Introduction 3

Q1 - Land Acquisition 3

Q2 - Cash Flows 4

Q3 - Risk aspects 5

Q4 - Decision Tree (large plant) 6

Q5 - Decision Tree (small plant) 7

Q6 - Conclusion on Decision Trees 8

Q7 - Coefficient of Variation 8

Q8 - Different Probability Profile 8

Q9 - Sensitivity Analysis 9

Q10 - Scenario Analysis for Capital Budgeting 10

Q11 - Monte Carlo Simulation 11

Q12 - Financial Analysis Recommendation 11

Conclusion 12

References 12

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 Introduction

Effective capital budgeting and risk assessment are vital in making project-based decisions by
delivering insights into investment opportunities, cost structures, and risk levels. Gulf Coast's current
exploration of the catfish project requires precise financial analyses to determine its viability. This
report investigates the use of staged entry capital budgeting and real options, offering Gulf Coast a
structured approach to understand and mitigate project-specific risks.

The report's objectives include evaluating land acquisition costs, R&D cash flows, and tax
implications on salvage values to inform decision-making for both large and small plant setups.
Furthermore, it addresses the need to analyze the project's expected outcomes through techniques like
net present value (NPV), internal rate of return (IRR), and modified internal rate of return (MIRR).
Additionally, decision trees for both plant scenarios will be analyzed to assess probability-based
scenarios, abandonment options, and resulting cash flow variabilities.

This paper also explores the use of sensitivity and scenario analyses, along with Monte Carlo
simulations, to deepen understanding of the project's risk profile. Lastly, a conclusion with actionable
recommendations, providing a roadmap for capital decision-making.

Q1 - Land Acquisition

The current value of Gulf Coast’s land is $1,500,000, even though the land was initially
purchased for $500,000. Additionally, buying new land would come with a cost of $1,500,000. If Gulf
Coast decides to use the land that is currently owned by the Gulf Coast Shrimp Division for their new
project the Shrimp Division would need to acquire new land in 2001. To account for this caveat, Gulf
Coast could buy a call option on a piece of land. The price of this call option would be $100,000 in
1995, and if exercised GFC would have the right to buy the land for $1,900,000 in 1999.
Nevertheless, the cost that should be attributed to the catfish project should be $1,500,000 because
that is the value of the land that is going to be used for the project

Considering an annual appreciation rate of 9%, it is possible to calculate the present value of
land, in 1999. By taking the current price of $1,500,000 and applying the annual growth rate over four
years the real value of the land can be calculated as observable in Table 1 equal to $2,117,372.42.
Then, by dividing the real value of the land by the 4% discount rate (based on the general inflation
rate) the present value of the land is calculated. Additionally, the present value of the appreciated plot
of land and the $1,900,000 investment cost are computed using the same discount rate. The present
value from the plot is $1,809,938.81 and the present value from the investment is $1,624,124.96.

Furthermore, by subtracting the two present values, the value for the gain from buying the
land now is assumed to be $185,813.85 . If from this value the $100,000 option price is subtracted, a

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profit of $85,813.85 is predicted if Gulf Coast decides to buy the land now instead of using the call
option. Therefore, in conclusion, Gulf Coast should decide to buy the land now for $1,500,000
because there is an associated profit with this strategy compared to realizing the call option.

Table 1: Gulf Coast - Land acquisition and Land value appreciation

Q2 - Cash Flows

Currently, 1M$ has been spent on R&D, including the design and marketing studies, from
which $400,000 has been spent on taxes and $600,000 will be capitalized and amortized over the three
first operating years of the project. Because the taxes have already been incurred and cannot be
recovered, the amount of $400,000 will be considered as sunk costs and as a result not be included in
the analysis. Using a straight-line depreciation over three years (1997, 1998 and 1999) over the
remaining $600,000, leads to an amortization sum of $200,000 per year. This amount can be used to
decrease the taxable income, leading to a tax deduction of $80,000 (200,000*0.4). Over three years,
this adds up to an amount of $240,000. Assuming cash flow will be $240,000 between 1997 and 1999
and $80,000 per year.

