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Mmi finance 4

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  • Answer: NO, the PV of 91.000 EUR next year is 82.727 today, less than 85.000
  • Transcript

    • 1. Chapter IV INVESTMENT RISK ANALYSIS
    • 2.
      • PRINCIPLE: “A dollar today is worth more than a dollar in the future”, vecause:
      • Inflation reduces the purchasing power of future money relative to current ones
      • The uncertainty of actually receiving the money as the date of receipt recedes into the future
      • The money today can be productively invested and will grow into the future
      Time Value of Money
    • 3.
      • Future value of an investment
      • FV = C x (1+r) t
      • Where C is cash flow, r is interest rate and t is time
      • Example: if you deposit 100 eUR into a saving account that gives 10% interest and you keep it there for 2 years, you will get 121 EUR
      • Present value of a project C PV =
      • (1+r) t
      • Exercice: you are recommended to invest in a magazine 85.000 EUR. You are certain thet the next year the magazine will worth 91.000 EUR. Given the discount rate of 10%, should you undertake this investment?
      Time Value of Money
    • 4.
      • How to decide if a particular project/investment is worth to be accepted?
      • While PV presents the value of a project in today’s term, it is not the gain you make. The amount that you can actualy pocket is called the NET PRESENT VALUE
      • NPV is the project’s net contribution to wealth
      • NPV is the measure of how much value is created or added by undertaking the investment
      • NPV = PV – Initial cost of investment
      • If NPV > 0 then the project is worth undertaking and should be accepted
      • IF NPV<0 then the project should be rejected
      Net Present Value of an Investment
    • 5.
      • NPV = -C 0 + Σ C t
      • t=1 (1+r t ) t
      • C 0 is negative because is usualy a cost (initial cash outlay)
      • C t are the PV of all cash flows
      • (1+r t ) t
      • EXERCICE
      • What is the NPV of following cash flow stream if the discount rate is 6% and the cash outlay is 5600 EUR?
        • Y1: 2000 EUR
        • Y2: 4000 EUR
        • Y3: 6000 EUR
      Net Present Value of an Investment
    • 6.
      • TEST: Which of the following investment opportunities do you prefer?
      • You pay 10.000 EUR today and flip a coin in one year to determine whether you will receive 50.000 EUR or pau another 20.000 EUR
      • You pau 10.000 EUR today and receive 15.000 EUR in one year
      • If your chice is 2, join the crowd; you are risk averse; studies indicate that most people prefer certainty of option 2. The presence of risk reduces the value of 1 relative to 2
      Are you RISK Averse?
    • 7.
      • Example
      • Investing in the ice cream stand isrisky, since the investor stands to make 60% return if it is sunny, but lose 20% if it rains
      • Investing in the umbrella shop is also risky, investor loosing 30% if tomorrow is sunny but make 50% if it rains
      • Despite that these 2 investments are risky viewed isolated, they are not risky as part of a portfolio. Regardless of the weather tomorrow, the outcome is a certain 15%
      RISK and diversification Investment Weather probability Return on investment Outcome Ice cream stand Sun 0.5 60% 30% Rain 0.5 -20% -10% 20% Umbrela shop Sun 0.5 -30% -15% Rain 0.5 50% 20% 10% Portfolio: Sun 0.5 15% 7.5% Stand and umbrela shop Rain 0.5 15% 7.5% 15%
    • 8.
      • An asset’s rosk in isolation is greather than its risk as part of a portfolio, even if the asset and the portfolio are not perfectly correlated
      • Total risk = Systematic risk + Unsystematic risk
      • Systematic risk reflects exposure to economywide events: interest rate changes, business cycles, and cannot be reduced by diversification
      • Unsystematic risk reflects investment specific events: fires, lawsuits, which can be eliminated by diversification
      RISK and diversification
    • 9.
      • 3 techniques:
      • Sensitivity analysis – involves an estimation of how the investment’s figure of merit (NPV) varies with changes in one of the uncertain economic factors that it depens on, such as: price, sales, etc. one approach is to calculate three returns coresponding to an optimistic, a pessimistic and a most likely forecast for the uncertain variables.
      • Scenario analysis – is a modest extension that changes several of the uncertain variables in a mutually consistent way to describe a particular event
      • Simulation – is an extension of 1 and 2, in which the analyst assigns aprobability distribution to each uncertain factor. For each set of values the computer calculates particula outcome
      Estimating Investment RISK
    • 10.
      • Example – sensitivity analysis:
      • Relative impact of key variables on NPV (Investment NPV=21.259 EUR)
      • Out of the 5 variables tested, the NPV is most sensitive to changes in the projected profit margin and sales growth rate.
      • This suggests that management would be smart to pay special attention to their estimates of these 2 variables, and once the investment is undertaken, to manage these quantities closely.
      Estimating Investment RISK A 1% increase in: Increase NPV by: % increase Sales growth rate 2240 10.5% Operating profit margin 2462 11.6% Capital investment -1249 -5.9% Working capital investment -1143 -5.4% Discount rate -1996 -9.4%

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