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Finance Chapter 11 (final)
Terms in this set (55)
portfolio risk: part of risk influences the the returns required by the investors of the firm.
Why are beta risk and total risk important when deciding projects?
beta: value of the firm's shares
Total risk:risk of the firm's failure and potential bankruptcy
expected profit per project / investment required per project
what are the techniques for analyzing total risk project?
1. net present value/payback approach
2. simulation analysis
3. sensitivity analysis
4. scenario analysis
5. risk adjusted discount rate approach
6. certainty equivalent approach
Net present value /payback approach
combine NPV and PB when analyzing a project risk
( must have positive NPV AND be in a certain amount of years)
estimate the probability distribution of each element that affects the cash flows of a project
example of elements in simulation analysis
units sold, market price, unit selling cost, unit production costs, NINV, and Project life
what do you need to do with the simulation analysis?
1. estimate probability dist of each input variable
2. combine input variables into the mathematical model to compute the NPV of the project
3. Select at a random value of each input based upon the probability dist. specified in step 1.
4. compute the projects NPV
5. must then obtain the mean of NPV and the st. dev of NPV
negative z score?
below the mean on the standard normal probability distribution
a procedure that calculates the change in net present value given a change in ONLY ONE of the cash flow elements such as product price
used to show the impact of NPV in sensitivity analysis
steep slope in sensitivity analysis
the NPV is very sensitive to changes in in the Price for which the product will be sold- if price changes slightly then cant do Project
flat slope in
the NPV is not very sensitive in changes to cost of capital. Little changes will not affect the cost of capital
considers the impact of simultaneous changes in key variables on the desirability of an investment project instead of one at a time
what are the three extreme scenarios?
most likely case
best case( optimistic )
most optimistic values of each of the most input variables ex. high prices and lost production costs
worst case ( pessimistic )
most pessimistic values of each of the most input variables ex. low prices and high production costs
what do you do with the scenario analysis?
1. calculate the NPVs for each scenario and form a probability distribution
2. use the z scores to find the probability of outcomes of interest
Certainty equivalent approach
convert expected risky cash flows to certainty equivalent amounts
discount rate is in the numerator of the equation instead of the denominator
what do you have to do for the certainty equivalent approach
compute the NPV of the certainty equivalent cash flows
what is the risk free rate used for?
as the discount for computing the NPV instead of the average cost of capital (k)
why is the risk free used as the discount instead of cost of capital?
cost of capital is a risky rate reflecting the firms average risk and using it would result in a double counting of risk
certain equivalent factor=certain return/ risky return
ratio of dollar amounts of risk
+ certainty equivalent NPV and 0 NPV
is ok to accept
- certainty equivalent NPV
why is the CE so sound?
1. account for specific cash flows
2. can put own risk preferences into analysis
risk adjusted discount approach (RADR)
adjusts for risk by varying the rate at which the expected net cash flows are discounted when determining a projects NPV
risk adjusted discount rate
k*=rf+ risk premium
is the risk adjusted discount approach subjective?
yes by management
when is total project risk relevant for a company?
when the company is not well diversified
risk adjusted discounted rate (RADR)
adjusts for risk by varying the rate at which the expected net cash flows are discounted when determining the a projects NPV
market risk premium
find the required return on that
average risk premium
the difference between the risk free rate an and firms required rate on return ( cost of capital)
0 average risk premium
rf risk free rate
ka required rate of return
risk premiums are established....
subjectively -might be evaluated below or above the cost of capital
how does the beta of a project impact the risk of the firm?
higher the beta the greater the risk
CAPM capital asset pricing model is used for...
computing an appropriate risk premium to evaluate individual projects ( apply CAPM to RADR)
All Equity case
projects that are highly correlated with the firms returns on its assets will have a beta similar to the firms beta
what is the discount rate for all equity cases is what?
firms cost of equity
CAPM capital asset pricing model with risk
greater the risk (beta) the greater rate on return
what if the firm has a more risk in the average risk in calculating in the all equity case?
the beta used in the calculating the equity should be adjusted higher
the equity and debt case
using a from another firm in the same investment class as the investment in your company and use that beta to estimate the risk adjusted discount rate
what are the steps in the equity and debt case?
1. calculate an unleveraged beta
2. calculate the new leveraged beta
3. calculate the risk adjusted discount rate
calculate the unleveraged beta
convert the observed leverage beta into an unleveaged or pure project beta
calculate the new leverage beta
calculate the new leveraged beta for the proposed capital structure of the new line of business
calculate the risk adjusted discount rate
calculate the required return on equity based on the new leveraged beta
then calculate the the risk adjusted required return ka on the new line of business
any risk adjusted discount rate
risk adjusted discount rate vs Weighted average cost of capital (chart) -WACC
3 and 4 are picked using the WACC bc above the weighted cost of capital line
risk adjusted discount rate vs Weighted average cost of capital (chart) -RADR
1 and 3 are picked with the RADR bc they are both above the risk free line
fours special elements when investing abroad
1. captive funds
2. foreign govt takeover assets
3. exchange rate risk
4. uncertain tax rates
provides investment solely to the one firm holding ownership
how does the certainty equivalent approach work?
finding the NPV but convert the risky values to risk free values and find the new NPV
how should beta be selected for project evaluation in all equity case?
adjust own stock to up or down to match beta
what is done with a beta estimate in evaluating projects?
use CAPM capital asset pricing model - greater the risk the greater rate on return of capital
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