Scenario III). What are Marshalls expected revenues for 2011?
13-12
Checkpoint 13.1
13-13
Checkpoint 13.1
13-14
Checkpoint 13.1
13-15
Checkpoint 13.1: Check Yourself

Consider your forecast of Marshall Homes
expected revenues for 2011 where the probability
of entering a deep recession increases to 40%,
the probability of mild recession drops to 50%,
and the probability of a turn-around declines to
only 10%. You may assume that the estimates of
the number of units sold and the selling price of
each remain unchanged.
13-16
Step 1: Picture the Problem

The following table lays out the number of
units the firms manager estimate they will
sell in each of three home categories for
each of the three possible states of the
economy:
13-17
Step 1: Picture the Problem (cont.)

Deep
Recession
Mild Recession
Turn-Around
Probability
40%
50%
10%
High Priced Home:

Total Revenues
$0
$40,000,000
$80,000,000
Medium Priced
Home:
Total Revenues
$20,000,000
$60,000,000
$120,000,000
Low-Priced Home:
Total Revenues
$20,000,000
$40,000,000
$120,000,000
Total Revenues for

each Scenario
$40,000,000
$140,000,000
$320,000,000
13-18
Step 2: Decide on a Solution

Strategy
To compute the expected total revenue, we
can proceed in three steps:
1. Estimate the probability of each state of the
economy.
2. Calculate the total revenue from each
category of homes for each of the three states
of the economy.
3. Calculate a probability weighted average of
the total revenues (step 2 times step 3).
13-19
Step 3: Solve
Deep
Recession
Mild
Recession
40%
50%
Step 1
Probability
Step 2
Total Revenues
for each
Scenario
$40,000,000
Step 3
Probability
Total Revenue
$16,000,000
Turn-around
10%
$140,000,000 $320,000,000
$70,000,000
$32,000,000
13-20
Step 3: Solve (cont.)

Thus the expected total revenues declines
from $156,000,000 to $118,0000.
13-21
Step 4: Analyze
The table in step 3 shows that there can
be wide variation in revenue based on the
future economic scenario. The table only
shows the revenues. To get a more
realistic picture, we should also consider
the impact on expenses and consequently,
profits and cash flows.
13-22
Value Drivers
Value drivers are the basic determinants
of an investments cash flows and
consequently its performance.
Value drivers may consist of determinants
of project revenues (e.g., market share,
market size, and price) and costs (e.g.,
variable and cash fixed costs)
13-23
Value Drivers (cont.)

Identification of value drivers allow the
financial manager to:
Allocate more time and money toward refining
their forecasts of these key variables.
Monitor the key value drivers regularly so that
prompt corrective action can be taken in the
event that the project is not proceeding as
expected.
13-24
Sensitivity Analysis
Sensitivity analysis occurs when a
financial manager evaluates the effect of
each value driver on the investments NPV.
It helps identify the variable that has the
most impact on NPV.
13-25
Checkpoint 13.2
Project Risk Analysis: Sensitivity Analysis
Crainium, Inc. is considering an investment in a new plasma cutting tool to be
used in cutting out steel silhouettes that will be sold through the firms catalog
sales operations. The silhouettes can be cut into any two-dimensional shape such
as a state, university mascot or logo, etc. The products are expected to sell for
an average price of $25 per unit, and the company analysts expect the firm can
sell 200,000 units per year at this price for a period of five years. Launching this
service will require the purchase of a $1.5 million plasma cutter and materials
handling system that has a residual or salvage value in five years of $250,000.
In addition, the firm expects to have to invest an additional $500,000 in working
capital to support the new business. Other pertinent information concerning the
business venture is provided below:
13-26
Checkpoint 13.2
Crainiums analysts have estimated the projects expected or base-case cash
flows as well as the NPV and IRR to be the following:
Although the project is expected to have a $209,934 NPV and a 15.59% IRR
(which exceeds the projects 10% discount rate), it is risky, so the firms
analysts want to explore the importance of uncertainty in the project cash
flows. Perform a sensitivity analysis on this proposed investment.
13-27
Checkpoint 13.2
13-28
Checkpoint 13.2
13-29

