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# CORPORATION FINANCE I FIN 3322

TTU

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This 7 page Class Notes was uploaded by Micah Klocko on Thursday October 22, 2015. The Class Notes belongs to FIN 3322 at Texas Tech University taught by John William Cooney in Fall. Since its upload, it has received 21 views. For similar materials see /class/226368/fin-3322-texas-tech-university in Finance at Texas Tech University.

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Date Created: 10/22/15

Chapter 10 Project Analysis Section 101 the first page of 102 and pages 257 to the top of 262 of section 103 In this chapter we will discuss other methods of assessing project risk In particular we will 1 Define standalone risk and withinfirm risk 2 Reemphasize that welldiversified investors are only concerned with nondiversifiable risk beta risk 3 Identify decision makers who are concerned about standalone risk and withinfirm risk 4 Learn how to measure standalone risk and when it is beneficial to buy additional information 5 Brie y discuss sensitivity analysis scenario analysis breakeven analysis MonteCarlo simulations and using decisiontrees Chapter 10 Project Analysis In the previous chapter we learned that beta is the appropriate measure of risk used to determine the discount rate for a project s cash flows This assumes that the CAPM is the correct model in calculating expected and required returns for assets Beta is the portion of a project s risk that affects a welldiversified investor Project beta is estimated by averaging the asset betas of other firms doing business in a similar industry Computer spreadsheet programs can be used to provide additional information regarding project risk particularly an assessment of standalone risk Standalone risk re ects the total riskiness of the project without consideration of any diversification benefits It is measured by examining the uncertainty of the project NPV Example ProjectX beta 00 the riskfree rate is 5 and the market risk premium is 84 discount rate 5 Initial investment 1000 Time one cash flow 50 chance 116550 Time one cash flow 50 chance 114450 NPV Project Y beta 00 the riskfree rate is 5 and the market risk premium is 84 discount rate 5 Initial investment 1000 Time one cash flow 50 chance 1302 Time one cash flow 50 chance 1029 NPV Side note Obviously there is risk with these two projects but the beta is zero How come Lowest Possible NPV Highest Possible NPV NPV 50 chance 50 chance Project X Project Y Which of the two projects has the higher standalone risk Which of the two projects has the higher NPV Important There is only one NPV for a project It is determined by discounting the project39s expected cash flows at the opportunity cost of capital We will call the highest and lowest NPVs in the above example whatif NPVs Whatif NPVs tell us how acceptance of the project will affect our firm if the worst set or best set of assumptions were realized The two extreme values for the whatif NPV give one measure for a project39s standalone risk More calculation methods are discussed later Within rm risk measures how the project contributes to the overall riskiness of the firm Withinfirm risk is related to the correlation of the new project s returns with the returns of the existing assets of the firm In most circumstances a project with high standalone risk will have high withinfirm risk However it is possible that a project with high standalone risk might actually reduce firm risk For example is it possible that ProjectX is risk increasing for the firm and Project Y is risk reducing Firm cash flows are high Firm cash flows are low Project X NPV Project Y NPV Welldiversi ed investors are concerned with nondiversifiable risk beta risk The beta risk of the project is not necessarily related to the standalone risk or within rm risk of a project For instance a project with high standalone risk and high withinfirm risk might depending on the correlation of the project s returns with the market s returns have a beta close to zero or even have a negative beta Consider the windmill project discussed during the first few days of this class Does the windmill project have high standalone risk Does the windmill project have high withinfirm risk Does the windmill project have high beta risk Who is concerned about a project39s standalone risk within rm risk or beta risk Consider the following set of concerned individuals 1 The project manager and other employees that work on the project Firm employees that work on other projects Managers of the firm President VP Treasurer etc Investors in the firm39s stock not diversified Investors in the firm39s stock welldiversified mgww VVVV Consider the project manager 1 above How can this project manager hurt the firm by being too concerned about the proj ect s standalone risk Consider the president of the rm 3 above How can this president hurt the firm by being too concerned about the project s withinfirm risk How can we get the project manager and rm president to think more like a welldiversi ed stockholder Even though standalone risk