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Investment Appraisal Techniques (The Impact of risk / Uncertainty…
Investment Appraisal Techniques
Capital Asset Pricing model
key elements
A methodology for measuring business risk
An equation for determining what level of required return is needed to compensate for the measured level of risk
only considers systematic risk
Unsystematic Risk
company specific factors eg system failure strikes, R&D successes. can be eliminated by diversification
Systematic Risk
General economic factors cannot by eliminated
Weighted average cost of capital
The weighted average cost of capital (WACC) is the average of cost of the company's finance (equity, bonds banks loans and preference shares) weighted according to the proportion each element bears to the total pool of funds
The Impact of risk / Uncertainty
Expected Values
Certainty equivalents
Steps: 1 - calc Cash Flows, 2 - adjusted down by multiplying by certainty equivalent, 3 - discount at risk free rate as already adjusted for risk
benefits
enable the decision make to reduce future cash flow for worset possible NPV
the certainty equivalent approach distinguishes between risk and time
simple way to adjust for risk
Drawback
Subjective
Sensitivity Analysis
eg cost of capital, sales, expenses, tax rates etc
can only test one at a time
doesn't take into account probability
useful as a aid but not a rule for decision making
Adjusted Discount Rates
Adjusted present value (APV)
if the capital structure is expected to change significantly, the APV method should be used. this approach separates the investment element of the decision from the financing element and appraises them independently
Real Options
The Abandonment Option
Timing Options (or "wait and see option")
Strategic Investment Option (or "Follow-on option")
Investment appraisal Techniques
Net Present Value
A positive NPV indicates present value of inflow outweighs the present value of cash outflow taking into account the time value of money
Internal Rate of Return
for most normal projects the project NPV will be positive for discount rates < IRR and negative for discount rates > IRR
The IRR can thus be viewed as a breakeven cost of capital
The IRR of a project indicates the discount rate at which the NPV is zero
IRR is therefore useful for sensitivity analysis
Discounted Cash Flow
Priciple - Time value of money. cash now is worth more now that the same amount later
Cost of Finance
Inflation
Investment opportunites
Risk