Chapter 6 • Risk in investment appraisal
lProblems of EV:
lThe averaging process hides information, e.g. on the NPV and probability
of occurrence in the worst-case scenario.
lThe calculated EV could easily be a value that cannot actually occur.Diversification
lDiversification =the combining of investments with others whose returns are
independent of one another.
lTends to increase the probability that the EV for the portfolio is close to the
sum of the EVs of the individual investments, thereby reducing risk.
lIn practice, most investments are not independent; they are affected by com-
mon factors, to some extent.
lSpecific (unsystematic) risk =the risk of an investment arising from factors
that are independent of other investment returns.
lSystematic risk =the risk that is common to most investments.Utility theory
lA way of representing an individual’s preferences between two competing
desires.
lIndividuals seek to reach their highest level of satisfaction or utility.
lIndividuals are generally risk-averse, that is, they require increasingly large
increments of wealth to compensate them for increasing their risk.
lRisk aversion =an unwillingness to pay as much as the expected value of a
risky project to invest (or wager) in it.Risk analysis in practice
lIncreasingly, businesses formally consider risk when making investment
decisions.
lSensitivity analysis/scenario building, probability analysis and beta analysis
are widely used means of assessing riskiness.
lIncreasing the required discount rate and decreasing the required payback
period are popular ways of allowing for risk.Risk generally is dealt with very thoroughly in a number of texts, including those by Emery,
Finnerty and Stowe (2007) and Atrill (2009). The subject of probabilities is well explained by
Bancroft and O’Sullivan (2000), which also deals with expected values. The research study
by Alkaraan and Northcott (2006), which was cited in the chapter, is well worth reading.Further
reading