Salvage value is described as the resale value at the end of the useful life of an asset after
adjusting for depreciation. Using the MACRS 31.5-year depreciation for 7 years with a ratio of 3.2%,
plan L results in a book value of $3,880,000.00 after 7 years of the project and a salvage value of
$1,940,000.00 (Table 2). IRS states that capital losses on investment property can be reclaimed, here
resulting in a $776,000 tax refund for plan L (Topic No. 409, n.d.). Similarly, for plan S with no
upgrade, book value after the project's lifespan equals $1,552,000.00 salvage value equals
$776,000.00 and a tax refund of $310,400.00 (Table 2). Lastly, when assuming it upgrade plan S in
December 2000 by investing an additional $4M and depreciating this over a period of three years,
culminating in a book and salvage value of $5,040,000.00 and $2,520,000.00 respectively, with a tax
refund of $1,008,000.00 (Table 2).

Table 2: Gulf Coast - Book value, Salvage value and Corporate tax

After calculating the total capital for 1995, which is equal to $1,740,000 (1,500,000 +
240,000). In 1996, the working capital was equal to $5,500,000 (22,000,000 * 0.25), the total capital

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was equal to $20,500,000. For the following years, working capital was equal to the sales of the
upcoming year minus the sales of the current year, multiplied by 25%. Filling in the blanks for the
capital cash flow, these were equal to the total capital. Finally, terminal value is calculated by
multiplying the net income by the exit multiplier, which is assumed to be 8 x, as this is the middle of
its expected worth ranging between 6 and 10 times its net income generated in 2003. This leads to a
terminal value of $53,203,200 and final net cash flow of $60,903,600 (Table 3). This approach works
for all different demands, growth rates and plant sizes (Table 3). An important point is that terminal
value is often used in business valuations, and is an estimate of future sale proceeds but does not
trigger a taxable event until the actual sale occurs. Golf Coast’s future remains uncertain, therefore a
concrete assumption regarding the project being sold cannot be made with certainty and so in this case
the terminal value has not been accounted for corporate tax (About Publication 544, n.d.).

Table 3: Gulf Coast - Cash flows Large plant (high demand, high growth)

Q3 - Risk Aspects

As the large plant project is judged to be of average risk, the general weighted average cost of
capital of 10% is used. The NPV for plant L shows us that the project’s added value to its shareholders
is equal to $19,504,750. The IRR, or in other words the estimated profitability of potential investment,
is equal to 23%. Finally, the MIRR, the adjusted IRR assuming that positive cash flows are reinvested
at the firm's cost of capital (10%), is equal to 20% for plant L. When comparing the NPV, IRR and
MIRR of plant S, the data shows values of $7,416,670, 19% and 16% respectively. However, this
holds when the small plant is not upgraded. If the small plant is upgraded in a high demand high
growth situation, this would yield a NPV, IRR and MIRR of $56,133,970; 40% and 30% respectively.
Balancing plant L and a not upgraded plant S, leads to the conclusion that plant L is a better
investment considering its NPV is greater. Also for IRR, Plant L ends up with a higher IRR, expecting
a higher rate of growth. The MIRR for plant L is 20%, slightly above the 16% for the non-upgraded
plant S. Since MIRR accounts for reinvestment at the firm’s cost of capital (10%), it provides a more

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conservative profitability estimate. The 20% MIRR for plant L still makes it preferable, as it suggests
a slightly better adjusted return on investment compared to the non-upgraded plant S (Table 4).

Table 4: Gulf Coast - Risk aspects (WACC, NPV, IRR and MIRR)

Q4 - Decision Tree (large plant)

Cash flow refers to the net amount of cash and cash equivalents being transferred into and out
of a business. It represents the liquidity of a business, essential for its operations and growth. Cash
flows can be positive (inflows) or negative (outflows). It is calculated by subtracting cash outflows
from cash inflows over a specific period. NPV is a financial metric used to assess the profitability of
an investment. It calculates the present value of future cash flows, discounted at a specific rate (for a
company like GCF evaluating a project with WACC is most commonly used), and finally subtracts
the initial investment cost. A positive NPV indicates a profitable investment.

Calculation: NPV = Σ (Ct / (1+r)^t) - Initial investment

Where: Ct = Net cash inflow during the period t; r = Discount rate, t = Time period

Joint probability is the probability of the occurrence of two or more events. It measures the
likelihood of two or more events happening simultaneously.

