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Risk Analysis

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.
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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
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Conventional Techniques to
Manage Risk
• Payback
• Risk-adjusted discount rate
• Certainty equivalent

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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.
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Advanced Techniques
• Sensitivity analysis
• Scenario analysis
• Simulation
• Decision tree analysis, etc.

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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

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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.

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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.

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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.

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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
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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

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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
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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%
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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%
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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)
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