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CHAPTER 7

INVESTMENT RISK APPRAISAL

Chapter outline
Introduction
What are uncertainty and risk and why do they need to
be assessed?
Types of risk in investment projects
Probability distributions and expected values
Using scenario analysis, sensitivity analysis and
simulation analysis to assess risk
Break-even analysis as a measure of dealing with risk
Conclusion

Learning outcomes
By the end of this chapter, you should be able to:
Understand the importance of recognizing risk in
investment appraisal
Identify the various types of risk involved in investment
projects
Discuss the use of probability distributions and expected
values in risk assessment
Discuss scenario analysis, sensitivity analysis and
simulation analysis in investment projects
Apply break-even analysis as a measure of dealing with
risk.

Introduction
Capital investment decisions carry level of risk
Risk may impact on end result of investment,
especially investments in businesses or
projects in foreign countries
Capital investment decisions are about the
future
Risk and uncertainty need to be taken into
account when decisions are made

Uncertainty and risk


Certainty where there is no doubt about the
outcome of something
Uncertainty where one does not know which
events or factors will influence the end result of
a project and cannot attach probabilities to the
occurrence of possible events
Risk there is the possibility of incurring loss or
misfortune because of uncertainty about the
future
Probability refers to the likelihood that a
particular event will occur

Risk vs return
Investment is done with the aim of generating
return
The percentage return from an investment can
be calculated as follows:
C P P
rt

t 1

Pt 1

Where:
rt = percentage return over period t-1 to t
C t = cash expected to be received over period t-1 to t
Pt 1 = price or value of the investment at the end of the investment
period, time t
Pt = price or value of the start of the investment period, at time t-1

Example 7.1
Beta Ltd purchased shares in Charlie Ltd as an
investment. Financial analysts predicted that Charlie Ltd
will do very well and that Beta Ltd will generate a healthy
return from an investment in Charlie Ltd. However, after
two years of having the investment, the board of directors
want to know what percentage of return the investment is
generating. The companys required rate of return is 15%
on similar investments, and the board wants to make sure
it is worth holding on to the investment.
The investment originally cost Beta Ltd R1 500 000. Beta
Ltd received R40 000 in dividends over the two-year
period of holding the investment. Based on market values,
the investment is worth R1 700 000 after the two years.

Example 7.1
The percentage return from the investment can
be calculated as follows:
rt

40 000 (1 700 000 1 500 000 )


0.16 16 %
1 500 000

This means that Beta Ltd is earning a 16% return


on the investment. Based on the required rate of
return of 15% that the company expects from its
investments, the return is acceptable.

Approaches to risk in investment


appraisal
Risk tolerance amount of risk a company is
willing to take when making an investment
Company-specific based on perceptions of
management and financial position of the
company
Usually an individual or company is willing to
accept more risk if a greater return can be
expected

Approaches to risk in investment


appraisal
Risk tolerance can be divided into three
categories:
Risk averse investors prefer to avoid risk and
would not accept higher risk unless the returns are
disproportionately higher to compensate for taking
on more risk
Risk seekers willing to take on more risk even if
expected returns are not proportionately higher
Risk neutral investors expect a proportionate
increase or decrease in return for accepting an
increase or decrease in risk

Risk tolerance levels


Risk seeking

Risk averse

Risk neutral

Risk-rating scale
Severity

Likelihood

Slight

Moderate

Extreme

Highly unlikely

Trivial

Low

Medium

Unlikely

Low

Medium

High

Likely

Medium

High

Intolerable

Types of risk in investment


projects
Elementary risks
Systematic basic market risk because of
economic changes or other events, e.g. political
event which affects portfolio
Unsystematic more specific, affects fewer
investments at the same time, e.g. fire at factory

Types of risk in investment


projects
Business risk company will not be able to
finance its operating costs, therefore having too
much in fixed cost versus variable cost
Financial risk company is not able to cover its
debt obligations
Interest-rate risk interest rate changes will
adversely affect the value of an investment
Liquidity risk an investment cannot be sold at
a reasonable price

Types of risk in investment


projects
Market risk market factors unrelated to the
investment (e.g. political, economic or social
factors) will adversely affect the value of an
investment
Event risk unexpected event will have an
effect on a company and/or investment
Exchange-rate risk investment and/or
investment returns will be negatively affected
by exchange rate fluctuations

