5.4 Evaluation of Risk
In the examples we have covered so far, we have started out by saying things like “the project will have an annual revenue of $2000” or “the equipment will have a salvage value of $500 after 10 years”. But what if these assumptions are wrong? In reality, a project may not be worth what you initially expect, and this discrepancy introduces risk. Using a MARR for discounting cash flows allows us to roughly control for risk (as discussed in Section 5.1); but what about unforeseen circumstances that might create a large impact? For example, what if the economy slows down unexpectedly, reducing sales by 20% of a company’s estimate? What if the company’s borrowing rate changes? Consider the effect on businesses when the price of oil fell dramatically in 2014. Crude oil prices fell from $111 USD/barrel in June 2014 to $48 USD/barrel in January 2015, devastating Alberta’s provincial economy.
If the project you are undertaking has very certain outcomes, or will not have severe negative implications if unsuccessful, then you may be able to rely on the basic approaches we have covered already in this chapter. Otherwise, you will want to prepare for risk in your project. In this section, we will see how to analyze and account for risk.
Terminology
Here are some basic terms that will be used in this section.
- Risk: The chance that a project’s actual return will differ from its expected return.
- Risk analysis: Identifying and evaluating the impact of various risks on the financial success of a project.
- Base case: A scenario representing the most likely case for a project, where the value of all project variables and cash flows is set at an average estimate. We measure risk by comparing different scenarios to the base case.
- Break-even point: The value of a specific project variable at which the overall project transitions from unprofitable to profitable (i.e. the project’s NPV is 0)
- Scenario: A possible set of conditions for a project. Estimates of project variables can be adjusted to create and compare different scenarios.
Methods of Evaluating Risk
We will cover three methods for evaluating risk. Below, we list each method and its application. We will review each method in more detail in the following sections.
- Sensitivity analysis → Used for identifying the project variables that, when varied, have the largest effect on the value of the project.
- Scenario analysis → In this method, a project’s base case is compared to one or more alternative scenarios (such as the best and worst cases) to identify the most extreme and most likely possible outcomes.
- Break-even analysis → This method identifies the value of a particular project variable that would cause the project to break even.
5.4.1 Sensitivity Analysis
In sensitivity analysis, we want to find the variables that have the largest effect on the project’s value. For example, if you were opening a commercial bakery whose profits were very sensitive to the price of grain, and