Investment Analysis As the Chief Term Paper

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Therefore the risk free rate is most likely slightly higher than would be if a ten-year treasury bond was used to determine the risk free rate.

Part 4:

You are having second thoughts about your choice of a proxy company and are concerned that a wrong choice may impact on the investment decision. To alleviate your fears (and those of the board) you run a sensitivity analysis to see how changes in the beta estimate affect your investment choice. You include this analysis in your report to the board and discuss the implications of you analysis.

Since the calculations used in the previous section were based off of a historical figure of beta that represents more of a conglomeration than just a grocer it is necessary to consider what would happen if the beta was incorrect. Since both organizations are at least remotely similar in their scope of operations a deviation of twenty percent error in should be sufficient to determine the sensitivity of the beta to such a miscalculation. Therefore an analysis can be conducted using betas of .74 (.93 * 80%) and also .84 (.93 * 90%). Since the beta is remarkably close to 1, it is unreasonable to suspect that the beta value was underestimated and hence the analysis should consider an overestimation by both ten and twenty percent.

Holding the variables used in the previous calculation constant (cet. par.) and changing the beta to .74 would result in a discount rate of roughly eleven and a half percent (11.52%).

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This would result in the discount rate being a full percentage point higher than previously estimated. If the beta value was only off by ten percent, then the discount rate would be roughly half a percentage point (10.82%). Since the Wesfarmers holdings are reasonably more diversified than the AusGrocer's holdings, it's reasonable to suspect that the AusGrocer beta would not be as high as Wesfarmers but, at the same time, it is doubtful that the beta would be a full twenty percent lower. Therefore it is recommended to the board that a beta of .81 be used (.93 * 85%) for future calculations.

However another interesting analysis would be to use a different risk free rate. The current coupon rate for a ten-year bond is 4.5% (Bloomberg, 2010). If this were substituted for the BAB risk free rate used in the prior analysis and the new beta was also substituted then the new discount rate would be 11.29%. This value is reasonably more accurate than using the BAB rate however the coupon rate was determined using the current rate as opposed to the historical rate and therefore subject to error.

To illustrate the effects that to the NPV values using a one percent change in the discount rate would have a stream of cash flows for ten years the following table was generated:

The table uses a discount rate of ten and eleven percent respectively and a million dollar per year stream of annual cash flows. It finds that a one percent change.....

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