Investment appraisal under

uncertainty

Risk and uncertainty

Investment appraisal faces the following problems:
 All decisions are based on forecasts
 All forecasts are subject to uncertainty
 This uncertainty needs to be reflected in the financial evaluation.

The decision maker must distinguish between:

 Risk – quantifiable – possible outcomes have associated probabilities,
thus allowing the use of mathematical techniques
 Uncertainty – unquantifiable – outcomes cannot be mathematically
modeled.

Risk  Several possible outcomes

 On basis of past relevant
experience, assign
probabilities to outcomes
 Increases as the variability of
returns increases

Uncertainty  Several possible outcomes

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 Investment appraisal under
uncertainty
 Little past experience, thus
difficult to assign probabilities
to outcomes
 Increases as project life
increases

In investment appraisal the areas of concern are therefore the accuracy of the
estimates concerning:

 Project life
 Predicted cash flows and associated probabilities
 Discount rate used.

Incorporating uncertainty

Sensitivity analysis
 This assesses the sensitivity of project NPV to changes in project
variables.
 It calculates the relative change in a project variable required to make
the NPV zero, or the relative change in NPV for a fixed change in a
project variable.
 Only one variable is considered at a time.
 When the sensitivities for each variable have been calculated, the key
or critical variables can be identified

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 Investment appraisal under
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However, since sensitivity analysis does not incorporate probabilities, it
cannot be described as a way of incorporating risk into investment appraisal,
although it is often described as such.

Calculating Sensitivity
The maximum possible change is often expressed as percentage

NPV
Sensitivity margin = ––––––––––––––––––– × 100%
Present value (PV) of
flow under consideration

The lower the sensitivity margin, the more sensitive the decision to the
particular parameter being considered, i.e. small changes in the estimate
could change the project decision from accept to reject.

NB Because we will need the PV of each cash flow separately, the

following tabular approach is the preferred layout for the NPV
calculation:

Time Cash flow Discount factor (DF) at x% PV

Test your understanding 1

An investment of $40,000 today is expected to give rise to annual contribution

of $25,000. This is based on selling one product, with a sales volume of
10,000 units, selling price of $12.50 and variable costs per unit of $10. Annual
fixed cost of $10,000 will be incurred for the next four years; the discount rate
is 10%.
Required:

a) Calculate the NPV of this investment.

b) Calculate the sensitivity margin of your calculation to the following:

I. Initial investment
II. Selling price per unit
III. Variable cost per unit
IV. Sales volume
V. Fixed costs
VI. Discount rate

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 Investment appraisal under
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Test your understanding 2
Bacher Co is considering investing $500,000 in equipment to produce a new
type of ball. Sales of the product are expected to continue for three years, at
the end of which the equipment will have a scrap value of $80,000. Sales
revenue of $600,000 pa will be generated at a variable cost of $350,000.
Annual fixed costs will increase by $40,000.

a) Determine whether, on the basis of the estimates given, the project should
be undertaken, assuming that all cash flows occur at annual intervals and
that Bacher Co has a cost of capital of 15%.

b) Find the percentage changes required in the following estimates for the
investment decision to change:
I. Initial investment
II. Scrap value
III. Selling price
IV. Unit variable cost
V. Annual fixed cost
VI. Sales volume
VII. Cost of capital.

Advantages and disadvantages of sensitivity analysis

Strengths of sensitivity analysis
 No complicated theory to understand.
 Information will be presented to management in a form, which
facilitates subjective judgment to decide the likelihood of the various
possible outcomes considered.
 Identifies areas, which are crucial to the success of the project. If the
project is chosen, those areas can be carefully monitored.
 Indicates just how critical are some of the forecasts which are
considered to be uncertain.

Weaknesses
a) The method requires that changes in each key variable are isolated,
assuming that all other values in the estimated cash flows are
unchanged. However, management may be more interested in the
combination of the effects of changes in two or more key variables.
b) Looking at factors in isolation is unrealistic since they are often
interdependent.
c) Sensitivity analysis is analysis when there is uncertainty. It does not
examine the probability that any particular variation in costs or
revenues might occur.
d) Critical factors may be those over which managers have no control.

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 Investment appraisal under
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e) In itself it does not provide a decision rule. Managers must lay down
parameters defining acceptability of an investment project, given the
uncertainty.

