Investment Decision

Under Conditions of
Uncertainty

A brief overview of investment

Investment decision isdecision
a process of committing companys

funds into long term projects with an expectation of future

benefits.
An investment decision would generally include expansion,
acquisition, modernization and replacement of fixed asset.
Investment decision of the firm are alternatively called the
capital budgeting, investment appraisal or capital
expenditure decisions.
Investment decisions are crucial because:
It involves commitment of large sum of money and
may introduce drastic change in a company
They have long term implications for the firm
They are usually irreversible

What is uncertainty?
It refers to a situation whereby the
investor or financial analyst can not
estimate future returns accurately.
Uncertainty occurs where the future
outcome cannot be predicted with
any degree of confidence from
knowledge of past or existing
events, so that no probability
estimates are available.

In conditions of uncertainty, the

probability of occurrence of
earning is not known. Some
factors like inflation, government
policies and political stability
impose substantial risk on the
business firm.
Inflation makes the future cash
flow of a business uncertain.
Frequent changes in government
also affect the pattern of cash flow

 Under conditions of uncertainty, the

investor cannot accurately predict
what the returns and the
probability of occurrence will be.
To handle uncertainty, the investor
identifies the various stages of
nature of the investment and then
attaches a subjective probability to
each of these stages.

 These probabilities are sometimes

subjective as may be based on
guesswork though predicated on the
experience of the analyst in a given
economic environment.
The probabilities can, however be
made objective if the project at hand is
not completely new. In this case an
objective probability can be established
based on empirical data of related
project.

 What is Risk?
Risk occurs where it is not known
what the future outcome will be but
where the various possible
outcomes
may be expected with some degree
of
confidence from knowledge of past
or existing events.

Measures of Risk and

Uncertainty

The risk of an investment

project is measured by the
variability or dispersion of its
cash flow about the expected
value (expected cash flow)

The common measures of risk

are
variance,
standard deviation
coefficient of variation.

 Variance is the average of the

squared deviation from the
expected value, while the
standard deviation is its positive
square root.Given as:
Variance 2 = X E(x) 2.P
Standard deviation () = of variance
Where:

2 = variance
= standard deviation
X = outcome
E(x) = expected value (outcome)
P = probability of the outcome

Illustration A
Calculate the variance and the
standard deviation from the following
probability distribution

Project A
Cash
P
flow
750
0.30
1,000
0.50
1,375
0.20

Project B
Cash
P
flow
5,500
0.20
1,000
0.50
-2,000
0.30

 Solution: Project A
Cash flow Probabilit X.P
(x)
y
P

750
1,000
1,375

(x
E(x))2

(x
E(x))2.P

0.30
0.50
0.20

225 62,500 18750

500 0
0
275 140,62 28,125
5
100 46,875
E(X) = 1000 Variance is = 46,8750
2 = 46,875
= 216.50

Standard deviation is

Project B
Cash
flow

Probabili X.P
ty

(X
E(X))

5,500

0.20

1100 2025000 4050000

0

1000

0.50

500

-2000

0.30

-600 9000000 2700000

1000 6750000

( X E(X) )
.P

For project B, E(X) = 1000

The variance is: 2 = 6750000
The standard deviation is:

=6750,000
= 2,598

The projects have the same

expected cash flow (E(x) =
1000), but with differences in
their variance and standard
deviation.
Project B has a higher
deviation, therefore it is more
risky

Coefficient of Variation
Coefficient of variation is the
relationship between the
expected value and the
standard deviation. It is
calculated thus:
Cov = / E(x)
This measures the risk per
naira of expected cash flow.

Illustration B
Expected
Cash flow
Standard
Deviation

Project
A
250

Project B

10

30

1000

The coefficient of variation are:

VA = 10/250 = 0.04
VB =30/1000 = 0.03
Since VB is less than VA, we
conclude that project A is more

Methods of Incorporating
Risk

The methods of incorporating

risk in capital budgeting include:
The payback period,
Risk Adjusted discount rate
Certainty equivalents
The expected net Present
Value
The variance of net present
value

Payback Period (PBP)

This refers to the length of time it takes for
the cash inflows to repay the outlays. It is
used to determine how quickly a project
repays its outlay.
It can be calculated in two different ways
depending on its cash flows
i. Annual constant cash flowi.e the same
amount every year. If the annual cash flows
are constant, the PBP is calculated as follows:
= Outlay
ACCF (Annual constant Cash flow)

ii. Non constant cash flows( Irregular):

if the cash flows are irregular a recouping approach
will have to be applied as follows.

CASH
Until
the balance
is zero
YEA
OUTLA
FLOW
R
Y
0

(A)

BALANCE

(A)

1
2
3

B
C
D

(A) + B
(A) + B+C
(A) +
B+C+D

(A) +

Illustration Payback
Period
1. Xerox Ltd is considering a project
requiring an investment of N10million.
You are required to calculate the PBP.
a) If the annual cash flow is N2.5 million
b)If the cash flows are as follows.
YEA
R
1
2
3
4

CASH
FlOW
2.1m
2.7m
3.4m
4.5m

Solution

a. Constant cash flow (PBP) = Outlay = N10m

ACCF
2.5m
= 4years

b.

YEAR
0
1
2
PBP
3
4

CASH
FLOW
10m
2.1m
2.7m
= 1.8
3.4m
4.5 = 0.4
; 3 yrs+
4.5m

BALANCE
(10m)
(7.9m)
(5.2m)
(1.8m)
0.4
yrs = 3.4years
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