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Chapter 6 Project Appraisal and Risk

SYLLABUS

1. Describe and discuss the difference between risk and uncertainty in relation to
probabilities and increasing project life.
2. Apply sensitivity analysis to investment projects and discuss the usefulness of
sensitivity analysis in assisting investment decisions.
3. Apply probability analysis to investment projects and discuss the usefulness of
probability analysis in assisting investment decisions.
4. Apply and discuss other techniques of adjusting for risk and uncertainty in investment
appraisal, including:
(a) simulation
(b) adjusted payback
(c) risk-adjusted discount rate

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1. Risk and Uncertainty (Dec 07, Jun 11, Jun 12, Jun 15)

1.1 Investment appraisal faces the following problems:

(a) all decisions are based on forecasts;
(b) all forecasts are subject to uncertainty;
(c) this uncertainty needs to be reflected in the financial evaluation.
1.2 The decision maker must distinguish between:
(a) Risk – can be quantifiable and be applied to a situation where there are
several possible outcomes and, on the basis of past relevant experience,
probabilities can be assigned to the various outcomes that could prevail.
(b) Uncertainty – is unquantifiable and can be applied to a situation where there
are several possible outcomes but there is little past experience to enable the
probability of the possible outcomes to be predicted.
1.3 If risk and uncertainty were not considered, managers might make 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.
1.4 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.

Multiple Choice Questions

1. A distinction should be made between the terms risk and uncertainty.

Which of the following statements is true?

1. Risk can be applied to a situation where there are several possible outcomes and,
on the basis of past relevant experience, probabilities can be assigned to the
various outcomes that could prevail.
2. Uncertainty can be applied to a situation where there are several possible
outcomes but there is little past relevant experience to enable the probability of
the possible outcomes to be predicted.

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Statement 1 Statement 2
A True True
B True False
C False True
D False False

2. Sensitivity Analysis (Dec 07, Jun 11, Dec 11, Jun 12, Jun 15)

2.1 Principles of sensitivity analysis

(a) It assesses the sensitivity of project NPV to changes in project variables.

(b) It calculates the (1) relative change in a project variable required to
make the NPV zero, or the (2) relative change in NPV for a fixed change
in a project variable. For example, what if demand fell by 10% compared to
our original forecasts? Would the project still be viable?
(c) Only one variable is considered at a time.
(d) These show where assumptions may need to be checked and where
managers could focus their attention in order to increase the likelihood that
the project will deliver its calculated benefits.
(e) However, since sensitivity analysis does not incorporate probabilities, it
cannot be described as a way of incorporating risk into investment
appraisal, although it is often described as such.

2.2 The NPV could depend on a number of uncertain independent variables.

(a) Selling price
(b) Sales volume
(c) Cost of capital
(d) Initial cost
(e) Operating costs
(f) Benefits

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2.3 Decision rule (Dec 11)

(a) A simple approach to deciding which variables the NPV is particularly

sensitive is to, the following formula can be applied:

NPV
Sensitivity = %
PV of project variable

(b) The lower the percentage, the more sensitive is NPV to that project
variable as the variable would need to change by a smaller amount to make
the project non-viable.

2.4 EXAMPLE 1
ABC Co is considering a project with the following cash flows.
Year Initial Variable costs Cash inflows Net cash flows
investment ($000) ($000) ($000)
($000)
0 7,000
1 (2,000) 6,500 4,500
2 (2,000) 6,500 4,500

Cash flows arise from selling 650,000 units at $10 per unit. ABC Co has a cost of
capital of 8%.

Required:

Measure the sensitivity of the project to changes in variables.

Solution:
The PVs of the cash flow are as follows.
Year Discount PV of initial PV of PV of cash PV of net
factor 8% investment variable costs inflows cash flow
$000 $000 $000 $000
0 1.000 (7,000) (7,000)

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1 0.926 (1,852) 6,019 4,167

2 0.857 (1,714) 5,571 3,857
(7,000) (3,566) 11,590 1,024

NPV = 1,024

The project has a positive NPV and would appear to be worthwhile. The sensitivity
of each project variable is as follows.