After a careful cost analysis of the costs for making the
silhouettes, Craniums management has determined
that it will be possible to reduce the variable cost per
unit down to $18 per unit by purchasing an additional
option for the equipment that will raise its initial cost
to $1.8 million (the residual or salvage value for this
configuration is estimated to be $300,000). All other
information remains the same as before. For this new
machinery configuration, analyze the sensitivity of the
project NPV to the same percent changes analyzed
above.
13-30

To evaluate the sensitivity of the projects
NPV and IRR to uncertainty surrounding
the projects value drivers, we need to
analyze the effects of the changes in the
value drivers (unit sales, price per unit,
variable cost per unit, and annual fixed
operating cost other than depreciation).
13-31

We consider the following changes:
Unit sales (-10%)

Price per unit (-10%)
Variable cost per unit (+10%)
Cash fixed costs per year (+10%)
13-32

Strategy
The objective of this analysis is to explore
the effects of the prescribed changes in the
value drivers on the projects NPV.
We will need to estimate the base-case
NPV based on given information and then
compute the NPV based on assumed
changes to the value drivers.
13-33
Step 3: Solve
Following are the projected cash flows for years 0-5:
Year-0
Revenues
Years 1-4
Year-5
5,000,000
5,000,000
$(3,600,000.00)
$(3,600,000.00)
Less: Depreciation Expense
$(300,000.00)
$(300,000.00)
Less: Cash Fixed Cost
$(400,000.00)
$(400,000.00)
$700,000.00
$700,000.00
$(210,000.00)
$(210,000.00)
Net operating profit after tax
$490,000.00
$490,000.00
Plus: Depreciation Expense
$300,000.00
$300,000.00
Less: Variable Cost
Net Operating Income

Les: Taxes
Less: CAPEX
Less: Change in Working Capital
Free Cash Flow
$(1,800,000.00)
$300,000.00
$(500,000.00)
$500,000.00
$(2,300,000.00)
$790,000.00
$1,590,000.00
13-34

Given the free cash flows for years 0-5, we
can compute the NPV and IRR on excel,
which gives us the following results:
Year
Free Cash Flow
$(2,300,000.00)
$790,000.00
$790,000.00
$790,000.00
$790,000.00
$1,590,000.00
NPV
$1,001,714.68
IRR
26.65%
13-35

What if sales drop by 10%?
Year-0
Years 1-4
Revenues
Year-5
4,500,000
4,500,000
$(3,240,000.00)
$(3,240,000.00)
$(300,000.00)
$(300,000.00)
$(400,000.00)
$(400,000.00)
$560,000.00
$560,000.00
$(168,000.00)
$(168,000.00)
$392,000.00
$392,000.00
$300,000.00
$300,000.00
Less: Variable Cost

Les: Taxes
Less: CAPEX
Free Cash Flow
$(1,800,000.00)
$300,000.00
$(500,000.00)
$500,000.00
$(2,300,000.00)
$692,000.00
NPV
$648,446.62
IRR
21.59%
$1,492,000.00
13-36

What if variable costs increase by 10%?
Year-0
Years 1-4
Revenues
Year-5
5,000,000
5,000,000
$(3,960,000.00)
$(3,960,000.00)
$(300,000.00)
$(300,000.00)
$(400,000.00)
$(400,000.00)
$340,000.00
$340,000.00
$(102,000.00)
$(102,000.00)
$238,000.00
$238,000.00
$300,000.00
$300,000.00
Less: Variable Cost

Les: Taxes
Less: CAPEX
Free Cash Flow
$(1,800,000.00)
$300,000.00
$(500,000.00)
$500,000.00
$(2,300,000.00)
$538,000.00
NPV
$220,414.70
IRR
15.19%
$1,338,000.00
13-37

What if price per unit drops by 10%
Year-0
Years 1-4
Revenues
Year-5
4,500,000
4,500,000
$(3,600,000.00)
$(3,600,000.00)
$(300,000.00)
$(300,000.00)
$(400,000.00)
$(400,000.00)
$200,000.00
$200,000.00
Les: Taxes
$(60,000.00)
$(60,000.00)
$140,000.00
$140,000.00
$300,000.00
$300,000.00
Less: Variable Cost
Less: CAPEX
Free Cash Flow
$(1,800,000.00)
$300,000.00
$(500,000.00)
$500,000.00
$(2,300,000.00)
$440,000.00
NPV
($259,956.99)
IRR
8.02%
$1,240,000.00
13-38

