Chapter 6 • Risk in investment appraisal
way that Example 6.4 suggests, because specific risk factors for separate projects are
independent of each other.
Consider the perhaps unlikely example of a business whose investments are
diversified between making light bulbs and making chocolate. Project X might fail if
a new means of making light bulbs is discovered by a competitor; Project Y might fail
if there is a world shortage of cocoa. These are specific risk factors for separate projects
that are independent of each other. There is no reason to believe that the world mar-
ket for cocoa could possibly affect light-bulb making.
That part of the risk that cannot be diversified away because it is caused by factors
common to all activities is known as systematic risk. Such factors would include the
general level of demand in the economy, interest rates, inflation rates and labour costs.
Few, if any, activities are unaffected by these factors so diversification will not remove
the risk. These factors seem likely to affect both light-bulb and chocolate manufacture.
Clearly, businesses eager to eliminate specific risk by diversifying between indus-
tries must have more than half an eye on the fact that this is likely to have the effect of
taking them into areas in which they have no expertise or experience.
The existence of systematic risk means that expected value is not the whole answer
to dealing with risk. Not all of the risk is susceptible to elimination through
diversification. Systematic factors mean that expected value may well not occur for the
business as a whole, even though forecast assessments of financial effect and prob-
ability of occurrence of the various possible outcomes may be impeccable.
Before going on to consider another reason why expected value may not be a
complete way of dealing with risk, let us take a brief look at a useful way of express-
ing attitudes towards risk.6.6 Utility theory
Trading off preferences
The notion of utility provides a means of expressing individual tastes and preferences.
This is an important aspect of business finance and something to which we shall return
on several occasions in this book. Utility is the level of satisfaction that an individual
derives from some desirable factor, for example going away on holiday, having drink-
ing water available, eating caviar or having wealth. Utility and differing levels of it are
frequently represented graphically by indifference curves, each one showing a constant
level of utility or satisfaction for differing combinations of related factors.
The curve UU in Figure 6.2 represents the utility curve of the attitude of a particu-
lar individual towards holidays and how much money the person is prepared to
devote to them. 0S represents the total of the person’s cash resources, all of which
could be spent on going away on holiday this year. Alternatively, all or part of this
money could be retained for other purposes. The curve suggests that this particular
individual is prepared to spend some money to go on holiday. In fact the person is
prepared to spend a lot of savings in order to go for a short time (the curve is fairly
close to being horizontal at the bottom right). As we move up the curve (bottom right
to top left), less and less utility is derived from each extra day of holiday so that the
individual is prepared to give up less and less money for it. In fact, this individual
reaches a point towards the top of the curve where there is a reluctance to spend any
more money to get extra days of holiday (the curve becomes vertical). This suggests
that once this person has had a certain amount of holiday there is an unwillingness to‘