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Jamal Munshi, Sonoma State Univesity, 1992 | ||
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The uncertainty in sales projection causes uncertainties in NCF values and therefore, an uncertainty in the net present value of the project NPV. The degree to which this affects risk depends on two variables: (a) project risk, the standard deviation of the project NPV and (b) correlation, the degree to which the sales projections are correlated with those of the firm as a whole. If the project is an expansion of the firm's existing business, then the sales are likely to be highly correlated (rifÅ1), i.e., when the firm does poorly, the project is also expected to do poorly and when the firm does well, the project also does well. If the project is a venture into a different kind of business as in diversification, then the project may be only weakly correlated with the firm's business (rifÅ0), i.e., when the firm performs poorly, the project is as likely to do well as poorly since its perfomance is not correlated with that of the firms's. Equations
Evaluation Without Portfolio Effect When portfolio effects are not taken into consideration, then the riskiness of the project can be evaluated on the basis if its total project risk si. The probability that mi will be negative will correspond to a z-value given by: zi = mi/si Evaluation With Portfolio Effect Consider the firm to be a portfolio of correlated projects. We are now considering adding the i-th project whose correlation to the existing firm's NPV is known. The project is chosen for inclusion into the firm based on the the increase in the overall NPV and riskiness of the firm. The probability that mp will be negative corresponds to the z-value: zp = mp/sp Between two mututally exclusive projects A and B, the one with the higher z value will be preferred since it offers a lower probability that the NPV of the combined firm will be negative. Acquisitions of other firms may be treated as projects and evaluated in this manner. Example Problem: Three mutually exclusive projects have the characteristics shown below. Our existing assets offer an expected NPV of $203 with a standard deviation of $145. Which project would you choose if risk is not to be taken into account? Ignoring portfolio effects, but taking risk into account, which of the projects is most desirable and why?? If portfolio effects are considered, which should be selected? Why?
Solution if project risk is not considered Choose the project with the highest NPV. Choose C since 33 gt 32 and 33 gt 19 Solution if correlations are not considered but portfolio effects are ignored The projects are evaluated on the basis of project risk si as folows:
Solution if correlations are considered
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