10. Risk and Uncertainty Flashcards
What is sensitivity analysis?
Seeing how much the estimates used to make the original decision can change before the decision becomes incorrect
What is the equation for sensitivity?
Project NPV / PV of variable
When calculating the sensitivity of selling prices, what does care need to be taken over?
Reducing the sales price by tax charges
How do you calculate sensitivity for cost of capital?
(IRR - Existing Cost of Capital) / Existing Cost of Capital
How much does can the cost of capital change before NPV is zero?
How do organisations measure the likelihood of risks?
By probabilities
How do organisations measure the impact of risks?
Estimating monetary amounts or using a scale of 1 to 100
What is Value at Risk?
A measure that quantifies the maximum loss that is acceptable to a company over a period of time, given normal market movements and a given level of probability
What is the formula for value at risk?
Confidence interval value x standard deviation
Where the confidence interval value is the Z score at Confidence % - 0.5
Given a 1 period Value at Risk, how would you calculate the X period Value at Risk?
Value at risk * Sqrt(X)
What is the expected value? E(V)
The weighted average payoff: Sum (Probability x Payoff)
What risk preference investor would use E(V) to base their decisions on?
Risk neutral
What are the 3 key limitations of E(V)?
- Not relevant in one offs as they represent a long run average
- Ignores the spread of possible returns
- Relies on the accuracy of probabilities
What is the equation for the value of perfect information?
VOPI = EV (with perfect information) - EV (without)
Where EV (with perfect information) comes from the expected values as if we know what the outcome scenario will be
What is the equation of the coefficient of variation?
SD / E(V)
What do we use the coefficient of variation for?
To compare relative risks of projects
What is a decision tree?
A pictorial method of showing a sequence of interrelated decisions and their expected outcomes
From what direction do you draw / read decision trees?
From the left / from the right
What is the EV at a decision point?
The of lower of all cost or higher of all return options to the right
What is maximax?
Maximising the maximum achievable profit - selecting the option with the best outcome possible
Who favours maximax criteria?
Risk seekers
What is maximin?
Maximising the minimum achievable profit - selecting the option with the best worst possible outcome
Who favours maximin criteria?
Risk averse investors
What is minimax regret?
Minimising the maximum regret of making the wrong decision
What is the payback period approach to assessing risk?
Projects with faster paybacks are less risky
What is the risk adjusted discount rate approach to assessing risk?
Adding a premium to the cost of capital when appraising higher risk projects - setting a higher hurdle rate
What is the certainty equivalent approach to assessing risk?
Multiplying each years cash flow by a ‘certainty equivalent factor’ to give a ‘risk free’ cash flow, before discounting to find an NPV
What are simulation techniques?
Statistical techniques, often using computers and random numbers, for simulating potential outcomes are useful in situations where they are multiple uncertain variables
What is stress testing?
Simulation designed to determine the ability of a project to deal with worse case situations
