Definition of 'Sunk Cost
A cost that has already been incurred and thus cannot be recovered. A sunk cost differs from other, future costs that a business may face, such as inventory costs or R&D expenses, because it has already happened. Sunks costs are independent of any event that may occur in the future.
investopedia explains 'Sunk Cost'
When making business or investment decisions, individuals and organizations typically look at the future costs that they may incur, by following a certain strategy. A company that has spent $5 million building a factory that is not yet complete, has to consider the $5 million sunk, since it cannot get the money back. It must decide whether continuing construction to complete the project will help the company regain the sunk cost, or whether it should walk away from the incomplete project.
Definition of 'Terminal Value - TV'
The value of a bond at maturity, or of an asset at a specified, future valuation date, taking into account factors such as interest rates and the current value of the asset, and assuming a stable growth rate. In addition to bond and asset applications, terminal value can also refer to the value of an entire company at a specified future valuation date. Two common approaches are used to evaluate the terminal value of an asset: the "perpetuity growth model" and the "exit approach." Also called continuing value or horizon value.
Investopedia explains 'Terminal Value - TV'
The terminal value of an asset is its anticipated value on a certain date in the future. It is used in multi-stage discounted cash flow analysis and the study of cash flow projections for a severalyear period. The perpetuity growth model is used to identify ongoing free cash flows. The exit or terminal multiple approach assumes the asset will be sold at the end of a specified time period, helping investors evaluate risk/reward scenarios for the asset. A commonly used value is enterprise value/EBITDA (earnings before interest, tax, depreciation and amortization) or EV/EBITDA. An asset's terminal value is a projection that is useful in budget planning, and also in evaluating the potential gain of an investment over a specified time period.
which is generally expressed as a number or rating.
Investopedia explains 'Risk-Adjusted Return'
There are five principal risk measures: alpha.FINANCIAL ASSETS VERSUS REAL ASSETS
The two basic types of investments are financial assets and real assets. they include real estate. options and warrants to buy stock at a later date. money market certificates. precious and common metals. commercial paper (unsecured short-term debt). or they show your right to buy or sell your ownership interest at a subsequent date. r-squared. preferred stock. Financial assets include common stock. They represent your equity ownership of a company. Risk-adjusted returns are applied to individual securities and investment funds and portfolios. and financial futures (contracts to buy financial instruments at a later date). General Flow of Funds among Financial Institutions and Financial Markets
Definition of 'Risk-Adjusted Return'
A concept that refines an investment's return by measuring how much risk is involved in producing that return. standard deviation and the Sharpe ratio. or they provide evidence that someone owes you a debt. and oil. Sometimes referred to as real property. savings accounts. bonds. Treasury bills. Your financial assets comprise intangible investments (things you cannot touch). When comparing two or more
. Figure 1-2. Each risk measure is unique in how it measures risk. machinery and equipment. Real assets are investments you can put your hands on. beta.
Where: rf = the risk-free rate Bs = the beta of the investment Emkg = the expected return of the market Es = the expected return of the investment The beta is thus the sensitivity of the investment to the market or current portfolio. The two most widely used methods of estimating beta are: 1. But like many estimations.15 Es = rf + Bs(Emkt . an investor should always compare the same risk measures to each different investment in order to get a relative performance perspective. it can be difficult to determine. this risk profile would be accounted for. When taken in isolation. Estimating Beta In risk analysis.5(12% . Example: When a new product line for Newco is considered.4%) = 16% The project's required return on retained earnings is thus 16% and should be used in our calculation of WACC.rf) = 4% + 1. compute the cost of equity for the new product line. Expected values are calculated with the following equation: Formula 11. market risk.Security Market Line and Beta Basics
The security market line(SML) is simply a plot of expected returns of investments with respect to its beta.
Corporate Finance . Answer: Cost of equity = rf + Bs(Emkt . It is the measure of the riskiness of a project. estimating the beta of a project is quite important.5.potential investments. a project may be considered more or less risky than the current risk profile of a company. the project's beta is 1.Accounting-beta method
.Pure-play method 2. Through the use of the SML as a means to calculate a company's WACC. Assuming the riskfree rate is 4% and the expected return on the market is 12%.
