This document provides an overview of the topics covered in the Advanced Financial Management unit. It discusses appraising risky investments using risk-adjusted discount rates and certainty equivalents of cash flows. Other topics include sensitivity analysis, simulation methods like Monte Carlo simulation, and using decision trees to evaluate investment decisions under uncertainty. Real options, which provide flexibility to modify projects over time, are also introduced.

1. CORPORATE FINANCE
UNIT 3: ADVANCED FINANCIAL
MANAGEMENT
SUBJECT CODE: 8014
Prepared and Presented by,
N. Ganesha Pandian
Reference:
1. Financial Management – MY Khan and PK
Jain
2. Corporate Finance – Richard A Brealey,
Stewarts C Myers, Franklin Allen, Pitabas
Mohanty
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2. UNIT 3: ADVANCED FINANCIAL MANAGEMENT
 Appraisal of risky Investments
 Certainly equivalent of cash flows
 Risk adjusted discount rate
 Risk analysis in context of DCF methods using
probability information
 Nature of cash flows
 Sensitivity analysis
 Simulation and investment decisions Decision tree
approach in Investment decisions
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3. APPRAISAL OF RISKY INVESTMENTS
 Risk –return - risk adjusted for risk in capital
budgeting
 Company’s cost of capital benchmark – risk
adjusted discount and rate for new investment
 Risky projects – more opportunity cost
 Less risky – less opportunity cost
 Company’s cost of capital otherwise called as
Weighted cost of capital (WACC)
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Contd…

4.  WACC – Average rate of return demanded by
investors in company’s equity and debt
 Cost of equity computation is complicated – CAPM
(Capital Asset Pricing Model) is used
 CAPM – expected rate of return equals the risk free
interest rate plus a risk premium depends on beta
(B) factor (i.e.) Market risk premium
 Risk varies from project to project and also over the
period of time
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5. COMPANY AND PROJECT COST OF CAPITAL
 The company cost of capital - defined as the expected
return on a portfolio of all the company’s existing
securities
 The company cost of capital is not correct discount rate
if the new projects are more or less risky than the firm’s
existing business
 So each project should be evaluated with its own
opportunity cost of capital
 Value additive principle
Firm value = P(AB) = P(A)+P(B)
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6. DEBT AND THE COMPANY COST OF CAPITAL
 As we know company cost of capital – “expected return on a portfolio of all the
company’s existing securities”
 Blend of cost of debt and cost equity. The cost of debt is otherwise called
“Interest rate”
 So D+E = V
D- debt E- Equity V –Value of firm
 The market value of equity is often much larger than the book value, so the
market debt ratio D/V is often much lower than computed book value
 The cost of debt is less than company’s cost of capital, because the debt is safer
than assets
 Company cost of capital (WACC) = rd D/V + re E/V
Tc – Corporate tax
After tax WACC = (1-Tc) rd D/V + re E/V
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7. MEASURING THE COST OF EQUITY
 The cost of equity is greater than the company cost of
capital and the equity is not a direct claim on the firm’s
free cash flow, it is residual claim after debt
 Estimate cost of equity re by using CAPM
Expected stock return = rf + B(rm–rf )
Rf = Risk free return
Rm = Market risk
B = Beta risk factor
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8. ESTIMATING BETA
 We are interested in future Beta of the company’s stock.
So we use historical data to forecast it
 R- squared (R2) measure the proportion of the total
variance in the stock’s return than can be explained by
market movements
 There are three types of Betas:
1. Company Beta
2. Industrial Beta
3. Asset Beta
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9. EXAMPLE PROBLEM
 Jet Airways decide to use a market risk premium of
12% and risk free rate of 7.4% and if Beta factor is
1.67, then find out the cost of equity.
Answer:
Cost of equity = Expected return = rf + B(rm–rf )
=7.4+(1.67*12)
= 27.44%
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10. DETERMINANTS OF ASSET BETA
1. Cyclicality:
Strength of the relationship between the firm’s
earnings and the aggregate earnings on all real
assets. We can measure this either by the
earnings beta or by the cash flow beta
- Firms whose revenues and earnings are strongly
dependent on the state of business cycle – tend to
be high beta firms
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Contd…

11. 2. OPERATING LEVERAGE
 A production facility with high fixed costs, relative to
variable cost is called “High operating leverage”
 Cash flow generated by assets can be written as,
Cash flow = revenues – fixed cost – variable cost
Present value,
PV (Cash flow) = PV (revenues) – PV(FC) – PV (VC)
(Or)
PV (revenues) = PV (cash flow) – PV (FC) – PV (VC)
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Contd…