(a) Initial investment

Sensitivity = 1,024 / 7,000 × 100% = 14.6%
i.e. 7,000 × 14.6% = $1,022
(b) Sales volume
Sensitivity = 1,024 / (11,590 – 3,566) × 100% = 12.8%
i.e. 650,000 units × 12.8% = 83,200 units
(c) Selling price
Sensitivity = 1,024 / 11,590 × 100% = 8.8%
i.e. $10 × 8.8% = $0.88
(d) Variable costs
Sensitivity = 1,024 / 3,566 × 100% = 28.7%
i.e. $3,566 × 28.7% = $1,023
(e) Cost of capital. We need to calculate the IRR of the project.

Year Net cash Discount PV Discount PV

flow factor 15% factor 20%
$000 $000 $000
0 (7,000) 1 (7,000) 1 (7,000)
1 4,500 0.870 3,915 0.833 3,749
2 4,500 0.756 3,402 0.694 3,123
317 (128)

IRR = 0.15 + = 18.56%

The cost of capital can therefore increase by 132% [(8 – 18.56)/8] before the NPV
becomes negative.

The elements to which the NPV appears to be most sensitive are the selling price

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followed by the sales volume. Management should thus pay particular attention to
these factors so that they can be carefully monitored.

Multiple Choice Questions

2. Which of the following statements is incorrect?

A Sensitivity analysis assesses how responsive the project's NPV is to changes in

the variables used to calculate that NPV
B When calculating the sensitivity of each variable, the lower the percentage, the
less sensitive is the NPV to that project variable
C Management should review critical variables to assess whether or not there is a
strong possibility of events occurring which will lead to a negative NPV
D Sensitivity analysis does not provide a decision rule. Parameters defining
acceptability must be laid down by managers

3. The following financial information relates to an investment project:

$000
Present value of sales revenue 50,025
Present value of variable costs 25,475
Present value of contribution 24,550
Present value of fixed costs 18,250
Present value of operating income 6,300
Initial investment 5,000
Net present value 1,300

What is the sensitivity of the net present value of the investment project to a
change in sales volume?

A 7·1%
B 2·6%
C 5·1%
D 5·3%
(ACCA F9 Financial Management Pilot Paper 2014)

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4. Arnold is contemplating purchasing for $280,000 a machine which he will use to

produce 50,000 units of a product per annum for five years. These products will be
sold for $10 each and unit variable costs are expected to be $6. Incremental fixed costs
will be $70,000 per annum for production costs and $25,000 per annum for selling and
administration costs. Arnold has a required return of 10% per annum.

By how many units must the estimate of production and sales volume fall for the
project to be regarded as not worthwhile?

A 2,875
B 7,785
C 8,115
D 12,315

5. A project has the following cash flows.

T0 Outflow $110,000
T1-4 Inflow $40,000

At the company’s cost of capital of 10% the NPV of the project is $16,800.

Applying sensitivity analysis to the cost of capital, what percentage change in the cost
of capital would cause the project NPV to fall to zero?

A 70%
B 17%
C 5%
D 41%

6. A company has a cost of capital of 10%. Project A has the following present values.

$
Initial investment 300,000
Cash inflows 600,000
Cash outflows 100,000

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What is the sensitivity of Project A to changes in the cash inflows?

A 33%
B 40%
C 67%
D 300%

Question 1 – NPV and Sensitivity Analysis

Betula Co has recently acquired a patent, at a cost of $1·3 million, which would allow it to
manufacture and sell a product for measuring an individual’s bio-rhythms. The marketing
department of Betula Co estimates that 300,000 units of this product can be sold during each
of the next four years. The selling price of the product is $24 and variable costs are
estimated to be $18 per product. Fixed costs (excluding depreciation) are estimated to be
$2·2 million per year. This figure consists of $1·4 million additional fixed costs and $0·8
million existing fixed costs that are to be apportioned to the new product.

