Uncertainty Analysis

Question 1

What is risk?

Answer 1

Potential that a chosen action will lead to an undesirable outcome

Risk is anything that varies from expectation

Question 2

What is upside risk?

Answer 2

Risk that something positive happens

Question 3

What is downside risk?

Answer 3

Risk that something negative happens - the focus for risk management

Question 4

What is systematic risk?

Answer 4

Affects all businesses.

Universal risk

Affects a number of projects and assets

e.g. Gov changing min labour wage or economy entering recession

V. difficult to manage this type of risk

Question 5

What is unsystematic risk?

Answer 5

It only affects your business

It is specific risk

Affects specific projects or assets

Examined & managed as necessary

Question 6

What are operational risks

Answer 6

Much more short term. Internal and relate to day to day functions e.g. an issue with staff sickness or an IT issue or legal issue, human error / fraud / damage, loss or theft of assets

Can have systems in place to manage these risks e.g. security guards to protect property, back-up IT systems etc

Question 7

When is it appropriate to take on risk?

Answer 7

When the potential reward is high e.g. Launch of new product has a high risk of failure but has a chance of very high upside in the long run e.g. Virgin Galactic

When managing the risk is costly e.g. Building fire risk but insurance is very high and actual probability of fire is low

Question 8

What should a business bear in mind when considering risk?

Answer 8

Risk and reasons for taking them must be understood

Methods and costs of managing those risks must be considered

Analyse effectivity

Balance cost to risk management

Question 9

What is uncertainty (when compared to risk)?

Answer 9

e.g. Brexit!

Future outcomes are unknown. Predictions cannot be made = the biggest difference between risk and uncertainty. With risk you can use the data to evaluate the risk - you know there are outcomes. Uncertainty - outcome is completely unknown

Question 10

How does an organisation manage uncertainty?

Answer 10

It tries to change it to risk. Diagnose outcomes and calculate the likelihood. Can then manage the risk and it becomes less likely to damage project lifespan

Question 11

What are expected values?

Answer 11

It looks at the likelihood of expected outcomes. Probabilities are a common way to account for risk. Shows the likelihood of different outcomes occurring.
Ultimately a weighted average of all the potential outcomes

Question 12

How to calculate expected values?

Answer 12

1. Assign a probability to each outcome e.g. best ouctome, most likely and worst
2. Fine the EV of each outcome
   Outcome value * probability
3. Generate the EV of the decision
   Sum together the individual EVs

Question 13

What is expected value used for?

Answer 13

It is NOT the most likely outcome. It is the weighted average of all expected outcomes.

It is used to decide between two options. The highest EV is the ideal selection. Look at two different projects and account for the risk

Question 14

What is attitude to risk?

Answer 14

It is a company’s appetite for risk / how willing they are to take on risk

Huge risk = huge reward

Risk appetite = how much risk is one willing to except

Question 15

What affects risk appetite?

Answer 15

1. Company culture (e.g. Virgin is a high risk appetite company)
2. Personnel

Question 16

What are the different types of risk?

Answer 16

1. Risk adverse - they want to avoid risk at any cost
2. Risk neutral - balances risk and reward. No excessive risks but understand they need a degree of risk. They will weigh up the risk and justify whether worth taking
3. Risk seeking - takes risk for high reward. They are always looking for best possible outcome and ignoring risk

Question 17

What is risk appetite also called?

Answer 17

Risk tolerance - accepted level of deviation from the norm

No deviation = risk adverse

Low tolerance - greater control, lower deviation

High tolerance - less control, higher deviation

Question 18

What affects the psychology of risk taking?

Answer 18

Beliefs, values, fears of decision maker

Personal gain e.g. bonuses, promotion

Personal loss e.g. no bonus, job loss

Culture - if everyone’s taking risk, then why wouldn’t I take the risk e.g. the financial crisis where there was a culture of risk taking

Question 19

What is a decision tree?

Answer 19

It is a visual representation of outcomes and probabilities

Detailed analysis of risk and uncertainty

They are very easy to understand. Represents it visually, doesn’t need advanced financial knowledge for instance

Question 20

What are the elements of a decision tree?

Answer 20

A box is a decision (the company has control over)

A circle is an unknown outcome (that the company does not have control over)

An outcome i.e. a circle, can be replaced by another decision i.e. square

The outcomes can then be multiplied by the probability to get the expected values

Question 21

What are the limitations of decision trees?

Answer 21

1. Probabilities are estimates, they are subjective. Accuracy of estimates
2. Does not take into account the time value of money. The value of money depreciates over time. One decision could take months and months or even yrs vs another that is money today
3. Does not take into account risk appetite. You simply take the option with the highest EV

Question 22

What is the value of perfect information?

