Robin Cunningham, PhD, FSA
Created 9/14/2018
This section only has a couple of ideas.
Many texts focus on how to make a ‘best-estimate’ projection or analysis of profit. In this section, the author’s main point is that we need to be aware how sensitive our projections and NPV calculations are to changes in parameters. If small changes in some parameters cause big swings in NPV, then we need to focus carefully on our estimates of those parameters.
Sensitivity Analysis - changing only one parameter from the best-estimate case, often by a unit amount or by a fixed percent.
Scenario Analysis - Changing multiple parameters at once to capture the effects of interactions between changes in parameters.
Those topics and how to calculate NPV of a set of cash flowsare all you need to know for Section 8.5.
Exercises: Chapter 8 #22, 23, 24. Exercise 24 is worked out in Lecture 1 for Chapters 8 and 9.
This is another short and simple section. The key point is that in a competitive and efficient market (like markets for US stocks or bonds), market prices are an excellent indicator of value and there are very few positive-NPV trading opportunities.
The main practical implication of this is that if you have a model that predicts a significantly different price for a company’s stock than the market indicates, it is likely that one of your parameters or assumptions need to change. This is much more likely than the stock being mis-valued by a competitive and efficient market.
Examples 9.11, 9.12, 9.13 are all useful and Exercises 30-33 are all worth doing. Solutions to exercises 30-32 are all in Lecture 2 for these sections.