ACCA Applied Skills · Financial Management · Adjusting for risk and uncertainty in investment appraisal
A project has three possible outcomes: an NPV of $120,000 with probability 0.3, an NPV of $50,000 with probability 0.5, and an NPV of -$40,000 with probability 0.2. What is the expected value of the project's NPV?
The expected NPV is $53,000. Each possible NPV is multiplied by its probability and the results are summed, including the negative outcome: 36,000 plus 25,000 minus 8,000. A simple average or the most likely outcome would ignore the probability weights.
- A$53,000Correct
- B$43,333
- C$61,000
- D$50,000
Explanation
EV = (0.3 × 120,000) + (0.5 × 50,000) + (0.2 × -40,000) = 36,000 + 25,000 - 8,000 = $53,000. $43,333 is a simple average that ignores the probabilities. $61,000 leaves out the negative outcome. $50,000 is only the most likely outcome.
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