THE CVM UNIVERSITY

Faculty of Commerce, Management and Law

S. G. M. English Medium College of Commerce and Management (SEMCOM)
A Constituent College of CVM University

M.COM Semester –II Paper Code: PPFM Paper Title: Principles and Practices of
Financial Management

Module Title/Topic Content

No. Session
5 Risk Analysis in Capital Budgeting 12
 Nature of Risk
 Statistical techniques for Risk Analysis
1. Probability
2. Expected NPV
3. Standard Deviation & Coefficient of variation
 Conventional techniques for Risk Analysis
1. Risk-Adjusted Discount Rate Approach
2. Certainty Equivalent Approach
3. Sensitivity Analysis
4. Decision – Tree Analysis

Nature of Risk
Introduction

Risk analysis gives management better information about the possible outcomes that may occur
so that management can use their judgment and experience to accept an investment or reject it.
Risk and uncertainty are quite inherent in capital budgeting decisions. This is so because
investment decisions and capital budgeting are actions of today which bear fruits in future which
is unforeseen. Future is uncertain and involves risk. The projection of probability of cash inflows

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made today is not certain to be achieved in the course of future. Seasonal fluctuations and
business cycles both deliver heavy impact upon the cash inflows and outflows projected for
different project proposals. The cost of capital which offers cut-off rates may also be inflated or
deflated under business cycle conditions. Inflation and deflation are bound to effect the
investment decision in future period rendering the degree of uncertainty more severe and
enhancing the scope of risk. Technological developments are other factors that enhance the
degree of risk and uncertainty by rendering the plants or equipment’s obsolete and the product
out of date. Tie up in the procurement in quantity and/or the marketing of products may at times
fail and frustrate a business unless possible alternative strategies are kept in view. All these
circumstances combined together affect capital budgeting decisions. It is therefore necessary to
allow discounting factor to cover risk. One way to compare risk in alternative proposals is the
use of Standard Deviation. Lower standard deviation indicates lower risk. However, wherever
returns are expressed in revenue terms the co-efficient of variation gives better measurement for
risk evaluation.

Nature of Risk
Risk is defines as an event having adverse impact on profitability and/or reputation due to
several distinct source of uncertainty.
Risk is defined in financial terms as the chance that an outcome or investment's actual gains will
differ from an expected outcome or return. Risk includes the possibility of losing some or all of
an original investment. Risk is the variability in terms of actual returns comparing with the
estimated returns.

1. Situational: Changes in a situation can result in new risks. Such changes include replacing a
team member, undergoing reorganization, changing the scope of the project.
2. Time-based: In this case, the probability of the risk occurring at the beginning of the project
is very high (due to the unknown factor), and diminishes along as the project progresses. In
contrast, the impact (cost) from a risk occurring is low at the beginning and higher at the end.
3. Interdependence: Within a project, many tasks and deliverables are interdependent on each
other. These delays in these tasks will have a cascading effect on the other related tasks, and
the result could be a domino effect.

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4. Magnitude Dependent: The relationship between probability and impact is not linear in this
case, and the magnitude of the risk makes a lot of difference. For example, consider the risk
of spending $1 for a 50/50 chance to win $5 versus the risk of spending $1000 for a 50/50
chance of winning $5000. Since the probability of loss is the same in both cases (50%), the
opportunity cost of losing is much greater in the latter case.
5. Value-Based: The risk may be affected by personal, corporate or cultural values. For
example, completing a project on schedule may be dependent on the time of the year and the
nationalities or religious beliefs of the work team. Projects being done in international
locations where multiple cultures are involved may have a higher risk than those done in a
single location with a similar kind of workforce.
6. Risk measurement: Most common techniques of risk measurement are Standard Deviation
and Coefficient of variations. There is a thin difference between risk and uncertainty. In case
of risk, probability distribution of cash flow is known. When no information is known to
formulate probability distribution of cash flows, the situation is referred as uncertainty.
However, these two terms are used interchangeably
7. Risk and Return: A fundamental idea in finance is the relationship between risk and return.
The greater the amount of risk an investor is willing to take, the greater the potential return.
Risks can come in various ways and investors need to be compensated for taking on
additional risk

In this way

 Business risks arise due to uncertainties.

