Page 115 - FM Integrated WorkBook STUDENT 2018-19

Investment appraisal under uncertainty

Risk and uncertainty

1.1 The difference between risk and uncertainty

Risk and uncertainty affect investment appraisals because the appraisals are an
attempt to forecast the future of such things as cash flows, inflation rates, taxation
laws, cost of capital, etc., none of which may be known for certain over the life of the
investment.

Risk – quantifiable. Possible outcomes have associated probabilities,
thus allowing the use of mathematical techniques.

 Expected values

 Simulation

 Adjusted payback

 Risk-adjusted discount rates

Uncertainty – unquantifiable. Outcomes cannot be mathematically
modelled.

 Set minimum payback periods

 Make prudent estimates of cash flows in the appraisal

 Assess best and worst case scenarios

 Use sensitivity analysis

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