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Risk Analysis in Capital Budgeting

Presentation · February 2018

DOI: 10.13140/RG.2.2.21007.07847

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Risk Analysis in Capital Budgeting

By Dr. Jagdish Raj Saini

 CONTENTS
• Sources and Perspectives on Risk,
• Sensitivity Analysis,
• Scenario Analysis,
• Break-even Analysis,
• Hillier Model,
• Managing Risk,
• Project selection under Risk
 Risk and Capital Budgeting
• Capital budgeting decisions involve costs and benefits extending over a
longer time horizon.

• During this many things can change in unanticipated ways.

• All investments being considered for inclusion in the capital budget has
the same risk as those of the existing investments of the firm. – A
simplifying assumption.

• This explains the usage of average cost of capital for project evaluation.

• Projects though differ in risk propositions and hence variations in risk

need to be evaluated explicitly in capital investment appraisal.
 TECHNIQUES FOR RISK ANALYSIS

Techniques of risk
analysis

Analysis of stand- Analysis of

alone risk contextual risk

Sensitivity Scenario Corporate Market risk

analysis analysis risk analysis analysis

Break-even Hillier
analysis model

Simulation Decision tree

analysis analysis
 Sources of Project Risk
• Project specific risk: Earnings and cash flows of the project may be lower than
expected because of estimation error or some factors specific to the project.

• Competitive risk: Earnings and cash flows being affected by unanticipated

actions of competitors.

• Industry specific risk: Unexpected technological developments and regulatory

changes within the project related industry will have an impact on its earnings
and cash flows.

• Market risk: Changes in macro-economic variables like GDP growth rate,

interest rate and inflation have an impact on all projects, though in varying
degrees.

• International risk: In case of a foreign project, the earnings and cash flows may
be different than expected due to exchange rate risk or political risk.
 Perspectives of Project Risk
• Stand-alone risk: This represents the risk of a project when it is
viewed in isolation.
• Corporate risk: Represents the contribution of a project to risk of
the firm.
• Market risk: Risk of a project from the point of view of a
diversified investor. It is also called systematic risk.

• Primary goal of firm being maximizing shareholder value, thus

risk that a project imposes on shareholders assumes real
significance.

• If shareholders are well diversified, market risk is the most

appropriate measure of risk.
 Significance of Stand-alone Project Risk
• Measuring a project’s stand-alone risk is relatively less complex
than measuring its corporate risk and market risk.

• In most of the cases stand-alone risk, corporate risk and market

risk are highly correlated.

• Proponent of a capital investment is likely to be judged on

performance of that investment.

• In most firms, the capital budgeting committee considers

investment proposals one at a time.
 Significance of Corporate Risk
• Undiversified shareholders (like promoters) are more concerned
about corporate risk than market risk.

• Diversified investors consider corporate risk in addition to market

risk when they specify requirement.

• Stability of overall corporate cash flows and earnings is valued by

all stakeholders of the firm.
 Sensitivity Analysis
• Evaluation of an investment project – Forecast of cash flows – Expected
revenue and costs.
• Expected revenue : Sales volume and unit selling price – Market size and firm’s
market share.
• Costs: variable costs (sales volume and unit VC) and fixed costs.
• NPV or IRR – After tax cash flows – Combined forecasts of various variables.
• Reliability of NPV or IRR – Reliability of the forecasts of variables underlying
the estimates of net cash flows.

• Sensitivity analysis is a way of analysing change in the project’s NPV (or IRR)
for a given change in one of the variables.

• The decision maker, while performing sensitivity analysis, computes the

project’s NPV (or IRR) for each forecast under three assumptions:
– pessimistic,
– expected, and
– optimistic.
 Sensitivity Analysis
• The following three steps are involved in the use of sensitivity analysis:

1. Identification of all those variables, which have an influence on the project’s

NPV (or IRR).
2. Definition of the underlying (mathematical) relationship between the
variables.
3. Analysis of the impact of the change in each of the variables on the project’s
NPV.

