Chapter 3

Question 1

Define risk

Answer 1

Decisions are subject to risk where there are several possible outcomes and the likelihood of those outcomes can be quantified in the form of possibilities

Question 2

Define uncertainty

Answer 2

Decisions are subject to uncertainty where there are several possible outcomes but the likelihood of those outcomes cannot be quantified

Question 3

What are 5 methods of dealing with decision making under risk and uncertainty

Answer 3

Setting a minimum payback period

Increasing discount rate (to use higher hurdle rate and get more conservative NPV)

Calculating worst outcome

Calculating range of outcomes

Sensitivity analysis

Question 4

What is sensitivity analysis?

What does it show?

Answer 4

Determines how sensitive the NPV of the project is to an individual estimated variable

Shows the % change in the variable necessary to change our decision eg to make NPV 0

Question 5

How do you calculate sensitivity to variables impacting cash flow?

Answer 5

NPV of project / PV of cash flows impacted by the variable

Question 6

How do you calculate sensitivity to COC?

Answer 6

IRR- COC/ COC

Question 7

What are 3 strengths and 3 weaknesses of sensitivity analysis?

Answer 7

Strengths:

Facilitates DM
Identifies critical areas and variables which should then be monitored
Simples

Weaknesses:

Assumes changes in variables can be made independently
Ignores probability
No clear answer: only gives context to NPV calculation

Question 8

What is predictive analysis ?

Answer 8

Uses historical and current data to create predictions about the future. Big data can be used to create predictions

Question 9

What is the Monte Carlo simulation?

Answer 9

Large number of variables with large range of possible values to enter into NPV calculation

In such situations, simulation is used to provide context for the inv appraisal

Involved identifying each of the different variables, the range of different values of those variables and the probability of those values occurring

Hundreds or thousands of simulations are run to record rhe NPV of the project for different combinations of values for the different variables

Results then show expected NPV and distribution of possible NPV values

Question 10

What are the two advantages and four disadvantages of simulation?

Answer 10

Advantages:

Gives more info about spread of possible outcomes

Useful for problems which cannot be solved analytically

Disadvantages

Not a technique for making a decision just gives context

Very time consuming to run

Prove expensive to design

Assumptions need to be made about the probabilities associated with different variables

Question 11

What is linear regression?

Answer 11

Statistical technique
Attempts to identify factors associated with a change in the value of a key variable
Variable business trying to predict: dependent variable
Factors thought to have an impact on this are called an independent variable

Question 12

Advantages and disadvantages of linear regression?

Answer 12

Advantages:

Simple to use and easy to explain to non financial managers

Can be used to predict the impact of expanding variables beyond current estimates

Limitations;

Not always be a linear relationship between variables and outcomes

Basic linear regression models only consider impact of one variable at a time

Do nor consider difference between correlation and causation

Will be less meaningful if the data collected is inaccurate or if error term too large

Question 13

How do you calculate correlation coefficient?

Answer 13

=correl(cell range 1, cell range 2)

Strong if coefficient is close to 1

-1 is a weak negative correlation

Question 14

What are the advantages and disadvantages of orecriotive analytics?

Answer 14

Adv:

Have the capability to itdentify optimum investment decisions whilst considering the impact of multiple decisions and variables

Limitations:

Creating reliable prescriptive models is complex and requires specialist data science skills which are typically outside the scope of finance managers

Reliability of models depends on the reliability of the data that they use

Question 15

Define data bias

Answer 15

When it is not representative of the population

Question 16

What is selection bias?

Answer 16

Occurs when the data is not selected randomly and leads to a sample that is not representative of the whole population. All items in the population should have an equal chance of being selected for the sample

Question 17

What is self selection bias?

Answer 17

Occurs when individuals select themselves such as customers choosing whether or not to respond to a survey

Question 18

What is omitted variable bias?

Answer 18

When a variable is excluded from the data model and therefore cause of a change in one variable is incorrectly attributed to another variable in the model.

Eg sales budgeting: may be easy to attribute an increase or decrease in sales volume to the wrong variable

Question 19

What is cognitive bias?

