University of Kelaniya, Sri Lanka

Mr. W.D.J. Daminda Weerasinghe

M.Sc. in Management (USJP), B.B. Mgt (Sp) Finance (Kln)

Department of Finance

11/01/2023 Investment Decision - Risk Analysis 1

OUTLINE

 Background to the Risk Analysis

 Nature of risks

 Risk vs Uncertainty

 Types of project risks

 Techniques of risk analysis

 Statistical techniques

 Other techniques

11/01/2023 Investment Decision - Risk Analysis 2

Background to Investment Decision

Risk is inherent in almost every business decision. More so in capital budgeting decisions as they involve
costs and benefits extending over a long period, expected results can be changed.

So far, assumed that the proposed investment projects do not involve any risk, simply to facilitate the
understanding of the investment evaluation techniques.

Thus, in real world the projects are exposed to different degrees of risk.

11/01/2023 Investment Decision - Risk Analysis 3

NATURE of risks
 Risk exists because of the inability of the decision maker to make perfect forecasts.

 Suppose a firm is considering investing in a new products thus the demand of the product is very
sensitive to the general economic conditions. Investing will be profitable when the economy is
favorable and vice versa.

 But it is difficult to predict the future economic conditions and there by the cash flows associated
are uncertain.
NATURE of risks – Cont.,
There are three main broad categories that influence forecasts;

1. General Economic Conditions

Internal and external economic, political situations, monetary & fiscal policies and social condition, etc.

2. Industry Factors
Industrial relations, innovations, change in the material costs, etc.

3. Company Factors
Changes in the management, labor strikes, supply shortages, etc.

Therefore, it is the best practice to take cash flows based on few scenarios, without limiting to single cash
flow. Assigning probabilities to general conditions and take expected values.

11/01/2023 Investment Decision - Risk Analysis 5

Risk vs Uncertainty
 Some use these two terms interchangeably.

 Risk is associated with the variability of future returns of a project. The greater the variability of the
expected returns, riskier the project is.

 Risk is referred to a situation where the probability distribution of the cash flow of an investment
project is known.

 If no information is available to formulate a probability distribution of the cash flows, the situation is
known as uncertainty.

11/01/2023 Investment Decision - Risk Analysis 6

TYPES of project risk
There are three types of project risks and each is identified below;
1) Stand Alone Risk
This is the project’s total risk as measured by the variability of the project’s expected returns.

2) Corporate Risk
This is the project’s risk to the company’s portfolio of projects. It is measured by the project’s impact on
the variability of the firm’s future earnings.

3) Market (Beta) Risk

This is the risk of the project as viewed by a well-diversified stockholder. Hence, it is that part of the
project’s standalone risk that cannot be eliminated by diversification.
Risk that cannot be diversified away is often called systematic risk and it is measured by a beta coefficient.

11/01/2023 Investment Decision - Risk Analysis 7

TECHNIQUES of risk analysis

1) Statistical Techniques

Statistical techniques are analytical tools for handling risky investments, which enables the decision maker
to make decisions under risk or uncertainty.
1) Assigning Probability
2) Use of Standard Deviation
3) Use of Coefficient of Variation

11/01/2023 Investment Decision - Risk Analysis 8

TECHNIQUES of risk analysis – Cont.,

1) Assigning Probability
Probability may be described as a measure of someone’s opinion about the likelihood that an event will
occur. If an event is certain to occur, we say that it has a probability of 1 of occurring. If an event is certain
not to occur, we say that its probability occurring is zero.
One commonly used form employ only the high, low and best guess estimates, or the optimistic, most
likely and pessimistic estimates. For example, annual CFs expected from a project could be as follows;
Scenario Cash Flows
Best Scenario (Optimistic) 200,000
Neutral Scenario (Most likely) 150,000
Weak Scenario (Pessimistic) 75,000

11/01/2023 Investment Decision - Risk Analysis 9

TECHNIQUES of risk analysis – Cont.,

It can easily be understood that this is an improvement over the single figure forecast. What does the forecaster feel
about the occurrence of these estimates? Are these forecasts are likely to be equal?
Therefore, it should describe the probability of these estimates of occurring. For example, the following probabilities
can be assigned;
Scenario Cash Flows Probability
Best Scenario (Optimistic) 200,000 0.20
Neutral Scenario (Most likely) 150,000 0.60
Weak Scenario (Pessimistic) 75,000 0.20

Once the probability assignments have been made to the future cash flows the next step is to find out the expected
value. The expected values so calculated are then discounted to find out the Expected Net Present Value (ENPV) of the
cash flows.

