PROJECT APPRAISAL UNDER RISK

Capital budgeting requires the projection of cash inflow and outflow of the future. The future
is always uncertain as estimated demand, production, selling price, cost etc., cannot be exact.
Risk:
Risk is the variability that is likely to occur in the future returns from the project. Risk arises
in investment evaluation because we cannot anticipate the occurrence of the possible future
events with certainty and consequently, cannot make any correct prediction about the cash
flow sequence. Risk can be applied to a situation where there are several possible outcomes
and, on the basis of past relevant experience, probabilities can be assigned to the various
outcomes that could prevail.
Uncertainty can be applied to a situation where there are several possible outcomes but there
is little past relevant experience to enable the probability of the possible outcomes to be
predicted.
Measuring Risk
Risk can be measured using
(a) Standard deviation
(b) Coefficient of variation
(c) Beta
Attitudes towards Risk
Three possible attitudes towards Risk can be identified. These are:
(a) Risk aversion: A Risk averter is an individual who prefers less risky investment. The
basic assumption in financial theory is that most investors and managers are risk averse.
(b) Desire for Risk: Risk seekers on the other hand are individuals who prefer risk. Given a
choice between more and less risky investments with identical expected monetary returns,
they would prefer the riskier investment.
(c) Indifference to Risk: The person who is indifferent to risk would not care which
investment he or she received.
Methods/Techniques of Incorporating Risk
(a) Expected monetary value approach
(b) Risk-adjusted discount rare (or method of varying discount rate)
(c) Certainly equivalent method.
(d) Sensitivity analysis technique.
(e) Scenario analysis
(f) Decision tree analysis.
(g) Simulation analysis
(h) Utility theory

EXAMPLE 1

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Company A is considering investing in a project which has a three year life. The project
would involve an initial investment of Sh.20 million. The finance manager has come up
with expected probabilities for various possible economic conditions as follows:
Sh.000
Year Economic Conditions Net cash flows Probability
0 (20,000) 1.0

1 High growth 10,000 0.2

Average growth 6,000 0.7
No growth 2,000 0.1

2 High growth 12,000 0.3

Average growth 8,000 0.5
No growth 4,000 0.2

3 High growth 16,000 0.4

Average growth 12,000 0.3
No growth 6,000 0.3
Required:
Assuming a discount rate of 15% should company A invest in the project? (12 marks)

EXAMPLE 2

ABC ltd is considering investing in a project that requires an immediate cash outlay of Sh.
20,000 that yield the following cash flows.

Probability Year 1 Year 2 Year 3

0.10 10,000 (5,000) (10,000)
0.25 15,000 - (5,000)
0.30 20,000 5,000 -
0.25 25,000 1,000 5,000
0.10 30,000 15,000 10,000
The project has a life of three years and operating cash flows in any year do not depend on
the operating cash flows in the previous year. The risk free cost of capital can be estimated at
10%
Required:
(a) Compute the expected NPV
(b) The standard deviation of the projects NPV
(c) Compute the co-efficient of variation of the projects NPV

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