Question 5.7: Frank N. Stein plc has the opportunity to invest in two inve...
Frank N. Stein plc has the opportunity to invest in two investment projects in Transylvania. The possible outcomes from each project will depend on whether the ruling party of the country wins or loses the next election. (For the sake of simplicity, we shall assume the ruling party will either win or lose outright and there is no possibility of another outcome, such as a hung parliament.) The NPV from each project under each outcome is estimated as follows:
| Project 1 NPV £m |
Project 2 NPV £m |
|
| Ruling party wins | (20) | 30 |
| Ruling party loses | 40 | (30) |
What should the business do to manage the risks involved in each project?
If the business invests in both projects, the total NPV under each outcome will be as follows:
| Project 1 NPV £m |
Project 2 NPV £m |
Total returns £m |
|
| Ruling party wins | (20) | 30 | 10 |
| Ruling party loses | 40 | (30) | 10 |
We can see that, whatever the outcome of the election, the total NPV for the business will be the same (that is, £10 million). Although the possible returns from each project vary according to the results of the election, they are inversely related and so the total returns will be stabilised. As risk can be diversified away in this manner, the relationship between the returns from individual investment projects is an important issue for managers.