What if fixed costs increase by 10%?
Year-0
Years 1-4
Revenues
Year-5
5,000,000
5,000,000
$(3,600,000.00)
$(3,600,000.00)
$(300,000.00)
$(300,000.00)
$(440,000.00)
$(440,000.00)
$660,000.00
$660,000.00
$(198,000.00)
$(198,000.00)
$462,000.00
$462,000.00
$300,000.00
$300,000.00
Less: Variable Cost

Les: Taxes
Less: CAPEX
Free Cash Flow
$(1,800,000.00)
$300,000.00
$(500,000.00)
$500,000.00
$(2,300,000.00)
$762,000.00
NPV
$900,780.95
IRR
25.22%
$1,562,000.00
13-39

The following table shows the impact on
NPV of changes in the value drivers.
Value Drivers
Expected NPV
Unit Sales (-10%)
$1,001,714.68
$648,446.62
-35%
Price per unit (-10%)
$1,001,714.68
$(259,956.99)
-126%
Variable Cost (+10%)
$1,001,714.68
$220,414.70
-78%
Cash Fixed Cost (+10%)
$1,001,714.68
$900,780.95
-10%
Revised NPV
% Change
13-40
Step 4: Analyze
Here we observe that a 10% adverse
change in value drivers has a significant
impact on NPV. If the price per unit drops
by 10%, the project turns negative with
the value of NPV declining by 126%.
13-41
Step 4: Analyze (cont.)

The results also show that NPV is most
sensitive to changes in the selling price
and variable cost. Thus management must
be doubly sure that the estimates on these
value drivers are accurate. Furthermore,
once the project is implemented, these two
value drivers must be closely monitored.
13-42
Scenario Analysis
Sensitivity analysis involves changing one
value driver at a time and analyzing its
effect on the investment NPV.
Scenario analysis considers the effect of
multiple changes in value drivers on the
NPV. For example, the scenarios could be
Expected or base-case, Worst-case and
Best-case.
13-43
Checkpoint 13.3
Project Risk Analysis: Scenario Analysis
The analysts performing the risk analysis on the plasma cutting tool
being considered by Crainium, Inc. (described in Checkpoint 13.2)
now want to evaluate the project risk using scenario analysis.
Specifically, they now want to evaluate thE projects risk using
scenario analysis aimed at evaluating the projects NPV under worstand best-case scenarios for the projects value drivers.
13-44
Checkpoint 13.3
13-45
Checkpoint 13.3
13-46

The deepening recession that characterized the
economy caused Craniums management to
reconsider the base-case scenario for the project by
lowering their unit sales estimates to 175,000 at
revised price per unit of $24.50. Based on these
projections, is the project still viable? What if
Longhorn followed a higher price strategy of $35
per unit but only sold 100,000 units? What would
you recommend Longhorn do?
13-47

We are given the following revised
estimates for two scenarios:
Scenario 1
Unit Sales
Price per unit
Scenario 2
$175,000.00
$100,000.00
$24.50
$35
Rest of the information is the same as

Checkpoint 13.2
13-48

Strategy
Our objective is to determine the
sensitivity of NPV to the two scenarios.
We can estimate the free cash flows as
before and then compute the NPVs for the
two scenarios and compare.
13-49
Step 3: Solve
Scenario 1 cash flow and NPV/IRR estimates
Year-0
Years 1-4
Revenues
Year-5
$4,287,500.00
$4,287,500.00
$(3,500,000.00)
$(3,500,000.00)
$(250,000.00)
$(250,000.00)
$(400,000.00)
$(400,000.00)
$137,500.00
$137,500.00
Les: Taxes
$(41,250.00)
$(41,250.00)
$96,250.00
$96,250.00
$250,000.00
$250,000.00
Less: Variable Cost

Less: CAPEX
Free Cash Flow
$(1,500,000.00)
$250,000.00
$(500,000.00)
$500,000.00
$(2,000,000.00)
$346,250.00
NPV
$326,276.10
IRR
6.29%
$1,096,250.00
13-50

