Chapter 12 –
Single Investment Risk Analysis

Reasons for looking at risk from a single project prospective
 lack comprehensive knowledge
 of the rest of the firm
 of other projects - since they arrive one at a time
 evaluation may be based on success/ failure of the project
 may be helpful in finding ways to reduce the risk of the
project
 basis for understanding contribution to company and
shareholder risk
Sensitivity Analysis
What can go wrong -- important variable
 Run what-ifs allowing the variables to change -for example break-even
 Look at possible outcomes
 Does not require assigning probabilities to
variables

Sensitivity Analysis

One typical sensitivity analysis is the earnings
break-even point.
 In
this you typically allow sales to vary until you
identify the minimum level of sales necessary to earn a
profit of zero (break-even).
 Other variables such as net operating income can be
used.
Sensitivity Analysis

Another more advanced and useful sensitivity
analysis is the net present value break-even point.
 Allow
sales to vary the first year and grow at different
rates over time until you identify the minimum level of
sales and growth rate necessary to earn a net present
value of zero (break-even).
 Other variables such as interest rates, and expenses can
be varied to generated meaningful sensitivity numbers
for management.
Methods Based on Probability

Simulation
 Simple
Simulation
 Build a model and change the important variables
 Monte Carlo Simulation
 Build model, assign probabilities, and let the
computer generate the output from the probabilities
 Disadvantages include expense, difficulty in
separating out nondiversifiable risk, lack of a clear
decision rule
Methods Based on Probability

Decision Trees
 Useful
in identifying embedded options
 Closer to reality in that there is significant correlation
between the beginning years and later years
 Parallels nicely with strategic planning
Methods Based on Probability

Developing Probability Estimates
 History
 Experiments
Test markets
 Pilot production facilities
 Judgment of knowledgeable people
Managing Risk

Trading variable for fixed costs
 Make
inside -- high fixed cost
 Buy outside -- high variable cost
 Measure with the net present value breakeven
 Good to find the crossover point in sales where one is
favored over the other
Managing Risk

Pricing Strategy
 Lower
price -- increased demand -- higher break-even
 Might pick off the innovator customers first with a
higher price and reduce as competition enters
 Might reduce price before competition enters -contestable market theory in economics
 Simulation and sensitivity analysis are useful in
conjunction with a net present value break-even
 Target costing goes along with this
Managing Risk

Other methods
 Sequential
investing
 More analysis -- Extent of the Analysis
 Cost in time and money -- Cost < Benefit rule
applies
 Financial Leverage
 Others to assume the risk -- Covered later in
financing section
 Trading fixed financing cost for variable
 Diversification
Project Selection Under Risk
Judgement
 Required return adjustment
 Certainty equivalents
 Payback period requirement

Risk Analysis of International Investments



Project risk
 Same process as for domestic projects except that more
sources of uncertainty are involved
 Projects may not correlate between countries due to
different economies -- Chapter 13
Political risk
 Dependent on the country
 Can be measured or estimated
Exchange rate risk
 Value of the cash flows back to the parent company