Calculation: Joint probability of events A and B: P(A and B) = P(A) * P(B|A)

The idea behind the decision tree is to illustrate the probability of different scenarios
occurring, their corresponding outcomes and how they affect subsequent events. The left side of the
decision tree corresponds to the probability of outcomes in the scenario where GCF decides to invest
in the large plant. The first chance node corresponds to the probabilities of whether the demand will
be high (80%) or low (20%). The subsequent two chance nodes represent whether the growth rate of
sales will be rapid 10% (with 70% probability) or slow 2% (with 30% probability) on an annual
basis. The middle part of the decision tree analysis in each row represents cash flows every year. The
two red rows show abandonment options, allowing GCF to back out from the investment and recover
their losses, which is a typical characteristic of a real option. If the city of Pascagoula excluded the
abandonment option, this would mean that the resources at GCF’s disposal would not be used

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efficiently. The NPV would equal to the corresponding scenarios when the abandonment option is not
exercised, which have significantly lower NPV’s. Furthermore, joint probabilities decrease for the two
scenarios without abandonment, therefore lowering the expected NPV from the entire project. The
right side of the table represents the NPV’s, joint probabilities, the corresponding products, standard
deviation and coefficient of variances for each possible scenario

Table 5: Gulf Coast - Decision tree for plant L

Q5 - Decision Tree (small plant)

The decision tree (table 6) shows expanding is the better option, except in low demand and
low growth. Also, abandonment is not viable with the small firm; it is more profitable to keep the firm
running, resulting in a less negative NPV compared to abandoning the project. Undertaking the
abandonment option would lower the overall expected NPV, therefore it would be an inefficient way
to allocate GCF resources. Because the choice to abandon the project in the small plant leads to a
financially worse position for the firm, the probability is 0, because the management ultimately
decides on not undertaking the option. This same logic applies to why there are multiple 0 probability
events, since the company will pick the highest NPV projects when it comes to expanding or not
expanding one option becomes redundant and will end up with a probability of 0.

Table 6: Gulf Coast - Decision tree for plant S

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 Q6 - Conclusion on Decision Trees

Based on the data from both decision trees, the investment in the smaller plant is a more
viable option. This is due to a smaller initial investment that bears less financial risk from uncertainty
in the demand and growth rate forecasts. The aggregate figures from decision tree analysis, which
adjust for all plausible outcomes, point in favor of the small plant. This claim is supported by a higher
expected NPV of $36,192,442 from a small plant in comparison to $7,448,960 for the large plant (see
table 5 and table 6). Furthermore, the coefficient of variance, measuring the standard deviation
relative to the mean return, again points in favor towards the small plant investment (0.33 for the
smaller initial investment against 1 for the higher investment).

Q7 - Coefficient of Variation

In capital budgeting and also risk analysis, the coefficient of variation (CV) is a useful
measure. The coefficient of variation states the risk of an investment relative to its return. In general, a
higher CV is interpreted as higher risk per unit of return. In the context of Golf Coast, a CV in the
range of 0.5 to 0.7 for most of the projects would be interpreted the same way. The range of the CV in
this case is the benchmark for Golf Coast based on the risk/return profile of other projects. When
analyzing a new project, such as the project in the case, comparing the CV of the new project to the
benchmark can help to identify the difference in risk compared to the risk profile of the whole
company. For instance, a CV below 0.5 would state that the new project is less risky compared to
other projects. Same goes for a CV above 0.7, which may be viewed as riskier than the typical
company’s projects. So, for the evaluation of an investment, the CV can help a company with the risk
evaluation, creating return requirements, and also compare alternatives to each other. In conclusion,
Gulf Coast can make well-informed judgments by ensuring that new projects fit within the company's
normal risk tolerance, directing necessary return modifications, and supporting project comparisons
when the 0.5 to 0.7 CV range is used as a benchmark.

Q8 - Different Probability Profile

The first probability profile, with a 90% possibility of high growth and high initial demand,
benefits the large plant. This situation is promising since the market is likely to support increased
capacity and long-term expansion. The large plant, which requires a large initial investment, would be
justified if it could generate enough cash flow to cover costs and make a profit. Due to the high initial
demand and expected 90% growth, capacity is less likely to be underutilized, making huge power
plants more profitable. This high-probability scenario matches the income estimates needed to fund a
capital-intensive project like the large plant, increasing the possibility of financial success. Thus, this
probability profile is favorable for funding a huge organization that can capitalize on strong market
demand and growth.

