AC6101

Project Risk Analysis

Probability Analysis of Project Cash-flows
 Introduction
• Investment decisions take place in a world of uncertain future outcomes,
where there are more things that can happen than will happen, which
makes investment analysis considerably more complex.
• Project Risk Analysis Confronts Uncertainty
• Project cash flows are based on pro forma, or forecasted statements and
are thus highly uncertain
• Various approaches are used to analyze risk and deal with uncertainty
– Primary approaches are scenario analysis and probability analysis.
 Evaluating new investment opportunities: 2
Phases
Phase II
I
• Analyst details
tries tounderlying
envision the sources
possible
of outcomes
risk. from an
– Identify value
investment (Qual & Quant
drivers forecasting)
and uncertainty (breakeven sensitivity
analysis/probability
• Analyst analysis) and forecast
prepares estimates
• Analyst incorporates
– Analysis risks
forms the basis for into projections
estimating (scenario
an expected analysis)
value for the
andinvestment
seeks ways to with
along mitigate risks
NPV, IRR, and
and monitors
other measuresthroughout the
of investment
life worth
of the project
 The Speakerz Example
• CSM, Inc., is considering an investment in Speakerz, a audio device in
2009.
• Developed by CSM’s product development dept over the past 3 years in
response to:
– growing demand from consumers
– Perceived gap in the market
• Initial investment €1.2m
• Project will be “up and running” by the end of 2009, with first year of
sales in 2010
• CSM financed from internally generated cash flows; project is all-equity-
financed
• Very promising investment opportunity
– Product has undergone extensive testing
 Speakerz PFCFs “The Assumptions”
• €1.2m
Straight-line
initial depreciation
investment at the end of 2009
• Sales
– PPE€500K
8-year in
life2010
–
– zero salvage
growing 15%value
annually throughout the 8-year planning period
• 20%
Grosstax rate 56%
margin
• CAPEX €1.2m
Operating in 2009before depreciation are 11% of sales plus
expenses
– annual
an zero in allfixed
future years
€100K
• Project end = 2017

Assumptions based on historic data from similar products, market research and qualitative
research
 Speakerz PFCF Forecast
       Speakerz          

  2009 2010 2011 2012 2013 2014 2015 2016 2017

Initial
Investment -1200000.00  

Revenues 500000.00 575000.00 661250.00 760437.50 874503.13 1005678.59 1156530.38 1330009.94

Gross Profit 280000.00 322000.00 370300.00 425845.00 489721.75 563180.01 647657.01 744805.57
Fixed
Expenses
(Excl Depr) 100000.00 100000.00 100000.00 100000.00 100000.00 100000.00 100000.00 100000.00
Variable
Operating
Expenses 55000.00 63250.00 72737.50 83648.13 96195.34 110624.65 127218.34 146301.09

Depr 150000.00 150000.00 150000.00 150000.00 150000.00 150000.00 150000.00 150000.00

Orev 25000.00 8750.00 47562.50 92196.88 143526.41 202555.37 270438.67 348504.47

Tax 5000.00 1750.00 9512.50 18439.38 28705.28 40511.07 54087.73 69700.89

NCF -1200000.00 130000.00 157000.00 188050.00 223757.50 264821.13 312044.29 366350.94 428803.58

NPV €45,617  IRR 11.3%    Disc Rate 10.45%      

 Speakerz DCF Valuation
NPV and IRR Assessment
• Discounting the Cash Flows
– Discount rate for the PFCFs is 10.45%
– Present value of the expected project free cash flows to be €171,584
• The Decision to Invest (or Not): Accept Project!
– NPV €45,617 exceeds zero
– IRR 11.3% exceeds the discount rate of 10.45%
• Since this is a risky project and things may not go exactly as
planned, CSM needs to learn more about the project to get a
better understanding of how confident we should be about
the NPV estimate
Sensitivity Analysis - Learning More
about the Project
• Phase I is complete: We have an NPV estimate of the
Speakerz investment
– How confident can we be that the project will unfold as we
expect?
– What are the key value drivers of the project that the firm
should monitor over the life of the investment to ensure
its success?
 Scenario Analysis
• Analyze scenarios involving multiple sets of
changes in assumptions and forecasts.
– Evaluate the project using base case, optimistic
and pessimistic estimates for the value drivers