12.  So the Beta of PV revenue is a weighted average of
the beta of its components parts
B rev = B FC [ PV(FC)/PV(R) ] +B vc [ PV(VC)/PV(R) + B assets
[ PV(assets)/PV(revenue) ]
So, B assets = B rev [1+ PV(FC)/PV(assets)]
These cyclicality of revenues, the asset B is proportional to the
ratio of PV(FC) to PV of project
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13. 3. ALLOWING FOR POSSIBLE BAD OUTCOMES
 Project z - product one cash flow - forecasted 1million a year
at a discounting 10% cost of capital
 So PV = C1/(1+r) = 1,000,000/(1+1/10) = 909,100
 The above cash flow is unbiased fore casts
 But in reality the forecasts turned to be high, other time low or
the same, but their errors average out over many projects
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Possible
cash flow (in
millions)
Probability Probability
weighted
cash flow
Unbiased
forecast
High 1.2 0.25 0.3
1 millionSame 1.0 0.5 0.5
Low 0.8 0.25 0.2

14. CERTAINTY EQUIVALENTS –ANOTHER WAY TO
ADJUST FOR RISK
 Capital Budgeting – a simple risk adjusted rate is
used to discount all future cash flows.
 -basic assumption that risk doesn’t change over
time and remains constant
 But in reality, it is not true and risk change over the
period of time
 So by converting the expected cash flows into
certainty equivalents of cash flows
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15. VALUATION OF CERTAINTY EQUIVALENTS
 Assuming that an office building constructed for Rs.
4,20,000 and which you are going to sell after 1 year
then the expected future cash flow with 12% is
PV = 4,20,000/1.12 = Rs. 3,75,000/-
 But if the cash flow fixed at the beginning if Rs.
393,750/- then the amount is certainty equivalent and
discount rate is 5% then
PV = 3,83,750/1.05 = Rs. 3,75,000/-
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16.  So, PV = C1/(1+r) = CEQ1(1+rf ) (for one year)
 PV = Ct/(1+r)t = CEQt(1+rf )t (for ‘t’ years)
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Discount for time and
risk
Future cash
flow C1
Hair cut for risk
Discount for
time
Present Value

17.  Single risk adjusted rate can be used for the uncertain cash flows
in future
 But when using an option’s risk which is continually changing and
here you can’t use single risk adjusted risk rate
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Year Forecasted
cash flow
Certainty
equivalent
cash flow
Deduction
for risk
PV at 6%
1 100 94.6 5.4 89.3
2 100 89.6 10.4 79.7
3 100 84.8 15.2 71.2

18. PROJECT ANALYSIS
 Managers use sensitivity analysis, breakeven analysis and Monte Carlo
simulation to identify the crucial assumptions in investment proposal and
to explore what can go wrong.
 Wise manager look for the ways to capitalize on success and to reduce
the cost of failure
 The investment process starts with the preparation of capital budget.
Sometimes inconsistent assumptions often creep into expenditure plans.
 There should be correlation between the capital budgeting and strategic
management process
 A Firm’s capital investment choices should reflect both bottom up and top
down views of business – capital budgeting and strategic planning
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19. MSMMBA-CF2019

20. THE PROBLEM OF BIASED FORECASTS
 Most people tend to be overconfident when they
forecast. But in reality, 80% of time unexpected will
only happen and only 20% of time things will
happen as expected
 This will cause bias. It is probably impossible to
completely. But can be avoided while making any
estimations
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21. POST AUDITS
 Most firms keep a check on the progress of large
projects by conducting post audits shortly after the
projects have begun to operate
 Post audit identify the problems that need fixing and
check the accuracy of forecasts
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22. SENSITIVITY ANALYSIS
 In this analysis, unidentified variables, which were
not included in the project to be identified
 Sensitivity analysis should be identified for market
size, market share and so on…
 The department staffs would prepare 3 possible
values pessimistic, optimistic and expected
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Contd…

23.  Pessimistic value is 1.09 billion as compared to
expected value 1.3 billion. So the manager can take
decision what if things go wrong
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Invested
Pessimistic
8%
Expected
10%
Optimistic
12%
15,000,000 1,200,000 1,500,000 1,800,000
NPV at 10% 1,09,909 1,363,636 1,636,363
Cash flow
Contd…

24. CASH FLOW CAN BE FURTHER BROUGHT DOWN AS:
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Year0 Year (1-10) (in billions)
1.
Investment
-15
Expected Optimistic Pessimistic
2. Revenue 20 22 18
3. Variable
cost
12 12.7 11.3
4. Fixed cost 6 7 1.7
5. Tax 0.5 0.5 0.5
Cash flow
(Net profit)
1.5 1.8 1.2
Net present
value (NPV)
1.09 1.3 1.6

25. LIMITS TO SENSITIVITY ANALYSIS
 It is expressing cash flows in terms of key project variables
and then calculating the consequences of Mis-estimating the
variables.
 But the terms “optimistic”, “pessimistic” is not clearly
understood and different people may hold different
perception
 So the forecasts may go wrong when it is not clearly
predefined
 The underlying variables such as revenue, variable cost and
fixed cost can’t be forecasted in isolation. They are strongly
interrelated to one another
 Total project cash flow estimation can’t project the exact
value of underlying variables
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26. SCENARIO ANALYSIS
 In order to make the words “optimistic” and “pessimistic”
more meaningful be relating to the scenario.
 If the variables are interrelated, it may help to consider
some alternative possible scenario
 For example, impact of oil prices increase in recessions
 Manager find “Scenario analysis” helpful. It allows them
to look at different but consistent combination of
variables
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27. BREAK EVEN ANALYSIS
 Sensitivity analysis alone doesn’t help the
managers to select the project
 Break-even analysis used by managers to know
how much units to be produced to make profit and
a favorable NPV.
 A project that breaks even in accounting terms will
surely have negative NPV
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Contd…

