LECTURE 6

Question 1

in NPV, what risks could occur ad what problems will arise?

Answer 1

Risks in the discount rate coudl occur, this leads to proelms such as:
-Cost of equity isn’t straight forward. There are problems with using CAPM analysis.

• Using project beta, levered / unlevered beta doesn’t solve the problems that CAPM beta isn’t a good estimation of cost of equity. Garbage in garbage out.
• Solution could be to use whatever cost of equity you would like or need to (Warren Buffett approach). Focus your time on future cash flows and margin of safety instead of worrying about correct cost of equity.

Question 2

What is sensitivity analysis? Explain how to use it

Answer 2

Sensitivity analysis is to analyze the effect of changing an input variable, holding all else constant. (draw a graph)
for example if we want to measure how important variable cost is, we make all the other variables equal to its expected (normal) value. We then adjusted varible cost at its optimal and pessimistic value to obtain its magnitude in change on the sales volume)

Question 3

What are the benefits of a sensitivity analysis? (hint: how many are there)

Answer 3

1. Areas of cash flow risks are highlighted - this is good for managers so they can choose to collect more data and conduct further research
2. After project begins, manaers know where t focus their attention as to prevent bad outcomes
3. it acts as a checklist, forcing managers to think about downsides (humans may not want to think about bad stuff yanno)
4. Scenario analysis: worst or best outcomes are simultaneously realised for many of the variables of interest

Question 4

what are the cons of sensitivity analysis?

Answer 4

It doesn’t consider how variables interrelate to each other. But analyst can view interrelation by picking and choosing variables the analyst think will occur together. (using own brain to figure out variables)

Question 5

Whta is the break even analysis?

Answer 5

It is similar to sensitivity analysis. It analyses how bad things can become until project becomes a negative NPV.
often expressed in terms of percentages

Question 6

What is the monte carlo method?

Answer 6

It runs simulations to identify average returns