6) Risk and investment appraisal Flashcards
What is risk
Risk is the term used when the degree of variation from an expected outcome can be quantified. This is normally done by using probabilities.
What is uncertainty
Uncertainty is the term used when the degree of variation from an expected outcome cannot be quantified.
What are the methods of dealing with risk and uncertainty
- Expected value
- Simulation
- Discounted payback
- Risk adjusted discount rate
Uncertainty= • Sensitivity analysis
What is expected value
Mean/average/ Mew/-is the weighted average of all the possible outcome.
The expected value can be calculated by multiplying the possible outcomes by their corresponding probabilities.
This will allow an expected NPV to be determined.
E(X) = Σpx
.
P=probability
X= cash flow from each outcome
What are the advantages of expected value
▪ Deals with multiple outcomes (cause you can put them all into one average)
▪ Quantifies probabilities
▪ Simple & straight forward
What are the disadvantages of expected value
▪ By asking for a series of forecasts the whole forecasting procedure is complicated. Inaccurate forecasting is already a major weakness in project evaluation.
▪ The EV gives no indication of the dispersion of possible outcomes about the EV. The more widely spread out the possible results are, the more risky the investment is usually seen to be. The EV ignores this aspect of the probability distribution.
In ignoring risk, the EV technique also ignores the investor’s attitude to risk. Some investors are more likely to take risks than others.
▪ Expected values will never occur ( It’ll only be one of the possibilities not the probability ) BECAUSE it is an average (therefore only appropriate for when we make a decision time and time again (repetitively) e.g. making sandwiches every week and therefore over time you will be in the average position. As an average, EV is based on the idea that a project is repeated many times. So if it is for a one off decision, its not very appropriate.
▪ Assigning probabilities is highly subjective
▪ Expected values do not evaluate the range of possible NPV outcomes. It’s a risk neutral approach therefore ignores the investors attitude to risk because it ignores the range of possible outcomes
Only appropriate for where we make decisions repetitively
What is sensitivity analysis?
It deals with uncertainty
Sensitivity analysis assesses the extent to which the net present value (NPV) of an investment project responds to changes in project variables.
Sensitivity analysis measures the amount of change in a variable that could arise before the decision to accept or reject the project changes. The decision to accept or reject the project changes if the NPV changes from being positive to being negative
How do you calculate sensitivity of any cash
Step 1 – Calculate the NPV of the project
Step 2 – Calculate the PV of the cash flows under consideration using the ANNUITY FACTOR at company’s COST OF CAPITAL
Step 3 – Apply to the following formula:
Sensitivity= NPV of project ÷ PV of CF under consideration
How do you calculate sensitivity to a change in discount rate (cost of capital)
Step 1 – Calculate the NPV of the project
Step 2 – Calculate the IRR of the project
Step 3 – Apply to the following formula:
Sensitivity= (IRR-Original Discount rate)÷ Original Discount rate
What are the advantages of sensitivity analysis
▪ Simple to calculate and understand
▪ Identifies critical estimates
▪ Allows managers to make better judgements by providing them with information as to the critical estimates
What are the disadvantages of sensitivity analysis
▪ Assumes variables change independently of one another e.g. assumes selling price has no impact on sales volume
▪ Sensitivity does not examine/assess the probability/chance of a variable changing
While sensitivity analysis can indicate the critical variables of an investment project, however, sensitivity analysis does not give any indication of the probability of a change in any critical variable.
▪ It does not provide a decision. This is dependent upon the management attitude to risk
What is simulation?
This is an advanced form of sensitivity analysis. it looks at the impact of many variables changing at the same time. An example of this might be that a 1% reduction in the selling price might be expected to result in a 0.5% increase in the volume of sales.
It uses a mathematical model to produce a distribution of the possible outcomes from the project and allows their probabilities to be calculated:
- The NPV is then calculated based on a large number of simulations or what if’s?
- The range of NPV results is therefore plotted on a graph and the range of results is likely to follow the pattern of a normal distribution.
- The normal distribution can be used to assess the level of risk. If might, for example be possible to determine that there is a 5% chance of the NPV being negative.
It DOES NOT asses the likelihood of a variable changing as well as not directly pointing to the correct investment decision
What is discounted payback (or adjusted pay back)?
This is the same technique as payback except that the cash flows are discounted before the payback period is calculated. You can build risk into a discount rate
The discount rate used can be adjusted to reflect the risk involved. The shorter the discounted payback period the less risk is attached to a project and the higher the discount rate, the higher the risk that we can use to evaluate the project.
The discounted payback period has the same advantages and disadvantages as traditional payback except that it has an additional advantage of taking into account the time value of money.
What is risk adjusted discount rate?
how is the risk incorporated? mention the two ways
The discount rate used to determine the NPV of a project will reflect the time value of money. The discount rate can, however, be adjusted to reflect the risk of the project. If risk is higher the discount rate will be increased. A higher discount rate results in a lower NPV.
A risk adjusted discount rate can be found using the CAPM
Increase the discount rates by adding a risk premiym OR use the CAPM with a risk appropriate beta factor
When is expected value appropriate- give 3 reasons
- If there is a reasonable basis for making the forecasts and estimates
- the decision and risk are small in relation to the business
- the decision is a common one for the business i.e. repetative
