Capital Investment Risk and Uncertainty

• Risk can be defined as uncertainty

• In capital Expenditure ( Capex), • risk is variability likely to occur between • Estimated and future / actual return

• SD = Standard Deviation = • average magnitude of deviation from expected value • SD2 = 2 = variance

Mode
• Definition: Mode is the • most frequently occurring value • in a frequency distribution. Example: To find the mode of 11,3,5,11,7,3,11,17,11,25

• • • So the number with most occurrances ( four occurances) is 11 • and is the Mode of this distribution. 3.25 Step 2: In the above distribution Number 11 occurs 4 times.11.11.3.5. Number 5 occurs 1 times. Number 7 occurs 1 times.Mode • Step 1:Arrange the numbers in ascending order.7. Number 25 occurs 1 times.11. Number 17 occurs 1 times.11. Mode = 11 . Number 3 occurs 2 times.17.

99 • Range = 45 to 99 .Measures of risk • 1) Range • Rg= ( Rh.Rl) • Example • CAT score of 6 students were • 55.88.77. 66.45.

Range • Definition : Range is the difference • between the highest and the lowest values • in a frequency distribution.9. Example: To find the range in 3.11 .7.5.3.4.

smallest number) • Range = 11-3 = 8 .Range • Step 1:Arrange the numbers in ascending order. 3.5.7.3.4.911 Step 2: In the above distribution The largest number is11 The smallest value is 3 Range =( largest number .

7%. +12.0. Range = Maximum – Minimum • = (+12.1.0%) = 7.Range • Example : • six mid-cap mutual funds. % +7. +12.3%.9%.3%) . +5.2% and +10. • five-year annual returns are • +10.3% .(+5.

Mean absolute deviation • .

the mean deviation is defined by where is the mean of the distribution. For a sample size .MAD • • • • The mean absolute deviation (MAD) is the mean of the absolute deviations of a set of data about the data's mean. .

MAD

• •

Example: six mid-cap mutual funds, five-year annual returns are +10.1, +7.7%, +5.0, +12.3%, +12.2% and +10.9%. Mean absolute deviation starts by finding the mean: (10.1% + 7.7% + 5.0% + 12.3% + 12.2% + 10.9%)/6 = 9.7%. =

Each of the six observations deviate from the 9.7%; the absolute deviation ignores +/-.
1st: 2nd: 3rd: 4th: 5th: 6th: 10.1 - 9.7 = 0.4 7.7 - 9.7 = 2.0 5.0 - 9.7 = 4.7 12.3 - 9.7 = 2.6 12.2 - 9.7 = 2.5 10.9 - 9.7 = 1.2

• • •

Next, the absolute deviations are summed and divided by 6: (0.4 + 2.0 + 4.7 + 2.6 + 2.5 + 1.2)/6 = 13.4/6 = 2.233333, or rounded, 2.2

Standard Deviation
• SD 2 = 2= variance =  pi * ( Xi – X’)2 • Where • pi = probability of occurance • • = occurance of ith item Xi ’= X mean of distribution

Variance
• Variance (σ2) • is a measure of dispersion • that in practice can be easier to apply than mean absolute deviation • because it removes +/- signs by squaring the deviations. • five-year annual returns are +10.1, +7.7%, +5.0, +12.3%, +12.2% and +10.9%. six deviations. • To compute variance, we take the square of each deviation, • add the terms together and • divide by the number of observations.

3% +12.4 2.5 1.0 4.09 6.7% +5.Variance Observation 1 2 3 4 5 6 Value +10.7 2.16 4.2 Square of Deviation 0.76 6.7% 0.1% +7.44 .6 2.9% Deviation from mean +9.2% +10.0% +12.0 22.25 1.

7833.16 + 4.0 + 22.Variance • Variance = • (0.76 + 6.7833% squared - . it's expressed as 6. • Variance is not in the same units as the underlying data. • In this case.44)/6 = 6.09 + 6.25 + 1.

Co-efficient of variation • CV =  / X’ • Where • X’ = arithmatic mean of variable .

.Distributions • Probability distributions: • Discrete probability distributions…… the outcomes can be separated • Continuous probability distributions…. • The outcomes can NOT be separated .

