258 views

Uploaded by ashishprk84

save

You are on page 1of 26

**Chandrakant@SOM,KIIT University 1
**

Risk & Uncertainty

• “In a world of certainty, the risk element is ZERO. In a real world, certainty element is

ZERO”.

• Reasons:

– Imperfect market

– Lack of information

• Minimizing the risk is all about risk analysis.

• Consider this two statements:

– “There is a 60% chance that I will get 80 marks and a 40% chance that I will score 50 marks.”

– “God only knows how I have done.”

**Chandrakant@SOM,KIIT University 2
**

Sources of Risk

• Project-specific Risk

– Affecting project CFs i.e. project environment

• Competitive Risk

– Project CFs affected by unanticipated competition

• Industry-specific Risk

– Regulatory changes, change in technology

• Market Risk

– Macro economic factors: GDP, interest rate, etc.

• International Risk

– Forex rates, political

Chandrakant@SOM,KIIT University 3

Risk & Uncertainty

• Risk is a situation • Uncertainty is a

where: situation where:

– Several outcomes, say, a – The range of outcomes

range of outcomes, are

is unknown.

possible.

– Within this range, any – The probability of

outcome can occur. outcomes is not

– Each possible outcome known.

has a known probability. – Or both are not known.

– Such probabilities are

assessed by reference to

past information about

relative frequencies of

outcome of relative

phenomena.

Chandrakant@SOM,KIIT University 4

Measures of Risk

• Range

• Standard Deviation

σ = [ Σ pi (Xi – X)2]1/2

• Coefficient of Variation

CV = Std deviation/ Expected value

• Semi Variance

SV = Σ pi di2 ; ׳where di = ׳di if di <0 and di0= ׳if di

≥0

Chandrakant@SOM,KIIT University 5

Conventional Techniques to

Manage Risk

• Payback

• Risk-adjusted discount rate

• Certainty equivalent

**Chandrakant@SOM,KIIT University 6
**

Risk-adjusted Discount Rate

• A premium is desired over and above the return which

is risk-free

• More uncertain the future is, greater should be the

premium

• Capital budgeting analysis should consider risk

adjustment. Means all projects should not be discounted

at the same rate, namely the company’s cost of capital.

• Discount rate should have two components:

– Risk-free rate, and

– Risk premium

**Chandrakant@SOM,KIIT University 7
**

Risk-Adjusted Discount Rate

• Risk-adjusted discount rate, will

allow for both time preference

and risk preference and will be a n

NCFt

sum of the risk-free rate and the

risk-premium rate reflecting the

NPV = ∑

t=0 (1 + k )

t

investor’s attitude towards risk.

**• 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

**Chandrakant@SOM,KIIT University 8
**

Irving Fisher Model: An Accurate Version

• Irving Fisher has propounded a formula for

computing risk-premium adjusted discount

rate . This model depicts a more exact

method of deriving the RADR as under:

**• (1+Base Discount Rate)*(1+Risk Premium)
**

= (1+Risk Adjusted Discount Rate)

**Chandrakant@SOM,KIIT University 9
**

Certainty Equivalent Factor

• CEF is the ratio of assured cash flows to uncertain

cash flows.

• Under this approach, the cash flows expected in a

project are converted into risk-less equivalent

amounts. The adjustment factor used is called

Certainty Equivalent Co-efficient. This varies

between 0 and 1.

• A co-efficient of 1 indicates that the cash flows

are certain.

• The greater the risk in a cash flow, the smaller will

be the certainty equivalent factor “for receipts”

and the larger will be the certainty equivalent

factor “for payments”.

Chandrakant@SOM,KIIT University 10

Certainty Equivalent Factor

• Reduce the forecasts of cash

flows to some conservative

levels. n

α t NCFt

• The certainty—equivalent NPV = ∑

coefficient assumes a value t = 0 (1 + kf )

t

**between 0 and 1, and varies
**

inversely with risk.

• Decision-maker subjectively

or objectively establishes the

coefficients.

• The certainty—equivalent

coefficient can be determined NCF*t Certain net cash flow

as a relationship between the α t = NCF = Risky net cash flow

certain cash flows and the t

risky cash flows.

**Chandrakant@SOM,KIIT University 11
**

Concept Problem:

• SFM Ltd whose cost of capital is 10% is considering a

project with the following cash flows. The risk free rate

is 8%. The NPV at 10% is found to be positive.

Year 0 1 2 3

CF(Rs) (22500) 17500 12500 12500

Due to uncertainties about future cash receipts, the

management decides to adjust these cash flows to

certainty equivalents, by taking only 60%, 55% and

50% of the cash flows of years 1 to 3 respectively.

