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McGraw-Hill Ryerson
2003 McGrawHill Ryerson Limited
Corporate Finance
Ross - Westerfield - Jaffe
Sixth Edition
8
Chapter Eight
Strategy and Analysis in
Using Net Present Value
Prepared by

Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
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Chapter Outline
8.1 Corporate Strategy and Positive NPV
8.2 Decision Trees
8.3 Sensitivity Analysis, Scenario Analysis, and
Break-Even Analysis
8.4 Options
8.5 Summary and Conclusions
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Introduce new products
McDonald Canadas introduction of its fast foods into Russia
Develop core technology
The TSEs development of CATS
Create barrier to entry
Qualcomms patents on proprietary technology
Introduce variations on existing products
Corels introduction of Corel Draw
Create product differentiation
Coca-Colaits the real thing
Utilize organizational innovation
Motorola just-in-time inventory management
Exploit a new technology
Yahoo!s use of banner advertisements on the Web
Corporate Strategy and Positive NPV
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Corporate Strategy and the Stock Market
There should be a connection between the stock
market and capital budgeting.
If the firm invests in a positive NPV project, the
firms stock price should go up.
Sometimes the stock market provides negative clues
as to a new projects NPV.
Consider Seagrams decision to acquire a stake in
Time Warner.
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8.2 Decision Trees
A fundamental problem in NPV analysis is dealing
with uncertain future outcomes.
There is usually a sequence of decisions in NPV
project analysis.
Decision trees are used to identify the sequential
decisions in NPV analysis.
Decision trees allow us to graphically represent the
alternatives available to us in each period and the
likely consequences of our actions.
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Example of Decision Tree
Do not
study
Study
finance
Open circles represent decisions to be made.
Filled circles represent
receipt of information
e.g., a test score in this
class.
The lines leading away
from the circles represent
the alternatives.
C
A
B
F
D
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Stewart Pharmaceuticals
The Stewart Pharmaceuticals Corporation is considering
investing in developing a drug that cures the common cold.
A corporate planning group, including representatives from
production, marketing, and engineering, has recommended
that the firm go ahead with the test and development phase.
This preliminary phase will last one year and cost $1 billion.
Furthermore, the group believes that there is a 60% chance
that tests will prove successful.
If the initial tests are successful, Stewart Pharmaceuticals can
go ahead with full-scale production. This investment phase
will cost $1,600 million. Production will occur over the next
four years.
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Stewart Pharmaceuticals NPV of Full-Scale
Production following Successful Test
Note that the NPV is calculated as of date 1, the date at which the investment of $1,600 million is
made. Later we bring this number back to date 0.
Investment Year 1 Years 2-5
Revenues $7,000
Variable Costs (3,000)
Fixed Costs (1,800)
Depreciation (400)
Pretax profit $1,800
Tax (34%) (612)
Net Profit $1,188
Cash Flow -$1,600 $1,588
75 . 433 , 3 $
) 10 . 1 (
588 , 1 $
600 , 1 $
4
1
= + =

= t
t
NPV
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Decision Tree for Stewart Pharmaceuticals
Do not
test
Test
Failure
Success
Do not
invest
Invest
Invest
611 , 3 $ = NPV
0 $ = NPV
The firm has two decisions to make:
To test or not to test.
To invest or not to invest.
m NPV 75 . 433 , 3 $ =
0 $ = NPV
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Stewart Pharmaceuticals: Decision to Test
Lets move back to the first stage, where the decision boils
down to the simple question: should we invest?
The expected payoff evaluated at date 1 is:
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failure given
Payoff
failure
Prob.
success given
Payoff
sucess
Prob.
payoff
Expected
( ) ( ) 25 . 060 , 2 $ 0 $ 40 . 75 . 433 , 3 $ 60 .
payoff
Expected
= + =
95 . 872 $
10 . 1
25 . 060 , 2 $
000 , 1 $ = + = NPV
The NPV evaluated at date 0 is:
So we should test.
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8.3 Sensitivity Analysis, Scenario Analysis,
and Break-Even Analysis
When a high NPV is calculated, ones temptation is
to accept the project immediately.
It is possible that the projected cash flow will go
unmet in practice.
These techniques allow the firm to get the NPV
technique to live up to its potential.
They also allow us to look behind the NPV number
to see from where our estimates are.
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Sensitivity Analysis and Scenario Analysis
In the Stewart
Pharmaceuticals
example, revenues
were projected to
be $7,000,000 per
year.
If they are only
$6,000,000 per
year, the NPV
falls to $1,341.64
Also known as what if analysis; we examine how
sensitive a particular NPV calculation is to changes in the
underlying assumptions.
64 . 341 , 1 $
) 10 . 1 (
928 $
600 , 1 $
4
1
= + =

