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Unformatted text preview: ivity Analysis­Sensitivity analysis uses several possible­return estimates to obtain a sense of the variability among outcomes. One common method involves making pessimistic (worst), most likely (expected), and optimistic (best) estimates of the returns associated with a given asset. In this case, the asset’s risk can be measured by the range of returns. The range is found by subtracting the pessimistic outcome from the optimistic outcome. The greater the range, the more variability, or risk, 17 Sensitivity Analysis­Example Sensitivity Analysis­Example Norman Company, a custom golf equipment manufacturer, wants to choose the better of two investments, A and B. Each requires an initial outlay of $10,000, (Payments made in cash or cash equivalents. Common examples of outlays include employee salaries) and each has a most likely annual rate of return of 15%. Management has made pessimistic and optimistic estimates of the returns associated with each. The three estimates for each asset, along with its range, are given in the following Table . 18 Sensitivity Analysis­Example Sensitivity Analysis­Example 19 Sensitivity Analysis­Example Sensitivity Analysis­Example Asset A appears to be less risky than asset B; its range of 4% (17% ­13%) is less than the range of 16% (23% ­7%) for asset B. The risk­averse decision maker would prefer asset A over asset B, because A offers the same most likely return as B (15%) with lower risk (smaller range). Although the use of sensitivity analysis and the range is rather crude, it does give the decision maker a feel for the behavior of returns, which can be used to estimate the risk involved. 20 Probability Distributions Probability Distributions Probability distributions provide a more quantitative insight into an asset’s risk. The probability of a given outcome is its chance of occurring. An outcome with an 80 percent probability of occurrence would be expected to occur 8 out of 10 times. An outcome with a probability of 10...
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