Answer 22

Gaining information can eliminate uncertainty. Ideally gaining perfect info

EV with perfect info vs EV without perfect info

Important to know how much to spend to gain perfect info

Question 23

How do you calculate whether it is worth gaining perfect info?

Answer 23

Take the option we would take if we knew it was going to be successful and the option we would take if we knew it wasn’t going to be successful

Then multiply these outcomes by their probability and sum together the two EVs

This equals EV with perfect info

Then compare to highest expected value without perfect info i.e. the expected value we calculated in decision tree

Deduct EV without perf info from the EV with perf info. That difference is the max a company should pay to get perfect info

Question 24

What is sensitivity analysis?

Answer 24

A type of ‘what if’ analysis. It is useful for assessing risk. Amount of flex in a factor before losses are incurred

Question 25

How do you start looking at sensitivity analysis

Answer 25

First calculate the expected profit taking into account fixed and variable costs

Unviable if project breaks even i.e. profit is zero

Can then start looking at changing various factors e.g. selling price. How much could the selling price fall by before the project becomes unviable?

Question 26

How would you calculate sales price sensitivity analysis?

Answer 26

Find the breakeven point for each varaible

£10 selling price per unit
1000 units
£4 per unit VC
£3,000 fixed costs

1000 * (sales price - £4) - £3,000 = 0

Rearrange formula to:
SP = 3000 / 1000 + 4

SP= £7

A 30% decrease (7/10) can be taken to the point of unviability. 30% sensitive to sales price

Question 27

What are the ads of sensitivity analysis?

Answer 27

Its very simple and easy to understand

Do not need to be trained in finance to understand

It identifies critical variables i.e. which variable is most sensitive

Question 28

What are the disads of sensitivity analysis?

Answer 28

It doesn’t consider changes to multiple values i.e. in reality a change in sales price will likely affect sales volume. i.e. interdependent variables

It doesn’t indicate probability of change i.e. there could be a 0% chance of one variable happening but a 90% chance of another variable happening

Question 29

What is standard deviation?

Answer 29

Looking at a range of outcomes compared to the average. How wide ranging outcomes are in comparison to the average

The wider the range = the greater the risk

Question 30

How do you calculate the standard deviation?

Answer 30

1. Calculate the EVs for each outcome. Then sum the EVs
2. Subtract the total EV from the NPV of different potential outcomes to get the deviation
3. Square the answers
4. Multiply by probability
5. Calculate the total
6. Sq root the total

Question 31

Why use coefficients?

Answer 31

The different standard deviations have different EVs. Therefore you cannot compare. Can’t compare the fastest car in the world against the fastest man in the world. Therefore you cannot compare the EVs but instead use coefficients

It puts the SD into a % format so you can compare project of different sizes against each other

Question 32

How do you calculate the coefficient?

Answer 32

Std dev / EV = Coefficient

This gives variation / deviation from average. The lower the % the closer it is to the average and therefore the less risky

The higher the SD or coefficient is the higher the risk. Much bigger chance of bigger sway on the EV

Question 33

What is the maximin approach?

Answer 33

Maximising the minimum profit. The best worst case scenario. Risk adverse individuals would choose

Question 34

What is the maximax approach?

Answer 34

The best case scenario. Risk seeker would take. The maximum max profit.

Question 35

What is the minimax regret approach?

Answer 35

Minimising the maximum regret. Regret = loss that is suffered by not picking the correct option
Option with smaller opportunity cost
Popular with risk neutral

Looks at regret felt at each level and finds one with the lowest max regret

e.g. downtown, uptown, beachside
Rainy day = £1000, £700, £100 respectively
Regret = £0, £300, £900
Max outcome less each outcome

Same for overcast and sunny days. Then choose the lowest max regret of downtown, uptown and beachside

Question 36

What are simulations?

Answer 36

Running simulations over and over again to find most likely outcome

Used to assess risk. Works best in situations with many uncertainities

Put all in a computer software programme and it will run as many times as needed to give frequency of outcomes

Question 37

How would you use simulation data?

Answer 37

Breakeven sales volume = 50 tickets

Simulations (frequencies) = 100

Ticket sales:
0 - 10 = 2
10 - 30 = 8
30 - 50 = 21
50 - 70 = 59
70 - 100 - 6
100+ = 4

Take frequencies above 50 e.g. 59% + 6% + 4% = 69%
So there is a 69% chance of breaking even
But, most likely outcomes are 30-50 and 50-70 tickets so can expect sales to be between 30 and 70

Question 38

When does simulation work best?

Answer 38

Works best in situations with many uncertainties

Question 39

What is a payoff table?

Answer 39

It is a tool for analysing a scenario where there are several outcomes based on various choices. The table shows profit or loss that will occur if a combination of factors happens

Analysing scenarios with several outcomes based on various choices.