The annual rates of return on your favorite stock were: -2.3%, 8.9%, and 11.2%,

Question

The annual rates of return on your favorite stock were: -2.3%, 8.9%, and 11.2%, respectively, over the recent 4-year holding horizon. Compute the average annual rate of return on this stock according to the buy-and-hold strategy. Which of the following statements concerning (forecasting) risk analysis in capital budgeting is correct? If the NPV of the expected scenario is negative then it is unnecessary to analyze the optimistic and the pessimistic scenarios. Scenario analysis is less apt than sensitivity analysis to determine which single variable has the greatest impact on the net present value. The simulation analysis is the best method to identify the variable that presents the highest degree of forecasting risk. a and b only. b and c only.

Explanation / Answer

The first part - Annual average rate of return = {(1-2.3%)*(1+8.9%)*(1+11.2%)}1/3 - 1

= 5.77%

The second part - (b). Sensitivity analysis is carried out by making changes to one of the variables while keeping the others constant, while scenario analysis considers chnages in more than one variable. Negative NPV never rules out scenario analysis as the future cashflows are based on simple expectations. Simulation analysis is analogous to scenario analysis.

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