Ch.3 - Risk and decision making

Question 1

What are expected values?

Answer 1

Sum of possible outcomes and probabilities assigned to each.
It is not most likely result, may not even be a possible result, but instead it finds the long run average outcome.

Question 2

What are limitations of expected values?

Answer 2

• discrete outcomes
• subjective probabilities
• ignores risk
• not a possible outcome

Question 3

What is sensitivity analysis?

Answer 3

• percentage change in an estimate that would lead to us changing the decision about the project (gives NPV=0)
  1. sensitivity affecting CF=NPV (whole project)/NPV(CF affected by change)
  2. sensitivity to other factors:
• discount rate = difference between cost of capital and IRR
• project life = discounted payback

Question 4

What are limitations of sensitivity analysis?

Answer 4

• assumes variables change independently of each other
• does not assess the likelihood of a variable changing
• does not identify correct decision

Question 5

What is simulation (Monte Carlo simulation)?

Answer 5

Simulation improves on sensitivity analysis by looking at the impact of many variables changing at the same time using mathematical modelling and producing a distribution of possible outcomes from the project.

Question 6

What are practical methods of how to incorporate uncertainty?

Answer 6

• minimum payback period
• higher discount rates
• prudent estimates of CF
• assessment of best and worst outcomes

Question 7

What is the effect of diversification?

Answer 7

• Initial diversification will bring about substantial risk reduction as additional investments are added to the portfolio. Risk reduction slows and becomes insignificant once 15-20 investments have been combined.
• That mean that diversification reduces unsystematic risk (that is unique to each investment), however leaves systematic (market) risk for the investor that affects all the companies in the same way.

Question 8

What are implications of diversification?

Answer 8

• Because investors are already FULLY-DIVERSIFIED, they do not suffer specific risk. Therefore, in estimating their required return they ONLY need to be compensated for SYSTEMATIC risk.
• When directors are making strategic decisions, they SHOULD NOT try to reduce risk by diversification as shareholders are ALREADY DIVERSIFIED and therefore cannot reduce their risk further.

Question 9

What is use of CAPM equation?

Answer 9

• most commonly used to find the required return from a project in situations where the project has a different risk profile from the company’s current business operations
• if returns from a company are currently higher than the CAPM return, then investors will be attracted to those shares (positive alpha value which is difference between current and CAPM return)

Question 10

What are problems with CAMP equation?

Answer 10

Estimating Rm = usually done using historic rather than expected future returns

Estimating Rf = gilts are not risk-free and returns will vary with the term of the bond

Calculation of beta = calculated using statistical analysis of the difference between market return and the return of the particular share or industry. It is too simplistic and risk premiums are made up of multiple factors rather than just one single ‘market’ factor.

Question 11

What are alternatives to CAPM?

Answer 11

Arbitrage Pricing Theory (APT) = similar to CAPM, however it divides the premium down into lots of bits (Re=Rf+(b1premium1)+(b2premium)…). Problem is then to decide what the bits are.

Bond yield plus premium approach = using rate of interest the company is able to borrow at instead of risk-free rate and adding fixed premium on top of that.

Dividend valuation model = by looking at predicted future dividends on a share compared to its share price, we can measure what return is ACTUALLY being achieved and assuming perfectly efficient market, that SHOULD be the return to compensate for risk.