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 The second probability profile, with 60% high initial demand and 50% high growth, favors
the smaller facility. This conservative scenario suggests a slight probability of strong demand and fast
growth, increasing the risk of overestimating demand. The small plant is safer because it costs less. Its
small capacity and cost structure lessen the risk of underutilization if demand is lower than expected
and provide flexibility. This likelihood profile shows a conservative market view where the business
may prioritize reducing negative risks. Gulf Coast can better match its investment with modest growth
and demand by choosing a small facility rather than a larger, more rigid structure that may not be fully
utilized if demand is low. According to the second set of probabilities, the small power plant is best
due to its lower risk and flexibility in responding to market changes.

The 90%–90% likelihood profile favors the large power plant because it has the capacity and
income to finance a huge investment. Small power plants are more appealing in modest development
scenarios because of their 60%–50% probability profile, which reduces risk and increases flexibility.
The probability profiles show that plant size depends on the likelihood of high demand and expansion.

Q9 - Sensitivity Analysis

A sensitivity analysis scopes out the possible different outcomes compared to the current
situation. A possibility in the case of GCF would be to compare different scenarios for the variable
cost, since the values for the large and small plant could vary from the current 60% and 65%
respectively. Variable costs of the small plant after the upgrade could be different as the controller of
GFC stated it might be too optimistic. WACC also differs based on the risk associated with each
project and in turn influences the NPV of each project. In this case the variable cost of the upgraded
small firm in a high demand high growth situation is analysed. The values for variable cost used are
the projected 30% and 60% for the small upgraded and large firm project respectively. Since the small
firm upgraded would be comparable in size and capacity to the big plant, an extra percentage included
is the average of the two variable costs. Table 7 shows the variable cost rising and the NPV going
down. If the variable cost of the small firm upgraded is too optimistic, adjusting it to be similar to the
large firm, the NPV of $12,783,800 is lower than the large firm ($19,504,750) ceteris paribus. To
illustrate the different results on the yearly variable cost, the yearly variable cost according to their
variable cost rate is also depicted in graph 1. As mentioned previously the WACC impacting the NPV
of the project could also differ based on the riskiness of a project, the values used are the WACC for a
project with an average risk and the 7% and 13% for a project with low risk or high risk respectively.
The sensitivity analysis for WACC is performed on the small upgraded business in a high demand
high growth situation. The WACC has quite some impact on the NPV, as shown in table 8. With
WACC increasing, NPV going down is explained by the future cash flows being discounted less. This
inverse relation of WACC and NPV holds for all possible outcomes of the projects. Performing an

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actual analysis regarding the risk associated with each project would be valuable, this would then in
turn allow for a more accurate comparison of the NPV from the different projects even better.

Table 7: Gulf Coast - Sensitivity analysis variable cost, Small upgraded firm, high growth and high
demand scenario

Graph 1: Gulf Coast - Different variable cost per year with different variable cost rates

Table 8: Gulf Coast - Sensitivity analysis WACC, Small upgraded firm, high growth and high demand
scenario

Q10 - Scenario Analysis for Capital Budgeting

As mentioned previously, scenario analysis is a useful investment planning method that

forecasts future values to evaluate project results. This method is important for Gulf Coast’s project
since it lets you evaluate how different scenarios affect financial criteria like NPV and IRR. Gulf
Coast may better assess the project's risks and rewards and make more informed investment decisions
by modeling best, worst, and most likely outcomes.

For the Gulf Coast project, scenario analysis may show how crucial assumptions affect
financial performance. Based on different scenarios, demand, growth, costs, and discount rates are
adjusted. The project is illustrated under low, average, and high economic conditions to detect risks
and assess cash flow resilience. In scenario analysis, initial demand, growth rate, selling price,
variable and fixed costs, discount rate, and capital expenditure are essential variables. Initial demand

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and growth rate directly affect predicted earnings. Selling price adjustments show how competitive
pressures and market movements affect revenues. Considering different variables and fixed costs in
scenarios helps determine the project's cost inflation and operational inefficiency risk. Lastly,
adjusting the discount rate represents project risk, whereas modifying capital expenditures reflects
equipment, construction, and regulatory cost changes.