Binomial Distribution • • • • • • • Definition : Probability distribution function Is a function Which serves as a tool To determine ALL the probabilities Of ALL the outcomes of a Given experiment .

probability distribution function having the parameters as n and p • And helps to find out the probabilities • When the outcomes are independent to each other • Or the outcomes are independently defined.Binomial Distribution • Is a discrete. .

blah….. More ….blah… blah B) ….blah….blah… blah C) ….some more ….. Still more …..blah… blah ..blah….blah….blah….Example of binomial distribution function • Objective type question paper • Q1 – – – – A)…..blah….blah….. Really … more and more ….blah… blah D) …....blah… blah B) ….blah… blah Q2) A) ….blah… blah D)….blah….blah… blah C) ….

r P(sssff) = p(s) * p(s) * p(s) * p(f)*p(f) Because p(s  f) = p(s) * p(f) Where  = intersection S and f are success and failure… independent events = 0.75 = ¾ per question nC = n! / ( n-r)! * r! r = n(n-1)(n-2)….(n-r-1) / 1*2*3….75*0.75 = (0.25*0.25 * 0.75)2 .25 = 0.25)3* (0.25 *0.• • • • • • • • • • • P(s) = probability of success in a question = 0.25 = ¼ PER question P(f) = probability of failure = 1-0.

• what are the probability that the retailer receives EXACTLY 8 good tyres ? . • If a retailer buys 10 of these tyres from the wholesaler.Example • A tyre wholesaler has 500 Super Brand Tyres in stock AND that • 50 of them are slightly damaged.

194 . p(r=8) = 10C8 * (450/500)8 * (1-450/500)10-8 = (10 * 9/1*2) * ((9/10)8)* ((1/10)2) = 0.• • • • • • • • • Given : n = number of tyres bought = 10 r = number of successes = 8 p = probability of success of each item = 450/500 So.194 The probability that the retailer receives EXACTLY 8 good tyres is 0.

• The poisson distribution is an appropriate model for count data .Poisson Distribution • The poisson distribution resembles the binomial distribution • if the probability of an event is very small.

05 then p is small . it is called a large number of experiments • If p < 0.Poisson vs Binomial • Poisson pdf is nothing but • binomial pdf where n is large and p is small • If n >= 20.

the number of misprints in a book. and the number of activations of a geiger counter.Examples • • • • mortality of infants in a city. • The poisson distribution was derived by the french mathematician Poisson in 1837. • and the first application was the description of • the number of death by horse kicking in the prussian army . the number of bacteria on a plate.

.

• The probability density function of a Poisson variable is given by . • is a mathematical rule • that assigns probabilities to the number occurances.The poisson distribution • This is sometimes also known as the law of rare events.

some evening. • but meaningless to ask how many such events have not occurred. • (2) occurrences are independent.The Poisson distribution • applies when: • (1) the event is something that can be counted in whole numbers. such as the number of times a firefly lights up in my garden in a given 5 seconds. so that one occurrence neither diminishes nor increases the chance of another. • (3) the average frequency of occurrence for the time period in question is known. and • (4) it is possible to count how many events have occurred. .

• where the probability of each of two mutually exclusive events (p and q) is known.3 cars • The Poisson Distribution. or 3. or 2. . you can’t have 1.9 children. • Poisson distribution is a discrete variable distribution’ and you cannot have a decimal answer: • For example. is the Binomial Distribution Without Q.7 computers. so to speak.• This last point sums up the contrast with the Binomial situation.

The classic Poisson example • is the data set of von Bortkiewicz (1898). • giving a total of 200 observations of one corps for a one year period. • Ten army corps were observed over 20 years. • and the average number of deaths per year per corps was thus 122/200 = 0. for the chance of a Prussian cavalryman being killed by the kick of a horse. • The total deaths from horse kicks were 122. . • This is a rate of less than 1. • The period or module of observation is thus one year. • It is also obvious that it is meaningless to ask how many times per year a cavalryman was not killed by the kick of a horse.61.

61 deaths in one corps (that is not possible. not exactly 0. . with observations made over many small intervals of time. sometimes one. deaths occur in modules of 1). but sometimes none. then. occasionally two. Here.Poisson Distribution • • • • • • • • • • • In any given year. perhaps once in a while three. and (we might intuitively expect) very rarely any more. is the classic Poisson situation: a rare event. whose average rate is small. we expect to observe.

