4

D
Risk Based Capital Budgeting
Content
01 Introduction

02 Risk types

03 Risk management
04 Risk based budgeting tools
05 Evidence
06 Team viewpoint
Capital Budgeting

Capital budgeting is a method of analysing and comparing substantial future

investments and expenditures to determine which ones are most

worthwhile.
 Risk Based Budgeting
“The process of decomposing the aggregate risk of a portfolio into its

constituents, using these risk measures to allocate assets, setting limits in terms

of these measures, and then using the limits to monitor the asset allocations

and portfolio managers is

known as risk budgeting”

Source: Wouter Elshof November (2012).

Risk types
Risk Types

01 Economic Risk

02 Political Risk

03 Environmental Risk

04 Country Risk

05 Financial Risk
Risk Types
Economic risk
• The risk that the firm's market value is affected. Source: Franke, G. (1992).
• Inflation/FDIs/economic crisis/riots & strikes.

Political risk
• The definite risk that firms face regardless of its size and nature due to
government changes and decisions that takes time to time.
Financial risk
• Risk of losing money or investments and financial assets.
Source: Shah, A. K. (1997). 

• Negative impacts on opportunities/income/returns.

Risk Types
Country risk
• The likelihood that a country will be unable or unwilling to repay its debt.
Source: Umar, M., & Sun, G. (2015).
Environmental risk
• Actual or potential threat of adverse effects on living organisms and the
environment by effluents, emissions, wastes, resource depletion, etc.,
arising out of an organization’s activities Source: ICIS. (2011).

Risk management
Risk Management

Management needs to manage and monitor risk due to

several reasons,

• To identify new risks that may affect the company so an

appropriate risk management strategy can be determined.

• To identify changes to existing or known risks so

amendments to the risk management strategy can be
made.
Source: Kaplan Financial Knowledge Bank.
Risk Management Process

Source: Kaplan Financial Knowledge Bank.

Risk Management Strategies
TARA
Transference

Avoidance

Reduction

Acceptance

Risk based budgeting tools Source: Kaplan Financial Knowledge Bank.

Risk Based Budgeting Tools
Risk analysis techniques.
 Subjective/qualitative
Intuitive judgement
methods  Risk-adjusted payback
 Risk-adjusted discount rate
Risk
 Risk-adjusted cash flows
analysis

Analytical  Certainty equivalent

methods  Probability distribution
 Sensitivity
 Simulation
 Decision tree
 
Source: Smith, D. J. (1994) Moyer, Mcguigan, & Kretlow, (2001).
Risk Based Budgeting Tools
Risk analysis tools used in Sri
Lanka. Capital budgeting method Ranking
Sensitivity analysis 1
Scenario analysis 2
CAPM 3
Simulation 4
Real options 5
Economic value added 6
Market value added 7
Decision tree 8
PERT/CPM 9
Linear programming 10
Complex mathematical model 11
Source: Nurullah, M., & Kengatharan, L. (2015).
Risk Based Budgeting Tools

Criteria's for selection of appropriate tool.

• Ease of use.

• Familiarity with the management.

• Acceptance in the relevant Industry.

Source: Nurullah, M., & Kengatharan, L. (2015).
Risk Based Budgeting Tools

01 Risk Adjusted Discount Rate (RADR)

02 Certainty Equivalent (CE)

03 Sensitivity Analysis

04 Scenario Analysis
Risk Based Budgeting Tools
Risk-Adjusted Discount Rate (RADR)

Risk-adjusted discount rate = Risk free rate + Risk premium

• Risk free rate / Risk free cost of capital.

• Risk premium: calculate base on the risk associated with the investment.
• Simultaneously adjusted the risk factors and the time value of money.

Source: Edirisinghe, R. (2010).

Risk Based Budgeting Tools
Certainty Equivalent (CE)

Forecasted Cash Flows are adjusted to reflect the risk.

• Certainty equivalent is reflecting the risk associate to the cash flow.

