Chapter 13 - Risk Assessment In Investment Appraisal Techniques Flashcards
How are investors categorised in terms of risk preference?
1) Risk-seeking investors – accept greater volatility and uncertainty in investments. More interested in capital gains from speculative assets than lower risks and lower rewards
2) Risk-averse investors – avoid risks and prefer lower returns with known risks. Usually require an additional return to compensate for any additional risk.
3) Risk-neutral investors – overlook risk when deciding between investments. Only concerned with an investments estimated return and don’t consider risk.
What are the risk assessment models that incorporate risk into decision making?
1) Non-probabilistic approaches:
a. Sensitivity analysis
b. Scenario analysis
c. Simulation modelling
2) Probabilistic approaches
a. Expected net present value (ENPV) and standard deviation
b. Event tree diagrams
3) Risk-adjusted discount rate
What is sensitivity analysis?
Predicts the outcome of a decision by ascertaining the most critical variables and their effect on the decision. Examines how sensitive the returns on a project are to changes made to each of the key variables such as an increase or decrease in capital costs, projected sales volumes or variable costs.
Methodology:
1) Specific a base case situation and calculate the net present value of the project on the basis of the best estimates and assumptions. Only projects that generate a positive NPV are accepted
2) Calculate the percentage change of each of the variables that would result in the breakeven position (with an NPV of 0) any further change resulting in negative NPV would change the decision.
Sensitivity margin = (NPV ÷ PV of flow under consideration) x 100%
The lower the sensitivity margin, the more sensitive the decision to the particular variable under consideration. A small change in the estimate could change the NPV from positive (accept) to negative (reject)
What are the advantages and disadvantages of sensitivity analysis?
Advantages:
• Analysis is based on simple theory and is easily understood
• Identifies areas and estimates crucial to the success of the project. Critical areas are carefully monitored if the project is chosen
• Provides info allowing management to make subjective judgements based on the likelihood of the various possible outcomes
Disadvantages:
• Technique changes one variable at a time which is unlikely to happen in real scenarios (e.g. in real life if cost of materials goes up, selling price will also go up)
• Does not identify other possible scenarios
• Considers the impact of all key areas one at a time. All info may overwhelm the decision maker
• Probability of assumptions is not tested
What is scenario analysis?
Provides info on possible outcomes for the proposed investment by creating various scenarios that may occur. Evaluates the expected value of a proposed investment in these different scenarios.
Involves calculating NPV. Calculates NPV in other possible scenarios or “states of the world” such as a most likely view, an optimistic view and a pessimistic view.
Decision makers will examine each possible outcome from the downside risk and upside potential as well as the most likely outcome.
Weaknesses:
• As the number of variables increases, the model can become increasingly difficult and time-consuming
• Does not consider the probability of each state of the world occurring when evaluating possible outcomes
What is simulation modelling?
Monte Carlo simulation method shows the effect of more than one variable changing at the same time.
Programmed on computers to deal with variable factors by use of random numbers.
ID’s key variables that drive costs and revenues (e.g. changes in material prices) and then assigns random numbers and probability statistics to each variable that might affect the success or failure of a proposed project.
E.g. if most likely outcomes will have 50% probability, optimistic outcomes a 30% probability and pessimistic outcomes a 20% probability, then a random number representing those attributes can be assigned to costs and revenues in those proportions. The randomly selected values of all variable factors are used to calculate the NPV. Gives management a view of all possible outcomes. Resulting set of NPVs can be used to show how NPV varies under the influence of all variable factors.
Weaknesses:
• Complex method and not simple to calculate
• Time and costs involved may outweigh the benefits gained from the improved decision making
What is the Expected Net Present Value (“ENPV”)?
Makes use of probabilities. Most investment appraisal decisions are based on forecasts which are subject to uncertainties resulting in multiple outcomes.
Uncertainties can be analysed through probabilities of each outcome. Probabilities are usually estimated on historical data or the trend of past performance.
Probabilities can be subjective and probabilities would usually be accepted based on experience and judgement.
ENPV is a capital budgeting and appraisal technique. Projects with positive ENPV will be accepted.
Advantages:
• Provides a more realistic picture by consideration of any uncertainties specific to the project
• Simple and easy to evaluate the feasibility of a project
Limitations:
• Expected value and ENPV are measures of return. They do not consider the volatility or risk of a project. Volatility is measured by standard deviation
• Probabilities are subjective and can be difficult to estimate.
