Notes on methods of dealing with risk and uncertainty

in investment appraisal

A. Traditional Methods
1. Risk adjusted discount rate
This is the riskless rate plus a risk premium which increases the discount rate for a
project as the investment increases in risk. The key issue is the extent of the adjustment
-if the risk-free rate is 4% how does the analyst judge the risk premium? It is not an
exact science and the NPV of the project might be sensitive to small changes in risk
premium.
Lewellen W. G. (1977) Some Observations on Risk-Adjusted Discount Rates, The Journal
of Finance, Vol. 32, No. 4, pp. 1331-1337
2. Expected Net Present Value
The expected net present value is calculates as follows:
(
Where ( )
But;

probability of outcome,

( )
.

Difficulty of defining probabilities if large losses are possible.

Essentially risk neutral.
The value of the project may be linked with other outcomes.
Assumes that all outcomes and their probabilities can be identified.

3. Sensitivity analysis
If probabilities cannot be assigned to outcomes then the analyst may calculate the NPV
based on an optimistic forecast, a pessimistic forecast and one in the middle of the two.
The projects are then compared in relation to the sensitivity of the results to the

changes assumptions and parameters (e.g. in relation to discount rates). It is, however,
possible that the analysis (choice of parameters) may be influenced by the risk attitude
(risk averse/lover/neutral).

B. Modern approaches
Modern approaches tend to focus on particular decision rules which are usually derived
from decision theory. The data in the table below will be used to illustrate some of
these concepts.
NPV
Project

N1
1
2
3

200
350
180

N2
180
100
240

N3
120
200
150

Bayes-Laplace criterion sometimes referred to as Laplace insufficient reason

criterion. In this case the probabilities of the outcome are unknown but are assumed
equal. Projects will then be judged on the payoffs generated by averaging over all states
of nature. This is somewhat similar to the expected payoff above but in that case
probabilities are not assumed equal.

Project

1
2
3

N1
200 x 1/3
350 x 1/3
180 x 1/3

NPV
N2
180 x 1/3
100 x 1/3
240 x 1/3

N3
120 x 1/3
200 x 1/3
150 x 1/3

Row sum
166.667
216.667
190

On the basis of this criterion Project 2 is chosen. But the outcome may be a function of
the number of events considered and whilst convenient the assumption of equal
probabilities is extremely strong.
Maximin assumes that decision-makers are risk averse. Consider the worst that
could happen and choose the outcome that has the maximum minimum value. In the
payoff matrix below the decision-maker lists the three worst payoffs and chooses
project 3 on that basis. This is an ultraconservative approach.
Maximax the decision-maker chooses the alternative which maximises the maximum
payoff and is thus a very optimistic approach because the decision-maker assumes the
best of all possible worlds.
Minimax regret this is a more complex approach which tries to assign penalties for
making the wrong decision. For example if Project 1 is chosen and outcome N2 occurs
then the opportunity cost of this decision is the foregone additional payoff of the best
outcome given that N2. In the above example it would have been better to choose

Project 3 because that has an extra 60 payoff. The difference between the best payoff
and the payoff for each project under a given assumption is set out in what is referred to
as the regret matrix and is given below.

Project

1
2
3

N1
50
0
170

NPV
N2
60
140
0

N3
80
0
50

Row Sum
290
140
220

Each element is the regret matrix is the cost of making the incorrect choice and the
decision-maker chooses the project with the lowest minimum regret. Thus in our
example Project 2 is chosen.
Hurwicz criterion uses a weighting system which depends on the decision-makers
attitude towards risk which attempts to strike a balance between the maximax and
minimax strategies. The maximum and minimum outcomes of each strategy is
calculated using weights and (1-) and the chosen value of reflects the decisionmakers attitude towards risk (to see that this is the case if = 1 the maximin criterion
is generated but if = 0 the outcome is the maximax criterion).