According to SAPAG's exercise:

Expected value (PV, NPV, etc)

Ex1 Variance=
Annual 2021
Projection
Scenario (k) Probability (pk) PV of cash flow (Ak) Ak*pk Deviation (Ak-Ay)
1 Expansion 40% 26,000 10,400 3,300
2 Normal 45% 22,000 9,900 -700
3 Recession 15% 16,000 2,400 -6,700
1 22,700
Ay
+ - deviation Average

+ - 2deviation Variance s2
Deviation s
pk Ay- # deviation Ay+ # deviation
68% Investment= Ay+-1 deviation 19,337 26,063 PV of project cf has 68% pro
95% Ay+- 2deviation 15,974 29,426 PV of project cf has 95% pro

Ex. 2 With the PV of above cf and the investment stated below, find average, deviation and 68-&95% -probability-range f
Invest= $20,000 Note. Use the same 3 scenarios and probabilities (40% for normal, 45% for expansion, and 15% recess

Scenario (k) Net Present Values Probability (pk) NPV*pk Deviation (Ak-Ay)
Expansion 6,000 40% 2400 3,300
Normal 2,000 45% 900 -700
Recession -4,000 15% -600 -6,700
Expected Net PV= 2,700

68% Ay+-1d -663

95% Ay+-2d -4,026

Ex-3 What is the probability that the NPV obtained in Ex2 is greater than zero.

=P(NPV)>0 ?
NPV= -663 0 2700

Z= (X- Mean)/deviation= 2700 0.8028545941124 0.34

X=0 3363
 Average NPV, Avg PV, etc
Risk

Squared Deviation (Ak-Ay) Pk* Squared Deviation (Ak-Ay)

10,890,000 4,356,000
490,000 220,500
44,890,000 6,733,500
11,310,000

22,700

11,310,000

3,363 11310000

roject cf has 68% prob of being in this range.

roject cf has 95% prob of being in this range.

&95% -probability-range for the avg NPV obtained.

expansion, and 15% recession) used in Ex1.

Squared Deviation (Ak-Ay) Pk* Squared Deviation (Ak-Ay)

10,890,000 4,356,000
490,000 220,500
44,890,000 6,733,500
Variance= 11,310,000 Same as Ex1
Deviation= 3,363

6,063
9,426

PV)>0 ?
 27.30%
(80% of 34%)
27.3% + 50%= 77.3% probability that NPV greater than zero
SENSITIVITY ANALYSIS AND PROJECT SELECTION

Projects (NPV)= Xk
Scenario (k) Probability (k) 1 2 3 4
Recessive 5% -10,000 0 -15,000 -3,000
Pessimistic 15% -4,000 6,000 -8,000 5,000
Normal 40% 0 7,000 1,000 11,000
Optimistic 25% 6,000 9,000 9,000 14,000
Expansive 15% 9,000 10,000 18,000 17,000
(Source: Example 9.3 Sapag, pp.282)

CRITERIA FOR DECISION MAKING PROCESS:

1- Dominance of one project over another project When expected results of Alternative X is better than
Say let's work with projects 1 and 2 another alternative Y in all scenarios
This criterion can be used to eliminate one of these alternati
Projects (NPV) Xk
Scenario (k) Probability (k) 1 2 3 4
Recessive 5% -10,000 0 -15,000 -3,000
Pessimistic 15% -4,000 6,000 -8,000 5,000
Normal 40% 0 7,000 1,000 11,000
Optimistic 25% 6,000 9,000 9,000 14,000
Expansive 15% 9,000 10,000 18,000 17,000

Since project 2 dominates projects 1 in NPV in all scenarios, project 1 is eliminated, thus simplying decision making.

2. Aspiration level: Can be project with the highest probability of sucess, given an aspiration level previously defined.

Of all of these projects, under very conservative scenarios (recessive, pessimistic and normal) project 2 has the highest N

Very conservative Projects

Scenario (k) Probability (k) 2 3 4Winning project
Recessive 5% 0 -15,000 -3,000 2
Pessimistic 15% 6,000 -8,000 5,000 2
Normal 40% 7,000 1,000 11,000 4

3. Expected Value E[ (X)] Find the highest Expected Value(NPV) E(X)= p1*X1+p2*X2+….+pn*Xn

Very conservative Projects

Scenario (k) Probability (k) 2 3 4
Recessive 5% 0 -15,000 -3,000
Pessimistic 15% 6,000 -8,000 5,000
Normal 40% 7,000 1,000 11,000
Optimistic 25% 9,000 9,000 14,000
Expansive 15% 10,000 18,000 17,000
100%
Find E(NPV) for each project and indicate which to choose. Assume that project 1 is eliminated by project 2.

