Risk in Decision making Flashcards
(6 cards)
Introduction - Decision making
Contribution = sales less TVC
Relevant costs are future, incremental costs and cashflows
NPV is the best long term decision making method which shows surplus of cash after accounting for all relevant cashflows and time value of money.
P.V = Cashflow*discount factor
Positive NPV means M.V of shares will increase and project should be accepted
M.V of shares is equal to P.V of the future cashflows of dividend.
IRR is the rate of interest for which NPV is zero, It shows sensitivity of project’s NPV. breakeven cosy of money.
Uncertainty on demand - Research may help but this is a genuine unknown
Risk & uncertainty -
Definition of Risk and Uncertainty
Role of accountants in risk and uncertainty
Main role of accountants
Risk is the degree of uncertainty or range of variation. greater the variation the higher the risk. the range of uncertainty can be narrow or wide.
Risk is measured by range and standard deviation
Uncertainty is an unknown outcome, value or variable, normally demand for goods or services in the exam. It is difficult to research demand.
role of accountants in risk and uncertainty
1. Listen to the client
2. Advice on potential sources of research
3. advise using business knowledge
main role of accountants
1. carry out financial analysis on the new project -
calculate potential returns and
Analyse data and
Communicate to the client or decision maker
2. Advise client on best course of action an client/ boss makes the decision - This depends on the risk profile of the decision maker
Methods of analysis - Decision Tables
Types of risk attitude - optimist risk seeker
Decision method that matches each risk attitude - Maximax
Decision table shows all possible results from a decision amidst uncertainty
Decision is at the top of table (horizontal), uncertainty is at the vertical
Client has to be advised appropriately, to do this accountant has to understand the RISK attitude of the client. different stakeholders have different risk attitudes
Analyse the risk profile of the decision maker and advise accordingly
Risk attitudes are complex in real life, e.g. below
stakeholders -
1. Venture capitalist/ serial entrepreneur - Optimistic/ risk seeker, willing to take risks, promises high returns to its own investors. Strategy is MAXIMAX . maximise the maximum possible return - GO FOR THE BIGGEST NUMBER IN THE TABLE. whilst ignoring huge potential downside due to risk, probability and consequences of failure.
- owners of family companies/ some directors/ most banks - Often need to protect family’s home so PESSIMISTIC in view and RISK AVERSE - MAXIMIN (best worst case scenario) Maximise the minimum possible return “at least I will make”
- Banks/ debt holders - worried about unsecured amounts and loss.
Not set up to take risk - so PESSIMISTIC in view and RISK AVERSE
MAXIMIN (best worst-case scenario) - People who have made mistakes in the past and have been left
scarred (can be directors) - They do not want to repeat mistakes -
MINIMAX REGRET - Regretter. Quite a complicated approach and most investors would not understand - Investor with large portfolio or those investing in multiple independent projects that will average out in terms of return. - Expected value
Regret table go from left to right to work out differences
Methods of analysis - Decision Tables - Expected value
Formula
definition
critique
EV=E(P*X)
P= probability
X = value
calculate for each product per uncertainty level, add up each product and select the highest.
E.V is a weighted average value, it gives prominence to the most likely result.
The EV does not equal an actual result on a any day, owner might think it should and hence think they have been misled. The average will be achieved if activity is repeated multiple times.
It hides a range of results in a single figure
E.V is amount we expect if the decision is repeated over and over since we will get the average result overall
E.V is just an average and is not ideal for one off, check the spread between options to see which one is more risky.
Always consider risk in your explanation as E.V calculation ignores risk.
Shareholders and directors might have conflicting risk profiles
Exam Slide
- Fixed costs tend not to be relevant to decisions unless incremental
- Contribution is a proxy for the RCF
- NPV is the best decision making technique, positive is accept and a gain to shareholders
- Uncertainty is unknown but risk is range
- Decision tables show all possible results before any adjustment for probability.
- Entrepreneurs are risk seekers and prefer Maximax
- Directors and family owners tend to be risk averse and prefer Maximin
- Those who have made mistakes previously are REGRETTERS and prefer minimax regret
- Those with large portfolios can ignore risk, become risk neutral and prefer expected values
- Expected values conceal risk and are not valid for one off decisions.
