TECHNIQUES FOR MEASURING

STAND-ALONE RISK

INTRODUCTION
 Firms use many techniques to determine

projects 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 projects 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 projects 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 projects NPV / IRR.  Definition of the underlying relationship between the variables  Analysis of the impact of the change in each of the variables on the projects NPV.

PROCEDURE- SENSITIVITY ANALYSIS

 While performing sensitivity analysis, the

projects 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 projects 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 projects 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.