FinancialManagement

Unit9

Unit9
Structure
9.1 Introduction

RiskAnalysisinCapitalBudgeting

9.2 TypesandsourcesofRiskincapitalBudgeting 9.3 RiskAdjustedDiscountRate 9.4 CertaintyEquivalent 9.5 SensitivityAnalysis 9.6 ProbabilityDistributionApproach: 9.7 Decisiontreeapproach 9.8 Summary: TerminalQuestions AnswertoSAQsandTQs

9.1 Introduction
Inthepreviouschapteroncapitalbudgetingtheprojectappraisaltechniqueswereappliedonthe assumptionthattheprojectwillgenerateagivensetofcashflows. ItisquiteobviousthatoneofthelimitationsofDCFtechniquesisthedifficultyinestimating cash flowswithcertaindegreeofcertainty.Certainprojectswhentakenupbythefirmwillchangethe businessriskcomplexionofthefirm. Thisbusinessriskcomplexionofthefirminfluencestherequiredrateofreturnoftheinvestors. Suppliersofcapitaltothefirmtendtoberiskaverseandtheacceptanceofaprojectthatchanges theriskprofileofthefirmmaychangetheirperceptionofrequiredratesofreturnforinvestingin firmsproject. Generallytheprojectsthatgeneratehighreturnsarerisky.Thiswillnaturallyalterthebusiness risk of thefirm. Becauseof thishigh riskperception associated with the new project a firmis forced to asses the impact of the risk on the firms cash flows and the discount factor to be employedintheprocessofevaluation. DefinitionofRisk:Riskmaybedefined asthevariationofactualcashflowsfrom theexpected cashflows.Thetermriskincapitalbudgetingdecisionsmaybedefinedasthevariabilitythatis likelytooccurinfuturebetweentheestimatedandtheactualreturns.Riskexistsonaccountof theinabilityofthefirmtomakeperfectforecastsofcashflows.

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Riskarisesinprojectevaluationbecausethefirmcannotpredicttheoccurrenceofpossiblefuture events with certainty and hence, cannot make any correct forecast about the cash flows. The uncertaineconomicconditionsarethesourcesofuncertaintyinthecashflows. For example, a company wants to produce and market a new product to their prospective customers.Thedemandisaffectedbythegeneraleconomicconditions.Demandmaybevery highifthecountryexperienceshighereconomicgrowth.Ontheotherhandeconomiceventslike weakeningofUSdollar,subprimecrisesmaytriggereconomicslowdown.Thismaycreatea pessimisticdemanddrasticallybringingdowntheestimateofcashflows. Riskisassociatedwiththevariabilityoffuturereturnsofaproject.Thegreaterthevariabilityof theexpectedreturns,theriskiertheproject. Everybusinessdecisioninvolvesrisk.Riskarisesoutoftheuncertainconditionsunderwhicha firmhastooperateitsactivities. Becauseoftheinabilityoffirmstoforecastaccuratelycashflows of future operations thefirmsfacethe risks of operations. The capitalbudgeting proposals are notbasedonperfectforecastofcostsand revenuesbecausetheassumptionsaboutthefuture behaviourofcostsandrevenuemaychange.Decisionshavetobemadeinadvanceassuming certainfutureeconomicconditions. ThereareManyfactorsthataffectforecastsofinvestment,costandrevenue. 1) Thebusinessisaffectedbychangesinpoliticalsituations,monetarypolicies,taxation,interest rates,policiesofthecentralbankofthecountryonlendingbybanksetc. 2) Industry specific factors influence the demand for the products of the industry to which the firmbelongs. 3) Company specific factors like change in management, wage negotiations with the workers, strikesorlockoutsaffectcompanyscostandrevenuepositions. Therefore, risk analysis in capital budgeting is part and parcel of enterprise risk management. Thebestbusinessdecisionsmaynotyieldthedesiredresultsbecausetheuncertainconditions likelytoemergeinfuturecanmateriallyalterthefortunesofthecompany. Every change gives birth to new challenges. New challenges are the source of new opportunities.Aproactivefirmwillconverteveryproblemintosuccessfulenterpriseopportunities. Afirmwhich avoids new opportunitiesfor theinherent risk associatedwith it, will stagnate and degenerate.Successfulfirmshaveempiricalhistoryofsuccessfulmanagementofrisks. Therefore,analysingtherisksoftheprojecttoreducetheelementofuncertaintyinexecutionhas becomeanessential aspectoftodayscorporateprojectmanagement.

