13.2 Risk Analysis and Real Options Flashcards
(11 cards)
A large conglomerate with operating divisions in many industries uses risk-adjusted discount rates in evaluating capital investment decisions. Consider the following statements concerning the use of risk-adjusted discount rates.
I. The conglomerate may accept some investments with internal rates of return less than the conglomerate’s overall average cost of capital.
II. Discount rates vary depending on the type of investment.
III. The conglomerate may reject some investments with internal rates of return greater than the cost of capital.
IV. Discount rates may vary depending on the division.
Which of the above statements are correct?
A. I and III only.
B. II and IV only.
C. II, III, and IV only.
D. I, II, III, and IV.
D. I, II, III, and IV.
Risk analysis attempts to measure the likelihood of the variability of future returns from the proposed capital investment. Risk can be incorporated into capital budgeting decisions in a number of ways, one of which is to use a risk-adjusted discount rate. A risk-adjusted discount rate is used when the capital investment is more or less risky than is normal for the company. This technique adjusts the interest rate used for discounting upward as an investment becomes riskier. The expected flow from the investment must be relatively larger, or the increased discount rate will generate a negative net present value, and the proposed acquisition will be rejected. Accordingly, the IRR (the rate at which the NPV is zero) for a rejected investment may exceed the cost of capital when the risk-adjusted rate is higher than the IRR. Conversely, the IRR for an accepted investment may be less than the cost of capital when the risk-adjusted rate is less than the IRR. In this case, the investment presumably has very little risk. Furthermore, risk-adjusted rates may also reflect the differing degrees of risk, not only among investments, but by the same investments undertaken by different organizational subunits.
A widely used approach that is used to recognize uncertainty about individual economic variables while obtaining an immediate financial estimate of the consequences of possible prediction errors is
A. Expected value analysis.
B. Learning curve analysis.
C. Sensitivity analysis.
D. Regression analysis.
C. Sensitivity analysis.
Sensitivity analysis recognizes uncertainty about estimates by making several calculations using varying estimates. For instance, several forecasts of net present value (NPV) might be calculated under various assumptions to determine the sensitivity of the NPV to changing conditions or prediction errors. Changing or relaxing the assumptions about a certain variable or group of variables may drastically alter the NPV, resulting in a much riskier asset than was originally forecast.
In preparing a multi-year revenue forecast, a financial analyst uses a technique that generates a distribution of possible results based on repeated sampling. The analyst is most likely using which one of the following?
A. Sensitivity analysis.
B. Monte Carlo simulation.
C. Scenario analysis.
D. Activity analysis.
B. Monte Carlo simulation.
The Monte Carlo simulation is used to generate the probability distribution of all possible outcomes of an event. The performance of a quantitative model under uncertainty (in this case, future sales revenues) may be investigated by randomly selecting values for each of the variables in the model and then calculating the value of the solution. This process is performed a large number of times. Thus, the Monte Carlo simulation technique is the one most likely to be used.
A company received a legal settlement of $1 million. The company could apply this $1 million toward its mortgage on the building it owns and save 4% in interest. The CFO suggested that based on historical analysis of the market over time, it was likely the company could earn around 8% over the term of the mortgage if it invested the money, which was a better return than the 4%. The business owners elected to apply the money to the mortgage rather than invest the money. Based on the decision described in this scenario, a reasonable conclusion would be that the company has a
A. Low risk tolerance and the certainty equivalent is less than expected value.
B. High risk tolerance and the risk tolerance equivalent is less than expected value.
C. High risk tolerance and the certainty equivalent is greater than expected value.
D. Low risk tolerance and the certainty equivalent is greater than expected value.
A. Low risk tolerance and the certainty equivalent is less than expected value.
The company decided to go with the guaranteed 4% return instead of taking the investment with an 8% return. This shows that they have a low risk tolerance, since they were not willing to take the additional risk associated with the 8% investment. The certainty equivalent specifies at what point the firm is indifferent to the choice between a certain sum of money and the expected value of a risky sum. Since the firm would rather take the sum of money than the expected value of the risky sum, the certainty equivalent is less than expected value.
When the risks of the individual components of a project’s cash flows are different, an acceptable procedure to evaluate these cash flows is to
A. Discount each cash flow using a discount rate that reflects the degree of risk.
B. Compute the net present value of each cash flow using the firm’s cost of capital.
C. Compare the internal rate of return from each cash flow to its risk.
D. Divide each cash flow by the payback period.
A. Discount each cash flow using a discount rate that reflects the degree of risk.
Risk-adjusted discount rates can be used to evaluate capital investment options. If risks differ among various elements of the cash flows, then different discount rates can be used for different flows.
