FNCE20005 Corporate Financial Decision Making

�1

Contents Course Overview 3Payout Policy 5WACC and Capital Structure Policy 16Mutually Exclusive Projects with Different Lives 28Sensitivity, Break-even, Simulation and Decision Tree Analyses 36Raising Capital: Equity 46Raising Capital: Debt and Leases 57Real Options 64Takeovers 78Corporate Restructuring 96Risk Management 102

�2

Sensitivity, Break-even, Simulation and Decision Tree Analyses

1. Project Cash Flow Risk Project Risk - Example • Your division is considering a unique investment opportunity.• It is a three-year project with initial cash outlay of $40,000 and the required rate of return is 10%

p.a.• Your team provides the following (annual) estimates to evaluate the project:

• Compute the NPV of the project:

• Accept the project because it has a positive NPV• But, how sensitive is this result to any change in your estimates (on the selling price, variable

cost, and sales volume)?

Project Risk - Why Analyse?

• Risk of project reflected in NPV discount rate (e.g. WACC): k > rf- Project risk = uncertainty about future cash flows- But, forecasted cash flows only base-case estimates

• Your job as manager:- Understand the chance of having bad outcomes and the main sources of project risk (main

value drivers of project)- You may need to choose among mutually exclusive projects with similar positive NPVs

Project Risk - Financial Tools Finance tools to help us analyse project risk:A. Sensitivity Analysis B. Break-even Analysis C. Simulation Analysis

�36

2. Sensitivity Analysis What is Sensitivity Analysis? • Analyse the effects of changing an input variable, holding all else constant • i.e. what if we changed …?

Previous Example Continued

• Selling price:

• Variable costs:

�37

↑ Known as the “base case” Net Present Value

Very large range of NPV as a result of small change in SP

In this case, optimistic is a lower figure (because increased costs = not good)

• Sales Volume:

• With respect to which variable is the project’s success most sensitive?- Selling price

Benefits of Sensitivity Analysis • Identifies the underlying key variables• Indicates where additional information is useful• Gives managers a chance to think about possible consequences of using incorrect forecasts

Limitations of Sensitivity Analysis • It uses ambiguous/subjective estimates - quantifying the “optimistic” and “pessimistic” values

of a variable can be inexact and vague• Underlying variables are likely to be interrelated - a change in one likely has an effect on another• It may be difficult to specify a precise relationship between variable and NPV

�38

3. Break-even Analysis

What is Break-even Analysis? • Sensitivity analysis: How serious would it be if sales or costs turn out to be worse than

forecasted?• Break-even analysis: How bad can sales or costs become to cause zero NPV?

Previous Example

• NPV is equal to zero if we keep all other variables at their expected values and if:- Sales price falls to $68.04 (-2.8% from expected value)- Variable costs increase to $61.96 (+3.3% from expected value)- Sales volume falls to 1608 units (-19.9% from expected value)

Limitation of Break-even analysis • Similar to sensitive analysis, break-even analysis assumes that only one variable changes at a

time

�39

How low can sales price go for NPV = 0?

Make NPV = 0

If sales price drops to $68.04, NPV will be zero

Another Example - Upside Down Tree • A mid-size Australian company did the following:• Each quarter they identified each of the variables that contributed to the firm’s overall wealth

creation• They then changed each of these variables by plus and minus 5% and recorded the change in

the overall value of the firm (value of the firm = value of the project!)• They then ranked each of these changes from most significant to least significant to get a

feeling for what was important for the firm to control

• But what happens if the probability of a ±5% change in sales volume is very low yet the probability of a ±5% change in variable costs is very high?- What if variables fluctuate out of this range?- Cannot be answered by this analysis

�40

4. Simulation Analysis

Monte Carlo Simulation Analysis • A technique that iteratively evaluates a deterministic model using sets of random numbers as

inputs- Explicitly accounts for the fact that all inputs have probabilities of variation