Poisson • 200 passengers have made reservations for a flight. • If the probability that a passenger who has a reservation will not show up is 0.Example .01. what is the probability that exactly three passengers will not show up ? .

1804 .718 Here. P(r) = nCr * pr * (1-p)n-r Probability of exactly r successes In case of Poisson distributions.• • • • • • • • • • • • • • For binomial distributions.01 which is less than < 0. P(r=3) = e-2 * (2)3 / 3! = 0. P( r) = ( e- * r) / r! E= exponential value is taken as 2.01 = 2 So.05 . so it satisfies condition (2)  = n * p = 200 * 0. n = 200 which is greater than 20 so it satisfies condition (1) P = 0.1804 The probability that exactly 3 passengers will NOT show up is 0.

To speak specifically of any normal distribution. two quantities have to be specified: the mean . which indicates the spread or girth of the bell curve .Normal distribution • • • • • • • • All normal distributions are symmetric and have bell-shaped density curves with a single peak. and the standard deviation . where the peak of the density occurs.

Accident at a spot vis-à-vis accident at a stretch of road • If area is not equal to 1..Normal pdf • • • • Is a continuous pdf Is symmetric with respect to its mean Eg. it is NOT a pd curve .

the shape of the curve is same .• • • • Normal pdf has two papameters  = mean  = standard deviation For continuous pdf. NOT by height • Because probability at a particular point or place is ZERO • In all standard normal variates or form. the mean and sigma are expected to be 0 and 1 respectively • For ALL normal pdf. you have to find by area.

The 68-95-99. that is.δ and µ + δ . • 68%of the observations fall within 1 standard deviation of the mean.7% Rule • Empirical Rule. • between µ .

2δ and µ + 2δ . that is.• 95%of the observations fall within 2 standard deviations of the mean. • between µ .

7%of the observations fall within 3 standard deviations of the mean.3δ and µ + 3δ • Thus. . that is. for a normal distribution. • between µ .• 99. almost all values lie within 3 standard deviations of the mean.

Risk adjusted discount rate • .assumption : • Investors expect a higher rate of return on riskier projects • rp= rf+p (rm-rf) • Where • rp=return of the portfolio • rf = return of risk free asset • p = beta of the portfolio .

• Eg. Project A Project B -20000 -20000 8000 10000 8000 12000 6000 6000 Rf = 5 % rp(A) = 5 % rp(B) = 10 % ? NPV of the projects ..

13 6000/1.1 10000/1.12 6000/1.1 8000/1.Risk adjusted discount rate rA= 10 % rB=15 % Project A Project B -20000 -20000 8000/1.13 NPV of Project A = (-1618) NPV of Project B = 1780 Since NPV of Project B is positive. select Project B .12 12000/1.

Merits • Simple and easy to calculate and understand • Takes into a/c investor’s risk averse attitude .

Demerits • Discount rate not objective • Wrong factor is adjusted ( discount rate instead of cash flows) • Assumes increasing risk over time • Assumes investors are risk averse .

6 0.8 0.Certainty Equivalent Co-Efficient • CEC = correction factor • CEC = riskless cash flow / risky cash flow Item Project A Project B CF A CF B -20000 -20000 Time period 1 0.9 0.5 6000 6000 .8 8000 10000 T2 0.7 8000 12000 T 3 0.

8 = 6400 12000*0.6 = 3600 6000*0.5= 3000 .8 = 8000 CF 2 8000*0.9= 7200 10000*0.• Rf = 5 % • Certain cash flows Item CFc CFc Projec t Proj A ProjB CF 0 -20000 -20000 CF 1 8000*0.7 = 8400 CF 3 6000*0.

05) + ( 6400/1.• DCF = • ProjA = -20000 + ( 7200/1.052 ) +(3600/1.053 ) • = -20000 + 6854 + 5804 + 3108 • NPVA = .4234 .

05) + (8400/ 1.• ProjB = -20000 + ( 8000 / 1.053 ) • = -20000 + 7616 + 7618 + 2592 • NPV = .2174 .052 )+ (3000/1.

Conclusion • Since NPV of ProjA is greater than NPV of Project B • Select Project A .

