Investment(2) - TIP If you do not understand something, ask...

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Unformatted text preview: TIP If you do not understand something, ask me! Todays Lecture Rules of Thumb Firm Valuation 2 Rules of Thumb We will look at two typically used rules of thumb Hurdle rates Profitability Index 3 Fixing an arbitrary threshold Consider the option to invest in a project with no operating cost that costs I. Assume the decision to invest is made when the value of the project hits V A Then the value of the option is ( , ) ( ) A A A V W V V V I V =- 4 Effect of Mistakes Since the shape of the curve is flat near the optimal, small mistakes do not have much effect. Investing too early is more costly than investing too late. 5 Hurdle Rate Rule This rule says invest whenever the NPV of the project is positive for discount rate . 6 Profitability Index Invest whenever the ratio of the NPV of the project over the initial investment is greater than 7 The Idea Model the firm as Collection of ongoing projects Options to invest in new projects --- Growth Stochastic Interest Rate Vasicek model 8 The Firm Consists of a continuously evolving portfolio of projects. Thus, the risk of the firm as a whole evolves as projects evolve. Projects require an initial investment, I , and provide cash flows for a random amount of time. Projects disappear randomly and independently of everything in the economy 9 Project Cashflow (while alive) IID series of cashflows It can be thought of as the optimal investment level (that results from an unmodeled optimization problem). 2 1 2 ( ) ( ) i i i C t i C t Ie - + = 10 Expected Cash Flow of the Firm Let j (t) be an indicator function describing whether the project taken on at time j is alive at time t , then the expected cash flow of the firm as a whole is b(t) has a natural interpretation as the book value of assets. 1 1 ( 1) ( 1) ( ) ( ) t t C t i i i i i C E C t t e I t e b t = = + + = = 11 Growth Each period the firm has an option to undertake a one time investment in a project (i.e., invest I and receive the cashflow C(t) so long as the project is alive.)...
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This note was uploaded on 05/20/2010 for the course DOF AAf001-6 taught by Professor Changchungdo during the Spring '10 term at 카이스트, 한국과학기술원.

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Investment(2) - TIP If you do not understand something, ask...

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