Risk

Question 1

Objective probability

Answer 1

• Uses past experience

Question 2

Subjective probability

Answer 2

personal judgement of the range of outcomes along with the likelihood of their occurrence

Question 3

discount rate

Answer 3

higher discount rate for higher risks

Question 4

pros of using discount rate

Answer 4

easy approach to understand and adopt

Question 5

cons of using discount rate

Answer 5

• risk perception and judgment are bound to be so some they’ll be personal bias
• a high degree of arbitrariness in the selection of risk premiums

Question 6

advantages of using sensitivity analysis

Answer 6

• information for decision making
• to direct search - focus on the most important areas
• to make contingency plans

Question 7

Disadvantages of using sensitivity analysis

Answer 7

• no probabilities - no likelihood of changes
• each variable is changed in isolation while all other factors remain constant

Question 8

Scenario analysis

Answer 8

allows all variables to change at the same time
- Worst case - NPV of all the variables at their worst
- Best case - NPV of all the variables at their best

Question 9

mean variance efficiency

Answer 9

• must has a common factor (same risk or return) to make decision

Question 10

conditional probability

Answer 10

if and then responses following first year outcome

Question 11

problems using probability analysis

Answer 11

• too much faith can be placed in subjective probabilities
• too complicated for managers to understand
• projects may be viewed in isolation ignoring their risk reducing possibilities

Question 12

Real options

Answer 12

Gives the right, but not the obligation, to take an action in the future
Eg.
- ending before scheduled end
- expansion
- differ to t1 or t2 rather than t0