Suppose Newco would like to add beer to its existing product line of soda. determining the beta for beer is not as intuitive for Newco as it has never produced it. companies continue to invest until their marginal returns equal their marginal cost of capital. The typical procedure for developing a risk-adjusted discount rate is as follows: 1. the company's WACC would be adjusted higher and if the project is less risky. Thus. A company first begins with its cost of capital for the firm. such as the S&P 500. There are times. When making decisions to invest in positive net-present-value (NPV) projects. The main issue in this procedure is that it is subjective. a company would run a regression using the company's return on assets (ROA) against the ROA for market benchmark. For projects that are riskier.
Definition of 'Sensitivity Analysis'
A technique used to determine how different values of an independent variable will impact a particular dependent variable under a given set of assumptions. such as Anheuser Busch and Coors.1. a company must ration its capital among the best combination of projects with the highest total NPV. to determine the beta of the new beer project.
. 2. the company would then take an average of those betas to determine its project beta.Accounting-Beta Method When using the accounting-beta method. The cost of capital then must be adjusted for the riskiness of the project. Newco can take the average beta of other beer makers. by adjusting the company's cost of capital either up or down depending on the risk of the project relative to the firm. Newco is quite familiar with the beta of making soda given its history. Once these companies are found. capital rationing is the process of allocating the company's capital among projects to maximize shareholder return. however. The accounting beta is the slope coefficient of the regression. 2. This technique is used within specific boundaries that will depend on one or more input variables. when a company may not have capital to do this. the company's WACC is adjusted lower. a company seeks out companies with a product line that is similar to the line for which the company is trying to estimate the beta. Capital Rationing Essentially. Pure-Play Method When using the pure-play method. such as the effect that changes in interest rates will have on a bond's price. However. As such.
probability tree: Web A decision tree is a decision support tool that uses a tree-like graph or model of decisions definition and their possible consequences. s:
Probability Tree Diagrams
Calculating probabilities can be hard. an analyst might create a financial model that will value a company's equity (the dependent variable) given the amount of earnings per share (an independent variable) the company reports at the end of the year and the company's price-to-earnings multiple (another independent variable) at that time. including.
Investopedia explains 'Sensitivity Analysis'
Sensitivity analysis is very useful when attempting to determine the impact the actual outcome of a particular variable will have if it differs from what was previously assumed. tree diagrams to the rescue!
Here is a tree diagram for the toss of a coin: There are two "branches" (Heads and Tails)
The probability of each branch is written on the branch The outcome is written at the end of the branch
. For example. sometimes you add them. By creating a given set of scenarios. sometimes you multiply them. and often it is hard to figure out what to do . the analyst can determine how changes in one variable(s) will impact the target variable. The analyst can create a table of predicted price-to-earnings multiples and a corresponding value of the company's equity based on different values for each of the independent variables...Sensitivity analysis is a way to predict the outcome of a decision if a situation turns out to be different compared to the key prediction(s)...
Head" is 0.We can extend the tree diagram to two tosses of a coin:
How do you calculate the overall probabilities?
You multiply probabilities along the branches You add probabilities down columns
Now we can see such things as:
The probability of "Head.5×0.25+0.5 = 0.. therefore a proposal that has a negative net present value today may
.25 = 0.75 . it is reasonable to accept or reject an investment proposal based on its net present value based on the expected cash flows and discount rates at the time of the analysis. and more
The Option to Delay a Project Under traditional investment analysis (such as that accomplished by the Investment Valuation model). However.25+0.0 (which is always a good check) The probability of getting at least one Head from two tosses is 0..25 All probabilities add to 1. such cash flows and discount rates change over time.
exercising the expansion option would let them purchase additional equipment to increase capacity for a price which is below market value.IFE'
An economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries' nominal interest rates for that time. it can purchase an expansion option.have a positive net present value in the future.
Definition of 'International Fisher Effect . The option to Delay a project represents the value gained by waiting to take advantage of any upside volatility in the net present value. If economic conditions are good and expansion is desirable. if a company is unsure as to whether or not its newly introduced product will be successful in the market. In terms of real estate. the expansion option expires. If the firm initially expected to produce 1. an expansion option holder can decide whether to move forward with the project.IFE'
. Otherwise. Once the initial stage of a capital project has been implemented. receives its worth from the flexibility it provides to a company. unlike typical options which obtain their value from an underlying security. the option will be exercised. Calculated as:
Where: "E" represents the % change in the exchange rate "i1" represents country A's interest rate "i2" represents country B's interest rate
Investopedia explains 'International Fisher Effect . The expansion option will allow the firm to assess the economic environment in the future and determine whether it is profitable to continue developing the particular product.