Assess the viability of the project.

(Ans: -ve i.e. -1922)

**Chandrakant@SOM,KIIT University 12
**

Risk-adjusted Discount Rate Vs.

Certainty–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.

Chandrakant@SOM,KIIT University 13

Advanced Techniques

• Sensitivity analysis

• Scenario analysis

• Simulation

• Decision tree analysis, etc.

**Chandrakant@SOM,KIIT University 14
**

Sensitivity Analysis - Simplified

• SA is one of the methods of analysing the risk surrounding the

capital expenditure decision and enables an assessment to be

made of how responsive the project’s NPV is to changes in

those variables based on which NPV is computed.

• Both these determinants depends upon many variables such

as:

– Sales Revenue, Input cost, sales volume, discount

rate, competition etc.

– Given the level of these variables there can be a set

series of cash flows & hence there will be a NPV of

the proposal

**Chandrakant@SOM,KIIT University 15
**

Cont…

• Thus value of an NPV is

sensitive to the said variables

in different degrees

• SA deals wit the

consideration of sensitivity Parameter Direction

of the NPV in relation to Size Increase

different variables Cash Flows Decrease

contributing to the NPV.

Life Decrease

• SA measures the percentage

Discount Rate Increase

change in input parameter,

which leads to a reversal of

an investment decision.

**Chandrakant@SOM,KIIT University 16
**

Cont…

• Values of these variable parameters (inputs) are

changed to denote different situations/ assumptions

• Effects of these changes are measured on the

expected value of the outcome (cash flows) on the

value of the NPV of the proposal

• It is based on judgement of the Analyst & the

information available.

• It may be noted that sensitivity percentage does not

carry “+” or “–” sign because sensitivity seeks to

measure only the downside risks.

**Chandrakant@SOM,KIIT University 17
**

Methods of Computation:

• Each input variable is considered separately and all

other assumptions are held constant.

• The extent of change in an input parameter that

would result in zero NPV is computed.

• The extent of change so determined is expressed as

a percentage.

• This process is repeated for all critical variables to

test their sensitivity.

• If a variable is likely to undergo change beyond the

levels tested, the project is reviewed afresh.

**Chandrakant@SOM,KIIT University 18
**

Decision Rule:

• Sensitivity measures the downside risks.

• The formula:

Sensitivity (%) = Change/Base*100

• The lower the change percentage the higher is

the sensitivity of the project to that input. This

is because a small change in input parameter

leads to a reversal of investment decision.

**Chandrakant@SOM,KIIT University 19
**

Example

**• The following forecasts are made about a
**

proposal which is being evaluated by a Firm

• Initial Outlay Rs.12,000

• Cash Inflow Rs.4,500 (Annual)

• Life 4 Years Ke = 14%

• PVAF(14%,4Y) = 2.9137

• PVAF(14%,3Y) = 2.3216

Chandrakant@SOM,KIIT University 20

Sensitivity of Different

variables with respect to NPV

**• The NPV of the Project is
**

= 4,500 x (2.9137) - Rs. 12,000

= Rs.1,112 /-

**Chandrakant@SOM,KIIT University 21
**

Sensitivity with respect to Initial

Outlay

• Since NPV = Rs. 1,112 /- , therefore the

outlay can increase from Rs. 12,000/- to Rs.

13,112/- before the NPV becomes zero

**• Therefore there is a margin of (Rs. 1,112 or)
**

9.4% of the initial outlay

**Chandrakant@SOM,KIIT University 22
**

Sensitivity with respect to

Payback Period

• Payback Period when NPV = 0 :

• PVF at 14% = Rs.12,000/Rs.4,500 = 2.667.

• Values nearest to 2.667 in 14% column falls

in between 3 years (2.322) and 4 years (2.914)

Therefore payback period lies between the above 3 years

& 4 years

The exact Payback period by interpolating

between 3 years & 4 years comes 3.58 years

THE LIFE OF THE PROJECT COULD FALL BY .

