Topic 4 - Risk and Uncertainty in Investment appraisal Flashcards
What is the difference between Risk and Uncertainty and what do we use?
Risk is the chance that the actual outcome is different to the expected outcome and risk can be quantiifed as there is a predicted amount.
Uncertainty is the lack of certainty that an outcome will have. We are unsure if an outcome will happen with uncertainty whereas we know there will be an outcome with risk but just not sure what outcome.
What is the formula for probability anaysis?
Probability analysis is the calculation to workout the expected value of an investment and can only be done when management assigns pobability to expected values.
Expected Value = Probability x possible outcome
What is the proforma of the joint probabilities?
Yr 1 PV|Yr 1 Prob|Yr 2 PV|Yr 2 Prob|Total PV|Joint Probability|Total - Could be more than 2 years if so just add them after Yr 2 Prob. Add all totals together to find total expected present value.
Why is probability analysis useful? B&D
Positives:
Ease - Starightforward to calculate
Multiple outcomes - allows multiple outcomes to consider.
Decision making - Easy to make decision as the project gets given either a positive or negative NPV
Negatives:
Long run average - Assumes we make a decision multiple times.
Not an actual answer - Doesnt give a definitive answer as its an average.
Risk Neutral - Ignores possible negative NPV chance and some companies may not want any chance.
How do we calculate sensitivity analysis? The steps.
Calculate the NPV of it normally and then calculate the npv with the variable change and the divide first calc by second calc.
NPV of investment / PV of the cashflow effect of variable being considered.
How do we calculate the sensitivity of a discount rate? + Formula
1.) Calculate NPV
2.) Calculate IRR
3.) Use formula
(IRR - Original discount rate) / Original discount rate = The sensitivity of a discount rate.
How to calculate the present value of each NPV factor?
Fixed cost = Stays the same
Variable costs = Take the figure affected (e.g selling price affects sales) x tax (1- Tax rate), Multiply tax affected figure by the annuity factor = PV of variable being considered.
Sales Volume = take contributions as the affected figures (Sales - variables).
What is joint probabilities?
It is mapping out all possible outcomes of an investments by finding present value of each outcome (adding the present values of each year) and multiplying by the joint probability (Mutiplying each present value probability to each year) adding all totals together to reach total expected present value.
What are the negatives of sensitivity analysis?
Ignores inter-relationships - Doesnt take into account that variables have affects on each other.
Ignores probability - ignores variables changing.
No decision criteria - Its just info, doesnt say to go ahead with an investment or not.
