CHAPTERS 2 & 3 – INVESTMENT APPRAISAL

Overview

Investment appraisal is a very common exam question.

Basic techniques Relevant cash Other Replacement Sensitivity

flows complications analysis analysis

ARR Working Capital Taxation

PAYBACK
PERIOD Opportunity Inflation
Costs

Capital
NPV
Rationing

Deprival Value

IRR

Net Present Value

▪ NPV is the most commonly examined method of investment appraisal. It is also the most theoretically sound
method, since the NPV gives the change in wealth for the investors if the business undertakes the project.
▪ For discounting purposes, cash flows are assumed to arise at the beginning or (usually) the end of the year.
This gives rise to the terminology t=0 meaning today (the start of the first year), t=1 meaning in one year’s
time (the end of the first year) etc.
▪ The PV of cash inflows minus the PV of cash outflows = NPV

Decision Rules:

▪ If the NPV is positive, it means that the cash inflows from a project will yield a return in excess of the cost of
capital, and so the project should be undertaken if the cost of capital is the organization’s target rate of
return.
▪ If the NPV is negative, it means that the cash inflows from a project will yield a return below the cost of capital,
and so the project should not be undertaken if the cost of capital is the organization’s target rate of return
▪ If the NPV is exactly zero, the cash inflows for a project will yield a return, which is exactly the same as the
cost of capital, and so if the cost of capital is the organization’s target rate of return, the project will be only
just worth undertaking.

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Discount cash flows using the following formulae:

Discount factor

▪ For a simple cash flow the discount factor is 1/(1 + r)n.

▪ Tables are provided.

Annuity factor

▪ For CFs t=1 – n: Annuity factor =

▪ Again tables are provided.

Perpetuity factor

▪ For a perpetuity cash flow i.e. t = 1 to n, this formula becomes DF = 1/r

Tricks to look out for

▪ If an annuity or perpetuity starts now or more than one year forward, then the tables /formulae must be adapted
e.g. DF (t=3 to 7) = DF (t=1 to 7) – DF (t=1 to 2)

DF (t=0 to 5) = DF (t=1-5) + 1.000

Layouts

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Internal rate of Return (“IRR”)

The IRR is the discount rate used by the company, which gives a zero NPV. At this rate, the PV of the cash
inflows will exactly equal the PV of the cash outflow.

IRR can be solved by: Linear interpolation – calculate 2 NPVs, choosing a

• Linear interpolation discount rate which will make one positive and one
negative.
• Graphs

Formula

IRR = Lower Discount rate + NPV @ Lower Discount rate x (Higher DR – Lower DR)

NPV @ Lower Discount rate - NPV @ Higher Discount rate

Decision Rules:
• Accept all projects with IRRs that exceed their minimum required rate of return.
• In the case of 1 project, accept if IRR is above management’s return cut-off point
• In the case of mutually exclusive projects, whichever offers the highest IRR

Comparison of the NPV and IRR methods

1. The reinvestment rate assumption – NPV assumes interim cash flows can be reinvested at the cost of
capital. IRR assumes reinvestment at IRR rate (this assumption is not always realistic).
2. For evaluating independent projects, NPV and IRR give the same decision.
3. For selecting mutually exclusive projects, use NPV approach. IRR approach may lead to a wrong decision.

Accounting rate of return (ARR or ROCE or ROI)

The ARR method takes the average accounting profit, which the investment will generate and expresses it as a
percentage of the average investment over the life of the project. Thus:

ARR = Average annual profit x 100

Average investment to earn that profit

Decision Rule:
Where there are competing projects which all seem capable of exceeding the minimum required rate of return of
the company, the one with the highest ARR would normally be selected.

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Payback Period
The payback period is the length of time required for the net revenues of an investment to cover the cost of the
investment.

Decision Rule:
A shorter payback period is better than a longer payback period.

EXAMPLE 1

A company is considering expanding its business. The expansion will cost £350,000 initially for the
premises and a further £150,000 to refurbish the premises with new equipment. Cash flow projections
from the project show the following cash flows over the next 6 years.