Scenario 2 cash flow and NPV/IRR estimates
Year-0
Years 1-4
Revenues
Year-5
$3,500,000.00
$3,500,000.00
$(2,000,000.00)
$(2,000,000.00)
$(250,000.00)
$(250,000.00)
$(400,000.00)
$(400,000.00)
$850,000.00
$850,000.00
$(255,000.00)
$(255,000.00)
$595,000.00
$595,000.00
$250,000.00
$250,000.00
Less: Variable Cost

Les: Taxes
Less: CAPEX
Free Cash Flow
$(1,500,000.00)
$250,000.00
$(500,000.00)
$500,000.00
$(2,000,000.00)
$845,000.00
NPV
$1,471,606.03
IRR
36.10%
$1,595,000.00
13-51
Step 4: Analyze
Examination of the two scenarios reveals
that this is a risky opportunity as there is a
wide divergence in the two NPV estimates.
The NPV could be as high as $1,491,606 or
as low as a negative $326,276.
13-52
Simulation Analysis
Scenario analysis provides the analyst with
a discrete number of estimates of project
NPVs for a limited number of cases or
scenarios.
Simulation analysis generates thousands
of estimates of NPV that are built upon
thousands of values for each of the
investments value drivers. These different
values arise out of each value drivers
individual probability distribution.
13-53
Simulation Analysis (cont.)

Simulation process involves the following
steps:
1. Estimate the probability distributions for
each of the investments key value drivers.
2. Randomly select one value for each of the
value drivers from their respective probability
distributions.
3. Combine the values selected for each of the
values drivers to estimate project cash flows
for each year of the projects life and
calculate the projects NPV.
13-54
Simulation Analysis (cont.)

4. Store or save the calculated value of the
NPV and repeat Steps 2 and 3. Computer
softwares can easily repeat steps 2 and 3
thousands of times.
5. Use the stored values of the project NPV
to construct a histogram or probability
distribution of NPV.
13-55
13-56
13.3 Break-Even
Analysis
Break-Even Analysis
Break-even analysis determines the
minimum level of output or sales that the
firm must achieve in order to avoid losing
money i.e. to break even.
In most cases, break-even sales is defined
as the level of sales for which net
operating income equals zero.
13-58
Accounting Break-Even Analysis

Accounting break-even analysis
involves determining the level of sales
necessary to cover total fixed costs (both
cash fixed costs and depreciation).
To compute the accounting break-even
point, we need to decompose the costs
into two components: fixed costs and
variable costs.
13-59

(cont.)
Fixed costs are costs that do not vary
directly with sales revenue. For example,
insurance premiums, administrative
salaries.
As the number of units sold increases,
fixed cost per unit decreases, as fixed
costs are spread over larger quantities of
output.
Fixed costs are also known as indirect
costs.
13-60

(cont.)
Variable costs are costs that vary directly
with the level of sales. Hence, they are
also referred to as direct costs. For
example, hourly wages, cost of materials
used, sales commission.
Variable costs per unit remain the same
regardless of the level of output.
13-61
13-62

(cont.)
The accounting break-even point is the
level of sales that is necessary to cover
both variable and total fixed costs, such
that the net operating income is equal to
zero.
13-63
Checkpoint 13.4
Project Risk Analysis: Accounting Break-Even Analysis
The new plasma cutting tool that Crainium, Inc. is considering
investing in as described in Checkpoint 13.2 has the following
value driver estimates of fixed and variable costs:
Company analysts are evaluating the projects risks and want to

estimate the accounting break-even for the projects annual
revenues and expenses. What is the break-even level of units?
13-64
Checkpoint 13.4
13-65
Checkpoint 13.4
13-66
Checkpoint 13.4
13-67
Checkpoint 13.4
13-68

Crainium, Inc.s analysts have estimated
the accounting break-even for the project
to be 130,000 units and now want to
consider how the worst-case scenario value
driver values would affect the accounting
break-even. Specifically, consider a unit
price of $23, variable cost per unit of $21,
and total fixed costs of $700,000.
13-69

The new investment that Crainium, Inc. is
planning to invest is described in
Checkpoint 13.2 with the following revised
estimates:
Price per unit =$25
Variable cost per unit = $23
Total fixed cost per year = $700,000
13-70

