Investment appraisal

In business, a manager should always look at opportunities from the perspective of the return.  All opportunities should be assessed with a view to the venture making a profit. When an opportunity is presented, an investor wants to be sure that there will be a profit on their investment.

However, not all opportunities have a positive outcome and it is better to assess the risk before making any commitments. Not everyone has the same view of risk.

There are many factors to consider from an individual’s perspective: some people are more risk adverse than others; some may be better informed, that’ not insider dealing either.

The accepted ways of assessing risk can be categorised as follows:-

Expected values

This is the probability of the outcome being achieved, generally worked with a range of values.

Risk adjusted discount factor

This is the subjective approach where an inherent risk factor is built into the calculation. Any project which has a negative value after applying the calculation is automatically disregarded.

 Payback

Not to be used in isolation, but the shorter the payback period, the lower the risk.

 Simulations

This involves using all the factors to complete a scenario analysis. This is often too complex to be undertaken without the use of specialist programmes.

Sensitivity analysis

Where each factor, sales, volumes, direct costs, fixed costs and profits are assessed and calculated to show how wrong the estimates in percentage terms has to move before profits go negative.

If the investment opportunity has a high profit margin then sales can fall or costs rise by acceptable percentages and still the project can be profitable. Conversely if profit margins are low then the acceptable margin of error is reduced and increasing risk.