• Sensitivity analysis is also knows as ‘What if’ analysis as it allows decision

maker to ask ‘What if’ Questions. For Example:

1. What (is the NPV) if volume increases or decreases?

2. What (is the NPV) if selling price increases or decreases?
3. What (is the NPV) if variable cost or fixed cost increases or decreases?
4. What (is the NPV) if project is delayed or outlay escalates?
5. What (is the NPV) if project’s life is more or less than anticipated?
 SENSITIVITY ANALYSIS
(‘000)
YEAR 0 YEAR 1 - 10
1. INVESTMENT (20,000)
2. SALES 18,000
3. VARIABLE COSTS (66 2/3 % OF SALES) 12,000
4. FIXED COSTS 1,000
5. DEPRECIATION 2,000
6. PRE-TAX PROFIT 3,000
7. TAXES 1,000
8. PROFIT AFTER TAXES 2,000
9. CASH FLOW FROM OPERATION (8 + 5) 4,000
10. NET CASH FLOW 4,000
 Sensitivity Analysis
• NPV of the proposed plant
(200,00,000) + 40,00,000 (PVIFA12%, 10)
= (200,00,000) + 40,00,000 (5.650)
= Rs. 26,00,000

• NPV based on expected values of underlying key variables is

positive and acceptable.

• To explore the effect of possible variations in variables on NPV,

define optimistic and pessimistic estimates of these variables.

• Based on such estimates, specific NPVs for optimistic and

pessimistic scenarios can be arrived at.
 Sensitivity Analysis
• One variable (i.e. IDV) is varied at a time keeping others constant,
to study the impact of its variations on project NPV (i.e. DV).
IDV: Independent Variable, DV: Dependent Variable
in Rs. million

Range NPV
Key Variables Pessimistic Expected Optimistic Pessimistic Expected Optimistic
Investment 24 20 18 - 0.65 2.60 4.22
Sales 15 18 21 - 1.17 2.60 6.40
VC as Sales% 70 66.67 65 0.34 2.60 3.73
Fixed Costs 1.3 1 0.8 1.47 2.60 3.33
 Sensitivity Analysis
Merits:
• Indicates how robustness or vulnerability of a project to changes in underlying
variables.
• If NPV is highly sensitive to changes in some factor, it may be worthwhile to
explore how the variability of that critical factor may be contained.
• Articulates the concerns of project evaluators, thus having intuitive appeal.

Limitations:
• Merely shows what happens to NPV when there is a change in some variable.
It doesn’t indicate the likelihood of such variations.
• Typically, in sensitivity analysis only one variable is changed at a time. In real
world, though, variables tend to move together.
• Inherently subjective. Same sensitivity analysis may lead one decision maker to
accept the project while another may reject it.
• It fails to focus on the interrelationship between variables. For example, sale
volume may be related to price and cost. A price cut may lead to high sales and
low operating cost.
 Scenario Analysis
• A major limitation of sensitivity analysis amounts to the assumption of only a
single variable varying at a time.
• Scenario Analysis addresses this concern by permitting variations in several key
variables of a project simultaneously.
• Specifically it indicates the impact on project NPV (i.e. DV) resulting from changes
in multiple influencing project variables (i.e. IDVs) at one go.

Limitations:
• Based on assumption that there are a few well-delineated scenarios. This may not
be true in many cases. A situation can exist anywhere on the continuum between
extremes.
Converting a continuum into discrete states of nature leads to loss of information.
• It expands the concept of value estimation. As the number of inputs variables go
up, need for value estimates multiplies exponentially.
 PESSIMISTIC, NORMAL AND OPTIMISTIC SCENARIO