Project E[ NPV x]
2 (0*.05)+(6000*.15)+(7000*.4)+(9000*.25)+(10000*.15)= 7450
3 (-15000*.05)+(-8000*.15)+(1000*.4)+(9000*.25)+(18000*.15)= 3400
 4 (-3000*.05)+(5000*.15)+(11000*.4)+(14000*.25)+(17000*.15)= 11050

((0-7450)^2)*.05+
4-Variance of projects: RISK CRITERION

Project Var[ NPV x]

2 ((0-7450)^2)*.05+((6000-7450)^2)*.15+((7000-7450)^2)*.4+((9000-7450)^2)*.25+((10000-7450)^2)*.15=
3 ((-15000-3400)^2)*.05+((-8000-3400)^2)*.15+((1000-3400)^2)*.4+((9000-3400)^2)*.25+((18000-3400)^2
4 ((-3000-11050)^2)*.05+((5000-11050)^2)*.15+((11000-11050)^2)*.4+((14000-11050)^2)*.25+((17000-110
Find deviation of these projects.
Project 3 has the highest variance (deviation), and hence the highest RISK.
Project Deviat proj Rank risk VARIATION COEFFICIENT= (DEVIATION/MEAN)= RELATIVE RI
2 2,178.88 3 0.292467 This has the lowest relative risk (that is includin
3 8,862.28
1
2.606553 lowest risk per p
4 4,779.91 2 0.432571
4. Certainty Equivalence:
CE =E(NPV) -(alpha*deviation)
Alpha= coefficient of risk aversion Assume that alpha= 0.7
Find CE and choose a project under this criterion.
Proj 4 is chosen for having
Project E(NPVXk) Deviat proj CE the highest CE
2 7,450.00 2,178.88 5,924.79
3 3,400.00 8,862.28 -2,803.60
4 11,050.00 4,779.91 7,704.07

5. Total yield ( Y ) Y= E(Y)+Ym+Ye

Expected Yield E(Y) Average return that is Free risk (return provided by a secured asset with gu
Market risk or sistematic risk Ym Return with market or sistematic risk
non-sistematic risk Ye Return with non-market or non-sistematic risk
4. Assume that TOTAL RISK ( R ) comprises 3 elements: free-risk, market risk or sistematic risk (m), and
non-sistematic risk ( e )
CAPM: Capital Pricing Model
rK= rfree-risk + beta (rm-rfree-risk) + re

rK= Total cost of capital= COK

rfree-risk = secured rate (usually low) provided by institutions such as US Treasury (T-Bills)
rm= market rate (usually determined by Open Market Operations or at Stock Exchange)
beta= coefficient specifies the type of actitute adopted by firm (risk averse: beta <1; risk lover: beta>1)
beta<1: firm pays a lower return than market; beta>1: firm pays higher return than market; beta=1: firm p
rK= rfree-risk + beta (rm-rfree-risk) + re
rK= rfree-risk + beta (rm-rfree-risk) + re
rm= market rate (usually determined by Open Market Operations or at Stock Exchange)

SAPAG book
Check on your notes or books from your previous Financial Management courses you have taken: CAPM
e X is better than

ate one of these alternatives.

g decision making.

previously defined.

oject 2 has the highest NPVs

rank
2
lowest profit Choose project 4 3
 (Highest profit) 1

^2)*.05+

+((10000-7450)^2)*.15= 4,747,500
2)*.25+((18000-3400)^2)*.15= 78,540,000
050)^2)*.25+((17000-11050)^2)*.15= 22,847,500

ON/MEAN)= RELATIVE RISK= RISK TO RETURN

lative risk (that is including the return= the expected value of NPV)

est risk per profit

y a secured asset with guaranted bank : example: US Treasury Bills

<1; risk lover: beta>1)

an market; beta=1: firm pays as much as the market.

you have taken: CAPM