= t
t
NPV
Investment Year 1 Years 2-5
Revenues $6,000
Variable Costs
Fixed Costs
Depreciation
Pretax profit
Tax (34%)
Net Profit
Cash Flow -$1,600
Investment Year 1 Years 2-5
Revenues $6,000
Variable Costs (3,000)
Fixed Costs
Depreciation
Pretax profit
Tax (34%)
Net Profit
Cash Flow -$1,600
Investment Year 1 Years 2-5
Revenues $6,000
Variable Costs (3,000)
Fixed Costs (1,800)
Depreciation
Pretax profit
Tax (34%)
Net Profit
Cash Flow -$1,600
Investment Year 1 Years 2-5
Revenues $6,000
Variable Costs (3,000)
Fixed Costs (1,800)
Depreciation (400)
Pretax profit
Tax (34%)
Net Profit
Cash Flow -$1,600
Investment Year 1 Years 2-5
Revenues $6,000
Variable Costs (3,000)
Fixed Costs (1,800)
Depreciation (400)
Pretax profit $800
Tax (34%)
Net Profit
Cash Flow -$1,600
Investment Year 1 Years 2-5
Revenues $6,000
Variable Costs (3,000)
Fixed Costs (1,800)
Depreciation (400)
Pretax profit $800
Tax (34%) (272)
Net Profit
Cash Flow -$1,600
Investment Year 1 Years 2-5
Revenues $6,000
Variable Costs (3,000)
Fixed Costs (1,800)
Depreciation (400)
Pretax profit $800
Tax (34%) (272)
Net Profit $528
Cash Flow -$1,600
Investment Year 1 Years 2-5
Revenues $6,000
Variable Costs (3,000)
Fixed Costs (1,800)
Depreciation (400)
Pretax profit $800
Tax (34%) (272)
Net Profit $528
Cash Flow -$1,600 $928
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Sensitivity Analysis
% 29 . 14
000 , 7 $
000 , 7 $ 000 , 6 $
Rev % =

= A
We can see that NPV is very sensitive to changes in
revenues. For example, a 14% drop in revenue leads to a
61% drop in NPV
% 93 . 60
75 . 433 , 3 $
75 . 433 , 3 $ 64 . 341 , 1 $
% =

= ANPV
For every 1% drop in revenue we can expect roughly a
4.25% drop in NPV
% 29 . 14
% 93 . 60
25 . 4

=
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Scenario Analysis
A variation on sensitivity analysis is scenario analysis.
For example, the following three scenarios could apply to
Stewart Pharmaceuticals:
1. The next years each have heavy cold seasons, and sales
exceed expectations, but labour costs skyrocket.
2. The next years are normal and sales meet expectations.
3. The next years each have lighter than normal cold
seasons, so sales fail to meet expectations.
Other scenarios could apply to government approval for
their drug.
For each scenario, calculate the NPV.
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Break-Even Analysis
Another way to examine variability in our forecasts is
break-even analysis.
In the Stewart Pharmaceuticals example, we could be
concerned with break-even revenue, break-even sales
volume, or break-even price.
The break-even IATCF is given by:
75 . 504 $
16987 . 3
600 , 1 $
$
) 10 . 1 (
$
600 , 1 $ 0
4
1
= =
+ = =

=
IATCF
IATCF
NPV
t
t
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Break-Even Analysis
We can start with the break-even incremental after-tax cash
flow and work backwards through the income statement to
back out break-even revenue:
Investment calculation Cash Flow
Revenues
Variable Costs
Fixed Costs
Depreciation
Pretax profit
Tax (34%)
Net Profit
Cash Flow $504.75
Investment calculation Cash Flow
Revenues
Variable Costs
Fixed Costs
Depreciation
Pretax profit
Tax (34%)
Net Profit = 504 - depreciation $104.75
Cash Flow $504.75
Investment calculation Cash Flow
Revenues
Variable Costs
Fixed Costs
Depreciation
Pretax profit = 104.75 (1-.34) $158.72
Tax (34%)
Net Profit = 504 - depreciation $104.75
Cash Flow $504.75
Investment calculation Cash Flow
Revenues = 158.72+VC+FC+D $5,358.72
Variable Costs (3,000)
Fixed Costs (1,800)
Depreciation (400)
Pretax profit = 104.75 (1-.34) $158.72
Tax (34%)
Net Profit = 504 - depreciation $104.75
Cash Flow $504.75
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Break-Even Analysis
Now that we have break-even revenue as $5,358.72 million
we can calculate break-even price and sales volume.
If the original plan was to generate revenues of $7,000
million by selling the cold cure at $10 per dose and selling
700 million doses per year, we can reach break-even revenue
with a sales volume of only:
year per million 87 . 535 $
10 $
72 . 358 , 5 $
volume sales even - Break
volume) sales ( price 72 . 358 , 5 $
= =
=
- We can reach break-even revenue with a price of only:

dose per 65 . 7 $
doses million 7
million 72 . 358 , 5 $
price even - Break = =
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8.4 Options
One of the fundamental insights of modern finance
theory is that options have value.
The phrase We are out of options is surely a sign
of trouble.
Because corporations make decisions in a dynamic
environment, they have options that should be
considered in project valuation.


