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By Akash Saxena
Nature of Risk
Risk exists because of the inability of the
decision-maker to make perfect forecasts.
In formal terms, the risk associated with an
investment may be defined as the variability
that is likely to occur in the future returns from
the investment.
Three broad categories of the events
influencing the investment forecasts:
General economic conditions
Industry factors
Company factors
By Akash Saxena
Techniques for Risk Analysis
Statistical Techniques for Risk Analysis
Probability
Variance or Standard Deviation
Coefficient of Variation
By Akash Saxena
Probability
A typical forecast is single figure for a period. This is
referred to as “best estimate” or “most likely” forecast:
Firstly, we do not know the chances of this figure actually
occurring, i.e., the uncertainty surrounding this figure.
Secondly, the meaning of best estimates or most likely is not
very clear. It is not known whether it is mean, median or
mode.
For these reasons, a forecaster should not give just
one estimate, but a range of associated probability–a
probability distribution.
Probability may be described as a measure of
someone’s opinion about the likelihood that an event
will occur.
By Akash Saxena
Assigning Probability
The probability estimate, which is based on a
very large number of observations, is known
as an objective probability.
Such probability assignments that reflect the
state of belief of a person rather than the
objective evidence of a large number of trials
are called personal or subjective
probabilities.
By Akash Saxena
Expected Net Present Value
Once the probability
assignments have
been made to the n
ENCF
future cash flows the ENPV = (1 k )
t
By Akash Saxena
Coefficient of Variation
The coefficient of variation is a useful
measure of risk when we are comparing the
projects which have
(i) same standard deviations but different expected
values, or
(ii) different standard deviations but same
expected values, or
(iii) different standard deviations and different
expected values.
By Akash Saxena
Risk Analysis in Practice
Most companies in India account for risk while evaluating their capital expenditure
decisions. The following factors are considered to influence the riskiness of
investment projects:
price of raw material and other inputs
price of product
product demand
government policies
technological changes
project life
inflation
Out of these factors, four factors thought to be contributing most to the project
riskiness are: selling price, product demand, technical changes and government
policies.
The most commonly used methods of risk analysis in practice are:
sensitivity analysis
conservative forecasts
Sensitivity analysis allows to see the impact of the change in the behaviour of critical
variables on the project profitability. Conservative forecasts include using short
payback or higher discount rate for discounting cash flows.
Except a very few companies most companies do not use the statistical and other
sophisticated techniques for analysing risk in investment decisions.
By Akash Saxena
Payback
This method, as applied in practice, is more an
attempt to allow for risk in capital budgeting decision
rather than a method to measure profitability.
The merit of payback
Its simplicity.
Focusing attention on the near term future and thereby
emphasising the liquidity of the firm through recovery of
capital.
Favouring short term projects over what may be riskier,
longer term projects.
Even as a method for allowing risks of time nature, it
ignores the time value of cash flows.
By Akash Saxena
Risk-Adjusted Discount Rate
Risk-adjusted discount rate,
will allow for both time
n
preference and risk NCFt
preference and will be a sum NPV =
t =0 (1 k )
t
of the risk-free rate and the
risk-premium rate reflecting
the investor’s attitude towards
risk.
By Akash Saxena
Evaluation of Risk-adjusted
Discount Rate
The following are the advantages of risk-adjusted discount
rate method:
It is simple and can be easily understood.
It has a great deal of intuitive appeal for risk-averse businessman.
It incorporates an attitude (risk-aversion) towards uncertainty.
By Akash Saxena
Certainty—Equivalent
Reduce the forecasts of
cash flows to some n
t NCFt
conservative levels.
The certainty—equivalent
NPV =
t = 0 (1 kf )
t
By Akash Saxena
Evaluation of Certainty—Equivalent
This method suffers from many dangers in a
large enterprise:
First, the forecaster, expecting the reduction that
will be made in his forecasts, may inflate them in
anticipation.
Second, if forecasts have to pass through several
layers of management, the effect may be to
greatly exaggerate the original forecast or to make
it ultra-conservative.
Third, by focusing explicit attention only on the
gloomy outcomes, chances are increased for
passing by some good investments.
By Akash Saxena
Risk-adjusted Discount Rate Vs.
Certainty–Equivalent
The certainty—equivalent approach recognises risk in
capital budgeting analysis by adjusting estimated cash
flows and employs risk-free rate to discount the
adjusted cash flows. On the other hand, the risk-
adjusted discount rate adjusts for risk by adjusting the
discount rate. It has been suggested that the certainty
—equivalent approach is theoretically a superior
technique.
The risk-adjusted discount rate approach will yield the
same result as the certainty—equivalent approach if
the risk-free rate is constant and the risk-adjusted
discount rate is the same for all future periods.
By Akash Saxena
Sensitivity Analysis
Sensitivity analysis is a way of analysing change in
the project’s NPV (or IRR) for a given change in one
of the variables.
The following three steps are involved in the use of
sensitivity analysis:
Identification of all those variables, which have an influence
on the project’s NPV (or IRR).
