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Chapter 12 Single Investment Risk Analysis


... Investment Risk Analysis. Reasons for looking ... Sensitivity Analysis ... Simulation and sensitivity analysis are useful in conjunction with a net present ... – PowerPoint PPT presentation

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Title: Chapter 12 Single Investment Risk Analysis

Chapter 12 Single Investment Risk Analysis
  • Reasons for looking at risk from a single project
  • lack comprehensive knowledge
  • of the rest of the firm
  • of other projects - since they arrive one at a
  • evaluation may be based on success/ failure of
    the project
  • may be helpful in finding ways to reduce the risk
    of the project
  • basis for understanding contribution to company
    and shareholder risk

Sensitivity Analysis
  • What can go wrong -- important variable
  • Run what-ifs allowing the variables to change --
    for example break-even
  • Look at possible outcomes
  • Does not require assigning probabilities to

Sensitivity Analysis
  • One typical sensitivity analysis is the earnings
    break-even point.
  • In this you typically allow sales to vary until
    you identify the minimum level of sales necessary
    to earn a profit of zero (break-even).
  • Other variables such as net operating income can
    be used.

Sensitivity Analysis
  • Another more advanced and useful sensitivity
    analysis is the net present value break-even
  • Allow sales to vary the first year and grow at
    different rates over time until you identify the
    minimum level of sales and growth rate necessary
    to earn a net present value of zero (break-even).
  • Other variables such as interest rates, and
    expenses can be varied to generated meaningful
    sensitivity numbers for management.

Methods Based on Probability
  • Simulation
  • Simple Simulation
  • Build a model and change the important variables
  • Monte Carlo Simulation
  • Build model, assign probabilities, and let the
    computer generate the output from the
  • Disadvantages include expense, difficulty in
    separating out nondiversifiable risk, lack of a
    clear decision rule

Methods Based on Probability
  • Decision Trees
  • Useful in identifying embedded options
  • Closer to reality in that there is significant
    correlation between the beginning years and later
  • Parallels nicely with strategic planning

Methods Based on Probability
  • Developing Probability Estimates
  • History
  • Experiments
  • Test markets
  • Pilot production facilities
  • Judgment of knowledgeable people

Managing Risk
  • Trading variable for fixed costs
  • Make inside -- high fixed cost
  • Buy outside -- high variable cost
  • Measure with the net present value breakeven
  • Good to find the crossover point in sales where
    one is favored over the other

Managing Risk
  • Pricing Strategy
  • Lower price -- increased demand -- higher
  • Might pick off the innovator customers first with
    a higher price and reduce as competition enters
  • Might reduce price before competition enters --
    contestable market theory in economics
  • Simulation and sensitivity analysis are useful in
    conjunction with a net present value break-even
  • Target costing goes along with this

Managing Risk
  • Other methods
  • Sequential investing
  • More analysis -- Extent of the Analysis
  • Cost in time and money -- Cost lt Benefit rule
  • Financial Leverage
  • Others to assume the risk -- Covered later in
    financing section
  • Trading fixed financing cost for variable
  • Diversification

Project Selection Under Risk
  • Judgement
  • Required return adjustment
  • Certainty equivalents
  • Payback period requirement

Risk Analysis of International Investments
  • Project risk
  • Same process as for domestic projects except that
    more sources of uncertainty are involved
  • Projects may not correlate between countries due
    to different economies -- Chapter 13
  • Political risk
  • Dependent on the country
  • Can be measured or estimated
  • Exchange rate risk
  • Value of the cash flows back to the parent company