Chapter 3 Flashcards
What is the formula for sensitivity to variables impacting on cash flows
NPV of project / PV of cash flows impacted by the variable
What is the equation for the sensitivity to the cost of capital
Sensitivity to the cost of capital = (IRR- COC) / COC
What are 3 strengths of sensitivity analysis
Facilitates decision making (once the sensitivity is known to an individual variable, mgmt can assess likelihood of such a change)
Identifies critical areas / variables
Simple to understand
What are 3 weaknesses of sensitivity analysis
Assumes changes to variables can be made independently
Ignores probability
No clear answer
What is the Monte Carlo simulation
Identifies a range of variables and the probabilities of those values occurring through different simulations.
The results then show the expected NPV and the distribution of possible NPV values
What are the advantages of Monte Carlo simulation (2)
What are the disadvantages of Monte Carlo simulation (4)
Advantages
Gives more info about the spread of possible outcomes
Useful for problems which cannot be solved analytically
Limitations
Not a technique for making a decision
Time consuming without a computer
Can prove expensive to design and run
Assumptions need to be made about the probs associated with different variables
What are the 2 advantages of linear regression models
What are the 4 disadvantages
Advantages
Simple to use and easy to explain
Can be used to predict the impact of expanding variables beyond current estimates
Disadvantages
Will not always be linear relationships between variables and outcomes
Basic linear regression models can only consider one variable at a time
Linear models may identify spurious relationships between variables
Will be less meaningful if data collected is inaccurate
What is prescriptive analysis
Uses AI and algorithms and can be used to calculate the optimum outcome from a variety of business decisions
What is 1 advantage and 2 limitations of prescriptive analytics
Advantage:
Capability to identify optimum investment decisions whilst considering the impact of multiple decisions and variables
Disadvantages:
Creating reliable models is complex and requires specialist data science skills
Reliability of models depends on the reliability of the data that they use
What are the 7 data biases
Selection bias - data not selected randomly
Self-selection - occurs when individuals select themselves
Observer bias - researcher allows their assumptions to influence observations
Omitted variable - cause of change of one variable is incorrectly attributed to another variable
Cognitive - eg framing and anchoring
Confirmation- people see data which confirm their beliefs
Survivorship - only items that survived some previous event are included in the sample
What is the formula for the coefficient of variation
COV = std deviation / mean
In normal distribution what are the percentages of
+ - 1 std dev
+ - 2 std dev
+ - 3 std dev
1: 34% each way of mean
2: 47.5% each way of mean
Or 95% in total
3: 49.9% each way of mean
How do you calculate expected value
Sum of ( probability of outcome * outcome)
What are the main issues with using probabilities to estimate expected values (4)
If done only once, there is a range of possible outcomes so it will likely not be the expected value
There is usually a good chance that a sub optimal outcome will be the result if only done once
Probabilities may be difficult to estimate
Expected value gives no indication of the spread of possible results
What are the two types of business risk
Specific risk and systematic risk
