Risk Analysis in Capital Budgeting
K. B. Singh
kritibr@[Link]
Nature of Risk
Risk exists because of the inability of the
decision-maker to make perfect forecasts.
In formal terms, the risk associated with an
investment may be defined as the variability
that is likely to occur in the future returns from
the investment.
Three broad categories of the events
influencing the investment forecasts:
General economic conditions
Industry factors
Company factors
Techniques for Risk Analysis
Statistical Techniques for Risk Analysis
Probability
Variance or Standard Deviation
Coefficient of Variation
Conventional Techniques of Risk Analysis
Risk-adjusted discount rate
Certainty equivalent
Sensitivity Analysis
Probability
A typical forecast is single figure for a period. This is
referred to as “best estimate” or “most likely” forecast:
Firstly, we do not know the chances of this figure actually occurring,
i.e., the uncertainty surrounding this figure.
Secondly, the meaning of best estimates or most likely is not very
clear. It is not known whether it is mean, median or mode.
For these reasons, a forecaster should not give just one
estimate, but a range of associated probability–a
probability distribution.
Probability may be described as a measure of
someone’s opinion about the likelihood that an event
will occur.
Assigning Probability
The probability estimate, which is based on a
very large number of observations, is known as
an objective probability.
Such probability assignments that reflect the
state of belief of a person rather than the
objective evidence of a large number of trials
are called personal or subjective probabilities.
Expected Net Present Value
Once the probability
assignments have been
made to the future n
ENCF
cash flows the next ENPV = (1 k )
t
step is to find out the t =0
expected net present
value.
Expected net present
value = Sum of
present values of ENCFt = NCFjt × Pjt
expected net cash
flows.
Variance or Standard Deviation
Simply stated,
variance measures the
deviation about
expected cash flow of n
each of the possible (NCF) =
2
(NCF
j =1
j – ENCF)2 Pj
cash flows.
Standard deviation is
the square root of
variance.
Absolute Measure of
Risk.
Risk-Adjusted Discount Rate
Risk-adjusted discount rate, will
allow for both time preference
n
and risk preference and will be NCFt
a sum of the risk-free rate and NPV =
t =0 (1 k )
t
the risk-premium rate
reflecting the 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 k = kf + kr
project.
Certainty—Equivalent
Reduce the forecasts of cash
flows to some conservative n
t NCFt
levels.
The certainty—equivalent
NPV =
t = 0 (1 kf )
t
coefficient assumes a value
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 t =
certain cash flows and the NCFt Risky net cash flow
risky cash flows.
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.
Sensitivity Analysis
Sensitivity analysis is a way of analysing change in
the project’s NPV (or IRR) for a given change in one
of the variables.
The following three steps are involved in the use of
sensitivity analysis:
Identification of all those variables, which have an influence on the
project’s NPV (or IRR).
Definition of the underlying (mathematical) relationship between
the variables.
Analysis of the impact of the change in each of the variables on the
project’s NPV.
The decision maker, while performing sensitivity analysis,
computes the project’s NPV (or IRR) for each forecast under
three assumptions: (a) pessimistic, (b) expected, and
(c) optimistic.
Pros and Cons of Sensitivity Analysis
Sensitivity analysis has the following advantages:
It compels the decision-maker to identify the variables, which affect the
cash flow forecasts. This helps him in understanding the investment
project in totality.
It indicates the critical variables for which additional information may be
obtained. The decision-maker can consider actions, which may help in
strengthening the ‘weak spots’ in the project.
It helps to expose inappropriate forecasts, and thus guides the decision-
maker to concentrate on relevant variables.
It has the following limitations:
It does not provide clear-cut results. The terms ‘optimistic’ and
‘pessimistic’ could mean different things to different persons in an
organisation. Thus, the range of values suggested may be inconsistent.
It fails to focus on the interrelationship between variables. For example,
sale volume may be related to price and cost. A price cut may lead to high
sales and low operating cost.
Scenario Analysis
One way to examine the risk of investment is
to analyse the impact of alternative
combinations of variables, called scenarios, on
the project’s NPV (or IRR).
The decision-maker can develop some
plausible scenarios for this purpose. For
instance, we can consider three scenarios:
pessimistic, optimistic and expected.
Decision Trees for Sequential Investment Decisions
Investment expenditures are not an isolated
period commitments, but as links in a chain
of present and future commitments. An
analytical technique to handle the sequential
decisions is to employ decision trees.
Steps in Decision Tree Approach
Define investment
Identify decision alternatives
Draw a decision tree
decision points
chance events
Analyse data
