RISK ANALYSIS IN CAPITAL BUDGETING

In the chapter III we have examined the various techniques for evaluating capital
investment proposals. Our basic assumption was that these proposals did not
involve any king of risk or irrespective of the proposal selected there would not
be any change in the business risk complexion of the firm as perceived by the
supplier of capital. However, this rarely happens in real world situations.
Decisions are made on the basis of forecasts which themselves depend upon
future events whose occurrence cannot be anticipated with absolute certainty
because of economic, social, fiscal, political and other reasons. Thus, risk is
linked with business decisions. Of course, it varies from one investment
proposal to another. Some proposals may not involve any risk, e.g., investment
in government securities which assure a return at a fixed rate. Some may be less
risky, e.g., expansion of the existing business, while others may be more risky,
e.g., taking up a new venture, etc.

A change in the business risk complexion of the firm also changes the perception
of the investors and creditors about the firm. For example, if the acceptance of a
proposal makes a firm more risky, that investors and creditors will not look to it
with favour. Such a change in their outlook will adversely affect the total
valuation of the firm. It is, therefore, necessary that while evaluating capital
investment proposals, a firm should take into account the effect that their
acceptance will have on the firm’s business risk as envisioned by its investors
and creditors. Other thinks remaining the same, a firm should prefer a less risky
investment proposal as compared to a more risky investment proposal.

Risk Definition:
Riskiness of an investment proposal can be judged from the variability of its
possible returns. For example, if a person invests $10,000 in government
securities carrying 10% interest he can accurately estimate the return that he will
get on his investment year after year. His investment is, therefore, risk free. On
the other hand, if he invests this amount in stocks of companies, he will not be in
a position to correctly estimate his return year after year on account of possible
variations in dividends rates. His investment in stocks is, therefore, relatively
risky as compared to his investment in government securities. Thus, the term
risk with reference to capital budgeting decisions may be defined as the
variability that is likely to occur in future between the estimated and the actual
returns. The greater is the variability between the two, the more risky is the
project and vice versa.

1
The decisions situations as to risk may be broken down into three types
(i) Certainty (no risk), (ii) Uncertainty, and (iii) Risk. A risk situation is one is
which the probabilities of a particular event occurring are known while an
uncertain situation is one where these probabilities are not known. In other
words in case of risk chance of future loss can be foreseen because of past
experience. For example, estimating loss in demand for tractors on account of
poor harvest, in such a case the danger has been identified, i.e., poor harvest, and
one can assign probabilities to this risk say 40% fall in demand due to this factor.
On the other hand, in case of uncertainty, the future loss cannot be foreseen;
hence the management cannot deal with it in the planning process. For example,
a firm investing in a foreign country may not foresee a revolution and takeover
by an unfriendly group. This happened in Cuba in the last 1950’s.

The basic difference between risk and uncertainty is that variability is less in risk
and compared to uncertainty.

Techniques to Handle Risk factor in Capital Budgeting Process

Techniques to
Handle Risk

General Techniques Quantitative Techniques

Risk Adjusted Discount Sensitivity Analysis.

Rate.
Probability Assignment

Certainty Equivalent. Standard Deviation

Method

Coefficient of Variation

Decision Tree Analysis

2
General Techniques:
Risk Adjusted Discount Rate:
The risk adjusted discount rate is based on the presumption that investors
expect a higher rate of return on risky project as compared to less risky projects.
The rate requires determination of (I) risk free rate, and (II) risk premium rate.
Risk-free rate is the rate at which the future cash inflows should be discounted
had there been no risk. Risk premium rate is that extra return expected by the
investor over the normal rate (i.e., the risk free rate) on account of the project
being risky. Thus, risk adjusted discount rate is a composite discount rate that
takes into account both the time and risk factors. A higher discount rate will be
used for more risky projects and lower rate for less risky projects.

Merits:
1. It is simple to calculate and easy to understand.
2. It incorporation the risk-averse attitude of investors.

Demerits:
1. The determination of appropriate discount rates keeping in view the
differing degrees of risk arbitrary. It may, therefore, not give objective
results.
2. Conceptually this method is incorrect since it adjusts the wrong element.
As a matter of fact it is the future cash flow which is subject to risk.
Hence, it is to be adjusted and not the required rate of return.
3. The method results in compounding of risk over time, since the premium
is added to the discount rate. This means that the method presumes that
the risk necessarily increases with time which may be not correct all cases.
4. The method presumes that the investors are averse to risk. Of course, this
is true in most of the cases. However, there are investors who are risk-
seekers and are prepared to pay premium for taking of risk. In their case
the discount rate would be reduced rather than increased with incr3ease
in degree of risk.