A manager wants to know the effect of a possible change in cash flows on the net present value of a project. The technique used for this purpose is
A. Cost behavior analysis.
B. Risk analysis.
C. Return on investment analysis.
D. Sensitivity analysis.
D. Sensitivity analysis.
Sensitivity analysis is a technique to evaluate a model in terms of the effect of changing the values of the parameters. It answers “what if” questions. In capital budgeting models, sensitivity analysis is the examination of alternative outcomes under different assumptions.
A builder of custom homes recently invested $360,000 of material, labor, and overhead in a residence for a customer. The customer, unfortunately, has just declared bankruptcy and must back out of their contract. The builder’s management has identified the following two courses of action:
- Sell the unfinished residence “as is.” The company’s sales manager has assigned the following selling prices and probabilities to this alternative:
Selling Price / Probabilities
$280,000 / 0.1
320,000 / 0.6
350,000 / 0.3
Make several design changes at a cost of $70,000, complete the project, and sell the home to another customer for $410,000.
On the basis of this information, the builder should
A. Redesign the residence for the new customer because, in comparison with the sell “as is” option, the firm is $20,000 better off.
B. Redesign the residence for the new customer because, in comparison with the sell “as is” option, the firm is $15,000 better off.
C. Consider the $360,000 investment as a key decision factor in selecting among alternatives.
D. Select the sell “as is” option because of the chance of a $350,000 selling price.
B. Redesign the residence for the new customer because, in comparison with the sell “as is” option, the firm is $15,000 better off.
The expected value of the sell “as is” option is $325,000 [($280,000 × .1) + ($320,000 × .6) + ($350,000 × .3)]. Thus, the firm is better off by redesigning the residence for a profit of $340,000 ($410,000 – $70,000).
Which one of the following is the best example of using sensitivity analysis in valuation?
A. Using discount rates that are higher in the later years.
B. Measuring the time to recoup the initial investment.
C. Dividing the average annual income by net initial investment.
D. Varying inputs to the net present value calculation.
D. Varying inputs to the net present value calculation
Sensitivity analysis requires making multiple calculations of a valuation or rate of return. Each calculation is based on varying inputs. Thus, calculating NPV using different estimates of cash flows or different estimates of rate of return is an example of the use of sensitivity analysis. The name comes from determining how “sensitive” the results are to changes in estimates.
When evaluating a capital budgeting project, a company’s treasurer wants to know how changes in operating income and the number of years in the project’s useful life will affect its breakeven internal rate of return. The treasurer is most likely to use
A. Sensitivity analysis.
B. Scenario analysis.
C. Learning curve analysis.
D. Monte Carlo simulation.
A. Sensitivity analysis.
Forecasts of many calculated NPVs under various assumptions are compared to see how sensitive NPV is to changing conditions. Changing or relaxing the assumptions about a certain variable or group of variables may drastically alter the NPV. Thus, the asset may appear to be much riskier than was originally predicted. In summary, sensitivity analysis is simply an iterative process of recalculated returns based on changing assumptions.
An analyst plans to use a Monte Carlo experiment to simulate daily demand. The probability distribution for the daily demand for heaters is as follows.
Daily demand: Probability /Random number intervals
0: .10 / 00-09
1: .15 / 10-24
2: .20 / 25-44
3: .20 / 45-64
4: .25 /
5: .10 /
The analyst is trying to assign random number intervals for each of the demand levels. She has done so for the first four levels. If a total of 100 two-digit numbers are used in a simulation, what random number intervals should the analyst assign to the 4 and 5 heater demand levels, respectively?
A. 65-84; 85-99.
B. 65-69; 70-88.
C. 65-89; 90-99.
D. 65-90; 91-100.
C. 65-89; 90-99.
Start with the next available number, which is 65. To find the random number interval for the daily demand for heaters of 4, use the next 25 (0.25 = 25 ÷ 100) numbers, which are 65-89. To find the random number interval for the daily demand for heaters of 5, use the next 10 (0.10 = 10 ÷ 100) numbers, which are 90-99.
A company wants to use discounted cash flow techniques when analyzing its capital investment projects. The company is aware of the uncertainty involved in estimating future cash flows. A simple method some companies employ to adjust for the uncertainty inherent in their estimates is to
A. Adjust the minimum desired rate of return.
B. Use accelerated depreciation.
C. Prepare a direct analysis of the probability of outcomes.
D. Increase the estimates of the cash flows.
A. Adjust the minimum desired rate of return.
Uncertainty can be compensated for by adjusting the desired rate of return. If projects have relatively uncertain returns, a higher rate should be required. A lower rate of return may be acceptable given greater certainty. The concept is that with increased risk should come increased rewards, i.e., a higher rate of return.