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LearningObjectives: Afterstudyingthisunit,youshouldbeabletounderstandthefollowing. 1. Defineriskincapitalbudgeting. 2. Examinetheimportanceofriskanalysisincapitalbudgeting. 3. Methodsofincorporatingtheriskfactorincapitalbudgetingdecision. 4. Understandthetypesandsourcesofriskincapitalbudgetingdescision

9.2TypesandsourcesofRiskincapitalBudgeting
Risksinaprojectaremany.Itispossibletoidentifythreeseparateanddistincttypesofriskin anyproject. 1) Standalonerisk:itismeasuredbythevariabilityofexpectedreturnsoftheproject. 2) Portfoliorisk: Afirmcanbeviewedasportfolioofprojectshavingascertaindegreeofrisk. Whennewprojectaddedtotheexistingportfolioofprojecttheriskprofilethefirm willalter. Thedegreeofthechangeintheriskdependonthecovarianceofreturnfromthenewproject andthereturnfromtheexistingportfoliooftheprojects.Ifthereturnfromthenewprojectis negativelycorrelatedwiththereturnfromportfolio,theriskofthefirmwillbefurtherdiversified away. 3) Marketorbetarisk:Itismeasuredbytheeffectoftheprojectonthebetaofthefirm.The marketriskforaprojectisdifficulttoestimate. Standaloneriskistheriskofaprojectwhentheprojectisconsideredinisolation.Corporate riskistheprojectsriskstotheriskofthefirm.Marketriskissystematicrisk.Themarketrisk isthemostimportantriskbecauseofthedirectinfluenceithasonstockprices. Sourcesofrisk:Thesourcesofrisksare 1. Projectspecificrisk 2. CompetitiveorCompetitionrisk 3. Industryspecificrisk 4. Internationalrisk 5. Marketrisk 1. Projectspecificrisk:Thesourcesofthisriskcouldbetracedtosomethingquitespecific to the project. Managerial deficiencies or error in estimationof cashflows or discount rate mayleadtoasituationofactualcashflowsrealisedbeinglessthanthatprojected. 2. Competitive risk or Competition risk: unanticipated actions of a firms competitors will materially affect the cash flows expected from a project. Because of this theactual cash flowsfromaprojectwillbelessthanthatoftheforecast.
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3. Industryspecific:industryspecificrisksarethosethataffectallthefirmsintheindustry. Itcouldbeagaingroupedintotechnologicalrisk,commodityriskandlegalrisk.Alltheserisks willaffecttheearningsandcashflowsoftheproject.Thechangesintechnologyaffectallthe firmsnotcapableofadaptingthemselvestoemergingnewtechnology. The best example is the case of firms manufacturing motor cycles with two strokes engines. Whentechnologicalinnovationsreplacedthetwostrokeenginesbythefourstrokeenginesthose firmswhichcouldnotadapttonewtechnologyhadtoshutdowntheiroperations. Commodity risk is the risk arising from the effect of price changes on goods produced and marketed. Legalriskarisesfromchangesinlawsandregulationsapplicabletotheindustrytowhichthefirm belongs.ThebestexampleistheimpositionofservicetaxonapartmentsbytheGovernmentof India when the total number of apartments built by a firm engaged in that industry exceeds a prescribedlimit.SimilarlychangesinImportExportpolicyoftheGovernmentofIndiahaveled totheclosureofsomefirmsorsicknessofsomefirms. 4. InternationalRisk: thesetypesofrisksarefacedbyfirmswhosebusinessconsistsmainly of exports or those who procure their main raw material from international markets. For example,rupeedollarcrisisaffectedthesoftwareandBPOsbecauseitdrasticallyreduced their profitability. Another best example is that of the textile units in Tirupur in Tamilnadu, exporting their major part of the garments produced. Rupee gaining and dollar Weakening reduced their competitiveness in the global markets. The surging Crude oil prices coupled with the governments delay in taking decision on pricing of petro products eroded the profitabilityofoilmarketingCompaniesinpublicsectorlikeHindustanPetroleumCorporation Limited.AnotherexampleistheimpactofUSsubprimecrisisoncertainsegmentsofIndian economy. Thechangesininternationalpoliticalscenarioalsoaffecttheoperationsofcertainfirms. 5. MarketRisk: Factorslikeinflation,changesininterestrates,andchanginggeneraleconomic conditionsaffectallfirmsandallindustries. Firmscannotdiversifythisriskinthenormalcourseofbusiness. Techniquesusedforincorporationofriskfactorincapitalbudgetingdecisions There are many techniques of incorporation of risk perceived in the evaluation of capital budgeting proposals. They differ in their approach and methodology so farasincorporationof riskintheevaluationprocessisconcerned. Conventionaltechniques PayBackPeriod

