Risk and Decision Making: Topic List

chapter 3
Risk and decision making
Contents
Introduction
Examination context
Topic List
1 Introduction to risk and uncertainty
2 Sensitivity analysis
3 Simulation
4 Expected values and attitude to risk
5 Diversification and the portfolio effect
Summary and Self-test
Answers to Self-test
Answers to Interactive questions
© The Institute of Chartered Accountants in England and Wales, March 2009 113
Financial management
Introduction
Learning objectives Tick off

 To understand the shortcomings of investment appraisal techniques and how these are
addressed practically
 To take account of uncertain outcomes by making use of expected values
 To appreciate the benefits of diversification and the resultant analysis of risk which is possible
 To be able to price systematic risk using the CAPM in determining a required rate of return
The syllabus references that relate to this chapter are 3f, g, i.
Practical significance
Risk and uncertainty is a constant feature of real life decision-making and the techniques explored in this
chapter illustrate how businesses can take account of it in their decision-making.
Stop and think

How reliable are the cash flow estimates in an NPV calculation? What steps would you take to address
shortcomings?
Working context
Dealing with uncertainty and subjective estimates is often part of an accountant's role – for example, in
assessing whether an asset's value is reasonable.
Syllabus links
This topic is taken forward at advanced level at a higher technical level, and in the case study where the
ideas are applied pragmatically.
114 © The Institute of Chartered Accountants in England and Wales, March 2009
RISK AND DECISION MAKING 3
Examination context
Exam requirements
In the exam you may be asked to take into account uncertainty either by commenting upon the
reasonableness of the estimates made, or by adjusting the required rate of return to reflect risk.
1 Introduction to risk and uncertainty
Section overview
 All business decisions are based on forecasts
 All forecasts are subject to varying degrees of uncertainty
 Consideration needs to be given as to how uncertainty can be reflected in financial evaluations.
There is possibly an upside to a decision – things may go better than expected (upside risk or potential). On
the other hand, there may be a downside where things go worse than expected (downside risk).
Shareholders are likely to be risk averse. This does not mean that they will not accept the potential
downside to projects (in order to avoid downside completely a firm would have to undertake no projects
at all) but it does mean that they will expect to be compensated for taking risks, i.e. the greater the risk
taken, the higher the returns required.
Some authors draw a distinction between risk and uncertainty as explained below.
1.1 Risk
When making a business decision, outcomes normally depend on the happening of various external events
beyond the firm's control. Decisions are usually said to be subject to risk if, although there may be several
possible outcomes, both these outcomes and their probabilities (i.e. the likelihood of each possible
outcome actually occurring) are known.
For example, the toss of a coin or the roll of the dice.
1.2 Uncertainty
It is quite likely that future outcomes cannot be predicted with much confidence from available data. It is
particularly the case that probabilities of various outcomes will be unknown.
Decisions are usually said to be subject to uncertainty if possible outcomes are known but probabilities are
unknown.
For example, most business decisions.
Although there is a clear distinction between these two problems, in practice the words 'risk' and
'uncertainty' are used interchangeably.
1.3 Methods of dealing with decision making under risk and

uncertainty
Risk is best handled by using probability distributions, expected values, simulation, portfolio theory, the
capital asset pricing model and risk-adjusted discount rates. All of these are dealt with later in this chapter.
Techniques for handling uncertainty are generally more crude but practically just as useful. These include
the following:
(a) Setting a minimum payback period for projects
(b) Increasing the discount rate subjectively in order to submit the project to a higher 'hurdle' rate in
investment appraisal
(c) Making prudent estimates of outcomes to assess the worst possible situation
(d) Assessing both the best and the worst possible situations to obtain a range of outcomes
(e) Using sensitivity analysis to measure the 'margin of safety' on input data (see next section)
2 Sensitivity analysis
Section overview
 How sensitive is the decision to the individual forecasts made?
 Technique is to take each forecast in turn and find the change needed that would cause the project to
breakeven.
2.1 Introduction
Investment involves expenditure now in return for a stream of future returns. The investment could be in
the form of physical assets (capital budgeting or working capital management) or securities. As in most
decision-making situations data is based on forecasts which are subject to varying degrees of uncertainty.
The task in investment appraisal involves deciding whether the uncertain cost of the investment is
outweighed by its uncertain benefits.
2.2 Basic principle

Sensitivity analysis is a formalised approach to incorporating alternative forecasts in the project evaluation.
The technique is to take each uncertain forecast one by one, and calculate the change necessary for the
NPV to fall to zero, i.e. this is essentially breakeven analysis in NPV terms. Breakeven analysis was
introduced in Management Information.
If sensitivity analysis is to be carried out, it is often useful to calculate net present values in such a way that
PVs are found of individual elements of costs and revenues over the life of the project. This means that the
tabular approach with headings 'Time', 'Cash flow', 'Discount factor', 'Present value ' may be preferred,
unless it becomes very cumbersome.
Worked example: Sensitivity analysis

Butcher Ltd is considering whether to set up a division in order to manufacture a new product, the Azam.
The following statement has been prepared, showing the projected profitability per unit of the new product.
CU CU
Selling price 22.00
Less Direct labour 5.00
Material 3 kg @ CU1.50 per kg 4.50
Variable overheads 2.50
(12.00)
Net contribution per unit 10.00
It is expected that 10,000 Azams would be sold each year at the above selling price. Demand for Azams is
expected to cease after five years. Direct labour and material costs would be incurred only for the duration
of the product life.
Other overheads have been calculated as follows.
CU
Rent 8,000
Salary 5,000
Manufacture of the Azam would require a specialised machine costing CU250,000.
The cost of capital of Butcher Ltd is estimated at 5% pa in real terms. Assume all costs and prices given
above will remain constant in real terms. All cash flows would arise at the end of each year, with the
exception of the cost of the machine which would be payable immediately.
Requirements
(a) Prepare net present value calculations, based on the estimates provided, to show whether Butcher Ltd
should proceed with the manufacture of the Azam.
(b) Prepare a statement showing the sensitivity of the net present value of manufacturing Azams to errors
of estimation in each of the three factors: material cost per unit, annual sales volume, and product life.
Ignore taxation.
Solution
(a) NPV calculation
Cash flows resulting from manufacture and sale of Azams:
Time Notes Cash Discount Present
flows factor value
CU'000 CU
0 Machine (a) (250) 1 (250,000)
1–5 Factory rent (8) 4.329 (34,632)

1–5 Manager's salary (b) (5) 4.329 (21,645)
1–5 Materials cost (c) (45) 4.329 (194,805)
1–5 Direct labour (c) (50) 4.329 (216,450) 432,900
1–5 Variable overheads (c) (25) 4.329 (108,225)
1–5 Sales revenue 220 4.329 952,380
Annual cash flow 87
Net present value 126,623
On the basis of the estimates given, manufacture of the Azam is worthwhile.

(b) Sensitivity to forecast errors
A summary of the analysis is shown in the following table:
Item Upper/lower limit for Maximum percentage error
project acceptability not affecting decision
Material cost per Azam (W1) CU7.425 65%
Annual sales volume (W2) 7,075 units 29%
Product life (W3) 3.2 years (approx) 36%
The table shows that the manufacture of Azams would still be worthwhile if product life were to fall to
about 3.2 years, or if annual sales were to fall to 7,075 units, or if material costs were to increase to
CU7.43 per Azam. These figures represent percentage errors of 36%, 29% and 65% respectively on
the original estimates. If the actual figures were within these percentages of the original estimates, the
decision to go ahead would still have been valid. These are large percentages and the net present value
is, therefore, remarkably insensitive to errors of estimation in the three factors.
WORKINGS
The approach taken is:
NPV of project
Sensitivity =
PV of cash flows subject to uncertainty
(1) Material price

For the project to break even:
The NPV must fall by CU126,623
The PV of materials cost (CU194,805) must rise by CU126,623
This PV must rise by CU126,623 ÷ CU194,805 = 65%.
Annual materials cost, and therefore unit materials cost, must rise by 65%.
If this unit price rise were caused entirely by a rise in material price:
the increase per unit would be CU4.50  0.65 = CU2.925
and the break-even materials price would be CU7.425 (CU4.50 + CU2.925).
(2) Annual sales volume
The part of NPV that is affected by change in sales volume is:
(CU952,380 revenue – CU108,225 variable overheads – CU216,450 direct labour – CU194,805
materials) = CU432,900
(see cash flow table in NPV above)
If the project NPV is to fall by CU126,623 as a result of the sales volume falling, this PV of CU432,900
must fall by CU126,623. This is a fall in PV contribution of:
NPV of project
Sensitivity =
PV of cashflows subject to uncertainty
CU126,623
= 0.2925 (29%)
CU432,900
The way in which the PV of annual contribution will fall by 29% is if contribution itself falls by 29%. This
in turn is the result if sales volume falls by 29%.
An alternative approach to this calculation is to use contribution and the annuity factor:
Contribution per unit = CU10 (CU22 sales revenue – CU12 variable cost)
The fall in annual contribution which gives a drop in NPV to break-even point (i.e. a drop of
CU126,623) is, using 4.329 the 5 year annuity factor:
Fall in annual contribution  4.329 = CU126,623
CU126,623
Fall in annual contribution = = CU29,250
4.329
i.e. if annual contribution falls by CU29,250 pa the NPV will be zero.
This is caused by a fall in annual demand of:
CU29,250
= 2,925 units
CU10
i.e. a fall of 29.25% of the planned volume of 10,000 units. The breakeven volume is therefore 7,075
units (10,000 – 2,925).
(3) Product life
The approach to sensitivity analysis to find the breakeven position is to set the NPV equal to zero.
i.e. NPV = (outlay) + PV of inflows
Zero = (250,000) + 87,000  Annuity factor for product life at 5%
250,000
 Annuity factor for product life at 5% = = 2.874
87,000
It is necessary to know for how many years this is the 5% annuity factor:
From annuity tables
Annuity factor for three years @ 5% = 2.723
Annuity factor for four years @ 5% = 3.546
Therefore, project NPV is zero if life is greater than:
2.874  2.723
3+ years (approximately) = 3.2 years
3.546  2.723
(Strictly speaking it should be said that the project will only change from being a success to a failure if
its life falls from four to three years, as all cash flows are assumed to be at the year end.)
The project's planned life is 5 years. It can be shortened by 1.8 years (5 – 3.2 breakeven life) which is
36% of the planned life.
In a practical situation this process would be continued to determine the sensitivity of the project to
all variables involved. This would include all costs, revenues and the discount rate (i.e. finding the IRR
of the project). Managers could then assess which variables were most crucial to the success of the
investment, and decide whether there were any ways of reducing the uncertainty relating to them.
Interactive question 1: Sensitivity analysis [Difficulty level: Intermediate]