Sensitivity Analysis • • • • • • More than one cash flow estimates in a year Takes into consideration variability of return Three scenarios Optimistic Pessimistic Most likely .

15 years Pessimist CFA ic Most likely CFA -20000 -20000 -20000 3000 4000 5000 3000 4000 5000 3000 4000 5000 …… …… …….606 7. 3000 4000 5000 7.10 .606 7.606 Optimisti CFA c Ke = 10 % = 0.Cash flow estimates Scenario Cash Flow CF 0 CF 1 CF 2 CF 3 …… CF 15 PVIFA @10 %.

606 7.606 22818 30414 2818 10414 Optimisti c -20000 5000 7.606 38030 18030 . 15 years NPV Pessimist -20000 ic Most Likely -20000 7.DCF Project A • Project A Item CF 0 CF 1 to CF 15 3000 4000 PVIFA @10 PV %.

10 . 0 4000 8000 7.606 7.606 Optimisti CFB c Ke = 10 % = 0.Cash flow estimates Scenario Cash Flow CF 0 CF 1 CF 2 CF 3 …… CF 15 PVIFA @10 %. 15 years Pessimist CFB ic Most likely CFB -20000 -20000 -20000 0 4000 8000 0 4000 8000 0 4000 8000 …… …… …….606 7.

DCF Project B • Project B Item CF 0 CF 1 to CF 15 0 4000 PVIFA @10 PV %. 15 years NPV Pessimist -20000 ic Most Likely -20000 7.606 0 30414 0 10414 Optimisti c -20000 8000 7.606 60848 40848 .606 7.

Conclusions • Project B is more profitable • And MORE RISKY than Project A • So. select according to your risk appetite • Issues : • Probability estimates of cash flows under different conditions is NOT known .

Problem • Same # as above Probability Project A Pi Pessimistic 0.4 0.2 Most likely 0.6 Optimistic 0.2 Project B 0.2 0.4 .

6=2400 5000*0.2 = 1000 4000 Project B 0 * 0.Estimated CF Pessimistic Most likely Optimistic Expected CF Project A 3000*0.4 = 3200 4800 Probability = Likelihood of an event happening .2 =0 4000 * 0.2= 600 4000*0.4 = 1600 4000*0.

606 7.606 Expected NPV 4562 18254 7606 Pessimistic Most Likely Optimistic -20000 -20000 -20000 Total 30422 .606 7.Project A Scenario CF 0 Expected CF 1 to 15 600 2400 1000 PVIFA 10 %. 15 years 7.

Project B Scenario CF 0 Expected CF 1 to 15 0 1600 3200 PVIFA 10 %.606 Expected NPV 0 12088 24338 Pessimistic Most Likely Optimistic -20000 -20000 -20000 TOTAL 36426 Recommendations: Project B has higher EMV than Project A … However. 15 years 7.606 7.606 7. Project B is more Risky. .

Mathematical Analysis • PCCF :Perfectly correlated cash flows • • • • • • • • • • Behaviour of cash flows in ALL periods is same n * SD of cash flow is same In other words. CF in other years will also be x times  to expected value  i = standard deviation of CF in year I n (NPV) =  (i’ / ( 1+rf)i i =1 . If actual cash flow in time t1 is x times  to expected value. Then.

n • NPV’ = ( Xi’ / ( 1+rf)i • i =1 • • • • • .CF0 =  ( CFi’ / ( 1+rf)i – I Where NPV’ = mean or average NPV i = time horizon rf = risk free rate of return ( discount rate) … we are trying to isolate risk of the project • Xi’ = mean or average cash flow in year i .

Example • Given : • CF0 = I = 20000 • rf = 0.5 13000 8000 12000 8400 P 0.06 or 6 % Year P 0.5 7000 4000 4000 3600 • Year 1 Year 2 Year 3 Year 4 xi ’ x1’ = 10000 x1’ = 6000 x1’ = 8000 x1’ = 6000 I’ 1’ = 3000 1’ = 2000 1’ = 4000 1’ = 2400 .

063) + (6000/1.CF0 • i =1 • = -20000 + {(10000 / 1.06) + (6000/1.064)} • = -20000 + 9432 + 5338 + 6716 + 4752 • = -20000 + 26238 = + 6238 .062) + ( 8000/1.n • NPV’ = ( Xi’ / ( 1+rf)i .

