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  • 1.  The difference between riskand uncertaintyRisk - when the decision makerknows the probability of each andevery state of nature and thus eachand every outcome. An expectedvalue of each alternative action canbe determined
  • 2. Uncertainty - when adecision maker hasinformation that is notcomplete and thereforecannot determine theexpected value of eachalternative
  • 3. Project Analysis Under Risk Incorporating risk into projectanalysis through adjustments to the discount rate, and by the certainty equivalent factor.
  • 4. What is Risk?Risk is the variation of future expectations around an expected value.Risk is measured as the range of variation around an expected value.Risk and uncertainty are interchangeable words.
  • 5. Handling Risk Risk may be accounted for by (1) applying a discount rate commensurate with the riskiness of the cash flows, and (2), by using a certainty equivalent factor
  • 6. Risk may be accounted for by evaluating the project using sensitivity and breakeven analysis.Risk may be accounted for by evaluating the project under simulated cash flow and discount rate scenarios.
  • 7. Analysis Under RiskRisk is the variation in future cash flows around a central expected value.Risk can be accounted for by adjusting the NPV calculation discount rate: there are two methods – either the WACC, or the CAPM
  • 8. Risk can also be accommodated via the Certainty Equivalent Method.All methods require management judgment and experience.
  • 9. SimulationSimulation is a flexible methodology wecan use to analyze the behavior of apresent or proposed businessactivity, new product, manufacturingline or plant expansion, and so on(analysts call this the system understudy).
  • 10. By performing simulations andanalyzing the results, we can gain anunderstanding of how a presentsystem operates, and what wouldhappen if we changed it -- or we canestimate how a proposed new systemwould behave
  • 11. Often -- but not always -- asimulation deals withuncertainty, in the systemitself, or in the world aroundit.
  • 12. Sensitivity AnalysisA technique used to determinehow different values of anindependent variable will impact aparticular dependent variableunder a given set of assumptions.
  • 13. This technique is used withinspecific boundaries that willdepend on one or more inputvariables, such as the effectthat changes in interest rateswill have on a bonds price.
  • 14. Scenario AnalysisThe process of estimating theexpected value of a portfolio after agiven period of time, assumingspecific changes in the values of theportfolios securities or key factorsthat would affect securityvalues, such as changes in theinterest rate.
  • 15. Using a Risky Discount RateThe structure of the cash flow discounting mechanism for risk is:- The $ amount used for a ‘risky cash flow’ is the expected dollar value for that time period. 15
  • 16.  A ‘risky rate’ is a discount rate calculated to include a risk premium. This rate is known as the RADR, the Risk Adjusted Discount Rate.
  • 17. Decision TreesA decision tree is a chronological representation of the decision problem.Each decision tree has two types of nodes; round nodes correspond to the states of nature while square nodes correspond to the decision alternatives.
  • 18. Decision Tree AnalysisA graphical tool for describing (1) the actions available to the decision-maker,
  • 19. (2) the events that canoccur, and(3) the relationshipbetween the actions andevents.
  • 20. Conditional Competitor’s price Profit Decision Points High $60 Our Price (0.5) Events (0.5) Low -$20( ) Probability High Competitive Market Product (0.7) High $40 Low (0.2) No Competitive (0.8) Product (0.3) Low $10 Do not market High $100 Low $0 $30First Decision Point Second Decision Point