3 - Risk and Decision Making

Question 1

Limitations of expected value

Answer 1

• EV may not be a possible outcome
• is an average value useful for a one-off project?
• the spread of possible outcomes has been lost

Question 2

Sensitivity to factors affecting cash flows

Answer 2

NPV of project / NPV of cash flows affected (including tax)

Question 3

Issues with using CAPM

Answer 3

Estimating Rf - Gilt return is not risk free and varies with term of the bond

Estimating Rm- historic return not necessarily a good guide for the future

Estimating beta - only uses systematic risk

Question 4

Alternatives to CAPM

Answer 4

Arbitrage pricing theory - similar to CAPM but divides up risk premium

Bond yield plus premium - adds fixed premium to reflect increase return on equity needed

Dividend valuation model - calculates return actually being achieved using company’s own dividends