Market Value of Equity and Total Value of Company

Market Value of Equity and Total Value of Company

Market Value of equity can be calculated from the Total value of entity and market value of debt. Formula for calculating market value of equity is

Ve= Vt-Vd

Ve= Market Value of equity

Vt= Total Market Value

Vd= Market Value of debt

Market Value of Equity Example

Company total market value is 250 million, the market value of debt is 50 million, and then market value of equity can be calculated as under

Ve= Vt-Vd

Ve= 250-50

Ve= 200 (Market value of equity)

Volatility of Project

Volatility of Project

Volatility of project varies with the length of period. it means longer period project has higher volatility and shorter period has small volatility. Relationship between time and volatility has been explained by the following formula

S.D (Longer period) = S.D (short period of time) √T – measure of volatility

Volatility of Project example

Project has cash inflow of 200,000 annual. Life of project is 5 years. Volatility in cash flow is 30,000. Calculate the cash inflow for 5 year and volatility.

Cash flow 5 years = 200,000 x 5 years = 1,000,000

Volatility for 5 Years = 30,000 x √5

=30,000x2.236

= 67080

Risk in Return

Risk in Return

Risk in return means that expected return may not be achieved. This risk can be measured with the help variance and standard deviation.

1.    High Volatile Return

High volatile return means return differ substantially from the expected value (average value of return. high volatile return also differ substantially from each other.

2.    Risk of Return measurement

Risk of return may be measured by statically technique i.e. calculating variance and standard deviation.

Variance = p Σ(r-r)²

S.D = √ p Σ(r-r)²

Risk Modeling

Risk Modeling

In risk modeling a project is treated as model and such model is constructed based on the expected outcomes. This model then checks by changing the outcomes (i.e. inflow and outflows).

1.    Model Construction

First step in risk modeling is construction of well planned model. Such model is based on future expected outcome is created. a lot of working and detail analyses is performed to create a suitable model for project.

2.    Analyses with Variation

Second step is risk Modeling is analyses with variation in outcome. It means that how the result (NPV) will change by changing the different outcome (variable) of model. For investment appraisal mainly there are two main variable revenue, cost, and investments.

NPV Sensitivity Analyses

NPV Sensitivity Analyses

In NPV sensitivity analyses, we recognize the impact of future uncertainty of cash flow on the NPV. We calculate margin of safety for different cash flow items i.e. revenue, cost, and contribution. Such analyses also give us an idea of contribution (importance) of each item in the NPV.

1.    NPV Sensitivity analyses for Cost

NPV Sensitivity analyses for cost are performed by calculating the margin of safety for cost. This margin of safety shows that what % of cost increase would make the NPV zero.

2.    NPV Sensitivity analyses for Revenue

NPV Sensitivity analyses for revenue is performed by calculating the margin of safety for revenue, that shows that how much decrease in revenue will bring the NPV at zero level.

3.    NPV Sensitivity analyses for Contribution

NPV Sensitivity analyses for contribution is performed by calculating the margin of safety for contribution, which shows that how much decrease in contribution in terms of percentage will bring NPV to zero.

Sensitivity Analyses for Cost Example

Sensitivity Analyses for Cost Example

In sensitivity analyses for cost, we see sensitivity (reaction) of NPV to cost. We calculate a margin of safety for cost. There are three steps for these analyses. In first place we calculate NPV, then we calculated Present value of cost and in last we calculate margin of safety for cost. (How much cost can be increase to get zero NPV?

Example of Sensitivity & Variable

Initial Investment	200,000
Volume of Sales	20,000 Units
Selling Price	12
Variable Price	8
Project term 4 years	4 years

Cost of Capital is 10%

Solution

1.     Calculate NPV

Cash outflow	$ 200,000
Cash inflow ( $ 20,000 x 4 x 3.170)	$ 253,600
NPV (253,600-200,000)	$ 53,600

2.     Calculate present Value of Variable Cost

Variable Cost ( 20,000 @ 8 )	160,000
Annuity Factor 4 years	3.170
Present Value of Variable Cost	$ 507,200

3.    Margin of safety for contribution

= $ 53,600/$ 507,200 x 100

=10.56%

Cost is to be raised by 10.56% to bring the NPV to the level of Zero. Therefore variable cost is more sensitive to the NPV.

Disadvantages of Expected Value

Disadvantages of Expected Value

Disadvantages of expected value can be explained in term subjective calculation, average results, limited use.

1.    Subjective Calculation

Expected value highly depends on the probability, which is a subjective thing. It means no accurate probabilities can be calculated, different people would give you different expectation (probabilities of outcome).

2.    Average Value

Expected value gives you an average result and not actual outcome. It means that results of expected can only be tele with actual result by chance.

3.    Only useful for repetitive outcome

Expected value concept has more usefulness, where outcome repeated. In case of one time activity (project analyses), it has little usefulness.

NPV (x)	Probability (p)	Expected Value (P*x)
5000	.2	1000
10,000	.8	8000
Expected Value		9,000