3. FM - Risk and Decision Making Flashcards
What are the problems that investment appraisals face?
- All decisions are based on forecasts
- All forecasts are subject to uncertainty
- This uncertainty needs to be reflected in the financial evaluation
What is the difference between risk and uncertainty?
Risk = quantifiable, where probabilities are known (i.e. roulette wheel) Uncertainty = Unquantifiable -- outcomes can't be mathematically predicted (i.e. most businessd decisions)
What do we assume about the risk levels of investors in FM?
Assume that investors are rational and risk averse
Even risk averse investors will have diff attitudes towards risk. Some will need greater levels of compensation than others for the same level of risk
What does it mean to be risk averse?
- Investors demand an increase in return for the increase in risk
- If 2 projects offers the same expected return, the one with the lower risk is preferred
Even risk averse investors will have diff attitudes towards risk. Some will need greater levels of compensation than others for the same level of risk
What are the practical ways to incorporate uncertainty?
Many practical ways to address uncertainty
- Minimum payback periods
- Prudent estimates of cash flows
- Assessment of best and worst outcomes
- Higher discount rates
What is EV?
Expected value
Used when there is a number of possible outcomes for a decision and probabilities can be assigned to each, then EV is calculated
This value can then be used for the purposes of investment appraisal
How do you calculate EV?
EV = sum of px
where X = value of the outcome
p = probability of the outcome
What does EV show (and not show)?
DOESN’T show the most likely result - may not even be a possible result
Shows the long run average outcome
TYU1: Cash flows from a new restaurant venture may depend on whether a competitor decides to open up in the same area. The following estimates have been made:
- Chance that the competitor opens up 30%
- Revenue if competitor opens up £4k
- Revenue if competitor does not open up £10k
What is the expected value of the revenue?
Competitor opens up - yes probability 0.3
Revenue £4k
EV = 0.3 x £4k = £1,200
Competitor opens up - No
Probability 0.7
Revenue £10k
EV = £7k
Therefore total EV = £1,200 + £7k
= £8,200
What are the limitations of expected values?
- Discrete outcomes
- Subjective probabilities
- Ignores risk
- Not a possible outcome, so less applicable to one off projects
What question does sensitivity analysis answer?
‘What % change in a particular estimate would lead to us to change the decision about the project?’
What is sensitivity?
It is the %age change in an estimate that gives NPV of nil
How do you calculate sensitivity?
2 methods depending on the time of estimate
- Sensitiviity to factors affecting cash flows e.g. price, volume, tax rate
= NPV of whole project / NPV of cash flows affected by the change
- Sensitivity to other factors
Sensitivity to discount rate = difference between the cost of capital and the IRR
Sensitivity to product life= discounted payback
How do you calculate sensitivity when it is factors affecting cash flows? and give some examples of what these factors could be
e.g. price, volume, tax rate
= NPV of whole project / NPV of cash flows affected by the change
How do you calculate sensitivity when it is sensitivity to the discount rate?
- Difference between the cost of capital and the IRR
How do you calculate sensitivity when it is sensitivity to project life?
Calculate discounted payback
What must be done when tax is included in sensitivity analysis?
The principle is the same, but you must include the tax effect, therefore the sensitivity calc becomes
= NPV of whole project / NPV of the cash flows affected net of tax
What are the limitations of sensitivity analysis?
- Assumes variables change independently of each other
- Does not assess the likelihood of a variable changing
- Does not identify a correct decision
What is the difference between sensitivity and simulation?
Sensitivity considers the effect of changing one variable at a time
Simulation improves on this by looking at the impact of many variables changing at the same time
How does simulation work and what are the steps for calculating it?
It uses a mathematical model to product a distribution of the possible outcomes from the project. The probability of diff outcomes can then be calculated.
3 stages
- Specify major variables and their probabilities
- Specify the relationships between the variables
- Simulate the environment
Results will usually be a probability distribution
What is the benefit of diversification?
It can reduce (BUT NOT ELIMINATE) risk
What is the effect of diversification?
If an inv holds a single share, then the return will fluctuate over time
If adds a second, it will also fluctuate but not in the same way as the first
So the average return achieved will be more stable as the are moving independently
How much risk can generally be removed?
As long as inv return profiles differ by at lease some degree, then risk will be reduced
- Initial inv diversification will bring a substantial risk reduction, but as additional inv are added this difference will reduce
i. e. will remove all the unsystematic risk, but can’t remove the systematic risk (market risk)
What type of risk can and can’t diversification reduce and WHY?
Can reduce Unsystematic risk (unique risk) - as these impact each firm differently depending on their circs
Can’t reduce systematic risk (market risk) - as these affect all companies in the same way (but to varying degrees)