CHAPTER 12 RISK ANALYSIS IN CAPITAL BUDGETING

LEARNING OBJECTIVES
2

 Discuss the concept of risk in investment decisions.

 Understand some commonly used techniques, i.e., payback,
certainty equivalent and risk-adjusted discount rate, of risk
analysis in capital budgeting.
 Focus on the need and mechanics of sensitivity analysis and
scenario analysis.
 Highlight the utility and methodology simulation analysis.
 Explain the decision tree approach in sequential investment
decisions.
 Focus on the relationship between utility theory and capital
budgeting decisions.
 Nature of Risk
3

 Risk exists because of the inability of the decision-

maker to make perfect forecasts.
 In formal terms, the risk associated with an
investment may be defined as the variability that is
likely to occur in the future returns from the
investment.
 Three broad categories of the events influencing the
investment forecasts:
 General economic conditions
 Industry factors
 Company factors
 Techniques for Risk Analysis
4

 Statistical Techniques for Risk Analysis

 Probability
 Variance or Standard Deviation
 Coefficient of Variation
 Conventional Techniques of Risk Analysis
 Payback
 Risk-adjusted discount rate
 Certainty equivalent
 Probability
5

 A typical forecast is single figure for a period. This is referred to

as “best estimate” or “most likely” forecast:
 Firstly, we do not know the chances of this figure actually occurring, i.e.,
the uncertainty surrounding this figure.
 Secondly, the meaning of best estimates or most likely is not very clear. It
is not known whether it is mean, median or mode.

 For these reasons, a forecaster should not give just one estimate,
but a range of associated probability–a probability distribution.

 Probability may be described as a measure of someone’s

opinion about the likelihood that an event will occur.
 Assigning Probability
6

 The probability estimate, which is based on a very

large number of observations, is known as an
objective probability.
 Such probability assignments that reflect the state of
belief of a person rather than the objective evidence
of a large number of trials are called personal or
subjective probabilities.
 Risk and Uncertainty
7

 Risk is referred to a situation where the probability

distribution of the cash flow of an investment
proposal is known.

 If no information is available to formulate a

probability distribution of the cash flows the
situation is known as uncertainty.
 Expected Net Present Value
8

 Once the probability assignments have been made to

the future cash flows the next step is to find out the
expected net present value.
n
ENCF
ENPV = t =0 (1 + k )
t

 Expected net present value = Sum of present values

of expected net cash flows.
ENCFt = NCFjt × Pjt
 Example
9

 Suppose an investment project has a life of three

years, and it would involve an initial cost of Rs
10,000. Expected Cash Flow

 Ifthe discount rate is 15 per cent, calculate the

expected NPV.
 Example
10
 Variance or Standard Deviation
11

 Variance measures the deviation about expected cash

flow of each of the possible cash flows.

 Standard deviation is the square root of variance.

n
 (NCF) =
2
 (NCF
j =1
j – ENCF) 2 Pj

 Absolute Measure of Risk.

 Coefficient of Variation
12

 Coefficient of variation is relative Measure of Risk.

 It is defined as the standard deviation of the

probability distribution divided by its expected value:
Expected value
Cofficient of variation = CV =
Standard deviation
 Coefficient of Variation
13

 The coefficient of variation is a useful measure of

risk when we are comparing the projects which have

 same standard deviations but different expected values, or

 different standard deviations but same expected values, or
 different standard deviations and different expected values.
CONVENTIONAL TECHNIQUES OF RISK ANALYSIS
14

 Payback
 Risk-adjusted discount rate
 Certainty equivalent
 Risk Analysis in Practice
15

 Most companies in India account for risk while

evaluating their capital expenditure decisions.
 The following factors are considered to influence the
riskiness of investment projects:
 price of raw material and other inputs
 price of product
 product demand
 government policies
 technological changes
 project life
 inflation
 Risk Analysis in Practice
16

 Four factors thought to be contributing most to the

project riskiness are:
 selling price
 product demand
 technical changes
 government policies

 Methods of risk analysis in practice are:

 sensitivity analysis
 conservative forecasts
Sensitivity Analysis & Conservative Forecasts
17

 Sensitivity analysis allows to see the impact of the

change in the behaviour of critical variables on the
project profitability.

 Conservative forecasts include using short payback

or higher discount rate for discounting cash flows.