To manufacture the new product, equipment costing $1·5 million will be acquired
immediately. The estimated residual value of this equipment in four years’ time is $0·5
million. The company calculates depreciation on a straight-line basis.

The cost of capital of Betula Co is 9%.

Betula is currently considering whether to go ahead with the project.

Required:

(a) Calculate the net present value of the decision to go ahead with the project. (5 marks)
(b) Undertake sensitivity analysis to show the change needed to each of the following
before a zero NPV is achieved:
(i) discount rate;
(ii) initial outlay on equipment;
(iii) net annual operating cash flows;
(iv) residual value of the equipment. (11 marks)
(c) Evaluate briefly the information produced in your answer to (a) and (b) above and
state, with reasons, whether or not the project should go ahead. (4 marks)
(Total 20 marks)

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2.8 Strengths and weaknesses of sensitivity analysis

Strengths Weaknesses
(a) No complicated theory to (a) It assumes that changes to
understand. variables can be made
(b) Information will be presented to independently, e.g. material
management in a form which prices will change independently
facilitates subjective judgement to of other variables. This is unlikely.
decide the likelihood of the If material prices went up the firm
various possible outcomes would probably increase selling
considered. price at the same time and there
(c) Identifies areas which are crucial would be little effect on NPV.
to the success of the project. If (b) It only identifies how far a
the project is chosen, those areas variable needs to change. It does
can be carefully monitored. not look at the probability of
(d) Indicates just how critical are such a change.
some of the forecasts which are (c) It is not an optimising technique.
considered to be uncertain. It provides information on the
basis of which decisions can be
made. It does not point directly to
the correct decision.

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3. Probability Analysis and Expected Value (EV)

(Dec 07, Jun 11, Jun 12, Jun 15)
3.1 Principles of probability analysis

3.1.1 Principles of probability analysis

(a) This approach involves assigning probabilities to each outcome of an

investment project, or assigning probabilities to different values of project
variables.
(b) The range of NPVs that can result from an investment project is then
calculated, together with the joint probability of each outcome. The NPVs
and their joint probabilities can be used to calculate the mean or average
NPV (the expected NPV or ENPV) which could arise if the investment
project could be repeated a large number of times.
(c) Other useful information that could be provided by the probability
analysis includes the worst outcome, the best outcome and the most
likely outcome. Managers could then make a decision on the investment
that took account more explicitly of its risk profile.

3.2 Expected value

3.2.1 EXPECTED VALUE

The EV is the weighted average of all possible outcomes, with the weightings
based on the probability estimates.

The formula for calculating an EV is:

EV =
Where: p = the probability of an outcome
x = the value of an outcome

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3.2.2 EXAMPLE 2
A firm has to choose between three mutually exclusive, the outcomes of which
depend on the state of the economy. The following estimates have been made:

State of the Recession Stable Growing

economy
Probability 0.5 0.4 0.1
NPV ($000) NPV ($000) NPV ($000)
Project A 100 200 1,400
Project B 0 500 600
Project C 180 190 200

Determine which project should be selected on the basis of expected market values.

Solution:

Project A

State of the economy Probability Project NPV EV

$000 $000
Recession 0.5 100 50
Stable 0.4 200 80
Growing 0.1 1,400 140
270

Project B

State of the economy Probability Project NPV EV

$000 $000
Recession 0.5 0 0
Stable 0.4 500 200
Growing 0.1 600 60
260

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Project C
State of the economy Probability Project NPV EV
$000 $000
Recession 0.5 180 90
Stable 0.4 190 76
Growing 0.1 200 20
186

On the basis of expected values, Project A should be selected.

However, it should be noted that Project A is also the most risky option as it has the
widest range of potential outcomes.

