Risks related to capital budgeting

Take n npv t1 fcft t 1 k io how can we adjust

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Unformatted text preview: take n NPV = Σ t=1 FCFt t (1 + k) - IO How can we adjust this model to take risk into account? take n NPV = Σ t=1 FCFt t (1 + k) - IO Adjust the After-tax Cash Flows (ACFs), Adjust or or Adjust the discount rate (k). Certainty Equivalent Approach: consider this; Certainty Play a roulette game for free Play (black and red). red If you win, you get $1,000. But if you If lose you get 0 (chance 50/50). lose So the expected value (risky CF) is So ((0.5x$1,000)+(0.5x$0)) = $500. ((0.5x$1,000)+(0.5x$0)) Certainty equivalent = the amount Certainty you would demand to make you indifferent with regard to playing and not playing the game = $300 not Certainty Equivalent Approach Certainty Adjusts the risky after-tax cash flows Adjusts risky to certain cash flows. certain The idea: The Certainty Equivalent Approach Certainty Adjusts the risky after-tax cash flows Adjusts risky to certain cash flows. certain The idea: (remove the risk from risky CFs by CE) (remove The Risky Cash Cash Flow X Certainty Equivalent Equivalent Factor (αt) Certain = Cash Flow Certainty Equivalent Approach Certainty Risky Cash X Cash Flow Risky $500 Certainty Equivalent Equivalent Factor (α ) t .60 = Certain Cash Flow “safe” $300 The greater the risk associated The greater with a particular cash flow, the smaller the CE factor. smaller Certainty Equivalent Method Certainty n NPV = Σ t=1 FCFt - IO t (1 + krf) t Risk-free discount rate Certainty Equivalent Approach Certainty Steps: 1) Adjust all after-tax cash flows by 1) certainty equivalent factors to get certain cash flows. certain 2) Discount the certain cash flows by 2) the risk-free rate of interest. risk-free Example Not given Project A: (A) Expected Year (Expected Cash Flow 0 1 2 3 4 -$1,000,000 500,000 700,000 600,000 500,000 NPVA = $ 726,380 (B) (A x B) (TVM Table) (NPV) αt Factor Cash Flow) x (αt) Present Value at Present 5% (Rf) Value 1.00 .95 .90 .80 .70 -$1,000,000 475,000 630,000 480,000 350,000 1.000 .952 .907 .864 .823 -$1,000,000 452,2...
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This document was uploaded on 02/03/2014.

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