Probability analysis
When there are several possible outcomes for a decision and probabilities
can be assigned to each, a probability distribution of expected cash flows can
often be estimated, recognizing there are several possible outcomes, not just
one. This could then be used to:
1. Calculate an expected value (EV);
2. Measure risk by:

a) Calculating the worst possible outcome and its probability;

b) Calculating the probability that the project will fail (for example, that a
negative NPV will result);
c) Assessing the standard deviation of the outcomes.

The EV is the weighted average of all the possible outcomes, with the
weightings based on the probability estimates.

The standard deviation is a statistical measure of the variability of a

distribution around its mean (i.e. it measures the dispersion of possible
outcomes about the EV). The tighter the distribution, the lower this measure
will be. It is a measure of risk – the wider the dispersion the riskier the
situation.

Calculating an EV

The formula for calculating an EV is:

EV =∑px

Where

p = the probability of an outcome

x = the value of an outcome.

The EV is not the most likely result. It may not even be a possible result, but
instead it finds the longrun average outcome.

Test your understanding 3 – Expected values

A firm has to choose between three mutually exclusive projects, the outcomes
of which depend on the state of the economy. The following estimates have
been made:

State of the economy recession stable growing

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 Investment appraisal under
uncertainty
Probability 0.5 0.4 0.1
NPV NPV NPV
($000) ($000) ($000)
Project A 100 200 1,400
Project B 0 500 600
Project C 180 190 200

Determine which project should be selected on the basis of expected market

values.

Test your understanding 4 – Expected values in larger NPV

Copper Co is concerned about the risk associated with a proposed investment

and is looking for ways to incorporate risk into its investment appraisal
process. The company has heard that probability analysis may be useful in
this respect and so the following information relating to the proposed
investment has been prepared:

Year 1 Year 2

Cash flow Probability Cash flow Probability

$ $

1,000,000 0.1 2,000,000 0.3

2,000,000 0.5 3,000,000 0.6
3,000,000 0.4 5,000,000 0.1

However, the company is not sure how to interpret the results of an

investment appraisal based on probability analysis.

The proposed investment will cost $3·5m, payable in full at the start of the first
year of operation. Copper Co uses a discount rate of 12% in investment
appraisal.

Using a joint probability table:

i. Calculate the mean (expected) NPV of the proposed investment;

ii. Calculate the probability of the investment having a negative NPV;

iii. Calculate the NPV of the most likely outcome;

iv. Comment on the financial acceptability of the proposed investment.

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 Investment appraisal under
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Advantages and limitations of EVs

Advantages of EVs
 The technique recognises that there are several possible outcomes and is,
therefore, more sophisticated than single value forecasts.
 Enables the probability of the different outcomes to be quantified.
 Leads directly to a simple optimising decision rule by reducing a range of
possible outcomes into one number. However, care should be taken
 Calculations are relatively simple.

Limitations of EVs
 By asking for a series of forecasts the whole forecasting procedure is
complicated. Inaccurate forecasting is already a major weakness in project
evaluation. The probabilities used are also usually very subjective.
 The EV is merely a weighted average of the probability distribution,
indicating the average payoff if the project is repeated many times.
 The EV gives no indication of the dispersion of possible outcomes about
the EV. The more widely spread out the possible results are, the more
risky the investment is usually seen to be. The EV ignores this aspect of
the probability distribution.
 In ignoring risk, the EV technique also ignores the investor’s attitude to
risk. Some investors are more likely to take risks than others.

Conclusions on EVs
The simple EV decision rule is appropriate if three conditions are met or
nearly met:
 There is a reasonable basis for making the forecasts and estimating the
probability of different outcomes
 The decision is relatively small in relation to the business. Risk is then
small in magnitude
 The decision is for a category of decisions that are often made. A
technique, which maximises average payoff, is then valid.

Further techniques for adjusting for risk and uncertainty

Simulation

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 Investment appraisal under
uncertainty
Sensitivity analysis considers the effect of changing one variable at a time.
Simulation improves on this by looking at the impact of many variables
changing at the same time.

Using mathematical models, it produces a distribution of the possible

outcomes from the project. The probability of different outcomes can then be
calculated.

You will never be expected to carry out a simulation exercise in the

exam although you may be asked to interpret the output.

The major advantages of simulation are as follows:

 it includes all possible outcomes in the decision-making process
 It is easy technique to understand.
 it has a wide variety of applications (inventory control, component
replacement, corporate models, etc.).

Drawbacks of simulation
However, it does have some significant drawbacks:
 Models can become extremely complex and the time and costs involved in
their construction can be more than is gained from the improved decisions
 Probability distributions may be difficult to formulate.

