Chapter 6 - Investment appraisal under uncertainty Flashcards
What is risk?
Quantifiable. Possible outcomes have associated probabilities, thus allowing the use of mathematical techniques.
What is uncertainty?
Unquantifiable. Outcomes cannot be mathematically modelled.
How do risk and uncertainty affect investment appraisals?
because the appraisals are on attempt to forecast the future of such things as cash flows, inflation rates, taxation laws, cost of capital etc, none of of which may be known for certain over the life of the investment
What techniques are used to calculate risk?
- Expected values
- adjusted payback
- risk-adjusted discount rates
What techniques are used to estimate uncertainty?
- Set shorter payback targets
- make prudent estimates of cash floes in the appraisal
- assess best and worst case scenarios
- use sensitivity analysis
How do we calculate the sensitivity margin?
(NPV / PV of cash flows under consideration) x100
What is sensitivity analysis?
Calculates how much one input value must change before the decision changes (say from accept to reject)
The smaller the margin means what regarding sensitivity?
the more sensitive is the project NPV is to the changes in that inout variable
If sensitivity analysis is with taxation how do we calculate the PV of flow under consideration, net of tax?
(PV of revenue) - (PV of revenue x 30% )
How would we calculate the sensitivity of the project to discount rate?
Calculate the IRR of the project
If sensitivity analysis is with taxation how do we calculate the PV of flow under consideration, net of tax and if the tax is a year in arrears?
(PV of revenue) - (PV of revenue x 30% x 1 year discount )
What are some advantages of sensitivity analysis?
- simple to calculate and evaluate
- provides further information to allow management to make subjective judgements
- identifies critical estimates
What are some disadvantages of sensitivity analysis?
- Assumes variables change independently of each other
- only assesses the impact of one variable changing at a time
- does not assess the likelihood of a variable changing
- Does not directly identify a correct accept/reject decision for a project
What is probability analysis techniques?
Allow us to take risk into account (i.e where our outcomes can be evaluated in terms of their likelihoods of occurring in our investment appraisal decisions.
What techniques will be used in terms of probability analysis?
Expected value (EV)
Measure risk by:
- calculating worst possible outcome and its probability
- calculating the probability that the project will fail (NPV negative)
- assessing the standard deviation of the outcomes
What is an expected value?
an average outcome weighted by the probabilities of each individual outcome
How do we calculate the expected value?
EV = SUM px
x = future outcome
p = probability of outcome occurring
What can expected values be used to find?
an average outcome for a project under different scenarios or to find an average outcome for a particular input to go into an NPV calculation
What are some advantages of EVs?
- Deals with multiple outcomes
- qualifies probabilities
- simple
- assists decision making
What are some disdvantages of EVs?
- subjective probabilities
- answer is only a long-run average
- ignore variability payoffs
- risk neutral decision, i.e., ignores investors’ attitudes to risk
EVs are appropriate to use when?
- a reasonable basis for making the forecasts and estimating the probabilities of different outcomes
- decision is relatively small in relation to business, so risk is small
- decision is for a category of decisions that are often made
Risk management techniques allow what?
a business to respond to quantifiable problems when appraising an investment.
What is simulation?
addresses one of the weaknesses of sensitivity analysis by calculating the effect of changes in multiple variables at a time
What is adjusted payback?
shortening the payback period required places more emphasis on earlier (less risky) cash flows
What is discounted payback?
it provides valuable insight in addition to the NPV of the project, allowing more informed decision to be made
What is risk-adjusted discount rates?
using a harsher discount rate builds in a buffer for interest, risk or inflation to increase
Increasing the discount rate used to appraise a project will do what to the NPV?
reduce it