3.2.3 EXAMPLE 3
ABC Co is considering an investment of $460,000 in a non-current asset expected
to generate substantial cash inflows over the next five years. Unfortunately the
annual cash flows from this investment are uncertain, but the following probability
distribution has been established:

Annual cash flow ($) Probability

50,000 0.3
100,000 0.5
150,000 0.2

At the end of its five-year life, the asset is expected to sell for $40,000. The cost of
capital is 5%.

Should the investment be undertaken?

Solution:

Expected annual cash flows are:

Annual cash flow Probability EV
50,000 0.3 15,000
100,000 0.5 50,000
150,000 0.2 30,000
95,000

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NPV calculation:
Time Cash flow DF 5% PV
0 (460,000) 1.000 (460,000)
1 95,000 4.329 411,255
2 40,000 0.784 31,360
NPV = (17,385)

As the ENPV is negative, the project should not be undertaken.

An alternative approach would be to calculate three separate NPVs and then

combine them, giving the following figures:

Annual cash flow Probability PV

50,000 0.3 (212,190)
100,000 0.5 4,260
150,000 0.2 220,710

ENPV = 0.3 × (212,190) + 0.5 × 4,260 + 0.2 × 220,710 = (17,385)

Even though the ENPV is negative these figures show that there is a 70% chance of
the project giving a positive NPV. Some investors may consider the project
acceptable on this basis.

3.2.4 Test your understanding 1

A company is considering whether to invest in equipment for providing a new
service to its clients. The equipment will cost $100,000 and will have a disposal
value of $20,000 after four years. Estimates of sales and incremental fixed cost
cash expenditures are as follows.

Annual cash flow ($) Probability

600,000 0.4
700,000 0.4
800,000 0.2

The company expects to achieve a contribution/sales ratio of 40% on all the

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services it provides. Incremental fixed costs will be $215,000 per annum. The
project has a four-year life.

The company’s cost of capital is 9%.

Calculate the three possible NPVs and the expected NPV. Comment on your
results.

Solution:

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Question 2 – ENPV
Carcross Co engages in off-shore drilling operations for oil deposits. The company has
recently spent $5 million in surveying a region in the Gulf of Mexico and has found the
existence of significant oil deposits there. The sea bed in the region, however, has a rock
formation that may make access to the oil deposits difficult. The total oil deposits in the
region have been estimated at 30 million barrels but the amount extracted will vary
according to the conditions faced when drilling operations commence. The company’s
senior geologist believes that three possible outcomes are likely from drilling operations and
has made the following estimates concerning the percentage of total oil deposits that will be
extracted under each outcome:

Outcome Percentage of total oil Probability

deposits extracted
1 100% 0.1
2 40% 0.5
3 25% 0.4

If the company decides to go ahead with the drilling operation, an immediate payment of
$40 million for drilling rights, along with annual payments of $5 for each barrel of oil
extracted must be made to the Mexican government. Equipment costing $125 million must
be acquired immediately but drilling will not commence until the second year of the four-
year licence period. It is expected that, whichever of the above outcomes arise, the oil will
be extracted evenly over the drilling period. Annual operating costs (excluding any
payments to the Mexican government) will be $120 million in the first year and $160
million for each of the remaining three years of the licence. At the end of the licence period,
the equipment will be sold at a price that is equal to its original cost less $8 for each barrel
of oil that has been extracted.

Oil prices over the period of the drilling licence are estimated to be as follows:

Year Price per barrel

1 $70
2 $85

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3 $75
4 $100

The company has a cost of capital of 14%.