Year Net cash flows

1 70,000

2 70,000

3 80,000

4 100,000

5 100,000

6 120,000

The equipment will be depreciated to a zero resale value over the same period and, after the sixth year, it
is expected that the new business could be sold for £350,000.

Requirement:

Calculate:

(a) The payback period for the project

(b) The ARR (using the average investment method)

(c) The NPV of the project. Assume the relevant cost of capital is 12%

(d) The IRR of the project

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Why cash flows rather than profits?

• Cash flows rather than profits should be used in investment appraisal, as this more closely reflects the
impact on shareholders’ wealth.
• Not all cash flows are necessarily relevant.
• 2 major adjustments made to convert earnings to cash flows
▪ Depreciation
▪ Working capital

WORKING CAPITAL

EXAMPLE 2

A company plans to enter a 4-year project that is forecast to generate revenue of £100,000 at t1, increasing by 10% per
annum until t4. Working capital equal to 15% of annual sales is required at the start of each year, and will be fully recovered
at the end of t4.

Requirement:

What are the working capital cash flows?

Year 0 1 2 3 4

Sales

WC Investment

WC Recovery

NCF

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RELEVANT CASH FLOWS

• Future incremental cash flows arising from the decision being made; the difference between
o the cash flow if the course of action is taken, and
o the cash flow if it not
• Irrelevant cash flows
o Sunk costs – money already spent
o Accounting entries – e.g. depreciation
o Book values – e.g. LIFO/FIFO
o Unavoidable costs – committed costs
o Finance costs – e.g. interest – dealt with by discounting
• Relevant cash flows
o Opportunity costs and revenues – cash flow forgone
o Incremental cash flows
o Differential cash flows
• The assessment of relevant cash flows needs to be done from the point of view of the business as a

whole and not individual divisions or departments.

• Deprival Value of assets – Refer to p.31

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RELEVANT COST OF MATERIAL

EXAMPLE 3

A new contract requires the use of 50 tonnes of metal ZX 81. This metal is used regularly on all the firm's projects.
At the moment there are in inventory 100 tonnes of ZX 81, which were bought for £200 per tonne. The current
purchase price is £210 per tonne, and the metal could be disposed of for net scrap proceeds of £150 per tonne.

With what cost should the new contract be charged for the ZX 81?

Relevant cost =

EXAMPLE 4

Suppose the organisation has no alternative use for the ZX 81 in inventory. What is the relevant cost of using it
on the new contract?

Relevant cost =

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EXAMPLE 5

Suppose again there is no alternative use for the ZX 81 other than a scrap sale, but that there are only 25
tonnes in inventory.

What is the relevant cost of using it on the new contract?

Relevant cost

RELEVANT COST OF LABOUR

EXAMPLE 6

A mining operation uses skilled labour costing £8 per hour, which generates a contribution of £6 per hour,
after deducting these labour costs.

A new project is now being considered which requires 5,000 hours of skilled labour. There is a shortage of
the required labour. Any used on the new project must be transferred from normal working.

What is the relevant cost of using the skilled labour on the project?

Relevant cost =

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EXAMPLE 7

Facts as in Example 6, but there is a surplus of skilled labour sufficient to cope with the new project. The idle
workers are being paid full wages.

What is the relevant cost?

EXAMPLE 8

A research project, which to date has cost the company £150,000, is under review.

If the project is allowed to proceed it will be completed in approximately one year, when the results are to be sold to a
government agency for £300,000.

Shown below are the additional expenses which the managing director estimates will be necessary to complete the
work:

Materials. This material has just been purchased at a cost of £60,000. It is toxic; and if not used in this project, it must
be disposed of at a cost of £5,000.

Labour. Skilled labour is hard to recruit. The workers concerned were transferred to the project from a production
department, and at a recent meeting the production manager claimed that if these people were returned to him they
could generate sales of £150,000 in the next year. The prime cost of these sales would be £100,000, including £40,000
for the labour cost itself. The overhead absorbed into this production would amount to £20,000.

Research staff. It has already been decided that, when work on this project ceases, the research department will be
closed. Research wages for the year are £60,000, and redundancy and severance pay has been estimated at £15,000
now, or £35,000 in one year's time.