Definition of the underlying (mathematical) relationship
between the variables.
Analysis of the impact of the change in each of the variables
on the project’s NPV.
The decision maker, while performing sensitivity
analysis, computes the project’s NPV (or IRR) for
each forecast under three assumptions:
(a) pessimistic, (b) expected, and (c) optimistic.
By Akash Saxena
DCF Break-even Analysis
Sensitivity analysis is a variation of the break-even
analysis.
What shall be the consequences if volume or price or
cost changes (Sensitivity analysis)? You can ask this
question differently: How much lower can the sales
volume become before the project becomes
unprofitable? What you are asking for is the break-
even point.
DCF break-even point is different from the accounting
break-even point. The accounting break-even point
is estimated as fixed costs divided by the contribution
ratio. It does not account for the opportunity cost of
capital, and fixed costs include both cash plus non-
cash costs (such as depreciation).
By Akash Saxena
Pros and Cons of Sensitivity Analysis
Sensitivity analysis has the following advantages:
It compels the decision-maker to identify the variables, which affect
the cash flow forecasts. This helps him in understanding the
investment project in totality.
It indicates the critical variables for which additional information
may be obtained. The decision-maker can consider actions, which
may help in strengthening the ‘weak spots’ in the project.
It helps to expose inappropriate forecasts, and thus guides the
decision-maker to concentrate on relevant variables.
It has the following limitations:
It does not provide clear-cut results. The terms ‘optimistic’ and
‘pessimistic’ could mean different things to different persons in an
organisation. Thus, the range of values suggested may be
inconsistent.
It fails to focus on the interrelationship between variables. For
example, sale volume may be related to price and cost. A price cut
may lead to high sales and low operating cost.
By Akash Saxena
Scenario Analysis
One way to examine the risk of investment is
to analyse the impact of alternative
combinations of variables, called scenarios,
on the project’s NPV (or IRR).
The decision-maker can develop some
plausible scenarios for this purpose. For
instance, we can consider three scenarios:
pessimistic, optimistic and expected.
By Akash Saxena
Simulation Analysis
The Monte Carlo simulation or simply the
simulation analysis considers the interactions
among variables and probabilities of the change in
variables. It computes the probability distribution of
NPV. The simulation analysis involves the following
steps:
First, you should identify variables that influence cash
inflows and outflows.
Second, specify the formulae that relate variables.
Third, indicate the probability distribution for each variable.
Fourth, develop a computer programme that randomly
selects one value from the probability distribution of each
variable and uses these values to calculate the project’s
NPV.
By Akash Saxena
Shortcomings
The model becomes quite complex to use.
It does not indicate whether or not the project
should be accepted.
Simulation analysis, like sensitivity or
scenario analysis, considers the risk of any
project in isolation of other projects.
By Akash Saxena
Decision Trees for Sequential
Investment Decisions
Investment expenditures are not an
isolated period commitments, but as links
in a chain of present and future
commitments. An analytical technique to
handle the sequential decisions is to
employ decision trees.
Steps in Decision Tree Approach
Define investment
Identify decision alternatives
Draw a decision tree
decision points
chance events
Analyse data
By Akash Saxena
Usefulness of Decision Tree Approach
The merits of the decision tree approach are:
It clearly brings out the implicit assumptions and calculations
for all to see, question and revise.
It allows a decision maker to visualise assumptions and
alternatives in graphic form, which is usually much easier to
understand than the more abstract, analytical form.
By Akash Saxena
Utility Theory and Capital Budgeting
Utility theory aims at incorporation of
decision-maker’s risk preference explicitly
into the decision procedure.
As regards the attitude of individual
investors towards risk, they can be
classified in three categories:
Risk-averse
Risk-neutral
Risk-seeking
Individuals are generally risk averters and
demonstrate a decreasing marginal utility
for money function.
By Akash Saxena
Let us assume that the owner of
a firm is considering an
investment project, which has 60
per cent of probability of yielding
a net present value of Rs 10 lakh
and 40 per cent probability of a
loss of net present value of Rs 10
lakh.
Project has a positive expected
NPV of Rs 2 lakh. However, the ENPV = 10 × 0.6 + (–10) × 0.4 = Rs 2 lakh
owner may be risk averse, and
he may consider the gain in utility
arising from the positive outcome
(positive PV of Rs 10 lakh) less
than the loss in utility as a result
of the negative outcome
(negative PV of Rs 10 lakh).
Tthe owner may reject the project
in spite of its positive ENPV.
By Akash Saxena
Benefits and Limitations of Utility
Theory
It suffers from a few advantages:
First, the risk preferences of the decision-maker are directly
incorporated in the capital budgeting analysis.
Second, it facilitates the process of delegating the authority
for decision.
It suffers from a few limitations:
First, in practice, difficulties are encountered in specifying a
utility function.
Second, even if the owner’s or a dominant shareholder’s
utility function be used as a guide, the derived utility function
at a point of time is valid only for that one point of time.
Third, it is quite difficult to specify the utility function if the
decision is taken by a group of persons.
By Akash Saxena