Certainty Equivalent Coefficient:

According to this method the estimated cash flows are reduced to a
conservative level is applying a correction factor termed as certainty equivalent
coefficient. The correction factor is the ration of risk less (or certain) cash flow to
risky cash flow.
Risk less Cash flow
Certainty Equivalent Coefficient = ---------------------------
Risky Cash flow

3
Risk less cash flow means the cash flow which the management is prepared to
accept it case there is not risk involved. Naturally, this will be lower than the
cash flow which will be there is case the project is risky. For example, a project is
expected to generate a cash flow of $ 20,000. The project is risky but
management feels that is will get a least a cash flow of $ 12,000. It means that
certainty equivalent coefficient is 0.6.

Quantitative Techniques:
Sensitivity Analysis:
In the methods explained so far we have considered only one figure of
cash flows foe each year. However, there are chances of making some estimation
errors. The sensitivity analysis approach takes care of this aspect by providing
more than one estimate of the future returns from a project. It is, superior to one
figure forecast since, it gives a more precise idea about the variability of returns.
Usually sensitivity analysis provides information about cash flow under
three assumption (i) Pessimistic, (ii) Most likely, and (iii) Optimistic outcomes
associate with the project explains how sensitive the cash flows are under these
three different situations. The larger the difference between the pessimistic
and optimistic cash flows, the more risky the project and vice versa.

Probability Assignment:
Sensitivity analysis approach, as explained above, suffers from a
limitation. No doubt it provides different cash flow estimates under three as
assumptions; it however does not provide chances of occurrence of each of these
estimates. For example, suppose possible cash inflows have been given, $ 1,500,
$ 2,000, and $ 2,500 in respect of a Project. The question is are these equally
likely? A better decision can be made if one can assign appropriate probabilities
to each of these estimates. Suppose the probabilities assigned are .20, .60 and .20
respectively, the cash flows as adjusted by probabilities will be as follows:
Cash Inflows Probabilities Expected Monetary
Pessimistic 1,500 .20 300
Most Likely 2,000 .60 1,200
Optimistic 2,500 .20 500
The above monetary values give a more precise estimate about the likely cash
flows as compared to those estimated without assigning probabilities.
Probabilities mean the likelihood of happening of an event. When it is
said that an event has I probability, it means it is bound to happen. In case it has
0 probability it means it is not going to happen. In the above example the
chances of having cash flow as $ 2,000 has a probability of .6 or 60%. In other
words, chances of not having cash flow of $ 2,000 are .4 or 40%.

4
Probability may be objective or subjective. An objective probability is based on a
large number of observations under independent and identical conditions
repeated over a period of time. A subjective probability is based on personal
judgement since there are not large numbers of independent and identical
observations. In capital budgeting decisions, the probabilities are of a subjective
type since they are based on a single event.

Standard Deviation:
The probability assignment approach for risk analysis in capital budgeting
does not provide the decision maker with a precise value indicating about the
variability of cash flows and therefore the risk. The limitation is overcome by
adoption of standard deviation approach. Standard deviation is a measure of
dispersion. It may be defined as the square root of squared deviations calculated
from the mean. In case of capital budget this measure is used to compare the
variability of possible cash flows of different projects from their respective
means or expected values.
A project having larger standard deviation will be more risky as compared to a
project having smaller standard deviation.

The following steps are to be followed for calculating standard deviation of

possible cash flows associated with a project:
1. Mean value of possible cash flows is computed.
2. Deviations between the mean value and the possible cash flows are found
out.
3. Deviations are squared.
4. Squared deviations are multiplied by the assigned probabilities which
give weighted squared deviations.
5. The weighted squared deviations are totaled and their square root is
found out. The resultant figure is the standard deviation.

Coefficient of Variation:
Standard deviation is a absolute measure. It is unfit for comparison
particularly where projects involved different cash outlays or different expected
(or mean) values. In such a case relative measure of dispersion should be
calculated. Coefficient of variation is one of such measures. It is calculated as
follows.
Standard Deviation σ
Coefficient of Variation = --------------------------- = ------
Mean µ
Higher the coefficient of variation higher is the risk and vice versa.

5
Decision Tree Analysis:
Decision three analyses is another technique which is helpful in tackling
risky capital investment proposals. Decision tree is a graphics display of
relationship between a presented decision and possible future events, future
decision and their consequences. The sequence of events is mapped out over
time in a format resembling branches of a tree. In other words, it is a pictorial
representation in tree form which indicates the magnitude, probability and
interrelationship of all possible outcomes.