Scribd
Upload
100 views26 pages

Project Risk Analysis: by Atul Pandey Shrija Konda Akanksha Sinha Harsha Aditi

This document discusses various techniques for analyzing risk in capital budgeting projects. It outlines sensitivity analysis, scenario analysis, break-even analysis, simulation analysis, and decision tree analysis as key methods. It also discusses ways to incorporate risk such as using conservative estimates, adding safety margins, flexible investment criteria, and assessing overall project certainty. The goal is to identify sources of risk and understand their potential consequences for long-term projects.

Uploaded by

Arshan Bhullar
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
100 views26 pages

Project Risk Analysis: by Atul Pandey Shrija Konda Akanksha Sinha Harsha Aditi

This document discusses various techniques for analyzing risk in capital budgeting projects. It outlines sensitivity analysis, scenario analysis, break-even analysis, simulation analysis, and decision tree analysis as key methods. It also discusses ways to incorporate risk such as using conservative estimates, adding safety margins, flexible investment criteria, and assessing overall project certainty. The goal is to identify sources of risk and understand their potential consequences for long-term projects.

Uploaded by

Arshan Bhullar
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 26

PROJECT RISK

ANALYSIS

By
Atul Pandey
Shrija Konda
Akanksha Sinha
Harsha
Aditi
INTRODUCTION
• Through this presentation we will try to identify the underlying sources
of risk and explore the consequences.
• Risk is inherent in almost every business decision. More so in capital
budgeting decisions as they involve cost and benefits extending over a
long period of time during which many things can change in
unanticipated ways.
• The following slide suggests ways to handle risk in capital budgeting.
Techniques of risk
analysis

Analysis of stand- Analysis of


alone risk contextual risk

Sensitivity Scenario Corporate risk Market risk


analysis analysis analysis analysis

Break-even
Hillier model
analysis

Simulation Decision tree


analysis analysis
SOURCES OF RISK
• Project risk
• Competitive risk
• Industry-specific risk
• Market risk
• International risk
MEASURES OF RISK

PROBABILITY WEIGHTED NPV:


E(NPV) = ∑Pi NPVi
= 0.3X200+0.5X600+0.2X900
= 540 (expected value)

RANGE= highest value – lowest value


=900-200
= 700
Standard deviation
_
σ = [∑Pi(X-X)*2]*1/2
= 249.8

VARIANCE = square of Std Deviation


= 249.8*2
= 62400
Coefficient = std dev/ expected value
of variance = 249.8/ 540
= 0.46
SEMI = ∑PiDi*2
VARIANCE = 0.3(200-540)*2
= 34680.
SENSITIVITY ANALYSIS
Sensitivity of NPV to variations in the value of key variables
SCENARIO ANALYSIS
• In this analysis several variables are varied simultaneously. Most
commonly 3 scenarios are considered.
• 3 scenarios are:
– Expected scenario
– Pessimistic scenario
– Optimistic scenario
Cont…
LIMITATIONS
• Based on the assumption that there are few extreme scenarios. the
economy does not necessarily lie in 3 discrete states -
Recession, Stability and Boom.
• It expands the concept of estimating the expected values. thus in a case
where there are 10 inputs the analyst has to estimate 30(3*10) expected
values to do the analysis
BREAK EVEN ANALYSIS
• This analysis helps in knowing how much should be produced and sold
at a minimum to ensure that the project does not “lose money”.
• BEP occurs when
• Total revenue = Total cost
TYPES OF BREAK EVEN ANALYSIS
• Accounting break even analysis:
• Break even in accounting terms is like a stock that gives a return of 0%
without considering the time value of money
• A project that merely breaks even in accounting terms will have a
negative NPV.
• Financial Break-even Analysis: It takes into account the time value of
money and is only concerned with the NPV and not accounting profits.
MANAGING RISK
A common way to Start with small Gather more
modify the risk is to A lower price increases
the potential product and later information about the
change the proportion expand as the market and
of fixed and variable demand, but also raises
the break-even level market grows. technology before
cost. taking the plunge.
Fixed and Pricing Sequential
Strategy Improving
Variable cost Investment Information