Test your understanding 5

Petra is contemplating purchasing a machine for $275,000, which she will use
to produce 50,000 units of a product per annum for five years. These products

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 Investment appraisal under
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will be sold for $10 each and unit variable costs are expected to be $6.
Incremental fixed costs will be $70,000 per annum for production costs and
$25,000 per annum for selling and distribution costs. Petra has a required rate
of return of 10% per annum.

By how many units must the estimate of production and sale volume fall for
the project to be regarded as not worthwhile?

Test your understanding 6

When using the expected value criterion, it is assumed that the individual
wants to
A. Minimise risk for a given level of return
B. Maximise return for a given level of risk
C. Minimise risk irrespective of the level of return
D. Maximise return irrespective of the level of risk

Test your understanding 7

Which of the following is incorrect?
A. Sensitivity analysis assesses how responsive the project's NPV is to
changes in the variables used to calculate that NPV
B. When calculating the sensitivity of each variable, the lower the
percentage, the less sensitive is the NPV to that project variable
C. Management should review critical variables to assess whether or not
there is a strong possibility of events occurring which will lead to a
negative NPV
D. Sensitivity analysis does not provide a decision rule. Parameters
defining acceptability must be laid down by managers

Test your understanding 8

Which of the following are true in respect of using expected values in net
present value calculations?
1. Appropriate for one-off events
2. Hides risk
3. Probably won't actually occur
4. Eliminates uncertainty
A. 1, 2 and 3 only
B. 3 and 4 only
C. 2 and 3 only
D. 1, 2 and 4

Test your understanding 9

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 Investment appraisal under
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Sales volumes are expected to be either 20,000 units with 60% probability or
they are expected to be 25,000 units. Price will either be $10 (0.3 probability)
or else $15. Margins are expected to be 30% or 40% of sales with an even
chance of each.
What is the expected total cost?
A. $103,950
B. $193,050
C. $297,000
D. $105,000

Test your understanding 10

SAC Co has a cost of capital of 8% and is appraising project Gamma. It has

the following cash flows.

T0 Investment 100,000
T1-5 Net cash inflow 40,000

What is the adjusted payback period for this project?

A. 2.5 years
B. Just under 3 years
C. 2 years
D. Just over 4 years

Test your understanding 11

A project has the following cash flows.

T0 Outflow $110,000
T1-4 Inflow $40,000

At the company's cost of capital of 10% the NPV of the project is $16,800.
Applying sensitivity analysis to the cost of capital, what percentage change in
the cost of capital would cause the project NPV to fall to zero?

A. 70%
B. 17%
C. 5%
D. 41%

Test your understanding 12

What is the main advantage of using simulations to assist in investment

appraisal?
A. A clear decision rule
B. More than one variable can change at a time

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 Investment appraisal under
uncertainty C.
S
tatistically more accurate than other methods
D. Being diagrammatic it is easier to understand

Practice question 1
Umunat Co is considering investing $50,000 in a new machine with an
expected life of five years. The machine will have no scrap value at the end of
five years. It is expected that 20,000 units will be sold each year at a selling
price of $3.00 per unit. Variable production costs are expected to be $1.65 per
unit, while incremental fixed costs, mainly the wages of a maintenance
engineer, are expected to be $10,000 per year. Umunat Co expects
investment projects to recover their initial investment within two years.
Required
a) Explain why risk and uncertainty should be considered in the investment
appraisal process. (5 marks)
b) Calculate and comment on the payback period of the project (5 marks)

Practice question 2
Tan Co is considering investing $50,000 in a new machine with an expected
life of five years. The machine will have no scrap value at the end of five
years. It is expected that 20,000 units will be sold each year at a selling price
of $3.00 per unit. Variable production costs are expected to be $1.65 per unit,
while incremental fixed costs, mainly the wages of a maintenance engineer,
are expected to be $10,000 per year. Tan Co uses a discount rate of 12% for
investment appraisal purposes.

Required
a) Evaluate the sensitivity of the project's net present value to a change in the
following project variables:
i. sales volume;
ii. sales price
iii. variable cost

and discuss the use of sensitivity analysis as a way of evaluating project

risk. (10 marks)

b) Upon further investigation it is found that there is a significant chance that

the expected sales volume of 20,000 units per year will not be achieved.
The sales manager of Tan Co suggests that sales volumes could depend
on expected economic states that could be assigned the following
probabilities:

Economic state Poor Normal Good

Probability 0.3 0.6 0.1

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 Investment appraisal under
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Annual sales volume (units) 17,500 20,000 22,500

Calculate and comment on the expected net present value of the project

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