11/01/2023 Investment Decision - Risk Analysis 10

TECHNIQUES of risk analysis – Cont.,

2) Use of Standard Deviation

Although, through the calculation of the expected NPV, the risk is explicitly incorporated, yet a better into
the risk analysis will be obtained if we find out the dispersion of cash flows. It shows the dispersion of
cash flows indicates the degree of risk. A commonly used measure of risk is the standard deviation and
variance.

The formula to calculate variance or standard deviation is as follows;

Variance = Σ𝑝 (𝑥−𝑋)2
Standard Deviation = √Σ𝑝 (𝑥−𝑋)2
Higher the Standard Deviation, higher the risk of the CFs moving away from the mean value.
11/01/2023 Investment Decision - Risk Analysis 11
TECHNIQUES of risk analysis – Cont.,

3) Coefficient of Variation
Relative measure of risk is the coefficient of variation. It is calculated as follows;

Coefficient of Variation = Standard Deviation

Expected Value

This method is a useful measurement of risk when we are comparing the projects , which are either
similar in standard deviation or expected value or both.

11/01/2023 Investment Decision - Risk Analysis 12

TECHNIQUES of risk analysis – Cont.,

2) Other Techniques

A number of other techniques to handle risk are used by managers in practice. They are;

1) Sensitivity Analysis
2) DCF Break even Analysis
3) Scenario Analysis
4) Monte Carlo Simulation

11/01/2023 Investment Decision - Risk Analysis 13

TECHNIQUES of risk analysis – Cont.,

1) Sensitivity Analysis
Sensitivity analysis is a way of analyzing change in the project’s NPV or IRR for a given change in one of
the variables. In applying sensitivity analysis, the key variables are changed one at a time to observe the
resulting change in the NPV or IRR.

Sensitivity analysis always look at the pessimistic side of a project. Although, the sensitivity analysis is very
widely used, it has following limitations;
 Each variable has to be considered in isolation whilst keeping all else constant.
 Difficulty in identifying variables to be changed
 It fails to focus on the interrelationship between variables
11/01/2023 Investment Decision - Risk Analysis 14
TECHNIQUES of risk analysis – Cont.,

2) DCF Break even Analysis

Sensitivity analysis is a variation of the break-even analysis. Simply, to NPV become zero, how much the
variables can be reduced or increased. This analysis is important in the highly competitive markets, to get
to know how much we can reduce or increase the variables until break evens.

3) Scenario Analysis
Sensitivity analysis assumes that the variables are independent. In practice, the variables will be
interrelated. One way out is to analyze the impact of alternative combinations of variables. The decision
maker can develop some scenarios to carry out the analysis.
This might affect two or three variables at the same time.
11/01/2023 Investment Decision - Risk Analysis 15
TECHNIQUES of risk analysis – Cont.,

4) Mote Carlo Simulation

Monte Carlo simulation is a further attempt to model real-world uncertainty.
This is a more sophisticated form of scenario analysis and sensitivity analysis, which produces, in theory,
an infinite number of outcomes. Each individual variable is allowed to vary between its best- and worst-
case values. A value for each variable is then picked at random from its permitted range and the resulting
cash flows and NPV for the project are calculated. The process is repeated over and over again to produce
lots of possible NPV’s. Finally, the mean, standard deviation and coefficient of variation of these possible
NPVs are calculated to indicate the expected return and risk of the project.
Monte Carlo Simulation is a useful technique but is a relatively complex procedure requiring a reasonably
powerful computer and efficient software.
11/01/2023 Investment Decision - Risk Analysis 16
 Thank You

11/01/2023 Investment Decision - Risk Analysis 17