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The oldest and commonlyused method of recognisingrisk associated with a capital budgeting proposalispaybackperiod.Underthismethod,shorterpaybackperiodisgivenpreferenceto longer ones. Firms establish guidelines for acceptance or rejections of projects based on standardsofpaybackperiods. Paybackperiodprefersprojectsofshorttermpaybackstothatoflongtermpaybacks.The emphasisisontheliquidityofthefirmthroughrecoveryofcapital.TraditionallyIndianbusiness communityemploysthistechniqueinevaluatingprojectswithveryhighlevelofuncertainty.The changingtrendsinfashionmakethefashionbusiness,oneofhighriskandtherefore,payback period has been endorsed by tradition in India to take decisions on acceptance or rejectionof suchprojects.Theusualriskinbusinessismoreconcernedwiththeforecastofcashflows.Itis thedownsideriskoflowercashflowsarisingfromlowersalesandhighercostsofoperationthat mattersinformulatingstandardsofpayback. Paybackperiodignorestimevalueofmany(cashflows).Forexample,thefollowingdetailsare availableinrespectoftwoprojects. Particulars Initialcashoutlay Cashflows Year1 Year2 Year3 Year4 ProjectA(Rs) 10lakhs 5lakhs 3lakhs 1lakhs 1lakhs ProjectB(Rs) 10lakhs 2lakhs 2lakhs 3lakhs 3lakhs

Boththeprojectshaveapaybackperiodof4years.TheprojectBisriskierthantheProjectA becauseProjectArecovers80%ofinitialcashoutlayinthefirsttwoyearsofitsoperationwhere as Project B generates higher Cash inflows only in the latter half of the payback period. This underminestheutilityofpaybackperiodasatechniqueofincorporatingriskinprojectevaluation. This method considers only time related risks and ignores all other risks of the project under consideration.

SelfAssessmentQuestions2 1. _____________ismeasuredbythevariabilityofexpectedreturnsoftheproject. 2. Marketriskismeasuredbytheeffectoftheprojectonthe____ofthefirm. 3. Firmscannot____marketriskinthenormalcourseofbusiness. 4. Impact of U.S sub prime crisis on certain segments of Indian economy is and example of _______________________.

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9.3RiskAdjustedDiscountRate
Thebasisofthisapproachisthatthereshouldbeadequaterewardintheformofreturntofirms whichdecidetoexecuteriskybusinessprojects.Manbynatureisriskaverseandtriestoavoid risk. Tomotivatefirmstotakeupriskyprojectsreturnsexpectedfromtheprojectshallhavetobe adequate,keepinginviewtheexpectationsoftheinvestors.Thereforeriskpremiumneedtobe incorporatedindiscountrateintheevaluationofriskyprojectproposals. Thereforethediscountrateforappraisalofprojectshastwocomponents. Thosecomponentsare 1. Risk freerateandriskpremium RiskAdjustedDiscountrate=Riskfreerate+Riskpremium Riskfreerateiscomputedbasedonthereturnongovernmentsecurities. Risk premium is the additional return that investors require as compensation for assuming the additionalriskassociatedwiththeprojecttobetakenupforexecution. The more uncertain the returns of the project the higher the risk. Higher the risk greater the premium. Therefore, risk adjusted Discount rate is a composite rate of risk free rate and risk premiumoftheproject. Example:AninvestmentwillhaveaninitialoutlayofRs100,000.Itisexpectedtogeneratecash inflowsasunder: Year 1 2 3 4 Cashinflows 40,000 50,000 15,000 30,000