 Risk can be minimized, but cannot be eliminated. It is an essential part of business.
 Degree of risk depends mainly upon the nature and size of business:
 Profit is the reward for risk-taking.

Sources/Types of risk
Risk arises from different sources, depending on the type of investment being considered, as well
as the circumstances and the industry in which the organisation is operating. Some of the sources
of risk are as follows

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1. Project-specific risk- Risks which are related to a particular project and affects the project’s
cash flows, it includes completion of the project in scheduled time, error of estimation in
resources and allocation, estimation of cash flows etc. For example, a nuclear power project of a
power generation company has different risks than hydel projects.

2. Company specific risk- Risk which arise due to company specific factors like downgrading
of credit rating, changes in key managerial persons, cases for violation of intellectual property
rights (IPR) and other laws and regulations, dispute with workers etc. All these factors affect the
cash flows of an entity and access to funds for capital investments. For example, two banks have
different exposure to default risk.

3. Industry-specific risk- These are the risks which effect the whole industry in which the
company operates. The risks include regulatory restrictions on industry, changes in technologies
etc. For example, regulatory restriction imposed on leather and breweries industries.

4. Market risk – The risk which arise due to market related conditions like entry of substitute,
changes in demand conditions, availability and access to resources etc. For example, a thermal
power project gets affected if the coal mines are unable to supply coal requirements of a thermal
power company etc.

5. Competition risk- These are risks related with competition in the market in which a company
operates. These risks are risk of entry of rival, product dynamism and change in taste and
preference of consumers etc.

6. Risk due to Economic conditions – These are the risks which are related with macro-
economic conditions like changes monetary policies by central banks, changes in fiscal policies
like introduction of new taxes and cess, inflation, changes in GDP, changes in savings and net
disposable income etc.

7. International risk – These are risk which are related with conditions which are caused by
global economic conditions like restriction on free trade, restrictions on market access,
recessions, bilateral agreements, political and geographical conditions etc. For example,
restriction on outsourcing of jobs to overseas markets.

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Statistical techniques of risk analysis

Techniques of risk analysis in capital budgeting can be classified as below:

Probability
Meaning: Probability is a measure about the chances that an event will occur. When an event is
certain to occur, probability will be 1 and when there is no chance of happening an event
probability will be 0.
Example:

In the above example chances that cash flow will be 3,00,000, 2,00,00 and 1,00,00 are 30%,60%
and 10% respectively
The concept of probability is fundamental to the use of the risk analysis techniques. It may be
defined as the likelihood of occurrence of an event. If an event is certain to occur, the probability
of its occurrence is one but if an event is certain not to occur, the probability of its occurrence is
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zero. Thus, probability of all events to occur lies between zero and one. Probability distribution
can be used to compute expected values. For this purpose following procedure is adopted: Step
1: Establish probability distribution Step 2: Multiply values with probability of each outcome
Step 3: Aggregate the result of Step 2

Illustration: X Ltd. is considering to start a new project for which it has gathered following data:

Expected Net Present Value

Expected net present value = Sum of present values of expected net cash flows

Where, ENPV is the expected net present value, ENCF, expected net cash flows
(Including both inflows and outflows) in period t and k is the discount rate.

(a) Expected Net Present Value- Single period

ILLUSTRATION 1
Possible net cash flows of Projects A and B at the end of first year and their probabilities are
given as below. Discount rate is 10 per cent. For both the project initial investment is ` 10,000.

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From the following information, CALCULATE the expected net present value for each project.
State which project is preferable?

SOLUTION
Calculation of Expected Value for Project A and Project B

The net present value for Project A is (0.909 × Rs. 12,000 – Rs. 10,000) = Rs. 908
The net present value for Project B is (0.909 × Rs. 16,000 – Rs. 10,000) = 4,544.

(b) Expected Net Present Value- Multiple period

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ILLUSTRATION 2
Probabilities for net cash flows for 3 years of a project are as follows:

CALCULATE the expected net cash flows. Also calculate net present value of the project using
expected cash flows using 10 per cent discount rate. Initial Investment is Rs. 10,000.

