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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
• Mmi finance 4

1. 1. Chapter IV INVESTMENT RISK ANALYSIS
2. 2. <ul><li>PRINCIPLE: “A dollar today is worth more than a dollar in the future”, vecause: </li></ul><ul><li>Inflation reduces the purchasing power of future money relative to current ones </li></ul><ul><li>The uncertainty of actually receiving the money as the date of receipt recedes into the future </li></ul><ul><li>The money today can be productively invested and will grow into the future </li></ul>Time Value of Money
3. 3. <ul><li>Future value of an investment </li></ul><ul><li>FV = C x (1+r) t </li></ul><ul><li>Where C is cash flow, r is interest rate and t is time </li></ul><ul><li>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 </li></ul><ul><li>Present value of a project C PV = </li></ul><ul><li>(1+r) t </li></ul><ul><li>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? </li></ul>Time Value of Money
4. 4. <ul><li>How to decide if a particular project/investment is worth to be accepted? </li></ul><ul><li>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 </li></ul><ul><li>NPV is the project’s net contribution to wealth </li></ul><ul><li>NPV is the measure of how much value is created or added by undertaking the investment </li></ul><ul><li>NPV = PV – Initial cost of investment </li></ul><ul><li>If NPV > 0 then the project is worth undertaking and should be accepted </li></ul><ul><li>IF NPV<0 then the project should be rejected </li></ul>Net Present Value of an Investment
5. 5. <ul><li>NPV = -C 0 + Σ C t </li></ul><ul><li>t=1 (1+r t ) t </li></ul><ul><li>C 0 is negative because is usualy a cost (initial cash outlay) </li></ul><ul><li>C t are the PV of all cash flows </li></ul><ul><li>(1+r t ) t </li></ul><ul><li>EXERCICE </li></ul><ul><li>What is the NPV of following cash flow stream if the discount rate is 6% and the cash outlay is 5600 EUR? </li></ul><ul><ul><li>Y1: 2000 EUR </li></ul></ul><ul><ul><li>Y2: 4000 EUR </li></ul></ul><ul><ul><li>Y3: 6000 EUR </li></ul></ul>Net Present Value of an Investment
6. 6. <ul><li>TEST: Which of the following investment opportunities do you prefer? </li></ul><ul><li>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 </li></ul><ul><li>You pau 10.000 EUR today and receive 15.000 EUR in one year </li></ul><ul><li>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 </li></ul>Are you RISK Averse?
7. 7. <ul><li>Example </li></ul><ul><li>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 </li></ul><ul><li>Investing in the umbrella shop is also risky, investor loosing 30% if tomorrow is sunny but make 50% if it rains </li></ul><ul><li>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% </li></ul>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. 8. <ul><li>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 </li></ul><ul><li>Total risk = Systematic risk + Unsystematic risk </li></ul><ul><li>Systematic risk reflects exposure to economywide events: interest rate changes, business cycles, and cannot be reduced by diversification </li></ul><ul><li>Unsystematic risk reflects investment specific events: fires, lawsuits, which can be eliminated by diversification </li></ul>RISK and diversification
9. 9. <ul><li>3 techniques: </li></ul><ul><li>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. </li></ul><ul><li>Scenario analysis – is a modest extension that changes several of the uncertain variables in a mutually consistent way to describe a particular event </li></ul><ul><li>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 </li></ul>Estimating Investment RISK
10. 10. <ul><li>Example – sensitivity analysis: </li></ul><ul><li>Relative impact of key variables on NPV (Investment NPV=21.259 EUR) </li></ul><ul><li>Out of the 5 variables tested, the NPV is most sensitive to changes in the projected profit margin and sales growth rate. </li></ul><ul><li>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. </li></ul>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%