Financial Management: Corporate Finance Answers Assessment Answer
Answer:
1. The risk aversion is the process of making the decision when an investor faces two similar expected returns and prefers the one with the lower risk. Yes, I agree that the risk aversion is process that will which is the outcome of the corporate managers to invest in a low risk project. The risk aversion process is driven by risk appetite, which comes with two variations on a particular project (Heron & Lie 2016).
For example, a project may look forward to invest $ 22 million and the expected return is $ 35 million over five years or the management may decide to invest in the project of $ 60 m with an expected return of 135 million over 8 years, followed by a bigger deviations in the earnings during the initial years. The management needs to decide upon the risk in each between the project failing or generating something in the initial years. The risk mitigation is the process of choosing a short-term profit during a short period. The source of the risk aversion should be further based on the weighing the two investment options and making a feasible decision to carry out a particular project (Guiso et al., 2013).
2. In order to decide whether the ordinary annuity can have the same present value as the perpetuity, the future value constraint needs to be taken into consideration. The present value is calculated using
PV = FV (1/1+R) n
Where,
R = Discounting rate
n = No. of years
By taking into consideration the above formula, we can say that even if the cash flows and the discount factor in nature of the ordinary annuity cannot have the same present value. This is because even if the discount factor is same, due to the increasing power of the value of n (no. of years) the ordinary annuity of the present value will also keep increasing (Brealey et al., 2012).
For example if the value of the r is 0.8 in a particular year for the first year then discounting factor is (1+0.8), the next year the discounting factor would become (1+0.8)2 which is 3.24. In this way, the free cash flow will reduce due to the increasing discounting factor, even if the cash flows and the discounting rates remains the same (Bierman & Smidt 2012).
Reference List
Bierman Jr, H., & Smidt, S. (2012). The capital budgeting decision: economic analysis of investment projects. Routledge.
Brealey, R. A., Myers, S. C., Allen, F., & Mohanty, P. (2012). Principles of corporate finance. Tata McGraw-Hill Education.
Guiso, L., Sapienza, P., & Zingales, L. (2013). Time varying risk aversion (No. w19284). National Bureau of Economic Research.
Heron, R. A., & Lie, E. (2016). Do Stock Options Overcome Managerial Risk Aversion? Evidence from Exercises of Executive Stock Options. Management Science.
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