Financial Management – Risk Analysis in Capital Budgeting CS Executive

CA. Pramod Prabhu. S.H, B.Sc, FCA, PGDBA, MCA, CISA (USA)

Need for Risk Analysis:

 While discussing capital budgeting techniques we have assumed that investment proposals do
not involve any risk and that cash flows of projects are known with certainty. In reality this
assumption does not hold good.
 Adjustment for Risk helps decision maker to arrive at conclusion whether returns available from
project are proportionate with risks undertaken and whether investing in project is worth
considering the risk factor too into account. Risk adjustment is required to know the real value
of cash inflows.
 Projects are exposed to various kinds of risk
 Decision making may be under situations
i. of certainty – Cash inflows are known with certainty (which is rare)
ii. involving risk – cash flows involve risk and probability can be assigned
iii. of uncertainty – cash flows are uncertain and probability cannot be assigned

Difference between Risk and Uncertainty:

 Risk is the variability in actual return as compared with estimated returns

Risk Uncertainty
Variability of actual returns compared with Variability exist
estimated returns
Probability distribution of cash flows is known Information not available to formulate probability
distribution of cash flows
Standard deviation and coefficient of variation are
the most common measures

Various sources of Risk:

Project Specific Completing a project within scheduled time, estimating resources, cash flows
Company specific Credit rating issues, change in KMP, worker disputes etc affecting cash flows
Industry Specific Affecting whole industry like regulatory restrictions, technological changes etc
Market Risk Risk in market related conditions like entry of substitutes, demand fluctuations,
resource availability etc
Competition Risk Risk related to competition in market in which the company functions like risk
of entry of rival, change in preference and tastes of consumers
Risk due to economic Macro economic changes like change in monetary policies of banks, inflation,
conditions GDP changes, fiscal policy changes like taxation regime changes
International Risk Risk due to global economic condition change like restriction on free trade,
recessions, market access restrictions etc

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Financial Management – Risk Analysis in Capital Budgeting CS Executive
CA. Pramod Prabhu. S.H, B.Sc, FCA, PGDBA, MCA, CISA (USA)

Various techniques for risk analysis in capital budgeting:

Statistical Techniques Conventional Techniques Other Techniques

Probability assignment Risk adjusted discount rate Sensitivity Analysis
Variance/ Standard Deviation Certainty Equivalent Scenario Analysis
Coefficient of Variation Simulation
Decision Tree Analysis

Statistical Technique – Probability:

 Under this method, probabilities are assigned to each cash flow estimated to arise and
expected cash flows are arrived at as [Cash flow x its Probability]
 Expected NPV =[Probability adjusted DCIF – Probability adjusted DCOF] or [E(DCIF) – E(DCOF)]

1. Compute expected cash flow from the details given below.

Assumption Cash Flows (Rs) Probability

Best Guess 5,00,000 0.30
High Guess 8,00,000 0.60
Low Guess 3,00,000 0.10

Statistical Technique – Expected NPV (Single Period):

2. Possible net cash flows from Project A and Project B and their probabilities are given. Discount
rate is 10% and initial investment Rs. 100000. Calculate expected NPV for each project. Which
project is preferable? (PVF @ 10% for Year 1 – 0.909)

Possible Project A Project B

Event
A 80000 0.10 40000 0.10
B 100000 0.20 200000 0.15
C 120000 0.40 160000 0.50
D 140000 0.20 120000 0.15
E 160000 0.10 800000 0.10

Statistical Technique – Expected NPV (Multiple Period):

3. Probabilities of net cash flows for 3 years of a project are as follows:

Year 1 Year 2 Year 3
Cash Flow Probability Cash Flow Probability Cash Flow Probability
20000 0.10 20000 0.20 20000 0.30
40000 0.20 40000 0.30 40000 0.40
60000 0.30 60000 0.40 60000 0.20
80000 0.40 80000 0.10 80000 0.10

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Financial Management – Risk Analysis in Capital Budgeting CS Executive
CA. Pramod Prabhu. S.H, B.Sc, FCA, PGDBA, MCA, CISA (USA)

Calculate expected net cash flows. Also calculate the present value of expected cash flow using
10% discount rate (PVF: Year 1 - 0.909; Year 2 - 0.826; Year 3 - 0.751). Initial investment is Rs. 1
lakh.