Riskfreerateofinterestis10%.Riskpremiumis10%(theriskcharacterisingtheproject) (a) (b) computetheNPVusingriskfreerate ComputeNPVusingriskadjusteddiscountrate

Solutions=(a)usingriskfreerate

Year 1 2 3 4

Cashflows(inflows)Rs 40,000 50,000 15,000 30,000 PVofcashinflows

PVFactorat10% 0.909 0.826 0.751 0.683

PVofCashflows(inflows) 36,360 41,300 11,265 20,490 1,09,415

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PVofCashoutflows NPV

1,00,000 9,415

(b) Usingriskadjusteddiscountrate Year 1 2 3 4 CashinflowsRs 40,000 50,000 15,000 30,000 PVofCashinflows PVofCashoutflows NPV PVfactorat20% 0.833 0.694 0.579 0.482 PVofcashinflows 33,320 34,700 8,685 14,460 91,165 100,000 (8,835)

Theprojectwouldbeacceptablewhennoallowanceismadeforrisk. Butitwillnotbeacceptableifriskpremiumisaddedtotheriskfreerate.Itmovesfrompositive NPVtonegativeNPV. Ifthefirmweretousetheinternalrateofreturn,thentheprojectwouldbeacceptedwhenIRRis greaterthantheriskadjusteddiscountrate. EvaluationofRiskadjusteddiscountrate: Advantages: 1. Itissimpleandeasytounderstand. 2. Riskpremiumtakescareoftheriskelementinfuturecashflows. 3. Itsatisfiesthebusinessmenwhoarerisk averse.

Limitations: 1. There are no objective basesof arriving at the risk premium. In this process the premium ratescomputedbecomearbitrary. 2. Theassumptionthatinvestorsareriskaversemaynotbetrueinrespectofcertaininvestors whoarewillingtotakerisks.Tosuchinvestors,asthelevelofriskincreases,thediscount ratewouldbereduced. 3. Cashflowsarenotadaptedtoincorporatetheriskadjustmentfornetcashinflows. SelfAssessmentQuestions2 1.Riskpremiumisthe__________________thattheinvestorsrequireascompensationfor
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assumptionofadditionalrisksofproject. 2.RADRisthesumof______________and______________. 3.Highertherisk__________________thepremium. 4.Manbynatureisriskaverseandtriestoavoidrisk.

9.4 CertaintyEquivalent: Underthismethodtheriskinguncertain,expectedfuturecashflowsareconvertedintocashflows with certainty. Here we multiply uncertain future cash flows by the certainty equivalent coefficient to convert uncertain cash flows into certain cash flows. The certainty equivalent coefficient is also known as the risk adjustment factor. Risk adjustment factor is normally denotedbyt(Alpha).Itistheratioofcertainnetcashflowtoriskynetcashflow =CertaintyEquivalent=CertainCashflow RiskyCashflow

Thediscountfactortobeusedistheriskfreerateofinterest.Certaintyequivalentcoefficientis between0and1.Thisriskadjustmentfactorvariesinverselywithrisk.Ifriskishighalower valueisusedforriskadjustment.Ifriskislowahighercoefficientofcertaintyequivalentis used Illustration(Example) AprojectcostsRs50,000.Itisexpectedtogeneratecashinflowsasunder Year 1 2 3 4 Cashinflows 32,000 27,000 20,000 10,000 CertaintyEquivalent 0.9 0.6 0.5 0.3

Riskfreediscountrateis10%computeNPV Answer: Year Uncertaincash inflows 1 2 3 4 32,000 27,000 20,000 10,000 0.9 0.6 0.5 0.3 CE Certaincash flows 28,800 16,200 10,000 3,000 PVFactorat PVofcertaincash 10% 0.909 0.826 0.751 0.683 inflows 26,179 13,381 7,510 2,049

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PVofcertaincashin flows Initialcashoutlay NPV

