Introduction To Risk Analysis in Capital Budgeting: Practical Problems

CHAPTER 8 INTRODUCTION TO RISK ANALYSIS
IN CAPITAL BUDGETING
PRACTICAL PROBLEMS
PROBABILISTIC APPROACH
Question 1: A project under consideration is likely to cost `50 lakh by way of fixed assets and requires another `20 lakh
for current assets. It is expected to have a life of 10 years, during which the returns are likely to be uniform, and at the
end of which, it is likely to be have scrap value of `5 lakh. Various estimates of the gross income before depreciation and tax
have been made. These are as follows:
Annual amount (` in lakh) Probability
5 0.1
10 0.2
20 0.5
30 0.1
40 0.1
The rate of income tax is 35 percent. The cut-off rate is 12 percent. Assuming straight line method of depreciation is allowed
for tax purposes, would you recommend acceptance of the project?
Solution: Computation of NPV (` in lakhs)
Mean CFBT - (1) (5 x 0.1) + (10 x 0.2) (20 x 0.5) + (30 x 0.1) + (40 x 0.1) 19.5
Less: Depreciation 50 – 5 (4.5)
10
PBT 15
Tax Liability (35%) – (2) 5.25
Mean CFAT (1) – (2) 14.25
Cumulative PVAF (1 – 10) (12%) 5.65
P.V. of CFAT 80.5125
Add: PV of terminal value (10th year) (20 lakhs + 5 lakhs) x 0.322 8.05
PVCI 88.5625
Less: PVCO (50 + 20) (70)
NPV 18.5625
Advise: Accept the Project.
Question 2: Cyber Company is considering two mutually exclusive projects. Investment outlay of both the projects is
`5,00,000 and each is expected to have a life of 5 years. Under three possible situations their annual cash flows and
probabilities are as under:
Cash Flows (`)
Situation Probabilities
Project A Project B
Good 0.3 6,00,000 5,00,000
Normal 0.4 4,00,000 4,00,000
Worse 0.3 2,00,000 3,00,000
The cost of capital is 7 percent, which project should be accepted? Explain with workings.
Solution: Computation of NPV of Project A:
Situation Probability NPV Expected NPV
Good 0.3 (6,00,000 x 4.100) - 5,00,000 = 19,60,000 5,88,000
Normal 0.4 (4,00,000 x 4.100) - 5,00,000 = 11,40,000 4,56,000
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INTRODUCTION TO RISK ANALYSIS IN CAPITAL BUDGETING By: CA Ashish Kalra
Worse 0.3 (2,00,000 x 4.100) - 5,00,000 = 3,20,000 96,000
2
Computation of NPV of Project B:
11,40,000
Situation Probability NPV Expected NPV

Good 0.3 (5,00,000 x 4.100) - 5,00,000 = 15,50,000 4,65,000
Normal 0.4 (4,00,000 x 4.100) - 5,00,000 = 11,40,000 4,56,000
Worse 0.3 (3,00,000 x 4.100) - 5,00,000 = 7,30,000 2,19,000
11,40,000
Computation of Standard Deviation
Project A: (19,60,000 – 11,40,000)2 x 0.3 + (11,40,000 – 11,40,000)2 x 0.4 + (3,20,000 – 11,40,000)2 x 0.3
= 6,35,169
Project B: (15,50,000 – 11,40,000)2 x 0.3 + (11,40,000 – 11,40,000)2 x 0.4 + (7,30,000 – 11,40,000)2 x 0.3
= 3,17,585
Since the both Projects have the same NPV but Project B has lesser standard deviation than Project A, hence Project B shall
be accepted.
Question 3: A company is considering Projects X and Y with following information:
Project Expected NPV (`) Standard deviation
X 1,22,000 90,000
Y 2,25,000 1,20,000
(i) Which project will you recommend based on the above data?
(ii) Explain whether your opinion will change, if you use coefficient of variation as a measure of risk.
(iii) Which measure is more appropriate in this situation and why?
Solution: (i) On the basis of standard deviation project X be chosen because it is less risky than Project Y having
higher standard deviation.
(ii) CV = SD [
ENPV
CVX = 90,000 = 0.738
1,22,000
CVY = 1,20,000 = 0.533

