CORPORATE
VALUATION RISK 6-7
The expected return is the sum of these products. Using the formula,
XYZ's expected annual return is:
E (k) = 0.30 x (100%) + 0.40 x (15%) + 0.30 x (-70%)
E (k) = 30% + 6% + -21%
E (k) = 15%
Expected Cash Flows
Although we used stock returns to illustrate the concept of expected
return, we just as easily could have calculated an expected cash flow.
Projects A
and B payoff
matrix
Suppose, for example, that analysts want to forecast the expected
cash flow for a given project. (Let's call it Project A.) They try to
anticipate future conditions and their effect on the cash flow. The
analysts decide that there are five possible cash flow payoffs for the
project and estimate the probability of each cash flow occurring.
Their analysis of the project's expected cash flow is summarized in a
payoff matrix (Figure 6.4).
(1)
(2)
(3)
(4)
Estimate
Number
Probability
Possible
Cash
Flow
Weighted
Cash Flow
(2) x (3)
1
2
3
4
5
0.15
0.15
0.40
0.15
0.15
$31,000
32,000
33,000
34,000
35,000
E(CF) =
$4,650
4,800
13,200
5,100
5,250
$33,000
Figure 6.4: Project A -- Payoff Matrix