4 Dealing with risk and uncertainty in project appraisal
During this course, we have dealt with information as if the cash flows from decisions are known with certainty. The cash flows used to calculate NPV have been supplied to you without any reference to how accurate they are or whether they are only estimates from a range of values. Information about this is needed, because in real life the future is never known for certain and we are interested in the range of outcomes which could occur, not just the best estimate of what might happen. Investment decisions are particularly susceptible to risk and uncertainty, because the cash inflows from an investment can take place over many years or even decades. The number of years these cash flows will last; how large these cash flows will be; and whether they will even take place at all are all uncertainties.
This section looks at risk and uncertainty in more detail, and how it can be taken into account during project appraisal. This section begins with a discussion on the difference between risk and uncertainty, and typical attitudes which people have towards risk and uncertainty. We discuss some simple ways to adjust the discount rate and payback period to take risk into account. We explain how combining cash flows with their probabilities of occurring can be used to provide information about the expected values for the outcomes of projects. Finally the value of further information when making decisions is defined.
At the end of this section you should:
- be able to discuss the technical definitions of risk and uncertainty, and the range of attitudes which can be taken towards them
- be able to demonstrate some simple adjustments to NPV analysis to deal with risk
- know how to calculate probability-weighted cash flows, and explain why this approach is effective when risk is present in NPV analysis
- be able to apply probabilities to future outcomes, and explain why this is an alternative to an increased discount rate
- be able to explain the meaning of value of information.