Page 176 - AFM Integrated Workbook STUDENT S18-J19

Chapter 9

Incorporating risk into investment

appraisal

2.1 Introduction

The input variables in an investment appraisal are all estimates of likely
future outcomes. There are several methods of incorporating risk into
an investment appraisal, for example:

 expected values (probability analysis)

 sensitivity analysis

 Value at Risk (VaR)

 use of the CAPM model to derive a discount rate (covered in detail
in the earlier Chapters 6 and 7)

2.2 Expected values (probability analysis)

The expected value is calculated as the sum of (each outcome multiplied by its
associated probability).

Illustration 1

For example, if sales are expected to be either $1,000,000 or $1,500,000 with
probabilities of 35% and 65% respectively, the expected sales can be
calculated as ($1,000,000 × 0.35) + ($1,500,000 × 0.65) = $1,325,000

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