Question 4.

Scenario Analysis as a Risk Assessment Tool

Scenario analysis is a risk assessment tool used to analyze the potential outcomes of an investment
under a variety of scenarios. It helps decision-makers understand the risk and reward potential by
exploring various possibilities, ranging from best-case to worst-case scenarios. This allows them to
consider all possible outcomes and make an informed decision about whether to pursue an investment
(Mun, 2019).

Explanation of Scenarios

Scenario 1 - Conservative Scenario: This scenario assumes less favorable conditions, with investment A
providing a higher return (11%) than investment B (6%).

Scenario 2 - Base Case Scenario: This is the most likely scenario, often reflecting the current market or
economic condition. Here, both investments A and B generate an equal return of 14%.

Scenario 3 - Aggressive Scenario: This scenario assumes very favorable conditions, with higher risk and
return. Here, investment B outperforms investment A with a return of 22% versus 16%.

Making the Decision & Calculating Variance

To make the decision and to further evaluate the risk associated with each investment, we can calculate
the variance of the returns. The variance gives us an idea of the dispersion or how spread out the
returns are likely to be from the expected return. Since equal probabilities are assumed for each
scenario, we would use these probabilities (1/3) for each scenario in our calculations.

For Investment A:

Expected return = (11% + 14% + 16%)/3 = 13.67%

Variance = [(1/3)((11%-13.67%)^2) + (1/3)((14%-13.67%)^2) + (1/3)*((16%-13.67%)^2)] = 0.044%

For Investment B:
Expected return = (6% + 14% + 22%)/3 = 14%

Variance = [(1/3)((6%-14%)^2) + (1/3)((14%-14%)^2) + (1/3)*((22%-14%)^2)] = 0.32%

The standard deviation, which is the square root of the variance, will give us a measure of the risk
associated with each investment.

For Investment A:

Standard deviation = √(0.044%) = 0.21%

For Investment B:

Standard deviation = √(0.32%) = 0.57%

Based on the scenario analysis and the calculated risk (standard deviation), Investment A appears to be
less risky. It also provides a comparable expected return to Investment B. However, if the management
team's risk tolerance is high and they are confident about the likelihood of Scenario 3, they might prefer
Investment B due to its higher potential returns in the aggressive scenario.

Question 4.22

Probability distribution is a tool used in statistics to provide a complete description of the likelihood of
various outcomes from a certain event. This tool is highly valuable in risk assessment as it allows
decision makers to consider all possible outcomes, the chance of each outcome occurring, and therefore
make the most informed decision.

In the case of NTPL Investments, probability distribution can be applied to evaluate the risk associated
with Investment A and Investment B. This can be done by assigning probabilities to each scenario, then
using these probabilities to calculate the expected return and the variance of each investment.

Assuming equal probabilities for simplicity, we could say each scenario has a 1/3 chance of occurring.
Thus, the expected return (ER) for each investment would be calculated as follows:
For Investment A:

ER = (1/3)*11% + (1/3)*14% + (1/3)*16% = 13.67%

For Investment B:

ER = (1/3)*6% + (1/3)*14% + (1/3)*22% = 14%

The variance (which measures the dispersion of returns) for each investment can be calculated:

For Investment A:

Variance = (1/3)(11%-13.67%)^2 + (1/3)(14%-13.67%)^2 + (1/3)*(16%-13.67%)^2 = 0.044%

For Investment B:

Variance = (1/3)(6%-14%)^2 + (1/3)(14%-14%)^2 + (1/3)*(22%-14%)^2 = 0.32%

The usefulness of probability distribution as a tool for risk assessment lies in its ability to provide a
comprehensive view of potential outcomes and their likelihoods, allowing for a more informed and
nuanced decision-making process (Crouhy, Galai, & Mark, 2019).