Chapter 12 – Single Investment Risk Analysis

1. 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

2. 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

3. 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.

4. 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.

5. 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

6. 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

7. Methods Based on Probability • Developing Probability Estimates • History • Experiments • Test markets • Pilot production facilities • Judgment of knowledgeable people

8. 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

9. 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

10. 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

11. Project Selection Under Risk • Judgement • Required return adjustment • Certainty equivalents • Payback period requirement

12. 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