Copyright © 2015 by McGraw Hill Education (India) Private Limited

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 stand- Analysis of

alone risk contextual risk

Sensitivity Scenario Corporate Market risk

analysis analysis risk analysis analysis

Break-even Hillier
analysis model

Simulation Decision tree

analysis 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
 Sensitivity analysis is a financial model that determines how target
variables are affected based on changes in other variables known as
input variables. This model is also referred to as what-if analysis.
 It is a way to predict the outcome of a decision given a certain range of
variables. By creating a given set of variables, an analyst can determine how
changes in one variable affect the outcome.
 Both the target and input—or independent and dependent—variables are
fully analyzed when sensitivity analysis is conducted. The person doing the
analysis looks at how the variables move as well as how the target is
affected by the input variable.
 Sensitivity analysis can be used to help make predictions in the share prices
of public companies. Some of the variables that affect stock prices include
company earnings, the number of shares outstanding, the debt-to-equity
ratios (D/E), and the number of competitors in the industry. The analysis can
be refined about future stock prices by making different assumptions or
adding different variables.
 This model can also be used to determine the effect that changes in interest
rates have on bond prices. In this case, the interest rates are the independent
variable, while bond prices are the dependent variable.
 SENSITIVITY ANALYSIS
(‘000)
YEAR 0 YEAR 1 - 10
1. INVESTMENT (20,000)
2. SALES 18,000
3. VARIABLE COSTS (66 2/3 % OF SALES) 12,000
4. FIXED COSTS 1,000
5. DEPRECIATION 2,000
6. PRE-TAX PROFIT 3,000
7. TAXES 1,000
8. PROFIT AFTER TAXES 2,000
9. CASH FLOW FROM OPERATION 4,000
10. NET CASH FLOW 4,000

NPV = -20,000,000 + 4,000,000 (5.650) = 2,600,000 ( discount rate = 12 % )

In this example, using Sensitivity analysis, we can change the value of Discount rate or Year or Sales to observe its
impact on the NPV.

Ex: Changing the Sales figure:

Ex: Changing the Year figure:

SENSITIVITY ANALYSIS
SENSITIVITY ANALYSIS
 SCENARIO ANALYSIS
 Scenario analysis is the process of estimating the expected value of
a portfolio after a given period of time, assuming specific changes in the
values of the portfolio's securities or key factors take place, such as a
change in the interest rate.
 Scenario analysis is commonly used to estimate changes to a portfolio's
value in response to an unfavorable event and may be used to examine a
theoretical worst-case scenario.

[Important: Scenario analysis is only as good as the inputs and assumptions

made by the analyst.]

 One type of scenario analysis that looks specifically at worst-case scenarios is stress
testing. Stress testing is often employed using a computer simulation technique to test the
resilience of institutions and investment portfolios against possible future critical
situations. Such testing is customarily used by the financial industry to help gauge
investment risk and the adequacy of assets, as well as to help evaluate internal processes
and controls.
 In recent years, regulators have also required financial institutions to carry out stress
tests to ensure their capital holdings and other assets are adequate.
 SCENARIO ANALYSIS
(‘000)
YEAR 0 YEAR 1 - 10
1. INVESTMENT (20,000)
2. SALES 18,000
3. VARIABLE COSTS (66 2/3 % OF SALES) 12,000
4. FIXED COSTS 1,000
5. DEPRECIATION 2,000
6. PRE-TAX PROFIT 3,000
7. TAXES 1,000
8. PROFIT AFTER TAXES 2,000
9. CASH FLOW FROM OPERATION 4,000
10. NET CASH FLOW 4,000

NPV = -20,000,000 + 4,000,000 (5.650) = 2,600,000 ( discount rate = 12 % )

RS. IN MILLION
RANGE NPV
KEY VARIABLE / SCENARIO  PESSIMISTIC EXPECTED OPTIMISTIC PESSIMISTIC EXPECTED OPTIMISTIC
INVESTMENT (RS. IN MILLION) 24 20 18 -0.65 2.60 4.22
SALES (RS. IN MILLION) 15 18 21 -1.17 2.60 6.40
VARIABLE COSTS AS A 70 66.66 65 0.34 2.60 3.73
PERCENT OF SALES
FIXED COSTS 1.3 1.0 0.8 1.47 2.60 3.33
 PESSIMISTIC, NORMAL AND OPTIMISTIC SCENARIO
RS. IN MILLION

