The Modigliani-Miller Propositions
A firm’s capital structure is the mix of debt and equity the company uses to finance its investments. The goal of a capital structure decision is to determine the financial leverage that will maximize the value of the company by…
Capital Budgeting Pitfalls
Here are some of the most common mistakes managers make when evaluating capital budgeting decisions: Economic responses: Failure to incorporate economic responses into investment analysis can greatly affect the profitability of the investment. Attractive investments entice competitors to enter, consequently…
Sensitivity Analysis, Scenario Analysis and Simulation Analysis
Simulation analysis, scenario analysis and sensitivity analysis are all stand-alone risk measures that depend on the variation of the project’s cash flows. Sensitivity Analysis Sensitivity analysis involves assessing the effect of changes in one input variable at a time on…
Project Analysis and Evaluation
Mutually Exclusive Projects with Unequal Lives Mutually exclusive projects compete for resources and management can therefore only pick one or a few out of a group of profitable projects. Usually, the project(s) with the highest NPV is (are) the most…
Effects of Inflation on Capital Budgeting Analysis
Inflation affects the analyst’s decision on whether to run the analysis in nominal or in real terms where nominal cash flows include the effects of inflation and real cash flows are adjusted downward to remove the effects of inflation. A…
Expansion Projects, Replacement Projects and Depreciation
Expansion Projects An expansion project is a capital project that involves a company increasing its business size. Expansion projects are independent projects because they do not affect the cash flows of the rest of the company. Cash flows of expansion…
Implied Volatility
We have seen that both the BSM model and Black model require the parameter, \(\sigma\) which is the volatility of the underlying asset price. However, future volatility cannot be observed directly from the market but rather estimated. One way of…
Delta Hedging
Delta hedging involves adding up the deltas of the individual assets and options making up a portfolio. A delta hedged portfolio is one for which the weighted sums of deltas of individual assets is zero. A position with a zero…
