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Flexibility in Capital Budgeting

Sensitivity analysis and break-even analysis help managers understand why a venture might fail. Once you know this you can decide whether it is worth investing more timeand effort in trying to resolve the uncertainty.

Of course it is impossible to clear up all doubts about the future. Therefore, managers also try to build flexibility into the project and they value more highly a project that allows them to mitigate the effect of unpleasant surprises and to capitalize on pleasant ones.

DECISION TREES

The scientists of MacCaugh have developed a diet whiskey and the firm is ready to go ahead with pilot production and test marketing. The preliminary phase will take a year and cost $200,000. Management feels that there is only a 50-50 chance that the pilot production and market tests will be successful. If they are, then MacCaugh will build a $2 million plant which will generate an expected annual cash flow in perpetuity of $480,000 a year after taxes. Given an opportunity cost of capital of 12 percent, project NPV in this case will be $2 million + $480,000/.12 = $2 million. If the tests are not successful, MacCaugh will discontinue the project and the cost of the pilot production will be wasted. How can MacCaugh decide whether to spend the money on the pilot program?

Notice that the only decision MacCaugh needs to make now is whether to go ahead with the preliminary phase. Depending on how that works out, it may choose to go ahead with full-scale production.

When faced with projects like this that involve sequential decisions, it is often helpful to draw a decision tree, as in Figure 5.3. You can think of the problem as a game between MacCaugh and fate. The square represents a decision point for MacCaugh and the circle represents a decision point for fate. MacCaugh starts the play at the left-hand box. If MacCaugh decides to test, then fate will cast the enchanted dice and decide the result of the tests. Given the test results, the firm faces a second decision: Should it invest $2 million and start full-scale production?

The second-stage decision is obvious: Invest if the tests indicate that NPV is positive, and stop if they indicate that NPV would be negative. Now the firm can easily decide between paying for the test program or stopping immediately. The net present value of stopping is zero, so the first-stage decision boils down to a simple problem: Should MacCaugh invest $200,000 now to obtain a 50 percent chance of a project with an NPV of $2 million a year later? If payoffs of zero and $2 million are equally likely, the expected payoff is (.5 АГАз 0) + (.5 АГАз 2 million) = $1 million. Thus the pilot project offers an expected payoff of $1 million on an investment of $200,000. At any reasonable cost of capital this is a good deal.

DECISION TREE Diagram of sequential decisions and possible outcomes.