The following information applies to a new project:
Initial cost CU125,000
Selling price CU100/unit
Variable costs CU30/unit
Fixed costs CU100,000 pa
Sales volume 2,000 units pa
Life 5 years
Discount rate 10%
Requirement
Calculate the project's NPV and show how sensitive the result is to the various input factors.
See Answer at the end of this chapter.
Where annual flows are not annuities, the approach remains the same (i.e. at what point does the NPV
become zero), although the calculations are rather more cumbersome.
Interactive question 2: Non-recurring cash flows [Difficulty level: Intermediate]

A company is about to embark on a two year project. Estimates of relevant inflows and outflows in current
terms are as follows:
Year 1 Year 2
CU CU
Sales 50,000 50,000
Costs 30,000 32,000
The following inflation rates are applicable to the flows:
Sales 6% pa
Costs 4% pa
Tax is payable at 30% on net flows.
The net cost of the project at t0, after allowing for capital allowance tax effects, is CU20,000.
The money cost of capital is 10% pa.
Requirements
(a) Calculate the NPV of the project.
(b) Assess the sensitivity of the investment decision to changes in sales revenue.
2.3 Strengths and weaknesses of sensitivity analysis

Strengths
Sensitivity Information will be presented to management in a form which facilitates subjective

judgment to decide the likelihood of the various possible outcomes considered.
Critical issues Identifies those areas which are critical to the success of the project; if it is undertaken
those areas can be carefully monitored.
 For example, if sales volume and/or price is identified as critical, further market
research may help to improve confidence in the estimates
 If the cost of materials or bought-in components is critical, then fixed price
contracts may be a possible way of limiting the cost and uncertainty. Alternatively,
it may be possible to use futures and options to limit materials costs
 However, it should be noted that these attempts to reduce risk are not costless –
market research costs money, option premiums must be paid, suppliers may
demand up-front payments on fixed price contracts
Simple No complicated theory to understand, it is relatively straightforward
Weaknesses
Independence It assumes that changes to variables can be made independently, e.g. material prices will
change independently of other variables, which is unlikely. If material prices were to rise,
the firm would probably increase selling price at the same time and there would be little
effect on NPV.
Ignores It only identifies how far a variable needs to change, it does not look at the probability of
probability such a change. In the above analysis, sales volume appears to be the most crucial variable
but, if the firm were facing volatile raw material markets, a 65% change in raw material
prices would be far more likely than a 29% change in sales volume.
No clear It is not an optimising technique. It provides information on the basis of which decisions
answer can be made. It does not point directly to the correct decision.
One way in which some of these short-comings can be addressed is scenario building. If the essentials of the
project being assessed are put on to a computer spreadsheet the analysis can be taken a lot further. A
series of assumptions can be made about the variables and the effect of each combination of assumptions
can be assessed, e.g. best and worst cases.
3 Simulation
Section overview
 Simulation allows for more than one variable at a time to change.
 Monte Carlo simulation uses random numbers to determine outcomes.
 Simulation has a number of drawbacks as a practical technique.
As noted above, one weakness of sensitivity analysis is that only one factor at a time is changed e.g. material
price, product life etc. In the real world it is likely that more than one factor will change at the same time.
Simulation is a technique which allows the effect of more than one variable changing at the same time to be
assessed.
3.1 Monte Carlo simulation

This is a simulation technique based on the use of random numbers and probability statistics to investigate
problems.
3.2 Who uses it?

Many companies use Monte Carlo simulation as an important tool for decision-making. For example
both General Motors and Procter and Gamble use simulation to estimate both the average return and the
riskiness of new products.
Worked example: Monte Carlo simulation

Outcome Probability
Head 0.5
Tail 0.5
A simulation of a coin being tossed might work as follows.
If a random number is selected:
Between: 0 – 4 (5 numbers) then a tail is assumed
Between: 5 – 9 (5 numbers) then a head is assumed
Random numbers Simulated outcome
9 H
4 T
3 T
7 H
7 H
0 T
0 T
1 T
9 H
8 H
Thus in this Monte Carlo simulation of a coin being tossed 10 times, heads and tails appeared an equal
number of times.
3.3 Results of a simulation exercise

Imagine that a firm is choosing between two projects and, using simulation, it has generated the distribution
of the NPVs for each project.
The results might look like this:
Distribution of simulated NPVs for two projects

Project A has the lower average NPV but also is less risky (its outcomes are less widely dispersed about the
mean).
Project B has the higher average NPV but also is more risky (higher dispersion of outcomes).
All simulation will do is to give the firm the above results. It will not tell the firm which is the better project.
That depends on the investors' attitude to risk (see section 4 below). A may be preferred to B as there is
no chance of it making a loss.
3.4 Advantages and limitations of simulation

Advantages
 It gives more information about the possible outcomes and their relative probabilities
 It is useful for problems which cannot be solved analytically
Limitations
 It is not a technique for making a decision, only for obtaining more information about the possible
outcomes
 It can be very time-consuming without a computer
 It can prove expensive in designing and running the simulation on a computer for complex projects
 Monte Carlo techniques require assumptions to be made about probability distributions and the
relationships between variables, that may turn out to be inaccurate
4 Expected values and attitude to risk
Section overview
 Expected values allow different outcomes to be built into the decision evaluation.
 Expected values ignore risk.
 Risk averse investors require an extra return to compensate for risk.
4.1 Expected values

The simplest way to work with a spread of possible outcomes is to use expected values or averages.
The expected value is an average (arithmetic mean) of possible outcomes, weighted by the probability of
each outcome occurring.
Worked example: Expected values

A firm has to choose between two possible projects, the outcome of which depend on whether the
economy is in recession or boom:
Project A Project B
Probability NPV NPV
CUm CUm
Recession 0.6 – 100 – 50
Boom 0.4 + 250 + 200
Using expected values which project should be chosen?
Solution
Project A expected NPV = (0.6  – CU100m) + (0.4  CU250m) = CU40m
Project B expected NPV = (0.6  – CU50m) + (0.4  CU200m) = CU50m
Based on expected values, project B is the better project.
Interactive question 3: Expected payoff [Difficulty level: Easy]

State of market Diminishing Static Expanding
Probability 0.4 0.3 0.3
Project 1 100 200 1,000
Project 2 0 500 600
Project 3 180 190 200
Payoffs represent the net present value of projects in CUm under each market state.
Requirement
Based on expected values which is the best project?
Interactive question 4: Uncertain sales [Difficulty level: Intermediate]

Harry is trying to evaluate a two year project using NPV. There is uncertainty as to the level of sales (in
units) in each of the two years:
Year 1 Year 2
Sales Probability Sales Probability
(units) (units)
10,000 0.3 8,000 0.2
10,000 0.8
(if year 1 sales are 10,000)
15,000 0.7 20,000 0.6
10,000 0.4
(if year 1 sales are 15,000)
Requirement
On what expected level of sales in years 1 and 2 should Harry base his NPV calculation?
Interactive question 5: Uncertain contribution [Difficulty level: Intermediate]

Imagine in Interactive question 4 above that the project outlay is CU230,000 and each unit sold has a
contribution of CU10.
Requirement
If Harry's cost of capital is 10%, what is the project's expected NPV?
4.2 Analysing the outcomes

In Interactive questions 4 and 5 the information could have been laid out as follows:
* probability of year 1 sales  probability of year 2 sales, e.g. year 1 (10,000) and year 2 (8,000), overall
probability is 0.3  0.2 = 0.06.
There are now four possible outcomes with NPVs as follows:

Probability
10,000  CU10 8,000  CU10
A  – CU230,000 = CU(72,975)  0.06 = (4,379)
1.1 1.12
10,000  CU10 10,000  CU10
B  – CU230,000 = CU(56,446)  0.24 = (13,547)
1.1 1.12
15,000  CU10 20,000  CU10
C  – CU230,000 = CU71,653  0.42 = 30,094
1.1 1.12
15,000  CU10 10,000  CU10
D  – CU230,000 = CU(10,992)  0.28 = (3,078)
1.1 1.12
The expected NPV can be calculated as: 9,090
i.e. exactly as in Example 5 but there is now much more information.
Range of It can be argued that as the expected NPV is positive, the project is worthwhile.
outcomes However, the expected outcome of CU9,090 cannot occur if this project is undertaken
only once, because a loss of CU72,975 or CU56,446 or CU10,992, or a gain of CU71,653
in NPV terms will result.
Probability In addition, the chance of a positive NPV is 0.42 (or 42%). The chance of a negative NPV
of must therefore be (1 – 0.42) = 0.58 or 58%. If the project is undertaken once only, it does
outcomes not look particularly attractive despite the expected positive NPV.
Average However, if the project were repeated very many times, then on average it would make
return CU9,090 and this would be acceptable.
4.3 Advantages and limitations of expected values

Advantages
The advantages of expected values are that:
 The information is reduced to a single number for each choice
 The idea of an average is readily understood
Limitations
The limitations of expected values are that:
 The probabilities of the different possible outcomes may be difficult to estimate
It is possible to use:
– Objective probabilities based on past experience of similar projects; or
– Subjective probabilities, e.g. from the results of market research, where the project is very
different
 The average may not correspond to any of the possible outcomes
 Unless the same decision has to be made many times, the average will not be achieved; it is therefore
not a valid way of making a decision in 'one-off' situations unless the firm has a number of independent
projects and there is a portfolio effect
 The average gives no indication of the spread of possible results, i.e. it ignores risk
4.4 Payoff tables

In certain situations the choices being faced can be mapped out using a payoff table, and the expected
return calculated for each possible course of action, to arrive at a decision.
Interactive question 6: Payoff table [Difficulty level: Intermediate]

