After studying this chapter you will be able to understand: Risk in investment appraisal, the risk adjusted discount rate, sensitivity analysis, sensitivity analysis – formulas, sensitivity analysis (d) sales volume, risk analysis in investment analysis, techniques for risk analysis. | Investment Analysis Lecture: 10 Course Code: MBF702 Outline RECAP Risk Analysis in investment analysis Techniques for risk analysis Comparing Methods 4 Risk in Investment Appraisal Risk: refers to a situation where the future is unclear and there is more than one possible outcomes. 4 5 Techniques for dealing with Risk The techniques for dealing with risk include: a) the expected NPV rule; b) the risk-adjusted discount rate approach; c) sensitivity analysis d) Simulation e) Scenario Analysis 5 6 Expected Net Present Value The expected NPV rule (ENPV): EV of a project is the mean value which will be obtained if the project was repeated many times over EV is not the most likely value of the project. It is only the weighted average of all the possible outcomes EV is calculated by multiplying the each possible outcome by its probability of occurrence and then add them up 7 Example Shorten Ltd needs to purchase a machine to manufacture a new product. The choice lies between two machines . | Investment Analysis Lecture: 10 Course Code: MBF702 Outline RECAP Risk Analysis in investment analysis Techniques for risk analysis Comparing Methods 4 Risk in Investment Appraisal Risk: refers to a situation where the future is unclear and there is more than one possible outcomes. 4 5 Techniques for dealing with Risk The techniques for dealing with risk include: a) the expected NPV rule; b) the risk-adjusted discount rate approach; c) sensitivity analysis d) Simulation e) Scenario Analysis 5 6 Expected Net Present Value The expected NPV rule (ENPV): EV of a project is the mean value which will be obtained if the project was repeated many times over EV is not the most likely value of the project. It is only the weighted average of all the possible outcomes EV is calculated by multiplying the each possible outcome by its probability of occurrence and then add them up 7 Example Shorten Ltd needs to purchase a machine to manufacture a new product. The choice lies between two machines (A and B). Each machine has an estimated life of three years with no scrap value. Machine A will cost £30,000 and machine B will cost £40,000, payable immediately in each case. The total variable cost of manufacture of each unit are £2 if made on machine A, but only £ if made on machine B. This is because machine B is more sophisticated and requires less labour to operate it. The product will sell for £8 each. The demand for the product is uncertain but is estimated at 2,000 units for each year, 3,000 units for each year or 5,000 units for each year. (Note that whatever sales level actually occurs, that level will apply to each year.) The sales manager has placed probabilities on the level of demand as follows: 7 8 Shorten Ltd: Example Annual demand Probability of occurrence 2000 3000 5000 Presume that both taxation and fixed costs will be unaffected by any decision made. Shorten Ltd’s cost of capital is 6% . Calculate the NPV for each of the three activity levels for
