Page 216 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Unit 13: Integration of Working Capital and Capital Investment Process

Quantifying Uncertainty Notes

Given the uncertainty inherent in project forecasting and valuation, analysts will wish to assess
the sensitivity of project NPV to the various inputs (i.e. assumptions) to the DCF model. In a
typical sensitivity analysis the analyst will vary one key factor while holding all other inputs
constant, ceteris paribus. The sensitivity of NPV to a change in that factor is then observed, and
is calculated as a “slope”:
 NPV /  factor.

Example: The analyst will determine NPV at various growth rates in annual revenue as
specified (usually at set increments, e.g. –10%, –5%, 0%, 5%....), and then determine the sensitivity
using this formula.
Often, several variables may be of interest, and the various results may be combined to produce
a “value-surface”, where NPV is a function of several variables.

Using a related technique, analysts also run scenario based forecasts of NPV. Here, a scenario
comprises a particular outcome for economy-wide, “global” factors (exchange rates, commodity
prices, etc.) as well as for company-specific factors (revenue growth rates, unit costs, etc.). As an
example, the analyst may specify specific growth scenarios.

Example: 5% for “Worst Case”, 10% for “Likely Case” and 25% for “Best Case”, where
all key inputs are adjusted so as to be consistent with the growth assumptions, and calculate the
NPV for each.
Note that for scenario based analysis, the various combinations of inputs must be internally
consistent, whereas for the sensitivity approach these need not be so. An application of this
methodology is to determine an “unbiased NPV”, where management determines a (subjective)
probability for each scenario – the NPV for the project is then the probability-weighted average
of the various scenarios.

13.1.2 Financing Decision

Achieving the goals of corporate finance requires that any corporate investment be financed
appropriately. As above, since both hurdle rate and cash flows (and hence the riskiness of the
firm) will be affected, the financing mix can impact the valuation. Management must therefore
identify the “optimal mix” of financing-the capital structures that result in maximum value.
The sources of financing will, generically, comprise some combination of debt and equity.
Financing a project through debt results in a liability that must be serviced and hence there are
cash flow implications regardless of the project’s success. Equity financing is less risky in the
sense of cash flow commitments, but results in a dilution of ownership and earnings. The cost of
equity is also typically higher than the cost of debt, and so equity financing may result in an
increased hurdle rate which may offset any reduction in cash flow risk.
Management must also attempt to match the financing mix to the asset being financed as closely
as possible, in terms of both timing and cash flows.

One of the main theories of how firms make their financing decisions is the Pecking Order
Theory, which suggests that firms avoid external financing while they have internal financing
available and avoid new equity financing while they can engage in new debt financing at
reasonably low interest rates.

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