Summary
Risk
lRisk is of vital concern to decision makers.
Sensitivity analysis (SA)
lIn the context of an NPV appraisal, SA involves six steps:
1 Identify and estimate the various input factors to the decision.
2 Assess the project on the basis of the best estimates.
3 Take each input factor in turn and determine the value for it that will give
a zero NPV for the project when the other factors are left at their original
estimated values.
4 Compare each of the values determined in step 3 with the original best
estimate to gain an impression of the riskiness of the factor under
consideration.
5 Carry out any necessary research (for example, market research) to reassess
the risk in sensitive areas.
6 Make the decision and take any appropriate actions to reduce the risk in
sensitive areas (for example, entering fixed-price contracts for raw material
purchases).lBenefits of SA:
lEnables the decision maker to ‘get inside’ the project and see what are the
key issues.
lEasy to carry out and understand.lProblems with SA:
lNo decision rule provided.
lSensitivities are not directly comparable from one input factor to the next.
lRather static approach; ‘scenario building’ might be better.Expected value (EV )
lEV =the weighted (by probabilities) average of the possible outcomes.
lIn the context of NPV appraisal, EV can be deduced by either of two routes:
1 finding the EV of each input factor and then using the single EV of each
factor in the NPV assessment; or
2 identifying the NPV and probability of occurrence for each of the possible
outcomes for the project (probably an enormously large number, in prac-
tice) and then finding the weighted average of these.lRoute 1 is much easier, but only the EV is known; information on the spread
of possible results is not revealed.
lRoute 2 gives all of the results but in practice it can be impossible to cope with
the volume of data.
lEV can be helpful because it summarises a large amount of data into one
value.
Summary
‘