Pessimistic Expected Optimistic

Scenario Scenario Scenario
1. Investment 24 20 18
2. Sales 15 18 21
3. Variable costs 10.5 (70%) 12 (66.7%) 13.65 (65%)
4. Fixed costs 1.3 1.0 0.8
5. Depreciation 2.4 2.0 1.8
6. Pre-tax profit 0.8 3.0 4.75
7. Tax 0.27 1.0 1.58
8. Profit after tax 0.53 2.0 3.17
9. Annual cash flow from operations 2.93 4.0 4.97
10. Net present value (7.45) 2.60 10.06
(9) x PVIFA (12%, 10 yrs) – (1)

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 BREAK EVEN ANALYSIS
 A break-even analysis is a financial tool which helps to
determine at what stage a company, or a new service or a
product, will be profitable. In other words, it’s a financial
calculation for determining the number of products or
services a company should sell to cover its costs
(particularly fixed costs).

 Break-even is a situation where you are neither making money

nor losing money, but all your costs have been covered.

 Break-even analysis is useful in studying the relation between

the variable cost, fixed cost and revenue. Generally, a company
with low fixed costs will have a low break-even point of sale.
For an example, a company has a fixed cost of Rs.0 (zero) will
automatically have broken even upon the first sale of its
product.
 BREAK-EVEN ANALYSIS
• ACCOUNTING BREAK-EVEN ANALYSIS
FIXED COSTS + DEPRECIATION 1+2
= = RS. 9 MILLION
CONTRIBUTION MARGIN RATIO 0.333
* Contribution Margin Ratio = (Sales-VC)/Sales = (18-12)/18 = 0.333
CASH FLOW FORECAST FOR NAVEEN’S FLOUR MILL PROJECT

(‘000)
YEAR 0 YEAR 1 - 10
1. INVESTMENT (20,000)
2. SALES 18,000
3. VARIABLE COSTS (66 2/3% OF SALES) 12,000
4. FIXED COSTS 1,000
5. DEPRECIATION 2,000
6. PRE-TAX PROFIT 3,000
7. TAXES 1,000
8. PROFIT AFTER TAXES 2,000
9. CASH FLOW FROM OPERATION 4,000
10. NET CASH FLOW (20,000) 4,000

• FINANCIAL BREAK-EVEN ANALYSIS: At NPV=0, Sales=15.93 Million

 HILLIER MODEL
Uncorrelated Cash Flows
When Cash Flows of different years are uncorrelated, the cash flow of
year t is independent of the cash flow of year t-1. Put differently, there is
no relationship between cash flows from period to period.
n Ct
NPV =  –I
t = 1 (1 + i)t
n  t2 ½
 (NPV) = 
t=1 (1 + i)2t
Here, NPV = Expected Net Present Value , Ct = Expected Cash Flow for Year t
i = Risk free Interest Rate
I = Initial Investment
 (NPV) = Standard Deviation of the Net Present Value
 t = Standard Deviation of the Cash Flow for the year t

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 HILLIER MODEL
Perfectly Correlated Cash Flows
n Ct
NPV =  –I
t=1 (1 + i) t
n t
 (NPV) = 
t=1 (1 + i)t
Standardising the Distribution:
Knowledge of Expected NPV and SD of NPV is very
useful for evaluating the risk characteristics of a project.
If the NPV of a project is approximately normally
distributed, we can calculate the probability of NPV
being less than or more than a certain specified value.
This probability is obtained by finding the area under
the probability distribution curve to the left or right of
the specified value.

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 SIMULATION ANALYSIS
Simulation Analysis helps in generating information which is useful for taking
a decision. For example, we may generate the probability profile of a criterion
of merit by randomly combining values of variables which may have a bearing
on the chosen criterion.

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 EMV (C2) = RS.194.2 m
150 m
C11 : S
D2 EMV (D2) = RS.44. 2 m C22 : LD ANNUAL CASH FLOW
p : 0.7 0.4 20 MILLION
D11 : PILOT PROD
C1 EMV (C1) = RS.30. 9 m D22 : STOP
& TEST MKTG
- RS.20 m C12 : F
D1 EMV (D1) = RS.10. 9 m D3 D31 : STOP
p : 0.3
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 doesn’t 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 project’s 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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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 project’s 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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