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A simulation is basically a computer model that attempts to replicate a reallife situation. In Finance, simulation analysis is a model that is applied to analyze large projects and determine how target variables are affected based on changes in input variables. The model uses simulations to predict how the outcome of a decision would vary if we tweak a set of input variables in a given range.Unlike scenario analysis and sensitivity analysis, simulation analysis does not offer a single result. Instead, it offers a range of probable outcomes due to the movement of variables.In simulation analysis, each input’s statistical distribution ... Read More
The only thing certain in life is uncertainty. Scenario analysis is a powerful tool to handle business uncertainty in a scientific and appropriate manner. It is done by analyzing the future events and their impacts on the business and considering the alternative possible outcomes. Companies normally use a broad range of spectrum of future situations such as risks and cash flows to determine the scenario of the business at a future date. Therefore, it is an intriguing process for analysts because it offers an insight into the future.What is Scenario Analysis?Businesses need to consider various scenarios from good to best ... Read More
When risk premium is added with risk-free rate to get the present value of a risky investment, it is called risk-adjusted discount rate (RADR). A risky investment refers to any investment that has a higher risk than normal investments. For example, high-risk investments may include real estate and other such investments.As investors want to know the present value of risky investments, the riskadjusted discount rate is a highly efficient tool for them. Although the market rate is taken as a standard in investment return calculations, the application of riskadjusted discount rate calculations becomes instrumental in some other cases.How Does RADR ... Read More
M&M TheoremThe first version of the M&M theorem (or M&M Theorem I) considers a perfect and hypothetical market condition. In such a case, the market is completely efficient, which implies the markets are working smoothly with all information being conveyed to the investors taking part in it. The theorem also considers that there are no taxes, no trading costs of equity, and bankruptcy being applicable without bankruptcy costs.The Key Assumptions of M&M TheoremThe theorem follows certain assumptions depending on the market conditions, risks, tax liabilities, and dividend payout. The assumptions are as follows −Perfect Capital MarketsThe perfect market condition applies ... Read More
What is Strategy?Strategy is specifically an action the managers of a company take to attain a specific goal. It can also be defined as a general direction set for the company and its various departments to attain a desired state in the future. To apply a strategy, a company must follow a strategic planning process.Strategy, in general, means integrating the organizational processes and using and allocating the scarce resources in the organizational environment so that the present objectives are met in a wholesome manner.While planning a strategy, it is required to consider the fact that decisions are not made without ... Read More
Businesses often need to source funds through debt and equity. Since equity cost is more than debt costs, organizations tend to choose debt over equity in their capital structure. Debt comes with a cost though because the companies need to pay interest to the lenders when they acquire debt. The interest they need to pay back is the minimum return they should earn to remain solvent in the long run.What is Debt Capacity?In general, a company should have all the funds required to pay back the minimum required amount of debt or contractual obligations. The amount of debt that can ... Read More
A company’s interest payments are tax deductible. That is, the interest expense paid by a company can be subject to tax deductions. Such a deductibility in tax is known as interest tax shield. For example, there are some cases where mortgages have an interest tax shield for the buyers as the mortgage interest is deductible on the income.Companies normally want to reduce their tax liability as much as possible. Interest tax shields therefore encourage firms to finance their projects with debt, as the dividends paid to the equity investors are not tax deductible.Valuation of the Interest Tax ShieldThe valuation of ... Read More
What is Financial Leverage?Financial leverage is the use of increasing debt to purchase more assets. Leverage is usually employed to increase the return on equity (ROE). However, an excess of financial leverage magnifies the risk of failure, as it becomes increasingly difficult to repay the debt by the borrower.Financial leverage is measured as the ratio of total debt to total assets in its formula. When the proportion of debt to assets increases, the amount of financial leverage does so too.Financial leverage is favorable when debt can be put to generate returns greater than the interest expense related to the debt.Many ... Read More
The EBIT-EPS analysis gives the best ratio of debttoequity which the businesses can use to find an optimum balance in their debt and equity financing. The analysis shows the effect of the balance sheet’s structure on the company’s earnings.Basics of EBIT-EPS ApproachIt is important to understand what EBIT and EPS mean to understand what the analysis is meant to be.EBIT refers to earnings before interest and tax. The metric makes interest and taxes irrelevant. Therefore, an investor can understand how the company is performing out of the balance sheet’s composition which essentially makes interest and taxes the focal point of ... Read More
Certainty equivalent is the amount of cash an investor would accept today than going for a larger amount of cash tomorrow. Investors often use this to deny the risk. The Certainty equivalent helps investors earn a guaranteed income on their investment rather than going for increased risk on their investment portfolios. It is a method of reducing risk while also reducing the income from given investment instruments.Certainty Equivalent is Popular among Risk-Averse InvestorsCertainty equivalent is quite a popular method among risk-averse investors. These investors do not want to invest in high-return but risky investments. Instead, they forgo higher returns for ... Read More