Chapter 11 Capital Budgeting and risk

# With spreadsheets can easily estimate the impact of

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With spreadsheets, can easily estimate the impact of various scenarios on the expected performance of a project Usually only look at a limited number of alternative scenarios Process of assigning probabilities to the outcomes expected from alternative scenarios is difficult and largely subjective Simulation Approach (see section 11-3B) Generally more appropriate for analyzing larger projects Simulation - financial planning tool that models some event Estimate the probability distribution of each element (rev., exp) influencing the cash flows of a project Elements: NINV Cost of capital Project life Units sold (volume) Unit selling price Unit production costs Calculate the NPV using randomly chosen numerical values for the elements Repeat the process until a probability distribution of the NPV can be estimated

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Can compute probability of achieving a NPV that is greater or less than any particular value Z scores Powerful approach because it explicitly recognizes all of interactions among the variables that influence a project’s NPV Gives a mean NPV and standard dev that can help decision maker analyze trade offs between risk and expected return Downside: takes a long time and effort to gather info necessary for each input Why large firms projects aren’t ideal Certainty Equivalent Approach Adjusts the NC in the numerator of the NPV equation Ratio of amt of cash someone would req with certainty at ap oint in time in order to make him or her indiff between that certain amt and an amt expected to be received with risk at hte same pt in time Involves converting expected risky cash flows to their certainty equivalents and then computing the NPV Risk free rate, not hte firm’s cost of capital, is used for the discount rate for computing NPV Bc cost of capital is a risky rate, using it would mean double counting of risk The certainty equivalent factor is the ratio of the certainty equivalent cash flow to the risky cash flow The higher the factor the more certain the expected cash flow Note that these alphas change with t (cash flows that occur further in the future are viewed as more uncertain than cash flows occurring sooner) Also, different people typically have different alphas based on their own levels of risk aversion Certainty equivalent NPV See end of chapter problem #11
Risk-adjusted discount rate Beta = systematic risk (leverage) Also a function of business risk and financial risk Business risk = when you go into an industry where it is competitive or an industry that is necessary no matter what (smaller business risk) Bigger beta for bigger risk Lot of business risk = low financial risk If my pay is all variable, paid on commission, not going to have a lot of debt because it is necessary for me to be variable If i am getting 3m a year, more comfortable with paying debt

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