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Options
The Option to Expand
Static analysis implicitly assumes that the scale of the project
is fixed.
If we find a positive NPV project, we should consider the
possibility of expanding the project to get a larger NPV.
For example,the option to expand has value if demand turns
out to be higher than expected.
All other things being equal, we underestimate NPV if we
ignore the option to expand.
The Option to Delay
Has value if the underlying variables are changing with a
favourable trend.
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The Option to Delay: Example
Consider the above project, which can be undertaken in any
of the next four years. The discount rate is 10-percent. The
present value of the benefits at the time the project is
launched remain constant at $25,000, but since costs are
declining the NPV at the time of launch steadily rises.
The best time to launch the project is in year 2this
schedule yields the highest NPV when judged today.
Year Cost PV NPV
t
NPV
0
0 20,000 $ 25,000 $ 5,000 $ 5,000 $
1 18,000 $ 25,000 $ 7,000 $ 6,364 $
2 17,100 $ 25,000 $ 7,900 $ 6,529 $
3 16,929 $ 25,000 $ 8,071 $ 6,064 $
4 16,760 $ 25,000 $ 8,240 $ 5,628 $
2
) 10 . 1 (
900 , 7 $
529 , 6 $ =
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Discounted Cash Flows and Options
We can calculate the market value of a project as the sum of
the NPV of the project without options and the value of the
managerial options implicit in the project.

Opt NPV M + =
- A good example would be comparing the desirability of a
specialized machine versus a more versatile machine. If
they both cost about the same and last the same amount of
time the more versatile machine is more valuable because
it comes with options.
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The Option to Abandon:
The option to abandon a project has value if demand turns
out to be lower than expected.

EXAMPLE
Suppose that we are drilling an oil well. The drilling rig costs
$300 today and in one year the well is either a success or a
failure.
The outcomes are equally likely. The discount rate is 10%.
The PV of the successful payoff at time one is $575.
The PV of the unsuccessful payoff at time one is $0.
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The Option to Abandon: Example
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failure given
Payoff
failure
Prob.
success given
Payoff
sucess
Prob.
payoff
Expected
( ) ( ) 5 . 287 $ 0 5 . 0 575 $ 5 . 0
payoff
Expected
= + =
64 . 38 $
) 10 . 1 (
50 . 287 $
300 $ = + =
t
NPV
Traditional NPV analysis would indicate rejection of the project.
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The Option to Abandon: Example
The firm has two decisions to make: drill or not, abandon or stay.
Do not
drill
Drill
0 $ = NPV
500 $
Failure
Success: PV = $500
Sell the rig;
salvage value
= $250
Sit on rig; stare
at empty hole:
PV = $0.
Traditional NPV analysis overlooks the option to abandon.
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The Option to Abandon: Example
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|
=
failure given
Payoff
failure
Prob.
success given
Payoff
sucess
Prob.
payoff
Expected
( ) ( ) 50 . 412 $ 0 25 5 . 0 575 $ 5 . 0
payoff
Expected
= + =
00 . 75 $
) 10 . 1 (
50 . 412 $
300 $ = + =
t
NPV
When we include the value of the option to abandon, the
drilling project should proceed:
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Valuation of the Option to Abandon
Recall that we can calculate the market value of a project as
the sum of the NPV of the project without options and the
value of the managerial options implicit in the project.

Opt NPV M + =
Opt + = 64 . 38 00 . 75 $
Opt = + 64 . 38 00 . 75 $
64 . 113 $ = Opt
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8.5 Summary and Conclusions
This chapter discusses a number of practical applications of
capital budgeting.
We ask about the sources of positive net present value and
explain what managers can do to create positive net present
value.
Sensitivity analysis gives managers a better feel for a
projects risks.
Scenario analysis considers the joint movement of several
different factors to give a richer sense of a projects risk.
Break-even analysis, calculated on a net present value basis,
gives managers minimum targets.
The hidden options in capital budgeting, such as the option
to expand, the option to abandon, and timing options were
discussed.