49,119

50,000 (881)negative

TheprojecthasanegativeNPV. Therefore,itisrejected. IfIRRisusedtherateofdiscountatwhichNPVisequaltozeroiscomputedandthencompared withtheminimum(required)riskfreerate.IfIRRisgreaterthanspecifiedminimumriskfreerate, theprojectisaccepted,otherwiserejected. Evaluation: Itrecognisesrisk.Recognitionofriskbyriskadjustmentfactorfacilitatestheconversionofrisky cashflowsintocertaincashflows.Buttherearechancesofbeinginconsistentintheprocedure employedfromoneprojecttoanother. Whenforecastspassthroughmanylayersofmanagement,originalforecastsmaybecomehighly conservative. Becauseofhighconservationinthisprocessonlygoodprojectsarelikelytobeclearedwhenthis methodisemployed. Certainty equivalentapproachisconsideredtobetheoreticallysuperiortotherisk adjusted discountrate. SelfAssessmentQuestions3 1.CEcoefficientisthe_______. 2.DiscountfactorstobeusedunderCEapproachis_____________. 3.Becauseofhigh______________CEclearsonlygoodprojects. 4.___________isconsideredtobesuperiortoRADR 9.5 SensitivityAnalysis: There are many variables like sales, cost of sales, investments, tax rates etc which affect the NPV and IRR ofa project. Analysing the change in the projects NPVor IRR on account ofa givenchangeinoneofthevariablesiscalledSensitivityAnalysis.Itisatechniquethatshowsthe changeinNPVgivenachangeinoneofthevariablesthatdeterminecashflowsofaproject.It measuresthesensitivityofNPVofaprojectinrespecttoachangeinoneoftheinputvariablesof NPV.

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The reliability of the NPV depends on the reliability of cash flows. If fore casts go wrong on account of changes in assumed economic environments, reliability of NPV & IRR is lost. Therefore,forecastsaremadeunderdifferenteconomicconditionsvizpessimistic,expectedand optimistic.NPVisarrivedatforallthethreeassumptions. FollowingstepsareinvolvedinSensitivityanalysis: 1. IdentificationofvariablesthatinfluencetheNPV&IRRoftheproject. 2. Examininganddefiningthemathematicalrelationshipbetweenthevariables. 3. AnalysisoftheeffectofthechangeineachofthevariablesontheNPVoftheproject. Example: A company has two mutuallyexclusive projects under considerationviz project A & projectB. EachprojectrequiresaninitialcashoutlayofRs3,00,000andhasaneffectivelifeof10years. The companys cost of capital is 12%. The following fore cast of cashflows are made by the management.

Economic Environment Pessimistic Expected Optimistic

ProjectA Annualcashinflows 65,000 75,000 90,000

ProjectB Annualcashinflows 25,000 75,000 1,00,000

WhatistheNPVoftheproject? Whichprojectshouldthemanagementconsider? GivenPVIFA=5.650 Answer/Solutions NPVofprojectA

Economic Environment

Project cashinflows at

PVIFA 12% 10

PVofcashinflows

NPV

years Pessimistic Expected Optimistic 65,000 75,000 90,000 5.650 5.650 5.650 3,67,250 4,23,750 5,08,500 67,250 1,23,750 2,08,500

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NPVofProjectB Pessimistic Expected Optimistic 25,000 75,000 1,00,000 5.650 5.650 5.650 1,41,250 4,23,750 5,65,000 (1,58,750) 1,23,750 2,65,000

Decision 1. UnderpessimisticconditionsprojectAgivesapositiveNPVofRs67,250andProjectBhasa negativeNPVofRs1,58,750ProjectAisaccepted. 2. Under expected conditions,both gave some positive NPV ofRs 1,23,000. Any one of two maybeaccepted. 3. UnderoptimisticconditionsProjectBhasahigherNPVofRs2,65,000comparedtothat of AsNPVofRs2,08,500. 4. Difference between optimistic and pessimistic NPV for Project A is Rs 1,41,250 and for ProjectBthedifferenceisRs4,23,750. 5. ProjectBisriskycomparedtoProjectAbecausetheNPVrangeisoflargedifferences. StatisticalTechniques: Statisticaltechniquesuseanalyticaltoolsforassessingrisksofinvestments. SelfAssessmentQuestions4 1._____________analysisthechangesintheprojectNPVonaccountofagivenchangeinone oftheinputvariablesoftheproject. 2. Examining and defining the mathematical relation between the variable of the NPV is _________________________. 3.Forecastsundersensitivityanalysisaremadeunder__________.

