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Unit 8 FM

Here are the steps to perform a Monte Carlo simulation analysis for this problem: 1. Identify the key uncertain variables: - Success/failure probabilities of each strategy 2. Specify probability distributions for each variable: - Strategy 1 success: 40% probability - Strategy 1 failure: 60% probability - Strategy 2 success: 50% probability - Strategy 2 failure: 50% probability - Strategy 3 success: 40% probability - Strategy 3 failure: 60% probability 3. Define the outcomes based on success/failure: - Strategy 1 success outcome: $25,000 profit - Strategy 1 failure outcome: $8,000 loss - Strategy 2 success outcome: $18,000 profit

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34 views26 pages

Unit 8 FM

Here are the steps to perform a Monte Carlo simulation analysis for this problem: 1. Identify the key uncertain variables: - Success/failure probabilities of each strategy 2. Specify probability distributions for each variable: - Strategy 1 success: 40% probability - Strategy 1 failure: 60% probability - Strategy 2 success: 50% probability - Strategy 2 failure: 50% probability - Strategy 3 success: 40% probability - Strategy 3 failure: 60% probability 3. Define the outcomes based on success/failure: - Strategy 1 success outcome: $25,000 profit - Strategy 1 failure outcome: $8,000 loss - Strategy 2 success outcome: $18,000 profit

Uploaded by

Alexis Parris
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Unit 8:

Project Finance Modelling


Prof. Hemendra Gupta
Risk-Adjusted Discount Rate
• Risk-adjusted discount rate, will allow for both time
preference and risk preference and will be a sum of the
risk-free rate and the risk-premium rate reflecting the
investor’s attitude towards risk.
n
NCFt
NPV = 
t =0 (1  k )
t

• Under CAPM, the risk-premium is the difference between


the market rate of return and the risk-free rate multiplied
by the beta of the project.
k = kf + kr
4
Risk-adjusted Discount Rate:
Merits
It is simple and can be easily understood.
 It has a great deal of intuitive appeal for risk-
averse businessman.
 It incorporates an attitude (risk-aversion)
towards uncertainty.

5
Risk-adjusted Discount Rate:
Limitations
There is no easy way of deriving a risk-adjusted discount
rate. CAPM provides a basis of calculating the risk-
adjusted discount rate.

It does not make any risk adjustment in the numerator


for the cash flows that are forecast over the future years.

It is based on the assumption that investors are risk-


averse. Though it is generally true, yet there exists a
category of risk seekers who do not demand premium for
assuming risks; they are willing to pay a premium to take
risks.

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Example

7
Example

8
Certainty-Equivalent
• Reduce the forecasts of cash flows to some
conservative levels.The certainty-equivalent coefficient
assumes a value between 0 and 1, and varies
inversely with risk. Decision-maker subjectively or
objectively establishes the coefficients.
n
 t NCFt
NPV = 
(1  kf )
t
t =0

• The certainty—equivalent coefficient can be


determined as a relationship between the certain cash
flows and the risky cash flows.
NCF*t Certain net cash flow
t  =
NCFt Risky net cash flow
9
Certainty-Equivalent: Evaluation
• First, the forecaster, expecting the reduction that will be made in his
forecasts, may inflate them in anticipation.

• Second, if forecasts have to pass through several layers of management, the


effect may be to greatly exaggerate the original forecast or to make it ultra-
conservative.

• Third, by focusing explicit attention only on the gloomy outcomes, chances


are increased for passing by some good investments.

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Example

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Risk-adjusted Discount Rate Vs.
Certainty-Equivalent
• The certainty-equivalent approach recognises risk in capital budgeting
analysis by adjusting estimated cash flows and employs risk-free rate to
discount the adjusted cash flows.
• On the other hand, the risk-adjusted discount rate adjusts for risk by
adjusting the discount rate. It has been suggested that the certainty-
equivalent approach is theoretically a superior technique.
• The risk-adjusted discount rate approach will yield the same result as
the certainty-equivalent approach if the risk-free rate is constant and
the risk-adjusted discount rate is the same for all future periods.

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SENSITIVITY ANALYSIS

• Sensitivity analysis is a way of analysing change in the


project’s NPV (or IRR) for a given change in one of the variables.

