Chapter 6 - Risk and investment appraisal

Question 1

What is risk?

Answer 1

The term used when the degree of variation from an expected outcome can be quantified

Question 2

What is uncertainty?

Answer 2

The term used when the degree of variation from an expected outcome cannot be quantified.

Question 3

What are the five methods used to deal with risk and uncertainty?

Answer 3

• Expected value
• Sensitivity analysis
• Simulation
• Discounted payback
• Risk adjusted discount rate

Question 4

What are the three advantages of the Expected values method?

Answer 4

• Deals with multiple outcomes
• Quantifies probabilities
• Simple & straight forward

Question 5

What are the three disadvantages of the Expected values method?

Answer 5

-Expected values will never occur
-Assigning probabilities is highly subjective
-Expected values do not evaluate the range of
possible NPV outcomes

Question 6

What does sensitivity analysis measure?

Answer 6

The change in a variable that can arise before the NPV equals zero

Question 7

What are the three steps to calculating sensitivity to change of any cashflow?

Answer 7

Step 1 – Calculate the NPV of the project
Step 2 – Calculate the PV of the cash flows under consideration
Step 3 – Apply to the following formula:

𝑆𝑒𝑛𝑠𝑖𝑡𝑖𝑣𝑖𝑡𝑦 =(𝑁𝑃𝑉 𝑜𝑓 𝑝𝑟𝑜𝑗𝑒𝑐𝑡) ÷ (𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑢𝑛𝑑𝑒𝑟 𝑐𝑜𝑛𝑠𝑖𝑑𝑒𝑟𝑎𝑡𝑖𝑜n)

Question 8

What are the three steps to calculating sensitivity to change in the discount rate?

Answer 8

Step 1 – Calculate the NPV of the project
Step 2 – Calculate the IRR of the project
Step 3 – Apply to the following formula:

𝑆𝑒𝑛𝑠𝑖𝑡𝑖𝑣𝑖𝑡𝑦 =(𝐼𝑅𝑅 − 𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒) ÷ (𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡e)

Question 9

What are the two strengths of the Sensitivity analysis method?

Answer 9

▪ Simple to calculate

▪ Identifies critical estimates

Question 10

What are the three weaknesses of the Sensitivity analysis method?

Answer 10

▪ Assumes variables change independently of one another
▪ Sensitivity does not examine the probability that any particular variation in costs or revenues may occur
▪ It does not provide a decision. This is dependent upon the management attitude to risk

Question 11

What are the two problems with investment appraisal?

Answer 11

• All decisions are based on forecasts

- All forecasts are subject to uncertainty

Question 12

What are the three areas where the accuracy of the estimates are a concern for investment appraisal?

Answer 12

• Project life
• Predicted cash flows and associated probabilities
• Discount rate used.

Question 13

What are four ways to asses uncertainty in investment appraisal?

Answer 13

• Shorter payback targets
• Make prudent estimates of cash flows to asses worst case scenario
• Assess best and worst possible situations to get a range of NPV’s
• Use sensitivity analysis to asses the margin of safety

Question 14

What are four ways to asses risk in investment appraisal?

Answer 14

• Expected values
• Simulation models
• Adjusted payback
• Risk adjusted discount rates

Question 15

What are three advantages of simulation?

Answer 15

• Shows all possible outcomes
• Easily understood
• Wide variety of application

Question 16

What are two disadvantages of simulation?

Answer 16

• Models can be complex and expensive

- Probability distributions may be difficult to formulate