28. EXAMPLE: IF INVESTMENT 15 MILLION AT 10%
DISCOUNTING (IN MILLIONS)
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Unit sales
(thousands
)
Revenue
Variable
cost
Fixed cost Cash flow
Newt
present
Value
(NPV)
0 0 0 3 -3 -2.72
100 35 30 3 2 1.81
200 69 60 3 6 5.45
Contd…

29. BREAK EVEN CHART
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0
10
20
30
40
50
60
70
80
0 100 200
Revenue
Variable cost
Fixed cost
Profit area

30. OPERATING LEVERAGE AND THE BREAK EVEN
POINT
 A project’s break even point depends on the extent to which
its cost vary with the level of sales
 A business with high fixed cost – High operating leverage
 So, operating leverage is defined in terms of accounting
profits rather than cash flows and measured by percentage
change in profit impacted by the change in sales of 1%
increase. This is called DOL (Degree of leverage)
DOL = Percentage change in profits/percentage change in sales
DOL = 1+fixed costs/profits
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31. MONTE CARLO SIMULATION
 Sensitivity analysis allows you to consider the effect
of changing one variable at a time.
 Monte Carlo simulation is a toll for considering all
possible combinations. So it enables a manager to
inspect the entire distribution of project outcomes
 The application of Monte Carlo simulation in capital
budgeting follows the steps:
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Contd…

32. THE STEPS FOLLOWED IN SIMULATION ARE:
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Step 1:
• Model the project
Step 2:
• Specify the probabilities of
forecast errors
Step 3:
• Select numbers for forecast
errors and calculate cash flows

33. MONTE CARLO SIMULATION STEPS
Step 1: Modeling the project
The first step in any simulation is to give the computer a
precise model of the project
The model consists of various important variables
impacting the capital budgeting decisions.
Step 2: Specifying probabilities:
There should be some errors in fore casting of cash flow
to be estimated its probabilities
The manager need to draw up similar estimates of the
possible forecasting error for each of other variables to be
identified
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34.  Step 3: Simulate the cash flows
The computer now samples from the
distribution of the forecast errors, calculates the expected
cash flows depends on the extent of the robust model
 Step 4: Calculate Present value
The distribution of project cash flows should
allow mangers to calculate the expected cash flows more
accurately
The final step - need to discount these
expected cash flows to find the present value
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35. MERITS AND LIMITATIONS OF MONTE CARLO
SIMULATION
1. Simulation techniques, complex yet forecaster to overcome the problem of
uncertainty and interdependencies
2. Once the simulation model setup, it is easy to calculate the principal sources
of uncertainty in cash flows
3. The manager can explore the possible changes in modification of the project
model
4. Even though it provides solution, simulation techniques carry many
limitations
5. It is extremely difficult to estimate inter-relationships between the variables
and the underlying probability distributions
6. A simulation model that attempts to be realistic will also be complex
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36. REAL OPTIONS AND REAL DECISION TREES
 When the DCF (Discounted cash flow) used to value a
project, the implicit assumption that the firm hold the
asset passively.
 But in reality, the project may be modified in future when
things go wrong
 The Monte Carlo simulation and sensitivity analysis
does not check the flexibility of the project
 Option to modify projects are known as “Real option” in
other words intangible advantages
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37. THE OPTION TO EXPAND
 Decision tree analysis – provide the knowledge
about the flexibility of project before the
commencement
 For example, when designing a factory, it can make
sense to provide extra land or floor space to reduce
the future cost of a second production line.
 When building a four-lane highway, it may pay to
build six lane bridges – so road can be converted to
six lanes in future in case of high traffic
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38. THE OPTION TO ABANDON
 The option to expand can be estimated and has a
value. But what if project fails
 Now the question that decision to abandon the
project and bail out has less impact
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39. SIMPLE DECISION TREE
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Acquire option
Observe
growth
In demand
High demand
Low demand
Option to expand
Option to abandon

40. A DECISION TREE FOR PHARMACEUTICAL
R&D
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Invest
18
million ?
Success
44%
Failure
56%
PV=0
Learn
potential
PV
25%
25%
50%
Invest 130?
Invest 130?
Invest 130?
NPV=+295
NPV=+52
Stop
NPV=0
Success 80%
Success 80%
Success 80%
Failure 20%
Failure 20%
Failure 20%
Upside PV =700
Most likely PV =300
Downside PV =100

41.  In the given example, the illustration of upside PV=+295
and the probabilities of success and failure, so we can
continue the procedure
 If most likely NPV=+52 and with probabilities 80% and
20% still can proceed
 But NPV = 0, se we can stop and abandon the project
 Decision tree does have pros and cons. It is the
simplified version of reality
 It displays the link between today’s decision and
tomorrow’s decision, which help finance manager to find
strategy with high NPV. But the real life is more complex
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