Equipment. The project utilises a special microscope which cost £18,000 three years ago. It will have a residual value
of £3,000 in another two years and has a current disposal value of £8,000. If used in the project it is estimated that
the disposal value in one year's time will be £6,000.

Share of general building services. The project is charged with £35,000 per annum to cover general building
expenses. Immediately the project is discontinued, the space occupied could be sub-let for an annual rental of £7,000.

Requirement:

Advise the managing director as to whether the project should be allowed to proceed, explaining the reasons for the
treatment of each item.

(Note: Ignore the time value of money.)

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PROJECT APPRAISAL ALLOWING FOR TAXATION

Project appraisal with

taxation
EITHER OR

Discount ‘taxable’ cash flows Discount ‘before-tax cash

at ‘post-tax’ discount rates flows at ‘pre-tax’ discount
rates

Formula to learn:

Post-tax rate = Pre-tax rate x (1-T)

▪ Only incremental relevant cash flows need to be considered (the incremental tax charge)
▪ Depreciation should be ignored (not allowed as a deduction from profits)
▪ Interest should be ignored (effect incorporated in cost of capital: see Chapter 5 later)
▪ For examination purposes unless otherwise stated corporation tax is assumed to be paid at 17%. Tax
paid in the same year.
▪ Working capital flows has no tax effects.

Capital Allowances

▪ Unless told otherwise, capital allowances are calculated at 18% reducing balance with a full year's allowance
in the year of purchase and none in the year of disposal.
▪ In a year of disposal the company is awarded a balancing allowance (c.f. loss on disposal) or a balancing
charge (c.f. profit on disposal). This ensures that total allowances claimed equal the drop in value of the asset
over its life.

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EXAMPLE 10

1. A company buys an asset for £10,000 at the end of its accounting period, 31 December 20X0, to undertake
a two-year project.
2. Net trading inflows at t1 and t2 are £5,000.
3. The asset has a £6,900 scrap value when it is disposed of at the end of year 2.
4. Tax is charged at 17%. WDAs are available at 18% pa.

Requirement:

Calculate the net cash flows for the project.

Project cash flows

31 December 20x0 20x1 20x2

t0 t1 t2

WDAs

Year Tax relief @ 17%

31 Dec 20x0 0 Machine cost

WDA

31 Dec 20x1 1 WDA

31 Dec 20x2 2 Disposal

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PROJECT APPRAISAL ALLOWING FOR INFLATION

Inflation is a state of affairs under which prices are constantly rising. When this happens the purchasing power of
money depreciates. The currency will buy fewer goods and services than previously and consequently the real
returns on investments will fall. When appraising investment opportunities the appraiser requires an understanding
of 3 discount rates – the Money Rates, Real Rates and Inflation Rates.

Interest Rates

In times of inflation, the fund providers will require a return made up of 2 elements:
• A return to compensate for inflation (to maintain purchasing power)
• A real return on top of this for the use of their funds
Thus the required rate of return is called money return (also known as the Nominal rate).

Project appraisal under

inflation
EITHER OR

Discount ‘money’ cash flows Discount ‘real’ cash flows at

at ‘money’ discount rates ‘real’ discount rates

Formula to learn:
(1 + money rate) = (1 + real rate) x (1 + inflation rateg)
Where: ig = general inflation rate

NOTE: If not told otherwise assume the given rate is the money rate.

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EXAMPLE 11 (MONEY METHOD)

Project details:

Invest £10,000 at t0 in new plant and equipment

Returns £5,000 pa in current terms for three years, inflating at 7% pa

Money rate of interest is 10%

Requirement:

Calculate the project's NPV using the money method.

Year Cash flows DF@ PV

0
1
2
3

NPV Calculations

There are two main ways of calculating NPVs with inflation:

▪ Discount money cash flows with a money discount rate (“Money method”)

▪ Leave cash flows in current terms and use an effective discount rate (different from the real rate if specific
inflation differs from the general rate)
(1 + m) = (1 + e)(1 + is) is = specific inflation for the cash flow (“Effective method”)

NOTE:

This method is suitable when there are perpetuities and long annuities. With this effective method you could end
up with a different effective rate for each cash flow.