2,25,000
On the basis of Co-efficient of Variation (C.V.) Project Y appears to be less risky and hence should be accepted.
(iii) However, the coefficient of variation as a measure of risk in such conflicting situation is best because it relates the risk
and return.
Question 4: Probabilities for net cash flows for 3 years of project (Project life) are as follows:
Year 1 Year 2 Year 3
Cash Flow (`) Probability Cash Flow (`) Probability Cash Flow (`) Probability
2,000 0.1 2,000 0.2 2,000 0.3
4,000 0.2 4,000 0.3 4,000 0.4
6,000 0.3 6,000 0.4 6,000 0.2
8,000 0.4 8,000 0.1 8,000 0.1
Calculate the expected net cash flows. Also calculate the present value of the expected cash flow, using 10 per cent discount
rate. Initial Investment is `10,000.
Solution:
Year 1 Year 2 Year 3
Cash Expected Cash Expected Cash Expected
Probability Probability Probability
Flow (`) Value (`) Flow (`) Value (`) Flow (`) Value (`)
2,000 0.1 200 2,000 0.2 400 2,000 0.3 600
4,000 0.2 800 4,000 0.3 1,200 4,000 0.4 1,600
6,000 0.3 1,800 6,000 0.4 2,400 6,000 0.2 1,200
8,000 0.4 3,200 8,000 0.1 800 8,000 0.1 800
6,000 4,800 4,200
Presentvalue of cash flows:
3
Years
1
Cash flows PVF
6,000 0.909
PV
5,454
2 4,800 0.826 3,965
3 4,200 0.751 3,154
PVCF 12,573
Expected Net Present Value = Present Value of cash flows – Initial Investment
= `12,573 - `10,000
= `2,573
CERTAINTY EQUIVALENT APPROACH

Question 5: XYZ Ltd is considering the proposal of buying one of the two machines to manufacture a new product. Each of
these machines requires an investment of `50,000, and is expected to provide benefits over a period of 4 years. After the
expiry of the useful life of the machines, the sellers of both the machines have guaranteed to buy back the machines at
`5,000. The management of the company uses CE approach to evaluate risky investments. The company's risk adjusted
discount rate is 16 percent and the risk-free rate is 10 percent. The expected values of net cash flows (CFAT) with their
respective CE are:
Proposal A Proposal B
Year
CFAT CE CFAT CE
1 30,000 0.8 18,000 0.9
2 30,000 0.7 36,000 0.8
3 30,000 0.6 24,000 0.7
4 30,000 0.5 32,000 0.4
Which machine, if either, should be purchased by the company?
Solution: Computation of NPV
Time PV factor Proposal A Proposal B
Cash Certain Cash Certain
CE PV CE PV
flow cash flow flow cash flow
1 0.909 30,000 0.8 24,000 21,816 18,000 0.9 16,200 14,726
2 0.826 30,000 0.7 21,000 17,346 36,000 0.8 28,800 23,789
3 0.751 30,000 0.6 18,000 13,518 24,000 0.7 16,800 12,617
4 0.683 30,000 0.5 15,000 10,245 32,000 0.4 12,800 8,742
(+) Terminal Value 0.683 5,000 3,415 5,000 3,415
PVCI 66,340 63,289
(-) PVCO (50,000) (50,000)
NPV 16,340 13,289
Advise: Proposal A should be accepted.
RISK ADJUSTED DISCOUNTING RATE
Question 6: An enterprise is investing `100 lakhs in a project. The risk-free rate of return is 7%. Risk premium expected by
the Management is 7%. The life of the project is 5 years. Following are the cash flows that are estimated over the life of
the project.
Year Cash flows (` in lakhs)
1 25
2 60
3 75
4 80
5 65
Calculate Net Present Value of the project based on Risk free rate and also on the basis of Risks adjusted discount rate.
Solution: The present Value of the Cash Flows for all the years by discounting the cash flow at 7% is calculated as below:
Cash flows Present value of Cash Flows