• Value of “Certainty Equivalent” depends the confidence level of receiving
future cash flows. (Certain cash flows and Uncertain cash flows).
• Once adjusted cash flows are discounted using risk free rate.
Source: Edirisinghe, R. (2010).
Risk Based Budgeting Tools
Sensitivity Analysis

Determine the viability of a project if some variables are

deviate from its expected value.

• Develop a “Based case” on the assumptions calculate NPV.

• Only change one variable at time and analyse the sensitivity to NPV.
• Identify the “Critical Variable” which are most sensitive to NPV.
• Develop mitigation plan to manage the Critical factors.

Source: Edirisinghe, R. (2020).

Risk Based Budgeting Tools
Scenario Analysis

Changing more than one variable at once  to see how the

other variables are change.

• Evaluate “Best-case scenario”, “Base-case scenario” and “Worst-case

scenario”.
• Develop mitigation plan to manage the Critical factors.

Source: Nurullah, M., & Kengatharan, L. (2015).

 Evidence
• Initial cost estimated was US $ 805 million without
Cinnamon Life
tax & interest and planned to finish it by 2018.

• The exchange rate of an US$ at the time of

planning was Rs.131 but now the rate is Rs. 176.

• Failed to allocate the fund for exchange rate

fluctuation.

• The over run of the project as at May 2019 was US

$ 10 million. Source: www.economynext.com (2020).
 Evidence
• In mid 1990s both Boeing and Airbus planned to
Super Jumbo Flights
create Super Jumbo Aircrafts.

• Boeing estimated the development cost of these

kind of flights will be US $ 5 to 7 billion.

• They thought that the demand for such flights

will be inadequate to cover the project cost.

• They cancelled the planned to create these jets.

• The Stocks jumped to $ 7.375 by 6.3%. Source: www.theguardian.com (2020).

 Evidence
• But Airbus carried out the project to create Super Jumbo Flights
Airbus Super Jumbo 380.
• The project cost was approximately US $ 6.8
billion.
• The demand fell slowly due to higher
maintenance cost.
• The largest buyer of Super Jumbo Emirates
last year cancelled ordering Super Jumbos.
Team viewpoint Sources: www.theguardian.com / Musobia & Daniel (2017).
Team Viewpoint
• It leads to innovative ideas.

• Over forecasting or under forecasting issues.

• Sudden unexpected events might have high impact over business.

• Methods are unique with their own advantages and disadvantages.

• Management vs prioritization of risk.

• Methods are complex, time consuming.

 Group – D4
MBA/19/5007 A. M. G. I. Amarasiri

MBA/19/5036 A. D. Dassanayake

MBA/19/5138 M. K. K. Kavindi

MBA/19/5160 M. J. Liyanage

MBA/19/5184 S. Nadarajah

MBA/19/5223 B. S. D. Perera

PIM MBA 2019

 References
• CIMA Sri Lanka Division - Technical Update December 2010.
• Edirisinghe, R., PIM Lecture Notes (2020).
• Franke, G. (1992). Uncertain Perception of Economic Exchange Risk and Financial Hedging.
Managerial Finance, 18(3), 53–70.
• https://www.spokesman.com/stories/1997/jan/21/boeing-scraps-superjumbo-jet-new-line-of-747s/.
• https://www.theguardian.com/business/2019/feb/14/a380-airbus-to-end-production-of-
superjumbo.
• Integrated Compliance Information System (ICIS); data source for previous fiscal years: ICIS.
• Mohamed Nurullah Lingesiya Kengatharan , (2015),"Capital budgeting practices: evidence from Sri
Lanka", Journal of Advances in Management Research, Vol. 12 Iss 1 pp. 55 – 82.
• Shah, A. K. (1997). The social dimensions of financial risk. Journal of Financial Regulation and
Compliance, 5(3), 195–207. doi:10.1108/eb024927.
• Umar, M., & Sun, G. (2015). Country risk, stock prices, and the exchange rate of the renminbi. Journal
of Financial Economic Policy, 7(4), 366–376. doi:10.1108/jfep-11-2014-0073.