Risk Analysis

Instructor: Maharouf Oyolola

 Introduction
• Until now we have examined managerial decision
making under conditions of certainty. In such cases, the
manager knows exactly the outcome of each possible
course of action.
• In many managerial decisions, however, the manager
often does not know the exact outcome of each possible
course of action.
• For example, the return on a long-run investment
depends on economic conditions in the future, the
degree of future competition, consumer tastes,
technological advances, the political climate, and many
other such factors about which the firm has only
imperfect knowledge. In such cases, we say that the firm
faces “risk” or “uncertainty”. Most strategic decisions of
the firm are of this type.
Risk and Uncertainty in Managerial
Decision Making
• Managerial decisions are made under
conditions of certainty, risk, or uncertainty
 Certainty
• Certainty refers to the situation where
there is only one possible outcome to a
decision and this outcome is known
precisely.
 Example
• Investing in Treasury bills or T-bills leads
to only one outcome (the amount of the
yield), and this is known with certainty.

• However, when there is more than one

outcome to a decision, risk or uncertainty
is present.
 Risk
• Risk refers to a situation in which there is more
than one possible outcome to a decision and the
probability of each specific outcome is known or
can be estimated.
• Risk requires that the decision maker know all
the possible outcomes of the decision and have
some idea of the probability of each outcome’s
occurrence.
 Example
• In tossing a coin, we can get either a head
or a tail, and each has an equal (i.e., a 50-
50) chance of occurring (if the coin is
balanced).
 Uncertainty
• Uncertainty is the case when there is more
than one possible outcome to a decision
and where the probability of each specific
outcome occurring is not known or even
meaningful.
• This may be due to insufficient past
information or instability in the structure of
the variables.
 States of nature
• Refers to conditions in the future that will have a
significant effect on the degree of success or
failure of any strategy, but over which the
decision maker has little or no control.
• For example, the economy may be booming,
normal, or in recession in the future. The
decision maker has no control over any of these
three states of nature.
 Measuring risk with probability
distributions
• In this section, we examine the meaning
and characteristics of probability
distributions, and then use these concepts
to develop a precise measure of risk.
 Probability Distributions
• The probability of an event is the chance or odds
that the event will occur. For example, if we say
that the probability of booming conditions in the
economy next year is 0.25, or 25 percent, this
means that there is 1 chance in 4 for this
condition to occur.
• By listing all the possible outcomes of an event
and the probability attached to each, we get a
probability distribution.
 Probability Distribution of states of
the economy
State of the economy Probability of occurrence

Boom 0.25

Normal 0.50

Recession 0.25

Total 1.00
• The concept of probability distributions is
essential in evaluating and comparing
investment projects.
• In general, the outcome or profit of an
investment project is highest when the
economy is booming and smallest when
the economy is in a recession.
 Expected Profit
• It is the weighted average of all possible profit
levels that can result from the investment under
the various states of the economy, with the
probability of those outcomes or profits used as
weights.
• The expected profit is a very important
consideration in deciding whether to undertake
the project or which of two or more projects is
preferable. − n
• Expected profit= E (π ) = π = ∑
i =1
π i . pi
Calculation of the expected profits
of two projects
Project State of the economy Probability of occurrence Outcome of investment Expected value

Boom 0.25 $600 $150

A Normal 0.5 500 250

Recession 0.25 400 100

Expected profit from project A $500

Boom 0.25 $800 $200

B Normal 0.5 500 250

Recession 0.25 200 50

expected profit from project B $500

 An Absolute measure of risk: the
standard deviation
• The standard deviation (σ) measures the
dispersion of possible outcomes from the
expected value.
• The smaller the value of σ, the lower the
risk.
 An Absolute measure of risk: the
standard deviation
• To find the value of the standard deviation
(σ) of a particular probability distribution,
we follow three steps:
−
di = X i − X
n −
var iance =σ = ∑( X i − X ) .Pi
2 2