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EXAMPLE 12 (EFFECTIVE METHOD)

Labour costs inflate at 8% pa in perpetuity

Money rate = 10%

Labour currently costs £10,000 in t0 terms

Requirement:

Calculate the present value of labour costs.

Year Cash Flows DF@ PV

Effects of taxation & inflation on project appraisal

The money method is best when both tax and inflation crop up.

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SPECIFIC INVESTMENT DECISIONS

1. CAPITAL RATIONING

Reasons for capital rationing

Hard capital rationing Soft capital rationing

▪ Restrictions on raising funds are due to ▪ Restrictions on the availability of funds that arise within a
causes external to the company. company and are imposed by managers. There are several
▪ For example, potential providers of reasons why managers might restrict available funds for capital
debt finance may refuse to provide investment.
further funding because they regard a ▪ Managers may prefer slower organic growth to a sudden
company as too risky. This may be in increase in size arising from accepting several large investment
terms of financial risk, for example if projects. This reason might apply in a family-owned business
the company’s gearing is too high or its that wishes to avoid hiring new managers.
interest cover is too low, or in terms of ▪ Managers may wish to avoid raising further equity finance if
business risk if they see the this will dilute the control of existing shareholders.
company’s business prospects as poor ▪ Managers may wish to avoid issuing new debt if their
or its operating cash flows as too expectations of future economic conditions are such as to
variable. suggest that an increased commitment to fixed interest
▪ In practice, large established payments would be unwise.
companies seeking long-term finance ▪ One of the main reasons suggested for soft capital rationing is
for capital investment are usually able to that managers wish to create an internal market for
find it, but small and medium-sized investment funds. It is suggested that requiring investment
enterprises will find raising such funds projects to compete for funds means that weaker or marginal
more difficult. projects, with only a small chance of success, are avoided. This
allows a company to focus on more robust investment projects
where the chance of success is higher1.
▪ This cause of soft capital rationing can be seen as a way of
reducing the risk and uncertainty associated with investment
projects, as it leads to accepting projects with greater margins of
safety.

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The NPV decision rule, to accept all projects with a positive net present value, requires the existence of a perfect
capital market where access to funds for capital investment is not restricted. In practice, companies are likely to
find that funds available for capital investment are restricted or rationed.

Allocation of limited capital

Single-period rationing Multi-period rationing

Divisible projects Indivisible projects Linear Programming

Technique: Technique:

Project divisibility

The approach to solving single-period capital rationing problems depends on whether projects are divisible or not. A divisible
project is one where a partial investment can be made in order to gain a pro rata net present value. For example, investing in
a forest is a divisible project, since the amount of land purchased can be varied according to the funds available for investment
(providing the seller agrees to a partial sale, of course). A non-divisible project is one where it is not possible to invest less
than the full amount of capital. When building an oil refinery, for example, it is not possible to build only one part of the overall
facility.

▪ Where projects are divisible, the objective of maximising the NPV arising from invested funds can be achieved by
ranking projects according to their PI and investing sequentially in order of decreasing profitability index, beginning with
the highest, assuming that each project can be invested in only once, i.e. is non-repeatable. The profitability index can
be defined as net present value divided by initial investment. Ranking projects by profitability index is an example of
limiting factor analysis. Because projects are divisible, there will be no investment funds left over: when investment funds
are insufficient to for the next ranked project, part of the project can be taken on because it is divisible.
▪ When projects are non-divisible, the objective of maximising the net present value arising from invested funds can be
achieved by calculating the net present value arising from different combinations of projects. With this approach, there
will usually be some surplus funds remaining from the funds initially available.

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EXAMPLE 13

A business has £50,000 available at t0 for investment. Four divisible projects are available:

Project NPV Funds required at t0

£ £
A 100 000 (50 000)
B (50 000) (10 000)
C 84 000 (10 000)
D 45 000 (15 000)

Requirement:
Which project(s) should be undertaken?

Project A B C D
NPV
Investment (t0)

PI

Ranking

Optimal investment schedule

Project Investment NPV

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Indivisible Projects

In reality projects may be indivisible, ie the investment is all or nothing, in which case trial and error is necessary
to find the optimal combination.