  Base Case Optimistic + 10% Pessimistic -10%

Initial Sales 500,000 550000 450000
Initial Investment 1,200,000 1080000 1320000
Rev Growth Rate 15.00% 16.5% 13.5%
GP Margin 56.00% 61.6% 50.4%
 Scenario Analysis
What is the critical value of a particular value driver that pushes NPV to zero?”
Results from Scenario Analysis

Base Case Optimistic Pessimistic

NPV €45,617 €612,625 (€450,099)
IRR 11.3% 21.7% -1.7%
 Limitations to Scenario Analysis
• Selection of Variables is somewhat arbitrary
(cut-off point)
• Scenarios are somewhat arbitrary
• Probabilities not assigned to scenarios
• Useful as a guide to identifying project
outcome if XYZ happens – e.g. fuel prices
increase, economy contracts etc.
 Probability analysis
•Expected return of a project
•Standard deviation of a project
•The mean–variance rule
•Conditional probabilities
Probability analysis
 Expected return
•The expected return is the mean or average outcome calculated by
weighting each of the possible outcomes by the probability of
occurrence and then summing the result
–
x = x1p1 + x2p2 + … xnpn

– i=n
x= Σ (xi pi)
– i=1
x = the expected return
i = each of the possible outcomes (outcome 1 to outcome n)
p = probability of outcome i occurring
n = the number of possible outcomes
i=n
means add together the results for each of the possible outcomes i
Σ from the first to the nth outcome.
i=1
Pentagon plc: Expected returns
 Standard deviation
•Standard deviation, σ, is a statistical measure of the
dispersion around the expected value
•The standard deviation is the square root of the variance, σ2
– 2
Variance of x = σ2 = (x1 –x) –2 2 –2
p1 + (x2 –x) p + … (xn – x) pn
x
i=n
or
σ =
2
x
Σ
i=1
–
{(xi – x)2 pi}

Standard deviation

ÖΣ
i=n
Öσ
2
σx = or – 2 p}
{(xi – x)
x i

i=1
Pentagon plc: Calculating the standard deviations
for the five projects
Pentagon plc: Calculating the standard deviations for
the five projects (continued)
Pentagon plc: Expected return and standard
deviation
 Returns and utility

•A risk averter prefers a more certain return to an alternative with an equal but more
risky expected outcome
•A risk lover prefers a more uncertain alternative to an alternative with an equal but
less risky expected outcome
 Mean-variance rule
•Project X will be preferred to Project Y if at least one of the following conditions
apply:
– 1 The expected return of X is at least equal to the expected return of Y,
and the variance is less than that of Y
– 2 The expected return of X exceeds that of Y and the variance is equal
to or less than that of Y
Pentagon plc: Expected returns
and standard deviations
 Expected net present values and standard
deviation
•Expected net present value is:
i=n
—–– =
NPV Σ
i=1
(NPVi pi)
—––
NPV = expected net present value
NPVi = the NPV if outcome i occurs
pi = probability of outcome i occurring
n = number of possible outcomes
i=n means add together the results of all the NPV × p calculations

Σi=1
for each outcome i from the first to the nth outcome

standard deviation of the net present value is:

ÖΣ
i=n
σNPV = {(NPVi – NPV)2 pi}
i=1
 Horizon plc

Purchase price, t0 £500,000

Refurbishment, t0 £200,000
–––––––––
£700,000
–––––––––
Horizon plc – Year 2 Conditional Probabilities
An event tree showing the probabilities of the
possible returns for Horizon plc
Expected net present value, Horizon plc
Standard deviation for Horizon plc