Ch.

12: Risk Analysis in Capital Budgeting

CHAPTER 12

RISK ANALYSIS IN CAPTAL BUDGETING

Problem 1

Expected Standard Coeff. of Accept/Reject Decision

value deviation var.
(i) Project A 10,000 500 0.05 Accept A since it has lower standard
Project B 10,000 1,000 0.1 deviation
(ii) Project A 10,000 500 0.05 Accept B it has higher expected value
Project B 12,000 500 0.04 and equal standard deviation.
(iii) Project A 10,000 1,000 0.1 In terms of coefficient of variation, A is
Project B 12,000 500 0.04 more risky than B
(iv) Project A 10,000 500 0.05 A and B are equally attractive.
Project B 12,000 600 0.05

Problem 2

ENCF PVF @ 10% PV

Project A -6000 1.000 -6000
Year 1: NCF: 0.40 x 2,000 + 0.60 x 3,000 = 2,600 2600 0.909 2364
Year 2: NCF: 0.30 x 4,000 + 0.70 x 2,000 = 2,600 2600 0.826 2149
Year 3: NCF: 0.50 x 3,000 + 0.50 x 2,200 = 2,600 2600 0.751 1953
NPV: 466

ENCF PVF @ 10% PV

Project B -5000 1.000 -5000
Year 1: NCF: 0.30 x 1,000 + 0.70 x 2,000 = 1,700 1700 0.909 1545
Year 2: NCF: 0.20 x 2,000 + 0.80 x 1,000 = 1,200 1200 0.826 992
Year 3: NCF: 0.40 x 2,000 + 0.60 x 4,000 = 3,200 3200 0.751 2404

Problem 3

Project A 0 1 2 3 4 5
NCF -5000 1000 2000 3300 4000 1000
CE 1.00 0.90 0.80 0.70 0.60 0.30
Certain CF -5000 900 1600 2310 2400 300
PVF at 6% 1.000 0.943 0.890 0.840 0.792 0.747
PV -5000 849 1424 1940 1901 224
NPV 1338
RADR 31.1%
Project B 0 1 2 3 4 5
NCF -8000 6000 5000 4000 3000 1000
CE 1.00 0.90 0.70 0.60 0.50 0.25
Certain CF -8000 5400 3500 2400 1500 250
PVF at 6% 1.000 0.943 0.890 0.840 0.792 0.747
PV -8000 5094 3115 2015 1188 187
NPV 3599
RADR 51.3%

RADR (risk-adjusted discount rates) are found by trial and error using given cash follows. Project
B has higher certainty-equivalent NPV as well as higher RADR. It is preferable over Project A.

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I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

Problem 4

Project 1: ENCF PVF @ 8% PV

NCF -30,000 1.000 -30,000
Year 1: 10,000 x 0.25 + 14,000 x 0.50 + 16,000 x 0.25 = 13,500 13,500 0.926 12,500
Year 2: 13,000 x 0.25 + 17,000 x 0.50 + 19,000 x 0.25 = 16,500 16,500 0.857 14,146
Year 3: 16.000 x 0.25 + 20,000 x 0.50 + 22,000 x 0.25 = 19,500 19,500 0.794 15,480
Year 4: 19,000 x 0.25 + 23,000 x 0.50 + 25,000 x 0.25 = 22,500 22,500 0.735 16,538
Year 5: 22,000 x 0.25 + 26,000 x 0.50 + 28,000 x 0.25 = 25,500 25,500 0.681 17,355
NPV 46,019

Project 2: ENCF PVF @ 8% PV

NCF -30000 1.000 -30000
Year 1: 4,000 x 0.20 + 12,000 x 0.50 + 25,000 x 0.30 = 13,250 14300 0.909 13000
Year 2: 7,000 x 0.20 + 15,000 x 0.50 + 28,000 x 0.30 = 16,250 17300 0.826 14298
Year 3: 10,000 x 0.20 + 18,000 x 0.50 + 31,000 x 0.30 = 19,250 20300 0.751 15252
Year 4: 13,000 x 0.20 + 21,000 x 0.50 + 34,000 x 0.30 = 22,250 23300 0.683 15914
Year 5: 16,000 x 0.20 + 24,000 x 0.50 + 37,000 x 0.30 = 25,250 26300 0.621 16330
NPV 44794

Problem 5

Year 1-2 Expansion* Year 3-10

H 0.5 125,000 H 0.5 125,000
Large plant -500,000 M 0.4 100,000 M 0.4 100,000
L 0.1 50,000 L 0.1 50,000

H 0.6 140,000
H 0.5 80,000 -300,000 M 0.3 110,000
L 0.1 80,000

H 0.6 110,000
Small plant -200,000 M 0.4 80,000 -150,000 M 0.3 80,000
L 0.1 25,000

L 0.1 40,000 L 1 40,000

* assumed at the end of year 2

The firm has to decide whether it should expand to a high, or a small size, or no expansion if initially a small plant were
built. These options can be compared on the basis of ENPV.