EXAMPLE 14

Using the data in Example 13 but assuming projects are indivisible, which project(s) should be undertaken?

Project(s) Investment NPV

Optimal combination:

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PRACTICE QUESTION

Project A B C D E

NPV (£000) 60 40 (20) 110 40

Advise in the following circumstances.

a) The company faces a perfect capital market, where the appropriate discount rate is 10%. All projects are

independent and divisible. Which projects should the firm accept?

b) The company faces capital rationing at t0. There is only £225,000 of finance available. None of the projects

can be delayed. Which projects should the firm accept?

c) The situation is as in part (b) above, except that you are now informed that projects A and B are mutually-

exclusive. Which projects should now be accepted?

d) The solution is as in part (b) above, except that you are now told that all projects are independent but indivisible.

Which projects should be accepted? What will be the maximum NPV available to the company?

e) All projects are independent and divisible. There is capital rationing at t1 only. No project can be delayed or

brought forward. There is only £150,000 of external finance available at t1. Which projects should be accepted?

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2. ASSET REPLACEMENT DECISIONS

▪ A project is likely to involve commitment to long-term production, and machinery will therefore need to be
replaced regularly at the end of its useful life. Hence, the business needs to know how often to replace such
assets. Replacing after a long time means not replacing as often, so delaying the cost of a new replacement
machine. However this invariably means keeping an asset whose value is declining and which costs more to
maintain and repair. These costs and benefits need to be balanced

▪ Suppose a firm is deciding how often to replace an asset. You cannot simply look at the NPV of each possible
cycle as they are different lengths and repeat. A better way is to calculate the equivalent annual cost as follows:

EAC = NPV of cycle / Annuity discount factor

So the method can be summarised as:

1. Calculate the NPV of each replacement strategy

2. Calculate the annual equivalent cost of the NPV for each strategy

3. Choose the strategy with the lowest annual equivalent cost.

EXAMPLE 15

A machine costs £20,000 and it can be replaced every year or every two years. Delaying the replacement
causes the running costs to increase and the scrap proceeds to decrease as follows:

Running costs Scrap proceeds

£ £

Year 1 5,000 16,000

Year 2 5,500 13,000

Company's cost of capital = 10%.

Requirement:

Should the machine be replaced every one or every two years?

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If machine is replaced every year:

Year Cash flows DF@10% PV

EAC =

If machine is replaced every 2 years:

Year Cash flows DF@10% PV

EAC =

Optimal replacement policy:

Limitations of the replacement analysis performed

This method assumes that a firm is continually replacing like with like, and therefore determines a once and- for-all optimal
replacement cycle. In practice this is unlikely to be valid due to:

• Changing technology, which can quickly make machines obsolete and shorten replacement cycles. This means that
when an asset is replaced, it is not replaced with an identical asset.
• Inflation, which by altering the costs of assets means that the optimal replacement cycle can vary over time If inflation
affects all variables equally it is best excluded from the analysis by discounting real cash flows at a real interest rate –
the optimal replacement cycle will remain valid. Differential inflation rates mean that the optimal replacement cycle varies
over time.
• The effects of taxation (which are ignored in the analysis above but they could be incorporated into the cash flows).
• The fact that use of the machines is unlikely to continue in perpetuity.

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PRACTICE QUESTION

Cern has an annual cost of capital of 10%. One of its most successful products is Hadtone, a mortar colouring agent.
Hadtone is made using a single processing machine which mixes the raw ingredients and dispenses the completed product
into five-litre cartons.

A five-litre carton of Hadtone sells for £12 and estimated maximum annual demand at this price is 300,000 cartons. At this
level of demand, Cern can justify the operation of only one processing machine, which Cern currently replaces every three
years, although the processing machine has a productive life of four years.

In the first year of its life the processing machine has a productive capacity in line with the maximum annual demand for
the product, but each year thereafter this productive capacity falls at a rate of 15,000 units pa. Annual maintenance costs
in the first year of operating the processing machine are estimated at £12,000. Thereafter, the directors expect the annual
maintenance costs to increase by £2,000 pa regardless of the actual number of five-litre cartons produced. Cern incurs
variable costs, excluding depreciation and maintenance costs, of £8.00 in producing each five-litre carton. Cern provides
for depreciation on all its non-current assets using the straight-line method.

