# CHAPTER 12

RISK ANALYSIS IN CAPITAL BUDGETING

LEARNING OBJECTIVES

2

Discuss the concept of risk in investment decisions. Understand some commonly used techniques, i.e., payback, certainty equivalent and risk-adjusted discount rate, of risk analysis in capital budgeting. Focus on the need and mechanics of sensitivity analysis and scenario analysis. Highlight the utility and methodology simulation analysis. Explain the decision tree approach in sequential investment decisions. Focus on the relationship between utility theory and capital budgeting decisions.

Nature of Risk

3

Risk exists because of the inability of the decisionmaker 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
**

4

**Statistical Techniques for Risk Analysis
**

Probability Variance or Standard Deviation Coefficient of Variation Payback Risk-adjusted discount rate Certainty equivalent

**Conventional Techniques of Risk Analysis
**

This is referred to as ³best estimate´ or ³most likely´ forecast:
Firstly.
For these reasons. we do not know the chances of this figure actually occurring. It is not known whether it is mean. the meaning of best estimates or most likely is not very clear.Probability
5
A typical forecast is single figure for a period. a forecaster should not give just one estimate.e.
.. Secondly. Probability may be described as a measure of someone¶s opinion about the likelihood that an event will occur. but a range of associated probability±a probability distribution. the uncertainty surrounding this figure. i. median or mode.

is known as an objective probability.
. which is based on a very large number of observations.Assigning Probability
6
The probability estimate. 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.

Risk and Uncertainty
7
Risk is referred to a situation where the probability distribution of the cash flow of an investment proposal is known. If no information is available to formulate a probability distribution of the cash flows the situation is known as uncertainty.
.

n
ENPV =
§
t=0
ENCF t (1 k )
Expected net present value = Sum of present values of expected net cash flows.
EN C F t
N C F jt × P jt
.Expected Net Present Value
8
Once the probability assignments have been made to the future cash flows the next step is to find out the expected net present value.

If the discount rate is 15 per cent. and it would involve an initial cost of Rs Expected Cash Flow 10.
.000. calculate the expected NPV.Example
9
Suppose an investment project has a life of three years.

Example
10
.

n
W
2
(N C F )
§ (NCF
j 1
j
± EN C F)2 Pj
Absolute Measure of Risk. Standard deviation is the square root of variance.
.Variance or Standard Deviation
11
Variance measures the deviation about expected cash flow of each of the possible cash flows.

It is defined as the standard deviation of the probability distribution divided by its expected value:
Co icient o variation CV Expected value tandard deviation
.Coefficient of Variation
12
Coefficient of variation is relative Measure of Risk.

or different standard deviations but same expected values. or different standard deviations and different expected values.
.Coefficient of Variation
13
The coefficient of variation is a useful measure of risk when we are comparing the projects which have
same standard deviations but different expected values.

CONVENTIONAL TECHNIQUES OF RISK ANALYSIS
14
Payback Risk-adjusted discount rate Certainty equivalent
.

Risk Analysis in Practice
15
Most companies in India account for risk while evaluating their capital expenditure decisions. The following factors are considered to influence the riskiness of investment projects:
price of raw material and other inputs price of product product demand government policies technological changes project life inflation
.

Risk Analysis in Practice
16
Four factors thought to be contributing most to the project riskiness are:
selling price product demand technical changes government policies
Methods of risk analysis in practice are:
sensitivity analysis conservative forecasts
.

Sensitivity Analysis & Conservative Forecasts
17
Sensitivity analysis allows to see the impact of the change in the behaviour of critical variables on the project profitability. Except a very few companies most companies do not use the statistical and other sophisticated techniques for analysing risk in investment decisions.
. Conservative forecasts include using short payback or higher discount rate for discounting cash flows.

as applied in practice. The merit of payback
Its simplicity. is more an attempt to allow for risk in capital budgeting decision rather than a method to measure profitability. Favouring short term projects over what may be riskier.
Even as a method for allowing risks of time nature. longer term projects. Focusing attention on the near term future and thereby emphasising the liquidity of the firm through recovery of capital. it ignores the time value of cash flows.
.Payback
18
This method.

Risk-Adjusted Discount Rate
19
Risk-adjusted discount rate.
k = kf + kr
.
n
NPV =
§
t=0
NCFt t (1 k )
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 project. will allow for both time preference and risk preference and will be a sum of the riskfree rate and the risk-premium rate reflecting the investor¶s attitude towards risk.

Risk-adjusted Discount Rate: Merits
20
It is simple and can be easily understood. It has a great deal of intuitive appeal for risk-averse businessman. It incorporates an attitude (risk-aversion) towards uncertainty.
.

. they are willing to pay a premium to take risks. Though it is generally true. 4 It is based on the assumption that investors are risk-averse. yet there exists a category of risk seekers who do not demand premium for assuming risks. CAPM provides a basis of calculating the risk-adjusted discount rate.Risk-adjusted Discount Rate: Limitations
21
4 There is no easy way of deriving a risk-adjusted discount rate. 4 It does not make any risk adjustment in the numerator for the cash flows that are forecast over the future years.

Example
22
.

Example
23
.

Certainty-Equivalent
24
Reduce the forecasts of cash flows to some conservative levels.The certainty-equivalent coefficient assumes a value between 0 and 1.
n
N V
§ (1 k )
t 0
f
E t NCFt
t
The certainty²equivalent coefficient can be determined as a relationship between the certain cash flows and the risky cash flows. and varies inversely with risk. Decisionmaker subjectively or objectively establishes the coefficients.
NCF* t Et ! NCFt Certain net cash lo Risky net cash lo
.

