Chapter 14 - Risk Assessment in Investment Appraisal Techniques Flashcards
Risk assessment methods
-
Non-probabilistic
– sensitivity analysis
– scenario analysis
– simulation modelling -
Probabilistic approaches
– expected net present value (ENPV) and standard deviation
– event tree diagrams - Risk-adjusted discount rate
Risk-seeing / risk-neutral / risk-adverse investors
- Risk-seeking: these are investors who accept greater volatility and uncertainty in investments or trading in exchange for anticipated higher returns. Risk-seeking investors are more interested in capital gains from speculative assets than investments with lower risks with lower returns. For example, a risk seeker would prefer investing their money in stocks as they have the potential to give higher returns than fixed deposits.
- Risk-averse : these are investors who avoid risks and prefer lower returns with known risks rather than
higher returns with unknown risks. Most investors and managers are risk-averse and require an additional return to compensate for any additional risk. For example, a risk-averse person would prefer investing in fixed deposits, government bonds and so on that involve less risk and provide a more certain return compared to stocks. - Risk-neutral : these investors overlook risk when deciding between investments. They are only
concerned with an investment’s estimated return.
What is sensitivity analysis?
Sensitivity analysis is a non-probabilistic approach used in investment appraisal that allows the analysis of changes in assumptions made in the forecast. It is a tool for quantitative risk assessment that predicts the outcome of a decision by ascertaining the most critical variables and their effect on the decision. It examines how sensitive the returns on a project are to changes made to each of the key variables, such as any increase or decrease in
* capital costs
* projected sales volumes
* variable costs
Sensitivity analysis methodology
The methodology follows the steps below.
1. Specify a base case situation and calculate the NPV of the project based on the best estimates and assumptions. Only projects that generate a positive NPV are accepted.
2. Calculate the percentage change (or sensitivity) of each of the variables that would result in the breakeven position (with a NPV of zero). Any further change resulting in negative NPV would change the decision. For example, what impact would the projected sales have on NPV if they decreased or increased by 10%? What if demand fell by 10% compared to the original forecasts? Would the project still be viable? How much of a fall in demand can be accepted before the NPV falls below zero or below the breakeven?
Sensitivity margin = (NPV ÷ PV of flow under consideration) × 100%
The lower the sensitivity margin, the more sensitive the decision to the particular variable under consideration. A small change in the estimate could change the NPV from positive (accept) to negative (reject).
Advantages and Disadvantages of sensitivity analysis
Advantages
* The analysis is based on a simple theory, can be calculated on a spreadsheet and is easily understood.
* It identifies areas and estimates crucial to the success of the project. These critical areas are carefully monitored if the project is chosen.
* It provides information to allow management to make subjective judgements based on the likelihood of the various possible outcomes.
* The analysis is used by a range of organisations. For example, this technique is popular in the National Health
Service (NHS) for capital appraisal.
Disadvantages
* The technique changes one variable at a time which is unlikely to happen in reality. For example, if the cost of
materials goes up, the selling price is also likely to go up. However, simulation techniques (discussed later) take into consideration changes in more than one variable at a time.
* It also does not identify other possible scenarios.
* It considers the impact of all key areas (one at a time). The amount of information may overwhelm the decision maker.
* The probability of each of the assumptions is not tested.
* It only provides information to help managers make decisions. It is not a technique in itself for making a decision.
What is scenario analysis?
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Scenario analysis provides information on possible outcomes for the proposed investment by creating various scenarios
that may occur. It evaluates the expected value of a proposed investment in different scenarios expected in a certain
situation.
As with sensitivity analysis, the method involves calculating NPV. Unlike sensitivity analysis, scenario analysis also
calculates NPVs in other possible scenarios or ‘states of the world’. The most used scenario analysis involves calculating
NPVs in three possible states of the world: a most likely view, an optimistic view and a pessimistic view.
By changing a number of key variables simultaneously, decision makers can examine each possible outcome from the
‘downside’ risk and ‘upside’ potential of a project, as well as the most likely outcome. However, this technique has several
key weaknesses:
* as the number of variables that are changed increases, the model can become increasingly difficult and time
consuming;
* it does not consider the probability of each ‘state of the world’ occurring when evaluating the possible outcomes;
and
* it does not consider other scenarios that may occur.**
What is simulation modelling>
The Monte Carlo simulation method is an investment modelling technique that shows the effect of more than one variable
changing at the same time. Complex structures of capital investment are investigated through simulation techniques,
particularly modelling the impact of uncertainty. Simulation models are programmed on computers to deal with variable
factors by use of random numbers.
The model identifies key variables that drive costs and revenues (such as market size, selling price, initial investment,
changes in material prices, rates of use of labour and materials and inflation). It then assigns random numbers and
probability statistics to each variable that might affect the success or failure of a proposed project. For example, if the
most likely outcomes are thought to have a 50% probability, optimistic outcomes a 30% probability and pessimistic
outcomes a 20% probability, then a random number representing those attributes can be assigned to costs and revenues
in those proportions. These randomly selected values are used to calculate the project NPV.
