Project Appraisal Under Risk

Question 1

What is a risk?

Answer 1

A condition in which several possible outcomes exist, the probabilities of which can be quantified from historical data

Question 2

What is uncertainty?

Answer 2

The inability to predict possible outcomes due to a lack of historical data

Question 3

What is sensitivity analysis?

Answer 3

Analysis of changes made to significant variables in order to determine their effect on a planned course of action.

Question 4

Lower percentage in a sensitivity analysis?

Answer 4

The more sensitive the NPV is to that project variable,

Question 5

Advantage of sensitivity analysis?

Answer 5

Sensitive the project is to changes in any of the original estimates

Identifies the critical success factors for the project

Question 6

Limitations of sensitivity analysis?

Answer 6

Assumes data for all other variables is accurate

Sensitivity analysis does not provide a decision rule

Question 7

What is a simulation?

Answer 7

A technique which allows more than one variable to change at the same time

Question 8

1st stage in a Monte Carlo siituation?

Answer 8

Specify the major variables (e.g. revenue and costs)

Question 9

2nd stage in a Monte Carlo siituation?

Answer 9

Specify the relationship between the variables

Question 10

3rd stage in a Monte Carlo siituation?

Answer 10

Attach probability distributions to each variable and assign random numbers to reflect the distribution

Question 11

4th stage in a Monte Carlo siituation?

Answer 11

Simulate the environment by generating random numbers for revenue and costs

Question 12

5th stage in a Monte Carlo siituation?

Answer 12

Record the outcome of each simulation

Question 13

6th stage in a Monte Carlo siituation?

Answer 13

Repeat the simulation many times to obtain a probability distribution of the possible outcomes

Question 14

Advantages of simulation?

Answer 14

Data can be used to calculate an expected NPV

Question 15

Disadvantages of simulation?

Answer 15

Very time-consuming and expensive

Monte Carlo simulation is not a technique for making a decision

Question 16

What is an expected value?

Answer 16

The quantitative result of weighting uncertain events by the probability of their occurrence

Question 17

Advantage of expected value?

Answer 17

The idea of an average is readily understood

Expected value reduces the information

Question 18

Disadvantage of expected value?

Answer 18

Average may not correspond to any of the possible outcomes and is difficult to estimate

It ignores risk

Question 19

What is a discounted payback?

Answer 19

The period of time for the discounted returns from a project to recover the initial investment

Question 20

Methods of keeping project risk within acceptable levels (payback)

Answer 20

Setting a maximum adjusted payback period for intiial screening of projects

Question 21

Methods of keeping project risk within acceptable levels (sensitivity)

Answer 21

Focusing attention on the critical success factors indicated by sensitivity analysis

Question 22

Methods of keeping project risk within acceptable levels (discount)

Answer 22

Using risk-adjusted discount rates for both NPV and adjusted payback

Question 23

Methods of keeping project risk within acceptable levels (forecasts)

Answer 23

Using conservative forecasts, such as reducing the forecast returns downwards to reflect the guaranteed minimum inflows from a project (certainty equivalents)