SOLUTION

The present value of the expected value of cash flow at 10 per cent discount rate has been
determined as follows:

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 Standard Deviation
Standard Deviation is a degree of variation of individual items of a set of data from its average.
The square root of variance is called Standard Deviation. For Capital Budgeting decisions,
Standard Deviation is used to calculate the risk associated with the estimated cash flows from the
project.

CALCULATE Variance and Standard Deviation on the basis of following information:

Calculation of Expected Value for Project A and Project B

SOLUTION

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Project A
Variance (σ2) = (8,000 – 12,000)2 × (0.1) + (10,000 -12,000)2 × (0.2) + (12,000 –
12000)2 × (0.4) + (14,000 – 12,000)2 × (0.2) + (16000 – 12,000)2 × (0.1)
= 16,00,000 + 8,00,000 + 0 + 8,00,000 + 16,00,000 = 48,00,000

Project B:
Variance (σ2) = (24,000 – 16,000)2 × (0.1) + (20,000 – 16,000)2 × (0.15) + (16,000 –
16,000)2 × (0.5) + (12,000 – 16,000)2 × (0.15) + (8,000 – 16,000)2 × (0.1)
= 64,00,000 + 24,00,000 + 0 + 24,00,000 + 64,00,000 = 1,76,00,000

The Coefficient of Variation

The standard deviation is a useful measure of calculating the risk associated with the estimated
cash inflows from an Investment. However, in Capital Budgeting decisions, the management is
several times faced with choosing between many investments avenues. Under such situations, it
becomes difficult for the management to compare the risk associated with different projects
using Standard Deviation as each project has different estimated cash flow values. In such cases,

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the Coefficient of Variation becomes useful. The Coefficient of Variation calculates the risk
borne for every percent of expected return. It is calculated as:

The Coefficient of Variation enables the management to calculate the risk borne by the concern
for every unit of estimated return from a particular investment. Simply put, the investment
avenue which has a lower ratio of standard deviation to expected return will provide a better risk
– return trade off. Thus, when a selection has to be made between two projects, the management
would select a project which has a lower Coefficient of Variation.
ILLUSTRATION 4
CALCULATE Coefficient of Variation based on the following information:

SOLUTION
Calculation of Expected Value for Project A and Project B

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In project A risk per rupee of cash flow is Rs. 0.15while in project B it is Rs. 0.23. Therefore
Project A is better than Project B.
CONVENTIONAL TECHNIQUES

Risk Adjusted Discount Rate

The use of risk adjusted discount rate (RADR) is based on the concept that investors demands
higher returns from the risky projects. The required rate of return on any investment should
include compensation for delaying consumption plus compensation for inflation equal to risk
free rate of return, plus compensation for any kind of risk taken. If the risk associated with any
investment project is higher than risk involved in a similar kind of project, discount rate is
adjusted upward in order to compensate this additional risk borne.

Where,
NCFt = Net cash flow
K = Risk adjusted discount rate.
I = Initial Investment
A risk adjusted discount rate is a sum of risk free rate and risk premium. The Risk Premium
depends on the perception of risk by the investor of a particular investment and risk aversion of
the Investor. So Risks adjusted discount rate = Risk free rate+ Risk premium
Risk Free Rate: It is the rate of return on Investments that bear no risk. For e.g., Government
securities yield a return of 6 % and bear no risk. In such case, 6 % is the risk-free rate.
Risk Premium: It is the rate of return over and above the risk-free rate, expected by the
Investors as a reward for bearing extra risk. For high risk project, the risk premium will be high
and for low risk projects, the risk premium would be lower.
ILLUSTRATION 5

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An enterprise is investing Rs. 100 lakhs in a project. The risk-free rate of return is 7%. Risk
premium expected by the Management is 7%. The life of the project is 5 years. Following are the
cash flows that are estimated over the life of the project.
Years Cash flows (Rs. in lakhs)
1 25
2 60
3 75
4 80
5 65
CALCULATE Net Present Value of the project based on Risk free rate and also on the basis of
Risks adjusted discount rate.

