Project Risk Analysis Flashcards
(15 cards)
Risk: Definition
Risk - Uncertainty around returns not matching expectations
Volatility of returns is a common measure of risk
Investor Risk Preferences - 3 Levels
1) Risk-averse - prefer safer, lower-return assets (e.g., bonds)
2) Risk-neutral - focus only on expected return, not risk
3) Risk-seeking - prefer high-return, high-risk assets (e.g., stocks)
Risk Assessment Models
Investment risks can affect cash flows, sales, costs
Models used:
1) Non-probabilistic: Sensitivity, Scenario
2) Probabilistic: Expected NPV, Event Tree Diagrams, Simulation
3) Risk-adjusted discount rate (to reflect required return for risk)
Sensitivity Analysis
Examines how changes in one variable at a time (e.g., sales, costs) affect NPV
Steps:
1) Calculate NPV using base case
2) Identify how much a variable can change before NPV = 0
Sensitivity Analysis Pros
Simple, easy to use
Identifies critical variables
Supports subjective judgment
Sensitivity Analysis Cons
Unrealistic (changes one variable at a time)
Ignores probability and interdependency of variables
Scenario Analysis
Considers multiple variables and evaluates NPV under:
Optimistic
Most likely
Pessimistic scenarios
Scenario Analysis Pros & Cons
+ Gives a range of possible outcomes
- Time-consuming as more variables are included
- Doesn’t assign probabilities to each scenario
Simulation Modelling
Models simultaneous changes in multiple variables using random numbers and probabilities
Repeats NPV calculations thousands of times to show distribution of outcomes
Simulation Modelling Pros & Cons
+ Captures complex variable interactions
+ Supports better-informed decisions
- Complex and costly
- Requires software and expertise
- Not a decision-making tool itself
Expected NPV
ENPV = Probability-weighted average of NPVs from different outcomes
ENPV Pros & Cons
+ Simple to calculate
+ Objective rule: Accept if ENPV > 0
+ Reflects uncertainty and improves decision-making
- Doesn’t consider risk/volatility
- Probabilities can be subjective
Event Tree Diagrams
Visual tool to map out sequential events and outcomes
Helps calculate total expected value of a project
Event Tree Diagrams Pros & Cons
+ Good for visualising complex scenarios
- Probabilities may be hard to determine
- Assumes independence of events
- Not efficient for projects with many interconnected events
Portfolio Management
Total portfolio return = weighted average of individual returns
Portfolio risk can be reduced by diversification
Most effective when assets have negative correlation
Helps offset losses in one investment with gains in another
