ABOUT THIS CONTENTNotes from various chapters in the core finance textbook, Financial Management, Concepts and Applications by Ramesh K.S. Rao.
Source: Financial Management, Concepts and Applications by Ramesh K.S. Rao
- Sensitivity analysis aids managers because it enables them to conduct “what-if’ scenarios for projects. This is important because expected cash flows are uncertain, and deviations in CFAT variables from their expected values can have varying degrees of influence on a project’s NPV. By looking at various potential outcomes, the manager is more informed about potential outcomes other than the expected outcome and can use the information to gain comfort about or otherwise reject a positive NPV project.
- Sensitivity analysis is advantageous for the reasons mentioned above, and it is relatively easy to perform. Disadvantages include its vagueness regarding optimistic or pessimistic scenarios, ignorance of potentially interrelated variables, and the inability to examine several scenarios simultaneously.
- Computer simulation is a computerized way of performing complicated sensitivity analysis. With the power of the computer, many more scenarios can be run (simultaneously if desired), providing a deeper analysis of the project.
- Disadvantages of computer simulation are primarily its expense, both in monetary terms and in time. Many simulation models are also often difficult to build. May not be suitable for a small company and most cost-effective for large projects at large companies.
- The logic underlying the WACC approach is that any project must return at least what it cost to obtain the funds to enter the project.
- The primary difficulty in calculating the cost of debt is bankruptcy risk and determining the appropriate interest rate that takes into account expected default or other non-compliance. It is assumed for practical purposes that the interest rate on the debt has been properly “bid-up” by the market and therefore takes those things into account.
- The WACC approach is considered company specific because it uses the company to determine the discount rate. This implicitly assumes that the cash flows for the project will be similar in nature to the company’s own cash flows – and therefore the risk associated with the project is based on the risk of the company considering the project.
- In its true form, the NPV calculation is based on the RRR, or opportunity cost, of the company, which may or may not be its WACC and certainly is not dependent on its cost of debt or equity. As such, WACC is often considered to be inconsistent with opportunity cost itself and as it relates to the NPV calculation.
- It is appropriate to use WACC in “scale-enhancing” projects because only in such projects are the future cash flows reasonably similar in nature the company’s current cash flows. It also might be acceptable in projects that were very similar to “scale-enhancing.”
- The Adjusted Present Value (APV) approach is designed to take into account the effects of subsidized financing of projects. In this three-step process, the equity-only NPV is calculated, and then to that the NPV of any flotation costs are added, along with the NPV of any subsidized debt financing.
- The major problem with implementing the APV approach is determining the appropriate beta to use when calculating the un-leveled cost of equity to be used in the equity-only discounting of future cash flows. Because projects deal with asset values, for which limited historical information generally exists, it is often impossible to calculate betas for the project (assets) based on historical figures (like can be done with securities).
- If historical information is available, project betas can be calculated in the same manner as company betas using regression analysis by comparing historical returns on assets vs. the market.
- A pure-play method is used when historical information about a project (its assets) is not available, and the project is not scale-enhancing in nature.
- The logic underlying the pure-play method is that companies or industries engaged full-time in the type of project under consideration have cash flows similar in nature and risk to the expected cash flows on the project. Therefore the risk, expressed as beta, for that company should approximate the risk for its underlying cash flows and therefore the risk for such a project.
- An adjustment is usually required to the pure-play’s beta value to account for leverage. Pure-play’s are usually not leveraged in the same manner as the company doing the capital budgeting. To get a true (all-equity) beta for the project, which is independent of the means of financing used for the project (or by the pure-play), the beta must be stripped of its financial risk components so that all that is left is the pure equity (market) risk.