Risk in Decision making Flashcards
Introduction
Contribution = sales less VC
Relevant costs are future and incremental costs
P.V = Cashflow*discount factor
Positive NPV means M.V of shares will increase if project is accepted
M.V of shares is equal to P.V of the future cashflows of dividend.
IRR is the rate of interest for which NPV is zero, It shows sensitivity of project’s NPV.
Uncertainty on demand - Research may help but this is a genuine unknown
Risk & uncertainty
Risk is the degree of uncertainty or range of variation. greater the variation the higher the risk
Risk is measured by standard deviation
Uncertainty is an unknown outcome or value
role of accountants in risk and uncertainty
1. Listen to the client
2. Advice on potential sources of research
3. advise using business knowledge
main
1. carry out financial analysis on the new project - calculate potential returns and analyse data
2. Advise client on best course of action an client/ boss makes the decision
Methods of analysis - Decision Tables
Decision table shows all possible results from a decision amidst uncertainty
Decision is at the top of table (horizontal), uncertainty is at the vertical
Client has to advised appropriately, to do this accountant has to understand the RISK attitude of the client. different stakeholders have different risk attitudes
Risk attitudes are complex in real life, e.g. below
stakeholders -
1. Venture capital - willing to take risks, promises high returns to its
own investors. Strategy is MAXIMAX . maximise the maximum
possible return - GO FOR THE BIGGEST NUMBER IN THE TABLE.
whilst ignoring huge potential downside due to risk, probability
and consequences of failure.
2. owners of family companies - Often need to protect family’s home
so pessimistic in view and RISK AVERSE - Maximin (best worst
case scenario) Maximise the minimum possible return “at least I
will make”
3. Banks/ debt holders - worried about unsecured amounts and loss.
Not set up to take risk - so pessimistic in view and RISK AVERSE -
Maximin (best worst-case scenario)
4. People who have made mistakes in the past and have been left
scarred (can be directors) - They do not want to repeat mistakes -
Minimax regret - Regretter
5. Investor with large portfolio or those investing in multiple independent projects that will average out in terms of return. - Expected value
Methods of analysis - Decision Tables - Expected value
The weighted average value is used
EV=E(P*X)
P= probability
X = value
calculate for each decision to see which one is higher
The EV does not equal an actual result on a any day, owner might think it should and hence think they have been misled
It hides a range of results in a single figure
E.V is amount we expect if the decision is repeated over and over since we will get the average result overall
E.V is just an average and is not ideal for one off, check the spread between options to see which one is more risky.
Always consider risk in your explanation as E.V calculation ignores risk.
