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
Uncertainty - when adecision maker hasinformation that is notcomplete and thereforecannot determine theexpected value of eachalternative
Project Analysis Under Risk Incorporating risk into projectanalysis through adjustments to the discount rate, and by the certainty equivalent factor.
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.
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
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.
Analysis Under RiskRisk 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
Risk can also be accommodated via the Certainty Equivalent Method.All methods require management judgment and experience.
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).
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
Often -- but not always -- asimulation deals withuncertainty, in the systemitself, or in the world aroundit.
Sensitivity AnalysisA technique used to determinehow different values of anindependent variable will impact aparticular dependent variableunder a given set of assumptions.
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.
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.
Using a Risky Discount RateThe 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
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.
Decision TreesA 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.
Decision Tree AnalysisA graphical tool for describing (1) the actions available to the decision-maker,
(2) the events that canoccur, and(3) the relationshipbetween the actions andevents.
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