AFMP4
Syllabus B. Advanced Investment Appraisal B1. Discounted cash flow techniques

B1aiv. Risk & Uncertainty basics 6 / 14

Syllabus B1aiv)

Evaluate the potential value added to an organisation arising from a specified capital investment project or portfolio using the net present value (NPV) model.

Project modelling should include explicit treatment and discussion of:

iv) Probability analysis and sensitivity analysis when adjusting for risk and uncertainty in investment appraisal

Risk

This is present when future events occur with measurable probability

Uncertainty

This is present when the likelihood of future events is incalculable

Risk & Uncertainty

  • Risk refers to the situation where probabilities can be assigned to a range of expected outcomes arising from an investment project and the likelihood of each outcome occurring can therefore be quantified

  • Uncertainty refers to the situation where probabilities cannot be assigned to expected outcomes. Investment project risk therefore increases with increasing variability of returns, while uncertainty increases with increasing project life

The analysis so far has assumed that all of the future cash flows are known with certainty. However, future cash flows are often uncertain or difficult to estimate.

A number of techniques are available for handling this complication. Some of these techniques are quite technical involving computer simulations or advanced mathematical skills and are beyond the scope of F9.

However, we can provide some very useful information to managers without getting too technical.

So there are 4 techniques we are going to look at:

  1. Sensitivity Analysis

  2. Probability Analysis

  3. Simulation

  4. Adjusted Payback