John must decide how best to use a monthly factory capacity of 1,200 units. His demand from regular
customers is uncertain, as follows.
Monthly demand
(units) Probability
400 0.2
500 0.3
700 0.4
900 0.1
1.0
Regular customers generate a contribution of CU5 per unit. John has the opportunity to enter a special
contract which will generate contribution of only CU3 per unit.
For the special contract John must enter a binding agreement now at a level of 800, 700, 500 or 300 units.
Entering such an agreement will leave John with spare capacity to meet the needs of his regular customers
of 400, 500, 700 and 900 units respectively.
John has calculated the following contributions (in CU) at various contract and demand levels.
Special contract (units)
Demand p 800 700 500 300
(units)
400 0.2 4,400 4,100 3,500 2,900
500 0.3 4,400 4,600 4,000 3,400
700 0.4 4,400 4,600 5,000 4,400
900 0.1 4,400 4,600 5,000 5,400
Requirement
Advise John as to the optimal level of special contract to commit to every month, assuming his aim is to
maximise profits.
4.5 Attitude to risk

The problems with applying expected values to a risky decision can be illustrated by a gambling example.
Worked example: Risk aversion

Suppose I am going to toss a coin 100 times.
Every time it shows heads you will pay me 30p, and every time it shows tails I will pay you 50p. Would you
accept the gamble? You probably would accept. The expected value of the gamble is as follows:
Payoff
Heads 0.5  (30p) (15)
Tails 0.5  50p 25
10
All that is meant by the expected value is that if I toss the coin a large number of times, your average win
per game is 10p. After 100 games you are likely to have won 100  10p = CU10 which is very acceptable,
considering that your maximum loss on any game is 30p, and the chances of losing anything significant are
very small.
The expected value computation is relevant because:
 The game is repeated many times; and
 The sums of money involved are small compared with your overall wealth.
Interactive question 7: Risk aversion [Difficulty level: Easy]

However, now suppose I offer you a different gamble. I am going to toss a coin just once.
If the result shows heads, you will pay me CU3,000. If tails, I will give you CU5,000.
Requirements
(a) Would you accept this gamble?
(b) What factors would determine your choice?
See the Answer at the end of the chapter.
Definition
A risk averse investor is one who requires a higher average return in order to take on a higher level of
risk
This principle applies just as much to decisions made by directors of companies. A project which has a
positive expected NPV, but which nevertheless carries a fair chance of forcing the company into liquidation
if things go wrong, would probably be rejected.
Worked example: Attitude to risk

Mr Smith is a retailer currently earning profits of CU40,000 pa. He is considering two alternatives for
expansion:
Alternative 1. Build a new counter in an unused area of the shop which will create an additional net
contribution of CU8,000 pa with a high degree of certainty.
Alternative 2. Open a completely new franchise operation. If the franchise proves successful, it will
generate an additional net contribution of CU40,000 pa. The problem, however, is that even if the franchise
is unsuccessful Mr Smith will be committed to minimum royalty payments of CU20,000 pa indefinitely into
the future. There is a 50% chance of success or failure.
Consider the intuitive reaction to such a decision. Most business people would prefer Alternative 1
because, although the possibility of very high contribution does not exist, there is no risk of any loss taking
place.
5 Diversification and the portfolio effect
Section overview
 Risk can be reduced by diversification.
 Well diversified investors face systematic risk, which can be measured by a beta value.
 CAPM gives a return for systematic risk - it assumes investors are well diversified.
 The beta value can be adjusted to reflect gearing.
5.1 Introduction
In the above section, the analysis of risk and uncertainty has concentrated on altering future returns to
allow for uncertainty of outcome (e.g. using probability distributions of returns).
An alternative approach is to allow for uncertainty by increasing the required rate of return on risky
projects.
This latter approach is commonly taken by investors.
For example, when comparing a low risk building society investment with one in high risk equities, a higher
return from equities would normally be required.
Similarly, when appraising equity investments in a well established property company against a similar
investment in a recently listed computer manufacturer, a higher return would usually be demanded from
the second investment to reflect its higher risk.
Investors seldom hold securities in isolation. They usually attempt to reduce their risks by 'not putting all
their eggs into one basket' and therefore hold portfolios of securities. Before a risk-adjusted discount rate
can be deduced from stock exchange returns, the risks taken by investors in their diversified investment
portfolios need to be identified, as discussed below.
5.2 The portfolio effect

A portfolio is simply a combination of investments. If an investor puts half of his funds into an engineering
company and half into a retail shops firm, it is possible that any misfortunes in the engineering company (e.g.
a strike) may be to some extent offset by the performance of the retail investment. It would be unlikely that
both would suffer a strike in the same period.
This effect can be demonstrated more formally in the following graphs. Assume two companies, A and B,
whose fortunes are inversely correlated (i.e. when A does well B does badly and vice versa).
Individual returns
Both investment A and investment B show fluctuating returns over time. They both have about the same
amount of variability. When A does well, B does badly, and vice versa. If both investments are held, the
resulting portfolio will show the same average return but a greatly reduced risk, because the 'ups' of A
cancel with the 'downs' of B and vice versa.
Time
The portfolio effect
The same effect can be illustrated by a simple computational example.
Worked example: Risk reduction

Two traders sell their goods from a stall on the seafront at Brighton during the tourist season. One sells ice
cream, the other umbrellas. Assuming there are two possible states of the weather – sun and rain, when
the sun is out the ice cream seller makes a daily contribution of CU200, but when it rains she only makes
CU20.
The returns made by the umbrella stall holder are the same, CU200 and CU20, but in rain and sun
respectively.
State Sun Rain Average Risk
Probability 0.5 0.5
Contribution – Ice creams 200 20 110 High
Contribution – Umbrellas 20 200 110 High
Although both businesses are profitable, the traders are a little unhappy about riding the rollercoaster of
risk.
What would happen if the two traders pooled their resources and each offers the other product as well as
their own?
Now both hold half their inventory as umbrellas and half as ice creams.
When it is sunny they would both make (1/2  CU20) + (1/2  CU200) = CU110, and,
When it rains they both make (1/2  CU20) + (1/2  CU200) = CU110.
State Sun Rain Average Risk
Probability 0.5 0.5
Contribution 110 110 110 Zero
The average return is the same as before, but the risk is diversified away.
The above illustration is extreme in that risk has been completely eliminated. In practice the risk reduction
is somewhat less when investments are combined.
Interactive question 8: Diversification [Difficulty level: Intermediate]

Morag Ltd can invest up to CU4m in either or both of the following projects:
Project Outcome Probability
(NPV as % of investment)
X (i) + 30% 0.5
(ii) – 15% 0.5
Y (i) + 30% 0.5
(ii) – 15% 0.5
X and Y are independent of each other, i.e. project X's outcome in no way influences that of project Y and
vice versa.
Requirements
Calculate the following:
(a) The best, worst and expected outcomes if the whole CU4m is invested in project X or project Y.
(b) The best, worst and expected outcomes, together with associated probabilities, if half of the CU4m is
invested in X and the other half in Y.
5.3 Systematic and non-systematic risk

As seen above, portfolios enable risk to be reduced. Evidence shows that the total risk of a security can be
split into the proportion that may be diversified away, and the proportion that will remain after
diversification. This remaining risk is the relevant risk for appraising investments.
Evidence shows that increasing the number of securities in a portfolio reduces the risk.
Starting by constructing a portfolio with one share and gradually adding other shares to it, the total risk of
the portfolio reduces. The portfolios are constructed randomly.
Total Unsystematic risk
risk (unique risk or specific risk)
Systematic risk
(market risk)
15-20 Number of
securities securities
Portfolio size and risk reduction
Initially, substantial reductions in total risk are possible. However, as the portfolio becomes more and more
diversified, risk reduction slows down and eventually stops, i.e. each additional share yields successively less
risk reduction.
Definition
Unsystematic, unique or specific risk: The risk that can be eliminated by diversification.
Unsystematic risk is related to factors that affect the returns of individual investments in unique ways (e.g.
the risk that a particular firm's labour force might go on strike or its equipment might fail).
Definition
Systematic or market risk: The risk that cannot be eliminated by diversification.
To some extent the fortunes of all companies are dependent on the economy. Changes in macroeconomic
variables such as interest rates, exchange rates, taxation, inflation, etc affect all companies to a greater or
lesser extent and cannot be avoided by diversification, i.e. they apply systematically right across the market.
5.4 Systematic risk and return

5.4.1 Systematic risk
The relevant risk of an individual security is its systematic risk and it is on this basis that investments should
be judged. Unsystematic risk can be eliminated and is of no consequence to the well-diversified investor.
Note that it is not necessary to hold the whole market portfolio to diversify away unsystematic risk – a
portfolio of 15-20 randomly selected securities will eliminate the vast majority of it.
It is not the case that individual shares carry the same amount of systematic risk. Some shares are more
susceptible to economic factors than others. For example, food retailing is less susceptible to economic
factors than the construction industry.
As unsystematic risk can be diversified away, investors need only concern themselves with (and will only
earn returns for taking) systematic risk.
5.4.2 Measuring systematic risk

The next problem is how to measure the systematic risk of investments and the required returns. The
model adopted is the capital asset pricing model (CAPM).
The method adopted by CAPM is to measure systematic risk as an index, normally referred to as beta ().
As with any index some base points need to be established and then other observations will be calibrated
around these points. The two base points are as follows:
(a) The risk-free security – this carries no risk and therefore no systematic risk. The risk-free security
hence has a beta of zero.
(b) The market portfolio – this is a portfolio of all risky investments. This represents the ultimate in
diversification and therefore contains only systematic risk. CAPM sets beta to 1.00 for the market
portfolio and this will represent the average systematic risk for the market.
These two points may be represented on the following graph:
Graphical representation of CAPM

The upward sloping line gives the relationship between systematic risk and return. From the graph it can be
seen that the higher the systematic risk, the higher the required rate of return.
Do not be surprised that some securities carry a systematic risk greater than 1.0. This merely means that
these investments are more affected by changes in macroeconomic variables than the average market
investment.
For example, shares in construction companies are strongly influenced by economic factors and therefore
have betas greater than 1.0.
5.5 CAPM equation

