Chapter 13

RISK ANALYSIS IN CAPITAL BUDGETING

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OUTLINE
Sources and Perspectives of Risk Sensitivity Analysis Scenario Analysis Break-even Analysis Hillier Model Simulation Analysis Decision Tree Analysis Corporate Risk Analysis Managing Risk Project Selection under Risk Risk Analysis in Practice
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TECHNIQUES FOR RISK ANALYSIS

Techniques of risk analysis

Analysis of standalone risk

Analysis of contextual risk

Sensitivity analysis

Scenario analysis

Corporate risk analysis

Market risk analysis

Break-even analysis

Hillier model

Simulation analysis

Decision tree analysis

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SOURCES AND PERSPECTIVE OF RISK

Sources of Risk
Project-specific risk Competitive risk Industry-specific risk Market risk International risk Perspectives on Risk Standalone risk Firm risk Market risk
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SENSITIVITY ANALYSIS
(000)
YEAR 0 1. INVESTMENT 2. SALES 3. VARIABLE COSTS (66 2/3 % OF SALES) 4. FIXED COSTS 5. DEPRECIATION 6. PRE-TAX PROFIT 7. TAXES 8. PROFIT AFTER TAXES 9. CASH FLOW FROM OPERATION 10. NET CASH FLOW (20,000) 18,000 12,000 1,000 2,000 3,000 1,000 2,000 4,000 4,000 YEAR 1 - 10

NPV = -20,000,000 + 4,000,000 (5.650) = 2,600,000

( discount rate = 12 % ) RS. IN MILLION

RANGE
KEY VARIABLE PESSIMISTIC EXPECTED OPTIMISTIC PESSIMISTIC

NPV
EXPECTED OPTIMISTIC

INVESTMENT (RS. IN MILLION) SALES (RS. IN MILLION) VARIABLE COSTS AS A PERCENT OF SALES FIXED COSTS

24 15 70

20 18 66.66

18 21 65

-0.65 -1.17 0.34

2.60 2.60 2.60

4.22 6.40 3.73

1.3

1.0

0.8

1.47

2.60

3.33

PESSIMISTIC, NORMAL AND OPTIMISTIC SCENARIO

Pessimistic Scenario 1. Investment 2. Sales 3. Variable costs 4. Fixed costs 5. Depreciation 6. Pre-tax profit 24 15 10.5 (70%) 1.3 2.4 0.8 Expected Scenario 20 18 12 (66.7%) 1.0 2.0 3.0 Optimistic Scenario 18 21 13.65 (65%) 0.8 1.8 4.75

7. Tax
8. Profit after tax

0.27
0.53

1.0
2.0

1.58
3.17

9. Annual cash flow from operations

10. Net present value (9) x PVIFA (12%, 10 yrs) (1)

2.93
(7.45)

4.0
2.60

4.97
10.06

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BREAK-EVEN ANALYSIS
ACCOUNTING BREAK-EVEN ANALYSIS
FIXED COSTS + DEPRECIATION = CONTRIBUTION MARGIN RATIO 0.333 1+2 = RS. 9 MILLION

CASH FLOW FORECAST FOR NAVEENS FLOUR MILL PROJECT

(000) YEAR 1 - 10 18,000 12,000 1,000 2,000 3,000 1,000 2,000 4,000 4,000

1. INVESTMENT 2. SALES 3. VARIABLE COSTS (66 2/3% OF SALES) 4. FIXED COSTS 5. DEPRECIATION 6. PRE-TAX PROFIT 7. TAXES 8. PROFIT AFTER TAXES 9. CASH FLOW FROM OPERATION 10. NET CASH FLOW

YEAR 0 (20,000)

(20,000)

CASH BREAK-EVEN ANALYSIS

HILLIER MODEL
Uncorrelated Cash Flows
n Ct NPV = I t = 1 (1 + i)t n t2 (NPV) = t = 1 (1 + i)2t

