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

Mode
Step 1:Arrange the numbers in ascending order. 3,3,5,7,11,11,11,11,17,25 Step 2: In the above distribution Number 11 occurs 4 times, Number 3 occurs 2 times, Number 5 occurs 1 times, Number 7 occurs 1 times. Number 17 occurs 1 times. Number 25 occurs 1 times.

So the number with most occurrances ( four occurances) is 11 and is the Mode of this distribution. Mode = 11

Measures of risk
1) Range Rg= ( Rh- Rl) Example CAT score of 6 students were
55,

66,45,77,88,99

Range = 45 to 99

Range
Definition : Range is the difference between the highest and the lowest values in a frequency distribution. Example: To find the range in 3,4,5,7,3,9,11

Range
Step 1:Arrange the numbers in ascending order. 3,3,4,5,7,911 Step 2: In the above distribution The largest number is11 The smallest value is 3 Range =( largest number - smallest number)

Range = 11-3 = 8

Range

Example : six mid-cap mutual funds, five-year annual returns are +10.1, % +7.7%, +5.0, +12.3%, +12.2% and +10.9%.
Range = Maximum Minimum = (+12.3%) - (+5.0%) = 7.3%

Mean absolute deviation

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

where

is the mean of the distribution.

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 (2) 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.

Variance
Observation 1 2 3 4 5 6 Value +10.1% +7.7% +5.0% +12.3% +12.2% +10.9% Deviation from mean +9.7% 0.4 2.0 4.7 2.6 2.5 1.2 Square of Deviation 0.16 4.0 22.09 6.76 6.25 1.44

Variance
Variance = (0.16 + 4.0 + 22.09 + 6.76 + 6.25 + 1.44)/6 = 6.7833. Variance is not in the same units as the underlying data. In this case, it's expressed as 6.7833% squared -

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

Binomial Distribution
Is a discrete, 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.

Example of binomial distribution function

Objective type question paper Q1
A)..blah.blah blah B) ..blah.blah blah C) ..blah.blah blah D) ..blah.blah blah

Q2) A) . More ..blah.blah blah B) .some more ..blah.blah blah C) . Still more ..blah.blah blah D).. Really more and more ..blah.blah blah

P(s) = probability of success in a question = 0.25 = PER question P(f) = probability of failure = 1-0.25 = 0.75 = per question nC = n! / ( n-r)! * r! r = n(n-1)(n-2).(n-r-1) / 1*2*3.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 = 0.25 * 0.25 *0.25*0.75*0.75 = (0.25)3* (0.75)2

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

Given : n = number of tyres bought = 10 r = number of successes = 8 p = probability of success of each item = 450/500 So, p(r=8) = 10C8 * (450/500)8 * (1-450/500)10-8 = (10 * 9/1*2) * ((9/10)8)* ((1/10)2) = 0.194 The probability that the retailer receives EXACTLY 8 good tyres is 0.194

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

Poisson vs Binomial
Poisson pdf is nothing but binomial pdf where n is large and p is small

If n >= 20, it is called a large number of experiments If p < 0.05 then p is small

Examples
mortality of infants in a city, the number of misprints in a book, the number of bacteria on a plate, and the number of activations of a geiger counter. 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 poisson distribution

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

The Poisson distribution

applies when: (1) the event is something that can be counted in whole numbers; (2) occurrences are independent, 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, such as the number of times a firefly lights up in my garden in a given 5 seconds, some evening, but meaningless to ask how many such events have not occurred.

 This last point sums up the contrast with the Binomial situation, where the probability of each of two mutually exclusive events (p and q) is known.

Poisson distribution is a discrete variable distribution and you cannot have a decimal answer: For example, you cant have 1.9 children, or 3.7 computers, or 2.3 cars
The Poisson Distribution, so to speak, is the Binomial Distribution Without Q.

