Risk assessment in investment appraisal techniques

Question 1

Risk preferences of investors?

Answer 1

The attitude of investors to risk plays a vital part in the investment appraisal process.

Investors can be categorised as one of the following in terms of risk preference.

1. Risk-seeking investors:

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.

2. Risk-averse investors:

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.

3. Risk-neutral investors: these investors overlook risk when deciding between investments. They are only concerned with an investment’s estimated return.

An investor faces a ‘risk-return trade off’ when considering investment decisions.

Higher risk is linked with a greater probability of a higher return and lower risk with a greater probability of a smaller return

Question 2

Risk assessment models?

Answer 2

Risk assessment models

All companies face the risk of variable returns.

The actual outcome could be better (from upside potential) or worse than expected (from downside risk exposure).

For example, a company cannot predict future sales with certainty because
they could be higher or lower than expected.

An important aspect of risk assessment is to identify and assess potential sources of risk in terms of their potential impact on the company and how likely (probable) they are.

Question 3

What are the risk assessment models that incorporate risk into decision making?

Answer 3

There are several risk assessment models that incorporate risk into decision making.

These techniques involve both non-probabilistic as well as probabilistic approaches (that use a range of possible values) to project appraisal.

They include:

1. Non-probabilistic approaches
   – sensitivity analysis
   – scenario analysis
   – simulation modelling
2. Probabilistic approaches:

– expected net present value (ENPV) and standard deviation
– event tree diagrams

3. Risk-adjusted discount rate (covered in Chapter 12)

Question 4

Sensitivity analysis?

Answer 4

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

Question 5

What is the methodology for Sensitivity analysis?

Answer 5

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).

Question 6

Advantages of sensitivity analysis?

Answer 6

Advantages of sensitivity analysis

1. The analysis is based on a simple theory, can be calculated on a spreadsheet and is easily understood.
2. It identifies areas and estimates crucial to the success of the project. These critical areas are carefully monitored if the project is chosen.
3. It provides information to allow management to make subjective judgements based on the likelihood of the various possible outcomes.
4. The analysis is used by a range of organisations. For example, this technique is popular in the National Health Service (NHS) for capital appraisal

Question 7

Dis-advantages of sensitivity analysis

Answer 7

Disadvantages

1. 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.
2. It also does not identify other possible scenarios.
3. It considers the impact of all key areas (one at a time). The amount of information may overwhelm the decision maker.
4. The probability of each of the assumptions is not tested.
5. It only provides information to help managers make decisions. It is not a technique in itself for making a decision

Question 8

Scenario analysis ?

Answer 8

Scenario analysis

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:

1. a most likely view,
2. an optimistic view and
3. 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:

a. as the number of variables that are changed increases, the model can become increasingly difficult and time
consuming;

b. it does not consider the probability of each ‘state of the world’ occurring when evaluating the possible outcomes;
and

c. it does not consider other scenarios that may occur

Question 9

Simulation modelling?

Answer 9

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.

The key weaknesses of this technique are as follows:

1. It is not a technique for decision making, rather providing information about the possible outcomes upon which management makes a decision.
2. It is a complex method which is not simple to calculate.
3. The time and costs involved may outweigh the benefits gained from the improved decision making

Question 10

Expected net present value ?

Answer 10

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:

1. 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

Question 11

Expected net present value continued…

Answer 11

2. 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.
3. 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.

Probabilities in an investment decision are measured on return and risk metrics.

These measures are:

1. expected value and expected net present value (ENPV): these measure return
2. standard deviation: this measures risk or volatility

Question 12

Calculating Expected net present value and methodology?

Answer 12

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

Question 13

Expected net present value

Answer 13

Expected net present value

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 scenarios.

Question 14

Advantages and limitations of Expected net present value

Answer 14

Advantages

1. ENPV provides a clear ‘rule’ to aid decision making.
2. The expected value and ENPV tools are simple and easy to calculate.
3. A positive ENPV increases shareholder wealth if a project proceeds and outcomes follow expectations.

Limitations

1. 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.

2. While ENPV takes probabilities into account, they are subjective and may be difficult to estimate

also see worked examples on page 260 and 261

Question 15

The role of portfolio management

Answer 15

The role of portfolio management

A portfolio is a mix of investments or projects in a company.