5.5.1 Calculations
The line of the above graph is often referred to in the form of an equation:
rj = rf +j (rm – rf)
where rj = required rate of return on investment j
rf = risk-free rate of interest
rm = return on the market portfolio
j = index of systematic risk for security j
Note that when applied to shares, rj is the same as the cost of equity capital ke (see the chapter on cost of
capital).
This formula is provided in the examination. Very basic calculations are required and you are expected to
be able to explain how the equation works.
5.5.2 Explanation
There is a basic risk-free return (rf) which reflects the rational nature of investors i.e. they require a return
to reflect the time value of money. On top of this investors require a premium for systematic risk. The
average market premium for such risk is (rm – rf) which the  flexes, i.e. if the investment has more
systematic risk than the market average,  is > 1.00 and the premium ((rm – rf)) is therefore greater than
the market average.
5.5.3 Estimating the variables

The problem with estimating rf is finding a risk free asset and estimating its future returns. Government
short-dated (e.g. Treasury) bills are probably the closest thing available in the real world and the return
they provide can be predicted with reasonable accuracy by economic forecasters.
Estimating rm is perhaps even more difficult. History shows a very volatile performance for the stock market
over time. It is probably best to use the long-term average premium (i.e. rm – rf) which is around 5% pa in
real terms.
5.6 Aggressive and defensive shares

The expected returns on the market portfolio will change in relation to altered economic expectations.
This in turn will bring about a change in the expected return of shares, which depends on their beta factor.
Beta is a measure of the responsiveness of the expected share return to changes in the return of the
market. Shares with high betas are termed aggressive, and those with betas less than one are termed
defensive.
As far as stock market investment tactics are concerned, an investor should buy high beta shares if the
market is expected to rise (a 'bull' market) because they can be expected to rise faster than the market. If
the market is expected to fall (a 'bear' market) low beta shares are more attractive.
The only problem with this strategy is the need to forecast general market movements in advance,
otherwise the investor might end up holding an aggressive share in a falling (bear) market.
Interactive question 9: Different sectors [Difficulty level: Intermediate]

You are considering investing in the sectors listed below. For each, estimate the expected beta value and
thus the likely performance of the stock.
Question Answer
Supermarkets
Pharmaceuticals
Construction
Airlines
Car manufacturing
5.7 Application of the CAPM to project appraisal

5.7.1 Developed for shares
The capital asset pricing model was originally developed to explain how the returns earned on shares are
dependent on their risk characteristics. However, its greatest potential use in the financial management of a
company is in the setting of minimum required returns (i.e. risk-adjusted discount rates) for new capital
investment projects.
5.7.2 Risk-adjusted discount rate

The great advantage of using the CAPM for project appraisal is that it clearly shows that the discount rate
should be related to the project's risk. It is not good enough to assume that the firm's present cost of
capital can be used if the new project has different risk characteristics from the firm's existing operations.
After all, the cost of capital is merely a return which investors require on their money, and this will go up if
risk increases.
In addition, in making a distinction between systematic and unsystematic risk, it shows how a highly
speculative project such as mineral prospecting may have a lower than average required return because its
risk is highly specific and associated with the luck of making a strike, rather than with the ups and downs of
the market (i.e. it has a high total risk but a low systematic risk).
5.7.3 Logic behind use of CAPM

It is important to follow the logic behind the use of the CAPM in this way:
Assumed objective is to maximise the wealth of shareholders
Assumed that all shareholders all hold the market portfolio

and this is therefore appropriate as a benchmark
The new project is viewed as an additional investment to be

added to the market portfolio
Minimum required rate of return set using the CAPM formula

rj = rf +j (rm – rf) where j is the beta factor of the new project
The effect of the project on the company which appraises it is irrelevant.

All that matters is the effect of the project on the market portfolio.
The company's shareholders have many other shares in their portfolio.

They are unconcerned if the new project has an adverse effect on the
return/risk profile of the company which accepts it, so long as the effect
on the return and risk of the market portfolio is beneficial.
It is important to note that there are two major weaknesses with the assumptions:
Diversification The company's shareholders may not be diversified. Particularly in smaller companies
they may have invested most of their assets in this one company. In this case the CAPM
approach will be inappropriate.
Stakeholders Even in the case of larger companies the shareholders are not the only
participants in the firm. It is difficult to persuade directors and employees that the
effect of a project on the fortunes of their company is irrelevant. After all, they cannot
diversify their job and are exposed to both the systematic and specific risks of the
business, i.e. total risk. Thus managers may try to diversify, even though shareholders
are better placed to do so, in order to protect their jobs. This is another example of
agency costs.
Perfect capital In addition to these weaknesses there is the problem that the CAPM depends on a
market perfect capital market; for the purposes of the examination, however, this may be
ignored. There is also the obvious practical difficulty of estimating the beta of a new
investment project.
Chapter 5 explores further the use of CAPM in developing a discount rate for a project.
Summary and Self-test
Summary
Self-test
Answer the following questions.
1 Adrian is contemplating purchasing for CU60,000 a machine which he will use to produce 10,000 disks
per annum for five years. These disks will be sold for CU9 each and unit variable costs are expected to
be CU5. Incremental fixed costs will be CU14,000 per annum for production costs and CU5,000 per
annum for selling and administration costs. Adrian has a required return of 10% per annum.
By how many units must the estimate of production and sales volume fall for the project to be
regarded as not worthwhile?
A 575
B 1,293
C 1,623
D 2,463
2 A decision is constructed using estimated cash flows. Individual variables are then separately changed
in order to assess their effect on the result.
Such a process is called
A Limiting factor analysis
B Sensitivity analysis
C Simulation analysis
D Time series analysis
3 Dallara runs an office sandwich delivery service. He orders sandwiches at the start of each day for 45p
each and takes them round to local offices where he sells them for 75p. Any unsold sandwiches are
thrown away. Possible levels of daily demand are as follows:
Demand Probability
50 0.2
60 0.3
70 0.4
80 0.1
The number of sandwiches to be ordered each day in order to maximise long-term profit is
A 50
B 60
C 64
D 70
4 A shopkeeper has determined the following probability distribution of weekly demand for one of his
regular inventory items.
Demand Probability
300 0.2
400 0.3
500 0.3
600 0.1
700 0.1
The shopkeeper must order each week's sales in advance and any items left in inventory at the end of
the week are scrapped. The items cost the shopkeeper CU2.50 each and he sells them for CU3 each.
The optimal quantity to be ordered each week is
A 300
B 400
C 450
D 500
5 Demand on any day for bunches of carnations from a station florist shows the following probability
distribution:
Demand Probability
50 0.1
60 0.2
70 0.4
80 0.3
If flowers are ordered before demand is known at a cost of CU4.40 per bunch, sold for CU5.00 per
bunch and any unsold at the end of a day have to be thrown away, how many should be ordered?
A 60
B 65
C 69
D 70
6 A company has constructed a model for predicting profits. Net profit or loss depends on two
variables: gross profit and overheads. The following are independent probability distributions of the
two variables.
Gross profit Probability Overheads Probability
CU CU
12,000 0.1 6,000 0.3
6,000 0.4 4,000 0.3
4,000 0.4 3,000 0.3
3,000 0.1 2,000 0.1
What is the probability that the company will make a positive net profit?
A 0.27
B 0.55
C 0.73
D 0.82
7 The annual sales volume and the unit contribution margin of a new product are uncertain. Estimates
for these two variables are as follows:
Sales volume Unit Contribution Probability
(units) probability
80,000 0.1 CU2.00 0.5
75,000 0.6 CU1.50 0.5
50,000 0.3
The sales volume (which has an expected value of 68,000) and unit contribution margin (which has an
expected value of CU1.75) have been assumed to be independent.
If the annual fixed costs are CU130,000, what is the probability that the company will make a loss?
A 0.30
B 0.50
C 0.65
D 1.00
8 A new customer has asked company X to undertake a contract. The following details are available:
CU
Contract price 10,000
Variable costs (7,500)
Contribution 2,500
It is estimated that there is a 0.2 probability that no money will be forthcoming from the customer
after completion of the contract, but a 0.8 probability that the contract price will be paid in full.
Alternatively, a credit report could be purchased for CU600 which would indicate for certain whether
the customer will pay the contract price.
What is the expected contribution from the contract if the company pursues the optimal strategy?
A CU500
B CU1,400
C CU1,500
D CU2,000
9 Chancie Ltd has made the following estimates of sales for a new product with an expected life of two
years:
High sales Average sales Low sales
Probability 0.4 0.3 0.3
CU CU CU
Year 1 15,000 10,000 8,000
Year 2 20,000 10,000 4,000
Variable costs are uncertain and the following estimates are made for the two year period:
Variable costs as a percentage of sales Probability
80% 0.1
70% 0.2
60% 0.4
50% 0.3
Fixed overheads will be increased by CU4,000 per annum if the product is manufactured. Chancie Ltd
has a cost of capital of 15% per annum.
What is the expected net present value (to the nearest CU100) of making and selling the product over
the next two years?
A CU5,200
B CU4,000
C CU1,100
D CU1,000
10 When using the expected value criterion, it is assumed that the individual wants to
A maximise return for a given level of risk
B maximise return irrespective of the level of risk
C minimise risk for a given level of return
D minimise risk irrespective of the level of return
11 The higher risk of a project can be recognised by decreasing
A the required rate of return of the project
B the internal rate of return of the project
C the estimates of future cash inflows from the project
D the cost of the initial investment of the project
12 An individual who is risk averse is faced with four mutually-exclusive investment opportunities, W, X,
Y and Z. The pay-off for each investment will vary depending on which of three equally likely future
states, I, II and III, applies.
I II III
CU CU CU
W 100 120 140
X 200 160 0
Y 120 140 100
Z 170 80 110
Which pair of investments would the individual choose?

