WOLLEGA UNIVERSITY

SCHOOL OF GRADUATE STUDIES

AGRICULTURAL ECONOMICS
AGRICULTURAL PROJECT PLANNING AND
ANALYSIS (AGEC 522)
BY ADMASSU T (PHD FELLOW)
1
AND
DEREJE F (MSC)
CHAPTER 5: ACCOUNTING FOR RISK AND UNCERTAINTY

Chapter 3 dealt with identifications of costs and

Benefits.

Chapter 4 dealt with investment decision criterions.

Most of tasks in project evaluations such as:

 Identifications of costs and benefits,
 Depreciation determinations,
 Financing schedules,
 Forecasted balance sheet, income statement,
 Net Cash flows determinations

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CHAPTER 5: ACCOUNTING FOR RISK…
 Most depends on some underlying assumptions.
 They are estimates.
 Estimations doesn’t mean certainty!
 Under what conditions are these decisions reached?
 What if the underlying assumptions change?
 What would happen to the projects already decided
as viable?
 Should they be abandoned or continued with?

This chapter deals with these questions
(Accounting for Risks and uncertainty).

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PROJECT APPRAISAL, RISK AND UNCERTAINTY

The various criterions of investment decision

involve predicting values for each of the various
elements entering into the analysis.
 some will be possible to determine with little
trouble while others may require the use of
elaborate statistical techniques.
 The degree of sophistication used in prediction
depends on how sensitive project cash flows are
to changes in the value of a particular element.
 Relative importance of cost and benefit items is
crucial to allocate time and other resources for
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estimating a given item.
PROJECT APPRAISAL, RISK ...

the degree of confidence to be associated with
such predictions will in turn depend on:
 the nature and quality of data available to the
analyst, and
 the extent to which factors that determine
changes in the variables (the underlying
functional relationships) are properly understood.

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PROJECT APPRAISAL, RISK ...
1. What is risk?
 In project planning, it is the chance of occurrence
of unexpected values of different variables:
prices, yield, costs, weather, and year of
implementation.
 probabilities can be attached to the outcomes

2. What is uncertainty?
 It is the plurality of outcomes to which objective
probabilities can’t be assigned.

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PROJECT APPRAISAL, RISK ...

An important factor in making a decision is the
degree of certainty associated with the
consequences.

The way the decision is reached is influenced by
our level of certainty.
 Accordingly, there are many decision making
conditions:
1. Decision making under certainty,
2. decision making under uncertainty,
3. decision making under risk.

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PROJECT APPRAISAL, RISK ...
1. Decision making under certainty
 It assumes as if the decision maker has complete
knowledge of the occurrence of specific state of nature.
 State of nature is a set of possible future conditions or
events beyond the control of the decision maker that
will be the primary determinants of the eventual
consequence of the decision.
 the project analyst selects an alternative with the
highest payoff under the column of the certain state of
nature.

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DECISION MAKING UNDER CERTAINTY…
 Example 1: assume that the following data
pertains to an investor contemplating to invest
in agriculture sector of Ethiopia.
States of nature (rainfall amounts/year)
Alternatives More than 400 mm 400 mm t0 200 mm to
300 mm 100 mm
Sorghum (NPV) 10,000 8,000 -5,000
Maize (NPV) 12,000 7,000 -6,000
Millet (NPV) 9,000 -3,000 -4,000
Seasame (NPV) -3,000 -2,000 10,000

Which alternative crop should the investor invest on had he (she) is

certain that rainfall distribution for the next five year :
1. Will not drop below 400mm? 9
2. What if he is certain that the rainfall will be below 200 mm?
DECISION MAKING UNDER CERTAINTY…
 search for the alternative with the maximum
payoff under the column of the state of nature
when the rain fall distribution is supposed to be :
1. above 400mm.
2. Below 200mm
 In the first case, maize production will yield the
maximum payoff (12,000); in the 2nd case
Seasame will provide the maximum payoff
(10,000).

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DECISION MAKING UNDER UNCERTAINTY

the project analyst either unable to get the

estimated probabilities for the occurrence of the
different states of nature or lacks confidence in
the available estimate of probabilities.
 the probabilities are not included in the analysis.
 There are many strategies under such situations:
1. Maximin strategy,
2. Maximax strategy,
3. Minimax regret strategy, and
4. insufficient reason.