It can refer to external or internal portfolios of investments or projects.

When a company has surplus funds available, it may make external investments in a portfolio of assets such as banknotes, bonds, debentures and stocks.

These external portfolios are also referred to as passive investments as they do not entail active management from the issuing company.

An internal portfolio refers to a group of projects managed together to achieve an organisation’s strategic objectives.

For instance, a company in the energy sector could include a portfolio of projects such as ‘development of solar energy
production’ or ‘improving efficiency by investing in new techniques’.

All of these will help it meet its objective of ‘reducing carbon emissions’

Question 16

Objectives of portfolio management?

Answer 16

Objectives of portfolio management

The objective of portfolio management is to select the right investments in the right proportions to generate optimum returns while minimising risk.

The key elements of a good portfolio are listed below:

1. Return:

the portfolio should yield steady returns that at least match the opportunity cost of the funds invested.

In general, the better the growth prospects of the company, the better the expected returns.

2. Risk reduction:

minimisation of risks is the most important objective of portfolio management.

A good portfolio tries to minimise the overall risk to an acceptable level in relation to the levels of return obtained.

3. Liquidity and marketability:

it is desirable to invest in assets which can be marketed without difficulty.

A good portfolio ensures that there are enough funds available at short notice.

4. Tax shelter:

the portfolio should be developed considering the impact from taxes.

A good portfolio enables companies to enjoy a favourable tax shelter from income tax, capital gains tax and gift tax.

5. Appreciation in the value of capital:

a balanced portfolio must consist of certain investments that appreciate in value, protecting investor from any erosion in purchasing power due to inflation

Question 17

Elements of portfolio management?

Answer 17

Elements of portfolio management:

The need for effective portfolio management arises once an entity builds a portfolio of investments.

Effective portfolio management increases the probability of higher returns through risk reduction.

Portfolio theory helps investment managers to construct portfolios that best meet the requirements of investors in terms of risk and return.

Portfolio management reduces risk and uncertainties through a number of strategies.

Question 18

Elements of portfolio management?

Answer 18

Elements of portfolio management:

1. Asset allocation

Uses a mix of assets according to the investor’s risk tolerance, goals and
investment horizon.

2. Diversification

Spreading risk across multiple investments. In other words don’t put all your eggs in one basket.

2. Rebalancing

Continuous process of monitoring portfolio
performance.

Question 19

Asset allocation ?

Answer 19

Asset allocation:

Asset allocation is an investment strategy that aims to balance risk and reward by adjusting the percentage of each asset in an investment portfolio according to the investor’s risk tolerance, goals and investment horizon.

Investments are made in suitable mix of assets according to the risk appetite or risk preferences of investors.

Risk-seeking investors can opt for more volatile assets with higher returns, while risk-averse investors look for ‘safer’
investments.

For example, if an entity that manages savings of pensioners is risk averse, it will adopt a policy of investing the pension savings in government or treasury bonds to avoid the risk of losing the entire capital.

Question 20

Diversification?

Answer 20

Diversification

Spreading the risk across multiple investments within an asset class is known as diversification.

This is based on the well-known rule of thumb ‘don’t put all your eggs in one basket’.

Effective diversification includes investments across different asset classes, securities, sectors and geography.

This will not only help to boost the returns but also lower the level of risk of a portfolio.

For example, a portfolio that is comprised of only bonds carries less risk (and lower returns) than a portfolio of only equities. If the percentage of equities is increased to, say, 20%, the risk of the portfolio increases but it will also increase the potential returns.

A unit trust typically spreads its funds among a large number of investments.

Question 21

Rebalancing?

Answer 21

Rebalancing:

Portfolio management is a continuous process of monitoring the performance of the portfolio, incorporating the latest
market conditions and implementing the strategies in tune with investment objectives that maximises returns and minimises risk.

Rebalancing is this continuous process of comparing portfolio weightings with planned asset allocation.

Rebalancing is usually done on an annual basis. However, it can be done at any time if a significant need arises.

Question 22

Portfolio risk and return?

Answer 22

Portfolio risk and return

A well-diversified portfolio contains multiple investments.

The relationship between the risk and return of the individual investments determines the overall risk and return of the portfolio.

