Chapter 6 •Risk in investment appraisal6.8 Particular risks associated with making investments
overseas
In principle, investing in a project based overseas is the same as investing in a similar
one in the UK. There are, however, several respects in which the overseas project is
likely to be more risky. These issues will be discussed at length in Chapter 15, which
deals with various aspects of international investment and financing.6.9 Some evidence on risk analysis in practice
To gain some insight into the extent to which, and how, risk is taken into account in
practical investment decision making we shall rely on the researches of Alkaraan and
Northcott (2006) (A&N), whose findings are consistent with similar studies conducted
recently. This evidence relates to a survey of the largest businesses in the UK, con-
ducted in 2002.
The evidence seems to suggest that:
l Formal consideration of risk is very popular in practice and has increased in
popularity over recent decades.
l Some of the businesses that formally take account of risk use more than one
approach to dealing with it.
l There are three main approaches to assessing the riskiness of projects:- sensitivity analysis/scenario building, used by 89 per cent of A&N’s
respondents; - use of probabilities, used by 77 per cent; and
- beta analysis (assessing riskiness on the basis of the project’s systematic risk – see
below), used by 43 per cent.
l There are also two main approaches to distinguishing between projects on the basis
of their riskiness: - raising the required rate of return, this method being used by 82 per cent; and
- shortening the required payback period, used by 75 per cent.
6.10 Risk – the story so far
We have seen that it is logical and important to consider the riskiness of potential
investment projects as a routine part of their appraisal. Most businesses try to gain
some impression concerning the riskiness of projected investments by, for example,
carrying out a sensitivity analysis. We have also seen that most businesses seem to
react in a totally rational way to project riskiness by increasing the required rate of
return (the discount rate in an NPV assessment). This raises the question as to how
decision makers can judge by what amount to raise the discount rate as a reaction to
the level of riskiness perceived for a particular investment project.
An approach to linking the discount rate to risk levels, referred to in Section 6.8 as
‘beta analysis’, has been developed and is widely used in practice. We shall discuss
this approach and its validity in Chapter 7.Openmirrors.com