Risky Projects

In: Business and Management

Submitted By navram
Words 2911
Pages 12
INVESTING IN RISKY PROJECTS

When valuing a project, managers first forecast the future cash flows of the investment then discount them at the same calculated discount rate. The issue arises when managers are investing in risky projects because they tend to value the risky projects the same way they do riskless projects. Here we have highlighted the two appropriate methods used to value risky projects, the Risk-Adjusted Discount Rate method and the Certainty Equivalent Method.

TRACKING PORTFOLIOS AND REAL ASSET VALUATION

Portfolio tracking is monitoring a collection of stocks, for the purpose of learning how the prices move and/or profiting from those movements.

The market price of a combination of financial investments that track the future cash flows of the project should be the same as the value of the projects future cash flows.

Analyst’s need to generate tracking portfolio’s with tracking error (a measure of how closely a portfolio follows the index to which it is benchmarked), PV=0 in order to value projects in these cases, i.e. Tracking Error = Cash Flows of Tracking Portfolio – Cash Flows of Project.

When tracking error exists, analysts use Asset Pricing Models, Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT), to derive projects PV.

If the CAPM holds, the tracking portfolio is a combination of the market portfolio and a risk free asset.

How to use tracking portfolio valuation

The idea is that we are trying to find the future cash flows of the project using a tracking portfolio

Assume there is perfect correlation between the Market Portfolio and the Project.

1. Value project using probabilities

2. Assume Tracking Portfolio with mix of Market Portfolio and Risk Free Asset

3. Calculate how much investment is required to track portfolio

4. Conclusion: Since portfolio of financial assets…...

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