Page 6 - CIMA MCS Workbook May 2019 - Day 2 Suggested Solutions

CIMA MAY 2019 – MANAGEMENT CASE STUDY

TASK 3 – DEALING WITH RISK/UNCERTAINTY IN INVESTMENT
APPRAISAL

To: Carla Holm

From: Finance manager
Date: Today
Subject: Evaluation of risk/uncertainty of projects

Risk/uncertainty means that there may be a number of variables that we need to incorporate into
our investment appraisal but that we don’t have reliable figures for these variables, which may be
subject to a range of potential values or more than one outcome. There are a number of
techniques that we can use to help us to make better decisions and to give us more confidence in
our decision making process.

Expected values

Expected values (EVs) are calculations of long‐run averages for figures. Calculation of an average
means that we can take a scenario where there is a range of possible variables, say for increases
in sales or for a variable cost per unit, and reduce that range down to one figure to be used in an
investment appraisal.

EVs can be used to simplify investment appraisals when there are a number of different possible
outcomes and where we have a good idea of the likelihood of the possible outcomes occurring.
Without these likelihoods (probabilities) no EV can be calculated.

So if we predicted that there was a70% possibility of there being slow growth in the market,
meaning that we could sell 6 houses in the first year and a 30% chance of the market growing
quickly and we would be able to sell 10 houses then we could calculate an average of (6 × 70% +
10 × 30%) 7.2 houses in the first year, with appropriate follow‐on growth assumptions made for
following years and use these numbers in our appraisal.

This can be a dangerous approach to take though as it hides the risk that applies to the decision.
Let’s say, for instance that the slow growth market would not lead to an overall positive NPV for
the UK project but that a high growth would. The use of EVs would give us an appraisal that uses
middle ground figures. This may end up showing a positive NPV. However, there is still a 70%
chance that the slow growth market will arise and that we would end up with a project that didn’t
give us a positive NPV.

The risk of the potential loss‐making side of the project is hidden because the average result has
been used.

This wouldn’t be such a big deal if the project were repeated over and over again, as in the long‐
run, results would tend towards the average anyway. However, for a one‐off project such as
entering the UK market or not, EVS may not be appropriate unless further analysis is also done to
assess the risk.

90 KAPLAN PUBLISHING