1) What does the term “risk” mean in the context of capital budgeting; to what extent can risk be quantified; and, when risk is quantified, is the quantification based primarily on statistical analysis of historical data or on subjective, judgmental estimates?
The term “risk”, in the context of capital budgeting, means the uncertainty about the future profitability of the plan. We should understand if the taking on the project will rise both firm and stockholders’ risk. About the quantification, we should mainly use statistical analysis, but also historical data can be used and risk analysis in capital budgeting is usually focused on subjective judgments.
2) What are the three types of ...view middle of the document...
Lastly, it is also important to say that stand-alone risk is really easy to measure, it is very intuitive; while all these projects are very correlated with other assets, so for example stand-alone risk reflects also market risk.
3) Sensitivity analysis:
a. What is sensitivity analysis?
Sensitivity analysis measures the percentage of changes on a NPV of a project; a change in an input variable such a unit sold or the sales price will the NPV to chage. Sensitivity analysisv shows in that way, how changes in a variable affects NPV or IRR when other inputs/variables are held at their expected value. It’s one of the most common type of risk analysis used and it starts with a base-case scenario.
Sensitivity analysis is the answer to the question “What if?”. Graphically speaking, it’s like a matrix where each variable is increased or decreased by a percentage from its value, holding other variables constant at their base-case value. Then the NPV is calculated using the changed input.
b. Perform a sensitivity analysis on the unit sales, salvage value and cost of capital for the project. Assume each of these variables can vary from its base case value by +/- 10%, +/- 20% and +/- 30%. Include a sensitivity diagram and discuss the results.
Unfortunately we couldn’t get the results but we can assume that different variables could affect the difference of the NPV value.
c. What is the primary weakness of sensitivity analysis? What is its primary usefulness?
The sensitivity analysis present several weaknesses / disadvantages:
- it doesn’t reflect the effects of diversification
- it doesn’t say any additional information about the possible size of the error
- it ignores any relationship between variables, such as unit sales and sales price
- in many situations sensitivity analysis is not a good indicator of risk
Its primary usefulness is that in many situations, sensitivity analysis, identify the variables / inputs that potentially could have a great impact on profitability and could help the management to focus on the most important variables / inputs. At the same time it identifies the dangerous variables and gives some information about the breakeven information.
4) Assume the company is confident in the estimates of all the variables that affect the project’s cash flows except for unit sales and sales price. If product acceptance is poor, unit sales would be only 900 units a year and the unit price would only be $160; a strong consumer response would produce sales of 1,600 units and a unit price of $240. The company believes there is a 25% chance of poor acceptance, a 25% chance of excellent acceptance, and a 50% chance of average acceptance (the base case).
a. What is scenario analysis?
In order to know what happens to the project’s NPV if several key variables turn out to be better or worse than expected, scenario extends risk analysis allowing us to assign probabilities to the base (the most likely) case, the worst and the best case;...