The annual costs consists of total fixed
costs and variable costs that vary by the
level of output.
Total costs
= Variable cost (# of units) + Total fixed costs
13-71

The following table shows the break-up of
total costs for four units of output.
Units of Output
Variable Costs
Fixed Costs
Total Costs
50,000.00
$1,050,000.00
$700,000.00
$1,750,000.00
100,000.00
$2,100,000.00
$700,000.00
$2,800,000.00
150,000.00
$3,150,000.00
$700,000.00
$3,850,000.00
200,000.00
$4,200,000.00
$700,000.00
$4,900,000.00
13-72

Strategy
To determine the accounting breakeven
quantity, we can use the following
equation:
QBreak-even = F (P-V)
Where
F = total fixed costs

P = Sale price per unit
V = Variable cost per unit
13-73
Step 3: Solve
QBreak-even = F (P-V)
= $700,000 ($23-$21)
= $700,000 $2
= 350,000 units
13-74

The table below shows that at 350,000
units of output, total costs = total revenue
i.e. the firm breaks even or accounting
profits are equal to zero.
Units of Output
Variable Costs
Fixed Costs
Total Costs
Revenue
Profit
50,000.00
$1,050,000.00
$700,000.00
$1,750,000.00
1,150,000.00
(600,000.00)
100,000.00
$2,100,000.00
$700,000.00
$2,800,000.00
2,300,000.00
(500,000.00)
150,000.00
$3,150,000.00
$700,000.00
$3,850,000.00
3,450,000.00
(400,000.00)
200,000.00
$4,200,000.00
$700,000.00
$4,900,000.00
4,600,000.00
(300,000.00)
350,000.00
$7,350,000.00
$700,000.00
$8,050,000.00
8,050,000.00
$0
13-75
Step 4: Analyze
Break-even analysis indicates the number
of units the firm must sell in order to
cover total fixed and variable costs
resulting in net operating income of zero.
Break-even point sets the lower limit on
the level of sales, from an accounting
perspective. Note projects that merely
break even in an accounting sense have
negative NPVs and results in a loss of
shareholder value.
13-76
Calculating the Cash Break-Even

Point
The cash break-even point computes
the level of sales where cash fixed costs
(ignoring depreciation) are covered and as
a result, cash flow is equal to zero.
13-77
NPV Break-Even Analysis

The NPV break-even analysis identifies
the level of sales necessary to produce a
zero level of NPV.
NPV break-even focuses on cash flows, not
accounting profits.
13-78
13-79
Operating Leverage and the

Volatility of Project Cash Flows
The composition of fixed and variable costs
vary by firm. For example, a
manufacturing firm is likely to have a
higher fixed cost component compared to
service firm.
13-80
Operating Leverage and the Volatility of

Most businesses may have some flexibility
in their cost structure and maybe able to
alter the composition of fixed and variable
costs, at least marginally.
The mix of fixed and variable costs will
impact the breakeven output and also the
operating leverage.
13-81

Operating leverage results from the use
of fixed costs in the operations of the firm
and measures the sensitivity of changes in
operating income to changes in sales.
Degree of operating leverage (DOL)
measures the firms operating leverage for
a particular level of sales.
13-82

DOL indicates by what percentage the NOI

will change for a given percentage change
in sales.
13-83
13-84

We can make the following observations
about operating leverage:
Operating leverage results from substitution of
fixed operating costs for variable operating
costs.
The effect of operating leverage is to increase
the effect of changes in sales on operating
income.
13-85

The degree of operating leverage is an indication

of the firms use of operating leverage. The DOL is
not a constant but decreases as the level of sales
increases beyond the breakeven point.
Operating leverage is a double-edged sword,

magnifying both profits and losses.
13-86
13.4 Real Options

in Capital
Budgeting
Real Options in Capital Budgeting

Opportunities to alter the projects cash
flow stream after the project has begun
are referred to as real options. The most
common sources of flexibility or real
options that can add value to an
investment opportunity include:
1. Timing Option the option to delay a project
until expected cash flows are more favorable.
13-88
Real Options in Capital Budgeting