Workings should be in $millions and to one decimal place.
Required:

(a) Calculate the expected net present value (ENPV) of the investment proposal.
(10 marks)
(b) Calculate the net present value of the worst possible outcome. (5 marks)
(c) Comment on the results of your calculations in (a) and (b) above. (2 marks)
(d) Discuss the weaknesses of the ENPV approach for decision-making purposes.
(3 marks)
(20 marks)

3.2.5 EXAMPLE 4
A company is considering a project involving the outlay of $300,000 which it
estimates will generate cash flows over its two year life at the probabilities shown
in the following table.
Year 1
Annual cash flow ($) Probability
100,000 0.25
200,000 0.50
300,000 0.25

Year 2
If cash flows in Year 1 There is probability of: That the cash flow in
is: Year 2 will be:
100,000 0.25 Nil
0.50 100,000
0.25 200,000

200,000 0.25 100,000

0.50 200,000
0.25 300,000

300,000 0.25 200,000

0.50 300,000

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0.25 350,000

The company’s investment criterion for this type of project is 10% DCF.

You are required to calculate the expected value of the project’s NPV and the
probability that the NPV will be negative.

Solution:

Calculate expected value of the NPV.

First we need to draw up a probability distribution of the expected cash flows. We
begin by calculating the PV of the cash flows.

Year Cash flow DF 10% PV

$000 $000
1 100 0.909 90.9
1 200 0.909 181.8
1 300 0.909 272.7
2 100 0.826 82.6
2 200 0.826 165.2
2 300 0.826 247.8
2 350 0.826 289.1

Year 1 Prob. Year 2 Prob. Joint Total PV EV of PV

PV of PV of cash Prob. of cash of cash
cash flow flow inflows inflows
$000 $000 $000 $000
(a) (b) (c) (d) (b) × (d) (a) + (c)
90.9 0.25 0.0 0.25 0.0625 90.9 5.681
90.9 0.25 82.6 0.50 0.125 173.5 21.688
90.0 0.25 165.2 0.25 0.0625 256.1 16.006
181.8 0.50 82.6 0.25 0.125 264.4 33.05
181.8 0.50 165.2 0.50 0.250 347 86.75
181.8 0.50 247.8 0.25 0.125 429.6 53.70
272.7 0.25 165.2 0.25 0.0625 437.9 27.369
272.7 0.25 247.8 0.50 0.125 520.5 65.063

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272.7 0.25 289.1 0.25 0.0625 561.8 35.113

344.420

$
EV of PV of cash inflows 344,420
Less: Project cost 300,000
EV of NPV 44,420
Measure risk:
Since the EV of the NPV is positive, the project should go ahead unless the risk is
unacceptably high. The probability that the project will have a negative NPV is the
probability that the total PV of cash inflows is less than $300,000. From the column
headed ‘Total PV of cash inflows’, we can establish that this probability is 0.0625 +
0.125 + 0.0625 + 0.125 = 0.375 or 37.5%. This might be considered an
unacceptably high risk.

Question 3 – Expected value and Working Capital Management

ZSE Co is concerned about exceeding its overdraft limit of $2 million in the next two
periods. It has been experiencing considerable volatility in cash flows in recent periods
because of trading difficulties experienced by its customers, who have often settled their
accounts after the agreed credit period of 60 days. ZSE has also experienced an increase in
bad debts due to a small number of customers going into liquidation.

The company has prepared the following forecasts of net cash flows for the next two
periods, together with their associated probabilities, in an attempt to anticipate liquidity and
financing problems. These probabilities have been produced by a computer model which
simulates a number of possible future economic scenarios. The computer model has been
built with the aid of a firm of financial consultants.

Period 1 cash flow Probability Period 2 cash flow Probability

$000 $000
8,000 10% 7,000 30%
4,000 60% 3,000 50%
(2,000) 30% (9,000) 20%

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ZSE Co expects to be overdrawn at the start of period 1 by $500,000.

