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Further aspects of investment appraisal

Dealing with risk in IA decisions

Investment appraisal often involves a degree of uncertainty and risk.
This may be dealt with in a number of ways:

 Adding a risk premium to the discount rate in order to compensate for risk

 Calculating the payback period to give an indication of risk

 Sensitivity Analysis

 Using probability distribution

 Monte Carlo simulation.

1.1 Sensitivity Analysis

Sensitivity analysis involves posing ‘what-if’ questions. The NPV is recalculated
under different conditions.

Alternatively, we may wish to discover the maximum possible change:

NPV
––––––––––––––––––––––––––– %
Sensitivity Margin =
PV of flow under consideration

Illustrations and further practice

Now try example 1 ‘Amador Ltd’ from Chapter 11.

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