AFM203 Lecture Notes - Lecture 3: Decision Analysis, Scenario Analysis, Discount Window
29 Sep 2018
School
Department
Course
Professor
Decision Support Tools
• Available for analysts to support executive decision making
• Conventional capital budgeting tools
o Discounted cash flow
o Expected rate of return
o NPV
• Quantitative multiple scenario tools
o Monte Carlo
o Decision analysis
o Real options
• Qualitative scenario analysis
o Developing a set of qualitative representative scenarios
• Case-based decision analysis
o Aggregating information from analogous past experience
• Information aggregation tools
o Tools that are used to collect information from diverse sources
Investment Decisions - Methods/Tools
• Net present value
• Discounted cash flow
• Internal rate of return
• Discounted payback period
• Return on investment
Conventional Capital Budgeting Tools
• Use the incremental cash flows from potential investments to establish whether a project is worth
being funded or not
o Cash flows from taking on new projects (not day-to-day)
o New project revenues, expenses and capital
• Net Present Value (NPV)
o PV of incremental cash inflows less PV of incremental cash outflows
o Profitability of a projected investment
o Often in business case analysis to support decisions
o Initial investment/project life is known
o If positive NPV, then a good project for the company (value created)
• Value destroyed if negative NPV
• Discounted Cash Flow (DCF)
o Analysis of incremental future free cash projections, discounting cash flows to estimate PV
o Estimates attractiveness of investment opportunity
o Often used to value companies, projects, assets
o Assess what the initial investment should be (value of the company)
• Internal Rate of Return (IRR)
o Discount rate that makes NPV = 0
o Higher IRR, the better the project (if IRR is higher than the discount rate, the project is
profitable)
o Used to decide between capital projects
• Discounted Payback Period
o Cost of project/net annual cash inflows
Document Summary
Information aggregation tools: tools that are used to collect information from diverse sources. Investment decisions - methods/tools: net present value, discounted cash flow. Internal rate of return: discounted payback period, return on investment. Incremental revenues (revenue model: npv & dcf - consider incremental/new revenues that are obtainable by making the investment, cost structure (cost drivers) Incremental fixed costs (overhead) & drivers: company requires these costs to maintain the business. Incremental capital expenses (dcf does not include initial investment, npv does: capital expenses grow the company, not part of the income statement, capitalized on the balance sheet, assets (property, plant & equipment, amortization. Income statement: discounted cash flows, calculate present value of net cash flows, terminal value considerations for dcf only, cash flows after 5 year forecast. Less: cost of goods sold (direct variable expenses) Set of qualitative, representative scenarios of how the present may evolve into the future.