Statistical Techniques – Variance, Standard Deviation and Coefficient of variation:

Variance Measure of degree of dispersion between

 numbers in a data set
 from its average

i.e. measure of difference between

 average of the data set
 from every number of the data set
It measures uncertainty of a value from its average and helps an organisation
understand the level of risk it might face on investing in a project

Analysis 1. Variance = 0 implies CFs over project life would be same, i.e unchanged (Ex. Pre
existing contracts)

2. Variance – High: Large variability expected between cash flows of Various years
(Ex. Innovative Projects)

3. Variance – Low: Somewhat stable cash flows throughout life of project (Ex. where
established markets exist)
Calculation Sum of (CF of the Year – Expected CF)² x Probability

Standard Deviation √ Variance i.e. (Square root of Variance)

It measures risk associated with estimated cash flows from a project

Coefficient of Variation Measures risk borne for every percentage of expected return
 Standard deviation fails in cases where management has to choose
among several avenues.
 As each project has different estimated cash flows, it becomes
difficult for management to compare risk associated with different
projects using standard deviation
 Coefficient of variation enables management to compute risk borne
by the concern for every unit of estimated return from an
investment
 Lower CV is preferred (i.e a project with lower ratio of SD to
E(Return) has better risk-return trade off
Calculation CV = Standard Deviation
Expected Return or E(CF)

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Financial Management – Risk Analysis in Capital Budgeting CS Executive
CA. Pramod Prabhu. S.H, B.Sc, FCA, PGDBA, MCA, CISA (USA)

4. Calculate Variance, Standard deviation and coefficient of variation from following data:
Possible Project A Project B
Event
A 80000 0.10 40000 0.10
B 100000 0.20 200000 0.15
C 120000 0.40 160000 0.50
D 140000 0.20 120000 0.15
E 160000 0.10 800000 0.10

Conventional Techniques – Risk adjusted discount rate:

RADR [Risk free rate + Risk Premium]

i.e RADR = [rate of return on investments that bear no risk + return over and above risk free rate
expected by investors as reward for bearing extra risk]
Here instead of adjusting cash flows, discount rate is adjusted to provide for risk in decision
making
NPV Usual method itself; Only that discount rate is higher (providing for risk also)
Computation

5. An organization is investing Rs. 100 lakhs in a project. The risk free rate of return is 7%. Risk
premium expected by management is 7%. Project life is 5 years. Following cash flows are
estimated over life of project. Calculate project NPV based on risk free rate and also based on
risk adjusted discount rate. [PVFs @ 7% are Year 1 - 0.935; Year 2 - 0.873; Year 3 – 0.816; Year 4
– 0.763; Year 5 – 0.713] and [PVFs @ 14% are Year 1 - 0.877; Year 2 - 0.769; Year 3 – 0.675; Year
4 – 0.592; Year 5 – 0.519]
Year Cash Flows (Lakhs)
1 25
2 60
3 75
4 80
5 65

Conventional Techniques – Certainty Equivalent:

Meaning Here risky higher CFs are converted to equivalent lower but riskless (or least risky) CFs, by
multiplying the CFs with certainty equivalents
i.e. Risk adjusted CFs = [Risky CFs x CE]
CE transforms expected value of uncertain CFs into their certain equivalent CFs
Value of CE coefficient lies between 0 and 1 (1 indicates that CF is certain/ management is
risk neutral)
NPV [Risk adjusted DCIF – DCOF]
CE Vs RADR 1. CE is superior as
 it does not assume that risk increases with time at constant rate
 Each year’s CE is based on level of risk impacting its CF
2. However it is difficult practically to specify a series of CE coefficients but easy to adjust
discount rates. Therefore despite its soundness it is not preferred compared to RADR.
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Financial Management – Risk Analysis in Capital Budgeting CS Executive
CA. Pramod Prabhu. S.H, B.Sc, FCA, PGDBA, MCA, CISA (USA)

6. Calculate NPV using certainty equivalent technique if investment proposal is Rs. 45 lakhs and
risk free rate is 5% from details below: [PVFs are Year 1 – 0.95; Year 2 – 0.91; Year 3 – 0.86; Year
4 – 0.82]
Year Expected Cash Flow CE Coefficient
1 1000000 0.90
2 1500000 0.85
3 2000000 0.82
4 2500000 0.78

Other Techniques – Sensitivity Analysis:

Meaning Used to study the impact of changes in variables on outcome of a project

Definition A modeling and risk assessment procedure where changes are made to significant
variables to determine the effect of these changes on planned outcome
Here one variable is altered and all others are maintained unchanged and variation
measured. That variable which causes highest deviation is considered as critical
variable and specially monitored
Thus SA is a way of finding impact on Project’s NPV for a given change in one of the
variables