Required:

(a) Calculate the following values:

(i) the expected value of the period 1 closing balance;
(ii) the expected value of the period 2 closing balance;
(iii) the probability of a negative cash balance at the end of period 2;
(iv) the probability of exceeding the overdraft limit at the end of period 2.
Discuss whether the above analysis can assist the company in managing its cash flows.
(13 marks)
(b) Identify and discuss the factors to be considered in formulating a trade receivables
management policy for ZSE Co. (8 marks)
(c) Discuss whether profitability or liquidity is the primary objective of working capital
management. (4 marks)
(Total 25 marks)
(ACCA F9 Financial Management June 2010 Q1)

3.3 The standard deviation of the NPV

3.3.1 The disadvantage of using the EV of NPV approach to assess the risk of the project is
that the construction of the probability distribution can become very complicated.
If we were considering a project over 4 years, each year have five different forecasted
cash flows, there would be 625 (5 4) NPVs to calculate. To avoid all of these
calculations, an indication of the risk may be obtained by calculating the standard
deviation of the NPV.

3.3.2 EXAMPLE 5
Frame Co is considering which of two mutually exclusive projects, A or B, to
undertake. There is some uncertainty about the running costs with each project, and
a probability distribution of the NPV for each project has been estimated, as
follows.

Project A Probability Project B Probability

NPV NPV
$000 $000
– 20 0.15 +5 0.2

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+ 10 0.20 + 15 0.3
+ 20 0.35 + 20 0.4
+ 40 0.30 + 25 0.1

You are required to decide which project should the company choose, if either.

Solution:

We can begin by calculating the EV of the NPV for each project.

Project A Project B
NPV Prob. EV NPV Prob. EV
$000 $000 $000 $000
– 20 0.15 (3.0) 5 0.2 1.0
10 0.20 2.0 15 0.3 4.5
20 0.35 7.0 20 0.4 8.0
40 0.30 12.0 25 0.1 2.5
18.0 16.0

Project A has a higher EV of NPV, but what about the risk of variation in the NPV
above or below the EV? This can be measured by the standard deviation of the
NPV.

The standard deviation of a project’s NPVs, can be calculated as:

, where is the EV of the NPV.

Project A, = 18 Project B, = 16
x p x- p(x - )2 x p x- p(x - )2
– 20 0.15 – 38 216.6 5 0.2 – 11 24.2
10 0.20 –8 12.8 15 0.3 –1 0.3
20 0.35 +2 1.4 20 0.4 +4 6.4
40 0.30 + 22 145.2 25 0.1 +9 8.1
376.0 39.0

Project A Project B

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Standard deviation Standard deviation

s= = 19.391 s= = 6.245
= $19,391 = $6,245

Although Project A has a higher EV of NPV, it also has a higher standard deviation
of NPV, and so has greater risk associated with it.

Which project should be selected? Clearly it depends on the attitude of the

company’s management to risk.
(a) If management are prepared to take the risk of a low NPV in the hope of a
high NPV they will opt for project A.
(b) If management are risk-averse, they will opt for the less risky project B.

3.4 Advantages and limitation of expected values

Advantages Limitations
(a) The technique recognises that (a) By asking for a series of forecasts
there are several possible the whole forecasting procedure
outcomes and is, therefore, more is complicated. Inaccurate
sophisticated than single value forecasting is already a major
forecasts. weakness in project evaluation.
(b) Enables the probability of the The probabilities used are also
different outcomes to be usually very subjective.
quantified. (b) The EV is merely a weighted
(c) Leads directly to a simple average of the probability
optimising decision rule. distribution, indicating the
(d) Calculations are relatively average payoff if the project is
simple. repeated many times.
(c) The EV gives no indication of
the dispersion of possible
outcomes about the EV. The more
widely spread out the possible
results are, the more risky the
investment is usually seen to be.
The EV ignores this aspect of the
probability distribution.
(d) The EV technique also ignores

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the investor’s attitude to risk.

Some investors are more likely to
take risks than others.

Multiple Choice Questions

7. A risk averse investor is considering four mutually exclusive investments, which have
the following characteristics:

Project Expected return Standard deviation of

expected returns
Alpha 15% 5%
Beta 14% 8%
Gamma 25% 10%
Delta 12% 5%

Which two of the above investments will the investor immediately REJECT?

