Chapter 10

degree of operating leverage (DOL)

1+[(FC+D)/EBIT]

value of information

NPV of investing in additional information (figuring out if it's worth spending the extra money to find out what the problem is)

Monte Carlo simulation

a tool for considering all possible combinations of variables

purpose of scenario analysis

allows managers to look at different but consistent combinations of variables

implications for high operating leverage

amplified any cyclicalities and any variables in general, bad during recession, going to have a higher cost of capital

advantages of scenario analysis

can look for multiple variables at one time for certain situations

disadvantages of scenario analysis

can't look at all possible scenarios and variables at once

scenario analysis

change several key variables at the same time, reflects relationships among key variables

disadvantages of Monte Carlo simulation

complexity is the main disadvantage and people will ignore it because they don't know what they're looking at

purpose of Monte Carlo simulation

enables you to inspect the entire distribution of project outcomes

4 types of real options

expansion options (call), abandonment options (put), timing [deferral] options (call), [flexible] production options (calls and puts)

advantages of acounting break-even

gives you an idea of the sensitivity of the project

advantages of financial break-even

gives you an idea of units needed to make your cost of capital

disadvantage of modeling real options

harder to explain and understand, complex (might be ignored)

operating leverage

increased sensitivity of EBIT (and NCF) to changes in revenues, due to the presence of fixed operating costs (FC are good with high sales)

advantages of modeling real options

more realistic, reflects value of active management, explicitly values flexibility, links capital budgeting/strategic management/long-range planning

accounting break-even

number of units to make NI=0 (algebra, graphing, constructing a data table, goal seek), NPV<0

financial break-even

number of units to make NPV=0

sensitivity analysis

one key variable at a time (optimistic, expected, pessimistic estimates)

disadvantages of sensitivity analysis

one variable at a time, no interactions between variables, subjectivity and ambiguity (optimistic, pessimistic, etc.)

real option

option to modify a project's business operations, an option on a real asset

advantages of sensitivity analysis

simple, gain understanding of key variables, helps determine area of focus

disadvantages of accounting break-even

still have a negative NPV

purpose of sensitivity analysis

understand key variables, determine where to focus time and resources before implementing a project

difference between Monte Carlo and sensitivity analysis

value that variables can take on, Monte Carlo can look at interactions among all of them