Risk and net Present value

Topics: Corporate finance, Net present value, Stock Pages: 31 (7842 words) Published: May 11, 2005
Table of Contents

1.1 Introduction

1.2 NET PRESENT VALUE (NPV)

1.3 ADVANTAGES OF NPV

1.4 DISADVANTAGES OF NPV

1.5 PAYBACK

1.6 Arguments in favour of payback

1.7 Debt vs Equity

1.8 Equity equals Ownership (Share Profits and Control)

1.9 Debt: Money You Owe

2.0 ADVANTAGES OF DEBT COMPARED TO EQUITY

2.1 DISADVANTAGES OF DEBT COMPARED TO EQUITY

2.2 Managerial Ownership and Agency Costs

2.3 Concentrated Ownership and Agency Costs

2.4 Debt and Agency Costs

2.5 PECKING ORDER THEORY OVERVIEW

2.6 CAPITAL MARKET TREATMENT OF NEW SECURITY ISSUES

2.7 HOW PECKING ORDER IS SUPERIOR TO THE TRADE-OFF MODEL

2.8 LIMITATIONS OF PECKING ORDER THEORY

2.9 Hedging

3.0 The Hedging Problem

3.1 Hedging Objectives

3.2 Risk Engineering

3.3 Controlling the risk

3.4 Profit after tax (PAIT)

3.5 Diversification

3.6 Beta

3.7 Advantages of Beta

3.8 Disadvantages of Beta

3.9 Re-Assessing Risk

4.0 Bonds and Debentures

4.1 Interest Rates.

4.2 Supply and Demand.

4.3 Preference Shareholders

4.4 Portfolio theory

4.5 Options

1.1Introduction

Characteristically, a decision to invest in a capital project involves a largely irreversible commitment of resources that is generally subject to a significant degree of risk. Such decisions have far-reaching effects on a company's profitability and flexibility over the long term, thus requiring that they be part of a carefully developed strategy that is based on reliable appraisal and forecasting procedures.

In order to handle these decisions, firms have to make an assessment of the size of the outflows and inflows of funds, the life span of the investment, the degree of risk attached and the cost of obtaining funds.

One of the most important steps in the capital budgeting cycle is working out if the benefits of investing large capital sums outweigh the costs of these investments. The range of methods that business organisations use can be categorised in one of two ways: traditional and discounted cash flow techniques. Traditional methods include the Average Rate of Return and Payback; discounted cash flow (DCF) methods using Net Present Value and Internal Rate of Return.

1.2 NET PRESENT VALUE (NPV)

Net present value is a way of comparing the value of money now with the value of money in the future. A euro today is worth more than a euro in the future, because inflation erodes the buying power of the future money, while money available today can be invested and so grow.

The technique is a three-stage process:

"to calculate the present value of each element of cash expenditure in a proposal and then, to add these individual present values together to provide a total present value of the expenditures;

to similarly calculate the present value of each element of cash income in a proposal and, then, to add these individual present values together to provide a total present value of the incomes;

to deduct the total present value of expenditures from the total present value of the incomes, in order to determine the net present value"; Tinic, S. M., and West, R. R. (1986)

If this calculation produces an NPV that is positive, the signal is to accept the proposal. If, however the NVP is negative, the signal is to reject the proposal

1.3 ADVANTAGES OF NPV

There are two major advantages of NPV as a capital expenditure appraisal technique

it accurately recognises the "time value of money" for all expenditures or receipts - irrespective of the exact time at which they are made or received

it enables alternative proposals to be ranked in order of attractiveness

It recognises the "time value of money" by converting future expenditures and receipts to their corresponding present value on investment criteria, taking account of the exact date on which they are expected to be made or received

Alternative proposals can be ranked in order of attractiveness. This is important when considering...

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