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Ch. 12: Risk Analysis in Capital Budgeting

Expand to a large size (Rs 300,000)

ENCF 140,000*0.6+110,000*0.3+80,000*0.1 125,000
ENPV 122,000*4.8684-300,000 366,866
PVAF10%,8 5.3349
Expand to a small size (Rs 150,000)
ENCF 110,000*0.6+80,000*0.3+25,000*0.1 92,500
ENPV 92,500*4.8684-150,000 343,481
PVAF10%,8 5.3349
No expansion
ENCH 40,000*1.0 40,000
ENPV 40,000*4.8684-0 213,397
PVAF10%,8 5.3349
Decision : Plant should be expanded to a large size as it has highest NPV.
Should the firm build initially a large or a small plant?
Large plant (Rs 500,000)
ENCF 125,000*0.5+100,000*0.4+50,000*0.1 107,500
ENPV 107,500*6.145-500,000 160,541
PVAF10%,10 6.1446
Small plant (Rs 150,000)
Initial high demand: ENCF in year : Rs 80,000 1 and year 2: 446,866(Rs 80,000+Rs 366,866). Similar
computations can be made when demand is medium or low.
Year 1 Year 2
H 80,000 0.5 40,000 446,866 0.5 223,433
M 80,000 0.4 32,000 423,481 0.4 169,392
L 40,000 0.1 4,000 253,397 0.1 25,340
ENCF 76,000 418,165
PV @ 10% 69,091 345,591
ENPV 76,000/1.1+418,165/1.1^2-200,000 214,682
Decision : The firm should bulid a small and later on expand it to a large size as this option has hogher NPV
than building a large plant.

Problem 6

Project A
Cash flow Prob. Expected Utilities Wght.
utilities
-20,000 0.10 -2000 -100 -10.00
10,000 0.20 2000 30 6.00
9,000 0.25 2250 25 6.25
8,000 0.30 2400 18 5.40
7,000 0.15 1050 10 1.50
5700 9.15

Project B
Cash flow Prob. Expected Utilities Wght.
utilities
-1,000 0.15 -150 -3 -0.45
7,000 0.25 1750 10 2.50
8,000 0.4 3200 18 7.20
9,000 0.2 1800 25 5.00
6600 14.25
Project B is preferable since it has higher expected value as well as higher weighted utilities.

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I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

Problem 7

Year 1 Year 2
NCF Prob. NCF Prob. NPV Joint Prob. Exp. value
122,800 0.7 -9,998 0.35 -3,499
153,000 0.5
184,300 0.3 33,777 0.15 5,067
-245,700
240,000 0.4 51,101 0.2 10,220
125,000 0.5
307,000 0.6 98,791 0.3 29,637
41,425

CF CF CF CF
1 -245,700 -245,700 -245,700 -245,700
2 153,000 153,000 125,000 125,000
3 122,800 184,300 240,000 307,000
NPV -9,998 33,777 51,101 98,791

Problem 8

Assumptions
Units 30,000 Tax 0.50
Selling price 25 SL dep. 50,000
Var. cost Dis. rate 0.10
Mat. 8 Outlay 300,000
Lab 4 Project life 6
Overheads 3 15
Contribution 10

Cash flow Year NCF PVF PV

Sales 750,000 0 -300,000 1.0000 -300,000
Var. costs 450,000 1 140,000 0.9091 127,274
Cont. 300,000 2 140,000 0.8264 115,696
FC 120,000 3 140,000 0.7513 105,182
PBT 180,000 4 140,000 0.6830 95,620
Tax 90,000 5 140,000 0.6209 86,926
PAT 90,000 6 140,000 0.5645 79,030
Add: dep. 50,000 NPV 309,728
CFO 140,000 B/E % change NPV
Volume 15,776 -47.4% 0
Sale price 20.26 -19.0% 0
Var. cost 19.74 31.6% 0
Outlay 609,728 103.2% 0

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Ch. 12: Risk Analysis in Capital Budgeting

APPENDIX 12A: PROBABILITY DISTRIBUTION APPROACHES

TO RISK ANALYSIS IN CAPITAL BUDGETING

Problem 12A.1

NCF Prob. NCF x Prob Deviation Dev2 Dev2 x Prob.

40,000 0.2 8,000 3,600 12,960,000 2,592,000
48,000 0.4 19,200 11,600 134,560,000 53,824,000
24,000 0.3 7,200 -12,400 153,760,000 46,128,000
20,000 0.1 2,000 -16,400 268,960,000 26,896,000
Expected value 36,400
Variance 129,440,000
Standard deviation 11,377

NPV: -20,000 + 36,400/1.10 = Rs 13,091 13091

Probability that NPV is zero or less:
S = (NPV - Expected NPV)/ Standard deviation = (0 - 13,091)/11,377 = -1.15. -1.15
From Table E in the text, we obtain a probability of 12.5 percent that NPV will be zero or less.

