Risk and Investment appraisal Flashcards
When the degree of variation from an expected outcome can be quantified, usually by using probabilities.
Risk
When the degree of variation from an expected outcome cannot be quantified.
Uncertainty
Which are the 5 methods of dealing with risk and uncertainty?
- Expected Values
- Sensitivity Analysis
- Simulation
- Discounted payback
- Risk adjusted discount rate
Mutilplying the possible outcomes by their corresponding probabilities is an…
expected value
Give 3 advantages of expected values
- Simple and Easy
- Quantifies probability
- Deals with multiple outcomes
Give 3 disadvantages of expected values
- EV will never occur
- Assigning probabilities - subjective
- EV’s do not evaluate the range of possible NPV outcomes
Measures the amount of change in a variable that could arise, before the decision to accept or reject the project changes. ( The NPV =0)
Sensitivity Analysis
What are the 3 steps to calculating the sensitivity of a cashflow?
- Calculate NPV of Project
- Calculate the PV of the cashflow under consersation
- NPV of Project / PV of Cashflow
What are the 3 steps to calculating the sensitivity to a change in discount rate ( cost of capital)?
- Calculate the NPV of project
- IRR of project
- IRR - Original Discount rate/
Original Discount rate
What are the strengths of sensitivity analysis? (2)
Simple
Identifies critical estimates
What are the weaknesses of sensitivity analysis? (3)
- Assumes variables change independently of one another
- Does not examine the probability that a particular variation may occur
- It doesn’t provide a decision! Depends of mngmnts attitude
An advanced form of senstivity analysis which determines the relationship between all the variables used in calculating an NPV
Simulation
What is the advantage of discounted payback over normal payback?
It takes into account the time value of money.
If risk is higher the discount rate will be increased. A high discount rate will result in a ——- NPV
Lower
