BUSF_A01.qxd

Chapter 6 • Risk in investment appraisal

Example 6.2 vastly oversimplifies the situation, both by assuming that there are

only three possible outcomes for sales volume and by assuming that there is only one

possible outcome for each of the other factors. Let us, however, take one more small

step towards reality.

Using the data from Example 6.1, let us assume that all the factors are known with certainty

(impossible in real life) except sales volume.

Extensive market research suggests that annual demand will be:

l 4,000 units (0.2 probable), or

l 4,500 units (0.5 probable), or

l 5,000 units (0.3 probable).

What are the possible outcomes (in terms of NPV) and how probable is each one?

Example 6.2

NPV at 4,000 units p.a. =−50,000 +[4,000 ×(10 −7) ×3.791]

=−£4,508 (probability 0.2)

NPV at 4,500 units p.a. =−50,000 +[4,500 ×(10 −7) ×3.791]

=+£1,179 (probability 0.5)

NPV at 5,000 units p.a. =−50,000 +[5,000 ×(10 −7) ×3.791]

=+£6,865 (probability 0.3)

Thus we have a description of the range and probabilities of the outcomes. (Remember

that it has been assumed that sales volume is the only factor whose value is not known with

certainty.)

Solution

Still staying with the data in Example 6.1, let us assume not only that the sales volume has

the same three possible outcomes, but that, independent of the sales volume, the cost of

labour will be:

l £3/unit (0.1 probable), or

l £4/unit (0.7 probable), or

l £5/unit (0.2 probable).

What are the possible outcomes and how likely is each one?

(Note that the word ‘independent’ in the above context means that the actual outcome as

regards sales volume implies nothing about the labour cost that is most likely.)

Example 6.3

l Subjective probabilities. These are based on opinions, preferably of experts, on the

possibilities and on their probability of occurrence.

However ascribed, the use of probabilities enables a fuller picture of the range of

outcomes to be considered.

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