Taking risks

Question 1

What is an issue with the expected value (EV) approach?

Answer 1

It is a long run average and assumes that a decision has been made many times

So it is unsuitable for a one-off decision making tool
The EV is unlikely to be the actual outcome of the project

Estimations of the probabilities and the cost of capital are subjective and could be inaccurate

Question 2

What type of investor is expected value suitable for?

Answer 2

Risk neutral

They will accept the project with the highest NPV value

Question 3

What type of investor is a maximax decision rule suitable for?

Answer 3

A risk seeker

E.g. if they have shares in the business

Question 4

What is the maximax decision rule?

Answer 4

The decision which maximises the maximum contribution

Question 5

What are the issues with the maximax decision making rule?

Answer 5

Does not take into account the probabilities of the outcome

Question 6

What does a higher standard deviation mean?

Answer 6

The higher the standard deviation, the greater the spread of possible outcomes

High standard deviation = high risk

Question 7

How does the standard deviation affect a decision?

Answer 7

A lower standard deviation would be chosen by a risk adverse/ risk neutral

Question 8

After NPV and standard deviation analysis, what further analysis can be carried out?

Answer 8

Sensitivity analysis

PEST (external environment)