What is standard deviation and how is it calculated?
Measures the amount of variation of a set of data from its mean. A measure of risk or volatility of returns. A project is best evaluated by measuring the standard deviation, the expected value and the ENPV.
Can only be used to compare projects with the same expected return. The higher the standard deviation, the larger the variance and the higher the risk.
Calculated as the square root of the variance. It measures how spread out numbers are from their mean. Variance is the average of the squared differences from the mean.
Calculated as:
1) Deviation (d) = NPV – expected value (EV)
2) Deviation is squared (d2) to remove the negative number
3) Variance is calculated as pd2 = probability x squared deviations
4) Standard deviation (Sd) is the square root of the variance
What is the coefficient of variation and how is it calculated?
The ratio of standard deviation to the mean. Allows comparison of different projects or investments of different sizes. Standard deviation measures the volatility of returns and coefficient of variation is a better measure of the relative risk.
Coefficient of variation = standard deviation ÷ expected value of ENPV
What are event tree diagrams?
Used for risk mapping where a project or task has multiple outcomes with different probabilities. Represent all possible outcomes of an event allowing managers to calculate their probability. Each branch represents one possible outcome of the project. If two events are independent, the outcome of one has no effect on the outcome of the other.
Steps:
1) project is identified
2) events or outcomes identified
3) probabilities for the success or failure of events are determined
4) the expected value for each event is calculated
5) the sum of all expected values gives the expected value for the project.
Limitations:
• Not realistic to identify the various possible outcomes and then attach probabilities to them
• Success or failure probabilities are hard to find
• Require an analyst with practical training and experience
• Not efficient where many events must occur in combination
• All events are assumed to be independent which may not always be the case
What is the objective and key elements of portfolio management?
To select the right investments in the right proportions to generate the optimum returns whilst minimising risk.
Asset allocation
Investment strategy that balances risk and reward by adjusting the percentage of each asset in the investment portfolio according to the investor’s risk tolerance, goals and investment horizon.
Diversification
Spreading the risk across multiple investments across different asset classes, securities, sectors and geography.
Rebalancing
Continuous process of monitoring performance, incorporating the latest market conditions and implementing strategies in line with investment objectives to maximise return and minimise risk.
What are the key elements of a good portfolio?
Key elements of a good portfolio:
• Return – yield steady returns that at least match invested funds.
• Risk reduction – try to minimise overall risk to an acceptable level in relation to returns received
• Liquidity and marketability – desirable to invest in assets which can be marketed easily to ensure there are sufficient funds available at short notice
• Tax shelter – portfolio should be developed with consideration to taxes. Favourable tax positions preferred to shelter from income tax, capital gains tax and gift tax
• Appreciation in the value of capital – balanced portfolio must contain investments that appreciate in value which will protect investors from erosion in purchasing power due to inflation
What are the 3 possible results of a correlational study?
1) Positive correlation (coefficient = 1) – where prices move in same direction/has same return. Usually this is investments in the same industry e.g. sun cream and sunglasses
2) Negative correlation (coefficient = -1) – where prices move in opposite directors. Inverse relationship between two variables. E.g. ice creams and umbrellas
3) Zero correlation (coefficient = 0) – where there is no relationship between underlying investments. Usually in different asset classes or geographic locations.
What is the efficient frontier?
Modern portfolio theory tool showing investors the best possible return they can expect from their portfolio for a defined level of risk.
Aims at optimum correlation between risk and return. Portfolios that do not provide enough return for the level of risk are considered sub-optimal and on
the efficient frontier graph, lay below the efficient frontier. Each point on the efficient frontier line is an optimal portfolio.
What are the limitations of portfolio theory?
• Single-period framework
• Probabilities are only estimates
• Based on several assumptions, including:
o Investors are risk-averse and behave rationally
o Risk of bankruptcy, legal and administrative constraints are ignored
• Assumes correlation between assets is constant. May not be applicable as every variable is changing
• Complex in terms of gathering historical numbers, model selection and calculating with accuracy
• Does not assume any tax pay-outs, legal and admin costs. These are essential factors in investment decisions
• Ignores timeframes (short, medium or long term) of investments. Returns may change over periods
• Not as widespread as portfolio managers are sceptical about the accuracy of forecast data. Own judgement is normally used.