A Alpha and Beta

B Alpha and Gamma
C Gamma and Delta
D Beta and Delta

8. When using the expected value criterion, it is assumed that the individual wants to

A Minimize risk for a given level of return

B Maximize return for a given level of risk
C Minimize risk irrespective of the level of return
D Maximize return irrespective of the level of risk

9. The lower risk of a project can be recognized by increasing

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A The cost of the initial investment of the project

B The estimates of future cash inflows from the project
C The internal rate of return of the project
D The required rate of return of the project

10. Which of the following are true in respect of using expected values in net present
value calculations?

1 Appropriate for one-off events

2 Hides risk
3 Probably won’t actually occur
4 Eliminates uncertainty

A 1, 2 and 3 only
B 3 and 4 only
C 2 and 3 only
D 1, 2 and 4

11. Sales volumes are expected to be either 20,000 units with 60% probability or they are
expected to be 25,000 units. Price will either be $10 (0.3 probability) or else $15.
Margins are expected to be 30% or 40% of sales with an even chance of each.

What is the expected total cost?

A $103,950
B $193,050
C $297,000
D $105,000

12. An investment project has a cost of $12,000, payable at the start of the first year of
operation. The possible future cash flows arising from the investment project have the

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following present values and associated probabilities:

PV of Year 1 cash Probability PV of Year 2 Cash Probability

flow ($) flow ($)
16,000 0.15 20,000 0.75
12,000 0.60 (2,000) 0.25
(4,000) 0.25

What is the expected value of the net present value of the investment project?

A $11,850
B $28,700
C $11,100
D $76,300
(ACCA F9 Financial Management December 2014)

13. Which of the following statements are correct?

(1) The sensitivity of a project variable can be calculated by dividing the project net
present value by the present value of the cash flows relating to that project
variable
(2) The expected net present value is the value expected to occur if an investment
project with several possible outcomes is undertaken once
(3) The discounted payback period is the time taken for the cumulative net present
value to change from negative to positive

A 1 and 2 only
B 1 and 3 only
C 2 and 3 only
D 1, 2 and 3
(ACCA F9 Financial Management June 2015)

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Question 4 – Risk, uncertainty, payback, sensitivity analysis and ENPV

Umunat plc is considering investing $50,000 in a new machine with an expected life of five
years. The machine will have no scrap value at the end of five years. It is expected that
20,000 units will be sold each year at a selling price of $3·00 per unit. Variable production
costs are expected to be $1·65 per unit, while incremental fixed costs, mainly the wages of a
maintenance engineer, are expected to be $10,000 per year. Umunat plc uses a discount rate
of 12% for investment appraisal purposes and expects investment projects to recover their
initial investment within two years.

Required:

(a) Explain why risk and uncertainty should be considered in the investment appraisal
process. (5 marks)
(b) Calculate and comment on the payback period of the project. (4 marks)
(c) Evaluate the sensitivity of the project’s net present value to a change in the following
project variables:
(i) sales volume;
(ii) sales price;
(iii) variable cost;
and discuss the use of sensitivity analysis as a way of evaluating project risk.
(10 marks)

(d) Upon further investigation it is found that there is a significant chance that the
expected sales volume of 20,000 units per year will not be achieved. The sales

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manager of Umunat plc suggests that sales volumes could depend on expected
economic states that could be assigned the following probabilities:

Economic state Poor Normal Good

Probability 0.3 0.6 0.1
Annual sales volume (units) 17,500 20,000 22,500

Calculate and comment on the expected net present value of the project.(6 marks)
(25 marks)
(ACCA 2.4 Financial Management and Control December 2004 Q5)

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4. Adjusted Payback
(Jun 09, Jun 11)
4.1.1 Payback can be adjusted for risk:
(a) Higher risk project should require shortening the payback period.
(b) It puts the focus on cash flows that are more certain (less risky) because they
are nearer in time.
4.1.2 Discounted payback:
(a) It can be adjusted for risk by discounting future cash flows with a risk-
adjusted discount rate.
(b) The normal payback period target can be applied to the discounted cash
flows, which will have decreased in value due to discounting.
(c) The overall effect is similar to reducing the payback period with
undiscounted cash flows.