Answer 19

Relates to human perception and includes bias on how data is presented.

Eg based on last years sales figures budgeting is very common and may lead to poor DM. Opportunities may be missed

Question 20

What is confirmation bias?

Answer 20

Occurs when people see data that confirms their beliefs and they ignore data that disagrees with their beliefs

Question 21

What is survivorship bias?

Answer 21

Tendency towards studying successful outcomes while excluding unsuccessful outcomes. Only items that survived previous events are included in the sample

Question 22

What is mean and how do you calculate it?

Answer 22

Average of a set of data. Taken by the sum of all values and dividing by number of values

=avg(cell range)

Question 23

What is standard deviation and how is it calculated?

Answer 23

Shows avg amount of variability in a data set, showing how far on average each result lies from the mean

Question 24

How do you calculate standard deviation?

Answer 24

=stdev(cell range)

Question 25

What is the coefficient of variation?

Answer 25

Measures standard deviation as a % of the mean. Higher the %, the wider dispersion of data around the mean.

=stdev(cell range) / avg

Question 26

What is normal distribution?

Answer 26

68.2% of values in data set lie within 1SD
95.4% of values within 2D

Question 27

What direction is a negative and positive skewed distribution?

Answer 27

Negative: left
Positive : right

Negative: mean median mode
Positive: mode median mean

Question 28

What is expected value?

Answer 28

Expected value is the probability weighted average of the possible outcomes

Sum: probability of outcome x outcome

Question 29

Adv and disadvantages of expected outcomes?

Answer 29

Adv:

Information is reduced to single number for each choice
Idea of avg is easily understood

Disadv:

Probabilities may be difficult to estimate

Expected value may not correspond to other values

Expected value represents long run avg . In one off situations it is less suitable to use

Gives no indication of the spread of possible outcomes

Question 30

How can you allow for risk and uncertainty?

Answer 30

Adjust COC (the hurdle rate) for risk (so that riskier projects are assessed against a higher cost of capital)

Question 31

What is business risk?

Answer 31

Variability of profits before interest and tax

Comprises systematic and specific risks

Question 32

What is systematic business risk?

Answer 32

Variability in PBIT due to factors specific to a company

Equipment failure, labour strikes etc

Risk can be diversified away

Question 33

What is systematic business risk (correct)

Answer 33

Variability in PBIT due to macro economic factors such as state of economy, FOREX

IMAPCTED by business sector of the company and its level of operational gearing

B measures a company’s exposure to systematic business risk

Question 34

What is the CAPM: required risk and return?

Answer 34

COC used to appraise an investment represents the minimum required return for an investment

Required return is set according to the risk associated (higher the risk, higher the return required)

If we assume investors are well diversified, then for the purposes of investment appraisal, only the systematic risk of an investment should be considered as its specific risk may be diversified away

Question 35

What does a beta factor show? How is it measured?

Answer 35

Is a measure of exposure to systematic risk which shows the relative riskiness of the investment compared to the market portfolio of shares.

By comparing the change in return on an individual share to the change in return on the market portfolio in the same period

B<1 investment is less exposed to systematic risk than market portfolio

B=1 investment has the same exposure to systematic risk as the market portfolio

B>1 investment is more exposed to systematic risk than market portfolio

Question 36

What is the CAPM formula?

Answer 36

Rj =rf + bj(rm-rf)

Rj= required rate of return on investment

Rf= risk free interest rate

Rm = return on market portfolio

Bj= index of systematic risk for security

Question 37

Adv and disadv of CAPM?

Answer 37

Adv:

Directly links the risk associated with an investment to the required return from that investment

Disadv:

Assumes investor is diversified and hence we only need to focus on systematic risk

Ignores the fact that other stakeholders are not diversified and will be concerned by specific risks

Assumes investor can despoti and borrow at the risk free rate

Assumes exposure to all systematic risks can be grouped into one measure (v) that b can be accurately measured and that b will remain unchanged over time

Historic figures used in the calculation (return on market portfolio and beta)