4.3.2 Calculating probability-weighted cash flows instead of increasing the discount rate
As mentioned above, it is tempting to try to estimate the increase of the discount rate rather than try to estimate the probability of certain outcomes occurring. However this practice should be avoided if possible (it is sometimes known as adding a fudge factor, obviously not a term of approval!). Ideally, major sources of risk that stem from one unknown outcome should be dealt with separately and then the remaining cash flows discounted at a lower discount rate.
For example, imagine that the project in Activity 8 also carries a risk that the project will not be approved by regulators, and consequently no sales will be made. If the project was originally going to be discounted at 10%, the company may now feel the project’s extra risk means it should be discounted at 15%. However a better approach is to estimate the probability of the undesirable outcome occurring. Table 20 shows the situation where there is a 20% probability of the project not being approved, and if it does go ahead, the likely revenue figures are in the same proportion as before.
| Sales revenue | Probability | Probability weighted cash flow |
|---|---|---|
| £ | £ | |
| 0 | 0.20 | 0 |
| 400,000 | 0.16 | 64,000 |
| 500,000 | 0.40 | 200,000 |
| 700,000 | 0.24 | Total 168,000 |
| Total | Total 432,000 |
So the cash flow used in an NPV calculation would be estimated as an expected value of £432,000 to take account of the possibility of a zero sale revenue.