does not take into account diversification it provides valuable information about the project39s total riskiness For example it might force managers to make better estimates or find ways to prevent bad outcomes Methods of Assessing StandAlone Risk I Sensitivity Analysis I Scenario Analysis I BreakEven Analysis I Monte Carlo Simulations Sensitivity Analysis How much does project NPV change when a single variable is changed Example A project involves purchasing a product for resale to the public The time zero initial investment 3770 Sales price 1450 20 chance 1400 50 chance or 1350 30 chance Unit sales 1080 20 chance 1010 50 chance or 930 30 chance Variable cost per unit 10 V eP Nf Perform a sensitivity analysis on the project s sales price and unit sales The beta of the time one expected cash flow 00 the riskfree rate is 5 and the market risk premium is 84 Use the CAPM Sales Price Sensitivity Analysis Be able to calculate the numbers in italics I What is the most likely sale39s price What is the expected sale39s price I What are the highest and lowest possible 39what if NPVs for the project I What is the NPV of the project Unit Sales Sensitivity Analysis Be able to calculate the numbers in italics Which of the two variables sales price or units presents the most standalone risk for the project Some questions How does the firm determine the above distributions of possible sales prices and unit sales Should the firm spend time and money to further refine these figures Wait 7 isn t the NPV negative 7 shouldn t we just reject the project If we plan to gather more information which variable sales price or unit sales should the firm address The value and costs of gathering more information What are the costs and benefits of gathering information e g a marketing survey Costs The fee charged by the marketing research firm and other costs incurred by your firm Benefits Assume that the marketing survey will reveal the exact sales price for the product Typically the marketing survey will not reveal a precise solution How would this benefit your firm You know whether the project will be good or bad m to investing the 3770 initial investment The reason the NPV is negative is because there is a 30 chance of 3770 3500 105 43667 the pessimistic whatif NPV Eliminating this possibility will raise the NPV of the project Another potential benefit is from a reduction in risk This could mean a reduction in the discount rate Is this a benefit in this problem Scenario analysis here the manager is asked to supply several sets of assumptions scenarios such as pessimistic mostlikely and optimistic scenarios with probabilities of each Unlike sensitivity analysis assumptions are not changed one at a time but all assumptions are modified to fit a particular scenario Advantage variables are likely to be interrelated Therefore it often doesn39t make sense to analyze variables oneatatime The pessimistic scenario will provide the worse case N39PV What if the worstcase NPV is positive Breakeven analysis is similar to sensitivity analysis Variables are adjusted oneatatime up or down to determine what value produces a 0 NP 1n the example above you would determine the sales price that makes the NPV exactly equal to zero The breakeven point is in terms of N39PV not accounting income accounting income ignores time value of money see example in book on pages 251 Breakeven analysis is well suited to a graphical presentation Monte Carlo Simulations is a more sophisticated technique of estimating the probability distribution or frequency distribution of possible project cash flows based on the probability distributions of the assumptions see figure 104 for an example This is used to help assess the riskiness of the project The book39s discussion in section 102 goes beyond the scope of this course We will not discuss this topic further Decision Tree analysis can be used to evaluate projects that require decisions over several time periods or over several stages See figures 105 gives a simple example and 106 and 107 more complicated examples Again the discussion in the section 103 of the book goes beyond the scope of this course However it is important to understand that a project with several stages gives managers a valuable real option A nancial option gives the owner the right to buy or sell a financial asset at a certain price for a certain period of time Example An option to purchase IBM stock at 100 per share at any time for the next three months A real option gives the owner a similar right to do something or not do something Just like a financial option has value a real option also has value Each project usually comes with two real options 1 to expand the project if the project is successful and 2 abandon the project if the project is unsuccessful Some also come with timing options the opportunity to postpone investment le A firm is considering selling a new product The firm can either market the product nationwide at considerable expense or sell first in a test market at a lower expense The testmarket decision gives the firm a valuable real option Describe the real option How should the company