A W and Z
B W and Y
C X and Z
D Y and Z
13 Characteristics of four portfolios are shown below:
Standard deviation Expected return
% %
Portfolio A 15 11
Portfolio B 26 16
Portfolio C 8 7
Portfolio D 14 13
Which portfolio would a risk-averse investor immediately reject?
A Portfolio A
B Portfolio B
C Portfolio C
D Portfolio D
14 Risk that cannot be diversified away can be described as
A systematic risk
B financial risk
C business risk
D unsystematic risk
15 The CAPM is the line which represents the relationship between the expected returns on securities
and
A the market risks of those securities
B the overall risks of those securities
C the expected returns on the market
D the expected returns on the risk-free asset
16 The systematic risk of a project's return is the result of uncertainties in the return caused by
A factors unique to the project
B factors unique to the firm undertaking the project
C factors unique to the industry to which the project belongs
D nation-wide economic factors
17 The following diagram shows the expected return and variance of return for four securities, A, B, C
and D.
Expected B
Return 
A C
 
D

Total risk
Assuming the capital asset pricing model applies and the securities are fairly priced, which security has
the greatest beta value?
A Security A
B Security B
C Security C
D Security D
18 The following diagram shows the expected return and beta values of two securities P and Q. The line
shows the return required by the CAPM: rj = rf + j (rm – rf)
Expected
return Q
rm
rf
P
=1
What does the diagram indicate about the pricing of securities P and Q?
Security P Security Q
A underpriced overpriced
B correctly priced underpriced
C correctly priced overpriced
D overpriced underpriced
19 Foods Ltd has made a public announcement that it intends to introduce a new product which will
decrease the beta of the firm. On the same day, Drinks Ltd has publicly announced that it is being sued
by a major customer for a batch of faulty goods.
If neither of these items of information had been made public before, what effect should they have on
the companies' share prices, assuming the Stock Market is semi-strong efficient?
Foods Ltd Drinks Ltd
A Decrease No change
B Decrease Decrease
C Increase No change
D Increase Decrease
20 The following data relates to the ordinary shares of Burton Ltd.

Average market return 20%
Risk-free rate of return 13%
Beta factor of Burton Ltd's equity 1.5
What is Burton's cost of equity, using the capital asset pricing model?
21 The cost of capital has three elements.
Assuming that shareholders hold well diversified portfolios, which of the following is not one of these
elements?
A The risk-free rate of return
B The premium for financial risk
C The specific risk of the company
D The premium for business risk
22 A portfolio consisting entirely of risk-free securities will have a beta factor of:
A 0.5
B 1
C –1
D 0
23 Gardener Ltd is an all-equity company whose shares have a beta value of 1.4. In a month when a
dividend of 6p per share was paid, the share price and stock market all-share index values were:
Share price All-share index
At the start of the month 100p 400
At the end of the month 95p 408
The return on a risk-free investment in the month would have been ½%.
Return due to unsystematic risk can be estimated as the difference between actual return and the
return predicted by the CAPM. What was the size of return on Gardener's shares due to unsystematic
risk in the month, based on the start-of-month share price and share index value? Ignore taxation.
A Positive return of 3.4%
B Negative return of 7.6%
C Negative return of 2.3%
D Negative return of 1.6%
24 STRATHBURN LTD
Strathburn Ltd is a family-owned medium-sized company specialising in the distribution of office
stationery. It is currently reviewing its investment plans for the future and has under consideration
three projects to be funded out of CU2 million of investments which have been specially set aside.
The projects and their respective cash flows and probabilities are as follows.
Project Initial cost PV of net earnings Probability
CUm CUm
LMT 2.0 7.0 0.417
1.0 0.583
GTV 1.0 3.5 0.5
0.5 0.5
CUJ 1.0 3.0 0.5
0 0.5
Requirements
(a) Compare the outcomes of investing all the funds in project LMT with that of sharing them
between projects GTV and CUJ (round to nearest CU5,000). (4 marks)
(b) (i) On the basis of the expected values calculated, in which project(s) would you invest?
(ii) What are the weaknesses inherent in this approach to decision-making?
(iii) What other factors should be considered in making this decision? (8 marks)
(12 marks)
25 SENATOR TERRY TRUFO
Senator Terry Trufo's firm, TT Bonus Inc, has undertaken some legal and academic research at a cost
of CU4,000 into the possibilities of selling university degrees. The firm is unsure of the outcome of
such a venture but feels that there is a 60% chance of annual income of CU70,000 and a 40% chance of
annual income of CU40,000.
Printing machinery would need to be bought at a cost of some CU40,000 payable in two equal annual
instalments, one immediately and one in one year's time if the equipment had been operating correctly
for a year. The equipment would be depreciated on a straight line basis by CU3,500 per annum for ten
years and then sold. Use would also be made of some existing equipment which originally cost
CU6,000, has a book value of CU1,000, and would cost CU9,000 to replace, though the firm is
considering selling it for CU2,000.
Production and labour costs in the first year would amount to CU55,000 payable in one year's time,
though the next nine years' costs would fall to CU30,000 if demand were low in the first year.
Revenue would first be receivable in two years' time and for the following nine years. Fixed costs of
CU5,000 per annum would be reallocated to the degree project.
Requirements
Calculate the following.
(a) Accounting rate of return by expressing
(i) Average annual pre-tax accounting profit on the project as a percentage of the book value
of the initial investment
(ii) The same profit as a percentage of the average book value of the investment
(iii) Total accounting profit as a percentage of the initial investment. (2 marks)
(b) Payback period. (2 marks)
(c) Internal rate of return of the project. (2 marks)
(d) Net present value of the project at the company's required rate of return of 8%. (2 marks)
(e) The sensitivity of your result in (d) to the estimates of
(i) The required rate of return
(ii) Sales revenue
(iii) Life of the project (6 marks)
(14 marks)
Note: Requirements (a) – (c) are revision of basic techniques
26 COMFIFEET LTD
Comfifeet Ltd, a footwear manufacturer, has a factory in Hampshire that it rents on a lease due to
expire at the end of December 20X4. The factory is entirely devoted to making Old Faithful carpet
slippers (OFs). The market for the slippers has been declining and a decision had been taken two years
ago not to seek to renew the lease in 20X4, but to close down OF manufacture when the lease
expires. At a recent meeting of the company's board of directors the question was raised as to
whether it might be more beneficial to close at the end of December 20X1, three years earlier than
had originally been decided. As a member of the company's finance staff, you have been asked to look
into this question.
Sales of OFs are projected to be as follows for the next three years.
Year CU'000
20X2 10,000
20X3 7,500
20X4 5,000
The marketing director believes that these figures could be increased if an advertising campaign were
to be undertaken. Such a campaign would involve cash outlays of CU1 million on 31 December in each
of 20X1, 20X2 and 20X3. The marketing director acknowledges that the results of the advertising
campaign are uncertain, but she believes that there would be at least a 10% increase in sales on the
projected figures and the increase could be as high as 25%. To ease assessment it has been agreed that
it is reasonable to assume that the increase will be either 10% with a probability of 40%, or 25% with a
probability of 60%. If the advertising were to be undertaken, the expenditure would be available for
tax relief in the accounting year in which it would be incurred.
The variable costs of manufacture of OFs are estimated at 30% of the selling price. The rent of the
factory is CU5 million a year, payable on 1 January. The owner of the factory will not agree to an early
termination of the lease, but the company has the right to sublet the factory. The directors are
confident of finding a subtenant who would pay CU4 million on 1 January in each of the three relevant
years.
The plant used in the factory was all bought in January 20W8 for CU2,000,000. Were the factory to close
in 20X1, it would be sold in December for CU1,000,000, but if it were retained until 20X4 it would be sold
in December of that year for an estimated CU200,000. For the purposes of the present analysis, treat the
plant as if it had been excluded from the general pool. This means that it attracts 25% (reducing balance) tax
depreciation in the year of its acquisition and in every subsequent year of its being owned by the company
except the last year. In the last year, the difference between the plant's written down value for tax purposes
and its disposal proceeds will either be allowed to the company as an additional tax relief if the disposal
proceeds are less than the written down value, or be charged to the company if the disposal proceeds are
more than the tax written down value.
Apart from rent and depreciation, fixed costs are estimated to be CU1,000,000 each year, including a
CU300,000 allocation of head office costs.
When the factory closes certain staff would be entitled to redundancy payments. These would total
CU400,000 if closure were to take place in 20X1, but rise to CU450,000 if closure were in 20X4. In either
case the payment would be made on the day of closure and be fully allowable for corporation tax for the
year concerned.
Production of OFs gives rise to a working capital requirement of an amount equal to 5% of the sales
value. This needs to be in place by the beginning of each year concerned. By the end of the production
period all of the working capital will have been released. Closure on either date is not expected to
have any effect on any of the company's other activities. It is estimated that the appropriate cost of
capital is 10% per annum.
The company's accounting year is to 31 December and the corporation tax rate of 30% is payable at
the end of the year to which it relates.
Requirements
(a) Determine, on the basis of net present value (NPV), whether the advertising should be
undertaken, assuming that closure is delayed until 20X4. (6 marks)
(b) Taking account of your conclusion from (a) determine, on the basis of NPV, whether the
company should close the factory in 20X1 or in 20X4. (12 marks)
(18 marks)
27 GFL
George, Skinner and Fleet Ltd ('GFL') is a large construction company and has a financial year end of
31 December. It has been invited to bid, via a tender contract, for a major piece of ground preparation
work for one of the London Olympic Games sites. You have been asked by GFL’s senior management
to advise them.
You have the following information and estimates to aid your decision:
(1) The work would take two years to complete and would start in January 2007.
(2) The successful bidder for the contract would receive an advance payment of CU2 million in
January 2007 and the balance is receivable in early January 2009.
(3) Materials to be used on the work would cost CU820,000 (2007) and CU930,000 (2008).
(4) The company would need to transfer 20 of its highly skilled employees from other GFL
construction sites in London for the last eighteen months of the contract (i.e. from July 2007).
The current average annual wage of these employees is CU23,000, but they will each be paid a
premium of 15% above this figure for working on the Olympic site. They will be replaced at their
existing sites by new workers, who because of their comparative lack of experience will receive
an average annual wage of CU19,000.
(5) To supplement the transfers in (4) above, GFL would employ 45 new workers at a total cost of
CU830,000 per annum on the Olympic site for the whole two years (2007 and 2008).
(6) GFL will also need to hire additional site management staff for the duration of the contract at an
average annual total cost of CU420,000.
(7) To aid the ground preparation work, GFL will make use of one of its biggest earth removing
machines. This cost CU3.2 million when purchased in 2004, but it is currently under-utilised
because of the changing characteristics of GFL’s work. As a result, GFL was planning to sell it by
the end of 2006 and has received a firm offer of CU1.1 million from Tideford Construction Ltd.
GFL’s management consider that the machine, if it is employed on the Olympic site, will be
worth, at most, CU200,000 by the end of the contract.
The earth moving machine attracts tax depreciation, but is excluded from the general pool. This means
that it attracts 25% (reducing balance) tax depreciation in the year of expenditure and in every
subsequent year of being owned by the company, except the last year. In the last year, the difference
between the machinery’s written down value for tax purposes and its disposal proceeds will be either
(i) allowed to the company as an additional tax relief, if the disposal proceeds are less than the tax
written down value, or
(ii) be charged to the company, if the disposal proceeds are more than the tax written down value.
 The materials and labour costs outlined in (3) to (6) above are all stated at December 2006 price
levels. It is expected that these costs will inflate at the estimated annual general rate of inflation,
which is 2% for 2007 and 3% in subsequent years.
 Unless otherwise stated, you can assume that all cash flows take place at the end of the year in
question.
 The corporation tax rate is 30% per annum and is payable in the same year as the
investment/income/costs to which it relates.
GFL’s management is aware that this will be a very competitive bidding process. At the company’s
most recent board meeting, it was agreed that a total tender price of CU7 million for the contract
would be reasonable, but that, if there was a danger of being outbid, a lower price would be
considered as long as the 'figures added up'. GFL has of late used a post-tax money cost of capital of
9% to appraise its investments.
One of GFL’s directors has made the point that were the company to be successful with its London
bid, there is a possibility that it might be asked to tender again for the Olympic Games in 2016, which
are likely to be held in either Africa or South America. GFL has not to date undertaken any contracts
abroad.
Requirements
(a) Advise, with supporting calculations, GFL’s senior management as to whether tendering for the
contract at a total price of CU7 million would enhance shareholder value. (15 marks)
(b) Calculate the minimum total contract price that GFL should set that would be neutral in terms of
shareholder value. (5 marks)
(c) Advise GFl’s senior management as to the keys areas of risk (excluding the management of
foreign exchange risk) that could arise if GFL was to undertake investments abroad. (5 marks)
(25 marks)
Now go back to the Learning Objectives in the Introduction. If you are satisfied that you have achieved
these objectives, please tick them off.
Answers to Self-test
1 B
Cash 10%
flow factor PV
CU'000 CU
Time 0 machine (60) 1 (60,000)
Time 1-5 contribution 40 3.791 151,640
Time 1-5 fixed costs (19) 3.791 (72,029)
Positive NPV 19,611
PV of contribution must fall by CU19,611