The classic Poisson example

is the data set of von Bortkiewicz (1898), for the chance of a Prussian cavalryman being killed by the kick of a horse. Ten army corps were observed over 20 years, giving a total of 200 observations of one corps for a one year period. The period or module of observation is thus one year. The total deaths from horse kicks were 122, and the average number of deaths per year per corps was thus 122/200 = 0.61. This is a rate of less than 1. 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.

Poisson Distribution
In any given year, we expect to observe, not exactly 0.61 deaths in one corps (that is not possible; deaths occur in modules of 1), but sometimes none, sometimes one, occasionally two, perhaps once in a while three, and (we might intuitively expect) very rarely any more. Here, then, is the classic Poisson situation: a rare event, whose average rate is small, with observations made over many small intervals of time.

Example - Poisson
200 passengers have made reservations for a flight. If the probability that a passenger who has a reservation will not show up is 0.01, what is the probability that exactly three passengers will not show up ?

For binomial distributions, P(r) = nCr * pr * (1-p)n-r Probability of exactly r successes In case of Poisson distributions, P( r) = ( e- * r) / r! E= exponential value is taken as 2.718 Here, n = 200 which is greater than 20 so it satisfies condition (1) P = 0.01 which is less than < 0.05 , so it satisfies condition (2) = n * p = 200 * 0.01 = 2 So, P(r=3) = e-2 * (2)3 / 3! = 0.1804 The probability that exactly 3 passengers will NOT show up is 0.1804

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

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

Normal pdf has two papameters = mean = standard deviation For continuous pdf, you have to find by area, 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, the shape of the curve is same

The 68-95-99.7% Rule

Empirical Rule. 68%of the observations fall within 1 standard deviation of the mean, that is, between - and +

 95%of the observations fall within 2 standard deviations of the mean, that is, between - 2 and + 2

 99.7%of the observations fall within 3 standard deviations of the mean, that is, between - 3 and + 3 Thus, for a normal distribution, 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

Risk adjusted discount rate rA= 10 % rB=15 %

Project A Project B

-20000 -20000

8000/1.1 10000/1.1

8000/1.12 12000/1.12

6000/1.13 6000/1.13

NPV of Project A = (-1618) NPV of Project B = 1780

Since NPV of Project B is positive, select Project B

Merits
Simple and easy to calculate and understand Takes into a/c investors 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

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 0.8 8000 10000 T2 0.8 0.7 8000 12000 T 3 0.6 0.5 6000 6000

 Rf = 5 % Certain cash flows

Item CFc CFc

Projec t Proj A ProjB

CF 0 -20000 -20000

CF 1 8000*0.9= 7200 10000*0.8 = 8000

CF 2 8000*0.8 = 6400 12000*0.7 = 8400

CF 3 6000*0.6 = 3600 6000*0.5= 3000

 DCF = ProjA = -20000 + ( 7200/1.05) + ( 6400/1.052 ) +(3600/1.053 ) = -20000 + 6854 + 5804 + 3108 NPVA = - 4234

 ProjB = -20000 + ( 8000 / 1.05) + (8400/ 1.052 )+ (3000/1.053 ) = -20000 + 7616 + 7618 + 2592 NPV = - 2174

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

Cash flow estimates

Scenario Cash Flow CF 0 CF 1 CF 2 CF 3 CF 15 PVIFA
@10 %, 15

years

Pessimist CFA ic Most likely CFA

-20000 -20000 -20000

3000 4000 5000

3000 4000 5000

3000 4000 5000

3000 4000 5000

7.606 7.606 7.606

Optimisti CFA c

Ke = 10 % = 0.10

DCF Project A
Project A
Item CF 0 CF 1 to CF 15 3000 4000 PVIFA @10 PV
%, 15 years

NPV

Pessimist -20000 ic Most Likely -20000

7.606 7.606

22818 30414

2818 10414

Optimisti c

-20000

5000

7.606

38030

18030

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

0 4000 8000

7.606 7.606 7.606

Optimisti CFB c

Ke = 10 % = 0.10

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 7.606

0 30414

0 10414

Optimisti c

-20000

8000

7.606

60848

40848

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 0.2 Most likely 0.6 Optimistic 0.2 Project B 0.2 0.4 0.4

