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Risk Analysis in Capital Budgeting

The document discusses various methods for incorporating risk into capital budgeting decisions, including adjusting the discount rate, using certainty equivalent factors to adjust cash flows, sensitivity analysis using multiple scenarios, assigning probabilities to possible cash flows, calculating standard deviation to measure risk, and using decision tree analysis to evaluate sequential decisions under uncertainty. It also provides an example comparing investments X and Y using risk-adjusted discount rates to determine which has a higher expected return.

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RajyaLakshmi
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171 views21 pages

Risk Analysis in Capital Budgeting

The document discusses various methods for incorporating risk into capital budgeting decisions, including adjusting the discount rate, using certainty equivalent factors to adjust cash flows, sensitivity analysis using multiple scenarios, assigning probabilities to possible cash flows, calculating standard deviation to measure risk, and using decision tree analysis to evaluate sequential decisions under uncertainty. It also provides an example comparing investments X and Y using risk-adjusted discount rates to determine which has a higher expected return.

Uploaded by

RajyaLakshmi
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Risk Analysis in Capital

Budgeting
Why the concept of risk arises?
 Capital budgeting requires the projection of
cash inflow and outflow of the future.
 The future in always uncertain, estimate of
demand, production, selling price, cost etc.,
Cannot be exact.
 For example: The product at any time it
become obsolete therefore, the future in
unexpected, where the concept of risk arises.
 The following are the methods used for
accounting of risk in capital budgeting.
Incorporating Risk into
Capital Budgeting
Methods:
 Risk-Adjusted Discount Rate
 Certainty Equivalent Approach
 Sensitivity technique
 Probability technique
 Standard deviation method
 Decision tree analysis
How can we adjust this model to
take risk into account?
n


ACFt
NPV = - Co
(1 + k) t
t=1
How can we adjust this model to
take risk into account?
n


ACFt
NPV = - IO
(1 + k) t
t=1
 Adjust the discount rate (k).
 The Ramakrishna Ltd., in considering the purchase
of a new investment. Two alternative investments are
available (X and Y) each costing Rs. 150000. Cash
inflows are expected to be as follows:
Year Investment X Investment Y

1 60,000 65,000
2 45,000 55,000
3 35,000 40,000
4 30,000 40,000
 The company has a target return on capital of 10%.
Risk premium rate are 2% and 8% respectively for
investment X and Y. Which investment should be
preferred?
Certainty Equivalent Approach
 Adjusts the risky after-tax cash flows
to certain cash flows.
 The idea:

Risky Certainty Certain


Cash X Equivalent = Cash
Flow Factor (a) Flow
Certainly equivalent method
Certainty Equivalent Approach

 simplest method
 Reduces the risk and uncertainty in
decision making by employing only
certain cash flows through certainty
equivalent coefficient factor.
= certain cash flows / expected
cash flows
Sensitivity technique

 When cash inflows are sensitive under different


circumstances more than one forecast of the future
cash inflows may be made.
 These inflows may be regarded on ‘Optimistic’,
‘most likely’ and ‘pessimistic’. Further cash inflows
may be discounted to find out the net present values
under these three different situations.
 If the net present values under the three situations
differ widely it implies that there is a great risk in the
project and the investor’s is decision to accept or
reject a project will depend upon his risk bearing
activities.
 Mr. Selva is considering two mutually exclusive project
‘X’ and ‘Y’. You are required to advise him about the
acceptability of the projects from the following
information.
Probability Technique
 refers to the each event of future happenings are
assigned with relative frequency probability.
 Probability means the likelihood of future event.
 Expected cash inflow * probability = Actual cash
flows
 Actual cash flows are discounted .
 Out of all available projects, the project with
higher net present value may be accepted.
 Two mutually exclusive investment proposals
are being considered. The following information
in available. Cost of each project is Rs 10,000/-
Standard Deviation

 Two Projects have the same cash outflow and


their net values are also the same,
 standard deviation of the expected cash
inflows of the two Projects may be calculated
to measure the comparative and risk of the
Projects.
 The project having a higher standard deviation
in said to be more risky as compared to the
other.
Decision Tree analysis
 It is helpful for taking risky and complex decisions
 Because it consider all the possible outcomes and each
possible outcomes are assigned with the probability.
 Project requires decisions to be made in sequential parts.

Construction of Decision Tree


 1. Define the problem
 2. Evaluate the different alternatives
 3. Indicating the decision points
 4. Assign the probabilities of the monetary values
 5. Analysis the alternatives.
 Accept/Reject criteria: If the net present values are positive
the project may be accepted otherwise it is rejected.

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