CU19,611
Sales volume must fall by = 12.93%
CU151,640
Fall in sales volume = 0.1293  10,000
= 1,293
2 B
By definition
3 B
Profit matrix 50 15 15 15 15 EV = CU15
60 10.5 18 18 18 EV = CU16.50
70 6 13.5 21 21 EV = CU15.75
80 1.5 9 16.5 24 EV = CU12
Optimal policy is to order 60 (B)
4 A
Profit matrix 300 150 150 150 150 150 EV = CU150
400 (100) 200 200 200 200 EV = CU140
500 (350) (50) 250 250 250 EV = CU40
600 (600) (300) 0 300 300 EV = CU(150)
700 (850) (550) (250) 50 350 EV = CU(370)
Optimal quantity is to order 300 (A)
5 A
Profit matrix 50 30 30 30 30 EV = CU30
60 (14) 36 36 36 EV = CU31
70 (58) (8) 42 42 EV = CU22
80 (102) (52) (2) 48 EV = CU(7)
Optimal policy is to order 60 (A)
6 B
Gross profit Overheads Probability
CU'000 CU'000
12 Any 0.1
6 4, 3 or 2 0.4  0.7
4 3 or 2 0.4  0.4
3 2 0.1  0.1
Total = 0.55
7 C
Sales volume Margin Profit/(loss)
CU CU'000
80,000 2.00 (80  2.00)  130 = 30.0
80,000 1.50 (80  1.50)  130 = (10.0)
75,000 2.00 (75  2.00)  130 = 20.0
75,000 1.50 (75  1.50)  130 = (17.5)
50,000 2.00 (50  2.00)  130 = (30.0)
50,000 1.50 (50  1.50)  130 = (55.0)
Probability of a loss = (0.1  0.5) + (0.6  0.5) + 0.3
= 0.65
8 B
Although decision trees are not examinable, they often help to answer the 'simpler' EV questions.
EV no report = (0.8  2,500) – (0.2  7,500)

= CU500
EV report = (0.8  2,500) – 600
= CU1,400
9 D
Expected variable cost as percentage of sales = 61%
Year 1 expected sales = CU11,400
Expected contribution CU11,400  0.39 = CU4,446
Expected profit CU(4,446 – 4,000) = CU446
PV of profit CU446 ÷ 1.15 = CU388
Year 2 expected sales = CU12,200
Expected contribution CU12,200  0.39 = CU4,758
Expected profit CU(4,758 – 4,000) = CU758
PV of profit CU758 ÷ 1.15 2 = CU573
Total expected NPV CU(388 + 573) = CU961
≈ CU1,000 rounded
10 B
The expected value criterion is independent of risk.
11 C
The internal rate of return and the cost of the initial investment are independent of the risk of the
project.
The higher the risk of the project, the greater the required rate of return.
12 B
All four projects have the same expected return (CU120). The lowest risk is shown by W and Y.
A mean-variance utility function indicates risk-aversion.
13 A
Portfolio A cannot be efficient because it has a higher risk than portfolio D but a lower return.
14 A
Systematic risk cannot be diversified: it is linked to market factors which influence all shares in a
similar way.
15 A
The security market line represents the relationship between the expected return on a security and its
market (or systematic) risk.
16 D
Systematic risk reflects variations in the return of a security due to general market factors.
17 B
If CAPM holds then all are correctly valued and the one giving the highest return has the highest 
factor. Total risk is completely irrelevant as CAPM only rewards the systematic element. Systematic
and unsystematic risk are independent of one another.
18 D
P is overpriced since return offered is less than that required by CAPM.
Income
Return =
Price
Q is underpriced as return offered is greater than that required.
19 D
D
 decreases  ke decreases  MV increases since MV =
ke
Drinks being sued is likely to cause a fall in MV.
20 The correct answer is: 23.5%
ke = rf +  (rm – rf)
= 13% + 1.5 (20 – 13)%
= 23.5%
21 C
The correct answer is: The specific risk of the company.
The cost of capital to the company reflects the business and financial risk faced by the company and
the risk-free return. It is not affected by the specific risk, which is the risk that can be diversified away.
This is therefore the correct answer.
22 D
The correct answer is zero.
If a portfolio has risk-free securities only, there is no risk premium, so the beta factor must be zero.
23 D
The correct answer is negative return of 1.6%.
Pence
Actual return Dividend 6
Capital loss (95  100) (5)
Total return 1
i.e. a 1% return on the opening share price
Market return Increase in share index (408 – 400) = 8
As % of opening index (8/400) = 2%
Expectation on Gardener Ltd shares = rf + beta (rm – rf)

= ½ + 1.4 (2 – ½) = 2.6%
Return due to unsystematic risk = 1% – 2.6% = 1.6% loss
24 STRATHBURN LTD
(a) Outcomes
Project Initial PV of NPV Probability EV
cost earnings (NPV)
CUm CUm CUm CUm
LMT 2.0 7.0 5.0 0.417 2.085
2.0 1.0 (1.0) 0.583 (0.583)
1.502
or (rounding) 1.5
GTV 1.0 3.5 2.5 0.5 1.25
1.0 0.5 (0.5) 0.5 (0.25)
CUJ 1.0 3.0 2.0 0.5 1.0
1.0 0 (1.0) 0.5 (0.5)
Possible outcomes of projects

Option 1 Project LMT
Expected value = CU1.5m
Possible values = CU5.0m or – CU1.0m
Option 2 Projects GTV and CUJ
Expected values GTV CUJ Combined Probability EV
NPV NPV NPV
CUm CUm CUm CUm
2.5 2.0 4.5 0.5  0.5 1.125
2.5 (1.0) 1.5 0.5  0.5 0.375
(0.5) 2.0 1.5 0.5  0.5 0.375
(0.5) (1.0) (1.5) 0.5  0.5 (0.375)
1.5
(b) Evaluation
(i) If there were no restriction on funds and assuming that shareholder wealth maximisation is
the prime objective, then it would be in the interest of Strathburn Ltd to adopt all three
projects, since they have positive NPVs.
Given that the available capital funds are limited to CU2m, it is not possible to invest in all
projects and so a choice needs to be made. The fact that the same expected NPV (CU1.5m)
is achieved under options 1 and 2 means that either option can be selected.
(ii) The limitations of applying expected value analysis are clearly highlighted by Strathburn Ltd's
dilemma.
 Expected value analysis is only appropriate where an activity or process will recur
frequently. It is particularly inappropriate where a company's management are
considering a one-off decision such as this.
 Expected values take no account of the risks involved in an investment, i.e. the range
or variability of possible outcomes. For example, in Strathburn Ltd's case the first
option has a maximum value of CU5m and a low of – CU1m. Option 2 results in
outcomes which are less widely dispersed with a high of CU2.5m and a low of –
CU1m.
 Expected values ignore the investors' attitude to risk. This can be measured by the use
of indifference curves.
 Expected values will frequently not produce a value which corresponds with a possible
outcome. This is the case for option 1, although in the case of option 2 the expected
value of CU1.5m can in fact occur.
The fact that Strathburn Ltd is having to use probabilities in association with NPVs raises
problems, in that the probabilities are estimates and could be difficult to calculate. A
particular example is illustrated in the probabilities associated with project LMT.
(iii) Other factors that merit consideration are as follows.
 How well diversified are the shareholders of Strathburn Ltd?
Well diversified under portfolio theory/CAPM requires investors to hold 15-20 well
chosen shares. This will allow shareholders to diversify away any unsystematic risk.
Since Strathburn Ltd is a family-owned business, the owners are less likely to be fully
diversified and so they should select option 2 which spreads their investment across
two projects, rather than investment returns totally dependent on project LMT.
 Assuming shareholders are risk-averse, the fact that option 2 has only a 25% chance of
making a negative NPV while option 1 has a 58% chance would lend support to the
selection of projects GTV and CUJ.
 If the shareholders are well diversified, then the criteria for selecting a project or not
should be guided by the 'systematic risk' (market risk) carried by the investment, i.e.
the extent to which the investment earnings are sensitive to changes in the macro
economy.
 The choice of discount rate for the projects will need to take full account of the
business and finance risks associated with each.
25 SENATOR TERRY TRUFO
Calculations of cash flows
Average annual revenue = 0.6  CU70,000 + 0.4  CU40,000
= CU58,000
Post-first year annual costs = 0.6  CU55,000 + 0.4  CU30,000
= CU45,000
First year's costs = CU55,000
(a) Accounting rate of return

