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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.
potential investments, an investor should always compare the same risk measures to each different investment in order to get a relative performance perspective.
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. It is the measure of the riskiness of a project. When taken in isolation, a project may be considered more or less risky than the current risk profile of a company. Through the use of the SML as a means to calculate a company's WACC, this risk profile would be accounted for. Example: When a new product line for Newco is considered, the project's beta is 1.5. Assuming the riskfree rate is 4% and the expected return on the market is 12%, compute the cost of equity for the new product line. Answer: Cost of equity = rf + Bs(Emkt - rf) = 4% + 1.5(12% - 4%) = 16% The project's required return on retained earnings is thus 16% and should be used in our calculation of WACC. Estimating Beta In risk analysis, estimating the beta of a project is quite important. But like many estimations, it can be difficult to determine. The two most widely used methods of estimating beta are: 1.Pure-play method 2.Accounting-beta method
1. Pure-Play Method When using the pure-play method, 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. Once these companies are found, the company would then take an average of those betas to determine its project beta. Suppose Newco would like to add beer to its existing product line of soda. Newco is quite familiar with the beta of making soda given its history. However, determining the beta for beer is not as intuitive for Newco as it has never produced it. Thus, to determine the beta of the new beer project, Newco can take the average beta of other beer makers, such as Anheuser Busch and Coors. 2.Accounting-Beta Method When using the accounting-beta method, a company would run a regression using the company's return on assets (ROA) against the ROA for market benchmark, such as the S&P 500. The accounting beta is the slope coefficient of the regression. The typical procedure for developing a risk-adjusted discount rate is as follows: 1. A company first begins with its cost of capital for the firm. 2. The cost of capital then must be adjusted for the riskiness of the project, by adjusting the company's cost of capital either up or down depending on the risk of the project relative to the firm. For projects that are riskier, the company's WACC would be adjusted higher and if the project is less risky, the company's WACC is adjusted lower. The main issue in this procedure is that it is subjective. Capital Rationing Essentially, capital rationing is the process of allocating the company's capital among projects to maximize shareholder return. When making decisions to invest in positive net-present-value (NPV) projects, companies continue to invest until their marginal returns equal their marginal cost of capital. There are times, however, when a company may not have capital to do this. As such, a company must ration its capital among the best combination of projects with the highest total NPV.
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).
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
You multiply probabilities along the branches You add probabilities down columns
The probability of "Head, Head" is 0.50.5 = 0.25 All probabilities add to 1.0 (which is always a good check) The probability of getting at least one Head from two tosses is 0.25+0.25+0.25 = 0.75 ... and more
The Option to Delay a Project Under traditional investment analysis (such as that accomplished by the Investment Valuation model), 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. However, such cash flows and discount rates change over time, therefore a proposal that has a negative net present value today may
have a positive net present value in the future. The option to Delay a project represents the value gained by waiting to take advantage of any upside volatility in the net present value.
Where: "E" represents the % change in the exchange rate "i1" represents country A's interest rate "i2" represents country B's interest rate
For example, if country A's interest rate is 10% and country B's interest rate is 5%, country B's currency should appreciate roughly 5% compared to country A's currency. The rational for the IFE is that a country with a higher interest rate will also tend to have a higher inflation rate. 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.
CF6 = 200000 Discounted Net Cash Flows at 11% DCF1 = 120000/(1+11%)1 = 120000/1.11 = 108108.11 DCF2 = 115500/(1+11%)2 = 115500/1.2321 = 93742.39 DCF3 = 130000/(1+11%)3 = 130000/1.36763 = 95054.88 DCF4 = 116500/(1+11%)4 = 116500/1.51807 = 76742.16 DCF5 = 117250/(1+11%)5 = 117250/1.68506 = 69582.17 DCF6 = 200000/(1+11%)6 = 200000/1.87041 = 106928.17 NPV Calculation at 11% NPV = 108108.11 + 93742.39 + 95054.88 + 76742.16 + 69582.17 + 106928.17 -500000 NPV = 550157.88 -500000 NPV at 11% = 50157.88
Discounted Net Cash Flows at 16% DCF1 = 120000/(1+16%)1 = 120000/1.16 = 103448.28 DCF2 = 115500/(1+16%)2 = 115500/1.3456 = 85835.32 DCF3 = 130000/(1+16%)3 = 130000/1.5609 = 83285.5 DCF4 = 116500/(1+16%)4 = 116500/1.81064 = 64341.91 DCF5 = 117250/(1+16%)5 = 117250/2.10034 = 55824.25 DCF6 = 200000/(1+16%)6 = 200000/2.4364 = 82088.45 NPV Calculation at 16% NPV = 103448.28 + 85835.32 + 83285.5 + 64341.91 + 55824.25 + 82088.45 -500000 NPV = 474823.71 -500000 NPV at 16% = -25176.29
IRR with Linear Interpolation iL = 11% iU = 16% npvL = 50157.88 npvU = -25176.29irr = iL + [(iU-iL)(npvL)] / [npvL-npvU] irr = 0.11 + [(0.16-0.11)(50157.88)] / [50157.88--25176.29] irr = 0.11 + [(0.05)(50157.88)] / [75334.17] irr = 0.11 + 2507.894 / 75334.17 irr = 0.11 + 0.0333 irr = 0.1433 irr = 14.33%
1 Then irr = irr * log(p/sum) / log(npv/sum) is the iteration you need to successively apply. 2. 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.com http://suite101.com/article/investment-appraisals-how-to-calculate-irr-a297184#ixzz22w103E1E