RISK AND UNCERTAINTY
Risk in investment appraisal refers to the attachment of probabilities to the possible outcomes of an
investment project and therefore represents a quantified assessment of the variability of expected
returns.
Uncertainty cannot be quantified by attaching probabilities and often the terms are used
interchangeably but the difference is important in investment appraisal.
Simulation:
Simulation is a computer based method of evaluating an investment project whereby the probability
distributions associated with individual project variables and interdependencies between those
variables are incorporated.
Random numbers are assigned to a range of different values of a project variable to reflect it
probability distribution. Each simulation runs randomly and select values of a project variable using
random numbers and calculate mean (expected) NPV.
A picture of the probability distributions of mean NPV can be built up from several simulation runs.
The project risk can be assessed from the probability distribution as the standard deviation of
expected returns, with the most likely outcome and the probability of negative NPV.
Sensitivity Analysis:
Sensitivity analysis assess the extent to which the NPV of an investment project responds to the
changes in project variables. Two methods are commonly used: One method determines percentage
change in project variables which result in a negative NPV while the other method determines the
change in NPV which results from a fixed percentage change in each project variable in turn.
Whichever method is used, the key or critical project variable are identified as to which the NPV is
most sensitive, for example, those variables in which a slight change will cause the NPV to be
negative. Sensitivity analysis is therefore concerned with calculating relative changes in project
variables.
While sensitivity analysis can indicate the critical variables, however, sensitivity analysis does not
give any indication about the probability of a change in any critical variable. Sensitivity analysis will
not therefore assist in assessing risk of the investment project. However, it does provide useful
information which management might use to gain a deeper understanding of investment project
and focuses management attention to the aspects of the investment project which might be critical.
Probability Analysis:
Probability analysis can be used to calculate the values of the possible outcomes and their
probability distributions, the value of the worst possible outcomes and its probability, the probability
that the investment will generate a positive NPV, the standard deviation (mean) of the possible
outcomes and the expected net present value. One difficulty with probability analysis is its
assumption that an investment is repeated a large number of times. In reality, many investment
projects cannot be repeated and so only one of the possible outcomes will actually occur. Another
difficulty with the probability analysis is the question of how the probabilities of possible outcomes
were assessed and calculated.
Risk-Adjusted Discount Rate:
It is often said that “the higher the risk, the higher the returns”. Investment project with higher risk
should therefore be discounted with higher discount rate than the lower investment projects. Better
still, the discount rate should reflect the risk of the investment project.
Theoretically the capital asset pricing model CAPM method can be used to determine a project
specific discount rate that reflects the investment project’s systematic risk. This can be done by
selecting a proxy company with similar business activities and ungearing their equity beta of
company to get asset beta which does not reflect the financial risk of that company then it should be
regeared to give the equity beta reflecting the systematic financial of the investing company, and
using the CAPM to calculate a project specific cost of equity for investment project.
Adjusted Payback:
If uncertainty and risk are seen to be same then payback can consider them by shortening the
payback period. As uncertainty (risk) increases with projects life, shortening the payback period will
require a risky project to pay back sooner, thereby focusing on cash flows which are nearer in time
(less uncertain) and so less risky.
Discounted payback period can also be seen as considering risk because future cashflows need to be
converted in present value terms using risk adjusted discounted rate. The target payback period
normally used by a company can then be applied to the discounted cashflows. Overall, the effect is
likely to be similar to shortening the payback period with undiscounted cashflows.
Capital Asset Pricing Model (CAPM):
The capital asset pricing model (CAPM) assumes that investors hold diversified portfolios, so that
unsystematic risk can has been diversified away. Companies using CAPM to calculate a project
specific discount rate are therefore concerned only with determining the minimum return that must
be generated by an investment project as compensation for its systematic risk.
The CAPM is useful where the business risk of an investment project is different from the business
risk of investing company existing business operations. In such a situation, one or more proxy
companies are identified that have similar business risk to the investment project. The equity beta of
the proxy company represents the systematic risk of the company, and reflects both business risk
arising from the proxy company’s business operations and financial risk of proxy company’s capital
structure.
Since the investing company is only interested in business risk of the proxy company, the proxy
company’s equity beta is ungeared to remove the effect of financial risk of its capital structure.
Ungearing the equity beta results in asset beta which represents business risk alone of the company.
The asset betas of multiple proxy companies can be averaged in order to remove any small
differences in business operations.
The asset beta is then regeared, giving project specific equity beta whose systematic risk takes
account of the financial risk of investing company as well as the business risk of the investment
project. Both ungearing and regearing use the weighted average beta formula, which equates the
asset beta with weighted average of equity beta and debt beta.
The project specific equity beta resulting from the regearing process can then be used to calculate a
project specific cost of equity using CAPM. This can be used as the discount rate when evaluating the
investment project with a DCF investment appraisal method such as NPV or IRR. Alternatively, the
project specific cost of equity can be used in calculating a project specific WACC, which can also be
used in DCF evaluation.