The Gulf Coast can use many sources to estimate variable ranges and probabilities. A history
of similar initiatives in the company or sector can give demand, cost, and growth benchmarks.
Industry reports and competition assessments provide crucial market forecasts. Inflation, interest, and
GDP growth anticipate the economy and guide expenses and discount rates. Industry professionals
and CEO’s evaluate probability based on experience and market knowledge. Finally, the sensitivity
analysis helps clarify probability ranges and identify the variables that most affect the project's
financial performance.

Q11 - Monte Carlo Simulation

The Monte Carlo simulation models the probability of the different outcomes in processes
influenced by random variables, assessing risk and uncertainty. Traditional models replace uncertain
values with averages, whereas Monte Carlo simulations assign random values repeatedly to the
variables and run the model multiple times. The average of the results estimates the outcome. It is
often used to evaluate the probable success of considered investments (Monte Carlo Simulation, n.d.).

To reflect the uncertainties in market conditions, the most interesting variables to modify
would be sales volumes, as demand is uncertain and divided into either low or high. Furthermore,
sales prices could fluctuate based on the supply/demand of the market, variable costs and growth rate,
which is currently equal to the inflation rate, but this rate is also subject to changes in the coming year.
To assign realistic probability distributions, historical data, market research and industry reports as
well as expert judgements and managerial estimates and economics and inflation forecasts (Monte
Carlo Simulation, n.d.).

Q12 - Financial Analysis Recommendation

For Gulf Coast, delaying a "full capacity" commitment by initially investing in a small plant
emerges as the most advantageous approach. This option offers a favorable balance of profitability
and risk compared to the large plant scenario, making it a prudent choice. By initially observing trends
in demand and growth, Gulf Coast gains the flexibility to adapt its strategy. If demand and growth are
robust, a subsequent investment to expand capacity can be pursued, capturing the value of this real
option. This added flexibility proves particularly valuable when comparing both scenarios under
conditions of low demand and growth. While the large plant would face inefficiencies from

11
underutilized capacity in a low-demand environment, the small plant could operate closer to full
capacity and defer further investment.

Furthermore, both projects show higher valuation when the option to abandon is considered,
as this allows Gulf Coast to mitigate potential losses by exiting the project in the face of persistently
poor demand and growth forecasts. Finally, the small plant scenario demonstrates lower sensitivity to
variables such as WACC, sales price, and other input assumptions, reinforcing its viability under
varying market conditions.

Conclusion

In conclusion, effective capital budgeting and risk assessment play a crucial role in Gulf
Coast’s project planning, enabling the company to set accurate benchmarks for potential investments.
Risk-adjusted decision frameworks, including real options and staged entry, are essential to account
for the unique risks associated with each project phase. For Gulf Coast’s catfish project, varying the
capital structure and expected returns based on the scale of the plant (large or small) and demand
scenarios allows for a more tailored approach to investment risk. Although these risk-adjusted
estimations are inherently approximations, they serve as essential tools in refining Gulf Coast’s
project evaluation process. Sensitivity analyses, scenario analyses, and Monte Carlo simulations
provide valuable insights into risk volatility and guide the tuning of hurdle rates based on
project-specific conditions. Regular reassessment of cost of capital and probability profiles is
necessary to ensure that Gulf Coast's capital allocation remains aligned with both market conditions
and corporate strategy.

References

Monte Carlo Simulation. (n.d.). Google Books.

https://books.google.nl/books?hl=nl&lr=&id=xQRgh4z_5acC&oi=fnd&pg=PA15&dq=monte

+carlo+simulation&ots=hjJCCRxmNO&sig=eat3f8FqnrJ1HDgckMo4RpxNK38&redir_esc=

y#v=onepage&q=monte%20carlo%20simulation&f=false

Topic no. 409, Capital gains and losses | Internal Revenue Service. (n.d.).

https://www.irs.gov/taxtopics/tc409

About publication 544, Sales and other dispositions of assets | Internal Revenue Service. (n.d.).

https://www.irs.gov/forms-pubs/about-publication-544

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