Year Discounting Factor @ 7%
4 1
(` in lakhs)
25 0.935
(` in lakhs)
23.38
2 60 0.873 52.38
3 75 0.816 61.20
4 80 0.763 61.04
5 65 0.713 46.35
Total of present value of Cash flow 244.34
Less: Initial Investment (100)
Net Present Value (NPV) 144.34
Now when the risk-free rate is 7% and the risk premium expected by the Management is 7%. So the risk adjusted discount
rate is 7% + 7% = 14%.
Discounting the above cash flows using the Risk Adjusted Discount Rate would be as below:
Cash flows Present value of Cash Flows
Year Discounting Factor @ 14%
(` in lakhs) (` in lakhs)
1 25 0.877 21.93
2 60 0.769 46.14
3 75 0.675 50.63
4 80 0.592 47.36
5 65 0.519 33.74
Total of present value of Cash flows 199.79
Less: Initial Investment (100)
Net Present Value (NPV) 99.79
Question 7: Determine the risk adjusted net present value of the following projects:
X Y Z
Net cash outlays (`) 2,10,000 1,20,000 1,00,000
Project life 5 years 5 years 5 years
Annual Cash inflow (`) 70,000 42,000 30,000
Coefficient of variation 1.2 0.8 0.4
The Company selects the risk-adjusted rate of discount on the basis of the coefficient of variation:
Risk-Adjusted Rate P.V. Factor 1 to 5 years At
Coefficient of Variation
of Return risk adjusted rate of discount
0.0 10% 3.791
0.4 12% 3.605
0.8 14% 3.433
1.2 16% 3.274
1.6 18% 3.127
2.0 22% 2.864
More than 2.0 25% 2.689
Solution: Statement showing the determination of the Risk Adjusted Net Present Value
Net
Coefficient Risk Adjusted Annual PV Factor Discounted Net Present
Project Cash
of Variation Discounted Rate Cash Inflow 1-5 years Cash Inflows Value
Outlays
(i) (`) (ii) (iii) (iv) (`) (v) (vi) (vii) = (v) x (vi) (viii)=(vii) – (ii)
X 2,10,000 1.20 16% 70,000 3.274 2,29,180 19,180
Y 1,20,000 0.80 14% 42,000 3.433 1,44,186 24,186
Z 1,00,000 0.40 12% 30,000 3.605 1,08,150 8,150
SCENARIO ANALYSIS
Question 8: From the following information compute the net present value (NPVs) of the two projects for each of the
possible cash flows, using scenario analysis:
Project X(000’ `) Project Y(000’ `)
Initial cash outflows (t = 0) 30 30
Cash inflows estimates (t = 1 – 10)
5 Worst
Most Likely
5
8
8
10
Best 15 20
Required Rate of Return 14% 14%
Economic life (years) 10 10
Solution: The NPV of each project, assuming a 14% required rate of return, can be calculated for each of the possible cash
flows. The present value interest factor annuity (PVIFA) of `1 for 10 years at 14% discount is 5.216. Multiplying each possible
cash flows by PVIFA, we get the following information. (000’ `)
Determination of NPVs Project X Project Y
Expected cash inflows PV NPV PV NPV
Worst 26.08 (3.92) 41.73 11.73
Most likely 41.73 11.73 52.16 22.16
Best 78.24 48.24 104.32 74.32
Conclusion: The aforesaid table shows that in case of Project X under worst circumstances there is negative NPV whereas
in case of most likely and best circumstances there is positive NPV.
However, in case of Project Y there is positive NPV under all the circumstances, at the same time cash inflows are more, than
project X. Hence, Project Y is more profitable and hence, be accepted.
DECISION TREE
Question 9: A firm is required to choose between constructing a large or small factory to produce a new line of products. The
large plant would be needed if the future brings a high demand for new products. But the large plant would have new cash
inflows below the `10,00,000 outlay, if demand is medium or low. The present value cash flows are `14,00,000 with high demand,
`9,00,000 with medium demand, and `6,00,000 with low demand. The smaller plant produces a lower return if demand is high
but has positive net present values at medium demand. It would cost `2,00,000 as a cash outlay and would return a present
value inflow of `3,20,000 with high demand, `2,70,000 with medium demand, and `1,80,000 with low demand. Draw a Decision
tree for the proposals under consideration. The decision is mutually exclusive. What is the net present value of each
alternative if there is a 40% chance of high demand, 40% chance of medium demand and a 20% chance of low demand.
Solution:
0.4 NPV = 4,00,000
0.4 NPV = (1,00,000)

NPV = 40,000
Construct a
Large Factory 0.2 NPV = (4,00,000)
NPV = 72,000 0.4 NPV = 1,20,000

Construct a Small Factory
D1 0.4 NPV = 70,000
0.2 NPV = (20,000)

Do Nothing
NPV = 0
Advise: Construct a small factory.

