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K. B. Singh kritibr@gmail.com

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 .

the meaning of best estimates or most likely is not very clear. a forecaster should not give just one estimate.. For these reasons. but a range of associated probability²a probability distribution. median or mode. we do not know the chances of this figure actually occurring.Probability A typical forecast is single figure for a period. . This is referred to as ´best estimateµ or ´most likelyµ forecast: Firstly. Secondly.e. It is not known whether it is mean. i. the uncertainty surrounding this figure. Probability may be described as a measure of someone·s opinion about the likelihood that an event will occur.

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. .Assigning Probability The probability estimate. which is based on a very large number of observations. is known as an objective probability.

Expected Net Present Value Once the probability assignments have been made to the future cash flows the next step is to find out the expected net present value. Expected net present value = Sum of present values of expected net cash flows. n ENPV = § t =0 ENCF t (1 k ) ENCFt NCFjt × Pjt .

Absolute Measure of Risk. n W 2 (NCF) = § (NCF j =1 j ± ENCF) 2 j . Standard deviation is the square root of variance. variance measures the deviation about expected cash flow of each of the possible cash flows.Variance or Standard Deviation Simply stated.

Risk-Adjusted Discount Rate Risk-adjusted discount rate. Under CAPM. the riskpremium is the difference between the market rate of return and the risk-free rate multiplied by the beta of the project. will allow for both time preference and risk preference and will be a sum of the risk-free rate and the risk-premium rate reflecting the investor·s attitude towards risk. NCFt NPV = § t (1 k ) t =0 n k = kf + k r .

NPV = § t t = 0 (1 kf ) The certainty³equivalent coefficient assumes a value between 0 and 1. and varies inversely with risk.Certainty²Equivalent Reduce the forecasts of cash flows to some n E t NCFt conservative levels. . The certainty³equivalent NCF* Certain net cash flow t Et ! = coefficient can be NCFt Risky net cash flow determined as a relationship between the certain cash flows and the risky cash flows. Decision-maker subjectively or objectively establishes the coefficients.

On the other hand. Certainty²Equivalent The certainty³equivalent approach recognises risk in capital budgeting analysis by adjusting estimated cash flows and employs risk-free rate to discount the adjusted cash flows. The risk-adjusted discount rate approach will yield the same result as the certainty³equivalent approach if the risk-free rate is constant and the risk-adjusted discount rate is the same for all future periods. .Risk-adjusted Discount Rate Vs. It has been suggested that the certainty³equivalent approach is theoretically a superior technique. the risk-adjusted discount rate adjusts for risk by adjusting the discount rate.

Definition of the underlying (mathematical) relationship between the variables. while performing sensitivity analysis. 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). The decision maker. computes the project·s NPV (or IRR) for each forecast under three assumptions: (a) pessimistic. (b) expected. and (c) optimistic.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. Analysis of the impact of the change in each of the variables on the project·s NPV.

The terms ¶optimistic· and ¶pessimistic· could mean different things to different persons in an organisation. A price cut may lead to high sales and low operating cost. For example. It helps to expose inappropriate forecasts. The decision-maker can consider actions. . and thus guides the decisionmaker to concentrate on relevant variables. This helps him in understanding the investment project in totality. the range of values suggested may be inconsistent. which affect the cash flow forecasts. sale volume may be related to price and cost. It indicates the critical variables for which additional information may be obtained.Pros and Cons of Sensitivity Analysis Sensitivity analysis has the following advantages: It compels the decision-maker to identify the variables. It has the following limitations: It does not provide clear-cut results. It fails to focus on the interrelationship between variables. which may help in strengthening the ¶weak spots· in the project. Thus.

. The decision-maker can develop some plausible scenarios for this purpose. optimistic and expected.Scenario Analysis One way to examine the risk of investment is to analyse the impact of alternative combinations of variables. on the project·s NPV (or IRR). called scenarios. For instance. we can consider three scenarios: pessimistic.

An analytical technique to handle the sequential decisions is to employ decision trees. but as links in a chain of present and future commitments.Decision Trees for Sequential Investment Decisions Investment expenditures are not an isolated period commitments. Steps in Decision Tree Approach Define investment Identify decision alternatives Draw a decision tree decision points chance events Analyse data .

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