5. Simulation (模擬)

5.1 Sensitivity analysis considered the effect of changing one variable at a time.
Simulation improves on this by looking at the impact of many variables changing
at the same time.
5.2 Using mathematical, it produces a distribution of the possible outcomes from the
project. The probability of different outcomes can then be calculated.

5.3 EXAMPLE 6
The following probability estimates have been prepared for a proposed project.

Year Probability
Cost of equipment 0 1.00 (40,000)
Revenue each year 1–5 0.15 40,000
0.40 50,000
0.30 55,000
0.15 60,000

Running costs each year 1–5 0.10 25,000

0.25 30,000
0.35 35,000
0.30 40,000

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The cost of capital is 12%. Assess how a simulation model might be used to assess
the project’s NPV.

Solution:

A simulation model could be constructed by assigning a range of random number

digits to each possible value for each of the uncertain variables. The random
numbers must exactly match their respective probabilities. This is achieved by
working upwards cumulatively from the lowest to the highest cash flow values and
assigning numbers that will correspond to probability groupings as follows.

Revenue Running costs

$ Prob. Random $ Prob. Random
No. No.
40,000 0.15 00 – 14 * 25,000 0.10 00 – 09
50,000 0.40 15 – 54 ** 30,000 0.25 10 – 34
55,000 0.30 55 – 84 *** 35,000 0.35 35 – 69
60,000 0.15 85 – 99 40,000 0.30 70 – 99

* Probability is 0.15 (15%). Random numbers are 15% of range 00 – 99.

** Probability is 0.40 (40%). Random numbers are 40% of range 00 – 99 but
starting at 15.
*** Probability is 0.30 (30%). Random numbers are 30% of range 00 – 99 but
starting at 55.

For revenue, the selection of a random number in the range 00 and 14 has a
probability of 0.15. This probability represents revenue of $40,000. Numbers have
been assigned to cash flows so that when numbers are selected at random, the cash
flows have exactly the same probability of being selected as is indicated in their
respective probability distribution above.

Random numbers would be generated, for example by a computer program, and

these would be used to assign values to each of the uncertain variables.

For example, if random numbers 378420015689 were generated, the values

assigned to the variables would be as follows.

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Revenue Running costs

Calculation Random No. Value Random No. Value
$ $
1 37 50,000 84 40,000
2 20 50,000 01 25,000
3 56 55,000 89 40,000

A computer would calculate the NPV many times over using the values established
in this way with more random numbers, and the results would be analysed to
provide the following.

(a) An expected value for the project.

(b) A statistical distribution pattern for the possible variation in the NPV above
or below this average.

The decision whether to go ahead with the project would then be made on the basis
of expected return and risk.

5.4 Advantages and drawbacks of simulation

Advantages Drawbacks
(a) It includes all possible outcomes (a) Models can become extremely
in the decision-making process. complex and the time and costs
(b) It is a relatively easily involved in their construction can
understood technique. be more than is gained from the
(c) It has a wide variety of improved decisions.
applications (inventory control, (b) Probability distributions may be
component replacement, etc.) difficult to formulate.

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Multiple Choice Questions

14. When considering investment appraisal under uncertainty, a simulation exercise

A Considers the effect of changing one variable at a time

B Considers the impact of many variables changing at the same time
C Points directly to the correct investment decision
D Assesses the likelihood of a variable changing

15. What is the main advantage of using simulations to assist in investment appraisal?

A A clear decision rule

B More than one variable can change at a time
C Statistically more accurate than other methods
D Being diagrammatic it is easier to understand

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