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Chapter 12 - Strategy and the Analysis of Capital Investments
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Reading 12-6: Using Monte Carlo Simulation for a Capital Budgeting Project
Although many types of analyses are useful in determining the scope and possible success of a project,
Monte Carlo simulation actually helps managers understand and visualize risk and uncertainty by
mapping all possible outcomes of a project.
Discussion Questions
1. What was the managerial decision discussed in the article?
A physician’s practice group (medical doctors) was considering the purchase, installation, and
2. Define the term “Monte Carlo Simulation” and distinguish this (MCS) from sensitivity analysis
and scenario analysis (both of which can be done in Excel).
Monte Carlo Simulation is a sophisticated managerial tool that enables decision makers to visualize
risk and uncertainty in complex decisions, such as capital expenditure decisions (illustrated by the MRI
scanner example). Essentially, that value of each factor in a decision model (e.g., NPV, which is used
to evaluate the financial viability of proposed long-term investments) is represented in the form of a
Other, but cruder, methods of handling risk and uncertainty include:
1. Sensitivity analysis (varying one factor at a time, and observing the impact on the change on the
decision variable (e.g., indicated NPV of a proposed investment)
2. Scenario analysis (identifying a limited number of combinations of values associated with the input
factors in a decision model, each combination of which is considered a “scenario;” in practice, one
input factor to the model.
3. Describe four of the variables that entered into the decision discussed in the article. (That is,
which items were defined in the analysis as “assumption cells”?)
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© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
1. Product/Service Mix (represented as a weighted average of type of scan (CPT code), its RVU, and
the number of scans; operationally, this variable was represented in binary form: % low-RVU scans,
and % high-RVU scans.
2. Reimbursement Rates (i.e., projected reimbursement rate per scan)
3. Volume (i.e., annual number of MRI scans performed)
4. Capital Expenditure Amount (i.e., required investment outlay for the MRI scan, residual value of the
asset, additional net working capital required)
5. Financing (cost of equity capital; income tax rate, t)
6. Operating costs (both variable (supplies) and fixed (personnel, utilities, insurance, etc.)
In this particular case, all input variables were assumed to follow a triangular distribution, formed on
the basis of the end-point and expected values for each variable reflected in Table 4.
MCS analysis (100,000 random draws from each distribution) was then used to estimate the NPV of
the proposed investment, in probabilistic terms. The resulting distribution of NPVs based on the
simulation is presented in Figure 2 of the article.
4. Which probability density functions were used in the analysis reported in this article?
(See Figure 1 for an example—Number of MRI scans per year.)
5. Figure 3 of the article presented what the authors called a “contribution to variance chart.” For
what purpose was this information useful to decision makers?
Decision makers would be interested in knowing which of the input factors (see question 3 above) are
most important to the estimation of NPV for the project at hand. Put differently, they’d be interested in
how sensitive estimated NPV for the project is with respect to the value assumed by each of the input
(negative) correlation between two of the input factors: first year number of scans, and subsequent
growth rate in number of scans per year.
Chapter 12 - Strategy and the Analysis of Capital Investments
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Reading 12-7: VOFI—A More Realistic Method of Investment Appraisal
Investment decision making is one of the greatest challenges for upper management. There is a critical
need to make the right decision. A unique—and advanced—investment appraisal method, the
visualization of financial implications (VOFI) method, considers an imperfect capital market. Mainly
known in some academic discussions in German-speaking countries, VOFI has started to receive wider
attention. The author describes the concept and looks at the method’s strengths and weaknesses.
Discussion Questions
1. Describe what is meant by the “Visualization of Financial Implications” (VOFI) method of
appraising proposed capital-investment projects.
The VOFI method, developed in but not widely known outside of German-speaking countries, is
described as a comprehensive and more realistic picture of an investment project’s profitability. Of
particular interest is the disclosure of a project’s own financial reinvestments (i.e., what are called
investment. Table 1 in the article provides an example of such a table. As noted by the author, “the
table offers a clear, understandable view of the investment project during its economic life.”
2. Describe the major components of the standardized table presented as Table 1 in the article.
Line 1 of Table 1 presents after-tax cash flow data similar to what would be included in a traditional
presented as Table 2 and Table 3 in the article.
3. What does the author indicate as the critical assumption needed to justify the VOFI approach?
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© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
4. What complications arise when trying to implement the VOFI approach in practice?
First, the allocation of debt and equity allocations to individual projects can be exceedingly difficult
(equity and debt funds are typically raised at the total organization level, not at the project level).
Second, while offered by the author as an advantage, the possibility of recording financing costs for
VOFI method, as claimed by the author of this article.
Chapter 12 - Strategy and the Analysis of Capital Investments
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Reading 12-8: Using Real Options to Make Decisions in the Motion Picture
Industry
The article presents the summarized findings of a study of risk as it applies to one of the riskiest
industries, the U.S. motion picture industry. The focus is on using a real options approach to capital
investments rather than traditional DCF (discounted cash flow). The research offers statistical analyses of
how real options work within the decision-making process for a motion picture. This article is based on a
study funded by the IMA® Research Foundation.
