Risk and Project Appraisal

Two types of expectations about the future:

1 Certainty future outcome has only one value
2 Risk and uncertainty range of possible outcomes
Objective probabilities established using historic data

What is risk?
Personal judgement of the range of outcomes along with
the likelihood of their occurrence
The alternative is merely stating the most likely outcomes
Subjective Probabilities
Presenting a more realistic and rounded view of a
projects prospects by incorporating risk in an
appraisal by:
1. Varying the discount rate
2. Sensitivity Analysis
3. Scenario Analysis
4. Probability Analysis

Risk and Project Appraisal
1.Adjusting for risk through the discount rate
Advantage: This is an easy approach to understand
and adopt
Drawbacks:
Risk perception and judgment are bound to be, to some extent,
subjective and susceptible to personal bias
A high degree of arbitrariness in the selection of risk premiums.
1. Adjusting for risk through the discount rate

Acemart plc has developed a new product line called Marts, likely
demand is 1,000,000 per year for the four-year life of the project
2. Sensitivity Analysis
- examines the impact of a change in the value of one
variable on the project NPV
Required rate of return on a project of this risk class is 15%
Expected net present value:
2. Sensitivity Analysis

2. Sensitivity Analysis

The finance department are aware that when the proposal is placed
before the capital investment committee they will want to know how
the project NPV changes if certain key assumptions are altered. As
part of the report the finance team ask some what-if questions and
draw a sensitivity graph.
1. What if the price achieved is only 95p (5% below the expected 1)
for sales of 1m units (all other factors remaining constant)?
2. What if the price rose by 1%?
3. What if the quantity demanded is 5% more than anticipated?
4. What if the quantity demanded is 10% less than expected?
5. What if the appropriate discount rate is 20% higher than originally
assumed (i.e. 18% not 15%)?
6. What if the discount rate is s10% lower than assumed (i.e.13.5%)?
Sensitivity graph

Initial investment
Sales price
Material costs
Discount rate

The break-even point where NPV=zero
% 100
Pr
= =
ble ojectVaria PVof
NPV
y Sensitivit
Advantages
Information for decision making
To direct search
To make contingency plans
Drawbacks
The absence of any formal assignment of probabilities to the
variations of the parameters
Each variable is changed in isolation while all other factors
remain constant
Advantages & disadvantages of using sensitivity analysis
Acmart plc:
3. Scenario analysis
- Situations where a number of factors change
3. Scenario analysis
4. Probability Analysis
The expected return is the mean or average outcome calculated by
weighting each of the possible outcomes by the probability of
occurrence and then summing the result
Step 1 expected return

=
=
=
n i
i
i i
p R R
1
n n
p R p R p R R ...
2 2 1 1
+ + =
= the expected return
i = each of the possible outcomes (outcome 1 to outcome n)
p = probability of outcome i occurring
n = the number of possible outcomes
= means add together the results for each of the possible outcomes i
from the first to the nth outcome
R

=
=
n i
i 1
Standard deviation, , is a statistical measure of the
dispersion around the expected value
The standard deviation is the square root of the variance,
2
Step 2 - Standard Deviation
( ) { }

=
=
=
n i
i
i i i
p R R
1
2
o
Project X will be preferred to Project Y if at least one of the
following conditions apply:
1. The expected return of X is at least equal to the expected return
of Y, and the variance is less than that of Y
2. The expected return of X exceeds that of Y and the variance is
equal to or less than that of Y
Mean-variance rule
NPV = expected net present value
NPV
i
= the NPV if outcome i occurs
p
i
= probability of outcome i occurring
n = number of possible outcomes
means add together the results of all the NPV p calculations
for each outcome i from the first to the nth outcome

standard deviation of the net present value is:
i=n
i=1

{(NPV
i
NPV)
2
p
i
}
\

NPV
=
i=n
i=1

=

NPV
i=n
i=1

(NPV
i
p
i
)
Expected NPVs & standard deviation
Purchase price, t
0
700,000

e.g. Horizon plc
Expected NPVs & standard deviation
Cost of Capital 10%.
Horizon plc cont.

An event tree showing the probabilities of the possible returns for Horizon