Risk Project Appraisal for Portal

7/28/2019 Risk Project Appraisal for Portal

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Risk and Project Appraisal



• Two types of expectations about the future:

1 Certainty – future outcome has only one value2 Risk and uncertainty – range of possible outcomes

Objective probabilities – established using historic data

What is risk?



• Personal judgement of the range of outcomes along with

the likelihood of their occurrence

• The alternative is merely stating the most likely outcomes

Subjective Probabilities



Presenting a more realistic and rounded view of a

project’s prospects by incorporating risk in an

appraisal by:

1. Varying the discount rate

2. Sensitivity Analysis

3. Scenario Analysis

4. Probability Analysis

Risk and Project Appraisal



1.Adjusting for risk through the discount rate



• Advantage: This is an easy approach to understandand adopt

• Drawbacks:

– Risk perception and judgment are bound to be, to some extent,

subjective and susceptible to personal bias

– A high degree of arbitrariness in the selection of risk premiums.

1. Adjusting for risk through the discount rate



• Acemart plc has developed a new product line called Marts, likely

demand is 1,000,000 per year for the four-year life of the project


- examines the impact of a change in the value of one

variable on the project NPV



• Required rate of return on a project of this risk class is 15%

• Expected net present value:




2. Sensitivity AnalysisThe finance department are aware that when the proposal is placed

before the capital investment committee they will want to know how

the project NPV changes if certain key assumptions are altered. As

part of the report the finance team ask some ‘what-if’ questions and

draw a sensitivity graph.

1. What if the price achieved is only 95p (5% below the expected £1)

for sales of 1m units (all other factors remaining constant)?

2. What if the price rose by 1%?

3. What if the quantity demanded is 5% more than anticipated?

4. What if the quantity demanded is 10% less than expected?

5. What if the appropriate discount rate is 20% higher than originally

assumed (i.e. 18% not 15%)?

6. What if the discount rate is s10% lower than assumed (i.e.13.5%)?



Sensitivity graph



• Initial investment

• Sales price

• Material costs

• Discount rate

The break-even point where NPV=zero

%100

Pr

bleojectVaria PVof

NPV ySensitivit



• Advantages

– Information for decision making

– To direct search

– To make contingency plans

• Drawbacks – The absence of any formal assignment of probabilities to the

variations of the parameters

– Each variable is changed in isolation while all other factors

remain constant

Advantages & disadvantages of using sensitivity analysis



Acmart plc:

3. Scenario analysis- Situations where a number of factors change



3. Scenario analysis



4. Probability Analysis



The expected return is the mean or average outcome calculated by

weighting each of the possible outcomes by the probability of

occurrence and then summing the result

Step 1 – expected return

ni

i

ii p R R1

nn p R p R p R R ...2211

= the expected return

i = each of the possible outcomes (outcome 1 to outcome n)

p = probability of outcome i occurring

n = the number of possible outcomes

= means add together the results for each of the possible outcomes i

from the first to the nth outcome

R

ni

i 1





• Standard deviation, σ, is a statistical measure of the

dispersion around the expected value

• The standard deviation is the square root of the variance, σ2

Step 2 - Standard Deviation

ni

i

iii p R R1

2





NPV = expected net present value

NPV i = the NPV if outcome i occurs

pi = probability of outcome i occurring

n = number of possible outcomes

means add together the results of all the NPV × p calculations

for each outcome i from the first to the nth outcome

—––

standard deviation of the net present value is:i =n

i =1Σ {(NPV i – NPV )2 pi }σNPV =

i =n

i =1Σ

=—–– NPV

i =n

i =1Σ (NPV i pi )

Expected NPV’s & standard deviation



Purchase price, t0 £700,000e.g. Horizon plc

Expected NPV’s & standard deviation

Cost of Capital 10%.



Horizon plc cont.



An event tree showing the probabilities of the possible returns for Horizon

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Risk Project Appraisal for Portal