Page 10 - FINAL CFA II SLIDES JUNE 2019 DAY 6

READING 20: CAPITAL BUDGETING
Simulation analysis (or Monte Carlo simulation) results in
a probability distribution of project NPV outcomes, rather than just
a limited number of outcomes as with sensitivity or scenario MODULE 20.2: EVALUATION OF PROJECTS AND DISCOUNT RATE ESTIMATION
analysis (e.g., base case, best case, worst case).

Key steps…

Step 1: Assume a specific probability distribution for each input variable. For example, we might assume that unit sales are normally distributed with a mean of
100,000 and a standard deviation of 15,000, unit prices are normally distributed with a mean of $40 and a standard deviation of $5, and so on for each input variable.

Step 2: Simulate a random draw from the assumed distribution of each input variable. That results in a single value for each of the inputs. For example, our first
draw might be unit sales of 85,000, a unit price of $42.00, and so on.

Step 3: Given each of the inputs from Step 2, calculate the project NPV.

Step 4: Repeat Step 2 and Step 3 10,000 times.

Step 5: Calculate the mean NPV, the standard deviation of the NPV, and the correlation of
NPV with each input variable.

Step 6: Graph the resulting 10,000 NPV
LOS 20.e: Explain and calculate the discount rate, based on market risk
methods, to use in valuing a capital project.

In the CAPM, risk is separated into systematic and unsystematic components. A diversified investor is compensated for taking on systematic risk, but not unsystematic
risk. Beta, a systematic risk measure, is appropriate for measuring project or asset risk when a company is, or the company’s investors are, diversified.

EXAMPLE: Using the SML to estimate the discount rate for a capital project: Compute the NPV for a 3-year
project that has a beta of 1.2. The initial investment is $1,000, and the project will generate annual cash flows of
$400. Use a risk-free interest rate of 8% and an expected market return of 13%.

R project = R + β project [E(R MKT ) − R ] = 8% + [1.2(13% − 8%)] = 14%
F
F
The project’s NPV at a cost of capital of 14% is –$71.35.
Simply using the company’s WACC will overstate the required return for a conservative (low beta) project and will
understate the required return for an aggressive (high beta) project. This is why we had to work out a Hurdle rate for
this specific project!