If Cern were to dispose of the processing machine after one year, the directors estimate sale proceeds of £320,000, but
these would fall by £120,000 pa in each of the following two years. Once the machine has reached the end of its four-year
productive life its residual value will be £10,000.

Following a recent increase in the cost of a processing machine to £480,000, Cern's directors are reconsidering their current
replacement policy with a view to maximising the present value of the company's cash-flows. It can be assumed that all
revenues and costs are received or paid in cash at the end of the year to which they relate, with the exception of the initial
price of the processing machine which is paid in full at the time of purchase.

Requirement:
Assuming that the processing machine is used to maximum capacity, and showing all your supporting calculations, advise
Cern's directors how often they should replace the processing machine.
(10 marks)

Note: Ignore inflation and taxation

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SHAREHOLDER VALUE ANALYSIS (SVA)

▪ Shareholder value analysis (SVA) concentrates on a company’s ability to generate value and thereby increase
shareholder wealth. SVA is based on the premise that the value of a business is equal to the sum of the
present values of all of its activities.
▪ The value of the business is calculated from the cash flows generated by drivers 1-6 which are then discounted
at the company’s cost of capital (driver 7). SVA links a business’ value to its strategy (via the value drivers).
▪ The seven value drivers are a key element of the SVA approach to valuing a company. [SLOTIIC]

DRIVER Impact on operating cash flows, value of the business

and shareholder wealth

1 Sales growth rate Higher sales generate more cash

2 Life of cash flows The longer the life of the cash flows, the higher the value

contributed

3 Operating profit margin The higher the margin, the more profit generated per sale and

so the higher the cash flows generated

4 Corporation tax rate Tax drains cash

5 Investment in NCA Cash is drained into CAPEX but can enhance wealth

6 Investment in working capital Ties up cash

7 Cost of capital Cheaper sources of long-term finance will enhance value

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REAL OPTIONS

Whether APV or NPV is used, it may understate the true value of a project. This is because they fail to capture
the value of strategic options that may be “embedded” within a project. These are known as “real options” as they
are options within physical company projects, as opposed to being derivatives.

True NPV = Traditional NPV + Value of embedded options

Types Explanation

Flexibility options A more expensive option may give increased flexibility e.g. a machine
could run off electricity or gas, allowing the company to pick the better
option as appropriate.
Abandonment options Some projects allow assets to be sold at a good price if abandoned. Some
projects have inbuilt options to reduce capacity and to suspend operations
temporarily. These rights are similar to put options.
Timing options Projects with options to delay are more attractive – allows the company to
wait and see. However, this is only valuable if it more than offsets the loss
of business/profits to competitors during the delay.
Follow on options Launching this project gives an opportunity to launch a second and third
projects. This is similar to a call option.
Growth options Project provides an ability to start small and expand if market conditions
are good. JVs and strategic alliances. Also relates to follow on options.

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INVESTING OVERSEAS

Key considerations in determining whether to invest overseas:

Market attractiveness Forecast demand, growth rates

Competitive advantage Prior experience, understanding, language barriers
Risk Political stability, government intervention and similar external influences

POLITICAL RISK

POLITICAL RISKS Ways to deal with political risk Measures a foreign

government could implement
to prevent exploitation of its
country by multinationals:

1. Government stability  Negotiations with host government  Quotas

2. Economic stability  Insurance e.g. Export Credits  Tariffs

Guarantee Department
3. Inflation  Production strategies e.g.  Non-tariff barriers
outsource, produce locally
4. Degree of international  Management structure e.g JVs,  Restrictions
indebtedness sharing control with locals, local
investment
5. Level of import restrictions  Finance e.g. obtain finance locally  Minimum shareholding
so that local banks are stakeholders

6. Remittance restrictions

7. Special taxes or investment

incentives

CULTURAL RISK

• Cultures and practices of customers and consumers in individual markets

• Media and distribution systems in overseas markets
• Different ways of doing business in overseas markets
• Degree to which national cultural differences matter for the product concerned

