13.2 Risk Analysis and Real Options Flashcards
A large conglomerate with operating divisions in many industries uses risk-adjusted discount rates in evaluating capital investment decisions. Consider the following statements concerning the use of risk-adjusted discount rates.
I. The conglomerate may accept some investments with internal rates of return less than the conglomerate’s overall average cost of capital.
II. Discount rates vary depending on the type of investment.
III. The conglomerate may reject some investments with internal rates of return greater than the cost of capital.
IV. Discount rates may vary depending on the division.
Which of the above statements are correct?
A. I and III only.
B. II and IV only.
C. II, III, and IV only.
D. I, II, III, and IV.
D. I, II, III, and IV.
Risk analysis attempts to measure the likelihood of the variability of future returns from the proposed capital investment. Risk can be incorporated into capital budgeting decisions in a number of ways, one of which is to use a risk-adjusted discount rate. A risk-adjusted discount rate is used when the capital investment is more or less risky than is normal for the company. This technique adjusts the interest rate used for discounting upward as an investment becomes riskier. The expected flow from the investment must be relatively larger, or the increased discount rate will generate a negative net present value, and the proposed acquisition will be rejected. Accordingly, the IRR (the rate at which the NPV is zero) for a rejected investment may exceed the cost of capital when the risk-adjusted rate is higher than the IRR. Conversely, the IRR for an accepted investment may be less than the cost of capital when the risk-adjusted rate is less than the IRR. In this case, the investment presumably has very little risk. Furthermore, risk-adjusted rates may also reflect the differing degrees of risk, not only among investments, but by the same investments undertaken by different organizational subunits.
A widely used approach that is used to recognize uncertainty about individual economic variables while obtaining an immediate financial estimate of the consequences of possible prediction errors is
A. Expected value analysis.
B. Learning curve analysis.
C. Sensitivity analysis.
D. Regression analysis.
C. Sensitivity analysis.
Sensitivity analysis recognizes uncertainty about estimates by making several calculations using varying estimates. For instance, several forecasts of net present value (NPV) might be calculated under various assumptions to determine the sensitivity of the NPV to changing conditions or prediction errors. Changing or relaxing the assumptions about a certain variable or group of variables may drastically alter the NPV, resulting in a much riskier asset than was originally forecast.
In preparing a multi-year revenue forecast, a financial analyst uses a technique that generates a distribution of possible results based on repeated sampling. The analyst is most likely using which one of the following?
A. Sensitivity analysis.
B. Monte Carlo simulation.
C. Scenario analysis.
D. Activity analysis.
B. Monte Carlo simulation.
The Monte Carlo simulation is used to generate the probability distribution of all possible outcomes of an event. The performance of a quantitative model under uncertainty (in this case, future sales revenues) may be investigated by randomly selecting values for each of the variables in the model and then calculating the value of the solution. This process is performed a large number of times. Thus, the Monte Carlo simulation technique is the one most likely to be used.
A company received a legal settlement of $1 million. The company could apply this $1 million toward its mortgage on the building it owns and save 4% in interest. The CFO suggested that based on historical analysis of the market over time, it was likely the company could earn around 8% over the term of the mortgage if it invested the money, which was a better return than the 4%. The business owners elected to apply the money to the mortgage rather than invest the money. Based on the decision described in this scenario, a reasonable conclusion would be that the company has a
A. Low risk tolerance and the certainty equivalent is less than expected value.
B. High risk tolerance and the risk tolerance equivalent is less than expected value.
C. High risk tolerance and the certainty equivalent is greater than expected value.
D. Low risk tolerance and the certainty equivalent is greater than expected value.
A. Low risk tolerance and the certainty equivalent is less than expected value.
The company decided to go with the guaranteed 4% return instead of taking the investment with an 8% return. This shows that they have a low risk tolerance, since they were not willing to take the additional risk associated with the 8% investment. The certainty equivalent specifies at what point the firm is indifferent to the choice between a certain sum of money and the expected value of a risky sum. Since the firm would rather take the sum of money than the expected value of the risky sum, the certainty equivalent is less than expected value.