CU
Initial investment
Legal costs 4,000
Machinery 40,000
Existing equipment 1,000
45,000
Final book value
Machinery 5,000
Total depreciation (45,000 – 5,000) 40,000
Total production and labour costs (average) (9  45,000 + 55,000) 460,000
Total reallocated fixed costs 50,000
550,000
Total revenue (average) 580,000
Total profit 30,000
Average annual profit 3,000
3,000 2
(i) ARR =  100 = 6 /3%
45,000
3,000
(ii) ARR =  100 = 12%
1
2 (45,000  5,000)
30,000 2
(iii) ARR =  100 = 66 /3%
45,000
(b) Payback
Payback is a measure based on relevant cash flows, which are as follows.
Time Cash flow Narrative
CU
0 (20,000) First instalment on printing machinery
0 (2,000) Opportunity cost of existing plant
1 (20,000) Second instalment on printing machinery
1 (55,000) First year's labour and production cost
2 – 10 13,000 Net cash inflows from project
10 5,000 Scrap proceeds of plant
11 58,000 Final year's revenue
Notes
(1) The legal and academic research has already been done, and the cost of it is not saved if the
project does not proceed. It is a sunk cost.
(2) Fixed costs reallocated to the project are not cash flows.
The cash outflows at times 0 and 1 (total CU97,000) are recouped at a rate of CU13,000
per year and hence are repaid in 7.46 years
Since cash inflows start at time 2, payback is in 8.46 years or nine years if receipts are
assumed to arise at year-ends.
(c) Internal rate of return
NPV @ 8% = CU10,939 (see part (d) below)
Since this is positive the second 'guess' is higher, reducing the effect of the later positive cash
flows.
Hence, NPV @ 12% = CU(8,878) (again, see part (d))
The IRR must therefore be between 8% and 12%.
By interpolation,
NPV1
IRR = a + (b – a)
NPV1  NPV2
10,939
=8+  (12 – 8)
10,939  ( 8,878)
= 8 + 2.2
= 10.2%, say 10%.
(d) Net present value
Time Cash flows Discount Present Discount Present
factor value factor value
@8% @8% @12% @12%
CU'000 CU'000 CU'000
0 (22) 1 (22) 1 (22)
1 (75) 0.926 (69.45) 0.893 (66.975)
2 – 10 13 5.784 (W1) 75.192 4.757(W1) 61.841
10 5 0.463 2.315 0.322 1.61
11 58 0.429 (W2) 24.882 0.287 (W2) 16.646
10.939 (8.878)
WORKINGS
(1) AF(2 – 10) = AF(1 – 10) – DF(1)
At 8% AF(2 – 10) = 6.71 – 0.926 = 5.784
At 12% AF(2 – 10) = 5.65 – 0.893 = 4.757
1
(2) DF(11) =
(1  r)11
1
At 8% DF(11) = = 0.429
1.0811
1
At 12% DF(11) = = 0.287
1.1211
(e) Sensitivity
(i) Required rate of return
As shown in part (c) the project has an IRR of 10%; therefore the required rate of return
can rise from 8% to 10% before the investment decision would change. This represents a
rise of 2 percentage points or
2
 100 = 25%
8
(ii) Sales revenue
Present value of sales revenue is
AF(2 – 11 @ 8%)  CU58,000 = (5.784 + 0.429)  CU58,000
= CU360,354
The percentage change in sales revenue required to change the decision is given by
10,939
 100% = 3.04%
360,354
(iii) Life of project

If project were shortened by one year the NPV would fall by
DF(11 @ 8%)  58,000 – DF(10 @ 8%)  45,000
= 0.429  58,000 – 0.463  45,000
= CU4,047
Shorten the project by a further year and the NPV falls by
DF(10 @ 8%)  58,000 – DF(9 @ 8%)  45,000
= 0.463  58,000 – 0.500  45,000
= CU4,354
The NPV of the project is thus reduced to 10,939 – 4,047 – 4,354 = CU2,538
PV of cash flows of the eighth year are
DF(9 @ 8%)  58,000 – DF(8 @ 8%)  45,000
= 0.50  58,000 – 0.54  45,000
= CU4,700
This is sufficient to change the positive NPV (CU2,538) into a negative and hence alter the
initial decision to go ahead.
3 years
Sensitivity = or 30%
10 years
Note: The effect of receiving the sale proceeds of plant earlier is small and has been
ignored.
26 COMFIFEET LTD
(a) Determination of the benefit of advertising
Assessment of the advertising decision
20X1 20X2 20X3 20X4
CUm CUm CUm CUm
Additional contributions (W1) 1.330 0.998 0.665
Tax thereon (0.399) (0.299) (0.200)
Working capital (W2) (0.095) 0.024 0.024 0.047
Advertising (1.000) (1.000) (1.000)
Tax thereon 0.300 0.300 0.300
(0.795) 0.255 0.023 0.512
Discount factor 1.000 0.909 0.826 0.751
Discounted (0.795) 0.231 0.019 0.385
NPV = CU(0.160)m
Therefore, do not advertise.
WORKINGS
(1) Additional contributions
CUm
20X2 CU10m ((0.25  0.60) + (0.10  0.40))  0.70 1.330
20X3 CU7.5m ((0.25  0.60) + (0.10  0.40))  0.70 0.998
20X4 CU5m ((0.25  0.60) + (0.10  0.40))  0.70 0.665
(2) Working capital on additional sales
20X1 1.900  0.05 (0.095)
20X2 (1.900 – 1.425)  0.05 0.024
20X3 (1.425 – 0.950)  0.05 0.024
20X4 0.950  0.05 0.047
(b) Determination of the factory closure date

Assessment of the closure decision
20X1 20X2 20X3 20X4
CUm CUm CUm CUm
Contributions (sales  0.70) 7.000 5.250 3.500
Tax thereon (2.100) (1.575) (1.050)
Rent (4.000) (4.000) (4.000)
Tax thereon 1.200 1.200 1.200
Plant (1.000) 0.200
Tax depreciation (W3) 0.063 0.048 0.036 0.047
0.047
Fixed costs (0.700) (0.700) (0.700)
Tax thereon 0.210 0.210 0.210
Redundancy payments 0.400 (0.450)
Tax thereon (0.120) 0.135
Working capital (W4) (0.500) 0.125 0.125 0.250
(5.110) 1.783 0.546 3.342
Discount factor 1.000 0.909 0.826 0.751
Discounted (5.110) 1.621 0.451 2.510
NPV = CU(0.528)m
Therefore close the factory in 20X1.
WORKINGS
(3) Tax depreciation
CUm CUm
20W8 Cost 2.000
TDA 0.500
1.500
20W9 TDA 0.375
1.125
20X0 TDA 0.281
0.844
either
20X1 Disposal 1.000
Balancing charge 0.156 @ 30% 0.047
or
20X1 TDA 0.211 @ 30% 0.063
0.633
20X2 TDA 0.159 @ 30% 0.048
0.474
20X3 TDA 0.119 @ 30% 0.036
0.355
20X4 Disposal 0.200
Balancing allowance 0.155 @ 30% 0.047
(4) Working capital on basic sales

CUm
20X1 10.000  0.05 (0.500)
20X2 (10.000 – 7.500)  0.05 0.125
20X3 (7.500 – 5.000)  0.05 0.125
20X4 5.000  0.05 0.250
27 GFL
(a)
2006 2007 2008 2009
Y0 Y1 Y2 Y3
CU'000 CU'000 CU'000 CU'000
Machine sale forgone (W1) (1,100.000)
Tax on machine sale forgone (W1) (210.000)
Revised machine sale (W2) 200.000
Revised machine tax savings (W2) 135.000 101.250 243.750
Contract price 2,000.000 5,000.000

Tax on contract (600.000) (1,500.000)
Materials (W3) (836.400) (977.058)

Labour (W3) (1,503.990) (1,784.969)
Tax saved on Mats/Lab 702.117 828.608
Total cash flow 825.000 (2,137.023) 3,510.331 (1,500.000)
Factor 1.000 0.917 0.842 0.772
PV 825.000 (1,959.650) 2,955.699 (1,158.000)
NPV 663.049
Thus the NPV is positive with a total project price of CU7 million and should be accepted.
(b) Break even project price:
y = reduction in income in year 2.
0.842y – 0.3y x 0.772 = CU663,049
0.6104y = CU663,049
y = CU1,086,253
Thus breakeven income in year 2 = CU5,000,000 – CU1,086,253 = CU3,913,747
Total project price = CU5,913,747
(c) Possible risks with overseas investment (excluding forex) are:
 Financing, e.g. borrow locally to offset political risk?
 Political risk, e.g. mild political interference or more severe?
 Business risk, e.g. level of systematic business risk abroad and discount rate?
 Tax, e.g. corporation tax rate, tax depreciation, tax treaties?
 Remitting funds back to Bangladesh, e.g. dividends, royalties, management charges?
 Culture, e.g. different business practices?
WORKINGS
(1) Machine – sell
CU'000
Cost 3,200.000
TDA 04 800.000
WDV 04 2,400.000
TDA 05 600.000
WDV 05 1,800.000
Bal Adj 06 700.000
sale 06 1,100.000
Tax on Bal all @ 30% 210.000
(2) Machine – carry on