9.6 ProbabilityDistributionApproach: When we incorporatethe chances ofoccurrences ofvariouseconomicenvironments computed NPV becomes more reliable. The chances of occurrences are expressed in the form of probability.Probabilityisthelikelihoodofoccurrenceofaparticulareconomicenvironment.After assigningprobabilitiestofuturecashflowsexpectednetpresentvalueiscomputed. Illustration: A company has identified aproject with an initial cash outlay of Rs 50,000. The followingdistributionofcashflowisgivenbelowforthelifeoftheprojectof3years.
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Year1 Cashinflow 15,000 18,000 35,000 32,000 Probability 0.2 0.1 0.4 0.3

Year2 Cashinflow 20,000 15,000 15,000 30,000 Probability 0.3 0.2 0.2 0.2

Year3 Cashinflow 25,000 20,000 20,000 45,000 Probability 0.4 0.3 0.3 0.1

Discountrateis10% Year1 =15,000x0.2+18,000x0.1+35,000x0.4+32,000x0.300 3,000+1,800+14,000+9,600=28,400 Year2 20,000x0.3+15,000x0.2+30,000x0.3+30,000x0.2 =6,000+3,000+9,000+6,000=24,000 Year3 25,000x0.4+20,000x0.3+40,000x0.2+5,000x0.1= 10,000+6,000+8,000+4,500==28,500

Year 1 2 3

Expectedcashinflows 28,400 24,000 28,500 PVofexpectedcashinflows PVofinitialcashoutlay ExpectedNPV

PVfactorat10% 0.909 0.826 0.751

PVofexpected cashinflows 25,816 19,824 21,403 67,043 50,000 17,043

Variance: A study of dispersion of cash flows of projects will help the management in assessing the risk associated with the investment proposal. Dispersion is computed by variance or standard deviation. Variance measures the deviation of each possible cash flow from the expected. Squarerootofvarianceisstandarddeviation. Example:Followingdetailsareavailableinrespectofaprojectwhichrequiresaninitialcostof Rs5,00,000.

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Year 1

EconomicConditions Highgrowth Averagegrowth Nogrowth

Cashflows 2,00,000 1,50,000 40,000 3,00,00 2,00,000 5,00,000 4,00,000 2,50,000 30,000

Probability 0.3 0.6 0.1 0.3 0.5 0.2 0.2 0.6 0.2

Highgrowth Averagegrowth Nogrowth

Highgrowth Averagegrowth Nogrowth

Discountrateis10% Solution: Year1 EconomicCondition 1 Highgrowth Averagegrowth Nogrowth Cashinflow 2 2,00,000 1,50,000 40,000 Probability 3 0.3 0.6 0.1 ExpectedValue 60,000 90,000 4,000 1,54,000 ExpectedvalueofCashinflow

Year2 EconomicCondition Highgrowth Averagegrowth Nogrowth Cashinflow 3,00,000 2,00,000 50,000 Probability 0.3 0.5 0.2 ExpectedValue ExpectedvalueofCashinflow 90,000 1,00,000 10,000 2,00,000

Year3 EconomicCondition Highgrowth Averagegrowth Nogrowth Cashinflow 4,00,000 2,50,000 30,000 Probability 0.2 0.6 0.2 ExpectedvalueofCashinflow 80,000 1,50,000 6,000

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ExpectedValueof Cashinflows 1,54,0002,00,000 2,36,000

3 + (1.10)

2,36,000

ExpectedNPV= 1.10(110) + 2

5,00,000

=1,40,000+1,65,289+1,77,3105,00,000=(17,401)negativeNPV

StandardDeviationforIyear Cashinflow C 2,00,000 1,50,000 40,000 ExpectedValue E 1,54,000 1,54,000 1,54,000

2 (46,000) 2 (4000) 2 (1,14,000) 2 (46,000) x0.3=634800000 2 (4,000) x0.3=9600000 2 (1,14,000) x0.3=1299600000 2 (CE) 2 (CE) xprob

Total

1944000000

StandarddeviationofCashflowsforIyear=44091
nd For2 year 2 (CE) 2 (CE) xprob

Cashinflow C 3,00,000 2,00,000 50,000

ExpectedValue E 2,00,000 2,00,000 2,00,000

2 (1,00,000) 2 (0) 2 (1,50,000)

