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ACCA Applied Skills · Financial Management · Adjusting for risk and uncertainty in investment appraisal

Kestrel Ltd is appraising a project with three possible outcomes. Its analyst has estimated the probability of each outcome from past experience of similar projects and calculated an expected net present value (NPV) of $84,000. Which statement about this situation is correct?

This is a situation of risk, because the outcomes are identified and probabilities can be assigned to them, allowing an expected NPV to be calculated. Uncertainty arises when probabilities cannot be estimated. The expected value is only an average and does not guarantee the result or eliminate variability.

  1. AThe situation involves risk, because probabilities can be assigned to the outcomes and an expected value calculatedCorrect
  2. BThe situation involves uncertainty, because the future cash flows are not known with certainty
  3. CThe expected NPV of $84,000 is the NPV that will definitely arise if the project is accepted
  4. DThe expected NPV removes all variability, so the project can be regarded as risk-free

Explanation

In ACCA terminology, risk exists when the possible outcomes are known and probabilities can be attached to them, which allows an expected value to be calculated. Uncertainty applies when probabilities cannot be assigned. The expected NPV is only a weighted average and does not guarantee the outcome or remove variability, so options 2-4 are wrong or misleading.

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