Perfectly Correlated Cash Flows

n NPV = t=1 Ct I

(1 + i) t

n (NPV) = t=1

t
(1 + i)t

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SIMULATION ANALYSIS

PROCEDURE
1. CHOOSE VARIABLES WHOSE EXPECTED VALUES WILL BE REPLACED WITH DISTRIBUTIONS 2. SPECIFY THE PROBABILITY DISTRIBUTIONS OF THESE VARIABLES 3. DRAW VALUES AT RANDOM AND CALCULATE NPV 4. REPEAT 3 MANY TIMES AND PLOT DISTRIBUTION 5. EVALUATE THE RESULTS
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DECISION TREE ANALYSIS

STEPS
DELINEATE THE DECISION TREE EVALUATE THE ALTERNATIVES
C21 : HD ANNUAL CASH FLOW 0.6 30 MILLION

D21 : INV C2 150 m C11 : S D2 p : 0.7 D11 : PILOT PROD C1 EMV (C1) = RS.30. 9 m & TEST MKTG D22 : STOP EMV (D2) = RS.44. 2 m C22 : LD 0.4 ANNUAL CASH FLOW 20 MILLION EMV (C2) = RS.194.2 m

- RS.20 m
D1 EMV (D1) = RS.10. 9 m

C12 : F
D3 p : 0.3 D31 : STOP

D12 : DO NOTHING

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LIMITATIONS
SENSITIVITY ANALYSIS

NO IDEA OF LIKELIHOOD ONE FACTOR IS VARIED AT A TIME

SCENARIO ANALYSIS

SCENARIOS MAY NOT BE CLEARLY DELINEATED

SIMULATION ANALYSIS

DEFINING THE DISTRIBUTIONS IS DIFFICULT TRADITIONAL SIMULATION ANALYSIS DOESNT PERMIT

INTERACTIONS AMONG VARIABLE

BUSINESS AS USUAL ASSUMPTIONS

DECISION TREE ANALYSIS

STAGES MAY NOT BE CLEARLY DEFINED

OUTCOMES MAY NOT BE CLASSIFIED INTO BROAD CLASSES

PROBABILITIES & CASH FLOWS ARE DIFFICULT TO DEFINE

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CORPORATE RISK ANALYSIS A projects corporate risk is its contribution to the overall risk of the firm On a stand-alone basis a project may be very risky but

if its returns are not highly correlated or, even better,

negatively correlated with the returns on the other

projects of the firm, its corporate risk tends to be low

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MANAGING RISK FIXED AND VARIABLE COST PRICING STRATEGY SEQUENTIAL INVESTMENT FINANCIAL LEVERAGE

INSURANCE
LONG-TERM ARRANGEMENTS

STRATEGIC ALLIANCE
DERIVATIVES
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PROJECT SELECTION UNDER RISK Judgmental Evaluation

Payback Period Requirement

Risk Adjusted Discount Rate Certainty Equivalent Method

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RISK ANALYSIS IN PRACTICE Conservative Estimation of Revenues Safety Margin in Cost Figures Flexible Investment Yardsticks Acceptable Overall Certainty Index

Judgment on Three Point Estimates

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SUMMING UP
A variety of techniques have been developed to handle risk in capital budgeting. Sensitivity analysis or what if analysis answers questions like what happens

to NPV if sales decline by 5 percent?

Scenario analysis is an extension of sensitivity analysis Break-even analysis establishes the minimum quantity at which loss is avoided.

The break-even point may be defined in accounting terms or financial terms.

Simulation analysis is a technique for developing the profitability profile of a

criterion of merit by combining values of variables that have a bearing on the chosen criterion.
Decision tree analysis is a useful tool for analysing sequential decisions in the

face of risk.
A projects corporate risk is its contribution to the overall risk of the firm.

There are several ways of incorporating risk in the decision process : judgmental evaluation, payback period requirement, risk-adjusted discount rate method, and certainty equivalent method
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