• The decision maker, while performing sensitivity analysis,


computes the project’s NPV (or IRR) for each forecast under
three assumptions:
• pessimistic,
• expected, and
• optimistic.

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SENSITIVITY ANALYSIS
• The following three steps are involved in the use
of sensitivity analysis:

1. Identification of all those variables, which have an


influence on the project’s NPV (or IRR).
2. Definition of the underlying (mathematical)
relationship between the variables.
3. Analysis of the impact of the change in each of the
variables on the project’s NPV.

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DCF Break-even Analysis
• Sensitivity analysis is a variation of the break-even
analysis.

• DCF break-even point is different from the


accounting break-even point. The accounting break-
even point is estimated as fixed costs divided by the
contribution ratio. It does not account for the
opportunity cost of capital, and fixed costs include
both cash plus non-cash costs (such as depreciation).

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Sensitivity Analysis: Pros and
Cons
It compels the decision-maker to identify the variables,
which affect the cash flow forecasts. This helps him in
understanding the investment project in totality.

It indicates the critical variables for which additional


information may be obtained. The decision-maker can
consider actions, which may help in strengthening the
‘weak spots’ in the project.

It helps to expose inappropriate forecasts, and thus


guides the decision-maker to concentrate on relevant
variables.

16
Sensitivity Analysis: Pros and
Cons
It does not provide clear-cut results. The terms
‘optimistic’ and ‘pessimistic’ could mean different
things to different persons in an organisation.
Thus, the range of values suggested may be
inconsistent.

It fails to focus on the interrelationship between


variables. For example, sale volume may be
related to price and cost. A price cut may lead to
high sales and low operating cost.

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SCENARIO ANALYSIS
• One way to examine the risk of investment is to
analyse the impact of alternative combinations of
variables, called scenarios, on the project’s NPV
(or IRR).

• The decision-maker can develop some plausible


scenarios for this purpose. For instance, we can
consider three scenarios: pessimistic, optimistic
and expected.

18
SIMULATION ANALYSIS
• The Monte Carlo simulation or simply the simulation
analysis considers the interactions among variables
and probabilities of the change in variables. It
computes the probability distribution of NPV.

• The simulation analysis involves the following steps:


• First, you should identify variables that influence cash inflows
and outflows.
• Second, specify the formulae that relate variables.
• Third, indicate the probability distribution for each variable.
• Fourth, develop a computer programme that randomly
selects one value from the probability distribution of each
variable and uses these values to calculate the project’s
NPV.

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Simulation Analysis:
Shortcomings
 The model becomes quite complex to use.
 It does not indicate whether or not the
project should be accepted.
 Simulation analysis, like sensitivity or
scenario analysis, considers the risk of any
project in isolation of other projects.

20
Company A is a market leader in its industry, but the competition is rising now. So now the
management needs to take a call and come up with the right strategy to handle or beat the
upcoming competition. It has three options.
1.The first is to expand into more regions.
2.The second is to launch a new product.
3.And the third is to do nothing and wait for rivals to make a mistake.
After thorough research and discussions, the management has come up with the possible
outcomes and the probabilities of the success of each strategy.
I. For the first option (expand into more regions), management estimates that there is a 40%
chance that this strategy will help to raise the market share. This may give a profit of $25,000. Also,
management estimates that there is a 60% chance that this strategy may not work. And rivals may take
over the market share. This may give a loss of $8,000.

II. For the second option (launch a new product), the management estimates a 50% chance for the success
of the new product. This would raise the profit by $18,000. This strategy also has a 50% failure rate,
resulting in a loss of $6,000.

III. The third option of doing nothing also has two outcomes. Management estimates that it has a 40%
chance to up its market share and post a gain of $10,000. Also, there is a 60% chance that if Company A
does nothing, it will lose to rivals, leading to a loss of $4,000.
Monte Carlo Modeling
In Monte Carlo modeling, the analyst runs multiple trials (sometimes even thousands of them) to determine all the
possible outcomes and the probability that they will occur.
Monte Carlo analysis is useful because many investment and business decisions are made on the basis of one
outcome. In other words, many analysts derive one possible scenario and then compare that outcome to the
various impediments to that outcome to decide whether to proceed.

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