Types of risk
Purchasing-power risk price level changes
because of inflation which will affect
investments and/or investment returns
Tax risk changes in tax laws will negatively
affect investment and/or investment returns
Credit or default risk company or individual
cannot pay the returns due on an investment or
in a worst case cannot pay back the amount
originally invested
Country risk political and/or financial events
in a country will affect the worth of or the
investment returns

Probability distribution
Probability distribution statistical technique
that establishes what the likely outcome of an
uncertain event will be
Depicted on a graph as follows:

Expected value
Average of the possible outcomes, weighted by
the probability of the outcomes actually occurring,
calculated as follows:

__

Where:

r = expected (average) return


rj = the return for the jth outcome
Prj = the probability of occurrence for the jth
outcome
n = the number of outcomes considered to
calculate an expected value

Example 7.3
Joy Ltd commissioned an economic expert about
a new product that the company plan to launch in
the near future. At best, the company expects to
sell 200 000 units of product. The marketing
expert has prepared the following table of
probable outcomes:
Outcome

Probability

Units sold

Strong economy

30%

200 000

Normal economy

50%

145 000

Weak economy

20%

25 000

Example 7.3
The expected value will be:
n

r r j Pr j (200 000 0.30 ) (130 000 0.50 ) (25 000 0.20 ) 137 500 units
j1

This means that the business can expect to sell an


average of 137 500 units of product. At best it would sell
200 000 units and at the worst 25 000. This is the most
basic method to evaluate whether it is worthwhile taking
on a project, taking into account also the companys risk
tolerance levels.

Scenario analysis
Analyses future events by considering
alternative possible outcomes
What happens to NPV under different cash flow
scenarios?

Various scenarios are indicated and effect on


the outcome of investment is evaluated
Useful for indicating viability of an investment
or capital project if the values of the variables
are different to what is expected both in a
positive and negative sense
Useful for indicating potential downside

Scenario analysis
Has limitations:
It analyses the effect on return if one changes the
value of one variable at a time the other variables
are held constant
Does not indicate whether the project should be
accepted or rejected

Sensitivity analysis
Method of establishing how sensitive the
expected return is to a change in the value of a
key variable
What happens to NPV when one variable at a time
is changed?

Variables include discount rate, annual


operating revenues, annual operating costs,
expected project life and residual value
Using several different variables shows which
variables best- and worst-case scenarios
produce the biggest changes to NPV

Sensitivity analysis
First step is to calculate a single expected
outcome for an investment and to use as base
value
Using additional information, two or more
situations can be formulated by making
changes to relevant variables

Simulation analysis
Statistical method using probability distributions
and random numbers to estimate a variety of
risk outcomes
Simulation is really just an expanded sensitivity and
scenario analysis

By applying and repeating the process, a


probability distribution of project returns can be
established
More times the analyst can repeat the process,
the more feasible the end result is likely to be
Gives investor a better risk-adjusted indication
of return

Simulation analysis
Computers and advanced statistical software
have made analyses easier and cost-effective
Monte Carlo Method randomly generates
values for different uncertain variables

Break-even analysis
Common tool for analyzing the relationship
between sales volume and profitability
Measures the point at which a capital project
breaks even and identifies the sales level
below which it will start losing money
Indicates the level to which revenue could fall
without there being a reduction in the value of
the firm

Break-even analysis
Total cost (TC) is equal to the sum of variable
cost (VC) (costs that change with the quantity of
output) and fixed operating cost (FC) (costs that
dont change with the quantity of output)
TC = VC(Q) + FC

Break-even analysis
Three common break-even measures
Accounting break-even
Sales volume at which net income = 0

Cash break-even
Sales volume at which operating cash flow = 0

Financial break-even
Sales volume at which net present value = 0

Conclusion
It is important to incorporate risk into the evaluation of
investments and when deciding about accepting or
rejecting projects.
Risk is the likelihood that the return on an investment
can be affected in an unfavorable way.
Certainty is a state where only one end result is
possible.
Uncertainty is a state where it is impossible to exactly
predict the future return on an investment.

Conclusion (cont.)
Sensitivity analysis is used to establish how sensitive
the return on an investment is to changes in the values
of key variables in the evaluation of investment
projects.
Scenario analysis overcomes the limitations of
sensitivity analysis by taking into consideration the
probability of changes in key variables associated with
inputs in the cash flows.

Conclusion (cont.)
Break even analysis is a measure of dealing with risk.

These methods make is possible to reduce the risk of


unforeseen circumstances having a negative impact
on the value of investments