examen Flashcards

Question

Explain real options.

Answer 1

Real options are extra value to a project that occurs as possible adjustments after the project is initiated. It is important to include in a project's evaluation, since it will only provide a positive (or at least = 0) addition to the project's value. Real option = NPV with flexibility - NPV without flexibility The flexibility may be the option to: - Abandon - Expand - Delay

Answer 2

Monte Carlo algorithm: 1.Identify NPV-formula and dependent variables - 2. Estimate/assume probability distributions for dependant variables - 3. Draw random numbers from probability distribution in (2). Calculate NPV. - 4. Repeat (3) for a number of times (e.g. 10 000 times). - 5. Sort results from (4) and construct the simulated NPV probability distribution. - Advantages: Possibility to define advanced/complex NPV-estimations, and include correlation. - Disadvantages: Relies on correct probability distribution in (2). May become too complex. Time consuming.

Answer 3

The CAPM-model estimates the return of an asset by using the covariation between the market return and the asset return compared to variations in the market. This provides us with Beta which allow us to adjust the expected market risk premium with the relative riskiness of the asset. - A beta = 2 indicates that the asset is twice as risky compared to the market, and consequently the investors require twice the expected return.

Answer 4

NPV discounts all cash flows and compare future cash flows with the initial investment. If NPV > 0 then project is profitable. Important to use correct discount rate which should reflect level of risk associated with project. High discount rate = high risk. IRR is the discount rate where NPV = 0. This can then be compared to the company's or project's discount rate r. If IRR > r then project is profitable since NPV @r > 0. Has 3 pitfalls: scaling, timing and borrowing/lending. IRR and NPV is often used together.

Answer 5

Risk aversion considers how an agent values risk. In general investors consider safe cash flows more valuable than uncertain cash flows. However, a risk lover (gambler) would prefer the extra uncertainty and perhaps the opportunity to win big over certainty and the possibility of a small safe bet. The opposite is true for a risk averse person. Finally, a risk neutral person would make decisions based only on the expected cash flow.

Answer 6

Sensitivity analysis compares the outcome of a project by varying the value of one input at a time. E.g. a project that is dependent on oil price and construction cost, may choose to do sensitivity analysis by varying the oil price by +/- 10% and 20% or vary the construction cost by +/- 10% and 20%, and study how the NPV of the project varies as the input varies. Major disadvantage is that we only vary one variable at the time, while there is a chance many of the variable may experience changes at the same time due to correlation. Moreover, we do not know what change is more likely, e.g. is a reduction in oil price by 20% equally probable as a 10% increase in construction cost?

Answer 7

And calculates the expected return of an asset i by using a risk premium against the market and the risk associated with the market, as defined by Beta. A Beta of 2 means that the asset is twice as risky as the market, and with a 10% increase (decrease) in the market the asset will increase (decrease) with 20%.

Answer 8

The opportunity cost of capital is the expected rate of return investors could earn in financial markets at the same level of risk as the asset to be valued.

Answer 9

CAPM describes the relationship between risk and the expected return. (formel 1) rA is the return for the asset, which depends on the time value of money (risk free interest rate, rf) and the asset specific risk. This asset specific risk is represented by the other half of the formula: Beta*(rM-rf), where rM-rf is called the market risk premium. The asset specific risk represents how much the investor must be compensated when investing in the asset (compared to a risk-free investment and the market premium). CAPM explains the risk/return trade-off: Higher risk = Higher returns. - - Beta represents the relative riskiness of an asset to the market: (formel 2) A beta bigger than 1 represents an asset which is riskier than the market. A beta smaller than 1 represents an asset which is less risky than the market. In CAPM beta is the only risk the investor should receive an expected return higher than the risk-free interest rate. CAPM assumes that investors have the same information and expectations.

Answer 10

- The Weighted Average Cost of Capital (WACC) is one of the key inputs in discounted cash flow (DCF) analysis and is frequently the topic of technical investment banking interviews. - The WACC is the rate at which a company’s future cash flows need to be discounted to arrive at a present value for the business. It reflects the perceived riskiness of the cash flows. - Put simply, if the value of a company equals the present value of its future cash flows, WACC is the rate we use to discount those future cash flows to the present.

Answer 11

Notice in the Weighted Average Cost of Capital (WACC) formula above that the cost of debt is adjusted lower to reflect the company’s tax rate. For example, a company with a 10% cost of debt and a 25% tax rate has a cost of debt of 10% x (1-0.25) = 7.5% after the tax adjustment. That’s because the interest payments companies make are tax deductible, thus lowering the company’s tax bill. Ignoring the tax shield ignores a potentially significant tax benefit of borrowing and would lead to undervaluing the business.

Answer 12

MM I without taxes states that the company value is indifferent to how the company is financed, however MM II notes that the risk is increasing with increasing debt levels. However, this gearing also provides a higher expected return to equity holders. With taxes, MM I advices to take on as much debt as possible due to the extra value added from the tax shield. The same tax shield reduces some of the risk, but risk still increases with increasing debt levels according to MMII.

Answer 13

Real options to consider is: - Expand - Abandon - Delay - Synergy/cannibalism

Answer 14

A risk averse individual or firm dislikes risk. It will accept a smaller amount of money with certainty than the amount that it could expect to receive in a gamble (i.e. expected wealth, E(W)). For a risk averse individual this means that the certainty equivalent wealth would be less than the expected wealth associated with the gamble (see answer to question c). In mathematical terms the von Neumann-Morgenstern utility function of a risk averse individual has a negative second derivative, i.e. U''(W)<0.

Answer 15

IRR has 4 pitfalls: - Multiple IRRs - Borrowing/lending - Scaling - Timing Can use incremental IRR to counter scaling issues.

Answer 16

Projects A and B are preferred by a risk neutral investor. Project B is preferred to project C by a risk averse investor, but one need more information on risk preferences to determine if A or B is preferred.