2006 2007 2008
WDV b/f 1,800.000 1,350.000 1,012.500
TDA 450.000 337.500 812.500
WDV/sale 1,350.000 1,012.500 200.000
Tax on TDA 135.000 101.250 243.750
(3)
1.02 1.03
Materials Real –820.000 –930.000
Money –836.400 –977.058
Labour t/f Y1 – 6 months (premium) Real –34.500
Labour t/f Y2 (premium) Real –69.000
Labour new Y1– 6 months Real –190.000
Labour new Y2 Real –380.000
Supplementary workers Real –830.000 –830.000
Extra management Real –420.000 –420.000
Total wages Real –1,474.500 –1,699.000
Money –1,503.990 –1,784.969
Answers to Interactive questions
Answer to Interactive question 1

NPV = – 125,000 + [(100 – 30) 2,000 – 100,000]  3.791
= CU26,640
Sensitivity to
(1) Selling price
125,000 = [(P – 30) 2,000 – 100,000]  3.791 Alternatively
32,973 = 2,000P – 60,000 – 100,000 CU26,640
P = 96.49 2,000  CU100  3.791
i.e. fall of 3.51% before NPV is zero.
(2) Variable costs
125,000 = [(100 – V) 2,000 – 100,000]  3.791 Alternatively
32,973 = 200,000 – 2,000V – 100,000 CU26,640
V = 33.51 2,000  CU30  3.791
i.e. increase of 11.7% before NPV is zero.
(3) Volume
125,000 = [(100 – 30) q – 100,000]  3.791 Alternatively
32,973 = 70q – 100,000 CU26,640
q = 1,900 2,000  (CU100 – 30)  3.791
i.e. fall of 5% before NPV is zero.
(4) Initial cost Alternatively
CU(125,000 + 26,640) = CU151,640 CU26,640
i.e. increase of 21% before NPV is zero. CU125,000
(5) Fixed costs
125,000 = [(100 – 30) 2,000 – F]  3.791 Alternatively
32,973 = 140,000 – F CU26,640
F = 107,027 CU100,000  3.791
i.e. an increase of 7% before NPV is zero.
(6) Life
125,000 = 40,000  AFn @ 10%
3.125 = AFn @ 10%
AF for 4 years at 10% is 3.17
i.e. life can fall to approximately 4 years before NPV is zero.
(7) Discount rate
3.125 = AF for 5 years @ x %
From tables AF for 5 years @ 18% is 3.127, so x is approximately 18%
i.e. an increase of 80% before NPV is zero.

(a) NPV
t0 t1 t2
CU CU CU
Sales – current values inflated @ 6% 53,000 56,180
Costs – current values inflated @ 4% (31,200) (34,611)
21,800 21,569
Tax @ 30% (6,540) (6,471)
Investment (20,000)
(20,000) 15,260 15,098
DF @ 10% 1 0.909 0.826
PV (20,000) 13,871 12,471
NPV = CU6,342
(b) Sensitivity
Let R = revenue at t1 and t2 in current terms.
CU Time DF PV
Investment (20,000) t0 1 (20,000)
After tax revenue 0.7  1.06R t1 0.909 0.674R
After tax revenue 0.7  1.062R t2 0.826 0.650R
After tax costs 0.7  (31,200) t1 0.909 (19,853)
After tax costs 0.7  (34,611) t2 0.826 (20,012)
1.324R – 59,865
If 1.324R – 59,865 = 0, then R = CU45,215

This is CU4,785 less than the CU50,000 estimated. CU4,785 is 9.6% of CU50,000, so revenue can fall
by 9.6% before the NPV becomes zero.
Alternatively
PV of revenue
t1 t2
CU CU
Revenue 53,000 56,180
Tax effect (15,900) (16,854)
37,100 39,326
DF @ 10% 0.909 0.826
PV 33,724 32,483
PV = CU66,207
NPV £6,342
Sensitivity =  100% =  100% = 9.6%
PV of CFs affected £66,207

Project 1 Expected value = (CU100  0.4) + (CU200  0.3) + (CU1,000  0.3) = CU400m
Project 2 Expected value = (0  0.4) + (CU500  0.3) + (CU600  0.3) = CU330m
Project 3 Expected value = (CU180  0.4) + (CU190  0.3) + (CU200  0.3)= CU189m
Therefore, based on expected values, Project 1 should be adopted.

Year 1 Expected sales = (10,000  0.3) + (15,000  0.7)
= 13,500
Year 2 Expected sales = (0.3 (8,000  0.2 + 10,000  0.8)) + (0.7 (20,000  0.6 + 10,000  0.4))
= 14,080

13,500  CU10 14,080  CU10
NPV = – CU230,000 +  = CU9,090
1.1 1.12
Alternatively (using discount tables):
NPV = – CU230,000 + (13,500  CU10  0.909) + (14,080  CU10  0.826) = CU9,016
(difference due to rounding).

If a special contract of 800 units is agreed, the fixed capacity of 1,200 units means that John can only meet
demand from regular customers of 400 units even if they want more than that.
CU
Hence contribution is: 800  CU3 = 2,400
+ 400  CU5 = 2,000
4,400
If a special contract of 700 units is agreed John will have spare capacity of 500 units.
If demand from regular customer is 400 units, John will have unused capacity of 100 units and contribution
of
CU
700  CU3 = 2,100
+ 400  CU5 = 2,000
4,100
If demand is higher than 400, contribution will be:
CU
700  CU3 = 2,100
+ 500  CU5 = 2,500
4,600
The other pay offs are calculated in a similar fashion.
Having found each pay off, the expected value for each choice can be found
Special contract (units)
800 700 500 300
1  4,400 0.2  4,100 0.2  3,500 0.2  2,900
0.8  4,600 0.3  4,000 0.3  3,400
0.5  5,000 0.4  4,400
0.1  5,400
EV 4,400 4,500 4,400 3,900
John should commit to a special contract of 700 units, based on expected value.

The odds are the same as in the previous game but the sums of money involved are much larger and the
game will not be repeated. If you lose, you do not have a chance of winning back your money.
Whether or not you accept this gamble depends on much more than the expected value of CU1,000. You
would somehow be weighing up the following factors in your mind:
(a) The chances of winning CU5,000
(b) How much you would enjoy winning CU5,000 (the level of satisfaction is often referred to as 'utility')
(c) The chances of losing CU3,000
(d) How much you would dislike losing CU3,000
(e) How much you like or dislike taking risks
(f) How much you trust me!
For most people the unacceptability of incurring a loss of CU3,000 would prevent them playing, even
though the game has a positive expected value. They are risk-averse.

(a) All CU4m in X
Expected outcome = (0.5  30%) + (0.5  –15%) = 7½%
So 7½%  CU4m = CU300,000 NPV
(Best outcome 30%  CU4m = CU1.2m; worst outcome – 15%  CU4m = – CU0.6m)
All CU4m in Y – as X above.
(b)
EV NPV Probability
Y + 30% 0.5 30% CU1.2m 0.25
X 30% 0.5 O
Y – 15% 0.5 71/2% CU0.3m 0.25
O
Y + 30% 0.5 71/2% CU0.3m 0.25
X - 15% 0.5 O
Y – 15% 0.5 -15% CU0.6m 0.25
E(NPV) C0.3m 1.00

Sector Likely beta Performance
Supermarkets <1 Food retailers and drug companies tend to be recession proof due
to selling necessities. Their fortunes however do not lift
Pharmaceuticals
significantly when economic prosperity arrives.
Construction >1 Industries involved in capital goods, or which make and sell non-
essential goods and services e.g. air travel, will show a high degree
Airlines
of systematic risk.
Car manufacturing

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chapter 3

Risk and decision making

Learning objectives Tick off

The syllabus references that relate to this chapter are 3f, g, i.

Stop and think

1 Introduction to risk and uncertainty

1.3 Methods of dealing with decision making under risk and

2.2 Basic principle

Worked example: Sensitivity analysis

1–5 Factory rent (8) 4.329 (34,632)

On the basis of the estimates given, manufacture of the Azam is worthwhile.

(1) Material price

Interactive question 1: Sensitivity analysis [Difficulty level: Intermediate]

See Answer at the end of this chapter.

Interactive question 2: Non-recurring cash flows [Difficulty level: Intermediate]

See Answer at the end of this chapter.

2.3 Strengths and weaknesses of sensitivity analysis

Sensitivity Information will be presented to management in a form which facilitates subjective

3.1 Monte Carlo simulation

3.2 Who uses it?

Worked example: Monte Carlo simulation

3.3 Results of a simulation exercise

Distribution of simulated NPVs for two projects

3.4 Advantages and limitations of simulation

4 Expected values and attitude to risk

4.1 Expected values

Worked example: Expected values

Interactive question 3: Expected payoff [Difficulty level: Easy]

See Answer at the end of this chapter.

Interactive question 4: Uncertain sales [Difficulty level: Intermediate]

See Answer at the end of this chapter.

Interactive question 5: Uncertain contribution [Difficulty level: Intermediate]

See Answer at the end of this chapter.

4.2 Analysing the outcomes

There are now four possible outcomes with NPVs as follows:

i.e. exactly as in Example 5 but there is now much more information.

4.3 Advantages and limitations of expected values

4.4 Payoff tables

Interactive question 6: Payoff table [Difficulty level: Intermediate]

See Answer at the end of this chapter.

4.5 Attitude to risk

Worked example: Risk aversion

Interactive question 7: Risk aversion [Difficulty level: Easy]

See the Answer at the end of the chapter.

Worked example: Attitude to risk

5 Diversification and the portfolio effect

5.2 The portfolio effect

Worked example: Risk reduction

Interactive question 8: Diversification [Difficulty level: Intermediate]

See Answer at the end of this chapter.

5.3 Systematic and non-systematic risk

5.4 Systematic risk and return

5.4.2 Measuring systematic risk

Graphical representation of CAPM

5.5 CAPM equation

5.5.3 Estimating the variables

5.6 Aggressive and defensive shares

Interactive question 9: Different sectors [Difficulty level: Intermediate]

See Answer at the end of this chapter.