SOLUTION

The Present Value of the Cash Flows for all the years by discounting the cash flow at 7% is
calculated as below:

Now when the risk-free rate is 7% and the risk premium expected by the Management is 7%. So
the risk adjusted discount rate is 7% + 7% =14%. Discounting the above cash flows using the
Risk Adjusted Discount Rate would be as below:

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 Certainty Equivalent (CE) Method for Risk Analysis
Certainty equivalent method –Definition: As per CIMA terminology, “An approach to dealing
with risk in a capital budgeting context. It involves expressing risky future cash flows in terms of
the certain cashflow which would be considered, by the decision maker, as their equivalent, that
is the decision maker would be indifferent between the risky amount and the (lower) riskless
amount considered to be its equivalent.”

The certainty equivalent is a guaranteed return that the management would accept rather than
accepting a higher but uncertain return. This approach allows the decision maker to incorporate
his or her utility function into the analysis. In this approach a set of risk less cash flow is
generated in place of the original cash flows.

Steps in the Certainty Equivalent (CE) approach

Step 1: Remove risks by substituting equivalent certain cash flows from risky cash flows. This
can be done by multiplying each risky cash flow by the appropriate α t value (CE coefficient)

Suppose on tossing out a coin, if it comes head you will get Rs.10,000 and if it comes out to be
tail, you will win nothing. Thus, you have 50% chance of winning and expected value is
Rs.5,000. In such case if you are indifferent at receiving Rs.3,000 for a certain amount and not

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playing then Rs.3,000 will be certainty equivalent and 0.3 (i.e. 3,000/10,000) will be certainty
equivalent coefficient.

Step 2: Discounted value of cash flow is obtained by applying risk less rate of interest. Since you
have already accounted for risk in the numerator using CE coefficient, using the cost of capital to
discount cash flows will tantamount to double counting of risk.

Step 3: After that normal capital budgeting method is applied except in case of IRR method,
where IRR is compared with risk free rate of interest rather than the firm’s required rate of
return. Certainty Equivalent Coefficients transform expected values of uncertain flows into their
Certainty Equivalents. It is important to note that the value of Certainty Equivalent Coefficient
lies between 0 & 1. Certainty Equivalent Coefficient 1 indicates that the cash flow is certain or
management is risk neutral. In industrial situation, cash flows are generally uncertain and
managements are usually risk averse. Under this method

Where, NCFt = the forecasts of net cash flow for year ‘t’ without risk-adjustment αt = the risk-
adjustment factor or the certainly equivalent coefficient. Kf = risk-free rate assumed to be
constant for all periods. I = amount of initial Investment.
ILLUSTRATION 6: If Investment proposal is Rs. 45,00,000 and risk free rate is 5%,
CALCULATE net present value under certainty equivalent technique.

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Advantages of Certainty Equivalent Method

1. The certainty equivalent method is simple and easy to understand and apply.

2. It can easily be calculated for different risk levels applicable to different cash flows. For
example, if in a particular year, a higher risk is associated with the cash flow, it can be easily
adjusted and the NPV can be recalculated accordingly.

Disadvantages of Certainty Equivalent Method

1. There is no objective or mathematical method to estimate certainty equivalents. Certainty

Equivalents are subjective and vary as per each individual’s estimate.

2. Certainty equivalents are decided by the management based on their perception of risk.
However, the risk perception of the shareholders who are the money lenders for the project is
ignored. Hence it is not used often in corporate decision making.

Sensitivity Analysis
Definition of sensitivity analysis: As per CIMA terminology,” A modeling and risk assessment
procedure in which changes are made to significant variables in order to determine the effect of
these changes on the planned outcome.

Particular attention is thereafter paid to variables identifies as being of special significance”

Sensitivity analysis put in simple terms is a modeling technique which is used in Capital
Budgeting decisions which is used to study the impact of changes in the variables on the
outcome of the project. In a project, several variables like weighted average cost of capital,
consumer demand, price of the product, cost price per unit etc. operate simultaneously. The
changes in these variables impact the outcome of the project. It therefore becomes very difficult
to assess change in which variable impacts the project outcome in a significant way. In
Sensitivity Analysis, the project outcome is studied after taking into change in only one
variable. The more sensitive is the NPV, the more critical is that variable. So, Sensitivity
analysis is a way of finding impact in the project’s NPV (or IRR) for a given change in one of
the variables.

