Pondicherry University

Programme: MBA
Course: Strategic Financial Management

Faculty: POORNIMA SREERAGHAVAN

Session 2 - August 16, 2018

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Understanding Uncertainty and Risk
• Uncertainty
• Uncertainty of economic/market conditions Unanticipated
• Volatility in business environment changes

Mismatch between the firm’s assessment

of the business conditions and reality

• Risk: Exposure to potential loss

• Outright loss of investment or Variability in the returns
• Probability is either known or can be estimated
• What to do? Identify Measure Evaluate the Manage the
sources of risk extent of risk risks situation

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Risk assessment
• Types of risk
• External considerations •Interest rate risk •Systemic risk

Origin

Impact
• Probability of risk •Exchange rate risk •Non systemic or
•Commodity risk specific risk or
• Frequency of risk diversifiable risk
•Credit risk
• Internal considerations •Operational risk
•Market risk
(Firm related) •Others
• Vulnerability
• Extent of exposure
• Resilience
Shareholders
• How to measure? Company
• Risk indicators – probability Perspective for
Project
• Risk metrics – extent measuring risk

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Managing risk
• Accounting for risk
• Certainty equivalent method
• Adjusting expected cash flows (scaling down of risky cash flows) to reflect project risk
• Risk-adjusted discount rate method
• Adjusting discount rate to reflect the above-average-risk in cash flows

• Measuring risk

Statistical Monte
Sensitivity Scenario Decision
(probability) Carlo
analysis analysis tree analysis
distribution simulation

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Certainty equivalent method
• Certainty equivalent of a cash flow
• Smallest certain return for the exchange of a risky cash flow

𝐶𝐸𝑄𝑡
𝐶𝑒𝑟𝑡𝑎𝑖𝑛𝑡𝑦 𝑒𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑐𝑜𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑡 𝛼𝑡 = Normally 0 < 𝛼𝑡 < 1
𝐶𝑡
• where 𝐶𝑡 is the cash flow and 𝐶𝐸𝑄𝑡 is the equivalent cash flow for time 𝑡

𝑛
𝛼𝑡 𝐶ഥ𝑡
𝑁𝑒𝑡 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑁𝑃𝑉 = ෍ 𝑡 −𝐼
𝑡−1 1 + 𝑘𝑓
• where 𝐶𝑡 is the cash flow for time 𝑡, 𝑘𝑓 is the risk free interest rate, 𝐼 is the initial
investment (no uncertainty in this)

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Risk-adjusted discount rate method
• Risk adjusted discount rate used instead of the risk free discount rate
• Risky projects are discounted at a higher cost of capital

𝑅𝑖𝑠𝑘 𝑎𝑑𝑗𝑢𝑠𝑡𝑒𝑑 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑟𝑎𝑡𝑒 𝑘 = 𝑘𝑓 + 𝑘𝑟

• where 𝑘𝑓 = risk free discount rate, 𝑘𝑟 = risk premium

𝑛
𝐶ഥ𝑡
𝑁𝑒𝑡 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑁𝑃𝑉 = ෍ 𝑡
−𝐼
1+𝑘
𝑡−1
• Where 𝐶𝑡 is the cash flow for time 𝑡, 𝑘 is the risk adjusted interest rate, 𝐼 is the
initial investment (no uncertainty in this)

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Statistical distribution
• NPV distribution with 2 parameters 𝑛
𝑛

𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝐶𝑡ҧ = ෍ 𝐶𝑥𝑡 . 𝑃𝑥𝑡 𝑆𝐷 𝜎𝑡 = ෍ 𝐶𝑥𝑡 − 𝐶ഥ𝑡 2. 𝑃𝑥𝑡
𝑥=1 𝑥=1
• where 𝐶𝑥𝑡 = cash flow for the possibility at time 𝑡 and
𝑥th
𝑃𝑥𝑡 = probability of that cash flow occurring
• Expected NPV
• Summation of expected values of all cash flows discounted appropriately
• If Expected NPV>0, project is acceptable
• Variance in NPV distribution – 3 situations - Frederick Hillier

No Perfect
Mixed
correlation correlation

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Simulation analysis
• Developing and analyzing the conceptual model of a situation and
evaluating all possible outcomes and probabilities for any choice of
action based on innumerable events

• Hertz’s Simulation model

Within that
Estimate the
Identify and range Compute the
range of Calculate the
list all factors estimate the Combine the rate of return
values of expected
impacting likelihood of values of all (or PV) for
uncertainty values for
risk-return occurrence factors that
of each each factor
profile of these combination
factor
values

• Defining and evaluation of the odds of occurrence of each possible rate of return
• Result: Range of rates of return from loss to profit
• Do statistical analysis

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Sensitivity analysis
• Also called “What-if analysis”
• Measures change of response to a change in input variable
• Determines the viability of an event if some variables deviate from its expected value

Analyze impact of
Identify variables Define
change of variables
impacting NPV relationships
on NPV

• Forecasts are made for pessimistic, optimistic and expected conditions.

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Scenario Analysis
• Feasibility of an event determined in terms of the change of several underlying
variables simultaneously
• Considers both sensitivity to change in variables as well as the range of likely
variable values
Base scenario is evaluated

Then worst case & best case scenarios are evaluated

Probabilities are assigned to each scenario based on inherent risk

Computation done. Expected return compared to the expected

risk for each scenario against the firm’s risk tolerance level

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Decision tree analysis
P: 70% D2 ……….
C1 D3 ……….
P: 30%
D1
P: 60% ……….
D4
C2
……….
P: 40% D5

• Cost involved at each choice of option.

• Outcome factors both cost and its probability
• Decision alternatives evaluation
• Branch: Conditional probability is obtained by multiplying together all probabilities on a particular
branch.
• NPV: Joint probability obtained by multiplying the probabilities of occurrences and summing.

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Assignment
• How different is the certainty equivalent method from the risk-adjusted discount
rate method? When is the latter preferred?
• How did David Hertz use the simulation approach to determine the risk and return
profile of the medium size industrial chemicals company? Explain
• You are testing the effectiveness of a specific quantity of a drug on a substrate.
• Which among the three types of analysis – simulation, sensitivity, scenario analysis –
would you choose to find to the extent to which the result was close to the hypothesis
and why?
• If you have the chance to experiment with the quantity to get a particular result which
one would you choose and why?

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