Chapter 14 Risk Assessment in investment appraisal techniques Flashcards
What are the three categories of risk preference for investors
Risk - seeking
Risk-averse
Risk Neutral
What are the two approaches to risk assessment?
Probabilistic
Non-Probabalistic
Risk adjusted discount rate
What elements does the Non probablistic approach include
sensitivity analysis
scenario analysis
simulation modelling
What elements does the probablistic approach include
expected net present value (ENPV) and standard deviation
Event tree diagrams
What is sensitivity analysis
Non-probabilistic approach
ALlows the analysis of changes in assumptions made in the forecast
Predicts the outcome of a decision by ascertaining the most critical variables and their effect on the decision.
How sensitve returns of a project are to changes made to the variables.
what is the sensitivity analysis methodology?
- Specify the base situation and calculate the NPV based on best estimates and assumptions. only projects that generate positive NPV accepted.
- Chalcuate percentage change, or sensitivity of each of teh variables that would result in the breakeven position (with an NPV of zero). Any further change resulting in a negative NPV would change the decision.
sensitivity margin = NPV / PV of flow under consideration) x 100%
What is the calculation for how much the cost of capital would need to increase by for the investment decision to change?
If NPV is to fall, cost of capital must rise.
The figure the cost of capital must rise to is the projects IRR.
Find the IRR estimate a higher % then…
IRR = R1 + NPV1 / (NPV1-NPV2) x(R1-R2)
This will tell you the percentage the investment decision would have to increase by before the investment decision changes.
What headings to you need in working out ENPV - you are given the amount of investment, the number of years, told its unpredictable, The cost of capital and a table with the annual cash flow and probabilities based on historical data.
Year TItles Prob Annual CF PX DF Disc CF
(X) (prob x X) Totals
minus the project cost at the end.
What headings to you need in working out ENPV - you are given the amount of investment, the number of years, told its unpredictable, The cost of capital and a table with the annual cash flow and probabilities based on historical data.
Year Cash flow Prob Outcome PX DF Totals
(X) (prob x X)
minus the project cost at the end.
How do you calculate the P/E ratio?
P/E ratio = price of shares / EPS = (ie if £14)
For every £1 of earnings form teh companys profits the investor has to invest £14 in the company shares. or
THe payback period is 14 years.
What is the average market P/E ratio?
20 - 25 times earnings
It shows the number of years it would take the company to pay back the amount paid for the shares
What is CAPM?
Capital Asset Pricing Model
Describes the relationship between systematic risk and expected return for assets (shares)
RADR (Risk adjusted discount rate) = RFR + B (RM-RFR)
RFR = Risk Free Rate
RM -= Return on stock market portfolio
B = meaure of a stocks risk (1 is the market level)
What is WACC
Weighted average cost of capital
WACC - (Proportion of equity x Cost of equity) + (proportion of debt x post tax cost of debt)
