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