Question 10: X Ltd. is considering the purchase of a new plant requiring a cash outlay of `20,000. The plant is expected to have
a useful life of 2 years without any salvage value.
The cash flows and their associated probabilities for the two years are as follows:
1st year Cash flows Probability
`8,000 0.3
`11,000 0.4
`15,000 0.3
Depending upon the cash flows of year 1 to be `8,000, or `11,000 or `15,000, the cash flows for year 2 may be:
Year 1 - `8,000 Year 1 - `11,000 Year 1 - `15,000
6Yr. 2 CF (`) Probability Yr. 2 CF (`) Probability Yr. 2 CF (`) Probability

4,000 0.2 13,000 0.3 16,000 0.1
10,000 0.6 15,000 0.4 20,000 0.8
15,000 0.2 16,000 0.3 24,000 0.1
Draw a Decision tree for the proposal under consideration. Presuming that 10% is the cost of capital, calculate the NPV
of the project and suggest whether the project should be undertaken.
Solution:
0.2 4,000
0.6
8,000 10,000
0.2
0.3 15,000
13,000
0.3
0.4 0.4 15,000
(20,000) 11,000
0.3
16,000
0.3
16,000
0.1
0.8
15,000 20,000
0.1
24,000
Mean Cash Inflows (Year 1): (8,000 x 0.3) + (11,000 x 0.4) + (15,000 x 0.3) = 11,300
Mean Cash Inflows (year 2): (4,000 x 0.06) + (10,000 x 0.18) + (15,000 x 0.06) + (13,000 x 0.12) + (15,000 x 0.16)
+ (16,000 x 0.12) + (16,000 x 0.03) + (20,000 x 0.24) + (24,000 x 0.03) = 14,820
Mean NPV = (11,300 x 0.909) + (14,820 x 0.826) – 20,000 = 2,513
Advise: Accept the proposal.
 Question 11: Pearson Publishing House, a small publisher is publishing economy edition of a new book on Financial
Management. The cost of typesetting and other related cost will be `1,00,000. The cost of printing per book will be `20. If
additional books are needed at a later time, the setup cost will be `50,000 per setup, however, cost of printing the book shall
remain the same.
The book will be sold for `140 per copy. Royalty to author, commission of agent and other related delivery charges shall be
`40 per book.
The future sale of book depends upon the review of the book. In case book gets good review. It is expected that sale of book
will 5,000 copies per year for three years. On the other hand, if it gets bad review, the sale will be 2,000 copies in the first
year and then sale will be ceased.
Probability for good review is 0.3. Mr. X, owner of publishing house faces a choice between ordering an immediate production
of 15,000 copies or 5,000 copies, followed by additional production run at the end of the first year if the book is successful.
The cost of capital is 10%.
Using Decision Tree analysis recommend production schedule and decide whether book should be published or not.
Solution:
7 NPV = 1,00,310
0.3
Success of book
NPV = (100 x 5,000 x 2.487) – 4,00,000* = 8,43,500
Print 15,000
copies
0.7 Failure of book
NPV = (100 x 2,000 x 0.909) – 4,00,000* = (-) 2,18,200

NPV = 2,32,135
Print 5,000 Success of book

copies 0.3 NPV = (100 x 5,000 x 2.487) – 2,00,000** – 2,50,000*** x 0.909
= 8,16,250
D1 0.7
Failure of book
NPV = (100 x 2,000 x 0.909) – 2,00,000** = (-) 18,200
0
Do nothing
* (1,00,000 + 20 x 15,000) = 4,00,000