Second.Certainty-Equivalent: Evaluation
25
First. if forecasts have to pass through several layers of management. the effect may be to greatly exaggerate the original forecast or to make it ultra-conservative. expecting the reduction that will be made in his forecasts. may inflate them in anticipation. Third. the forecaster.
. chances are increased for passing by some good investments. by focusing explicit attention only on the gloomy outcomes.

Example
26
.

On the other hand.Risk-adjusted Discount Rate Vs. 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.
. CertaintyEquivalent
27
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. It has been suggested that the certainty-equivalent approach is theoretically a superior technique. the risk-adjusted discount rate adjusts for risk by adjusting the discount rate.

computes the project¶s NPV (or IRR) for each forecast under three assumptions:
pessimistic.
. expected.SENSITIVITY ANALYSIS
28
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 decision maker. while performing sensitivity analysis. and optimistic.

Identification of all those variables. 3.
. Definition of the underlying (mathematical) relationship between the variables. which have an influence on the project¶s NPV (or IRR). Analysis of the impact of the change in each of the variables on the project¶s NPV. 2.SENSITIVITY ANALYSIS
29
The following three steps are involved in the use of sensitivity analysis:
1.

The accounting break-even point is estimated as fixed costs divided by the contribution ratio.DCF Break-even Analysis
30
Sensitivity analysis is a variation of the break-even analysis. DCF break-even point is different from the accounting break-even point.
. It does not account for the opportunity cost of capital. and fixed costs include both cash plus non-cash costs (such as depreciation).

The decision-maker can consider actions. which may help in strengthening the µweak spots¶ in the project. This helps him in understanding the investment project in totality. which affect the cash flow forecasts.Sensitivity Analysis: Pros and Cons
31
It compels the decision-maker to identify the variables.
. and thus guides the decision-maker to concentrate on relevant variables. It indicates the critical variables for which additional information may be obtained. It helps to expose inappropriate forecasts.

The terms µoptimistic¶ and µpessimistic¶ could mean different things to different persons in an organisation.
. sale volume may be related to price and cost. Thus.Sensitivity Analysis: Pros and Cons
32
4It does not provide clear-cut results. For example. the range of values suggested may be inconsistent. 4It fails to focus on the interrelationship between variables. A price cut may lead to high sales and low operating cost.

we can consider three scenarios: pessimistic. The decision-maker can develop some plausible scenarios for this purpose. called scenarios. optimistic and expected.
. on the project¶s NPV (or IRR).SCENARIO ANALYSIS
33
One way to examine the risk of investment is to analyse the impact of alternative combinations of variables. For instance.

you should identify variables that influence cash inflows and outflows. develop a computer programme that randomly selects one value from the probability distribution of each variable and uses these values to calculate the project¶s NPV. The simulation analysis involves the following steps:
First. specify the formulae that relate variables. Third. Fourth.SIMULATION ANALYSIS
34
The Monte Carlo simulation or simply the simulation analysis considers the interactions among variables and probabilities of the change in variables. It computes the probability distribution of NPV. indicate the probability distribution for each variable.
. Second.

Simulation Analysis: Shortcomings
35
4 The model becomes quite complex to use. 4 It does not indicate whether or not the project should be accepted.
. like sensitivity or scenario analysis. 4 Simulation analysis. considers the risk of any project in isolation of other projects.

Decision Trees for Sequential Investment Decisions
36
Investment expenditures are not an isolated period commitments. An analytical technique to handle the sequential decisions is to employ decision trees. but as links in a chain of present and future commitments.
.

Steps in Decision Tree Approach
37
Define investment Identify decision alternatives Draw a decision tree
decision points chance events
Analyse data
.

analytical form. which is usually much easier to understand than the more abstract. Graphic visualization: It allows a decision maker to visualise assumptions and alternatives in graphic form. question and revise.Usefulness of Decision Tree Approach
38
Clarity: It clearly brings out the implicit assumptions and calculations for all to see.
.

. It is complicated even further if the analysis is extended to include interdependent alternatives and variables that are dependent upon one another.Decision Tree Approach: Limitations
39
The decision tree diagrams can become more and more complicated as the decision maker decides to include more alternatives and more variables and to look farther and farther in time.

As regards the attitude of individual investors towards risk.
. they can be classified in three categories:
Risk-averse Risk-neutral Risk-seeking
Individuals are generally risk averters and demonstrate a decreasing marginal utility for money function.UTILITY THEORY AND CAPITAL BUDGETING
40
Utility theory aims at incorporation of decisionmaker¶s risk preference explicitly into the decision procedure.

The owner may reject the project in spite of its positive ENPV. However. Project has a positive expected NPV of Rs 2 lakh. and he may consider the gain in utility arising from the positive outcome (positive PV of Rs 10 lakh) less than the loss in utility as a result of the negative outcome (negative PV of Rs 10 lakh). which has 60 per cent probability of yielding a net present value of Rs 10 lakh and 40 per cent probability of a loss of net present value of Rs 10 lakh.Utility Theory and Capital Budgeting
41
Assume that the owner of a firm is considering an investment project. the owner may be risk averse.
.

it facilitates the process of delegating the authority for decision. the risk preferences of the decision-maker are directly incorporated in the capital budgeting analysis. it is quite difficult to specify the utility function if the decision is taken by a group of persons. the derived utility function at a point of time is valid only for that one point of time. Second. First. even if the owner¶s or a dominant shareholder¶s utility function be used as a guide. Third. in practice. Second.
It suffers from a few limitations:
. difficulties are encountered in specifying a utility function.Benefits and Limitations of Utility Theory
42
It suffers from a few advantages:
First.