CH 05 - Risk Analysis

1 5.
1 Sources, measures and perspectives on risk
Sources of Risk
Project specific risk-estimation error or poor
management
 Competitive risk-adverse effect on project cash
flows driven by unanticipated action by
competitors
industry-specific risk-unexpected technological
or regulatory changes adversly affecting project
cashProject
flows Financing and Management-Market and Demand Analysis Saturday, December 28, 2019
2 5.1 Sources, measures and perspectives on risk
Sources of Risk...
Market risk-unanticipated changes in
macroeconomic variables like inflation,
interest rate, GDP, foreign exchange rate
having impact across projects.
International risk- changes in cash flows due
to exchange rate movements and political risk
Project Financing and Management-Market and Demand Analysis Saturday, December 28, 2019
Measures of Risk
Standard deviation – measures variability of
values from the mean. The higher the standard
deviation the higher the risk.
 Coefficient of variation– the ratio of standard

deviation to the mean( expected value)
Example
Consider a project with the following set of
NPV with different probabilities
NPV(in mill) Probabilities
Br 250 0.10
450 0.20
300 0.25
500 0.15
700 0.30
Example...
Expected value (𝑋 ) =(250x0.1)+(450x0.20)
+(300 x 0.25)+(500x0.15)
+(700 x 0.30)
= Br 475mill
STDV = Br 168mill
Coefficient of Variation= 168/475
= 0.35
6 5.2 Methods of Risk Analysis
1. Sensitivity analysis(what if analysis)

invloves analysis of change in NPV when
certain variables change( like sales,
investment cost, cost of capital etc)
only the effect of change in one variable
at a time is analyzed
Example
Suppose a project with a life of 10 years and
initial investment of Br 500mill has the
following operating cash flow components:
Sales Br 800mill
Variable costs 385mill
Fixed costs 330mill
Cash flow from operation 85 mill
Example
Assuming cost of capital of 10% NPV would be
= Br 22.3mill
Determine NPV under each of the following cases:
1. Sales decreases by 10%
2. Investment cost increases by 5%
3. Variable costs increase by 15%
4. Cost of capital increases to 12%
2. Break-even analysis
the level at which no profit or loss is made
Accounting break even is where
Sales = VC+FC
BE sales = FC/Contribution margin ratio
Financial break even is where
PV of cash flows=Initial investment
Break-even analysis...
Example
 Suppose a project with initial investment of Br 500mill
has the following information on sales and cost structure:
Sales Br 800 mill
Variable costs 200 mill
Fixed costs (including depreciation) 400 mill
Net cash flow 200 mill
Assume also that funds are raised at a cost of capital of 10%.

Break-even analysis.
Example...
Accounting BE sales
= Br 400mill/ 0.75 (TR-TVC) = 800-200
TR 800
= Br 533 mill
Break-even analysis...
Financial BE sales
CF is 25% of sales (Br 200mill/800mill)
PV of CF = 0.25 x PV of annuity factor @10% and
n=10 (6.14)
= 1.54 sales
1.54sales = Br 500mill
Sales = Br 324.6mill
3. Decision Tree Analysis

is a tool for analyzing situations where sequential
decision making in face of risk is involved.
STEPS
1. Identifying the problem and alternatives
2. Delineating(draw) the decision tree
3. Specifying probabilities and monetary outcomes
4. Evaluating various decision alternatives
Decision Tree Analysis...

The decision tree, exhibiting the anatomy of
the decision situation, shows
(i) The decision points and the alternative options
available for experimentation and action at these
decision points.
(ii) The chance points where outcomes are
dependent on a chance process and the likely
outcomes at these points.

Evaluation of Alternatives
1. Start at the right-hand end of the tree and calculate the
expected monetary value at various chance points that
come first as we proceed leftward.
2. Given the expected monetary values of chance points in
step 1, evaluate the alternatives at the final stage decision
points in terms of their expected monetary values.

Evaluation of Alternatives…
3. At each of the final stage decision points, select the
alternative which has the highest expected monetary value
and truncate the other alternatives
4. Proceed backward (leftward) in the same manner,
calculating the expected monetary value at chance points,
selecting the decision alternative with the highest expected
monetary value at various decision points.
Example
A computer engineer at the Ethio Telecom designed
a new cellphone apparatus. The firm is ready for
pilot production and test marketing. This will cost
ETB 20 million and take six months. Management
believes that there is a 70 percent chance that the
pilot production and test marketing will be
successful. In case of success, ETC can build a plant
costing Br 150 million.
Example...
The plant will generate an annual cash inflow of
Br 30 million for 20 years if the demand is high or
an annual cash inflow of Br 20 million if the
demand is moderate. High demand has a
probability of 0.6; Moderate demand has a
probability of 0.4. Assume cost of capital is 12%.
Decision Tree Analysis

 The alternatives in the decision tree shown are evaluated as
follows:
1. Start at the right-hand end of the tree and calculate the EMV at
chance point C2 that comes first as we proceed leftward.
EMV(C2) = 0.6 [30xPVIFA (20, 12%)] + 0.4 [20 x PVIFA (20, 12%)]
= Br 194.2 million
2. Evaluate the EMV of the decision alternatives at D2 the last
stage decision point. Alternative EMV D21 (Invest Br 150
million) Br 44.2 million D22 (Stop) 0
3. Select D21 and truncate D22 as EMV(D21) > EMV(D22).

4. Calculate the EMV at chance point C1 that comes
next as we roll backwards.
EMV (C1) = 0.7 [44.2] + 0.3 [0] = Br 30.9 million
5. Evaluate the EMV of the decision alternatives at D1
the first stage decision point :
Alternative EMV D11 (Carry out pilot production and
market test at a cost of Br 20 million) Br 10.9 million
D12 (Do nothing) Br 0
22 5.3 Managing Risk
Fixed and variable cost

Pricing strategy
Sequential investment
Improving information
“Don’t test the depth of a river with both feet”
Financial leverage
Insurance
Long-term arrangements
Strategic alliance
23 Financial estimates & projections

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1 5.

1 Sources, measures and perspectives on risk

 Coefficient of variation– the ratio of standard

1. Sensitivity analysis(what if analysis)

3. Decision Tree Analysis

Decision Tree Analysis...

Decision Tree Analysis...

Decision Tree Analysis...

Decision Tree Analysis

3. Select D21 and truncate D22 as EMV(D21) > EMV(D22).

Fixed and variable cost

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