Discussion Questions
1. How, fundamentally, does a real-options analysis (for capital investment projects) differ from
traditional DCF decision models (such as NPV or IRR)?
Traditional approaches to capital investment analysis, including discounted cash flow (DCF) methods
considered dynamic and staggered in nature.
Table 1 in the article provides a summary comparison of traditional DCF methods and a real-options
approach to capital-investment analysis.
A real options approach can be implemented in practice using either an options-pricing approach (e.g.,
Black-Scholes-Miller) or decision trees. For an illustration of the latter, see the article by Stout et al.
published in the Journal of Accounting Education.
2. This article uses as the basis for discussion the motion picture (movie) industry. What do the
authors of the article identify as two embedded real options associated with the production of a
typical movie?
As noted in the article (p. 56), “the first real option is a growth option, which is the right to make
additional investments if the initial investment is successful. The growth option in the movie industry
is to produce sequels after a successful original movie. The second type of real option is an
original movie is successful (is a “hit”), the movie production company could exercise an expansion
option, in the form of commissioning a sequel. As shown in Figure 1 (based on assumed cash flows
and associated probabilities for the sequel) we see that once the real option is taken into consideration,
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the original investment decision is seen as profitable—in the words of the authors, it is “green-
lighted.”
Abandonment option: Based on pre-release audience test results, studios may make several decisions
about the film, with the following possible outcomes:
1. If the film generates good audience test results, then the marketing budget is kept as is.
reception), or (b) the film can be “abandoned,” and its planned marketing budget is saved. In
this case, the film is often sent straight to video.
Figure 2 illustrates the above-listed real-options logic applied to advertising cost. If a movie generates
low box office revenue during the opening weekend, the studio usually abandons it and saves the
planned advertising money for other movies. On the other hand, if the movie generates high box office
revenue in the opening weekend, studios will invest more on advertising with the aim of the movie
proceeding to become a hit. Studios are then more likely to produce a sequel following the movie.
3. Which additional examples of the application of real options in practice are offered by the
authors of this article?
In the pharmaceutical industry, Merck is the best-known user of real options to manage risk. In the
paper industry, Kimberly-Clark’s strategic imperative of organic growth leads to managerial
Chapter 12 - Strategy and the Analysis of Capital Investments
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Reading 12-9: Is a Solar Energy System Right for Your Organization?
Increased incentives—especially federal income tax incentives—and the falling cost of equipment have
contributed to a growing interest in the potential of photovoltaic solar energy systems to provide
electricity at a cost that competes with conventional energy sources. This article describes what
accountants and financial professionals need to know in order to decide whether or not to purchase a
system. Three real-world examples are presented to illustrate how the inputs to such a decision should be
scrutinized using a capital budgeting analysis.
Discussion Questions
1. This article presents a structured framework that can be used to assess the financial viability/
desirability of investments in solar energy systems. The underlying economics of this decision are a
function of which four variables?
The net financial return or desirability of an investment in a solar energy system is a function of the
following four factors:
1. Cost of electricity (both the cost avoided by the use of a solar energy system and the revenue for any
2. Discuss some of the complexities associated with estimating items within each of the four classes
of information you identified above in answer to question 1.
Cost of Electricity—Factors complicating this seeming straightforward estimate include the following:
A. cost per kilowatt hour used can vary by time of day (“time-of-use” rate scheduling), the month of
the year, and/or the total electricity used during the month
B. cost received per kilowatt hour returned to the system (fed into the electrical grid from the solar
system) is, in some states, fixed for a number of years AND generally above the price paid per
C. whether the collecting device is stationary or tracking
System Costs—things to consider:
A. What is the cost per watt of electricity generated by the system (i.e., how much potential energy is
Chapter 12 - Strategy and the Analysis of Capital Investments
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C. The other critical component of a system is the “inverter” (which contributes about 15% of the total
cost of the system); however, the expected life of inverters is much less than the predicted life of
solar cells.
Financial Incentives
D. Solar Renewable Energy Certificates (SRECs)—some states require electric utility companies to
produce a certain percentage of electricity from renewable sources. Those utilities who fail to meet
this requirement can either pay a specified penalty or purchase from SRECs from producers of solar
energy
E. Miscellaneous:
A. some states exempt some portion of the value of a renewable energy system from property taxes
B. Some electric utilities, as well as state/local governments, make low-interest or zero-interest
3. The article concludes with an analysis of a proposed solar energy system (consisting of a 50-
kilowatt system costing $300,000, i.e., cost per DC watt = $6.00) in three different locations across
the U.S. What is the result of the author’s analysis?
The summary comparison of these investment alternatives is presented in Table 2 (p. 46). The primary
point is that the financial return (IRR) on the proposed investment differs significantly across context
(geographic location). This set of case studies reinforces the point that ultimately the financial