 Except a very few companies most companies do

not use the statistical and other sophisticated
techniques for analysing risk in investment
decisions.
 Payback
18

 This method, as applied in practice, is more an attempt to

allow for risk in capital budgeting decision rather than a
method to measure profitability.
 The merit of payback
 Its simplicity.
 Focusing attention on the near term future and thereby emphasising
the liquidity of the firm through recovery of capital.
 Favouring short term projects over what may be riskier, longer term
projects.
 Even as a method for allowing risks of time nature, it
ignores the time value of cash flows.
 Risk-Adjusted Discount Rate
19

 Risk-adjusted discount rate, will allow for both time

preference and risk preference and will be a sum of the risk-
free rate and the risk-premium rate reflecting the investor’s
attitude towards risk.
n
NCFt
NPV = 
t =0 (1 + k )
t

 Under CAPM, the risk-premium is the difference between the

market rate of return and the risk-free rate multiplied by the
beta of the project.

k = kf + kr
 Risk-adjusted Discount Rate: Merits
20

✓It is simple and can be easily understood.

✓ It has a great deal of intuitive appeal for risk-averse
businessman.
✓ It incorporates an attitude (risk-aversion) towards
uncertainty.
 Risk-adjusted Discount Rate: Limitations
21

 There is no easy way of deriving a risk-adjusted discount rate.

CAPM provides a basis of calculating the risk-adjusted
discount rate.

 It does not make any risk adjustment in the numerator for the
cash flows that are forecast over the future years.

 It is based on the assumption that investors are risk-averse.

Though it is generally true, yet there exists a category of risk
seekers who do not demand premium for assuming risks; they
are willing to pay a premium to take risks.
 Example
22
 Example
23
 Certainty-Equivalent
24

 Reduce the forecasts of cash flows to some conservative

levels.The certainty-equivalent coefficient assumes a value
between 0 and 1, and varies inversely with risk. Decision-
maker subjectively or objectively establishes the
coefficients.
n
 t NCFt
NPV =  (1 + k )
t =0
t
f

 The certainty—equivalent coefficient can be determined as

a relationship between the certain cash flows and the risky
cash flows.

NCF*t Certain net cash flow

t = =
NCFt Risky net cash flow
 Certainty-Equivalent: Evaluation
25

 First,
the forecaster, expecting the reduction that will be
made in his forecasts, may inflate them in anticipation.

 Second, if forecasts have to pass through several layers of

management, the effect may be to greatly exaggerate the
original forecast or to make it ultra-conservative.

 Third, by focusing explicit attention only on the gloomy

outcomes, chances are increased for passing by some good
investments.
 Example
26
 Risk-adjusted Discount Rate Vs. Certainty-
27
Equivalent
 The certainty-equivalent approach recognises risk in capital
budgeting analysis by adjusting estimated cash flows and
employs risk-free rate to discount the adjusted cash flows.
 On the other hand, the risk-adjusted discount rate adjusts for
risk by adjusting the discount rate. It has been suggested that
the certainty-equivalent approach is theoretically a superior
technique.
 The risk-adjusted discount rate approach will yield the
same result as the certainty-equivalent approach if the
risk-free rate is constant and the risk-adjusted discount
rate is the same for all future periods.
 SENSITIVITY ANALYSIS
28

 Sensitivity analysis is a way of analysing

change in the project’s NPV (or IRR) for a given
change in one of the variables.

 The decision maker, while performing sensitivity

analysis, computes the project’s NPV (or IRR)
for each forecast under three assumptions:
 pessimistic,
 expected, and
 optimistic.
 SENSITIVITY ANALYSIS
29

 The following three steps are involved in the use of

sensitivity analysis:

1. Identification of all those variables, which have an

influence on the project’s NPV (or IRR).
2. Definition of the underlying (mathematical) relationship
between the variables.
3. Analysis of the impact of the change in each of the
variables on the project’s NPV.
 DCF Break-even Analysis
30

 Sensitivity analysis is a variation of the break-even

analysis.

 DCF break-even point is different from the accounting

break-even point. The accounting break-even point is
estimated as fixed costs divided by the contribution ratio. It
does not account for the opportunity cost of capital, and
fixed costs include both cash plus non-cash costs (such as
depreciation).
 Sensitivity Analysis: Pros and Cons
31

✓ It compels the decision-maker to identify the variables, which

affect the cash flow forecasts. This helps him in understanding
the investment project in totality.

