finance
Fin319
week5.pptxAgenda
Comprehending risk when modeling investment (project) decisions
Standalone Risk
Market Risk
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Project Risk
Standalone Risk: Risk based on uncertainty of a projects cash flows
Sensitivity
Scenarios
Breakeven
Simulations
Market Risk: Risk of the project as seen by a well diversified investor
Beta
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Sensitivity, Scenario, and Break-Even
Each allows us to look behind the NPV number to see how stable our estimates are.
Breakeven: sales required to breakeven
Accounting break-even: sales volume at which net income = 0
Cash break-even: sales volume at which operating cash flow = 0
Financial break-even: sales volume at which net present value = 0
Sensitivity: how sensitive a particular NPV calculation is to changes in an input variable holding all other assumptions are held constant
Scenario: examine impact on NPV given a confluence of factors
When working with spreadsheets, try to build your model so that you can adjust variables in a single cell and have the NPV calculations update accordingly.
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Monte Carlo Simulation
A more sophisticated variation of the scenario analysis is Monte Carlo simulation.
In a Monte Carlo simulation, analysts specify a range or a distribution of potential outcomes for each of the model’s assumptions.
Pick a probability distribution for each input variable (units, price, variable costs, etc).
The computer program will pick a random value from each input variable, calculate the NPV and store the result. This is a trial.
Repeat the process many times, saving the input variables and the output (NPV).
End result: Probability distribution of NPV based on sample of simulated values.
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Example
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When a firm with both debt and equity invests in an asset similar to its existing assets (business), the WACC is the appropriate discount rate to use in NPV calculations.
In conglomerates, the WACC reflects the return that the firm must earn on average across all its assets to satisfy investors, but using the WACC to discount cash flows of a particular investment leads to mistakes.
Any project’s cost of capital depends on the use to which the capital is being put—not the source.
Therefore, it depends on the risk of the project and not the risk of the company.
When a firm invests in an asset that is different from its existing assets, it should look for pure-play firms to find the right discount rate.
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Finding the Right Discount Rate
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You are a financial analyst at General Electric and are preparing a cost of equity estimate for a project analysis using NPV:
CAPM = Risk Free Rate + Beta * Market Risk Premium
9.5% = 3.0% + 1.1 * 5.9%
Lines of Business
Financial Services
Power Generation
Aviation
Transportation
Health Care
Consumer Goods
When evaluating a new power generation investment for GE, which cost of capital should be used?
Capital Budgeting & Project Risk
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Beta
1.8
0.6
1.2
1.3
0.8
1.1
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Capital Budgeting & Project Risk
Project IRR
Project’s risk (b)
9.5%
1.1
1.8
0.6
R = 3% + 0.6×(5.9% ) = 6.5%
6.5% reflects the opportunity cost of capital on an investment in power generation, given the unique risk of the project.
6.5%
13.6%
Investments in Financial Services have higher risk and should have higher discount rates
Security Market Line (SML)
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Using an Industry Beta Pure Play Approach
It can be argued that a better estimate of a firm’s beta or project beta can be developed by analyzing companies in the industry.
If you believe that the operations of the firm are similar to the operations of the rest of the industry you can use an industry beta.
If you believe that the operations of the firm are fundamentally different from the operations of the rest of the industry, you should use the firm’s beta.
The Industry approach can also be used if
The company being analyzed is not public as Beta can not be directly observed.
Attempting to estimate a Beta for a division or project
Steps to use an industry beta:
Indentify Comparable Firms and their beta
Calculate the unlevered (asset beta) for each comparable firm (pure plays)
Beta is influenced by nature of industry, operating leverage, financial leverage (debt)
Calculate an average asset beta based for the firms
Lever the beta (equity beta) based on the capital structure of the firm of interest.
Controls for capital structure (amount of debt), which impacts beta
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Levered Beta = Unlevered Beta * [ 1 + ( 1- tax rate) * (Debt / Equity Ratio)]
Or if your firm is private
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Industry Beta Example
You want to estimate cost of equity for an energy project. You have identified a comparable company in the energy industry (Energy Inc)
Beta (levered) 0.43
Debt / Equity Ratio 0.75
Tax Rate 35%
Energy Inc’s unlevered (asset) beta = 0.29
0.29 = 0.43 / [1 + (1 - .35) * (0.75)]
Unlevered Beta = Levered Beta / [ 1 + ( 1- tax rate) * (Debt / Equity Ratio)]
General Electric has chosen to have more debt in their capital structure.
GE Debt / Equity Ratio 1.4
GE Tax Rate 25%
An estimate of GE’s beta for it’s energy business is 0.6
0.6 = 0.29 * [ 1 + (1 - .25) * (1.4)]
Levered Beta = Unlevered Beta * [ 1 + ( 1- tax rate) * (Debt / Equity Ratio)]
The Beta of 0.6 would be appropriate to use for calculating the cost of capital of a project in GE’s energy business unit.
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Look at some online betas, are they asset or equity betas?
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Assignments for Next Week
Monday, November 3rd
Case #2 Due and in class review
Mid term Exam overview.
Wednesday, November 5th
Mid Term Exam
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Firms establish a “base-case” set of assumptions for a particular project and calculate the NPV based on those assumptions.
Managers allow one variable to change while holding all others fixed, and they recalculate the NPV based on that change.
Repeating this process for all the uncertain variables in an NPV calculation:
Allows managers to see how sensitive the NPV is to changes in baseline assumptions.
Understand which variables have the most impact on the NPV
Issues: Ignores relationships among variables
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Sensitivity Analysis
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Scenario Analysis
A more complex variation on sensitivity analysis
Rather than adjust one assumption up or down, analysts conduct scenario analysis by calculating the project NPV when a whole set of assumptions changes in a particular way.
Assign probabilities to the to scenarios
For Example: Best, Worse, Base Case Scenarios
Better understanding of project risk
Issues:
Only considers a few possible out-comes.
Assumes that inputs are perfectly correlated—all “bad” values occur together and all “good” values occur together.
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Capital Budgeting & Project Risk
A firm that uses one discount rate for all projects may over time increase the risk of the firm while decreasing its value.
Project IRR
Firm’s risk (beta)
rf
bFIRM
Incorrectly rejected positive NPV projects
Incorrectly accepted negative NPV projects
Hurdle rate
The SML can tell us why:
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To estimate the cost of capital for a division, a “pure play” approach could be used, although finding exactly similar firms may be difficult, particularly considering underlying financial and operational structure.
0%
2%
4%
6%
8%
10%
12%
14%
16%
18%
($475,145)($339,389)($203,634)($67,878)$67,878$203,634$339,389$475,145
NPV
Probability of NPV
SML
)(
F
M
FIRMF
RRβR