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FACTORS INFLUENCING THE CHOICE OF FINANCE FOR AN OVERSEAS SUBSIDIARY

• Local finance costs, and any subsidies which may be available

• Taxation systems of the countries in which the subsidiary is operating.
• Restrictions on dividend remittances
• Possibility of flexibility in repayments which may arise from the parent/subsidiary relationship
• Access to capital

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RISK AND UNCERTAINTY

The investment appraisal process is concerned with assessing the value of future cash flows compared to the cost
of investment. Since future cash flows cannot be predicted with certainty, managers must consider how much
confidence can be placed in the results of the investment appraisal process. They must therefore be concerned
with the risk and uncertainty of a project.

• Uncertainty refers to the situation where probabilities cannot be assigned to future cash flows. Uncertainty
cannot therefore be quantified and increases with project life: it is usually true to say that the more distant is a
cash flow, the more uncertain is its value.

Decisions are usually said to be subject to uncertainty if the possible outcomes of a decision are known but

the probabilities attaching to each possible outcome are unknown.

• Risk refers to the situation where probabilities can be assigned to future cash flows, for example as a result of
managerial experience and judgement or scenario analysis. Where such probabilities can be assigned, it is
possible to quantify the risk associated with project variables and hence of the project as a whole. Risk
increases with increasing variability of returns.

Decisions are usually said to be subject to risk if, although there are several possible outcomes of a decision,

these outcomes as well as the respective probabilities attaching to each of these possible outcomes are known.

If risk and uncertainty were not considered in the investment appraisal process:

• Managers might make the mistake of placing too much confidence in the results of investment appraisal,
or they may fail to monitor investment projects in order to ensure that expected results are in fact being
achieved.
• Assessment of project risk can also indicate projects that might be rejected as being too risky compared
with existing business operations, or projects that might be worthy of reconsideration if ways of reducing
project risk could be found in order to make project outcomes more acceptable.

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Methods of dealing with decision making under risk and uncertainty

Risk is best handled by using:

• Expected values – p.117
• Simulation –p.115
• Portfolio theory – p.121
• The CAPM model – p.125
• Risk-adjusted discounted rates –p.267

Techniques for handling uncertainty are generally more crude but practically just as useful. These include
the following:
• Setting a minimum payback period for projects.

• Increasing the discount rate subjectively in order to submit the project to a high ‘hurdle’ rate in investment

appraisal.

• Making prudent estimates of outcomes to assess the worst possible situation.

• Assessing both the best and the worst possible situations to obtain a range of outcomes.

• Using sensitivity analysis (p.110) to measure the ‘margin of safety’ on input data.

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SENSITIVITY ANALYSIS

• Determines the effect on project net present value of a change in individual project variables.
• The analysis highlights the project variable to which the project net present value is most sensitive in relative
terms.
• However, since sensitivity analysis changes only one variable at a time, it ignores interrelationships between
project variables.
• While sensitivity analysis can indicate the key or critical variable, it does not indicate the likelihood of a change
in the future value of this variable, i.e. sensitivity analysis does not indicate the probability of a change in the
future value of the key or critical variable.
• For this reason, it can be said that sensitivity analysis is not a method of including risk in the investment
appraisal process.

Change in estimate allowed = (Project NPV / PV of CFs subject to uncertainty) x 100%

Example 16

The following information applies to a new project

Initial cost £125 000
Selling price £100/unit
Variable costs £30/unit
Fixed costs £100 000 p.a.
Sales volume 2 000 units p.a.
Life 5 years
Discount rate 10%

Requirement:
Calculate the project’s NPV and show how sensitive the result is to the various input factors.

