BA7024 CORPORATE FINANCE

Unit III

- Appraisal of risky investments

-CE and RAD cashflows
-Nature of cashflows
-Sensitivity analysis
-Decision tree approach
 Types of Investment Decisions
Replacement investment
Replacement of worn out machineries with new one.
Expansion investment
Expand the productive capacity for existing ones.
Expansion investment on a new product line
Firm decides to diversify into new business.
Modernization investment expenditure
Decides to adopt a new and better technology
Strategic investment expenditure
Investment decision to make its market stronger
 Risk and Uncertainty
Risk
Chance of the actual outcome from an investment
differs from the expected outcome
Uncertainty
Is the inability to specify something with
precision.
Risk and Uncertainty go together
Risk is the consequence of making the wrong
decision, because of this the decision becomes
uncertain
 Sources of Risk
Project Specific risk
Individual project having higher or lower cashflows
Competitive risk
Cashflows get affected due to the actions of the competitiors.
Industry specific risk
Technology risk technology that change or evolve
Legal risk effect of changing laws and regulations
Commodity risk effect of price changes in commodity.
International risk
Generation of cash flow outside the home country
Market risk
Macro economic factors that decide the fate of cashflow.
 Measurement of Risk
Range = Maximum value of Return
Minimum Value of Return.
Variance and Standard Deviation
Coefficient of variation standard
deviation/expected value
 Time Horizon for Cashflow
Analysis
Physical life of the plant
Technological life of the plant
Product market life of the plant
Investment planning horizon of the
firm.
Difficulties in determining cash flows

Sunk costs
Initial outlays required to analyse a project.
Opportunity costs
Cost of not going forward with a project.
Side effect
Incremental cash flows from the side effects.
Allocated cost
Particular expenditure benefits a number of
projects.
 Appraisal of risky investments
Certainty equivalent factor
Risk adjusted discount rate
Standard deviation method
Probability and expected values
Sensitivity analysis
Simulation method
Decision trees approach.
 Certainty Equivalent Method
Alternative method to incorporate risk into
project analysis.
Adjusting the expected cashflow rather than
the discount rate.
Coefficients reflect subjective management
perceptions.
Greater the uncertainty, lower is the value of
coefficient.
 Risk adjusted discount rate method

Performance measure that adjusts for the

initial risk.
More informed decisions can be taken when
the risk is quantified.
Enable investors to compare volatile stocks
with steadier ones.
It has the merit of operational feasibility.
 Standard Deviation Method
Project that has smaller variations in expected
values will have lower standard variation.
Which means the project is less risky and
therefore selected by the decision maker.
Standard deviation should be considered
together with the measurements.
The coefficient of variation is equal to the ratio
of the standard deviation to te expected value .
 Probability and expected values
Actions, events, expected value and Pay offs are
the terms essential to be known.
Actions are choosing the action amongst
alternatives
Events talks about the influence on the specific
action.
Expected value results from the multiplication of
each possible outcome.
Pay off is related to the action and event.
 Discounted Cash Flow (DCF) methods
using Probability Function
Valuation method used to estimate the
attractiveness of an investment opportunity.
Uses future free cash flow projections and
discounts them.
WACC is used to arrive at the Present Value.
Value through DCF is higher, then opportunity
is seen as a good one.
 Nature of cashflows
Absolute cashflow
Relative cashflow
Incremental cashflow
Conventional and non conventional cashflow
 Determining cash flows
Initial investment
Operating cash inflows
Terminal cash inflow
 Sensitivity Analysis
Technique to measure the change in the
profitability of the project.
The profitability change may be due to the
changes in the factors that affect the cash
inflows.
Less sensitive projects are normally taken into
account.
 Simulation and Investment
Evaluation of investment projects the returns
from which are subject to a high level of
uncertainty.
Probability distributions are attached to a
number of non controllable exogenous
variables.
Overall distribution is presented to the
decision maker perhaps with some summary
information.
 Decision Trees Approach
A decision is taken by comparing various
alternatives.
Group of all decisions present as well as future
viewed in relation to one another is called a
decision tree.
Graphical display of the relationship between a
present decision and future events.
 Steps in decision tree approach
Investment proposal
Various decision alternatives should be
identified
Decision tree should be graphed
Relevant data should be presented
Analyze the result
 Advantages of Decision Trees
It is an implicit assumption
Its a calculation for all to see.
Allows the decision maker to visualize the
assumptions in a graphical form.
It is much easier to understand, more abstract
and gives a more analytical view.
 Disadvantages of Decision Trees
Difficult to apply when the product or service
is new
Difficult to apply when the investments are
gradually made over a period of time.
When including more alternatives the decision
tree diagram becomes more complicated.
Calculations become more time consuming.