Chapter 3 Risk and Decision Making

Question 1

What is expected values and how is it calculated

Answer 1

When there are a number of possible outcomes for a decision
EV = sum of p*x for every outcome where
p = probability
x = outcome value

Question 2

Limitations of expected values

Answer 2

Discrete outcomes
subjective probabilities
ignores risk
less applicable to one off projects

Question 3

What is Sensitivity and how do you calculate

Answer 3

The % change in an estimate that gives an NPV of nil

Cash flows:
NPV of whole project/NPV of cash flow affected
When cash flow affects tax, NPV of cash flow must be net of tax

Other factors:
Discount rate =IRR(cashflows)
Project Life = Payback

Question 4

What is specific risk

Answer 4

Volatility that occurs due to industry specific factors

Question 5

What is systematic risk

Answer 5

Volatility that occurs due to market wide factors such as the state of the economy

Question 6

What does CAPM estimate

Answer 6

The rate of return that a fully diversified equity shareholder would require , considers the level of systematic risk (market wide, economy etc) compared to average

Used when a project has a different risk profile from the company’s current operations

Question 7

Problems with CAPM

Answer 7

Estimating Rm is usually done with historic figures rather than expected future returns

Estimating Rf, gilts are not risk free and returns on gilts will vary with the term of the bond

Calculation of beta too simplistic and should made with more than one single market factor

Assumes the shareholders are fully diversified