Pessimistic Expected Optimistic

Scenario Scenario Scenario
1. Investment 24 20 18
2. Sales 15 18 21
3. Variable costs 10.5 (70%) 12 (66.7%) 13.65 (65%)
4. Fixed costs 1.3 1.0 0.8
5. Depreciation 2.4 2.0 1.8
6. Pre-tax profit 0.8 3.0 4.75
7. Tax 0.27 1.0 1.58
8. Profit after tax 0.53 2.0 3.17
9. Annual cash flow from operations 2.93 4.0 4.97
10. Net present value (7.45) 2.60 10.06
(9) x PVIFA (12%, 10 yrs) – (1)
Firm considering risk characteristics of a project identified following factors along
with their expected values having a bearing on the NPV of this project:

Initial Investment Rs. 30,000

Cost of Capital 10%
Quantity Manufactured & Sold Annually 1,400
Price per Unit Rs. 30
Variable Cost per unit Rs. 20
Fixed Costs Rs. 3,000
Depreciation (per annum) Rs. 2,000
Tax Rate 50%
Life of the Project 5 years
Net Salvage Value Nil

Underlying Variable Pessimistic Optimistic

Quantity mfgd. & sold 800 1800
Price per unit Rs. 20 Rs. 50
VC per unit Rs. 40 Rs. 15

Calculate the sensitivity of NPV to variations in the quantity manufactured.

 Break Even Analysis
• Sensitivity analysis and Scenario analysis reveal what will happen to
the project if sales decline or costs increase or something else
happens, either individually or together.

• Break even analysis attempts to answer how much should be

produced and sold at a minimum to ensure that the project doesn’t
lose money.

• Minimum quantity at which loss is avoided is called the Break-even

Point.

• Break even point may be defined in accounting terms or financial

terms.
Break Even Analysis
Accounting Break-Even Analysis (in Rs. ‘000)
Year 0 Years 1 - 10
Investment (20,000)
Sales 18,000
Variable Costs @ 66.67% of sales 12,000
Fixed Costs 1,000
Depreciation (SLM) 2,000
PBT 3,000
Taxes@33.33% 1,000
PAT 2,000
Operating cash flow 4,000
Net cash flow 4,000

• Variable costs to sales is 0.667. This means that every rupee of sales makes a contribution
of Rs. 0.333. Hence, Break-even sales will be:
(Fixed costs + Depreciation) ÷ Contribution margin ratio = (1 + 2) million/0.333 = Rs. 9 million
Contribution Margin Ratio = 1 – (Variable Cost ÷ Sales)
Break Even Analysis
Cash Break-Even Point
• Defined as the level of sales at which the firm neither makes a cash profit
nor incurs a cash loss.
Cash Break-even sales = Fixed costs ÷ Contribution margin ratio
= 1 million ÷ 0.333 = Rs. 3 million

Financial Break-Even Point

• Focus of financial break-even analysis is on NPV instead of accounting profit.
It attempts to answer at what level of sales will the project have a zero NPV.

• Financial break even analysis evidences that the annual cash-flow of project
depends on sales.
Break Even Analysis
Financial Break-Even Point
1 Variable Costs 66.67 % of sales
2 Contribution 33.33% of sales
3 Fixed Costs Rs. 1 million
4 Depreciation Rs. 2 million
5 Pre-tax Profit (0.333 x sales) – Rs. 3 million
6 Tax (at 33.3%) 0.333 (0.333 sales – Rs. 3 million)
7 PAT 0.667 (0.333 x sales – Rs. 3 million)
8 Cash flow (4+7) Rs. 2 million + 0.667(0.333 x sales – Rs. 3 million)
= 0.222 sales

• Cash flows lasting for 10 years. Its PV at a discount rate of 12% is

PV(cash flows) = Investment
1.254 sales = Rs. 20 million
Sales = Rs. 15.95 million
• Sales for the plant must be Rs. 15.95 million per year for the investment to have a
zero NPV.
Hillier Model
• An approach suggesting derivation of expected NPV and standard deviation
of NPV through analytical procedures.