Reducing the Enter into long-term Partnership between Derivative instruments


dependence on debt arrangements with two or more companies like options and futures
lowers risk. suppliers, employees, le to achieve a common can be used for
nders and customers. purpose. managing risk.
Financial Long-term Strategic
Derivatives
Leverage Arrangements Alliance
PROJECT SELECTION UNDER RISK

Judgmental Evaluation

Payback Period Requirement

Risk Adjusted Discount Rate Method

Certainty Equivalent Method


JUDGMENTAL EVALUATION:

The decision is made on the basis of risk and return


characteristics of a project without using any
formal method.

PAYBACK PERIOD REQUIREMENT:

If an investment is considered more risky, a shorter


payback period is required even if the NPV is positive
or IRR exceeds the hurdle rate.
RISK ADJUSTED DISCOUNT RATE METHOD:
This method calls for adjusting the discount rate to reflect project risk.

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

• If project risk is equal to the risk of existing investment of the firm, the discount rate
used is the average cost of capital of the firm.
• If project risk is greater than the risk of existing investment of the firm, the discount
rate used is higher than the average cost of capital of the firm.
• If project risk is less than the risk of existing investment of the firm, the discount rate
used is less than the average cost of capital of the firm.
The project is accepted if its NPV is positive:

NPV Σ At - 1
= t=1
(1+rk)t

Where, NPV is the net present value of project k,


At is the expected cash flow for year t, and
rk is the risk adjust discount rate of project k,
Simulation Analysis
• Procedure
1. Model the project. The model of the project shows how the net present
value is related to the parameters and the exogenous variables.
2. Specify the values of parameters and the probability distributions of
the exogenous variables.
3. Select a value, at random, from the probability distribution of each of
the exogenous variable.
4. Determine the net present value corresponding to the randomly
generated values of exogenous variables and pre-specified parameter
values.
5. Repeat 3 & 4 steps to get a large number of simulated net present
values
6. Plot frequency distribution of the net present value.
Issues in Applying simulation
• What should the output be?
• Is project variability enough?
• How should the extreme values be used?
• How should the results of simulation be used?
Decision Tree Analysis
• Identify the Problem & Alternatives.
• Delineating the Decision Tree.
• Specifying the probabilities & Monetary Outcomes.
• Evaluating various decision alternatives.
D11 carry out pilot production
and market test Rs 20 million

D1

C11 Success C12


C1 Failure D12
success Do
0.7 Nothing
D21 Invest RS 150
million

D2 D3

D22
C2
Stop

C21
C22 low
high
demand
demand
0.4
0.6
CERTAINITY EQUIVALENT METHOD
• It is a method which is used to calculate a guaranteed return that
someone would accept, rather than taking a chance on a higher, but
uncertain, return.
• Under this method NPV is calculated as
• NPV = sum(αt*At/(1+i)^t)-I
• αt=certainty equivalent coefficient(0.5-1)
• At=expected cash flow
• i=risk free interest rate
• I=initial investment
METHODS TO INCORPORATE RISK
• Conservative estimation of revenues: Revenues expected from a project
are conservatively estimated to ensure the viability of the project
• Safety margin in cost figures: A margin of safety is included in
estimating cost figures
• Flexible investment yardsticks: The cut off point for an investment varies
according to the judgment of management about the riskiness of the
project
Cont…

• Acceptable overall certainty index: Most companies calculate this index


based on factors affecting the success of the project.
E.g.:
Raw material availability 70%
Power availability 60%
Freedom from competition 80%
Overall certainty = (70+60+80)/3 =70%
Cont…

• Judgment on three point estimates:


• Three estimates are developed for one or more aspects of the proposed
investment.
• E.g.:
• Rate of return:
– Pessimistic
– Likely
– optimistic

You might also like