Chapter 7

Analysing investment risk

 Learning Objectives
• To understand how uncertainty affects investment decisions.
• To explore managers’ risk attitudes.
• To appreciate the levels at which risk can be viewed.
• To be able to measure the expected NPV and its variability.
• To appreciate the main risk-handling techniques and apply them to capital budgeting
problems.
 Risk and Uncertainty
Risk and Uncertainty.
Risk refers to the set of unique consequences for a given decision that can be
assigned probabilities, while uncertainty implies that it is not fully possible to
identify outcomes or to assign probabilities.
 Expected NPV
Expected net present value (ENPV), is the mean of the NPV
distribution when weighted by the probabilities of occurrence.
ATTITUDES TO RISK
 Types of Risk
• Business Risk – Operating Gearing
• Financial Risk – Financial Gearing
• Market Risk
 Measurement of Risk
• Standard Deviation
• Coefficient of Variation
• Mean Variance Rule
 Risk Techniques
• Sensitivity Analysis
• Scenario Analysis
• Simulation Analysis
 ADJUSTING THE NPV FOR RISK

Certainty Equivalent Method

Adjustment of the cash flows is achieved by the
certainty equivalent method.

Risk Adjusted Discount Rate

Risk-adjusted discount rate increases the risk premium
for higher-risk projects.
End of chapter