decide whether to go directly to the expensive fullscale project or if it should use the smaller testmarket project first What are the incremental costs of the testmarketing project What are the incremental benefits of the testmarketing project This example can be presented in a decision tree framework Selected Quiz Questions from the Textbook for Chapter 10 101 102 a b c and d 103 104 Chapter 10 Review Questions 1 Understand the difference between a proj ect s standalone risk withinfirm risk and beta risk Be able to determine whether the different groups of individuals listed towards the beginning of the Chapter 10 notes would be concerned or unconcerned with these various types of risk 2 What factors would cause a project s withinfirm risk to be low in relation to its standalone risk What factors would cause a proj ect s beta risk to be low in relation to its standalone risk or withinfirm risk 3 Know the methods used to calculate standalone risk sensitivity analysis scenario analysis and breakeven analysis We skipped the discussion of how MonteCarlo simulations could be used to evaluate standalone risk 4 Understand the difference between a project s quotmost likely outcome and its quot expected outcomequot for a particular variable Know how to use expected outcomes to calculate the NPV of a project Know how to use pessimistic most likely and optimistic outcomes to calculate quotwhatifquot NPVs 5 Understand how to determine the benefits of obtaining additional information 6 Understand how a decision tree analysis can assist a manager in analyzing projects that require decisions to be made in several steps What are the factors that would make it beneficial or detrimental for a firm to use a te stm arket Chapter 10 Practice Problems 1 Assume that Project XYZ has a beta 00 the riskfree rate is 5 and the market risk premium is 84 Therefore the discount rate for Project XYZ 5 Initial investment l350 Highest possible time one cash flow 60 chance 1650 Lowest possible time one cash flow 40 chance 1100 What is the NPV for Project XYZ 311905 What is the highest possible whatif NPV for Project XYZ 3221429 2 ABC Corporation is considering Project Z Identify which measure of risk is the most relevant measure of risk for each of the following individuals on Project Z s stand alone risk Project Z s within firm risk Project Z s beta risk The chairman of the board of directors of ABC Corporation The chairman does not receive any salary or other benefits from the corporation and only owns a small amount of the stock of ABC Corporation The vast majority of the chairman s wealth is invested in a welldiversified mutual fund Answer Projech s beta risk A stockholder that has most of her wealth invested in the stock of the corporation Answer Project Z s within rm risk An employee that works in the firm s Treasury department and does not work on Project Z This employee does not have any investments besides the stock she owns in ABC Corporation Answer Projech s within rm risk 9 Similar to the example given in the notes the following project requires an initial investment of 3500 and will end in one year The project s beta is 0 What is the NPV of the project using a 5 riskfree opportunity cost of capital Be able to calculate the numbers in italics using the other numbers Expected sale s price 1340 NPV 26I90 Therefore reject the project 4 ABC Corporation is considering Project ZZZ Project ZZZ involves the sale of TTU souvenir basketballs You have calculated the NPV of Project ZZZ using an opportunity cost of capital of 10 and the project s expected cash flows The NPV is 1000 Determine if the breakeven point for the following variables is above or below each of these variables expected values I The expected sale s price for TTU basketballs is 20 Answer The breakeven paint is below 20 I The expected cost of purchasing the TTU basketballs from the manufacturer is 10 Answer The breakeven paint is above 10 5 Consider the following information for a oneyear project Expected sales price 15 Expected variable costs per unit 12 Expected unit sales 2400 Time one expected cash flow 15122400 7200 Initial investment 5000 Discount rate 5 Using the 5 discount rate the NPV of the project 7200 105 5000 185714 What is the breakeven point for variable costs per unit rounded to the nearest penny 1281 6 Consider the following information for a oneyear project Expected sales price 179 Expected variable costs per unit 138 Expected unit sales 200 Time one expected cash flow 1791382000 8200 Initial investment 5250 Discount rate 5 Using the 5 discount rate the NPV of the project 8200 105 5250 255952 What is the breakeven point for unit sales rounded to two decimal places 1344 51 7 Consider the following information for a oneyear project Expected sales price 187 Expected variable costs per unit 132 Expected unit sales 2200 Time one expected cash flow 1871322200 12100 Initial investment 10000 Discount rate 5 Using the 5 discount rate the NPV of the project 12100 105 10000 152381 What is the breakeven point for unit sales rounded to two decimal places 1909 09 7

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