Making capital investment decisions – further issues

Profitability index (PI)

Frequency of use of profitability index by large businesses

Comparing projects with unequal lives

NPV for Machine A using a common period of time

Inflation and investment appraisal

Investment appraisal and risk

Methods of dealing with risk in investment appraisal

      Sensitivity analysis

      Scenario analysis

      Simulations

      Risk-adjusted discount rate

      Expected values

      Portfolio approach

Factors affecting the sensitivity of NPV calculations for a new machine

Sensitivity analysis

      Helps managers see the margin of safety of each key factor.

      Can provide a basis for planning.

However,

      Does not give clear decision rules concerning acceptance or rejection of the project.

      Is a static form of analysis - Only one factor is considered at a time while the rest are held constant.

Scenario analysis

      Unlike Sensitivity analysis, Scenario analysis overcomes the problem of dealing with a single variable at a time.

      Scenario analysis changes a number of variables simultaneously so as to provide a particular ‘state of the world’, or ‘scenario’, for managers to consider.

      A popular form of scenario analysis is to provide 3 different states of the world or scenarios as follows:

                - Optimistic view of likely future events

                - Pessimistic view of likely future events

                - ‘Most likely’ view of future events

      This popular approach, however, does not indicate the likelihood of each scenario occurring and because it does not identify other possible scenarios that might occur.

      Nevertheless, optimistic and pessimistic scenarios may be useful in providing managers with some feel for the ‘downside’ risk and ‘upside’ potential associated with a project.

Simulations

      The Simulation approach is really a development of Sensitivity analysis.

      This approach involves a likelihood/probability distribution of occurrence.

      The main steps in simulation:

                Step 1 -  Identify the key variables and their interrelations

                Step 2 -  Specify the possible values for each variable

                Step 3 -  Carry out repeated trials using a selected value for each key variable and obtain a probability distribution of the cash flows of the project.

      Benefits of simulations approach include:

                - can help managers understand the nature of an investment project and the key issues to be resolved.

                -  provides a distribution of outcomes that can help assess the riskiness of a project.

      However, simulations can be costly and time-consuming.

Risk preferences

Relationship between risk and return

Expected value – standard deviation rule

Two projects whose returns have a perfect positive correlation

Two projects whose returns have a perfect negative correlation

 Diversifiable and Non-diversifiable risk

Diversifiable risk (Unsystematic risk):

      Specific to a particular project so a business can avoid/reduce the diversifiable risk associated with its projects by holding a diversified portfolio of investment projects.

      Ideally, a business should hold a spread of projects, such that when certain projects generate low returns, others generate high returns.

                Non-diversifiable risk (Systematic risk):

      Common to all projects so cannot be diversified away and

      Is based on general economic conditions (such as inflation rate, general level of interest rates, and economic growth rate) so all businesses are affected by systematic risk.

Reducing risk through diversification