Professional Documents
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Sources of Risk
Project-specific risk Competitive risk Industry-specific risk Market risk International risk Perspectives on Risk Standalone risk Firm risk Market risk
Sensitivity analysis
Scenario analysis
Break-even analysis
Simulation analysis
Certainty-Equivalent..Example
If you invest in stock than there are two possible outcomes:
0.6 probability of receiving 10,000 0.4 probability of receiving 5,000
If you keep money in fixed deposit 1.00 probability of receiving 7000 Certainty equivalent is 7000/8000 = 0.875
Certainty-Equivalent
Reduce the forecasts of cash flows to some conservative levels.The certainty-equivalent coefficient assumes a value between 0 and 1, and varies inversely with risk. Decision-maker subjectively or objectively establishes the coefficients.
NPV =
t =0 n
t NCFt
(1 kf )
t
The certaintyequivalent coefficient can be determined as a relationship between the certain cash flows and the risky cash flows.
NCF* Certain net cash flow t t = NCFt Risky net cash flow
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Example
Under CAPM, the risk-premium is the difference between the market rate of return and the risk-free rate multiplied by the beta of the project.
k = kf + kr
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RADR in Practice..Example
Investment Category Replacement Investments Expansion Investments Investment in related lines RADR WACC WACC + 3% WACC + 6%
WACC + 10%
Example
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Example
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Sensitivity Analysis
Sensitivity analysis is a way of analysing change in the projects NPV (or IRR) for a given change in one of the variables. The decision maker, while performing sensitivity analysis, computes the projects NPV (or IRR) for each forecast under three assumptions:
pessimistic, expected, and optimistic.
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Sensitivity Analysis
The following three steps are involved in the use of sensitivity analysis:
1. Identification of all those variables, which have an influence on the projects NPV (or IRR). 2. Definition of the underlying (mathematical) relationship between the variables. 3. Analysis of the impact of the change in each of the variables on the projects NPV.
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Sensitivity Analysis
(000)
YEAR 0 1. INVESTMENT 2. SALES 3. VARIABLE COSTS (66 2/3 % OF SALES) 4. FIXED COSTS 5. DEPRECIATION 6. PRE-TAX PROFIT 7. TAXES 8. PROFIT AFTER TAXES 9. CASH FLOW FROM OPERATION 10. NET CASH FLOW (20,000) 18,000 12,000 1,000 2,000 3,000 1,000 2,000 4,000 4,000 YEAR 1 - 10
RANGE
KEY VARIABLE PESSIMISTIC EXPECTED OPTIMISTIC PESSIMISTIC
NPV
EXPECTED OPTIMISTIC
INVESTMENT (RS. IN MILLION) SALES (RS. IN MILLION) VARIABLE COSTS AS A PERCENT OF SALES FIXED COSTS
24 15 70
20 18 66.66
18 21 65
1.3
1.0
0.8
1.47
2.60
3.33
It helps to expose inappropriate forecasts, and thus guides the decision-maker to concentrate on relevant variables.
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It fails to focus on the interrelationship between variables. For example, sale volume may be related to price and cost. A price cut may lead to high sales and low operating cost.
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Scenario Analysis
One way to examine the risk of investment is to analyse the impact of alternative combinations of variables, called scenarios, on the projects NPV (or IRR). The decision-maker can develop some plausible scenarios for this purpose. For instance, we can consider three scenarios: pessimistic, optimistic and expected.
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Pessimistic Scenario 1. Investment 2. Sales 3. Variable costs 4. Fixed costs 5. Depreciation 6. Pre-tax profit 24 15 10.5 (70%) 1.3 2.4 0.8
7. Tax
8. Profit after tax
0.27
0.53
1.0
2.0
1.58
3.17
2.93
(7.45)
4.0
2.60
4.97
10.06
Simulation Analysis
The Monte Carlo simulation or simply the simulation analysis considers the interactions among variables and probabilities of the change in variables. It computes the probability distribution of NPV. The simulation analysis involves the following steps:
First, you should identify variables that influence cash inflows and outflows. Second, specify the formulae that relate variables. Third, indicate the probability distribution for each variable. Fourth, develop a computer programme that randomly selects one value from the probability distribution of each variable and uses these values to calculate the projects NPV.
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Break-even Analysis
Accounting Break-even Analysis
FIXED COSTS + DEPRECIATION = CONTRIBUTION MARGIN RATIO 0.333 1+2 = RS. 9 MILLION
1. INVESTMENT 2. SALES 3. VARIABLE COSTS (66 2/3% OF SALES) 4. FIXED COSTS 5. DEPRECIATION 6. PRE-TAX PROFIT 7. TAXES 8. PROFIT AFTER TAXES 9. CASH FLOW FROM OPERATION 10. NET CASH FLOW
YEAR 0 (20,000)
(20,000)
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Simulation Analysis
Procedure
1. Choose variables whose expected values will be replaced with distributions 2. Specify the probability distributions of these variables 3. Draw values at random and calculate NPV 4. Repeat 3 many times and plot distribution 5. Evaluate the results
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Analyse data
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D21 : INV C2 150 m C11 : S D2 p : 0.7 D11 : PILOT PROD C1 EMV (C1) = RS.30. 9 m & TEST MKTG D22 : STOP EMV (D2) = RS.44. 2 m C22 : LD 0.4 ANNUAL CASH FLOW 20 MILLION EMV (C2) = RS.194.2 m
- RS.20 m
D1 EMV (D1) = RS.10. 9 m
C12 : F
D3 p : 0.3 D31 : STOP
D12 : DO NOTHING
Analysis
1. Start at thee right hand end of the tree and calculate the NPV at chance point C2 that comes first as we proceed left
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price of raw material and other inputs price of product product demand government policies technological changes project life inflation
Case Exercises
Richa Foods Limited Weston Plastic Airways Limited