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Session - 4

Long-term decision analysis; Capital investments (Risk analysis)

Session objectives To familiarize students with the stages of project (capital investment) appraisal and management; To provide them with knowledge on deeper aspects of project appraisal; To impart the skill of conducting a comprehensive project appraisal exercise.

A few salient concepts and measures Risk: The chance that some unfavorable event will occur; Probability distribution: A listing of all possible outcomes, or events, with a probability (chance of occurrence) assigned to each outcome; Expected rate of return: The rate of return expected to be realized from an investment; the mean value of the probability distribution of possible results.

Standard deviation (): A statistical measurement of the variability of a set of observations. Coefficient of variation: Standardized measure of the risk per unit of return; calculated as the standard deviation divided by the expected return. Risk aversion: A dislike for risk. Risk averse investors have higher required rates of return for higher risk investments.

Performance of A vs. B under conditions of risk

State of economy Boom Normal Recession Mean Standard deviation Coefficient of variation Prob. 0.3 0.4 0.3 15 Rate of return Firm A (%) 100 15 -70 15 65.84 4.39 Rate of return Firm B (%) 20 15 10 15 3.87 0.26

Types of project risk

Stand alone risk: the risk an asset would have if it were a firms only asset; it is measured by the variability of the assets expected returns. Within-firm risk: Risk not considering the effects of stockholders diversification; it is measured by a projects effect on the firms earnings variability. Market, or beta, risk: That part of a projects risk that cannot be eliminated by diversification; it is measured by the projects beta coefficient.

Stand-alone risk
Easier to compute than within firm risk or market risk; It is generally a good proxy for hard to measure market risk; In firms much time is spent to compute the stand alone risk.

Assessment of stand-alone risk Sensitivity analysis

A risk analysis technique in which key variables are changed and the resulting changes in the NPV and the rate of return are observed. Strengths: (a) Easy to perform and explain; (b) Focuses on critical variables. Weaknesses: (a) Does not incorporate information on the possible magnitude of forecast errors; (b) Disregards within-firm risk and market risk.

Scenario analysis
A risk analysis technique in which bad and good sets of financial circumstances are compared with a most likely, or base case situation.

It certainly is an improvement on sensitivity analysis as, at least, three possible scenarios are considered. However, the world is much more complex and there are an innumerable number of possible scenarios to be considered.

Scenario analysis (cont.)

Worst case scenario: An analysis in which all of the input variables are set at their worst reasonably forecasted values; Best case scenario: An analysis in which all of the input variables are et at their worst reasonably forecasted values; Base case: An analysis in which all of the input variables are set at their most likely values.

Simulation analysis Monte Carlo simulation

A risk analysis technique in which probable future events are simulated on a computer, generating estimated rates of return and risk indices.

Monte Carlo simulation (cont.)

The computer chooses at random a value for each uncertain variable based on the variable's specified probability distribution; Assess cash flows and the projects NPV in the first run; Continue the process, say 500 times, and develop thereby the probability distribution. The method shows a range of possible outcomes along with their attached probabilities.

Self work
Revise knowledge on the basics of Capital Budgeting. Read Chapter 3 Part II Re-work the case McReath Corpoartion B Work an assortment of end of chapter exercises that matches with the above case