Lesson 2: Project Analysis

Question 1

What is the cost of capital?

Answer 1

The interest rate that has to be paid to investors in order to get them to invest in the project.

Question 2

What is NPV?

Answer 2

Net present value. This is the present value of free cash flows of a project. Non-cash accounting items are not taken into account.

Question 3

For what values of NPV would a company invest in a project?

Answer 3

A project is considered investment worthy if NPV > 0

Question 4

What is the NPV for constant free cash flows in perpetuity?

Answer 4

NPV = 1 / (i - g)

Question 5

What is a break-even analysis?

Answer 5

The process of determining the value of each parameter for which the NPV is 0, assuming that the other assumption parameters are at their baseline values.

Question 6

What is a sensitivity analysis?

Answer 6

Calculating the change in the NPV resulting from a change in a single parameter.

Question 7

What is a scenario analysis?

Answer 7

Calculating the NPV for various scenarios. A scenario may vary two correlated parameters in a consistent manner, leaving the other parameters unchanged if they are uncorrelated.

Question 8

What is translation invariance?

Answer 8

Adding a constant to the random variable should add the the same constant to the risk measure.

g(X + c) = g(X) + c

This is reasonable, since a constant gain or loss generates no risk beyond its amount.

Question 9

What is positive homogeneity?

Answer 9

Multiplying the random variable by a positive constant should multiply the risk measure by the same constant.

g(cX) = cg(X)

This is reasonable, since expressing the random variable in a different currency (for example) should not affect the risk measure.

Question 10

What is subadditivity?

Answer 10

For any two random losses X and Y, the risk measure for X + Y should not be greater than the sum of the risk measures for X and Y separately:

g(X + Y) <= g(X) + g(Y)

This is for upside risk, the equality is reversed for downside risk.

This is reasonable, since combing losses may result in diversification and reducing the total risk measure, but it should not be possible by breaking a risk into two sub-risks to reduce the total risk measure.

Question 11

What is monotonicity?

Answer 11

For any two losses X and Y, if X is always less than Y, or even if the probability that X is less than Or equal to Y is 1, then the risk measure for X should be no greater than the risk measure for Y.

g(X) <= g(Y) if Pr(X <= Y) = 1 (Upside)

This is reasonable, since X clearly has no more risk than Y.

g(X) >= g(Y) if Pr(X >= Y) = 1 (Downside)

Question 12

Is Value at Risk a coherent risk measure?

Answer 12

It fails subadditivity unless all distributions are normal, then it is.

Question 13

Name a coherent risk measure

Answer 13

Tail value at risk is a coherent risk measure

Question 14

Which risk measures does variance fail?

Answer 14

Variance and semi variance fail all risk measures.