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IncorporatingUncertainty and Risk-Sensitivity Analysis
What happens if…..?
Investment appraisal is about projecting into the future so…
Nothing is certain…..
•All estimates have a margin of error
•A distinction can be made between riskand uncertainty
•Riskis related to the probability of an occurrence and is potentially insurable
•Uncertaintyis inherently unpredictable but…
•The distinction is not always very clear
Sources of Uncertainty
•Technical
–Materials –quality and quantity
–Spare parts –availability and delivery time
–Energy/fuel sources
–Technology –first time? –no experience, transfer of managerial control
•Organisational
–Organisational capacity (owner, contractors, suppliers, consultants)
–Managerial skills
–Labour –skills, quantity, availability, motivation
Sources of Uncertainty
•Economic factors
–Price changes
–Exchange rates and foreign exchange
–Competition from other producers/employers for:
•Markets
•Labour
•Raw materials
•Land and buildings
Sources of Uncertainty
•Socio-Political/Legal
–Administrative/bureaucratic
–Political uncertainty
–Social acceptability
–Changes in/clarity of laws affecting project
•Environmental
–Climate –rainfall
–Water supply/quality
–Earthquakes/volcanoes
Identifying Key Areas of Uncertainty
•Importance relates to
–The probabilityof a problem occurring and…
–The potential size of the impactin terms of cost and time
–Impact on output quality
•Approaches can be based on
–Expert consultation (qualitative/managerial approach)
–Identification of key parameters determining economic/financial performance (quantitative approach) or…
–A combination of both
Incorporating Uncertainty –Unsystematic Approaches
•Contingencies
–Expected physical contingencies are part of cost estimation but…
–Arbitrary addition of contingencies is not systematic
•Shorten the time horizon for analysis of the investment (e.g. use payback method)
–Commonly used by small businesses if they are very risk averse but……
–The approach is arbitrary –it puts no value on anything after payback period completed so….
–No consistent trade off is defined between benefits received at different points of time
Incorporating Uncertainty –Changing the Discount Rate
•One way to take account of uncertainty is to add a risk premium to the discount rate
–The more risky the project the higher the return expected
–Raising interest rates for risky loans is a common strategy used by banks so….
–Companies may also add a risk premium to the discount rate used for higher risk investments but…
–This procedure is biased against long term investments because….
–……it assumes uncertainty is directly related to time whereas the factors making a project more risky may not
Sensitivity Analysis
•Break even analysis
–Conventionally used to estimate break even production level (capacity utilisation)
–Can also be used for other parameters –‘switching values
•Range of Estimates
–‘Best’
–‘Optimistic’
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