42 YEARS BEFORE IT BECOMES UNVIABLE

Chandrakant@SOM,KIIT University 23

Sensitivity with respect to

Annual Cash Inflows

• The PVF(14%,4Y) = 2.9137

• Therefore Rs. 12,000 =

Annual Cash inflows x 2.9137 = Rs.4,118

Therefore the Annual Cash inflow can decrease

from the present level of Rs.4,500 to Rs.4,118

before the NPV becomes Zero

Thus the annual Cash inflow has a margin of Rs.382

i.e., 8.5%

Chandrakant@SOM,KIIT University 24

Sensitivity with respect to

Discount Rate

• Say the Discount Rate at which NPV is zero is ‘X’

• Therefore Rs.12,000 = 4,500 x ‘X’

• Therefore, ‘X’ = 2.667

• The PVAF of 2.667 for 4 years period is

approximately found in 18% column in the PVAF

Table

• Therefore, Discount Rate can increase from the

present level of 14% to 18% before the NPV

becomes negative. Thus there is a margin of 29%

Chandrakant@SOM,KIIT University 25

Findings

• The project is most sensitive to the Annual Cash

Inflows and even a change of 8.5% in the cash

inflows can make the project as unviable

• It is relevant to focus on two sets of variables in

particular:

– Those matter most in affecting the Cash flows

– Those matter most for uncertainty (operating

margin)

Chandrakant@SOM,KIIT University 26

- Yes PleaseAmy Poehler
- The Unwinding: An Inner History of the New AmericaGeorge Packer
- Sapiens: A Brief History of HumankindYuval Noah Harari
- The Innovators: How a Group of Hackers, Geniuses, and Geeks Created the Digital RevolutionWalter Isaacson
- Elon Musk: Tesla, SpaceX, and the Quest for a Fantastic FutureAshlee Vance
- Dispatches from Pluto: Lost and Found in the Mississippi DeltaRichard Grant
- Devil in the Grove: Thurgood Marshall, the Groveland Boys, and the Dawn of a New AmericaGilbert King
- John AdamsDavid McCullough
- The Prize: The Epic Quest for Oil, Money & PowerDaniel Yergin
- The Emperor of All Maladies: A Biography of CancerSiddhartha Mukherjee
- Grand Pursuit: The Story of Economic GeniusSylvia Nasar
- This Changes Everything: Capitalism vs. The ClimateNaomi Klein
- A Heartbreaking Work Of Staggering Genius: A Memoir Based on a True StoryDave Eggers
- The New Confessions of an Economic Hit ManJohn Perkins
- Team of Rivals: The Political Genius of Abraham LincolnDoris Kearns Goodwin
- The Hard Thing About Hard Things: Building a Business When There Are No Easy AnswersBen Horowitz
- Smart People Should Build Things: How to Restore Our Culture of Achievement, Build a Path for Entrepreneurs, and Create New Jobs in AmericaAndrew Yang
- Rise of ISIS: A Threat We Can't IgnoreJay Sekulow
- The World Is Flat 3.0: A Brief History of the Twenty-first CenturyThomas L. Friedman
- Bad Feminist: EssaysRoxane Gay
- Angela's Ashes: A MemoirFrank McCourt
- Steve JobsWalter Isaacson
- How To Win Friends and Influence PeopleDale Carnegie

- The Sympathizer: A Novel (Pulitzer Prize for Fiction)Viet Thanh Nguyen
- Extremely Loud and Incredibly Close: A NovelJonathan Safran Foer
- Leaving Berlin: A NovelJoseph Kanon
- The Silver Linings Playbook: A NovelMatthew Quick
- The Light Between Oceans: A NovelM.L. Stedman
- The Incarnations: A NovelSusan Barker
- You Too Can Have a Body Like Mine: A NovelAlexandra Kleeman
- The Love Affairs of Nathaniel P.: A NovelAdelle Waldman
- Life of PiYann Martel
- Brooklyn: A NovelColm Tóibín
- The Flamethrowers: A NovelRachel Kushner
- The First Bad Man: A NovelMiranda July
- We Are Not Ourselves: A NovelMatthew Thomas
- The Blazing World: A NovelSiri Hustvedt
- The Rosie Project: A NovelGraeme Simsion
- The MasterColm Tóibín
- Bel CantoAnn Patchett
- A Man Called Ove: A NovelFredrik Backman
- The Kitchen House: A NovelKathleen Grissom
- Beautiful Ruins: A NovelJess Walter
- Interpreter of MaladiesJhumpa Lahiri
- The WallcreeperNell Zink
- The Art of Racing in the Rain: A NovelGarth Stein
- Wolf Hall: A NovelHilary Mantel
- The Cider House RulesJohn Irving
- A Prayer for Owen Meany: A NovelJohn Irving
- My Sister's Keeper: A NovelJodi Picoult
- Lovers at the Chameleon Club, Paris 1932: A NovelFrancine Prose
- The Bonfire of the Vanities: A NovelTom Wolfe
- The Perks of Being a WallflowerStephen Chbosky