Techniques for Risk Analysis

Scenario Analysis

Q.1
From the under mentioned facts, compute NPVs of the two projects
for each of the possible cash flows, using sensitivity analysis.

Particular Project X Project Y

Initial cash outlay (t = 0) Rs.40,000 Rs.40,000

Cash flow estimate (t = 1-15)

Worst Rs.6,000 0

Most-likely Rs.8,000 8,000

Best Rs.10,000 16,000

Required rate of return 0.10 0.10

Economic life (years) 15 15

10% PVAF 7.606

Q.2

The following information is available regarding the expected cash

flows generated, and their probability for company X. What is
expected return on the project? Assuming 10% as cost of capital find
out the present values of expected monetary values. Cash outflow of
the project is Rs. 20,000

Year 1 Year 2 Year 3

Cash Probability Cash Probability Cash Probability
Flows Flows Flows
Rs.3,000 0.25 3,000 0.50 3,000 0.25
Rs.6,000 0.50 6,000 0.25 6,000 0.25
Rs.8,000 0.25 8,000 0.25 8,000 0.50

Q. 3 SD

Suppose there is a project which involves initial cost of Rs.20,000

( cost at t =0). It is expected to generate net cash flows during the first
3 years with the probability as shown in table below, cost of capital
10%:

Year 1 Year 2 Year 3

Net Net
Net Cash
Probability Cash Probability Cash Probability
Flows
Flows Flows
0.10 6,000 0.10 4,000 0.10 2,000
0.25 8,000 0.25 6,000 0.25 4,000
0.30 10,000 0.30 8,000 0.30 6,000
0.25 12,000 0.25 10,000 0.25 8,000
0.10 14,000 0.10 12,000 0.10 10,000

σ 1= Rs.2,280
σ 2= Rs.2,280
σ 3= Rs.2,280

σ (NPV) = Rs.3,283 2=.826, 4=.683, 6=.564

SD
Q.
A company is considering taking up one of the two projects ‘X’ and
‘Y’. Both projects have same life, require equal investments of rs.80
lakh each and both are estimated to have almost the same yield. As
the company is new to these type of business, the cash flow arising
from the project can not measure with certainty. An attempt was,
therefore, to made, to use probability to analyse the pattern of cash
flow during the first year of operation. The pattern is like to continue
during the life of these projects. The result of the analysis are as
follows:
Project X Project Y
Net Cash Flows Net Cash Flows (Rs.
Probability Probability
(Rs. Lakh) Lakh)
0.10 12 0.10 8
0.20 14 0.25 12
0.40 16 0.30 16
0.20 18 0.25 24
0.10 20 0.10 20

Which project should company take up?

Q.4 Assume that a project has a mean of Rs.40 and Standard

Deviation of Rs.20. The management wants to determine the
probability of the NPV under the following ranges: (i) Zero or less;
(ii) Greater than Zero; (iii) between the range of Rs.25 and Rs.45; (iv)
between the range of Rs.15 and Rs.30

Q.5 The Delta corporation is considering an investment in one of the

two mutually exclusive proposals: Project A which involves an initial
outlay of Rs.1,70,000 and Project B which has an outlay of Rs.1,50,000.
The certainty-Equivalent approach is employed in evaluating risky
investments. The current yield on treasury bills is 0.05 and the
company uses this as a riskless rate. The expected values of the cash
flows with their respective CE coefficients are:

Year Project A Project B

Cash Flows Certainty Cash Flows Certainty
(Rs. ‘000) Equivalent (Rs. ‘000) Equivalent
1 90 0.8 90 0.9
2 100 0.7 90 0.8
3 110 0.5 100 0.6

(i) Which project should be acceptable to the company?

(ii) Which project is riskier? How do you know?
(iii) If the company was to use the RADR method, which project
would be analyzed with the higher rate?

ANS: i-NPV of A = 9,554 and NPV of B = Rs.44,256

Q.6 Suppose a firm has an investment proposal, requiring an outlay

of Rs.2,00,000 at present (t = 0). The investment proposal is expected
to have 2 years’ economic life with no salvage value. In year 1 there is
0.3 probability that CFAT will be Rs.80,000; a 0.4 probability that
CFAT will be Rs.1,10,000 and a 0.3 probability that CFAT will be
Rs.1,50,000. In year 2, the CFAT possibilities depend on the CFAT
that occurs in the year 1. That is, the CFAT for the year 2 are
conditional on CFAT for the year 1. Accordingly, the probabilities
assigned with the CFAT of the year 2 are conditional probabilities.
The estimated conditional CFAT and their associated conditional
probabilities are as follows:

If CFAT3 =
If CFAT1 = Rs.80,000 If CFAT2 = Rs.1,10,000
Rs.1,50,000
Probabilit Probabi Probabi
CFAT2 CFAT2 CFAT2
y lity lity
Rs.40,000 0.2 Rs.1,30,000 0.3 Rs.1,60,000 0.1
1,00,000 0.6 1,50,000 0.4 2,00,000 0.8
1,50,000 0.2 1,60,000 0.3 2,40,000 0.1

Should the firm invest when the company’s cost of capital is 10%?

Q. A company is considering an investment in a project that requires

an initial net investment of Rs.3,000 with an expected cash flow
(CFAT) generated over three years as follows:

CFAT Probability CFAT Probability CFAT Probability

Rs.800 0.1 Rs.800 0.1 Rs.800 0.2
1,000 0.2 1,000 0.3 1,000 0.5
1,500 0.4 1,500 0.4 1,500 0.2
2,000 0.3 2,000 0.2 2,000 0.1

(a) What is expected NPV of this project? (Assume the probability

distributions are independent and the risk free rate of interest
in the market is 0.05).

(b)Calculate the standard deviation about the expected value.

(c) Find the probability that the NPV will be less than Zero.
(Assume the distribution is normal and continuous)
 (d)What is the probability that the NPV will be greater than Zero.

(e) What is the probability that the NPV will be (i) between the
range of Rs.500 and Rs.750, (ii) between the range of Rs.400 and
Rs.600, (iii) at least Rs.300 and (iv) at least Rs.1,000.
EANV approach of selecting project

A firm is considering to buy one of the following two mutually

exclusive investment projects:

PROJECT A: Buy a machine that requires an initial outlay of

Rs.1,00,000 and will generate CFAT of Rs.30,000 per year for 5 years.

PROJECT B: Buy a machine that requires an initial outlay of

Rs.1,25,000 and will generate CFAT of Rs.27,000 per year for 8 years.

Which project should be undertaken by the firm? Assume 10% cost of

capital.

Q. BREAK EVEN ANALYSIS

A firm has the following income statement. For a month.

Sales: 3,000 units at Rs.80/unit Rs.240,000

Less: Cost of Goods Sold:
Variable Production Cost 180,000
Fixed Production Cost 19,800

Gross Margin 40,200

Selling and Administrative Expenses

Variable Selling Cost 21,000
Fixed Selling Expenses 7,500
Net Income Before Taxes 11,700
1. Find the firm’s breakeven output.

2. If it wishes to have a monthly net income before taxes of

Rs.18,000 and its cost structure remains as above, what quantity of
output will it need to sell?

3. If its variable production costs increase by Rs.4 per unit, what

will be its breakeven output?

4. After the increase in costs in 3, what output will it need to sell if

it wishes to have the Rs.18,000 monthly pretax profit stated
earlier?
5. Given the variable production cost increase but no change in
fixed costs, what will be the firm’s monthly profit if it sells 4,000
units of output per month?

ANSWERS. 1. 2,100
2. 3,485
3. 3,033
4. 5,033
5. 8,700