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TOTAL RISK FOR

MULTIPLE

INVESTMENTS

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Total risk for multiple investments

The measurement of risk differs whenmultiple investments are involved due toproperties of diversification.

As diversification applies to securities, it alsoapplies to capital investments.

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S TANDARD DEVIATION

Total risk is the sum of systematic andunsystematic risk.The total variance or risk of combinationdepends on degree of correlation betweeninvestments.S.D. can be expressed as-

=¥m m�r jk jkJ=1 k=1

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S TANDARD DEVIATION

The S.D. or risk of a portfolio depends upon-Degree of correlation between various cashflowsS.D. of possible NPVs for each projectHigher positive correlation ±Higher S.D.Higher S.D. of individual projects- Higher S.D. if correlation is positive.

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C ORRELATION BETWEEN

PROJE C TS

The correlation between NPV of two projectsmaybe positive, negative or zero.If r= 1, NPV of projects vary directly.If r=-1, NPV of projects vary inverselyIf r=0, NPV of projects are independent

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RANGE OF C ORRELATION

Projects in the same line of business tend tobe highly correlated with each other.Projects in unrelated lines of business tend tohave low degree of correlation.

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FEASIBLE C OMBINATIONS AND

DOMINAN C E

A combination includes all existing investmentprojects and one or more proposals under consideration.

Existing projects and proposals are evaluated toanalyze 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.

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ANALY S IS OF AN ACQUI S ITION

In general, we can evaluate in the samemanner and the same kind of information thatwe use for evaluating an investment proposalgenerated internally.Investment proposals can consist of acquisition of a company or a part there of.

Acquisition of another company can betreated as capital budgeting decision.

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ANALY S IS OF AN ACQUI S ITION

There is an initial outlay , which is expected tobe followed by expected future benefits.

Many times, investment outlay is not may notbe established, indeed it frequently subject to

bargaining.

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ANALY S IS OF AN ACQUI S ITION

MEASURING FREE CASH FLOWSIn evaluating capital budgeting projects, thebuying company should first estimate thefuture cash income that the acquisition isexpected to add.Synergy

Free cash flows should be measured.

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ANALY S IS OF AN ACQUI S ITION

Free cash flows are cash flows that remainafter all necessary expenditure and determineacquisition value.For ex-

Incremental EBITDA $3500Less: Tax $ 500

Capital exp. $1500W.C. addition $ 200Free C.F. $ 1300

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ANALY S IS OF AN ACQUI S ITION

Preparing cash flows for analysisIn case of an acquisition, the life of the projectis indefinite. So, we cash flows are shown inperpetuity.Cash flows are discounted at appropriate rateof return

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ANALY S IS OF AN ACQUI S ITION

NON-CASH PAYMENTS AND LIABILITYASSUMPTION

In many cases, the buyer assumes theliabilities of the company it acquires.Payment to acquired company¶s shareholdersmay involve common stock, debt, cash or anyother combination.If securities are used in acquisition, theyshould be converted into their cashequivalent values.