✓ It indicates the critical variables for which additional

information may be obtained. The decision-maker can consider
actions, which may help in strengthening the ‘weak spots’ in
the project.

✓ It helps to expose inappropriate forecasts, and thus guides the

decision-maker to concentrate on relevant variables.
 Sensitivity Analysis: Pros and Cons
32

It does not provide clear-cut results. The terms

‘optimistic’ and ‘pessimistic’ could mean different
things to different persons in an organisation. Thus,
the range of values suggested may be inconsistent.

It fails to focus on the interrelationship between

variables. For example, sale volume may be related
to price and cost. A price cut may lead to high sales
and low operating cost.
 SCENARIO ANALYSIS
33

 One way to examine the risk of investment is to

analyse the impact of alternative combinations of
variables, called scenarios, on the project’s NPV (or
IRR).

 The decision-maker can develop some plausible

scenarios for this purpose. For instance, we can
consider three scenarios: pessimistic, optimistic and
expected.
 SIMULATION ANALYSIS
34

 The Monte Carlo simulation or simply the simulation

analysis considers the interactions among variables and
probabilities of the change in variables. It computes the
probability distribution of NPV.

 The simulation analysis involves the following steps:

 First, you should identify variables that influence cash inflows and
outflows.
 Second, specify the formulae that relate variables.
 Third, indicate the probability distribution for each variable.
 Fourth, develop a computer programme that randomly selects one
value from the probability distribution of each variable and uses
these values to calculate the project’s NPV.
 Simulation Analysis: Shortcomings
35

 The model becomes quite complex to use.

 It does not indicate whether or not the project
should be accepted.
 Simulation analysis, like sensitivity or scenario
analysis, considers the risk of any project in
isolation of other projects.
 Decision Trees for Sequential Investment Decisions
36

Investment expenditures are not an isolated

period commitments, but as links in a chain of
present and future commitments.

 An analytical technique to handle the sequential

decisions is to employ decision trees.
 Steps in Decision Tree Approach
37

Define investment
Identify decision alternatives
Draw a decision tree
 decision points
 chance events
Analyse data
 Usefulness of Decision Tree Approach
38

 Clarity: It clearly brings out the implicit

assumptions and calculations for all to see,
question and revise.

 Graphic visualization: It allows a decision

maker to visualise assumptions and alternatives
in graphic form, which is usually much easier to
understand than the more abstract, analytical
form.
 Decision Tree Approach: Limitations
39

 The decision tree diagrams can become more and

more complicated as the decision maker decides to
include more alternatives and more variables and to
look farther and farther in time.

 It is complicated even further if the analysis is

extended to include interdependent alternatives and
variables that are dependent upon one another.
 UTILITY THEORY AND CAPITAL BUDGETING
40

 Utility theory aims at incorporation of decision-

maker’s risk preference explicitly into the decision
procedure.
 As regards the attitude of individual investors towards
risk, they can be classified in three categories:
 Risk-averse
 Risk-neutral
 Risk-seeking
 Individuals aregenerally risk averters and demonstrate
a decreasing marginal utility for money function.
 Utility Theory and Capital Budgeting
41

 Assume that the owner of a firm is considering an investment

project, which has 60 per cent probability of yielding a net present
value of Rs 10 lakh and 40 per cent probability of a loss of net
present value of Rs 10 lakh.
 Project has a positive expected NPV of Rs 2 lakh. However, the
owner may be risk averse, and he may consider the gain in utility
arising from the positive outcome (positive PV of Rs 10 lakh) less
than the loss in utility as a result of the negative outcome (negative
PV of Rs 10 lakh).
 The owner may reject the project in spite of its positive ENPV.
 Benefits and Limitations of Utility Theory
42

 It suffers from a few advantages:

 First, the risk preferences of the decision-maker are directly
incorporated in the capital budgeting analysis.
 Second, it facilitates the process of delegating the authority
for decision.
 It suffers from a few limitations:
 First, in practice, difficulties are encountered in specifying a
utility function.
 Second, even if the owner’s or a dominant shareholder’s
utility function be used as a guide, the derived utility function
at a point of time is valid only for that one point of time.
 Third, it is quite difficult to specify the utility function if the
decision is taken by a group of persons.