Loose ends

Methods incorporating risk

Adjust the discount rate

Justification:
a) providers of funds need a higher
reward to compensate for the higher risk
b) risky projects should be assessed
using a higher discount rate compared
with safe projects

Drawbacks:
Arbitrary:
How do we divide projects into different
risk categories?
What is a suitable risk premium?

Probability Analysis
Method cash flows are projected for each variable
(e.g. sales, cost of resources)
rather than a single value for each
variable, a range of outcomes are
estimated
probabilities are attached to each possible
outcome
the expected value can then be estimated

 Drawbacks:
the outcome is based on undertaking the
projects many times most projects are a one
off
the outcome is an average figure that may not
be capable of occurring
the average figure may give a misleading
impression of the risk involved what is the
downside potential of the project?
it does not indicate the likelihood of actual
outcome differing from the expected outcome

Standard Deviation
Justification:
it measures the dispersal of outcomes
around the expected outcome
the standard deviation is expressed in
terms of a meaningful measuring unit
e.g. money or return
comparisons can be made between
different projects

The risk of insolvency

The normal curve

The Z statistic
X
Z=

where Z is the number of standard deviations from the mean

X is the outcome that you are concerned about
is the mean of the possible outcomes
is the standard deviation of the outcome distribution

The standard normal distribution

Worked example Roulette plc

Roulette plc can take a maximum loss on this project
of 5m
If the loss is more than 5m the firm will become
bankrupt
The managers are keen to know the percentage
probability that more than 5m will be lost
The expected return is at 8m
X deviation is 6.5m
The standard
Z =

5 8
Z =
- = 2
6.5

Probability of outcome between

and 2 from

The probability that the return will be above the mean is 50 per cent
The probability of the firm achieving a return greater than a loss of
5m is 97.72 per cent

 Drawbacks:
it is not possible to make meaningful
comparisons when the projects are of
different size
the comparison can be made more
meaningful by calculating the coefficient of
variation

Sensitivity analysis
Examines the extent to which variables can
change before a negative NPV results
E.g. what % fall in selling price, increase in fixed
costs would result in a viable project being
rejected?
Alternatives:
effects of combinations of variables changing
effect of changes in variables on payback etc

Sensitivity Analysis
Advantages:
informs managers of how sensitive projects are
to changes in variables - assess whether to take
the risk
managers can focus efforts on key variables
managers can devise alternative plans in
advance for key variables

Sensitivity Analysis
Disadvantages
Misleading impression given of project
vulnerability - probabilities of changes not
assigned
Each variable is considered in isolation combinations of variables likely to change
simultaneously

Simulation
Useful where probability distributions of
variable elements of the cash flows are known
(e.g. sales revenue, running costs)
Method:
Take samples from the probability distributions
and calculate NPV in each case
Repeat process large number of times to
obtain a reliable distribution of NPV
Estimate mean & standard deviation of the
NPV distribution

Simulation
Benefits:
Forces decision makers to consider relationship
between factors affecting cash flows
Model building may lead to deeper
understanding of the project
Once model constructed, can be interrogated
how are outcomes affected by changes in
variables

Simulation
Disadvantages:
Not always feasible as method of risk analysis
Number of variables with independent
uncertainty must not be too many computation
time increases rapidly
May only be appropriate for most important
projects