TOTAL RISK FOR MULTIPLE

INVESTMENTS

Total risk for multiple investments

 The measurement of risk differs when

multiple investments are involved due to properties of diversification.

 As diversification applies to securities, it also

applies to capital investments.

STANDARD DEVIATION
 Total risk is the sum of systematic and

unsystematic risk.  The total variance or risk of combination depends on degree of correlation between investments.  S.D. can be expressed as=mmrjk jk
J=1 k=1

STANDARD DEVIATION
 The S.D. or risk of a portfolio depends upon Degree of correlation between various cash

flows  S.D. of possible NPVs for each project

 Higher positive correlation Higher S.D.

 Higher S.D. of individual projects- Higher S.D. if

correlation is positive.

CORRELATION BETWEEN PROJECTS

 The correlation between NPV of two projects

maybe positive, negative or zero.  If r= 1, NPV of projects vary directly.  If r=-1, NPV of projects vary inversely  If r=0, NPV of projects are independent

RANGE OF CORRELATION
 Projects in the same line of business tend to

be highly correlated with each other.  Projects in unrelated lines of business tend to have low degree of correlation.

FEASIBLE COMBINATIONS AND DOMINANCE

 A combination includes all existing investment

projects and one or more proposals under consideration.  Existing projects and proposals are evaluated to analyze feasible combinations according to their NPV or S.D.  Dominance determines the efficient frontier of projects. Projects dominate others in terms of higher NPV and same S.D. or same NPV or lower S.D. or higher NPV and lower S.D.

ANALYSIS OF AN ACQUISITION
 In general, we can evaluate in the same

manner and the same kind of information that we use for evaluating an investment proposal generated internally.  Investment proposals can consist of acquisition of a company or a part there of.  Acquisition of another company can be treated as capital budgeting decision.

ANALYSIS OF AN ACQUISITION
 There is an initial outlay , which is expected to

be followed by expected future benefits.

 Many times, investment outlay is not may not

be established, indeed it frequently subject to bargaining.

ANALYSIS OF AN ACQUISITION
 MEASURING FREE CASH FLOWS  In evaluating capital budgeting projects, the

buying company should first estimate the future cash income that the acquisition is expected to add.  Synergy  Free cash flows should be measured.

ANALYSIS OF AN ACQUISITION
 Free cash flows are cash flows that remain

after all necessary expenditure and determine acquisition value.  For exIncremental EBITDA $3500 Less: Tax $ 500 Capital exp. $1500 W.C. addition $ 200 Free C.F. $ 1300

ANALYSIS OF AN ACQUISITION
 Preparing cash flows for analysis  In case of an acquisition, the life of the project

is indefinite. So, we cash flows are shown in perpetuity.  Cash flows are discounted at appropriate rate of return

ANALYSIS OF AN ACQUISITION
 NON-CASH PAYMENTS AND LIABILITY

ASSUMPTION

 In many cases, the buyer assumes the

liabilities of the company it acquires.  Payment to acquired companys shareholders may involve common stock, debt, cash or any other combination.  If securities are used in acquisition, they should be converted into their cash equivalent values.