Risk Flashcards
(11 cards)
Limitations of EV
- Discrete outcomes
- Subjective probabilities
- Ignores risk
- Not one possible outcome so less applicable to one-off projects.
Sensitivity to factors affecting cashflow
= NPV of project as a whole / NPV of CF affected by change net of tax
Sensitivity to discount rate
= Cost of capital - IRR
Sensitivity to project life
Discounted payback
Limitations of sensitivity analysis
- Assumes variables change independently of each other
- Does not assess likelihood of variable changing
- Does not identify a correct decision.
Linear regression models
+ Simple and easy to explain
+ Used to predict impact of changes in estimates
- Not always a linear relationship between variables
- Correlation vs causation
- Data may be inaccurate
Decision trees
+ Simple to explain and logical
+ Considers multiple decisions
- Large with many possible outcomes are difficult to interpret
Simulation
+ Looks at multiple variables at once
+ Useful for problems that can’t be solved analytically
- Doesn’t identify decision
- Time consuming and complex
- Expensive
- Requires assumptions to be made
ESG risks
Physical - climate change e.g. flooding
Transition - changes in regulation
Social - how the business interacts with stakeholders including non-compliance with labour laws
Governance - how the business operates e.g. lack of proper assurance over data protection
CAPM equation
Rj = Rf + B(Rm-Rf)
Rj: required return
Rf: risk free rate (rate on Treasury bills)
Rm: Average market return
(Rm - Rf): equity risk premium
Beta: investment risk vs market, therefore amount of premium needed.
Problems with CAPM
Rm: Estimated using historic data
Rf: Gilts are not risk free making the estimate inaccurate
B: Beta estimation is too simplistic for estimating risk missing other risk factors that should be considered instead of 1 ‘market’ factor.
B: Accounts for systematic risk only, assuming shareholders are fully diversified.
