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Investment appraisal under uncertainty

Probability analysis

When there are several possible outcomes for a decision and probabilities can be
assigned to each, a probability distribution of expected cash flows can be estimated,
recognising that there are several possible outcomes, not just one. This could then
be used to:

 Calculate an expected value (EV)

 Measure risk by:

 calculating the worst possible outcome and its probability

 calculating the probability that the project will fail (e.g. that a negative NPV
will be the outcome)

 assessing the standard deviation of the outcomes

2.1 Expected values

An expected value is an average outcome weighted by the probabilities of each
individual income.

EV = ∑ p x

Where x = future outcome and p = probability of outcome occurring.

It can be used to find an average outcome for a project under different scenarios or
to find an average outcome for a particular input to go into an NPV calculation.

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