Chapter 6 • Risk in investment appraisal
some major uncertainties but it will never remove them all. For example, a business
manufacturing armaments might await an expected major policy statement by the
government on the future of UK defence policy before making a decision on a
significant investment in its own manufacturing capacity.Risk and uncertainty
Some observers have sought to distinguish between risk and uncertainty. Risk is seen
as the phenomenon that arises from circumstances where we are able to identify the
possible outcomes and even their likelihood of occurrence without being sure which
will actually occur. The outcome of throwing a true die is an example of risk. We know
that the outcome must be a number from 1 to 6 (inclusive) and we know that each
number has an equal (1 in 6) chance of occurrence, but we are not sure which one will
actually occur on any particular throw.
Uncertainty describes the position where we simply are not able to identify all, or
perhaps not even any, of the possible outcomes, and we are still less able to assess their
likelihood of occurrence. Probably most business decisions are characterised by uncer-
tainty to some extent.
Uncertainty represents a particularly difficult area. Perhaps the best that decision
makers can do is to try to identify as many as possible of the feasible outcomes of their
decision and attempt to assess each outcome’s likelihood of occurrence.The importance of taking account of risk
It is vital that we take account of risk. This should be done in the most formal possible
way, not as an afterthought. The level of risk fundamentally affects a decision. We
should view very differently the opportunity to wager on a throw of a die and to
wager on the spin of a coin. If on payment of £1, we could either guess which face
of the die or which side of a coin would land upward, in either case the prize for a
correct guess being £5, which would we choose? Most people would probably be
happy to enter the coin-spinning wager, but few would be eager to go in for the die
throwing. This is because the level of risk attaching to each wager would cause us to
view them differently, even though they both have only two possible outcomes (lose
£1 or gain £4). It is the likelihood of each possible occurrence that would cause us to
distinguish between them.
We shall now go on to consider some ways in which risk in investment decisions
can be dealt with.6.2 Sensitivity analysis
All business investment decisions have to be made on the basis of predictions of the
various inputs. One approach is to assess the decision on the basis of the ‘best estim-
ate’ (that is, what the decision maker believes to be the most accurate prediction) of
each of the input factors. Assuming that the NPV is positive, the risk of the project can
be assessed by taking each input factor and asking by how much the estimate of that
factor could prove to be incorrect before it would have the effect of making the deci-
‘ sion a bad one. This approach is known as sensitivity analysis.