2 (1,00,000) x0.3=3000000000 2 (0) x0.5=0 2 (1,50,000) x0.2=4500000000

Total
nd VarianceofCashflowsfor2 year=7500000000 nd StandardDeviationofcashflowsfor2 year=8660

750000000

Forthethirdyear Cashinflow C 4,00,000 2,50,000 30,000 ExpectedValue E 2,36,000 2,36,000 2,36,000

2 (1,64,000) 2 (14,000) 2 (2,00,000) 2 (1,64,000) x0.2=5379200 000 2 (14,000) x0.6=117600000 2 (2,00,000) x0.2=8000000000 2 (CE) 2 (CE) xprob

Total

13496800000

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rd VarianceofCashflowsfor3 year=13496800000 rd StandardDeviationofcashflowsfor3 year=116175

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StandardDeviationofNPV
2 (44091) 2 (8660) 2 (116175)

sNPV =

2 (1.10)

4 (1.10)

6 (1.10)

= 1606625026+51223004+7618496131 = 9276344161 =96314 Heretheassumptionisthatthereisnorelationshipbetweencashflowsfromoneperiodto another.Underthisassumptionthestandarddeviation ofNPV isRs96,314. On the other hand, if cash flows are perfectly correlated, cash flows of all years have linearcorrelationtooneanother,then

440918660116175

sNPV =

1.10

2 + (1.10)

+ (1.10) 3

=40083+7157+87284=134524 The standard deviation of NPV when cash flows are perfectly correlated will be higher thanthatunderthesituationofindependentcashflows. SelfAssessmentQuestions.5 1. Probability distribution approach incorporates the probability of occurrences of various economicenvironment,tomaketheNPV________. 2._______islikelihoodofoccurrenceofaparticulareconomicenvironment.

9.7 Decisiontreeapproach: Manyprojectdecisionsarecomplexinvestmentdecisions.Suchcomplexinvestmentdecisions involveasequenceofdecisionsovertime.Decisionstreecanhandlethesequentialdecisionsof complex investment proposals. The decision of taking up an investment project is broken into differentstages.Ateachstagetheproposalisexaminedtodecidewhethertogoaheadornot. The multi stages approach can be handled effectively with the help of decision trees. A decisiontreepresentsgraphicallytherelationshipbetweenapresentdecisionandfutureevents, futuredecisionsandtheconsequencesofsuchdecisions.

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Example R&Dsectionofacompanyhasdevelopedanelectricmoped.Thefirmisreadyforpilot productionandtest marketing. This will cost Rs 20 millionand take six months. Management believesthatthereisa70%chancethatthepilotproductionandtestmarketingwillbesuccessful. IfsuccessfulthecompanycanbuildaplantcostingRs200million. TheplantwillgenerateannualcashinflowofRs50millionfor20yearsifthedemandishighor anannualcashinflowor20millionifthedemandislow. Highdemandhasaprobabilityof0.6andlowdemandhasaprobabilityof0.4.Costofcapitalis 12%. Suggest the optimal course of action using decision tree analysis (Bangalore University MBA, adapted).
D21 Investment Rs.200million D11 Carryoutpilot Production AndMarket test(20million) C11 Success D2 D22 Stop D3
C12

C2

HighDemand Probability 0.6 C21 AnnualCashinflow Rs.50million AnnualCashinflow Rs.20million C22 LowDemand Probability 0.4

0.7
C1 failure Probability0.3

D31 Stop

D12 DoNothing

WorkingNotes:Fromrighthandsideofthedecisiontree I step: ComputationofExpected Monetary Valueatpoint C2. HereEMV representsexpected NPV.