Estimated CF Pessimistic Most likely Optimistic Expected CF

Project A 3000*0.2= 600 4000*0.6=2400 5000*0.2 = 1000 4000

Project B 0 * 0.2 =0 4000 * 0.4 = 1600 4000*0.4 = 3200 4800

Probability = Likelihood of an event happening

Project A
Scenario CF 0 Expected CF 1 to 15 600 2400 1000 PVIFA 10 %, 15 years 7.606 7.606 7.606 Expected NPV 4562 18254 7606

Pessimistic Most Likely Optimistic

-20000 -20000 -20000

Total

30422

Project B
Scenario CF 0 Expected CF 1 to 15 0 1600 3200 PVIFA 10 %, 15 years 7.606 7.606 7.606 Expected NPV 0 12088 24338

Pessimistic Most Likely Optimistic

-20000 -20000 -20000

TOTAL

36426

Recommendations: Project B has higher EMV than Project A However, 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, If actual cash flow in time t1 is x times to expected value, Then, 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

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 = 0.06 or 6 %
Year P 0.5 13000 8000 12000 8400 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

n NPV = ( Xi / ( 1+rf)i - CF0 i =1

= -20000 + {(10000 / 1.06) + (6000/1.062) + ( 8000/1.063) + (6000/1.064)} = -20000 + 9432 + 5338 + 6716 + 4752 = -20000 + 26238 = + 6238

 n (NPV) = (i / ( 1+rf)i i =1 = (3000 / 1.06) + (2000/1.062) + (4000/1.063) + (2400/1.064) = 2830 + 1778 + 3358 + 1900 = 9866

Moderately Correlated Cash Flows

Joint probability p(xi to xn) = p( x1) *p ( x2/x1) * p(x3/x1,x2).. * p(xn/x1 to. Xn-1) Example CF0 = I = (-100000) Rf = 6 % = 0.06

Joint Probability Case

Year 1 Year 2 Year 2 Year 3 Year 3 CF JP (p(1,2,3) )

CF1 30000

P1 0.5

CF2 30000 40000

JP2/1 0.8 0.8 0.2 0.2

CF3 35000 40000 45000 50000 60000 70000 75000 90000

JP3/2,1 0.6 0.4 0.5 0.5 0.7 0.3 0.8 0.2 1 2 3 4 5 6 7 8 0.24 0.16 0.05 0.21 0.21 0.09 0.16 0.04

50000

0.5

50000 60000

0.6 0.4

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

CF 1 2 3 4

CF0 -100000 -100000 -100000 -100000

CF1 30000/1.06 30000/1.06 30000/1.06 30000/1.06

CF2 30000/1.062 30000/1.062 40000/1.062 40000/1.062

CF3 35000/1.063 40000/1.063 45000/1.063 45000/1.063

NPV -15612 -11414 1684 5882

JP 0.24 0.16 0.05 0.05

5
6 7 8

-100000
-100000 -100000 -100000

50000/1.06
50000/1.06 50000/1.06 50000/1.06

50000/1.062
50000/1.062 60000/1.062 60000/1.062

60000/1.063
70000/1.063 75000/1.063 90000/1.063

42046
50442 63540 76134

0.21
0.09 0.16 0.04

Decision Tree approach (cash flows from previous joint probability case)
CF JP NPV

Year 1

Year 2
30000(0.8)

35000(0.6)

1) JP 0.24 -15612

30000(0.5)

Year 3

45000(0.5)

40000(0.4)

2
4

0.16 0.05
0.05

-11414 1684
5882

50000(0.5)

40000(0.2)

50000(0.5)

50000(0.6)

60000(0.7) 70000(0.3)

5 6

0.21 0.06

42046 50442

60000(0.4)

75000(0.8)

0.16

63540

90000(0.2)

0.04

76134

analysis
The joint probability of the project having lowest NPV of -15612 is 0.24 The joint probability of the project having highest NPV of 76134is 0.04 The expected NPV of the project is +212702 Decision: select