7. Y Ltd is considering its new project with following details. i) Calculate NPV of the project ii) Find
impact on NPV of a 2.50% adverse variance in each variable. Which variable has maximum
effect? (PVAF @ 6% for 3 years – 2.6730)

Sl No Particulars Figures
1 Initial Capital Cost Rs. 400 Cr
2 Annual Unit Sales 5 Cr
3 Selling Price per unit Rs. 100
4 Variable cost per unit Rs. 50
5 Fixed cost per year Rs. 50 Cr
6 Discount rate 6%

Other Techniques – Scenario Analysis:

Meaning Examines risk of investment as to analyse the impact of alternative combination of

variables on a project’s NPV/IRR
It deals with probability distribution of Inputs
More than one variable is varied at a time to see combined effect of changes in variables
It brings in probability of changes in key variables and allows to change more than one
variable at a time
Analysis Begins with base case/ most likely set of values for input variables, then goes for worst
case scenario and best case scenario
Practically CFs are worked out for 3 different scenarios (Worst, most likely, best case)
If NPV is to be worked out considering worst case in a year, take most likely CFs for other
years work out NPV by discounting
Sensitivity Analysis Scenario Analysis
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Financial Management – Risk Analysis in Capital Budgeting CS Executive
CA. Pramod Prabhu. S.H, B.Sc, FCA, PGDBA, MCA, CISA (USA)

Helps assess impact of change in Input variable on Helps assess impact of change in input variable on
project outcome project outcome
impact of change in single Input variable on outcome Multiple input variable change considered based on
measured scenario – Recession/boom
helps identify the single most critical variable that can calculates outcome considering the scenario where all
impact the outcome variables change and hence more complex practically

8. X Ltd is considering project A with an initial outlay of Rs. 14 lakhs and three possible cash flows
attached with the project are:
(Rs in 000)
Particulars Year 1 Year 2 Year 3

Worst Case 450 400 700

Most Likely 550 450 800
Best Case 650 500 900
Assuming cost of capital to be 9%, determine NPV in each scenario. If XYZ is certain about most
likely result but uncertain about the third year’s cash flow, what will be the NPV expecting worst
scenario in third year? [PVF @ 9% are Year 1 – 0.917; Year 2 – 0.842 and Year 3 – 0.772]

Conventional Techniques – Decision tree analysis:

Need Earlier methods view current investments in isolation from subsequent decisions. However
practically investment decisions may have impact on future and further investment
decisions and events. Such situations can be handled by a sequence of decisions over a
period of time through decision tree technique
Meaning Graphical representation of relationship between future decisions and their consequence.
The sequence of events are shown in a format resembling branches of a tree, each branch
representing a single possible decision, its alternatives and probable result in terms of NPV/
ROI etc
Steps involved 1. Define Investment
2. Identify decision alternatives
3. Draw decision tree
4. Evaluate alternatives
Practical List out various paths with events and probabilities
Compute joint probability of each path
Compute (NPV x Joint Probability for that Path)
It total E (NPV) is positive, accept the project
Advantages 1. Sets out all options available and ensures that no option is left out
2. All options available are considered simultaneously thus allowing comparison
3. Risk addressed objectively using probabilities
4. Enables evaluation of options considering Cash inflow and outflow
5. Simple to understand and apply

Limitations 1. Probabilities cannot be calculated objectively

2. Uses only quantifiable data
3. Probability and expected value assignments does not have any relevant basis

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Financial Management – Risk Analysis in Capital Budgeting CS Executive
CA. Pramod Prabhu. S.H, B.Sc, FCA, PGDBA, MCA, CISA (USA)

9. A firm has an investment proposal requiring an outlay of Rs. 80000. The investment proposal is
expected to have two years’ economic life with no salvage value. In year 1 there is 0.40
probability that cash inflow after tax will be Rs. 50000 and 0.60 probability that cash inflow after
tax will be Rs. 60000. The probabilities assigned to cash flows after tax for year 2 are:
Year Cash Flow Probability Cash Flow Probability
1 50000 0.40 60000 0.60
2
24000 0.20 40000 0.40
32000 0.30 50000 0.50
44000 0.50 60000 0.10
The firm uses 10% discount rate for these kind of investments. Required:
(Note: 10% discount factor – Year 1: 0.909; Year 2: 0.826)
 Construct a decision tree for proposed investment project and calculate expected NPV
 What NPV will the project yield if worst outcome is realized? What is the probability for
occurrence of this NPV?
 What will the best outcome and probability of its occurrence?
 Will the project be accepted?

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