1 Financiering Jeroen E. Ligterink 2001

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4 BMM 8: Topics Covered How Firms Organize Their Investment Process Some “What If” Questions  Sensitivity Analysis  Break Even Analysis Flexibility in Capital Budgeting  Decision Trees  Options

5 Capital Budgeting Process Capital Budgeting Problems  Consistent forecasts  Conflict of interest  Forecast bias  Selection criteria (NPV and others)

6 How To Handle Uncertainty Sensitivity Analysis - Analysis of the effects of changes in sales, costs, etc. on a project. Scenario Analysis - Project analysis given a particular combination of assumptions. Simulation Analysis - Estimation of the probabilities of different possible outcomes. Break Even Analysis - Analysis of the level of sales (or other variable) at which the company breaks even.

7 Operating Leverage Operating Leverage- The degree to which costs are fixed. Degree of Operating Leverage (DOL) - Percentage change in profits given a 1 percent change in sales.

8 Operating Leverage Example - A company has sales outcomes that range from $16mil to $19 mil, Depending on the economy. The same conditions can produce profits in the range from $550,000 to $1,112,000. What is the DOL?

9 Flexibility & Options Decision Trees - Diagram of sequential decisions and possible outcomes. Decision trees help companies determine their Options by showing the various choices and outcomes. The Option to avoid a loss or produce extra profit has value. The ability to create an Option thus has value that can be bought or sold.

10 Decision Trees NPV=0 Don’t test Test (Invest $200,000) Success Failure Pursue project NPV=$2million Stop project NPV=0

11 BMM 9: Topics Covered Rates of Return 73 Years of Capital Market History Measuring Risk Risk & Diversification Thinking About Risk

12 Rates of Return

13 Rates of Return

14 Rates of Return

15 Rates of Return Nominal vs. Real

16 Market Indexes Dow Jones Industrial Average (The Dow) Value of a portfolio holding one share in each of 30 large industrial firms. Standard & Poor’s Composite Index (The S&P 500) Value of a portfolio holding shares in 500 firms. Holdings are proportional to the number of shares in the issues.

17 The Value of an Investment of $1 in 1926 Source: Ibbotson Associates Index Year End

18 Rates of Return Source: Ibbotson Associates Year Percentage Return

19 Expected Return

20 Measuring Risk Variance - Average value of squared deviations from mean. A measure of volatility. Standard Deviation - Average value of squared deviations from mean. A measure of volatility.

21 Measuring Risk Coin Toss Game-calculating variance and standard deviation

22 Risk and Diversification Diversification - Strategy designed to reduce risk by spreading the portfolio across many investments. Unique Risk - Risk factors affecting only that firm. Also called “diversifiable risk.” Market Risk - Economy-wide sources of risk that affect the overall stock market. Also called “systematic risk.”

23 Risk and Diversification

24 Risk and Diversification

25 Stock Market Volatility Std Dev

26 Risk and Diversification

27 Risk and Diversification