Chapter 6 - Investment appraisal under uncertainty

Question 1

What is risk?

Answer 1

Quantifiable. Possible outcomes have associated probabilities, thus allowing the use of mathematical techniques.

Question 2

What is uncertainty?

Answer 2

Unquantifiable. Outcomes cannot be mathematically modelled.

Question 3

How do risk and uncertainty affect investment appraisals?

Answer 3

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

Question 4

What techniques are used to calculate risk?

Answer 4

• Expected values
• adjusted payback
• risk-adjusted discount rates

Question 5

What techniques are used to estimate uncertainty?

Answer 5

• Set shorter payback targets
• make prudent estimates of cash floes in the appraisal
• assess best and worst case scenarios
• use sensitivity analysis

Question 6

How do we calculate the sensitivity margin?

Answer 6

(NPV / PV of cash flows under consideration) x100

Question 7

What is sensitivity analysis?

Answer 7

Calculates how much one input value must change before the decision changes (say from accept to reject)

Question 8

The smaller the margin means what regarding sensitivity?

Answer 8

the more sensitive is the project NPV is to the changes in that inout variable

Question 9

If sensitivity analysis is with taxation how do we calculate the PV of flow under consideration, net of tax?

Answer 9

(PV of revenue) - (PV of revenue x 30% )

Question 10

How would we calculate the sensitivity of the project to discount rate?

Answer 10

Calculate the IRR of the project

Question 11

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?

Answer 11

(PV of revenue) - (PV of revenue x 30% x 1 year discount )

Question 12

What are some advantages of sensitivity analysis?

Answer 12

• simple to calculate and evaluate
• provides further information to allow management to make subjective judgements
• identifies critical estimates

Question 13

What are some disadvantages of sensitivity analysis?

Answer 13

• 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

Question 14

What is probability analysis techniques?

Answer 14

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.

Question 15

What techniques will be used in terms of probability analysis?

Answer 15

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

Question 16

What is an expected value?

Answer 16

an average outcome weighted by the probabilities of each individual outcome

Question 17

How do we calculate the expected value?

Answer 17

EV = SUM px
x = future outcome
p = probability of outcome occurring

Question 18

What can expected values be used to find?

Answer 18

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

Question 19

What are some advantages of EVs?

Answer 19

• Deals with multiple outcomes
• qualifies probabilities
• simple
• assists decision making

Question 20

What are some disdvantages of EVs?

Answer 20

• subjective probabilities
• answer is only a long-run average
• ignore variability payoffs
• risk neutral decision, i.e., ignores investors’ attitudes to risk

Question 21

EVs are appropriate to use when?

Answer 21

• 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

Question 22

Risk management techniques allow what?

Answer 22

a business to respond to quantifiable problems when appraising an investment.

Question 23

What is simulation?

Answer 23

addresses one of the weaknesses of sensitivity analysis by calculating the effect of changes in multiple variables at a time

Question 24

What is adjusted payback?

Answer 24

shortening the payback period required places more emphasis on earlier (less risky) cash flows

Question 25

What is discounted payback?

Answer 25

it provides valuable insight in addition to the NPV of the project, allowing more informed decision to be made

Question 26

What is risk-adjusted discount rates?

Answer 26

using a harsher discount rate builds in a buffer for interest, risk or inflation to increase

Question 27

Increasing the discount rate used to appraise a project will do what to the NPV?

Answer 27

reduce it