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(c) Within the context of investment appraisal, risk relates to the variability of returns and so it can be quantified, for example by forecasting the probabilities related to future cash flows. From this point of view, risk can be differentiated from uncertainty,which cannot be quantified. Uncertainty can be said to increase with project life, while risk increases with the variability of
returns.
It is commonly said that risk can be included in the investment appraisal process by using sensitivity analysis, which determines the effect on project net present value of a change in individual project variables. The analysis highlights the project variable to which the project net present value is most sensitive in relative terms. However, since sensitivity analysis
changes only one variable at a time, it ignores interrelationships between project variables.
While sensitivity analysis can indicate the key or critical variable, it does not indicate the likelihood of a change in the future value of this variable, i.e. sensitivity analysis does not indicate the probability of a change in the future value of the key or critical variable. For this reason, given the earlier comments on risk and uncertainty, it can be said that sensitivity analysis is not a method of including risk in the investment appraisal process.
Probability analysis, as its name implies, attaches probabilities to the expected future cash flows of an investment project and uses these to calculate the expected net present value (ENPV). The ENPV is the average NPV that would be expected to occur
if an investment project could be repeated a large number of times. The ENPV can also be seen as the mean or expected value of an NPV probability distribution. Given the earlier discussion of risk and uncertainty, it is clear that probability analysis is a way of including a consideration of risk in the investment appraisal process. It is certainly a more effective way of
considering the risk of investment projects than sensitivity analysis.
A weakness of probability analysis, however, lies in the difficulty of estimating the probabilities that are to be attached to expected future cash flows. While these probabilities can be based on expert judgement and previous experience of similar investment projects, there remains an element of subjectivity which cannot be escaped.