• n • (NPV) =  (i’ / ( 1+rf)i • i =1 • = (3000 / 1.062) + (4000/1.064) • = 2830 + 1778 + 3358 + 1900 • = 9866 .06) + (2000/1.063) + (2400/1.

. * p(xn/x1… to….x2)….06 .Moderately Correlated Cash Flows • Joint probability • p(xi to xn) = p( x1) *p ( x2/x1) * p(x3/x1. Xn-1) • Example • CF0 = I = (-100000) • Rf = 6 % = 0.

8 0.24 0.05 0.2 0.4 .04 50000 0.5 0.16 0.09 0.3) ) CF1 30000 P1 0.8 0.2 CF3 35000 40000 45000 50000 60000 70000 75000 90000 JP3/2.21 0.1 0.7 0.21 0.5 0.2 1 2 3 4 5 6 7 8 0.5 50000 60000 0.8 0.6 0.2.5 CF2 30000 40000 JP2/1 0.3 0.16 0.4 0.Joint Probability Case Year 1 Year 2 Year 2 Year 3 Year 3 CF JP (p(1.6 0.

Cash Flows CFx CF1 CF2 CF3 CF4 CF5 CF6 CF7 CF8 Year 1 30000 30000 30000 30000 50000 50000 50000 50000 Year 2 30000 30000 40000 40000 50000 50000 60000 60000 Year 3 35000 40000 45000 50000 60000 70000 75000 90000 .

06 30000/1.09 0.062 30000/1.062 40000/1.05 0.063 75000/1.063 90000/1.063 NPV -15612 -11414 1684 5882 JP 0.04 .062 60000/1.062 50000/1.063 70000/1.06 50000/1.06 50000/1.063 40000/1.06 50000/1.062 60000/1.063 45000/1.05 5 6 7 8 -100000 -100000 -100000 -100000 50000/1.06 30000/1.06 30000/1.063 42046 50442 63540 76134 0.062 40000/1.16 0.06 50000/1.16 0.062 CF3 35000/1.CF 1 2 3 4 CF0 -100000 -100000 -100000 -100000 CF1 30000/1.24 0.062 60000/1.21 0.06 CF2 30000/1.063 45000/1.

16 0.5) 50000(0.4) 75000(0.16 63540 90000(0.24 -15612 • • 30000(0.2) 50000(0.5) 40000(0.3) 5 6 0.05 -11414 1684 5882 • • • • 50000(0.4) 3 2 4 0.21 0.5) Year 3 45000(0.06 42046 50442 60000(0.6) 1) JP 0.04 76134 .7) 70000(0.8) 7 0.Decision Tree approach (cash flows from previous joint probability case) CF JP NPV Year 1 Year 2 30000(0.2) 8 0.8) 35000(0.05 0.5) 40000(0.6) 60000(0.

04 • The expected NPV of the project is +212702 • Decision: • select .24 • The joint probability of the project having highest NPV of 76134is 0.analysis • The joint probability of the project having lowest NPV of -15612 is 0.

Uncorrelated cash flows • Cash flows of various period are independent • In other words. no relationship between the CF from one period to another .

• • • • • • • • • NPV ‘ = -I +  i = 1 to n (xi’ / ( 1+rf)i 2(NPV) =  i = 1 to n (i2/ ( 1+rf)2i Where NPV ‘ = expected NPV xi’ = expected CF in year i rf = risk free rate of return I = CF0 (NPV) = Standard Deviation of NPV I = Standard deviation of Cash Flow for year i .

it would result in double counting of risk factor .• • Reason for rf : We are trying to separate time value of money AND risk factor • NPV ‘ is computed using risk adjusted discount rate and then viewed along with (NPV).

06 .063 = +4948 .06+8000/1.3 Xi’ 10000 8000 10000 =-20000+10000/1.3 CF 10000 8000 10000 Pi 0.2 0. rf = 0.062+10000/1.6 0.Example CF0 = 20000. Year Year 1 Year 2 Year 3 CF 6000 4000 6000 Pi 0.4 CF 14000 12000 14000 Pi 0.3 0.2 0.3 0.4 0.