(cont.)
2. Expansion options the option to
increase the scale and scope of an
investment in response to realized
demand; and
3. Contract, Shut-down, and Abandonment
option the option to slow down
production, halt production temporarily, or
stop production permanently
(abandonment).
13-89
Checkpoint 13.5
Analyzing Real Options: Option to Expand
You are considering introducing a new drive-in restaurant called Smooth-Thru
featuring high protein and vitamin-laced smoothies along with other organic
foods. The initial outlay on this new restaurant is $2.4 million and the present
value of the free cash flows (excluding the initial outlay) is $2 million, such that
the project has a negative expected NPV of$400,000. Looking closer, you find
that there is a 50% chance that this new restaurant will be well received and
will produce annual cash flows of $320,000 per year forever (a perpetuity),
while there is a 50% chance of it producing a cash flow of only $80,000 per
year forever (a perpetuity) if it isnt received well. The required rate of return
you use to discount the project cash flows is 10%. However, if the new
restaurant is successful, you will be able to build 4 more of them and they will
have costs and cash flows similar to the successful restaurants cash flows. If
your new restaurant is not received favorably, you will not expand. Ignoring the
fact that there would be a time delay in building additional new restaurants if
the project is favorably received, determine the projects NPV.
13-90
Checkpoint 13.5
13-91
Checkpoint 13.5
13-92
Checkpoint 13.5 Check Yourself

If you thought there was a 40% chance
that this project would be favorably
received and 60% chance that the project
would be unfavorably received, what
would be the NPV of the project if you
were to introduce 10 additional
restaurants if it is well received?
13-93

P(favorable)
=.4
P(Unfavorable)
=.6
13-94

Strategy
We need to determine the NPV of this
project assuming we will build 10
restaurants if the project is favorably
received and will not build any additional
restaurants if it is not favorably received.
13-95
Step 3: Solve
We are given the following information
(per Restaurant):
Perpetual annual cash flow (if favorably received)
= $320,000
Perpetual annual cash flow (if not favorably
received) = $80,000
Probability of being favorably received = 40%
Discount rate = 10%
13-96

We use the PV of perpetuity equation
(given by CF/i) to determine the present
value of cash flows.
NPV (if favorably received)
=($320,000 .10) - $2,400,000 = $800,000
NPV (if not favorably received)

= ($80,000 .10) - $2,400,000 = $1,600,000
13-97

Assuming we will open 10 restaurants if it
is favorably received and only one if it is
unfavorably received, we can determine
the expected NPV as follows:
Expected NPV
= 10 (.4)($800,000) + 1(.60)(-1,600,000)
= $2,240,000
13-98
Step 4: Analyze
Without the option to expand, this project
would have had a NPV of -$640,000.
NPV = $800,000(.4) + (-$1,600,000)(.6)
= -$640,000
However, by considering the option to
expand, the project has a positive NPV.
13-99
Key Terms
Accounting break-even analysis

Break-even analysis
Cash break-even point
Contribution margin
Degree of operating leverage
Direct cost
Expected value
13-100
Key Terms (cont.)
Fixed cost
Indirect cost
NPV break-even analysis
Operating leverage
Real options
Scenario analysis
Sensitivity analysis
13-101
Key Terms (cont.)

Simulation analysis
Value drivers
Variable costs
13-102

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Chapter 13

Risk Analysis and

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Principles Used in This Chapter

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The Importance of Risk Analysis

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13.2 Tools for

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Tools for Analyzing the Risk of

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Tools for Analyzing the Risk of

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Key Concepts - Expected Values and

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Key Concepts - Expected Values and

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= .25 ( 100) + .75 (400)

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Checkpoint 13.1: Check Yourself

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Step 1: Picture the Problem

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Step 1: Picture the Problem (cont.)

High Priced Home:

Total Revenues for

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Step 2: Decide on a Solution

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Step 3: Solve (cont.)

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Value Drivers (cont.)

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Checkpoint 13.2: Check Yourself

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Step 1: Picture the Problem

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Step 1: Picture the Problem (cont.)

Unit sales (-10%)

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Step 2: Decide on a Solution

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Less: Depreciation Expense

Less: Cash Fixed Cost

Net operating profit after tax

Plus: Depreciation Expense

Less: Variable Cost

Net Operating Income

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Step 3: Solve (cont.)