** (1,00,000 + 20 x 5,000) = 2,00,000
*** (50,000 + 20 x 10,000) = 2,50,000
The expected net present value is larger and the potential loss is smaller if the initial run is 5,000 copies. The 5,000 copy
choice is preferred since it produces both more expected value and less risk.
* In above answer it has been assumed that to avoid again set up cost in the beginning of 2 nd year 10000 copies will be printed
in the end of first year.
 Question 12: A business man has two independent investments A and B available to him: but he lacks the capital to
undertake both of them simultaneously. He can choose to take A first and then stop, or if A is successful then take B, or
vice versa. The probability of success on A is 0.7, while for B it is 0.4. Both investment require an initial capital outlay of
`2,000, and both return nothing if the venture is unsuccessful. Successful completion of A will return `3,000 (over cost),
and successful completion of B will return `5,000 (over cost). Draw the decision tree and determine the best strategy.
Solution:
(2,000)
0.3 Fail (2,000)
0.6 Fail
0.7 Succeed 800
+ 800 Accept B
3,000 0.4 Succeed
2,060 5,000
Accept A D2 Stop
0
Do nothing 0
D1A
Accept B
0
1,400 Stop
0.4 Succeed
5,000 D3 3,000
1,500 0.7 Succeed
+ 1,500 Accept A
0.6 Fail 0.3 Fail
(2,000) (2,000)
The required decision tree is as shown below:

There are three decision points in this tree. These are indicated as 1, 2 and 3.
Evaluation of decision point 3:
8
1. Accept A
Outcome Probability Conditional Values
(Amount in `)
Expected Values
Success 0.7 3,000 2,100
Failure 0.3 (2,000) (600)
1,500
2. Stop: Expected value = 0
1. Accept B (Amount in `)
Outcome Probability Conditional Values Expected Values
Success 0.4 5,000 2,000
Failure 0.6 (2,000) (1,200)
800
2. Stop: Expected value = 0
1. Accept A (Amount in `)
Success 0.7 3,000 + 800 2,660
Failure 0.3 (2,000) (600)
2,060
2. Accept B (Amount in `)
Success 0.4 5,000 + 1,500 2,600
Failure 0.6 (2,000) (1,200)
1,400
3. Do Nothing: Expected value = 0
Hence, the best strategy is to accept A first, and if it is successful, then accept B.
 Question 13: MCL Technologies is evaluating new software for ERP. The software will have a 3-year life and cost
`1,000 thousands. Its impact on cash flows is subject to risk. Management estimates that there is a 50-50 chance that the
software will either save the company `1,000 thousands in the first year or save it nothing at all. If nothing at all, savings in
the last 2 years would be zero. Even worse, in the second year an additional outlay of `300 thousands may be required to
convert back to the original process, for the new software may result in less efficiency. Management attaches a 40 percent
probability to this occurrence, given the fact that the new software “failed” in the first year. If the software proves itself,
second-year cash flows may be either `1,800 thousands, `1,400 thousands, or `1,000 thousands, with probabilities of 0.20,
0.60 and 0.20, respectively. In the third year, cash, inflows are expected to be `200 thousands greater or `200 thousands
less than the cash flow in period 2, with an equal chance of occurrence. (Again, these cash flows depend on the cash flow in
period 1 being `1,000 thousands.) All the cash flows are after taxes.
(a) Set up a probability tree to depict the foregoing cash-flow possibilities.
(b) Calculate a net present value for each three-year possibility, using a risk-free rate of 5 percent.
(c) What is the risk of the project?
Solution:
(a)
9 First Year Second Year Third Year

2,000
0.5
1,800
0.5
1,600
0.2
1,600
0.5
1,000 0.6 1,400
0.5
1,200
0.2 1,200
Invest in 0.5 0.5
1,000
Software 0.5
800
0 0
0.5
0.6
0
D1 0.4
(300) 0
Do not
invest
(b) Statement showing computation of NPV

