4.5 The value of information
You saw in the example in Subsection 4.3.3 that by determining whether or not the product will be a success in advance, the company can increase the expected NPV from the project by £225,000. Without this information the project would not go ahead at all so the NPV would be zero. With this information the company has a 50% chance of gaining an NPV of £450,000, so the expected value is 50% of £450,000. The increase of £225,000 in NPV, attributable to holding information that is used in decisions about whether to proceed with projects, is sometimes called the value of information.
More formally, the value of information is the weighted average of the increase in value which having that information will generate. The NPV that would be achieved with the information is compared with the NPV that would be achieved without the information for each possible scenario. Table 21 shows this for the example above:
Table 21 Demonstrating the probability-weighted increase in NPV from having information about demand
|Good demand NPV||Poor demand NPV|
|With information about demand||450,000||0*|
|Without information about demand||0*||0*|
|Difference in NPV from information||450,000||0|
|Probability of scenario||0.5||0.5|
|Difference from information weighted by probability of that scenario||Total 225,000||0|
|Total of differences in NPV weighted by probability of each scenario||Total 225,000|
The value of information of £225,000 is the maximum amount that it is worth paying for the market research to determine the demand for the product. Since in this case the market information costs only £25,000, there is an overall increase in NPV of £200,000 after paying for the market research.
Calculating the value of knowing information about a project can highlight areas where a company can benefit from putting more resources into resolving uncertainty. Obtaining certain information can change what decisions are made and increase the expected NPV and, if so, it is worthwhile spending some money to obtain that extra information.
This section has reviewed how risk and uncertainty arise in project appraisal, and described some techniques to deal with them. The difference between risk and uncertainty and the attitudes towards them that people can take were discussed. You saw some simple adjustments which can be made to account for risk; how to combine probabilities and cash flows to account for risk; and how to model different scenarios in a spreadsheet. You also learned how to work out the value of gaining additional information when making decisions.