Diageo

Dear Students,

On this email, you can find my 3rd set of notes. this is a follow up of the information which I have included in my 2nd email, focusing on 'sensitivity analysis'.

The sensitivity analysis is equivalent to a "what-if" analysis. This is done AFTER the DCF model (that is, after you compute your intrinsic value), and you test - essentially - how sensitive your intrinsic value is (under the DCF model) to a change in certain variables.

Two variables are often used for the sensitivity analysis:

(a) WACC

(b) perpetual growth rate

In the DCF model (above) you would have already found the intrinsic value - using a specific WACC and a specific perpetual growth rate (that you have constructed based on your assumptions and method adopted). Now, in the sensitivity analysis, you wish to see how sensitive your intrinsic value is (i.e. the one that you found in the DCF model) to changes in the WACC and the perpetual growth rate. Let's assume that your intrinsic value (above) was derived whilst using a WACC of 6% and perpetual growth rate of 3%.

In the sensitivity analysis, you wish to change these variables (i.e. the 6% WACC and the 3% perpetual growth rate) to see what the intrinsic value would have been (to see how sensitive your intrinsic value is to changes in these parameters). Specifically, you shall change the WACC by +/- 1% and the perpetual growth rate by +/- 0.5%. Hence, you wish to find the intrinsic value, where:

7 % WACC AND 3.5 % perpetual growth rate

7 % WACC AND 3 % perpetual growth rate

7% WACC and 2.5% perpetual growth rate

6 % WACC AND 3.5 % perpetual growth rate

6 % (i.e. same) WACC AND 3% (i.e. same) perpetual growth rate ----> this is the initial intrinsic value from the DCF model above

6 % WACC and 2.5 % perpetual growth rate

5 % WACC AND 3.5 % perpetual growth rate 5 % WACC AND 3 % perpetual growth rate

5% WACC AND 2.5% perpetual growth rate

Please see the attached table as an example of how you can present this. In effect, you observe how sensitive the intrinsic value you found from your DCF model is to changes in the two parameters. If the resulting intrinsic value (when using a WACC of 7% and perpetual growth rate of 3.5%, for instance) is very different to the original one, then your price is sensitive to parameter changes etc.