What methods are used to mitigate risk in investment appraisal?

Risk in investment appraisal can be mitigated through diversification, sensitivity analysis, scenario analysis, and the use of real options.

Diversification is a key method used to mitigate risk in investment appraisal. This involves spreading investments across a variety of assets or asset classes to reduce exposure to any single investment. By doing this, the potential loss from one investment can be offset by gains from others. This method is based on the principle that not all investments will perform poorly at the same time or at the same rate.

Sensitivity analysis is another method used to manage risk. This involves changing the values of key variables in an investment appraisal to see how sensitive the outcome is to those changes. For example, if the projected revenue from an investment is highly sensitive to changes in the price of a key input, this could be a significant risk. By identifying these risks, steps can be taken to manage them, such as securing long-term contracts for key inputs at fixed prices.

Scenario analysis is a similar method to sensitivity analysis, but instead of changing one variable at a time, it involves creating different scenarios that reflect a range of possible outcomes. These scenarios might include best-case, worst-case, and most likely outcomes. By considering a range of scenarios, investors can better understand the potential risks and rewards of an investment.

Finally, the use of real options can also help to mitigate risk. Real options are choices that investors have that can change the value of an investment. For example, an investor might have the option to expand, contract, or abandon an investment at certain points in time. By exercising these options, investors can respond to changes in the market or the performance of the investment, thereby managing risk.