Risk and Return 1 Flashcards
(24 cards)
What is return
Return is the expected outcome of an investment decision
What does return refer to in capital budgeting
In capital budgeting return refers to:
- Net Present Value (NPV)
- Internal Rate of Return
What is NPV
NPV is value created from the project
What is IRR
IRR is the % return earned on the investment
What are the two key dimensions of risk
The two key dimensions are:
- Extent of variability
- Probability of variance
What does extent of variability mean
Extent of variability - how much actual outcomes might differ from the expected outcome
What does probability of variance mean
Probability of variance - how likely these differences are to occur
What is risk in corporate finance
In corporate finance, risk is not just loss, but the uncertainty around outcomes
What should the financial manager do with risk management
The financial manager should:
- Identify sources of risk
- Evaluate their impact and likelihood
- Respond using one of three strategies
- Accept
- Risk
- Avoid
When should financial managers accept risk
Accept risk if it’s necessary and manageable
How can financial managers reduce risk
Financial managers can reduce risk via hedging, insurance, contracts
How can financial managers avoid unnecessary risks
Avoid unnecessary risk by changing plans
What are the four common risk evaluation methods
Four common methods:
1. Sensitivity Analysis
2. Probability Analysis
3. Modern Portfolio Theory (MPT)
4. Capital Asset Pricing Model (CAPM)
What is the purpose of sensitivity analysis
The purpose of sensitivity analysis is to assess how sensitive a projects NPV or IRR is to changes in key input variables
What does sensitivity analysis look at
Sensitivity analysis looks at:
- Sales volume
- Selling price
- Costs
- Discount rate
- Project life
How does sensitivity analysis work
Sensitivity analysis works by:
- Set up the NPV model
- Change one input at a time
- Identify the “breakeven point” where NPV = 0
- Measure % change needed from the original forecast - “safety margin”
What does a smaller % change required to push NPV to zero mean
The smaller the % change required to push NPV to zero, the higher the risk
Contribution per year (C) =
C = (Selling Price - Direct Cost) X Sales Volume
NPV =
NPV = (C X Annuity Factor) - Initial Investment
Breakeven Initial Investment
II =
II = C X AF
Breakeven Contribution (C)
C =
C = II/AF
Breakeven Annuity Factor (AF)
AF =
AF = II/C
Sensitivity =
Sensitivity = (Breakeven - Forecast) / Forecast
What are the limitations of sensitivity analysis
Limitations of sensitivity analysis:
- One variable at a time
- No probabilities
- On interdependence
- Not good for comparing projects
