Chapter 10 - Investment Appraisal Under Uncertainty

Question 1

What approaches are there to attempt to reduce uncertainties of the estimates in the cash flows ?

Answer 1

Sensitivity analysis

Simulation

Expected values

Risk adjusted discount rate

Question 2

What is sensitivity analysis

Answer 2

The most important for this exam

We measure the % change in the flow that results in an net present value or zero

To do this you need to first find the net present value

For example let’s imagine the NPV is +£5,329

1. Initial investment was £150,000 so the sensitivity analysis is +3.55% (5329/150000). Meaning if the cost of the investment was more than +3.55% then it is not worth doing
2. Sales volume p.a was 15,000 x £2.75 = 41250 @ 5.847 = 241,189 therefore for the total to change by -5329 there sales volume will also fall therefore it’s -2.21% (5329/241189)
3. Contribution per unit, same as above as to get the revenue it’s sales volume x contribution of £2.75 therefore answer is -2.21%
4. Fixed costs - same as initial cost, it’s a + % using the total npv for fixed costs
5. Cost of capital - first calculate the internal rate of return (calculate twice and work out from there) let’s say it’s 16% and the current cost of capital is 15% then 1% / 15% = +6.67%
6. Scrap value was 1845 however 5329 / 1845 = -288.8% but this is silly because scrap can only fall by 1845 therefore even if scrap was zero we would have a positive npv therefore we say it is NOT SENSITIVE AT ALL

Question 3

What is simulation

Answer 3

Can’t be asked to do numbers on it just know what it is

The problem with sensitivity analysis is that in this exam only was factor can change e.g sales volume however this isn’t practical in real life as multiple factors can be uncertain

With simulation you look at different factors at the same time, run simulation like the contribution at 2.75 and 3.00 and 2.50 etc and the sales volume at 15,000 and 12,500 etc. set up all the possible outcomes for the factors that could change and work out all the different possible NPVs

Question 4

What is expected values and how to calculate

Answer 4

Like in PM exam it is the weighted average. For example if the volume and probability is 100,000 units at 40% and 50,000 units at 60% then the weighted average is 100000 x 40% and 50000 x 60% = 70,000 units

Question 5

What is the risk adjusted discount rate

Answer 5

No number (:

The idea is that the more uncertain the flows are (cash flows, inflows outflows etc) the more risk we are taking by going ahead. So if it is more risky, then let’s discount at a higher cost of capital. Refer to capital asset pricing model in later chapter to explain further