Cashinflow 50 20

Probability 0.6 0.4 EMV

Expectedvalueofcashinflows 30 8 38

PresentValueofEMV=ExpectedvalueofcashinflowxPVIFA(12%20) 38x7.469=Rs283.82million

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Step2: ComputationofEMVatdecisionpointD2. Decisiontaken D2 D22 Consequences InvestRs200million Stop TheresultingEMVatthislevel 283.8220083.82million 0

HerethedecisioncriterionisselecttheEMVwiththehighestvalue. Stage3: ThereforeEMVwithRs83.82millionwillbeconsideredthereforeweselectthedecisiontakenat D2, Stage4: ComputationofEMVatthepointC, EMV 83.82 0 Probability 0.7 0.3 EMVatthisstage ExpectedValue 58.67 0 58.67

Step5: ComputeEMVatdecisionspointD, Decisiontaken Consequences TheresultingEmatthis level D11carry outpilot productionandmarkettest D12Donothing Invest 20million 0 EMVatthisstage 0 38.67Million (ApplytheEMVcriterion)i.e selecttheEMVwiththe highestvalue 58.6720=Rs38.67Million

Thereforeoptimalstrategyis 1. Carryoutpilotproductionandmarkettest. 2. If the result ofpilotproduction and market test is successful, go ahead with theinvestment decisionofRs200millioninestablishingaplant. 3. Iftheresultofpilotproductionandmarkettestisfuture,stop.

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EvaluationofDecisiontreeapproach: 1. Itportraysinterrelated,sequential andcriticalmultidimensionalelementsofmajorproject decisions. 2. Adequateattentionisgiventothecriticalaspectsinaninvestmentdecisionwhichspreadover atimesequence. 3. Complex projects involve huge out lay and hence risky. There is the need to define and evaluate scientifically the complex managerial problems arising out of the sequence of interrelateddecisionswithconsequentialoutcomesofhighrisk.Itiseffectivelyansweredby decisiontreeapproach. 4. Structuringa complexproject decision with many sequentialinvestment decisionsdemands effectiveprojectriskmanagement.Thisispossibleonlywiththehelpofananalyticaltoollike decisiontreeapproach. 5. Able to eliminateunprofitableoutcomes andhelps in arriving at optimumdecisionstagesin timesequence.

SelfAssessmentQuestions6 1.Decisiontreecanhandlethe_____________ofcomplexinvestmentproposals. 2._____portraysinterrelated,sequentialandcriticalmultidimensionalelementsofmajorproject decisions. 3. Adequate attention is given to the ______ in an investment decision under decision tree approachs. 4.____________areeffectivelyhandledbydecisiontreeapproachs.

9.8Summary Riskinprojectevaluationarisesonaccountoftheinabilityofthefirmtopredicttheperformance ofthefirm with certainty. Riskincapitalbudgeting decision may be defined as thevariabilityof actual returns from the expected. There are many factors that affect forecasts of investment, costsandrevenuesofaproject.Itispossibletoidentifythreetypeofriskinanyproject,vizstand alonerisk,corporateriskandmarketrisk.Thesourcesofrisksare: a. Project b. Competition c. Industry d. Internationalfactorsand e. Market
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Thetechniquesforincorporationofriskfactorincapitalbudgetingdecisioncouldbegroupedinto conventionaltechniquesandstatisticaltechniques.

TerminalQuestions 1. Definerisk.Examinetheneedforassessingtherisksinaproject. 2. Examinethetypeandsourcesofriskincapitalbudgeting. 3. Examine risk adjusted discount rate as a technique of incorporating risk factor in capital budgeting. 4. Examinethestepsinvolvedinsensitivityanalysis. 5. ExaminethefeaturesofDecisiontreeapproaches.

AnswerforSelfAssessmentQuestions SelfAssessmentQuestions1 1. Standalonerisk. 2. Beta 3. Diversify 4. Internationalrisk

SelfAssessmentQuestion2 1. Additionalreturn 2. Riskfreerate,riskpremium. 3. Greater.

SelfAssessmentQuestion3 1. Riskadjustmentfactor 2. Riskfreerateofinterest. 3. Conservation. 4. CE

SelfAssessmentQuestion4 1. Sensitivityanalysis 2. Oneofthestepsofsensitivityanalysis 3. Differenteconomicconditions

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SelfAssessmentQuestion5 1. Morereliable 2. Probability

SelfAssessmentQuestion6 1. Sequentialdecisions 2. Decisiontree. 3. Criticalaspects 4. Complexprojects.

AnswerforTerminalQuestions 1. Refertounits9.1 2. Refertounits9.2 3. Refertounits9.3 4. Refertounit9.5 5. Refertounit9.7

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