A company can measure the average return for the portfolio by calculating the correlation among the individual investments.

Correlation, in terms of portfolio management, is a statistical tool that measures the degree to which two securities move in relation to each other.

One reason for this might be that two securities have generally opposite reactions to the same external news or event.

For instance, financial stocks such as banks or insurance companies tend to get a boost when interest rates rise, while the real estate and utilities sector get hit particularly hard when interest rates increase.

Question 23

Portfolio risk and return continued…

Positive correlation (Coefficient = 1)

Answer 23

Positive correlation (Coefficient = 1)

The correlation of investments in a portfolio is positive (or +1) when their prices move in same direction or offer same kind of return in the specified period. Usually, the investments in the same industries, or with the same set of products that can substitute each other, demonstrate positive correlation.

For example, if the price of stock A increases by 5% and price of stock Z also increases by 5% in a month, stock A and stock Z are said to have a positive correlation of +1. When a company invests in Stock A and Z at the same time, the portfolio price will increase by 5% (assuming the same amount of investment in both stocks).

The positive correlation also applies in case of falling prices. Holding both investments can dramatically increase returns but can also dramatically increase losses.

Question 24

Portfolio risk and return continued…

Negative correlation (Coefficient = minus 1)

Answer 24

Negative correlation (Coefficient = minus 1)
The correlation of investments in a portfolio is negative (or minus 1) when their prices move in opposite directions.

There is an inverse relationship between two variables. Usually, the investments in industries which are dependent on each
other for raw materials or services offer negative correlation.

When the price of oil rises, it is likely to result in the rise of the price of an oil company’s shares (ignoring other factors), but the shares of companies such as airlines are likely to fall in value.

For example, if the price of stock A increases by 5% and the price of stock Z decreases by 5% in a month, stock A and stock Z are said to have negative correlation of minus 1.

When a company invests in stock A and Z at the same time, the portfolio will be constant with no change in the price (assuming the same amount is invested in both the stocks).

Essentially, gain from stock A is offset by the loss in stock Z

Question 25

Portfolio risk and return continued…

Zero correlation (Coefficient = 0):

Answer 25

Zero correlation (Coefficient = 0):

Zero correlation applies where underlying investments have no relationship that indicates any kind of correlation.

Usually, investments in different asset classes or different geographic locations have zero correlation. With zero correlation, each investment performance holds the price and risk without any dependency on the performance of other investments.

Question 26

Portfolio risk and return continued…

The efficient frontier?

Answer 26

The efficient frontier

The ‘efficient frontier’ is a modern portfolio theory tool that shows investors the best possible return they can expect from their portfolio for a defined level of risk.

The efficient frontier aims for optimum correlation between risk and return.

The portfolio manager scouts for the investment opportunities which offer optimum correlation to maximise return for the portfolio.

The efficient frontier is curved (see Figure 14.4), representing a diminishing marginal return to risk.

Portfolios that do not provide enough return for the level of risk are considered as suboptimal (they lie below the efficient
frontier). Each point on the efficient frontier line represents optimal portfolio.

Question 27

The application and limitations of portfolio theory:

Answer 27

The application and limitations of portfolio theory:

The core principles of portfolio theory are based on asset allocation, diversification and rebalancing – diversifying away the risk with carefully selected investments or optimum portfolios.

It can be applied to a selection of projects and company ventures as well as securities. Companies can reduce risk and stabilise profits by investing in negatively correlated companies.

Question 28

Limitations of portfolio theory?

Answer 28

Limitations of portfolio theory:

1. It is a single-period framework.
2. Probabilities are only estimates.
3. It is based on several assumptions, including:

a. investors are risk-averse and behave rationally

b. the risk of bankruptcy, legal and administrative constraints are ignored

4. Portfolio theory assumes that the correlation between assets is constant. This may not be applicable in the real world as every variable is constantly changing.
5. The theory ignores the timeframes (short term, medium term or long term) of the investments. Return expectations may change depending on these timeframes.

Some randomly selected portfolios may have performed better than optimally selected portfolios, at least for a short time.

6. Despite the availability of software programs to perform the calculations, the portfolio model is still not widespread
   as portfolio managers are sceptical about the accuracy of the forecast data.

They may prefer to use their own
judgement in selecting investments.