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Project NPV
Year Cash flows DF@ 10% PV

Sensitivity Analysis
Variable Sensitivity Ranking Remarks
Initial cost
Unit selling price
Unit variable cost
Total fixed cost
Sales volume
Project life
Discount rate

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Example 17

A company is about to embark on a two-year project. Estimates of relevant inflows and outflows in current
terms are as follows:
Year 1 Year 2
Sales £50 000 £ 50 000
Costs £30 000 £ 32 000
The following inflation rates are applicable to the flows:
Sales 6% pa
Costs 4% pa
Tax is payable at 30% on net flows.
The net cost of the project at to, after allowing for capital allowance tax effects, is £20 000.
The money cost of capital is 10% pa.
Required:
a) Calculate the NPV of the project
b) Assess the sensitivity of the investment decision to changes in sales revenue.

a) Project NPV

Sales

Costs

PBT

Tax

PAT

Investment
NCF

DF@

PV

NPV =

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b) Sensitivity to changes in sales revenue

STRENGTHS AND WEAKNESSES OF SENSITIVITY ANALYSIS

STRENGTHS WEAKNESSES
Sensitivity Independence
Information will be presented to management in a form which facilitates It assumes that ∆s to variables can be made independently, eg material
subjective judgment to decide the likelihood of the various possible prices will ∆ independently of other variables, which is unlikely. If material
outcomes considered. prices were to rise, the firm would probably increase selling price at the
same time and there may be little effect on NPV (depending on the effect
Critical issues of a price rise on sales demand).

Identifies those areas which are critical to the success of the project; if the
project is undertaken, those areas can be carefully monitored. Ignores probability

• For example, if sales volume and/or price is identified as critical, It only identifies how far a variable need to ∆; it does not look at the
further market research may help to improve confidence in the probability of such a ∆. In the above worked example, sales volume
estimates appears to be the most crucial variable, but if the firm were facing volatile
• If the cost of materials or bought-in components is critical, then fixed raw material markets, a 65% ∆ in raw material prices would be far more
price contracts may be a possible way of limiting the cost and likely than a 29% ∆ in sales volume.
uncertainty. Alternatively, it may be possible to use futures and
options to limit materials costs No clear answer
• However, these attempts to reduce risk are not costless – market It is not an optimising technique. It provides information on the basis of
research costs money, option premiums must be paid, suppliers may which decisions can be made. It does not point directly to a correct
demand up-front payments on fixed price contracts decision.

Simple
No complicated theory to understand; it is relatively straightforward

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PROBABILITY ANALYSIS

• Probability analysis, attaches probabilities to the expected future cash flows of an investment project
and uses these to calculate the expected net present value (ENPV). The ENPV is the average NPV that would
be expected to occur if an investment project could be repeated a large number of times.
• The ENPV can also be seen as the mean or expected value of an NPV probability distribution. Probability
analysis is a way of including a consideration of risk in the investment appraisal process. It is certainly a more
effective way of considering the risk of investment projects than sensitivity analysis.
• A weakness of probability analysis, however, lies in the difficulty of estimating the probabilities that are to
be attached to expected future cash flows.
• While these probabilities can be based on expert judgement and previous experience of similar investment
projects, there remains an element of subjectivity which cannot be escaped.

Example 18

Expected Value of Sales

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If the project outlay is £230,000 and each unit sold has a contribution of £10.

Requirement:

If Mun's cost of capital is 10%, what is her project's expected NPV?

Year Cash flows DF@ PV

ADVANTAGES AND LIMITATIONS OF EXPECTED VALUES

ADVANTAGES LIMITATIONS
▪ The information is reduced to a single number for each ▪ The probabilities of the different possible outcomes may be
decision option difficult to estimate
▪ The idea of an average is readily understood
It is possible to use:
❖ Objective probabilities based on past experience of similar
projects; or
❖ Subjective probabilities, eg from the results of market research,
where there is no past experience as a guide to the future
▪ The EV may not correspond to any of the possible expected
outcomes
▪ Unless the same decision has to be made many times, the EV
will not be achieved; it is therefore not a valid way of making a
decision in 'one-off' situations unless the firm has a number of
independent projects and there is a portfolio effect
▪ The average gives no indication of the spread of possible
results, ie it ignores risk

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Probability Analysis
Assessing the probabilities of future events linked to an investment project.
Scenario Analysis
If these events are general circumstances, eg. outcome of an investment project under poor, moderate and
good economic conditions and the probability of each economic state arising.
Monte Carlo Method (Simulation)
Likelihood of particular values of project variables occurring, so that a probability distribution for each variable
can be determined.

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PRACTICE QUESTIONS

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