P.V. Cash Expected
Case Time P.V.C.I P.V.C.O NPV Prob.
Factor Inflows NPV
I 1 0.952 1,000 952
2 0.907 1,800 1,632.6
3 0.864 2,000 1,728
4,312.6 (1,000) 3,312.6 0.05 165.63
II 1 0.952 1,000 952
2 0.907 1,800 1,632.6
3 0.864 1,600 1,382.4
3,967 (1,000) 2,967 0.05 148.35
III 1 0.952 1,000 952
2 0.907 1,400 1,269.8
3 0.864 1,600 1,382.4
3,604.2 (1,000) 2,604.2 0.15 390.63
IV 1 0.952 1,000 952
2 0.907 1,400 1,269.8
3 0.864 1,200 1,036.8
3,258.6 (1,000) 2,258.6 0.15 338.79
V 1 0.952 1,000 952
2 0.907 1,000 907
3 0.864 1,200 1,036.8
2,895.8 (1,000) 1,895.5 0.05 94.77
VI 1 0.952 1,000 952
2 0.907 1,000 907
3 0.864 800 691.2
2,550.2 (1,000) 1,550.2 0.05 77.51
VII 1 0.952 0 0
2 0.907 0 0
3 0.864 0 0
0 (1,000) (1,000) 0.30 (300)
VIII 1 0.952 0 0
2 0.907 (300) (272.1) (1,000) (1,272.1) 0.20 (254.42)
10 3 0.864 0 0
(272.1) 661.25
2
(c) Standard Deviation = (3,312.6 – 661.25) x 0.05
+ (2,967 – 661.25)2 x 0.05
+ (2,604.2 – 661.25)2 x 0.15
+ (2,258.6 – 661.25)2 x 0.15
+ (1,895.8 – 661.25)2 x 0.05
+ (1,550.2 – 661.25)2 x 0.05
+ (-1,000 – 661.25)2 x 0.30
+ (-1,272.1 – 661.25)2 x 0.20
= 1,804.9
SENSITIVITY ANALYSIS
 Question 14: Red Ltd. is considering a project with the following Cash flows:
Amount in (`)
Years Cost of Plant Recurring Cost Savings
0 10,000
1 4,000 12,000
2 5,000 14,000
The cost of capital is 9%. Measure the sensitivity of the project to changes in the levels of plant value, running cost and
savings (considering each factor at a time) such that the NPV becomes zero. The P.V. factor at 9% are as under:
Year Factor
0 1
1 0.917
2 0.842
Which factor is the most sensitive to affect the acceptability of the project?
Solution: P.V of Cash Flows: Amount in (`)
Year 1 Running Cost 4,000 x 0.917 = (3,668)
Savings 12000 x 0.917 = 11,004
Year 2 Running Cost 5,000 x 0.842 = (4,210)
Savings 14,000 x 0.842 = 11,788
14,914
Year 0 Less: P.V of Cash outflow 10,000 x 1 (10,000)
NPV 4,914
Sensitivity Analysis:
(i) Increase of Plant Value by `4,914
4,914 x 100 = 49.14%
10,000
(ii) Increase of Running Cost by `4,914

4,914 = 4,914 x 100 = 62.38%
3,668 + 4,210 7,878
(iii) Fall in saving by `4,914
4,914 = 4,914 x 100 = 21.56%
11,004 + 11,788 22,792
Hence, savings factor is the most sensitive to affect the acceptability of the project.
 Question 15: A company is considering investing in a new manufacturing project with following characteristics:
A. Initial investment `350 lakhs – scrap value nil
B. Expected life 10 years
C. Sales volume 20,000 unit per year
D. Selling price `2,000 per unit
E. Variable direct costs `1,500 per unit
F. Fixed costs excluding depreciation `25,00,000 per year.
11
The project shows an IRR of 17%. The MD is concerned about the viability of the investment as the return is close to
company’s threshold rate of 15%. He has requested a sensitivity analysis. You are required to:
a) Re-calculate IRR assuming each of the characteristics A to F above in isolation varies by 10%.
b) Advice the MD of the most vulnerable area likely to prevent the project meeting the company’s hurdle rate.
c) Revaluate the situation if another company, already manufacturing a similar product, offered to supply the units at
`1800 each; this would reduce the investment to `25 lakhs & fixed cost p.a. to `10 lakhs. Life of proposal = 10 years.
Solution: (a) (A) Revised Initial Investment (350 lakh x 110%) = 385 lakh
Cumulative PVAF (1 – 10) = 385 lakh = 5.133
75 lakh
Table B (10th year) Project IRR = 14.5%
(B) Revised expected life = 10 years x 90% = 9 years
75 lakh
th
Table B (9 year) Project IRR = 15.5%
(C) Revised Annual sales volume (20,000 units x 90%) 18,000 Units
Annual contribution (18,000 units x `500) `90 lakh
Less: Annual cash fixed cost (`25 lakh)
Annual net cash inflows `65 lakh
65 lakh
Table B (10th year) Project IRR = 13%
(D) Revised S.P. per unit (`2,000 x 90%) `1800
Less: Variable direct costs per unit (`1500)
Contribution per unit `300
Annual sales volume 2000 Units
Annual contribution `60 lakh
Less: Cash Fixed Cost p.a. (`25 lakh)
Cumulative PVAF of IRR = 350 lakh = 10
35 lakh
Project IRR = 0%
(E) Selling price per unit `2,000
Less: Revised V.C. per unit (1500 x 10%) (1,650)
Revised contribution per unit `350
Annual sales volume 20,000 Units
Annual contribution `70 lakh
Less: Cash fixed cost p.a. (`25 lakh)
Cum PVAF of 10 yrs of IRR = 350 lakh = 7.778

