Unit 8 FM
Unit 8 FM
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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.
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Example
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Example
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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
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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
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SENSITIVITY ANALYSIS
• The following three steps are involved in the use
of sensitivity analysis:
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DCF Break-even Analysis
• Sensitivity analysis is a variation of the break-even
analysis.
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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.
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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.
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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).
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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.
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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.
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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.