TECHNIQUES FOR MEASURING

STAND-ALONE RISK

INTRODUCTION

Firms use many techniques to determine project’s risk.

There are three distinct types of risk- Stand-alone risk Corporate risk Market risk

INTRODUCTION

Stand-alone risk- Risk of a project when the project is considered in isolation.

The three important techniques used for assessing a project’s stand-alone risk –

Sensitivity analysis Scenario analysis Monte Carlo Simulation

SENSITIVITY ANALYSIS

Sensitivity analysis is a technique that indicates how much NPV will change in response to a given change in an input variable, other things held constant.

In other words, sensitivity analysis is a way of analyzing change in the project’s NPV or IRR for a given change in one of the variables.

PROCEDURE- SENSITIVITY ANALYSIS Three steps are involved- Identification of all those variables, which

have an influence on project’s NPV / IRR. Definition of the underlying relationship

between the variables Analysis of the impact of the change in each

of the variables on the project’s NPV.

PROCEDURE- SENSITIVITY ANALYSIS While performing sensitivity analysis, the

project’s NPV or IRR are calculated under three assumptions-

Pessimistic Expected Optimistic

ADVANTAGES AND DISADVANTGES ADVANTAGES It compels the decision maker to identify the

variables which affect on the cash flow forecasts.

It helps to expose the inappropriate forecasts Guides the decision maker to concentrate on

relevant variables.

ADVANTAGES AND DISADVANTGES DISADVANTGES It does not provide clear cut results. It does not focus on interrelationship between

variables. It assumes that only one variable is changed

at a time. In real world, variables tend to move together.

SCENARIO ANALYSIS

The sensitivity analysis assumes that only one variable changes at a time, but variables are interdependent.

One way to analyze the risk of project is to analyze the impact of alternative combinations of variables called scenarios.

PROCEDURE-SCENARIO ANALYSIS Select the factors around which scenarios will

be built. Estimate the values of each variable for each

scenario Calculate the NPV or IRR of each scenario

SCENARIO ANALYSIS

The decision maker can develop three scenarios –

For example, Optimistic, Expected and Pessimistic

or Best Scenario Normal Scenario Worst Scenario

ADVANTAGES AND DISADVANTGES ADVANTAGES It considers variations in different variables

together. It helps to identify the variables which affect

on cash flow forecasts. DISADVANTGES It considers only few discrete outcomes even

though there are many variables. It considers only three scenarios even though

economy lies in many scenarios.

SIMULATION

Simulation overcomes many limitations of sensitivity or scenario analysis.

Simulation is more complex than scenario analysis. It considers interactions among variables and probabilities of the change in variables.

SIMULATION

It does not give project’s NPV as a single number rather it computes the probability distribution of NPV.

In simulation, it generates a very large number of scenarios according to probability distribution of the variables.

PROCEDURE-SIMULATION

Identify variables that influence cash inflow and cash outflows.

Specify the formulae that relate variables. For example- Revenue depends on sales volume and price.

Indicate the probability distribution for each variable.

Random selection of one value from the probability distribution of each variable.

Use these values to calculate project’s NPV.

DISADVANTAGES

The model is quite complex to use because variables are interrelated with each other.

Time consuming Expensive It does not indicate whether or not the project

should be accepted. It considers the risk of projects in isolation of

other projects.