Project Appraisal Under Risk Flashcards
What is a risk?
A condition in which several possible outcomes exist, the probabilities of which can be quantified from historical data
What is uncertainty?
The inability to predict possible outcomes due to a lack of historical data
What is sensitivity analysis?
Analysis of changes made to significant variables in order to determine their effect on a planned course of action.
Lower percentage in a sensitivity analysis?
The more sensitive the NPV is to that project variable,
Advantage of sensitivity analysis?
Sensitive the project is to changes in any of the original estimates
Identifies the critical success factors for the project
Limitations of sensitivity analysis?
Assumes data for all other variables is accurate
Sensitivity analysis does not provide a decision rule
What is a simulation?
A technique which allows more than one variable to change at the same time
1st stage in a Monte Carlo siituation?
Specify the major variables (e.g. revenue and costs)
2nd stage in a Monte Carlo siituation?
Specify the relationship between the variables
3rd stage in a Monte Carlo siituation?
Attach probability distributions to each variable and assign random numbers to reflect the distribution
4th stage in a Monte Carlo siituation?
Simulate the environment by generating random numbers for revenue and costs
5th stage in a Monte Carlo siituation?
Record the outcome of each simulation
6th stage in a Monte Carlo siituation?
Repeat the simulation many times to obtain a probability distribution of the possible outcomes
Advantages of simulation?
Data can be used to calculate an expected NPV
Disadvantages of simulation?
Very time-consuming and expensive
Monte Carlo simulation is not a technique for making a decision
What is an expected value?
The quantitative result of weighting uncertain events by the probability of their occurrence
Advantage of expected value?
The idea of an average is readily understood
Expected value reduces the information
Disadvantage of expected value?
Average may not correspond to any of the possible outcomes and is difficult to estimate
It ignores risk
What is a discounted payback?
The period of time for the discounted returns from a project to recover the initial investment
Methods of keeping project risk within acceptable levels (payback)
Setting a maximum adjusted payback period for intiial screening of projects
Methods of keeping project risk within acceptable levels (sensitivity)
Focusing attention on the critical success factors indicated by sensitivity analysis
Methods of keeping project risk within acceptable levels (discount)
Using risk-adjusted discount rates for both NPV and adjusted payback
Methods of keeping project risk within acceptable levels (forecasts)
Using conservative forecasts, such as reducing the forecast returns downwards to reflect the guaranteed minimum inflows from a project (certainty equivalents)
