By C. J. Hawkins, D. W. Pearce (auth.)
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Extra resources for Capital Investment Appraisal
PROBABILITY DISTRIBUTION APPROACHES TO RISK Deriving distributions is not straightforward. There are problems of data and estimation, but for our purposes it is only necessary to note that some final probability distribution of NPV or IRR can often be obtained. Given a probability distribution, one simple rule often advanced is to rank projects by their expected NPV values. The expected value is the mean NPV taken from the distribution of NPVs. e. (0·3 xl) + (0·5 x 2) + (0·2 x 3). This expected value approach suffers from a number of defects.
If the firm's cost of capital is 5 per cent, then the annual capital charge (ACe) is £367, as shown in Table 14. Since the annual cash flow is £402, the annual value of the project is £35 (some writers refer fO the annual value as the 'annual yield'). Annual capital ckarge at 5 per cent 1. Interest on capital at 5 per cent 2. Annual capital charge at 10 per cent 1. Interest on capital at 10 per cent 2. Sinking fund at 10 per cent 100 302 100 302 100 302 Total=Annual capital charge 402 402 402 taking the project's ratio of cash flow to annual capital charge and comparing it to the ratio GPVjC.
An example should clarify this problem and also demonstrate the method of deriving the marginal overall cost of capital, with respect to a change in the quantity offunds. Let us suppose that a company currently has a total capital stock of £90,000, which has been raised using a combination of debt and equity in an optimal way. The average cost of this capital is currently 7·8 per cent. Table 15 can be taken as showing what the cost would be of an enlarged capital stock of £100,000. At the optimal mix, the new average cost of capital is 7·9 per cent.
Capital Investment Appraisal by C. J. Hawkins, D. W. Pearce (auth.)