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Steps involved in Sensitivity Analysis

Sensitivity Analysis is conducted by following the steps as below:

1. Finding variables, which have an influence on the NPV (or IRR) of the project

2. Establishing mathematical relationship between the variables.

3. Analysis the effect of the change in each of the variables on the NPV (or IRR) of the project.

ILLUSTRATION 7
X Ltd is considering its New Product ‘with the following details

Required: 1. CALCULATE the NPV of the project. 2. COMPUTE the impact on the project’s
NPV of a 2.5 per cent adverse variance in each variable. Which variable is having maximum
effect .Consider Life of the project as 3 years?
SOLUTION
1. Calculation of Net Cash Inflow per year:

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Here NPV represent the most likely outcomes and not the actual outcomes. The actual outcome
can be lower or higher than the expected outcome.

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The above table shows that the by varying one variable at a time by 2.5% while keeping the
others constant, the impact in percentage terms on the NPV of the project. Thus it can be seen
that the change in selling price has the maximum effect on the NPV by 24.82 %.

Advantages of Sensitivity Analysis:

Following are main advantages of Sensitivity Analysis

1) Critical Issues: This analysis identifies critical factors that impinge on a project’s success or
failure.

2) Simplicity: It is a simple technique.

Disadvantage of Sensitivity Analysis:

Following are main disadvantages of Sensitivity Analysis

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(1) Assumption of Independence: This analysis assumes that all variables are independent i.e.
they are not related to each other, which is unlikely in real life.

(2) Ignore probability: This analysis does not look to the probability of changes in the variables.

Decision Tree Analysis

Investment decisions may have implications for future or further investment decisions, and may
also impact future decision and events. Such situation can be handled by taking a sequence of
decisions over a period of time. The technique to handle this type of sequential decisions is done
Through “Decision Tree” technique.

A Decision tree is a graphical representation of relationship between future decisions and their
consequences. The sequence of events is shown in a format resembling branches of tree, each
branch representing a single possible decision, its alternatives and the probable result in terms of
NPV, ROI etc. The alternative with the highest amount of expected monetary value is selected.

Assumption in Decision Tree Analysis

This approach assumes that there are only two types of situation that a finance manager has to
face.
1. The first situation is where the manager has control or power to determine what happens next.
This is known as “Decision”, as he can do what he desires to do.
2. The second situation is where finance manager has no control over what happens next. This is
known as “Event”. Since the outcome of the events is not known, a probability distribution needs
to be assigned to the various outcomes or consequences.
3. When a finance manager faced with a decision situation, he is assumed to act rationally. For
example, in a commercial business, he will choose the most profitable course of action and in
non-profit organization; the lowest cost may be rational choice.
Steps involved in Decision Tree analysis:

Step 1- Define Investment: Decision three analysis can be applied to a variety of business
decision-making scenarios. Normally it includes following types of decisions.

 Whether or not to launch a new product, if so, whether this launch should be local, national,
or international. or by out sourcing it to an external supplier.
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 Whether to dig for oil or not if so, upto what height and continue to dig even after finding no
oil upto a certain depth.

Step 2- Identification of Decision Alternatives: It is very essential to clearly identity decision

alternatives. For example, if a company is planning to introduce a new product, it may be local
launch, national launch or international launch.

Step 3- Drawing a Decision Tree: After identifying decision alternatives, at the relevant data
such as the projected cash flows, probability distribution expected present value etc. should be
put in diagrammatic form called decision tree. While drawing a decision tree, it should be noted
that NPVs etc. should be placed on the branches of decision tree, coming out of the decisions
identified.

While drawing a decision tree, it should be noted that:-

 The decision point (traditionally represented by square (⭕), is the option available for
manager to take or not to take. This is known as decision node.
 The event or chance or outcome (traditionally represented by circle (◯) which is dependent
on chance process, along with the probabilities thereof, and monetary value associated with
them. This is known as chance node
 This diagram is drawn from left to right.

