Lecture 7 - Project Analysis and Uncertainty Flashcards
Investment appraisal faces what problems?
- All decisions are based on forecasts.
- All forecasts are subject to uncertainty.
- The uncertainty needs to be reflected in the financial evaluation.
The areas of concern are the accuracy of the estimates concerning…
Project life, predicted cash flows, probabilities and discount rate used.
Explain sensitivity analysis.
- Concerned with ‘what if’ questions.
- Analysis of the effects on project profitability of changes in sales and costs etc.
- Firms establish a ‘base case’ set of assumptions for a particular project and calculate the NPV.
- Mangers allow one variable to change while holding all others fixed, and then they recalculate the NPV.
- Repeating this process for all the uncertain variables, allows managers to see how sensitive the NPV is to changes in baseline assumptions.
Limitations of the sensitivity analysis.
Sensitivity analysis is concerned with expressing cash flows in terms of key project variables, such as, price, costs, change in working capital etc, and then calculating the consequences of misestimation. It forces managers to identify determinants for success and areas where more information is needed.
- However, results may be ambiguous. The meaning of optimism or pessimism is unknown. The probability is not precise.
- Additionally, underlying variables are likely to be interrelated. For example, sales and costs. Similarly, working capital and sales are highly linked.
- Only allows one variable to change at a time, in practice variables change simultaneously.
What is scenario analysis?
- Project analysis looks at different scenarios.
- Particular combination of assumptions.
- Variables are interrelated.
- Similar to sensitivity analysis, but takes into consideration the changes of several important variables simultaneously.
What is probability analysis?
- There are several possible outcomes for a decision and probabilities can be assigned to each.
- A probability distribution of expected cash flows can often be estimated.
What is expected value (EV)?
- Expected value (EV) is the weighted average of all the possible outcomes, with the weightings based on the probability estimates.
Risk can be measured by…
- The worst possible outcome and its probability.
2 The probability that the project will fail. - The standard deviation of the outcomes.
What are the advantages of probability analysis?
- Deals with multiple outcomes, scenarios.
- Quantifies probabilities.
- Relatively simple to calculate.
- Assists decision making.
What are the disadvantages of probability analysis?
- Subjective probability.
- Answer is only a long run average.
- Ignores variability of payoffs.
- Only deals with risk neutral decision, i.e. ignores investors’ attitude to risk.
Using expected value as a basis of decision making is appropriate if the three conditions are met. What are they?
- There is a reasonable basis for making the forecasts and estimating the probability of different outcomes.
- The decision is relatively small in relation to the business, so risk is small in magnitude.
- The decision is for a category of decisions that are often made.
What is simulation analysis, also known as Monte Carlo analysis?
- Unlimited scenarios.
- Considers multiple variables changing at the same time.
- A method for estimating project risk that assigns a probability distribution to each of the key variables.
- Uses random numbers to simulate a set of possible outcomes to arrive at an expected value and dispersion (all possible combinations).
- Analysts specify a range or a distribution of potential outcomes for each of the model’s assumptions.
- A distribution of the project NPV instead of several NPVs under specific circumstances.
What are the four main stages of simulation analysis?
- Specify major variables.
- Specify the relationships between variables to calculate an NPV. Computer builds model, for example, sales revenue is the product of sales unit and price per unit.
- Simulate the environment. Computer will randomly select a value for each variable.
- The results of a simulation exercise will be a probability distribution of NPVs.
What are the advantages of simulation analysis?
- It includes all possible outcomes in the decision making process.
- It is a relatively easily understood technique.
- It has a wide variety of applications (e.g. inventory control, component replacement).
What are the disadvantages of simulation analysis?
- Models can be extremely complex.
- Probability distribution may be difficult to formulate.