Probability that NPV is greater than Rs 20,000:

S = (NPV - Expected NPV)/ Standard deviation = (20,000 - 13,091)/11,377 = 0.61. 0.61

From Table E in the text, we obtain a probability of 66.6 percent that NPV will be greater than Rs
2,000.
Probability that NPV is less than Rs 2,000:
S = (NPV - Expected NPV)/ Standard deviation = (2,000 - 13,091)/11,377 = -0.97. -0.97
From Table E in the text, we obtain a probability of 66.6 percent that NPV will be greater than Rs
2,000.

Problem 12A.2

Expected value:
Year 1: 4,000 x 0.30 + 5,000 x 0.40 + 6,000 x 0.30 = Rs 5,000 5000
Year 2: 4,000 x 0.25 + 5,000 x 0.50 + 6,000 x 0.25 = Rs 5,000 5000
Year 3: 4,000 x 0.55 + 5,000 x 0.15 + 6,000 x 0.30 = Rs 4,750 4750
Standard deviation:
Year 1: (4,000 - 5,000)2 x 0.30 + (5,000 - 5,000)2 x 0.40 + (6,000 - 5,000)2 x 0.30 = Rs 775 775
Year 2: (4,000 - 5,000)2 x 0.25 + (5,000 - 5,000)2 x 0.50 + (6,000 - 5,000)2 x 0.25 = Rs 707 707
Year 3 : (4,000 - 5,650)2 x 0.55 + (5,000 - 5,650)2 x 0.15 + (6,000 - 5,650)2 x 0.30 = Rs 1,310 1310

NPV: -4,000 + 5,000/(1.06)1 + 5,000/(1.06)2 +5,650/(1.06)3 = Rs 9,155 9155

Profitability index: 1 + 9,155/4,000 = 2.29 2.29

Standard deviation about the expected value:

[775^2/(1.06)^2 + 707^2/(1.06)^4 + 1,310^2/(1.06)^6]^1/2 = Rs 1,463 1463

S=( 0 - 9,155)/1,463 = - 6.26 -6.26

S = (2,000 - 9,155)/1,463 = - 4.89 -4.89
S = ( 500 - 9,155)/1,463 = - 5.92 -5.92

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I. M. Pandey, Financial Management, 9th Edition, New Delhi: Vikas.

CASES

Case 12.1: Richa Food Limited

This case illustrates the scenario analysis to handle risky investment decisions. The instructor should encourage
students to use Excel in solving this case as they can easily see the impact of the changing assumptions on the
profitability of the project. The students should also understand the concept of the break-even NPV and be able to work
it out for important variables.

Scenario
Expected Pessimistic Optimistic
Cash outlay (Rs 000) 60,000 66,000 66,000
Life (years) 6
Salvage value 0
Sales (units 000) 1,000 950 1,100
Unit price (Rs) 60 54 69
Variable cost (Rs) 30 31.5 33
Fixed costs (Rs 000) 10,000 10,000 10,000
SL depreciation (Rs 000) 10,000 11,000 11,000
Tax rate 35%
Discount rate 12%

Annual cash flows

Sales 60,000 51,300 75,900
Variable costs 30,000 29,925 36,300
Contribution 30,000 21,375 39,600
Fixed costs 10,000 10,000 10,000
Depreciation 10,000 11,000 11,000
Profit before tax 10,000 375 18,600
Tax 3,500 131 6,510
Profit after tax 6,500 244 12,090
Add: depreciation 10,000 11,000 11,000
Cash flows 16,500 11,244 23,090
NPV 7,838 -19,772 28,932

Zero NPV
Unit price (Rs) 57.07
Variable costs (Rs) 32.93
Volume 70,311

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Ch. 12: Risk Analysis in Capital Budgeting

Case 12.2: Weston Plastic Company

The purpose of this case is to give students practice in using decision tree approach in investment analysis.

Years 1 - 10
Plant Cash
size outlay Demand Prob. NCF ENCF
H 0.5 12.50 6.25
Large 50 M 0.4 10.00 4.00
L 0.1 5.00 0.50
10.75
Discount rate 10% PVFA 10, 10% 6.145
PV (NCF) 66.05
NPV 16.05

Initial (1 - 2 years) Year 2 Years 3 - 10 Yr 3-10

Plant Cash Cash
size outlay Demand Prob. NCF Plant size outlay Demand Prob. NCF ENCF NPV
H 0.6 14 8.40
H 0.5 8 Expansion 30 M 0.3 11 3.30
L 0.1 8 0.80
12.50 36.69
PVFA8,10% 5.335
Small 20 M 0.4 8 Expansion 15 H 0.6 11 6.6
M 0.3 8 2.4
L 0.1 2.5 0.25
9.25
PVFA8,10% 5.335 34.35
L 0.1 4 L 1 4 4
PVFA8,10% 5.335 21.34

Year 1 Year 2
Prob. NCF ENCF NCF ENCF
H 0.5 8 4 8+36.69 44.69 22.34
M 0.4 8 3.2 8+34.35 42.35 16.94
L 0.1 4 0.4 4+21.34 25.34 2.53
7.60 41.82

Year 0 1 2
ENCF -20 7.60 41.82
PVF 1.000 0.909 0.826
PV -20 6.91 34.56
NPV 21.47