• Two cases of such analysis are:

 Uncorrelated cash flows
 Perfectly correlated cash flows

σt: Standard deviation of cash flow for year t,

i: risk-free rate or discount rate,
I: Initial investment
Hillier Model
A project involving an outlay of Rs. 15 million has the following benefits
associated with it.
Year 1 Year 2 Year 3
Cash Flow Probability Cash Flow Probability Cash Flow Probability
(in Rs. Mln) (in Rs. Mln) (in Rs. Mln)
7 0.3 6 0.5 5 0.4
8 0.5 8 0.2 7 0.3
9 0.2 10 0.3 9 0.3

Assume the cash flows to be independent. Calculate the expected NPV and
standard deviation of NPV considering a discount rate of 12 percent.
Managing Risk
• Ultimate aim of managers is not merely measuring risk,
but rather containment and mitigation of risks.

• Various risk reduction strategies have specific cost

associated with them. Their profitability depend on
circumstances.
Managing Risk
• Fixed and Variable Costs: Modifying the risk of an investment is
changing the proportions of fixed and variable costs. By increasing
the proportion of VC firm can achieve decline in break even sales.

• Pricing Strategy: A lower price increases potential demand, but

also raises the break-even level. Thus, firms often launch the
higher priced variant first, and later introduce an economy version.

• Sequential Investment: If uncertain about market response to

product, start small and later expand as the market grows. It can
lead to higher capital cost per unit given the fact that capacity is
created in stages.
Managing Risk
• Improving Information: Gathering more about the market and
technology before entering the business. Additional study
improves the quality of forecasts but involves direct costs as well as
opportunity costs of delayed action.

• Financial Leverage: Reducing the dependence on debt lowers risk.

High operating risk of project Low level of financial leverage

• Insurance: Insurance cover against physical damage, theft, loss of

key person, and so on.

• Long Term Arrangements: Entering into longer term contracts with

suppliers, employees, lenders and customers. Such contracts are
often indexed, factoring in inflation.
Managing Risk
• Strategic Alliance:
 When the resources required for a project or the risks inherent in a project
are beyond the capacity of a single company.
 Represents a partnership between two or more independent firms which
join hands to achieve a common purpose.
 Massive resource requirements and huge risks in modern enterprises have
compelled rivals to work together, leading to a phenomena called co-
optition.

• Derivatives:
 An option gives its owner the right to buy or sell an underlying asset on or
before a given date at a predetermined price
 A futures contract is an agreement between two parties to exchange an
asset for cash at a predetermined future date for a price specified today. It
eliminates price risk.
Managing Risk
• Shorter Time to Market:
 A way to reduce uncertainty is cutting time to market.
 Enables early generation of revenues on investments.
 Reduced risk exposure owing to need for anticipating customers needs and
preferences for a shorter time frame.

• Contingency Planning:
 Apart from undertaking risk reduction measures, well managed firms
prepare for the worst.
 Listing the things that could go wrong with a decision and then identifying
the actions that would be taken to cope with those adverse developments.
 Project Selection under Risk
(Conventional techniques of risk analysis)

• Judgmental Evaluation

• Payback Period Requirement

• Risk Adjusted Discount Rate

• Certainty Equivalent Method

 Project Selection Under Risk (Conventional techniques of risk analysis)
Payback Period Requirement: This method, as applied in practice, is more an
attempt to allow for risk in capital budgeting decision rather than a method to measure
profitability.
Merits:
 Simple to calculate and easy to understand.
 Allowance for risk:
 Emphasize on liquidity of the firm by focusing attention on near term future.
 Favour short term projects over what may be riskier, long term projects.
Limitations:
 Allowance of only a special type of risk – the risk that a project will go exactly as planned
for a certain period and will then suddenly cease altogether and be worth nothing. E.g.:
 Civil war in a country.
 Closure of the business due to an indefinite strike by the workers.
 Natural disasters such as flood or fire.
Such risks do not constitute a major proportion of business risk.
 Even as a method for allowing risks of time nature, it ignores the time value of cash flows.
 Project Selection Under Risk (Conventional techniques of risk analysis)
Risk-Adjusted Discount Rate (RADR):
• Risk-adjusted discount rate, will allow for both time preference and risk
preference and will be a sum of the risk-free rate and the risk-premium rate
reflecting the investor’s attitude towards risk.
n
NCFt
NPV = 

t
t =0 (1 k )
• Under CAPM, the risk-premium is the difference between the market rate of
return and the risk-free rate multiplied by the beta of the project.