i =1

n −
s tan dard =σ = ∑( X
i =1
i − X ) .Pi2
Calculation of the standard deviation of
profits for project A and project B
• See Microsoft Excel file
 A relative measure of risk: the
coefficient of variation
• The standard deviation is not a good
measure to compare the dispersion
(relative risk) associated with two or more
probability distributions with different
expected values or means.
• Thus, we use the coefficient of variation
(V) to calculate the relative measure of
risk.
 σ
A relative measure of risk: the
coefficient of variation
• Coefficient of variation=v= −
X
 Example
• If the expected value or mean and standard deviation of
project A were, respectively, XA (bar)= $5,000 and
σA=$707.11 while XB (bar)= $500 and σB=$212.13
• Project is less risky than project B

σA $707.11
VA = = = 0.14
XA $5000
σB $212.13
VB = = = 0.42
XB $500
 Risk-Adjusted Discount Rate
Approach
• When making long-term capital budgeting
(investment) decisions, the risk-adjusted
discount rate approach is a commonly
used method for dealing with the
uncertainty associated with future cash-
flow estimates.
 Risk-Adjusted Discount Rate
Approach
• Net present value is defined as

n
NCFt
NPV = ∑ − NINV
t =1 (1 + k )
t
 Risk-Adjusted Discount Rate
Approach
• NCFt=net cash flow in period t (for each of
n periods)
• NINV= the net investment
• K=the firm’s cost of capital
 Risk-Adjusted Discount Rate
Approach
• An investment is accepted if its NPV is
greater or equal to zero.
• In the risk-adjusted rate, k*, rather than the
firm’s cost of capital (k).
• The magnitude of k* depends on the risk
of the project- the higher the risk, the
higher the risk-adjusted discount rate.
 Example
• The Hamilton-Beach company has been offered
a contract to supply private-label food
processors to a regional discount store chain.
The investment required for this project is
$1,000,000. It is expected to produce annual net
cash flows of $290,000 for a period of five years.
Hamilton-Beach uses the risk-adjusted discount
rates shown in table 19.1 when evaluating
capital investment decisions.
 Risk-adjusted discount rates:
Hamilton-Beach Company
Project Risk Risk premium Risk-adjusted
(θ) discount rate
K*= k + θ
Average risk 0% 12%

Above-average 3 15
risk
High risk 8 20
 Information and Risk
• Risk often results from lack of or
inadequate information.
• The relationship between information and
risk can be analyzed by examining
asymmetric information, adverse
selection, and moral hazard.
 Asymmetric information
One party to a transaction (i.e., the buyer or
seller of a product or service) often has
less information than the other party with
regard to the quality of the product or
service.
 Example
• The market for “lemons” (i.e., a defective
product, such as a used car, that will require a
great deal of costly repairs and is not worth its
price).
• Specifically, sellers of used cars know exactly
the quality of the cars that they are selling but
prospective buyers do not. As a result, the
market price for used cars will depend on the
quality of the average used car available for
sale.
• The owners of lemons would tend to
receive a higher price than their cars are
worth, while the owners of high-quality
used cars would tend to get a lower price
than their cars are worth.
 Adverse selection
• The owners of high-quality used cars would
therefore withdraw their cars from the market.,
thus lowering the average quality and price of
the remaining used cars offered for sale.
• Sellers of the now above-average-quality cars
withdraw their cars from the market, further
reducing the quality and price of the remaining
used cars offered for sale.
• Thus, the end result is that low-quality cars drive
high-quality cars out of the market. This is
known as adverse selection.
 Adverse selection
• The problem of adverse selection that arises
from asymmetric information can be overcome
or reduced by the acquisition of more
information by the party lacking it.
• For example, in the used-car market, a
prospective buyer can have the car evaluated at
an independent automobile service center, or
the used car dealer can signal above-average-
quality cars providing guarantees.