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DECISION MAKING UNDER UNCERTAINTY…
1. Maximin strategy:
 involves identifying the worst (minimum) payoff for
each alternative under each state of nature,
 then selecting the alternative that has the best
(maximum) of the worst payoff.
 the decision maker is setting a floor for the potential
payoffs, and the actual payoff can’t be below that limit.
 this strategy is conservative one, and the project
analyst is pessimistic.

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DECISION MAKING UNDER UNCERTAINTY…
2. Maximax strategy:
 the project analyst is highly optimistic and the
strategy is the opposite of Maximin strategy.
 The analyst searches for the best payoffs under the
states of natures for each alternative ,
 selects the alternative with the maximum of the
maximum payoff.

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 DECISION MAKING UNDER UNCERTAINTY…
[Link] regret strategy:
 It involves developing opportunity loss table.
 To do so, the project analyst:
1. identifies the maximum (largest) payoffs under each states
of nature.
2. subtracts each of the other payoffs (values) in the column
from the selected payoff.
 The values in each opportunity loss table are potential
regrets that might be suffered as the result of choosing
various alternatives.
 Then, the project analyst :
1. identifies the maximum opportunity loss in each row ,
2. chooses the alternative that would provide the best
(minimum) of these regrets.
 alternative to minimize the maximum possible regret. 14
DECISION MAKING UNDER UNCERTAINTY…
4. Insufficient reason:

It assumes as if all of the states of nature are equally
likely to occur.

it focuses on the average payoff for each row and
selects the alternative that has the highest row
average.

the same conclusion can be reached by calculating the
row average of the opportunity loss table.
 But, choose the lowest figure in this case!

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DECISION MAKING UNDER UNCERTAINTY…
Example 2: Consider the information given under
example 1 above and determine the best alternative
under each of the following strategies.
1. Maximin strategy
2. Maximax strategy
3. Minimax regret strategy,
4. Insufficient reason.
The data is on the following slide!

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DECISION MAKING UNDER UNCERTAINTY…

States of nature (rainfall amounts/year)

Alternatives
More than 400 400 mm t0 200 mm
mm 300 mm to 100 mm
Sorghum (NPV) 10,000 8,000 -5,000
Maize (NPV) 12,000 7,000 -6,000
Millet (NPV) 9,000 -3,000 -4,000
Seasame (NPV) -3,000 -2,000 10,000

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DECISION MAKING UNDER UNCERTAINTY…
1. Under Maximin strategy
 The row minimum for each alternative (Sorghum,
Maize, Millet and Seasame) respectively is: -5,000, -
6,000, -3,000 and -2,000.
 The maximum of these minimum is -2,000. Thus,
Seasame will be selected as the best alternative under
this strategy.

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DECISION MAKING UNDER UNCERTAINTY…
2. Under Maximax strategy
 The row maximum for each alternative (Sorghum,
Maize, Millet and Seasame) respectively is: 10,000,
12,000, 9,000 and 10,000.
 The maximum of these maximum is 12,000.

 Thus, Maize production will be selected as the best

alternative under this strategy.

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DECISION MAKING UNDER UNCERTAINTY…
3. Minimax regret strategy
 start by identifying the maximum payoff under each
state of nature.
 the maximum payoffs under the situations when the
average rainfall distribution ranges: more than
400mm, between 300mm and 200mm, and between
200mm and 100mm respectively are 12,000, 8,000 and
10,000.
 after subtracting other values in the respective
columns, the opportunity cost table in (1000) is:

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 DECISION MAKING UNDER UNCERTAINTY…
States of nature (rainfall amounts/year)

Alternatives More than 400 mm 400 mm t0 200 mm to

300 mm 100 mm
Sorghum (NPV) 12-10 =2 8 -8= 0 10-(-5) = 15

Maize (NPV) 12 -12 = 0 8 -7 = 1 10-(-6) = 16

Millet (NPV) 12 - 9 =3 8-(-3) = 11 10-(-4)= 14
Seasame (NPV) 12 -(-3)= 15 8-(-2)= 10 10-10 =0
The maximum opportunity loss in (1,000) for each alternative (Sorghum, Maize,
Millet and Seasame) respectively is: 15, 16, 14, and 15.
The alternative that would provide the best (minimum) of these regrets is Millet
with the opportunity loss of 14,000.
Millet production will be selected as the best alternative under this strategy.
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DECISION MAKING UNDER UNCERTAINTY…