k = kf + kr

• RADR accounts for risk by varying the discount rate depending on the degree
of risk of projects.
• A higher discount rate will be used for riskier projects and a lower rate for less
risky projects.
• NPV will decrease with increasing k, indicating less chance of acceptance of
riskier projects.
31
 Project Selection Under Risk (Conventional techniques of risk analysis)
• Risk Adjusted Discount Rate (RADR)
Project Risk = Risk of Existing Investments…….Discount Rate = Firm’s WACC
Project Risk > Risk of Existing Investments…….Discount Rate > Firm’s WACC
Project Risk < Risk of Existing Investments…….Discount Rate < Firm’s WACC

K = Kr + n + dk
K: RADR
Kr: Risk free rate of interest,
n: Adjustment for firm’s normal risk, and
dk: Adjustment for the differential risk of project k
dk: Can be either positive or negative

If project NPV based on RADR is positive, it is accepted by the firm

 Project Selection Under Risk (Conventional techniques of risk analysis)
Risk-Adjusted Discount Rate (RADR):
Merits:
 It is simple and can be easily understood.
 It has a great deal of intuitive appeal for risk-averse businessman.
 It incorporates an attitude (risk-aversion) towards uncertainty.

Limitations:
 There is no easy way of deriving a risk-adjusted discount rate. CAPM provides
a basis of calculating the risk-adjusted discount rate.

 It does not make any risk adjustment in the numerator for the cash flows that
are forecast over the future years.

 It is based on the assumption that investors are risk-averse. Though it is

generally true, yet there exists a category of risk seekers who do not demand
premium for assuming risks; they are willing to pay a premium to take risks.
33
 Example

34
 Project Selection Under Risk (Conventional techniques of risk analysis)
Certainty Equivalent Method:
• Reduce the forecasts of cash flows to some conservative levels.
The certainty-equivalent coefficient assumes a value between 0
and 1, and varies inversely with risk. Decision-maker subjectively
or objectively establishes the coefficients.
n
 t NCFt
NPV = 
(1  kf )
t
t =0

• The certainty—equivalent coefficient can be determined as a

relationship between the certain cash flows and the risky cash
flows.
Certainty Equivalent Coefficient (αt) = Certain NCF ÷ Expected NCF

Expected NCF means Average NCF

• Certainty equivalent coefficients transform expected values of

uncertain flows into their certainty equivalents.
 Project Selection Under Risk (Conventional techniques of risk analysis)
Certainty Equivalent Method: Evaluation

• First, the forecaster, expecting the reduction

that will be made in his forecasts, may inflate
them in anticipation.

• Second, if forecasts have to pass through

several layers of management, the effect may
be to greatly exaggerate the original forecast
or to make it ultra-conservative.
 Example

37
 Certainty Equivalent Method
A project involves an outlay of Rs. 1,00,000. Its expected cash inflow at the
end of first year is Rs. 40,000. Thereafter it decreases annually by Rs.
2,000. It has an economic life of 6 years. The certainty equivalent factor is
αt = 1 – 0.05t. Calculate NPV of the project if the risk free rate of return is
10%.
Year Expected Certainty Certainty Equivalent Discount Factor@10% Present
Cash Flow Equivalent Factor Value Value
0
1
2
3
4
5
6
NPV = Rs. 31098
 References:
• Prasanna Chandra, Financial Management – Theory & Practice 9th
Ed, McGraw Hill Education (ISBN: 978-00-7107-840-5).
• I.M. Pandey, Financial Management 11th Ed, Vikas Publishing

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