Lectures so far…Weeks 4-6

Corporate objective = Maximise firm value

What you need to measure value?

– Type of cash flow

How to measure value?

– Bond value =

1

1 (1 r ) t

VB C

F r

1 r

– Timing of the cash flow

t – Riskiness of the cash flow

– Share value=

– Firm value =

– Project value =

Dn

P0 n n 1 1 R

Capital Budgeting: Evaluation

Step 1: Forecast cash flows

Ct

V t t 1 1 r

N

NPV t 1

Step 2: Determine risk of cash flows

Ct

1 r t

Step 3: Apply evaluation technique(s)

C0

Lecture 07

Step 4: Accept/reject proposal based on quantitative & qualitative analysis

1

Lecture 07

2

Lectures so far…Week 6

Incorporating risk (uncertain cash flows) into capital

budgeting analysis involves:

– applying techniques that assess the risk level of a project’s cash flows

Risk & Return

– using a risk-adjusted discount rate

RTBWJ Chapters 10 & 11

L7: Risk & Return

L8: Capital Asset Pricing Model

L9: Cost of Capital

Lecture 07

3

RETURNS ON INVESTMENT

When an investment is made, there is the expectation that this investment will generate positive returns.

There are two different ways of measuring the return generated by an investment

1.

Dollar Returns

2.

Rate of Return

Lecture 07

DOLLAR RETURNS

The dollar return is the difference between the amount you receive at the end of the investment and the amount initially invested. Dollar Return Amount Received

Amount Invested

5

Lecture 07

6

1

DOLLAR RETURNS (CONT.)

RATE OF RETURN

To fully understand this measure, you need two more pieces of information.

1.

The scale of the original investment.

2.

The length of time the investment has been held for.

A more useful measure is the rate of return:

Rate of Return

Dollar Return

Amount Invested

This gives a percentage answer which is much

easier to understand.

Lecture 07

7

DOLLAR VS RATE OF RETURN: EXAMPLE

Lecture 07

DOLLAR VERSUS RATE OF RETURN: EXAMPLE (CONT.)

A share investment costs $2 per share at the start of

Dollar Return

the year

Dollar Return Amount Received - Amount Invested

It is offering a year-end dividend of $0.20 and the

[$0.20 $2.50] - $2.00 $0.70

year–end share price is expected to be $2.50

What is your investment return if held for a year, in dollar and percentage terms?

Percentage Rate of Return

Rate of Return

Lecture 07

8

Dollar Return

Amount Invested

$0.70

0.35 or 35%

$2.00

9

Lecture 07

RETURNS AND RISK

RISK

Returns are closely related to risk.

– Investments are only undertaken if the expected return is high enough to compensate the investor for the perceived risk of the investment. Risk can be considered in different ways:

– Stand-Alone Risk. This is the level of risk when the asset / investment is considered alone

10

– Risk on a Portfolio Basis. The level of risk when the asset is just one of a number of items in a portfolio.

Risk is defined as:

– The possibility of exposure to loss or injury.

– Uncertainty regarding the outcome.

Lecture 07

11

Lecture 07

12

2

MEASURING RISK

Risk is often measured using probability.

A probability distribution is a list of all the possible outcomes and the probability that each will occur.

Probabilities can also be used to create a Payoff Matrix which associates probabilities with rates of return

Lecture 07

Economy

n

kˆ P1k1 P2 k 2 ... Pn kn Pi ki

Expected

rate of return

Probability of outcome n 0.2

Average

0.4

Above Ave

0.2

8%

Boom

0.1

8%

kˆ

-22%

22%

28%

10%

8%

-2%

14.7%

45%

1%

8%

20%

0%

7%

15%

35%

-10%

-10%

29%

50%

-20%

30%

43%

8%

17.4% 1.74% 13.8%

Lecture 07

-13%

13%

Below Ave

0.2

8%

-2%

14.7

%

45%

1%

Average

0.4

8%

20%

0%

7%

15%

Above Ave

0.2

8%

35%

-10% -10%

29%

Boom

0.1

8%

50%

-20%

43%

Total

1.0

30%

14

Using Equation we can calculate the expected rates of return

for