Risk and Project Appraisal

As you consider investing in a project it is necessary to think about the possibility of failure. So, therefore, this chance that you might fail needs to be captured in the appraisal model.

Raising the discount rate is one way of dealing with project risk. There are 2 difficulties with this approach: A high degree of subjectivity in categorising projects into risk categories, and the difficulty of choosing an appropriate risk premium.

Sensitivity analysis: A method of allowing for risk (and one used by over 80% of large companies) which builds up a picture of possible outcomes by recalculating the NPV when one or more of the variables at a time is changed by a certain percentage or round amount. With sensitivity analysis managers can pay special attention to the potential for deviations from estimated mostly likely value for the variables. They may also pre-plan to control cash flows in that area.

We can also use the break-even model. Break-even represents the point at which no profits or losses are made. And, this occurs when total costs equals total revenue or when total contribution equals total fixed costs. In break-even analysis we try to establish the point at which the NPV becomes zero as one variable deviates from the most likely outcome.

In both sensitivity analysis and break even analysis we can look into how changing two variables may affect the NPV, especially when those variables might be related, such as volume and sales price.

Scenario analysis: managers consider more drastic events occurring or looking at best and worse cases in a project and review the consequent NPV.

Probability analysis: calculate the expected return and the standard deviation of the project given estimated probabilities for a range of possible outturns. Probability analysis is conducted by about one-third of large companies.

Expected NPV: weight each of the outcomes by the probability of occurrence and sum the result

Standard deviation: Standard deviation is a statistical measure of the dispersion around the expected value. Standard deviation is the square root of the variance.

To rank projects we generally assume that investors (and managers) are risk averse. That is, Project X will be preferred to project Y if at least one of the following applies: The expected return (NPV) of X is at least equal to the expected return of Y, and the variance is less than that of Y: or the expected return of X exceeds that of Y and the variance is equal to or less than that of Y.