• I2 =  pi(xi-x1’) = {*0.3*(1400010000)2]} • I2 = 9600000 .3*(6000-10000)2] +{[0.4*(10000-10000)2+{[0.

• 22 =  pi(x2-x2’) = {*0.2*(4000-8000)2] +{[0.6*(8000-8000)2+{[0.2*(12000-8000)2]} • 22 = 6400000

• 32 =  pi(x2-x2’) = {*0.3*(6000-10000)2] +{[0.4*(10000-10000)2+{[0.3*(1400010000)2]} • 32 = 9600000

• • • •

2 = 9600000/1.062 +6400000/1.064 +9600000/1.066 =22356679

• (NPV) = 4728

Issues: • Investment proposals differ in risk • Subjective probability distribution • Non-availability of objective evidence for defining probability distributions • High degree of subjectivity .

Practical Issues • • • • Conservative estimation of revenues Safety margin in expenditure Flexibilty in investment yardsticks Like different post-tax rate of return. optimistic.. pay back period etc. pessimistic Subjective evaluation Question remains : what is the probability that NPV of a project are normally distributed ? • • • • . Use of certainty index for scarce inputs Judgement based on three point estimates – most likely.

Case Study Airbus A3xx • • • • • • • • • ? ? Project economics ? Break-even demand analysis ? required rate of return ? Realized price per plane ? Capacity to produce ? Market for VLA ? Boeing’s competitive response ? What happened ? .

Inc .Sampa Video .

Case .Sampa Video • • • • • • • • • • • To explore the concept of valuation When the project can support debt capacity What is the tax shield by debt To find and understand WACC Adjusted PV Capital cash flow ? Vale of the firm with all equity 50 % debt 25 % debt-to market value .

Case-Sampa Video-Assignment Questions • 1) What is the value of the firm assuming that the firm was entirely equity financed ? What are the annual projected cash flows ? What discount rate is appropriate ? • 2) Value the project using the Adjusted Present Value (APV) approach assuming the firm maintains a constant 25 % debt-to-market ratio. in perpetuity • 3)Value the firm using the APV approach assuming the firm raises $750 000 of debt to partially fund the project and keeps the level of debt constant in perpetuity .

WACC and CCF approaches compare ? How do the assumptions about the financial policy differ across the three approaches? • 7) Given the assumptions behind APV.Assignment Questions .continued • 4) What are the end-of-year debt balances implied by the 25% target debt-to-value ration ? • 5) using the debt balances from the above.WACC and CCF. • 6) How do the values from the APV. when is one method more appropriate or easier to implement than the others ? . use the Capital Cash flow (CCF) approach to value the project.

2 % • Unlevered cost of equity = expected return of assets = (5%+ 1.228 M USD .8 % • Value of unlevered firm = 1.5*7.2) = 15.000 USD is made immediately • No NWC • 5% growth in free cash flow as in perpetuity after 2005 • Market risk premium = long run excess return of USA equities = 7.Case-Sampa Videos-All Equity Valuation of the Project • Assumptions : initial investment of 1.500.

8% = $300000 • WACC = (1-t) *kd*D/V) + (ke*E/V) • Where V = Value of firm = debt + equity • Capitalisation ratio for debt = 25 % • Capitalisation ratio for equity = 75 % • Cost of debt = kd= 6.Calculations • Interest tax shield = ITS =debt*tax rate*cost of debt/debt weightage = $750000 *0.8 % .8%/6.40*6.

• Beta of the firm’s assets = (weighted average beta of debt and equity) • a = (D/D+E)* d + (E/D+E) * e • Levered beta = e = 1.92 • Levered return on equity = 18.8% .

8) = 15.12 % • • Required rate of return on levered equity using M&M proposition : • Re = Ra + (D/E) * (Ra-Rd) = 18.25*6.75 * 18.• WACC = (0.8) + (0.8 % .

470.528.500 • Value of the project with 25 % D/V forever = NPV = $1.228.• Value of the project with no debt = NPV = $1.500 • Value of the project with 50% debt $750000 = NPV = $1.000 .

Free cash flows Item Ebiat Source (A) From Ex 2 2002E -12000 200000 2003E 81000 225000 300000 0 2004E 201000 250000 300000 0 2005E 339000 275000 300000 0 2006e 495000 300000 300000 0 Depreciati (b) From on Ex 3 Capex Change in NWC Free CF © from ex 300000 4 (d) From Ex 5 (d) = a+bc-d 0 -112000 6000 151000 314000 495000 .

