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Inflation and Probability (Inflation (We need to be clear in the analysis,…
Inflation and Probability
Inflation
We need to be clear in the analysis
Have the cash flows been adjusted for inflation effects?
Has the discount factor been adjusted to incorporate risk of inflation?
There is both general and specific inflation
General inflation impacts on the cost of capital
Specific inflation impacts on investment costs and revenues
The uncertainty associated with the value of future cash flows is increased
We can use either a nominal or real terms approach to investment appraisal
Nominal terms: nominal cash flows use nominal cost of capital
Real terms: Real cash flows for the nominal approach, multiply the real rate (without inflation) by inflation
The real value of future cash flows can be seriously reduced
Inflation can have a serious effect on capital investment decisions
Risk and uncertainty
Risk refers to a set of unique circumstances, which can be assigned probabilities
Uncertainty implies probabilities cannot be assigned to different sets of circumstances
In practice the terms risk and uncertainty are often used interchangably
Risk increases with variability of returns
Uncertainty increases with project life
Probability Analysis
Probabilities allow risk to be quantified
A probability assigns a measurement to the likelihood of an event occurring. The event could be the cash flows or NPV.
Objective Probabilities can be established mathematically or from historical data.
Subjective probabilities involve personal judgement of the range of outcomes along with the likelihood of their occurrence
Probability distributions of expected cash flows can be used to obtain expected NPVs
Project risk can be evaluated in different ways
The expected net present value (ENPV)
The probability of a negative NPV
The probability of a worst case
The standard deviation of project NPV
The expected Rate of return is the average outcome based on a range of probabilities
Standard Deviation
Risk is measured by the standard deviation
Standard deviation is a measure of dispersion of the data around the expected return (equal to square root of deviation)
The data can be shown as a probability distribution, taking the form of a histogram or normal distribution curve
Expected return is the mean outcome calculated by:
Weighting each of the possible outcomes by the probability of occurrence
Then summing the result
Probability Analysis Steps - calculation
Build Step 1 Template
Economy
Probability
Returns X Probability
Add to get Expected Returns
Returns (NPV)
Build Step 2 Template
Returns
Expected Returns
Deviation
Deviation Squared
Proabability
Deviation Squared X Probability
Build Step 3 Template
Expected Return/NPV
Standard Deviation
CV
Standard Deviation/Expected Return