Risk Analysis Flashcards
Risk Analysis
attempts to measure the likelihood of the variability of future returns from the proposed capital investment , the following techniques used to analyze or account for risk : 1-Informal method 2-Risk-adjusted discount rates 3-Certainty equivalent adjustments. 4-Simulation analysis. 5-Sensitivity analysis. 6-Scenario analysis. 7-The Monte Carlo Simulation
Techniques are frequently used to analyze or account for RISK
1-Informal method 2-Risk-adjusted discount rates 3-Certainty equivalent adjustments. 4-Simulation analysis. 5-Sensitivity analysis. 6-Scenario analysis. 7-The Monte Carlo Simulation
Informal method ( Risk Analysis Technique )
NPVs are calculated at the firm’s desired rate of return, and the possible projects are individually reviewed.
If the NPVs are relatively close for two mutually exclusive projects, the apparently less risky project is chosen.
Risk-adjusted discount rates ( Risk Analysis Technique )
The discount rate of a capital investment is generally the company’s cost of capital.
1) However, when a capital investment is more or less risky than is normal for a company, its discount rate is adjusted accordingly. The discount rate is increased
(above the company’s cost of capital) for riskier projects, and decreased (below the
company’s cost of capital) for less risky projects.
2) Thus, discount rates may vary among capital investments depending on the company’s cost of capital and the type of investment.
3) Additionally, some investments may be accepted (rejected) with internal rates of return (IRR) that are less than (greater than) the company’s cost of capital
Certainty equivalent adjustments
This technique is directly drawn from the concept of utility theory. it forces the decision maker to specify at what point the firm is indifferent to choice between a certain sum of money and the expected value of risky sum ( the technique is not frequently used because decision makers are not familiar with the concept)
Simulation analysis
This method represents a refinement of standard profitability theory. the computer is used to generate many examples of results based upon various assumptions. Project simulation is frequently expensive . unless a project is exceptionally large and expensive , full-scale simulation is usually not worthless
This method represents a refinement of standard profitability theory. the computer is used to generate many examples of results based upon various assumptions. Project simulation is frequently expensive . unless a project is exceptionally large and expensive , full-scale simulation is usually not worthless
Simulation analysis
Sensitivity analysis.
Forecasts of many calculated NPVs under various assumptions are compared to see how sensitive NPV is to changing conditions. Changing or relaxing the assumptions about a certain variable or group of variables may drastically alter the NPV. Thus, the asset may appear to be much riskier than was originally predicted.
- In summary, sensitivity analysis is simply an iterative process of recalculated returns based on changing assumptions
The Monte Carlo technique
is used to generate the probability distribution of all possible outcomes from a capital investment
1) The performance of a quantitative model under uncertainty may be investigated
by randomly selecting values for each of the variables in the model (based on
the probability distribution of each variable) and then calculating the value of the
solution. This process is performed a large number of times.
This technique is directly drawn from the concept of utility theory. it forces the decision maker to specify at what point the firm is indifferent to choice between a certain sum of money and the expected value of risky sum ( the technique is not frequently used because decision makers are not familiar with the concept)
Certainty equivalent adjustments
The discount rate of a capital investment is generally the company’s cost of capital.
1) However, when a capital investment is more or less risky than is normal for a company, its discount rate is adjusted accordingly. The discount rate is increased (above the company’s cost of capital) for riskier projects, and decreased (below the company’s cost of capital) for less risky projects.
2) Thus, discount rates may vary among capital investments depending on the company’s cost of capital and the type of investment.
3) Additionally, some investments may be accepted (rejected) with internal rates of return (IRR) that are less than (greater than) the company’s cost of capital
Risk-adjusted discount rates ( Risk Analysis Technique )
NPVs are calculated at the firm’s desired rate of return, and the possible projects are individually reviewed.
If the NPVs are relatively close for two mutually exclusive projects, the apparently less risky project is chosen.
Informal method ( Risk Analysis Technique )
is often used in simulation to generate the individual
values for a random variable.
1) The performance of a quantitative model under uncertainty may be investigated
by randomly selecting values for each of the variables in the model (based on
the probability distribution of each variable) and then calculating the value of the
solution. This process is performed a large number of times.
The Monte Carlo technique
Forecasts of many calculated NPVs under various assumptions are compared to see how sensitive NPV is to changing conditions. Changing or relaxing the assumptions about a certain variable or group of variables may drastically alter the NPV. Thus, the asset may appear to be much riskier than was originally predicted. In summary, sensitivity analysis is simply an iterative process of recalculated returns based on changing assumptions
Sensitivity analysis.
The Profitability of a capital investment is analyzed under various economic scenarios
Scenario analysis