Investopedia explains 'Expansion Option'
Definition of 'Expansion Option'
An embedded option that allows the firm which purchased the real option to expand its operations in the future at little or no cost. An expansion option. expansion options provide tenants with the choice to add more space to their living premises.000 units five years.
dollars.84 euros.000 and you would be expecting six cash inflows at the end of each of the next six year in the following amount $120. The rational for the IFE is that a country with a higher interest rate will also tend to have a higher inflation rate. country B's currency should appreciate roughly 5% compared to country A's currency. we use linear interpolation to approximate the IRR As an example.84. the British pound and the euro. Here are the calculations as you can get from an online irr calculation tool listed in related link below Net Cash Flows CF0 = -500000 CF1 = 120000 CF2 = 115500 CF3 = 130000 CF4 = 116500 CF5 = 117250
. dollar for one euro was about 0.500 $130.
Definition of 'Exchange Rate'
The price of one country's currency expressed in another country's currency. In other words.250 and $200.For example. Manual calculation requires Trial and Error method where we first find two rates at which one NPV is negative and the other positive. This increased amount of inflation should cause the currency in the country with the high interest rate to depreciate against a country with lower interest rates.S. the rate at which one currency can be exchanged for another.
Answer: You can an online IRR Calculator as the one mentioned in the related section below or you can manually calculate IRR. currencies are expressed in terms of U. As of the beginning of 2006. the lower the relative value of the yen. say you were considering a project that had an initial cost of $500. if country A's interest rate is 10% and country B's interest rate is 5%.000. the higher the exchange rate for one euro in terms of one yen.
Investopedia explains 'Exchange Rate'
In most financial papers. while the dollar is commonly compared to the Japanese yen. the exchange rate of one U. For example.000 $115.500 $117.S. which means that one dollar can be exchanged for 0.000 $116. Once we have these two rates.
88--25176.5 DCF4 = 116500/(1+16%)4 = 116500/1.5609 = 83285.11 + [(0.88 DCF4 = 116500/(1+11%)4 = 116500/1.88)] / [50157.91 + 55824.05)(50157.51807 = 76742.25 DCF6 = 200000/(1+16%)6 = 200000/2.88 npvU = -25176.29] irr = 0.11 + 0.0333 irr = 0.CF6 = 200000 Discounted Net Cash Flows at 11% DCF1 = 120000/(1+11%)1 = 120000/1.17 DCF6 = 200000/(1+11%)6 = 200000/1.17 -500000 NPV = 550157.68506 = 69582.2321 = 93742.1433 irr = 14.88
Discounted Net Cash Flows at 16% DCF1 = 120000/(1+16%)1 = 120000/1.25 + 82088.81064 = 64341.16-0.87041 = 106928.17 NPV Calculation at 11% NPV = 108108.28 DCF2 = 115500/(1+16%)2 = 115500/1.33%
.5 + 64341.11)(50157.32 + 83285.88 + 76742.29irr = iL + [(iU-iL)(npvL)] / [npvL-npvU] irr = 0.17 irr = 0.29
IRR with Linear Interpolation iL = 11% iU = 16% npvL = 50157.894 / 75334.11 = 108108.11 + 93742.28 + 85835.16 = 103448.39 DCF3 = 130000/(1+11%)3 = 130000/1.11 DCF2 = 115500/(1+11%)2 = 115500/1.11 + [(0.16 DCF5 = 117250/(1+11%)5 = 117250/1.91 DCF5 = 117250/(1+16%)5 = 117250/2.16 + 69582.17] irr = 0.45 NPV Calculation at 16% NPV = 103448.32 DCF3 = 130000/(1+16%)3 = 130000/1.4364 = 82088.17 + 106928.88 -500000 NPV at 11% = 50157.36763 = 95054.71 -500000 NPV at 16% = -25176.11 + 2507.45 -500000 NPV = 474823.10034 = 55824.39 + 95054.3456 = 85835.88)] / [75334.
.1 Then irr = irr * log(p/sum) / log(npv/sum) is the iteration you need to successively apply.com http://suite101. Low Discount Rate + (1st NPV / [1st NPV + 2nd NPV] * Difference in Discount rates) 10 + (631/ [631 + 421] * 20) IRR = 22%
Read more at Suite101: Investment Appraisals: How to Calculate IRR | Suite101. 2.