INVESTMENT RISK APPRAISAL
CHAPTER 7
Chapter outline
• Introduction
• What are uncertainty and risk and why do
they need to be assessed?
• Types of risk in investment projects
• Probability distributions and expected
values
• Using scenario analysis, sensitivity analysis
and simulation analysis to assess risk
• Break-even analysis as a measure of
dealing with risk (EMAC revision)
• Conclusion
Learning outcomes
By the end of this chapter, you should be able
to:
• Understand the importance of recognising
risk in investment appraisal.
• Identify the various types of risk involved in
investment projects.
• Discuss the use of probability distributions
and expected values in risk assessment.
• Discuss and apply scenario analysis,
sensitivity analysis and simulation analysis in
investment projects.
• Apply break-even analysis as a measure of
dealing with risk.
Introduction
• Capital investment decisions carry level of
risk
• Risk may impact on the end-result of
investment, especially investments in
businesses or projects in foreign countries
• Capital investment decisions are about the
future
• Risk and uncertainty need to be considered
when decisions are made
Uncertainty and risk
• Certainty
– Where there is no doubt about the outcome of
something
• Uncertainty
– Where one does not know which events or
factors will influence the end result of a project
and cannot attach probabilities to the occurrence
of possible events
Uncertainty and risk
• Risk
– There is the possibility of incurring loss or
misfortune because of uncertainty about the
future
• Probability
– Refers to the likelihood that a particular event
will occur
Risk vs. return
• Investment is done with the aim of generating
return
• The percentage return from an investment can be
calculated as follows
Example 7.1
Approaches to risk in
investment appraisal
• Risk tolerance – amount of risk an entity is
willing to take when making an investment
• Entity-specific risk is based on perceptions
of management and financial position of
the entity
– Usually an individual or entity is willing to accept
more risk if a greater return can be expected
Risk tolerance
• Risk averse
– Investors prefer to avoid risk and would not
accept higher risk unless the returns are
disproportionately higher to compensate for
taking on more risk
• Risk seekers
– Investors willing to take on more risk even if
expected returns are not proportionately higher
• Risk neutral
– Investors expect a proportionate increase or
decrease in return for accepting an increase or
decrease in risk
Types of risk in investment
projects
• Elementary risks
– Systematic – basic market risk because of
economic changes or other events, e.g. political
event which affects portfolio
– Unsystematic – more specific, affects fewer
investments at the same time, e.g. fire at factory
Types of risk in investment
projects
• Business risk
– Entity will not be able to finance its operating
costs, therefore having too much in fixed cost
versus variable cost
• Financial risk
– Entity is not able to cover its debt obligations
• Interest-rate risk
– Interest rate changes will adversely affect the
value of an investment
• Liquidity risk
– An investment cannot be sold at a reasonable
price
Types of risk in investment
projects
• Market risk
– Market factors unrelated to the investment (e.g.
political, economic or social factors) will
adversely affect the value of an investment
• Event risk
– Unexpected event will have an effect on a entity
and/or investment
• Exchange-rate risk
– Investment and/or investment returns will be
negatively affected by exchange rate fluctuations
Types of risk in investment
projects
• Purchasing-power risk
– Price level changes because of inflation which
will affect investments and/or investment returns
• Tax risk
– Changes in tax laws will negatively affect
investment and/or investment returns
• Credit or default risk
– Entity or individual cannot pay the returns due
on an investment or in a worst case cannot pay
back the amount originally invested
• Country risk
– Political and/or financial events in a country will
affect the investment worth or investment returns
Expected value
• The expected value is an average of the
possible outcomes, weighted by the
probability of the outcomes actually
occurring
Example 7.3
Break-even analysis as a
measure of dealing with risk
• Common tool for analysing the relationship
between sales volume and profitability
• Measures the point at which a capital
project breaks even and identifies the sales
level below which it will start losing money
• Indicates the level to which revenue could
fall without there being a reduction in the
value of the firm
Break-even analysis as a
measure of dealing with risk
• Total cost (TC) is equal to the sum of
variable costs (VC) (costs that change with
the quantity of output) and fixed operating
costs (FC) (costs that do not change with
the quantity of output)
– FC is a short-term concept - in the long run, all
costs are variable in nature
Break-even analysis
• Three common break-even measures
• Accounting break-even
– Sales volume at which net income = 0
• Cash break-even
– Sales volume at which operating cash flow = 0
• Financial break-even
– Sales volume at which net present value = 0
Conclusion
• It is important to incorporate risk into the
evaluation of investments and when deciding
about accepting or rejecting projects.
• Risk is the likelihood that the return on an
investment can be affected in an unfavorable way.
• Certainty is a state where only one end result is
possible.
• Uncertainty is a state where it is impossible to
exactly predict the future return on an investment.
Conclusion (cont.)
• Sensitivity analysis is used to establish how
sensitive the return on an investment is to changes
in the values of key variables in the evaluation of
investment projects.
• Scenario analysis overcomes the limitations of
sensitivity analysis by taking into consideration the
probability of changes in key variables associated
with inputs in the cash flows.
• Break-even analysis is a measure of dealing with
risk.
Conclusion (cont.)
• These methods make it possible to reduce the risk
of unforeseen circumstances having a negative
impact on the value of investments.