# Chapter 12 Single Investment Risk Analysis - PowerPoint PPT Presentation

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## Chapter 12 Single Investment Risk Analysis

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### ... 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

1
Chapter 12 Single Investment Risk Analysis
• Reasons for looking at risk from a single project
prospective
• lack comprehensive knowledge
• of the rest of the firm
• of other projects - since they arrive one at a
time
• 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

2
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
variables

3
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.

4
Sensitivity Analysis
• Another more advanced and useful sensitivity
analysis is the net present value break-even
point.
• 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.

5
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
probabilities
• Disadvantages include expense, difficulty in
separating out nondiversifiable risk, lack of a
clear decision rule

6
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
years
• Parallels nicely with strategic planning

7
Methods Based on Probability
• Developing Probability Estimates
• History
• Experiments
• Test markets
• Pilot production facilities
• Judgment of knowledgeable people

8
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

9
Managing Risk
• Pricing Strategy
• Lower price -- increased demand -- higher
break-even
• 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

10
Managing Risk
• Other methods
• Sequential investing
• More analysis -- Extent of the Analysis
• Cost in time and money -- Cost lt Benefit rule
applies
• Financial Leverage
• Others to assume the risk -- Covered later in
financing section
• Trading fixed financing cost for variable
• Diversification

11
Project Selection Under Risk
• Judgement
• Certainty equivalents
• Payback period requirement

12
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