Step 4- Evaluating the Alternatives: After drawing out the decision the next step is the
evaluation of alternatives. The various alternatives can be evaluated as follows:

(i) This procedure is carried out from the last decision in the sequence (extreme right) and goes
on working back to the first (left) for each of the possible decision.

(ii) At each final stage decision point, select the alternative which has the highest NPV and
truncate the other alternatives. Each decision point is assigned a value equal to the NPV of the
alternative selected at the decision point.

(iii) Proceed backward in the same manner calculating the NPV at chance or event or outcome
points (◯) selecting the decisions alternative which has highest NPV at various decision points

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(⭕) rejecting the inferior decision option, assigning NPV to the decision point, till the first
decision point is reached.

ILLUSTRATION 10

A firm has an investment proposal, requiring an outlay of Rs. 80,000. The investment proposal is
expected to have two years’ economic life with no salvage value. In year 1, there is a 0.4
probability that cash inflow after tax will be Rs. 50,000 and 0.6 probability that cash inflow after
tax will be Rs.60,000. The probability assigned to cash inflow after tax for the year 2 is as
follows :

The firm uses a 10% discount rate for this type of investment.

Required: (i) Construct a decision tree for the proposed investment project and calculate the
expected net present value (NPV). (ii) What net present value will the project yield, if worst
outcome is realized? What is the probability of occurrence of this NPV? (iii) What will be the
best outcome and the probability of that occurrence? (iv) Will the project be accepted? (Note:
10% discount factor 1 year 0.909; 2 years 0.826)

Solution

(i) The decision tree diagram is presented in the chart, identifying various paths and outcomes,
and the computation of various paths/outcomes and NPV of each path are presented in the
following tables:

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The Net Present Value (NPV) of each path at 10% discount rate is given below:

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(ii) If the worst outcome is realized the project will yield NPV of – Rs. 14,726. The Probability
of occurrence of this NPV is 8% and a loss of Rs. 1,178 (path 1). (iii) The best outcome will be
path 6 when the NPV is at ` 24,100. The probability of occurrence of this NPV is 6% and an
expected profit of Rs. 1,446. (iv) The project should be accepted because the expected NPV is
positive at ` 6,223.76 based on joint probability

Advantages of using decision trees

1. The Decision nodes enable to set out the various options available thus ensuring that no option
is left out to be considered.
2. All the options available can are considered simultaneously thus allowing comparison.
3. Risk is addressed in an objective manner by use of probabilities.
4. Decision Trees enable the evaluation of the options by considering the Cash Outflows and the
Cash Inflows. Thus it enables to evaluate the different options on the basis of the Net benefit
arising out of that project.
5. Simple to understand and apply.
Limitations of using decision trees

1. Probabilities cannot be calculated objectively.

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2. Decision Trees use only that data which can be quantified. It ignores qualitative aspects of
decisions.
3. Assignment of probabilities and expected values do not have any relevant basis as it pertains
to a future outcome which is uncertain.
Illustration -2

A company has the following estimate of the present values of the future cash flow after
taxes associate with the investment proposal concern with expanding the plant capacity. It
intends to use a decision tree analysis approach to get a clear picture of the possible
outcomes of this investment . The plants expansion is expected to coast Rs. 300000. The
respective PVs of the future CFAT and Probability are as follows:

Present Value of Future CFAT:

With Expansion Without expansion Probability (Pi)

300000 200000 0.2
500000 200000 0.4
900000 350000 0.4
1.00
Advise the company regarding the financial feasibility of the project

1. Draw a decision tree

2. Assign route number
3. Calculation of NPV

Step-1 Preparation of decision Tree

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Step-2

From above we observed that with expansion company earns Rs.320000. If the company is not
expanding at that capacity, the current NPV benefit is Rs.260000. The difference of benefits
with expansion is Rs. 60000. Suppose the company pays 10% cost of capital on Rs. 300000 even
though company earns 30000 additionally.

*******

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