25 25% 6.8% 1.2 15.92 75% 18.06 1.Expected Returns Item Asset beta Sourc (a) From Ex 2 Value 1.5 Risk free rate Market risk premium Asset return Debt beta Debt % Debt return Debt beta contribution Equity beta Equity % Equity return Equity beta contribution (b) From Ex 2 © from Ex 2 (d) = (b)+(a)*c (e) From Ex 2 (f) From case (g) = (b)+(f)*© (h) = (e)* f (i) = (a) –(h) /j) J=1-f K=(b) + i*c (l) = i*j 5% 7.8% 0.44 .8 0.

480 PV Total PV of FCF Less initial investme nt Net PV (d)=a*c -96700 2728500 1500000 4500 97200 174600 237700 2311100 +1228500 .746 2004E 151000 15.8% 0.480 Terminal Value 4821500 15.8% 0.All equity Valuation Item Free CF Discount Rate Discount PV of $1 factor Source 2002 E -112000 15.864 2003 6000 15.8% 0.556 2006E 495000 15.8% 0.8% 0.644 2005E 314000 15.8% 0.

05/(0.050) = 495*1.8%) And g is the growth rate (5%) = 495*1.05/0.ALL Equity – Terminal Value • • • • • • • • = 2006E (estimated) cash flow .5 * 1000 $ .158-0. Grown by 5 % And discounted at R-g Where R is the appropriate discount rate (15.108 =4812.

1% 0.1% 0.569 2006E 495000 15.WACC valuation with a target debt-tovalue ratio of 25 % Item Free CF Discount Rate Discount C=PV of Factor $1 Source 2002E -112000 15.655 2005E 314000 15.755 2004E 151000 15.1% 0.1% 0.869 2003E 6000 15.1% 0.495 Terminal Value 5135900 PV Total PV of FCF D=a*c E=sum of d -97300 2970000 1500000 4500 99000 178800 244800 2540200 Less F from initial case investme nt NPV G=e-f + 1470000 .495 0.

1%) And g is the growth rate (5%) =495*1.1012) =5135.05 /(0.Terminal value with a target debtvalue ratio of 25% • • • • • • • • Equal to 2006E (estimated) cash flow Grown by 5% And discounted by R-g Where R is the appropriate discount rate(15.05/(0.9 ( including rounding-off error) .050) = 495 * 1.1512 -0.

Capital Cash flow valuation with a target debt-to-valuation ratio of 25% Item PV of FCF Debt at 25% of value Debt rate Tax rate Expecte d interest tax shield Free tax Source case B=25% of a C from ex 3 D from Ex 3 E=b*c*d 2002E 2003E 2004E 2005E 2006E Terminal Value 2970000 3531000 4058000 4521600 4891300 742500 882800 101470 130400 1222800 6.80% 40% 30700 6.80% 40% 20200 6.80% 40% 33300 F -112000 6000 151000 314000 495000 .80% 40% 24000 6.80% 40% 27600 6.

05) • =528.Terminal cash flows with a target debtto value ratio of 25% • • • • • • Equal to 2006E (estimated) cash flows Grown by 5% And discounted at R-r Where R is the appropriate discount rate And g is the growth rate @5% = free cash flow + expected interest tax shield = 495+33.108 • = 5135.9*1000 $ .05/0.3*1.158-0.05/(0.3 *1.3 = 528.

Normal Distribution • A continuous probability distribution function (pdf) • Which is systematic with respect to mean () • 2 parameters – Mean () of population or x’ of sample distribution – SD of population or  of sample You have to convert the normal distribution to standard normal form .

Pi Xi =0 Z .

• Z=(x-) /  • Or ( Xi -x )/  • Where • z = standard normal variant or standard difference • Xi = normal variant or random variable • In normal distribution. •  = 1 and x = 0 .

we need parameters () and  . probability (p ) at a particular point or place is zero • A range has to be given for x • In ALL standard normal variates or form. NOT by height • Because.• For continuous pdf. you have to calculate by area . the mean () or standard deviation (SD) are expected to be equal to 0 and 1 respectively • In ANY normal distribution.

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