Steps of Simulation Analysis 1. Identify relevant variables (only key variables) and specify the probability distribution of each

variable2. Specify any inter-relations between the variables

3. Use a computer to:(a) Randomly select values for each variable from its specified probability distribution(b) Calculate a NPV given the input values selected (c) Repeat steps (a) and (b) many times until a probability distribution for NPV is generated

�41

There may be many many more variables, can think of these within a probability distribution

Picking up possible values for each variable and placing them on a probability distribution

Example • Assumptions (model)

- Normal distribution for sales volume (mean=1250, std. dev.=200)- Normal distribution for variable cost (mean=50, std. dev.=10)- Selling price changes with changes in sales volume- It increases (decreases) as the sales volumes increases (decreases) from its mean value as

per the following equation: SP = $70[1+(SV-1250)/1250]

• Process (simulation):- Generate a set of input variables- Calculate NPV- Repeat 10,000

Simulation Results (Statistics):

Distribution of possible NPVs:

So, now you can answer questions like• What is the probability of the project destroying wealth?

Prob. (NPV<0) = 34.1%• What is the 95% central interval?

NPV at 2.5% = -$62,248 NPV at 97.5% = $150,215

Benefits of Simulation Analysis • Can see how changes in all inputs together (by taking into account their possible inter-relations)

affect the project value

Limitations of Simulation Analysis • Performing simulation analysis is typically costly

- Hard to specific the distributions of input variables and their inter-dependence - Necessary for projects that are complex and have bigger costs of errors

�42

66% chance of a positive NPV

5. Decision Tree Analysis Decision-tree Analysis • In typical NPV analysis, we assume investment is on auto pilot, therefore no alternatives

considered • Decision tree analysis provides a method of evaluating alternatives (real options) involving a

sequence of decisions over time• Necessary to obtain estimates of the probability of an even occurring and the cash flows

associated with the event• If there is more than one decision to male, the roll-back procedure is used

Roll-back procedure1. Involves assessment of the most distant decisions first2. Once this decision is analysed, next most distant decisions is assessed 3. Procedure is repeated until we reach today’s decision

Example • Company needs to expand its operations and has choice of expanding domestically or

overseas • Expansion overseas would require $3m whilst domestic expansion would require $0.5m• Chances of success are 30% overseas and 80% domestically • At the end of next year:

- Success (failure) overseas will result in $10m ($2m) - Success (failure) domestically will generate $3m ($1m)

• Opportunity cost of capital is 10% p.a. • Should the company expand overseas or domestically?

�43

Another Example • Assume you are a professional karaoke singer trying to decide whether you should spend the

last 2 years before you retire in Australia or whether you should travel to Japan for the last TWO years of your career.

• If you remain in Australia then you will sign a contract that guarantees earnings over the next 2 years of $15,000 p.a.

• If you choose to go to Japan, then there is a 20% chance of success in the first year. - If you are a success in the first year, then you will continue to succeed in the following year. - If you are a failure in the first year, then you have the option to spend $5,000 on advertising to

relaunch your international career. - If you spend this money, the probability of success for the following year is increased to

50%, whereas if you don’t spend the money, the probability of success remains at 20%. • Success in Japan is expected to generate a net cash flow of $25,000 p.a. whilst failure

generates a net cash flow of only $10,000 p.a. • If you choose to go to Japan, then you must buy an airplane ticket today that will cost you

$3,000. • The opportunity cost of capital is 10% p.a.

If you choose to go to Japan and are a failure in the first year, would you spend the additional $5,000 on advertising?

Conditional Probabilities • Given your decisions, what the probability of you failing over the entire two-year period in

Japan?

Note that we have already determined that we would not advertise if we failed in the first year, hence the relevant probability in the second year is 0.80

�44

=0.80 x 0.80 = 0.64

Would you decide to go to Japan for the next two years, or remain in Australia?

• Therefore, stay in Australia

Advantages of Decision Tree Analysis • Forces you to link today’s decisions with all possible future investment decisions

Possible Problems • Can become very complex very quickly

- Multiple decisions - Multiple outcomes- Impossible to account for all branches

• Should discount rate change over time?

Summary

�45