Chapter 6 – Investment appraisal under

risk & uncertainty

Chapter agenda

Investment
Sensitivity
deicisons under
analysis
uncertainity

EV

Adjusted PV and
DPB
Chapter 6
Investment Risk adjusted
decisions under discount factor
risk

Simulation

Investments are carried out in the future meaning there is always uncertainty regarding the
projected cashflows, the life of the projects & discount factors. In this chapter, uncertainty is
factored into the investment appraisal.

Are risks and uncertainties the same?

No.

Risks can be quantified using mathematical modelling (using probability theory) whereas
uncertainties cannot.

E.g., Insurance companies charge premiums on a vehicle based on several factors. In that,
the risk of getting into an accident is also accounted for.

E.g., It is difficult for a business to estimate the chance of a hacker breaching into their
system with the intent to manipulate data

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Incorporating uncertainty into project appraisal – Sensitivity analysis
Also known as “what if” analysis

Analyses the impact of changes in independent uncertain variables on a dependent

variable

E.g., In a project, NPV is dependent on several variables such as selling price, variable cost,
investment cost, discount factor etc.

How high should discounting factor increase to reverse the original decision to undertake the
project? (By how much the variable needs to change so that the original investment decision
is reversed)
This is calculated as,

𝑁𝑃𝑉
𝑆𝑒𝑛𝑠𝑖𝑡𝑖𝑣𝑖𝑡𝑦 𝑚𝑎𝑟𝑔𝑖𝑛 = 𝑥 100
𝑃𝑉 𝑜𝑓 𝐶𝐹 𝑢𝑛𝑑𝑒𝑟 𝑐𝑜𝑛𝑠𝑖𝑑𝑒𝑟𝑎𝑡𝑖𝑜𝑛

Lower the sensitivity margin, the higher the sensitivity of the variable to the original
decision

PV of CF under consideration –

• E.g., Sales volume changes. This leads to changes in sales revenue and variable costs.
Therefore, PV of CF under consideration should be a contribution.

• E.g., Selling price changes. This leads to a change in sales revenue. Therefore, PV of
PV of CF under consideration should be sales revenue.

Example – Sensitivity analysis

Cost of the investment - $250,000. Useful life - 3 years. Sales revenue & variable cost per
annum are $300,000 & $175,000. Scrapped value of$40,000.
Incremental fixed costs per annum is $20,000.

Should the project be undertaken at a cost of capital of 7.5%

Calculate the sensitivity of the following factors to the initial investment decision

a) initial investment
b) scrap value
c) selling price
d) unit variable cost
e) annual fixed cost
f) sales volume
g) cost of capital

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Pros and Cons
Pros Cons
Easy to understand Assumes variables are independent. E.g.,
Material price change independently of
other variables
Identifies factors which are crucial to the It does not calculate the probability of how
success of the project far the variable each change.
Facilitates decision making through No. of possible outcomes are identified but
assessment of likelihood of each outcome the correct outcome is not indicated.

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Incorporating risks into project appraisal
Risks can be factored into project appraisal using the following methods.

1. Expected values (EV)

2. Simulation models
3. Adjusted payback
4. Risk-adjusted discount rates

Expected values (EV)

In simple words, EV is the weighted average of the outcomes

EV is calculated using the following equation.

𝐸𝑉 = Σ𝑝𝑥

whereas

p- probability of the outcome

x – value of the outcome

Example I – Expected values

A firm has two mutually exclusive projects which generate the following NPVs under 3
economic states which are likely to arise with the following probabilities.

State of economy Recession Boom Stagnant

Probability 0.3 0.3 0.6
Project ABC (NPV $000) -200 400 150
Project XYZ (NPV $000) -300 500 175

Determine the best project based on expected NPV

Example II– Expected values

A project costs $500,000 today. It has a cost of capital of 10%. The project lasts for 3 years.
It is expected to generate the following probabilistic net cashflows per annum.

NCF Probability
100,000 0.3
300,000 0.5
700,000 0.2

Is it worthwhile to accept this project?

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Pros and Cons of EV
Pros Cons
Easy to understand Probabilities are subjective
Information is reduced to a single number EV does not indicate dispersion of different
outcomes
Considers uncertainty element of each EV may not correspond to actual possible
outcome through probabilities outcomes

Suitability of EV
When evaluating and selecting projects based on EV, the following 3 conditions should be
held

1. The decision made should be not of significant risk

2. The decision under consideration is often made
3. Reasonableness in making the forecasts and probabilities

Using joint probabilities (JP)

Joint probability can be illustrated with the following example.

The probability of business coming across a loss in Feb is 5% and Mar is 3%. The joint
probability of business coming across losses in both Feb & Mar is

5% x 3% = 1.5%

Sometimes exam questions may require you to calculate JPs. Calculation of JPs will differ
based on whether outcomes are mutually exclusive or not.

1. If the events are mutually exclusive – then add the individual probabilities of
different outcomes together to get the JP.

2. If the events are not mutually exclusive – then add the individual probabilities
together and then deduct the joint probability of them both occurring.

E.g., Assume you are likely to pay $5000 at a probability of 50% in the next month
and $10,000 at a probability of 65% in the month after that. The probability of
making one payment or the other is

50% + 65% - (50% x 65%)

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Example - JPs in investment appraisal

A company has estimated cash flows for a project over the next 2 years at the following
probabilities.

Year 1 Year 2
Probability Cashflows Probability Cashflows
20% 50,000 30% 100,000
80% 100,000 70% 150,000

The proposed investment will cost $200,000 which will be paid at the beginning.

What is the NPV of the project?

What is the probability of the project recording a negative NPV?
What is the probability of the project recording a zero NPV?

Adjusted payback
The shorter the payback, the faster the recovery of the initial investment, the lower the
overall risk.

To have shorter payback, the project must generate large positive cashflow in the initial
years.

Discounted payback (DPB)

Basic payback does not consider TVM concept. In the discounted payback method,
cashflows discounted when calculating the payback.

Example – Discounted payback

A project has following cashflows into the future. Calculate its payback assuming the cost of
capital is 5%.

Year Cashflow
0 (110,000)
1 45,000
2 35,000
3 42,000

Discount payback method has the same advantages and disadvantages as the basic payback
method, except now, the cashflows consider the TVM concept.

Adjusted payback & discounted payback methods are not typically used in appraising
projects under uncertainty and risk

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Risk-adjusted discount rate
The discount factor used in converting future values to present values reflects number of
factors

1. Risk of the project – Higher the risk, the higher the discount rate
2. Cost of borrowing funds at the loan rate
3. Rate of return demanded by shareholders

If the project under consideration is highly risky compared to the existing business risks of
an organisation, then the discount rate needs to be adjusted for risk.

This concept is thoroughly discussed in the Cost of Capital chapter.

Simulation
In sensitivity analysis, only one variable changes at a given time and the resulting impact of
the original decision is identified.

Simulation shows the effect of more than one variable changing at the same time. E.g., the
effect on NPV when labour cost increases by 10%, material costs increase by 25% and
investment expenditure falls by 5%.

Pros and Cons of simulation

Pros Cons
Used in the context of project appraisal, Highly complex. Requires specialist
inventory control, component replacement knowledge to interpret data

All possible outcomes are accounted for High cost of construction of the simulation
model

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