Risk Analysis

in Long term
investment
decisions
Three Warnings
regarding discount rate

• Even though debt is cheaper a

higher amount of debt leads to
higher risk and thus a higher
required rate of return by equity
investors.

• Use long term risk free rate in

CAPM.

• WACC should be calculated as

after tax (interest is tax
deductible).
Investment, Risks and Discount Rate

• Consider J&J, would a new baby lotion has the same risk as an
investment in R&D biotech.

• Thus the discount rate should be appropriate for each project.

• Most projects are average risks thus CAPM can be used.

Company Beta

• An company’s beta is the coefficient when the returns are regressed on market return.

• Following impact company’s beta:

Cyclicality – Firms whose business is cyclical have a cyclical beta.
Operating Leverage – A operating leverage (high fixed costs) leads to a high beta.
If risk free rate and/or market risk premium changes, discount rate will change (eg
change in repo rate).
Avoid fudge factors in discount rate
 How does a change in value of input variables
Sensitivity Analysis change NPV
Sensitivity Analysis

• Limits on number of scenarios and intensity of scenarios

• More than one variable change is called scenario analysis.
Break Even Analysis

• Level of variables which leads to NPV of 0.

• Level of sales for NPV 0

 • Degree of Operating Leverage = % change in profits/
Operating Leverage % change in sales
• DOL = 1 + (fixed cost including depreciation)/(pretax
profits)
Decision Tree
Decision tree for a pharma company
Decision Tree
Real Options

• Option to Expand – Eg option to buy aircraft at a predetermined price.

• Option to Abandon – Eg selling off a technology/machinery in case revenues are not

good