Cost Management: A Strategic Emphasis 5th Edition by David Stout, Edward Blocher, Gary Cokins

Exercise 52

Real Options and Sensitivity Analysis Refer to the XYZ Company example in the chapter. Based on the results in Panels A and B of Exhibit 12.11, management of the company decided to delay the implementation of the project for one year. Those managers are now interested in knowing how sensitive this decision is with respect to the assumptions they’ve made regarding the basic analysis. Therefore, they’ve asked you to prepare some supplementary analyses regarding Panel B of Exhibit 12.11.

Required

1. Holding everything else constant, what is the impact on expected NPV of the decision if the probabilties for the three scenarios change as follows: high (20%), medium (50%), low (30%). Does your decision change based on these revised assumptions? Why or why not? (Show calculations.)

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2. Holding everything else constant, what is the impact on expected NPV of the decision if the probabilities for the three scenarios change as follows: high (30%), medium (40%), low (30%). Does your decision change based on these revised assumptions? Why or why not? (Show calculations.)

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3. Prepare a 5 × 3 table containing the estimated NPV of the decision to delay for each combination of the following: risk-free rate of interest (4%, 5%, 6%) and weighted-average cost of capital (13%, 14%, 15%, 16%, and 17%). For example, one cell in your table would be the estimated NPV of the project if the risk-free rate of interest is 4 percent and the weighted-average cost of capital is 13 percent. What does your analysis suggest?

Step 1 of 9

Capital Budgeting is a process used to evaluate the various available projects to decide which project is to be proceeded with. First of all, we start process of capital budgeting with forecasting of future inflows and outflows of available projects. It is determined that what effect will it make on cash flows of the firm, and then NPV of project is calculated to determine how it would affect the value of firm. Net Present Value (NPV) means difference between present value of all inflows resulting from project and present value of outflows resulting from such project.