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

 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), it would result in double counting of risk factor

Example
CF0 = 20000, rf = 0.06 ,

Year Year 1 Year 2 Year 3

CF 6000 4000 6000

Pi 0.3 0.2 0.3

CF 10000 8000 10000

Pi 0.4 0.6 0.4

CF 14000 12000 14000

Pi 0.3 0.2 0.3

Xi 10000 8000 10000

=-20000+10000/1.06+8000/1.062+10000/1.063 = +4948

 I2 = pi(xi-x1) = {*0.3*(6000-10000)2] +{[0.4*(10000-10000)2+{[0.3*(1400010000)2]} I2 = 9600000

 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, pay back period etc., Use of certainty index for scarce inputs Judgement based on three point estimates most likely, optimistic, pessimistic Subjective evaluation Question remains : what is the probability that NPV of a project are normally distributed ?

Case Study Airbus A3xx

? ? Project economics ? Break-even demand analysis ? required rate of return ? Realized price per plane ? Capacity to produce ? Market for VLA ? Boeings competitive response ? What happened ?

Sampa Video ,Inc

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

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, use the Capital Cash flow (CCF) approach to value the project. 6) How do the values from the APV,WACC and CCF approaches compare ? How do the assumptions about the financial policy differ across the three approaches? 7) Given the assumptions behind APV,WACC and CCF, when is one method more appropriate or easier to implement than the others ?

Case-Sampa Videos-All Equity Valuation of the Project

Assumptions : initial investment of 1,500,000 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 = 7.2 % Unlevered cost of equity = expected return of assets = (5%+ 1.5*7.2) = 15.8 % Value of unlevered firm = 1.228 M USD

Calculations
Interest tax shield = ITS =debt*tax rate*cost of debt/debt weightage = $750000 *0.40*6.8%/6.8% = $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= 6.8 %

 Beta of the firms 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%

 WACC = (0.25*6.8) + (0.75 * 18.8) = 15.12 % Required rate of return on levered equity using M&M proposition : Re = Ra + (D/E) * (Ra-Rd) = 18.8 %

 Value of the project with no debt = NPV = $1,228,500 Value of the project with 50% debt $750000 = NPV = $1,528,500 Value of the project with 25 % D/V forever = NPV = $1,470,000

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

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% 7.2
15.8 0.25 25% 6.8% 0.06 1.92 75% 18.8% 1.44

All equity Valuation

Item Free CF Discount Rate Discount PV of $1 factor Source 2002 E -112000 15.8% 0.864 2003 6000 15.8% 0.746 2004E 151000 15.8% 0.644 2005E 314000 15.8% 0.556 2006E 495000 15.8% 0.480 Terminal Value 4821500 15.8% 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

ALL Equity Terminal Value

= 2006E (estimated) cash flow , Grown by 5 % And discounted at R-g Where R is the appropriate discount rate (15.8%) And g is the growth rate (5%) = 495*1.05/(0.158-0.050) = 495*1.05/0.108 =4812.5 * 1000 $

WACC valuation with a target debt-tovalue ratio of 25 %

Item Free CF Discount Rate Discount C=PV of Factor $1 Source 2002E -112000 15.1% 0.869 2003E 6000 15.1% 0.755 2004E 151000 15.1% 0.655 2005E 314000 15.1% 0.569 2006E 495000 15.1% 0.495 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

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(15.1%) And g is the growth rate (5%) =495*1.05/(0.1512 -0.050) = 495 * 1.05 /(0.1012) =5135.9 ( including rounding-off error)

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% 20200

6.80% 40% 24000

6.80% 40% 27600

6.80% 40% 30700

6.80% 40% 33300

-112000

6000

151000

314000

495000

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+33.3 = 528.3 *1.05/(0.158-0.05) =528.3*1.05/0.108 = 5135.9*1000 $

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=(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

 For continuous pdf, you have to calculate by area , NOT by height Because, 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, the mean () or standard deviation (SD) are expected to be equal to 0 and 1 respectively In ANY normal distribution, we need parameters () and