Computer modelling repeats the decision many times, calculating a different NPV each time. This gives management a
view of all possible outcomes. The resulting set of NPVs can be used to show how the NPV varies under the influence of
all the variable factors. A more informed decision can then be taken depending on the management’s attitude to risk. This
approach can also be used to test the vulnerability of outcomes to possible variations in uncontrolled factors.
4 key weaknesses of simulation modelling
- It is not a technique for decision making, rather providing information about the possible outcomes upon which management makes a decision.
- It is a complex method which is not simple to calculate.
- The time and costs involved may outweigh the benefits gained from the improved decision making.
EXPECTED NET PRESENT VALUE
Unlike the previous approaches, this method makes use of probabilities. In a complex world, most investment appraisal decisions are based on forecasts which are subject to uncertainties, resulting in multiple outcomes. It is imperative that these uncertainties are reflected in the investment decision. These uncertainties can be captured by assigning a probability to each outcome. The project performance is evaluated based on its expected value derived on a probability- driven cash flow.
To understand the term ‘probabilities’ or ‘probability of outcomes’, some key points are illustrated below.
* The numerical value of probability ranges between 0 to 1 and the sum of probabilities must always be exactly 1.
For example, the table below shows two scenarios of a new product being launched in the market. The result is
distributed between the probability of it being profitable (which is 0.9) and the probability of it going into loss (which is 0.1).
Outcomes Probability
Profit 0.9
Loss 0.1
Total 1.0
* Usually, the probability is estimated based on historical data or past performance trends. In the above example, the probabilities would have been derived by looking at company statistics, its past record and reputation, the trend of similar products in the market, their profitability and their success rate.
* In practice, probabilities can be subjective. Investment managers can assign different probabilities based on their experience and market research. These should be accepted if they are backed up by experience, understanding and good judgement.
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Expected net present value (ENPV) is a capital budgeting and appraisal technique. It is a simple tool to evaluate the feasibility of a project. It is based on net present value under different scenarios, probability weighted to adjust for uncertainties in each of these scenarios. A project with a positive ENPV will be accepted, taking the much of guesswork out of decision making. Unlike traditional NPV, ENPV produces a more realistic picture by considering any uncertainties inherent in project scenarios1
expected value
The expected value is the average value of the outcome, calculated on probability estimates. The methodology is as
follows.
1. The probability of an outcome and value of that outcome is specified.
2. The expected value of each outcome is calculated.
3. All the expected values are added with each probability to arrive at the expected value.
The formula for calculating expected value is:
Expected value = ∑PX
Where:
∑ = the sum of
P = the probability of outcome
X = the value of the outcome
Advantages & limitatipons of EV & ENVP
Advantages
* ENPV provides a clear ‘rule’ to aid decision making.
* The expected value and ENPV tools are simple and easy to calculate.
* A positive ENPV increases shareholder wealth if a project proceeds and outcomes follow expectations.
* ENPV provides a clear ‘rule’ to aid decision making.
* The expected value and ENPV tools are simple and easy to calculate.
* A positive ENPV increases shareholder wealth if a project proceeds and outcomes follow expectations.
Limitations
* Expected value and ENPV are measures of return. They do not take the volatility or the risk of a project into
consideration. Variability (volatility) or dispersion is measured by standard deviation.
* While ENPV takes probabilities into account, they are subjective and may be difficult to estimate
What is standard deviation
Standard deviation is a statistical tool which measures the amount of variation or dispersion of a set of data from its
mean. It is a measure of risk or volatility of returns. A project can be best evaluated by measuring the standard deviation,
along with the expected value and ENPV. The higher the standard deviation, the larger the variance and the higher the
risk of a project. Standard deviation is an absolute figure. It cannot be used to compare projects unless they have the
same expected return.
Standard deviation is calculated as the square root of the variance. It measures how spread out numbers are from their
mean. Variance is the average of the squared differences from the mean.
How is standard deviation caclucated
Standard deviation is calculated using the steps below:
1. Deviation (d) = NPV – expected value (EV)
2. The deviation is squared (d 2 ) to remove the negative number
3. The variance is calculated as pd 2 = probability × squared deviations
4. The standard deviation (Sd) is the square root of the variance
What is the coefficient of deviation
The coefficient of variation is the ratio of standard deviation to the mean (average). It measures the extent of variability or the dispersion of data points in a dataset in relation to the mean of the population.
The coefficient of variation allows comparison of different projects or investments. It can be used to compare standard deviations from projects of different sizes. While the standard deviation measures the volatility or dispersion of returns, the coefficient of variation is a better measure of the relative risk. It measures the relative dispersion of returns in relation to the expected return.
How is coefficient of deviation cacluated
standard deviation ÷ expected value or ENPV