45 lakh
Table B (10th year) Project IRR = 4.5%
(F) Existing annual contribution `100 lakh
Less: Revised cash annual fixed cost (`27.5 lakh)
Annual net cash inflows `72.5 lakh
Cum. PVAF of IRR (1 – 10) = 350 lakh = 4.828
72.5 lakh
Table B (10th year) Project IRR = 16%
(b) Most vulnerable (sensitive) variable = selling price per unit (As a 10% change in selling price per unit will bring down the
IRR to 0% level)
(c) Selling price per unit `2,000
Less: Variable cost per unit (`1,800)
Contribution per unit `200
12 Annual sales volume

Annual contribution
20,000 units
`40,00,000
Less: Annual cash fixed costs (`10,0,000)
Annual net cash inflow `30,00,000
Initial investment 25,00,000
The project IRR in the above case is more than 100% & hence the project should be accepted.
SIMULATION
 Question 16: The director of finance for a farm cooperative is concerned about the yield per acre he can expect from
this year’s corn crop. The probability distribution of the yields for the current weather conditions is:
Yield kg per acre Probability
120 0.18
140 0.26
160 0.44
180 0.12
He would like to see a simulation of the yields he might expect over the next 10 years for weather conditions similar to those
he is now experiencing.
(i) Simulate the average yield he might expect per acre during the next 10 years using the following random numbers:
20, 72, 34, 54, 30, 22, 48, 74, 76, 02
(ii) He is also interested in the effect of market price fluctuations on the co-operative’s farm revenue. He makes this
estimate of per kg. Prices for corn.
Price per kg (`) Probability
2.00 0.05
2.10 0.15
2.20 0.30
2.30 0.25
2.40 0.15
2.50 0.10
Simulate the revenues he might expect to observe over the next 10 years using the following random numbers for SP per kg:
82, 95, 18, 96, 20, 84, 56, 11, 52, 03.
Solution: If the numbers 0-99 are allocated in proportion to the probabilities associated with each category of yield per
acre, then various kinds of yields can be sampled using random number table:
Yields in kg per acre Probability Cumulative Probability Random Numbers assigned
120 0.18 0.18 00-17
140 0.26 0.44 18-43
160 0.44 0.88 44-87
180 0.12 1.00 88-99
(i) Let us simulate the yield per acre for the next 10 years based on the given 10 random numbers.
Year Random Number Simulated Yield