4. Insufficient reason:
 Assume that all of the states of nature are equally
likely to occur,
 calculate the average payoff for each row and select
the alternative that has the highest row average.
 the average payoffs of each alternative (Sorghum,
Maize, Millet and Seasame) in (1,000) Birr respectively
is:

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DECISION MAKING UNDER UNCERTAINTY…
[Link] reason….
According to this calculation, Sorghum
1.(10+8+-5)/3 = 13/3 = 4.33
and Maize have equal row average of
2. (9+-3+-4)/3 = 2/3 = 0.67
4.33. To select the best, we need
3. (12+7+-6)/3 = 13/3 =4.33
additional information
4. (-3+-2+10)/3 = 5/3 = 1.67

 The same decision using other alternative: average

opportunity loss method,
 the average opportunity loss for Sorghum, Maize,
Millet and Seasame respectively is:
5.67, 5.67, 9.33 and 8.33.
Sorghum and Maize have equal minimum average
opportunity loss of 5.67.
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DECISION MAKING UNDER RISK

The expected value approach

 As probabilistic information is available in this
particular case, expected value is an approach to
address problem of risk, not uncertainty.
 Expected value is just an average value of all possible
outcomes weighted by the probability of occurrence.
 Mathematically, expected value of an outcome

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DECISION MAKING UNDER RISK…

The expected monetary value approach…

n
EV = ∑ Pi x i
i =1
Where EV is Expected Value, pi is probability of
the ith event, xi is value of the ith event,
n

∑ Px
i =1
i i = 100 %
Example:
• Suppose agronomists say that with a rainfall of 400 mms during
the growing season, a crop will yield 1400kg/ha; with rainfall of
300 mms, the yield falls to 1000kg/ha; and with 200mms, the yield
is only 500kg/ha.
• Let the probabilities of these levels of rainfall is 15%, 50% and25
35%, respectively.
DECISION MAKING UNDER RISK…

The expected monetary value approach…

 Required? Determine the Expected Value of the crop
during the next growing season.
 Solution:

 the expected value of yield will be:

 885kg/ha (0.15*1400kg/ha + 0.50*1000kg/ha +

0.35*500kg/ha) = 885kg/ha.

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SWITCHING VALUES AND SENSITIVITY ANALYSIS

A. Switching values
 the value an element of a project would have to
reach as a result of a change in an unfavorable
direction before that project no longer meets the
minimum level of acceptability as indicated by
one of the measures of project worth.
 we ask, by how much an element would have to
change in an unfavorable direction before the
project would no longer meet the minimum
level of acceptability as indicated by one of the
measures of project worth.
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SWITCHING VALUES AND SENSITIVITY …
A. Switching values…
 Example 1: Assume that 25% short fall in net benefit
yields an NPV of 11,985 Birr and 30% shortfall yields
a negative NPV of -10,000 Birr.
 Then, by how much percent can the net benefit
continuous falling before the NPV of the project
becomes negative?

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 SWITCHING VALUES AND SENSITIVITY …
 Switching values…
 Use the interpolation method of IRR above:

+ ( D 2 − D1) * PVF 1
D 1
PVF 1 + PVF 2
25 + 5{11,985 ÷ (11,985+10,000)}] = 27.726%.
This means, shortfalls in net benefits by
27.726 percent may result in zero NPV.
 Any decline below this level will make the
project unacceptable for the financial purpose.
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SWITCHING VALUES AND SENSITIVITY …
 Switching values…
 Example 2: Think of a hypothetical 1 hectare
Apple project having sum of present value of
benefits equal to Birr 31,278.04 and sum of
present value of costs equal to Birr 24,093.70.
 Required?

1. By how much can cost rise before making the

project unacceptable?
2. By how much can benefits fall before making
the projects unacceptable?
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SWITCHING VALUES AND SENSITIVITY …
 Switching values…
 Solutions:

1. the Benefit Cost ration (B-C ratio) will be

31,278.04/ 24,093.70 = 1.30.
 costs could rise by 30% before the C -B - ratio
becomes below 1, [(31,278.04 – 24,093.70)/
(24093.70)] X 100.
 This means, 30 percent increase in cost will
leave the B-C ratio just at 1.00. (on the margin
of acceptability!)
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SWITCHING VALUES AND SENSITIVITY …
 Switching values…
 Solutions:

2. Benefits could fall by 23 percent before the ratio is

driven down to 1 [(31,278.04 - 24,093.70)/ (31,278.04)] X
100.
 Alternatively, taking the reciprocal of the B - C ratio
(1/1.3 = 0.77) and subtracting it from 1 = 23 percent
 In this case, the maximum tolerable fall in the benefits,
assuming costs remain constant is 24,084.1.
 Any fall below this number will lead the project to
unacceptable condition! 32
SWITCHING VALUES AND SENSITIVITY …
B. Sensitivity analysis
 It is just different ways of asking the same
question as the switching value.
 Sensitivity analysis asks the question ‘is the
project sensitive to a drop in output price by a
given percent?’?
 Computing switching values, on the other hand,
needs answering the question ‘by how much can
prices increase to bring a change from acceptance
to rejection or vice versa’.
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SWITCHING VALUES AND SENSITIVITY …
B. Sensitivity analysis…
 Sensitivity analysis essentially involves varying key
parameter values, usually one at a time but
sometimes in combination, and assessing the effect of
such changes on the central tendency estimate of
profitability.
 if one particular element can be varied over a wide
range of values without affecting the decision, the
decision is insensitive to uncertainties regarding that
particular element (more favorable the element).
 if a small change in the estimate of one element will
alter the decision, the decision is said to be very
sensitive to changes in the estimates of that element
(unfavorable). 34
SWITCHING VALUES AND SENSITIVITY …
B. Sensitivity analysis…
 Example: A project has 20 years life. The
discount factor is 10%; investment cost is Birr
10,000, salvage value is Birr 4,000, annual
output is 400 units per year, value of output is 12
Birr /unit, and cost of output is Birr 7 per unit.
 Required? Perform sensitivity analysis under
each of the following assumptions separately.

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SWITCHING VALUES AND SENSITIVITY …
B. Sensitivity analysis…
1. What If salvage value is abandoned?
2. What if investment cost is doubled?
3. What if selling price drop by 40 percent?
4. What if variable cost per unit rise by 40 percent?

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 SWITCHING VALUES AND SENSITIVITY …
 Sensitivity analysis…
 Solutions:

1. Given the above values the NPV can be estimated as:

 Cash inflows for the next 20 years will be = 400*12 = 4,800 Birr
 Cash outflows for the next 20 years will be = 400*7 = 2,800 Birr.
 Net cash flows from the operation will be = 2000 Birr.

 1− 1 n  
= A  r  .
(1 + r )

1. Apply Present values of Ordinary Annuity formula of:PVOAn  

 
Birr 2,000 (8.51356) = Birr 17,027.
2. In addition, we have present value of salvage converted using Pv = FV / (1+r)
n

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Birr 4,000 /(6.7275) = Birr 594.57.

SWITCHING VALUES AND SENSITIVITY …
 Sensitivity analysis…
 The total present value of the project (from its
operation and salvage values) would be Birr
17,027 plus Birr 594.57 = 17,622 Birr.
 The net present value of the project would be
Birr 17,622-10,000 = Birr 7,622.
1. If salvage value is abandoned, the would be:
 NPV = 17,027 Birr-10,000 Birr = Birr 7,027
 The project is insensitive to the change!

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SWITCHING VALUES AND SENSITIVITY …
 Solutions…
2. If the investment cost is doubled, the NPV
becomes -2, 378 Birr (17,622-20,000).
 With this knowledge, the project might be
rejected, redesigned, or accepted knowing that an
unfavorable result has a significant chance of
occurring.
 The project is sensitive to the change!

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SWITCHING VALUES AND SENSITIVITY …
 Sensitivity analysis…
 Solutions…

3. if price drop by 40 % , price would be 12-(12*.4) = 7.2

birr, and NPV will be:
 Cash inflows for the next 20 years will be = 400*7.2 = 2,880 Birr
 Cash outflows for the next 20 years will be = 400*7 = 2,800 Birr.
 Net cash flows from the operation will be = Birr, 80.
 The PVOA will be Birr 80 (8.51356) = Birr 681.1
 Add the PV of the salvage value of = 594.57 Birr.
 Total PV of inflows = 1,275 Birr
 Total investment cost of =10,000 Birr
 NPV of inflows would be = -8,724 Birr
 The project is sensitive to the price change!
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THE END OF
CHAPTER 5
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