Page 5 - CIMA MCS Workbook November 2018 - Day 2 Suggested Solutions

SUGGESTED SOLUTIONS

TASK 3 ‐ DEALING WITH UNCERTAINTY IN INVESTMENT APPRAISAL

To: David Guy

From: Finance manager
Date: Today
Subject: Dealing with uncertainty in investment appraisal

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 predicted figures for these variables that we are
confident in. There are a number of techniques that we can use to help us to make better
decisions and to give us more confidence in those decisions.

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 sales increasing by 4,000 units per year as a
result of the packaging changes and a 30% chance of them increasing by 6,000 units per year then
we could calculate an average of (4,000 × 70% + 6,000 × 30%) 4,600 units per year as the expected
sales increase and use this 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 an extra 4,000 units per year wouldn’t be enough to produce a positive
net present value (NPV) but that 4,600 units would be. The use of EVs would give us an appraisal
that says we should go ahead with the project. However, there is still a 70% chance that only
4,000 extra units would be sold 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. But for a one‐off project such as changing
the packaging, EVS may not be appropriate unless further analysis is also done to assess the risk.

Identify best and worst case scenarios

One way of highlighting the risk levels involved is to run appraisals on both the best case (highest
extra volumes and lowest costs) and worst case (lowest extra volumes and highest costs)
scenarios.

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