1 20 140
2 72 160
3 34 140
4 54 160
5 30 140
6 22 140
7 48 160
8 74 160
9 76 160
10 02 120
Total 1480
The average yield is 1480/10 = 148 kg/acre.
(ii) Let us now simulate the price he might expect in the next 10 years based on the random numbers given:
13
Price per kg. Probability Cumulative Probability Random Numbers assigned
2.00 0.05 0.05 00-04
2.10 0.15 0.20 05-19
2.20 0.30 0.50 20-49
2.30 0.25 0.75 50-74
2.40 0.15 0.90 75-89
2.50 0.10 1.00 90-99
This simulated prices are developed using the random numbers given for next 10 ten years.
Random Simulated Simulated Revenue
Year
Number Price Per Kg Yield per acre
1 82 2.40 140 336
2 95 2.50 160 400
3 18 2.10 140 294
4 96 2.50 160 400
5 20 2.20 140 308
6 84 2.40 140 336
7 56 2.30 160 368
8 11 2.10 160 336
9 52 2.30 160 368
10 03 2.00 120 240
Total 3,386
Question 17: Annual Net Cash Flows & Life of the project with their probability distribution are as follows:
Annual Cash Flow Project Life
Value (`) Probability Value (Year) Probability
10,000 0.02 3 0.05
15,000 0.03 4 0.10
20,000 0.15 5 0.30
25,000 0.15 6 0.25
30,000 0.30 7 0.15
35,000 0.20 8 0.10
40,000 0.15 9 0.03
10 0.02
Risk free rate is 10%, and Initial Investment is `1,30,000. Various Random Number generated are as follows:
53,479 81,115
97,344 70,328
66,023 38,277
99,776 75,723
30,176 48,979
81,874 83,339
19,839 90,630
09,337 33,435
31,151 58,295
67,619 52,515
Calculate NPV in each Run.
Solution: Correspondence between Values of Variables and two Digit Random Numbers:
Value Cumulative Two Digit Value Cumulative Two Digit
Probability Probability
(`) Probability Random No. (Year) Probability Random No.
10,000 0.02 0.02 00-01 3 0.05 0.05 00-04
15,000 0.03 0.05 02-04 4 0.10 0.15 05-14
20,000 0.15 0.20 05-19 5 0.30 0.45 15-44
25,000 0.15 0.35 20-34 6 0.25 0.70 45-69
30,000 0.30 0.65 35-64 7 0.15 0.85 70-84
14
35,000
40,000
0.20
0.15
0.85
1.00
65-84
85-99
8
9
0.10
0.03
0.95
0.98
85-94
95-97
10 0.02 1.00 98-99
For the first simulation run we need two digit random number (1) For Annual Cash Flow (2) For Project Life. The numbers are
53 & 97 and corresponding value of Annual Cash Flow and Project Life are `30,000 and 9 years respectively and so on.
Calculation of NPV through Simulation:
Run Random Annual Cash Flow Random Project PVAF @ 10% NPV (1) x (2) –
No. (1) No. Life (2) 1,30,000
1 53 30,000 97 9 5.759 42,770*
2 66 35,000 99 10 6.145 85,075
3 30 25,000 81 7 4.868 (8,300)
4 19 20,000 09 4 3.170 (66,600)
5 31 25,000 67 6 4.355 (21,125)
6 81 35,000 70 7 4.868 40,380
7 38 30,000 75 7 4.868 16,040
8 48 30,000 83 7 4.868 16,040
9 90 40,000 33 5 3.791 21,640
10 58 30,000 52 6 4.355 650
*(30,000 x 5.759 – 1,30,000), Cumulative PV @ 10% for 9 years is 5.759, NPV of other runs are calculated similarly.

Introduction To Risk Analysis in Capital Budgeting: Practical Problems

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CHAPTER 8 INTRODUCTION TO RISK ANALYSIS

Worse 0.3 (2,00,000 x 4.100) - 5,00,000 = 3,20,000 96,000

Situation Probability NPV Expected NPV

CVY = 1,20,000 = 0.533

Presentvalue of cash flows:

CERTAINTY EQUIVALENT APPROACH

Cash flows Present value of Cash Flows

Cash inflows estimates (t = 1 – 10)

0.4 NPV = 4,00,000

0.4 NPV = (1,00,000)

NPV = 72,000 0.4 NPV = 1,20,000

0.2 NPV = (20,000)

Advise: Construct a small factory.

Year 1 - `8,000 Year 1 - `11,000 Year 1 - `15,000

6Yr. 2 CF (`) Probability Yr. 2 CF (`) Probability Yr. 2 CF (`) Probability

NPV = (100 x 2,000 x 0.909) – 4,00,000* = (-) 2,18,200

Print 5,000 Success of book

* (1,00,000 + 20 x 15,000) = 4,00,000

The required decision tree is as shown below:

Evaluation of decision point 3:

9 First Year Second Year Third Year

(b) Statement showing computation of NPV

2 0.907 (300) (272.1) (1,000) (1,272.1) 0.20 (254.42)

(ii) Increase of Running Cost by `4,914

F. Fixed costs excluding depreciation `25,00,000 per year.

Cum PVAF of 10 yrs of IRR = 350 lakh = 7.778

Contribution per unit `200

12 Annual sales volume

Year Random Number Simulated Yield

30,000 0.30 0.65 35-64 7 0.15 0.85 70-84

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