Chapter 12 – Single Investment Risk Analysis u Reasons for looking at risk from a single project prospective u lack comprehensive knowledge u of the rest of the firm u of other projects - since they arrive one at a time u evaluation may be based on success/ failure of the project u may be helpful in finding ways to reduce the risk of the project u basis for understanding contribution to company and shareholder risk

Sensitivity Analysis u What can go wrong -- important variable u Run what-ifs allowing the variables to change -- for example break-even u Look at possible outcomes u Does not require assigning probabilities to variables

Sensitivity Analysis u One typical sensitivity analysis is the earnings break-even point. u 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). u Other variables such as net operating income can be used.

Sensitivity Analysis u Another more advanced and useful sensitivity analysis is the net present value break-even point. u 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). u Other variables such as interest rates, and expenses can be varied to generated meaningful sensitivity numbers for management.

Methods Based on Probability u Simulation u Simple Simulation u Build a model and change the important variables u Monte Carlo Simulation u Build model, assign probabilities, and let the computer generate the output from the probabilities u Disadvantages include expense, difficulty in separating out nondiversifiable risk, lack of a clear decision rule

Methods Based on Probability u Decision Trees u Useful in identifying embedded options u Closer to reality in that there is significant correlation between the beginning years and later years u Parallels nicely with strategic planning

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

Managing Risk u Trading variable for fixed costs u Make inside -- high fixed cost u Buy outside -- high variable cost u Measure with the net present value breakeven u Good to find the crossover point in sales where one is favored over the other

Managing Risk u Pricing Strategy u Lower price -- increased demand -- higher break-even u Might pick off the innovator customers first with a higher price and reduce as competition enters u Might reduce price before competition enters -- contestable market theory in economics u Simulation and sensitivity analysis are useful in conjunction with a net present value break-even u Target costing goes along with this

Managing Risk u Other methods u Sequential investing u More analysis -- Extent of the Analysis u Cost in time and money -- Cost < Benefit rule applies u Financial Leverage u Others to assume the risk -- Covered later in financing section u Trading fixed financing cost for variable u Diversification

Project Selection Under Risk u Judgement u Required return adjustment u Certainty equivalents u Payback period requirement

Risk Analysis of International Investments u Project risk u Same process as for domestic projects except that more sources of uncertainty are involved u Projects may not correlate between countries due to different economies -- Chapter 13 u Political risk u Dependent on the country u Can be measured or estimated u Exchange rate risk u Value of the cash flows back to the parent company