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Risk Analysis of Single Investments

1.1 Sources of Risk


There are several sources of risks in a project.
The important ones are:
Project-specific Risk The earnings and cash flows of the
project may be lower than expected because of an
estimation error or due to some other factors specific to
the project like quality of management.
Competitive Risk The earnings and cash flows of the project
may be affected by the unanticipated actions of competitors
Industry-specific Risk Unexpected technological
developments and regulatory changes, that are specific to
the industry to which the project belongs, will have an
impact on the earnings and cash flows of the project as well
Market Risk Unanticipated changes in macroeconomic
factors like GDP growth rate, interest rate, and inflation
have an impact on all projects, albeit in varying degrees.
International Risk In the case of a foreign project, the
earnings and cash flows may be different than expected due
to the exchange rate risk or political risk.
1.2 Measures of Risk
Risk refers to variability. It is a complex and multi-faceted
phenomenon. A variety of measures have been used to
capture different facets of risk. The more important are:
Range, Standard deviation, Coefficient of variation,
and semi-variance.
Perspectives on Risk:
Regardless of the risk measure employed, there are
different perspectives on risk, which are:-
Stand-alone risk This represents the risk of a project when
it is viewed in isolation
Firm risk Also called corporate risk, this reflects the
contribution of a project to the risk of the firm.
Systemic risk/ market risk This represents the risk of a
project from the point of view of a diversified investor.
The varieties of techniques developed to handle risk in
capital budgeting fall into two broad categories:
(i) Approaches that consider the stand-alone risk of a
project( sensitivity analysis, scenario analysis, breakeven
analysis, Hillier model, simulation analysis, and decision
tree analysis ).
(ii) Approaches that consider the contextual risk of a
project (corporate risk analysis and market risk analysis).
1.3 Sensitivity Analysis
Since future is uncertain, what will happen to the viability
of the project when some variable like sales or investment
deviates from its expected value. This type of analysis is
called sensitivity or “what if” analysis.
This is popular method for assessing risk. Sensitivity has
certain merits:
• It shows how robust or vulnerable a project is to
changes in values of the underlying variables.
• It indicates where further work may be done.
• It is intuitively a very appealing as it articulates the
concerns that project evaluators normally have.
Shortcomings:
• It merely shows what happens to NPV when there is a
change in some variable, without providing ant idea of
how likely that change will be.
• In sensitivity analysis only one variable is changed at a
time.
• It is inherently a very subjective analysis.
Illustration ( Rs. in’000) Year 0 Years 1-10
1. Investment (20,000)
2. Sales 18,000
3. Variable costs 12,000
(66 2/3 % of sales )
4. Fixed costs 1,000
5. Depreciation 2,000
6. PBT 3,000
7. Taxes 1,000
PAT 2,000
Cash flow from operation 4,000
NPV = -20,000,000 + 4,000,000 x PVIFA ( r = 12% and n= 10)
= -20,000,000 + 4,000,000 x 5.650 = 2,600,000
Let us define the optimistic and pessimistic estimates for the underlying
variables. ( Rs. in million)
Range NPV
Key variable Pessimistic Expected Optimistic Pessimistic Expected Optimistic
Investment24 20 18 -1.40 2.60 4.60
Sales 15 18 21 -1.17 2.60 4.93
Variable costs as 70 66.66 65 0.34 2.60 3.73
(% of Sales)
Fixed costs 1.3 1.0 0.8 1.47 2.60 3.33

1.4 Scenario Analysis


In sensitivity analysis, typically one variable is varied at a
time. If variables are interrelated, as they are most likely to
be, it will be helpful to look at some plausible scenarios,
each scenario representing a consistent combination of
variables.
Procedure:
1. Select the factor around which scenarios will be built.
The factor chosen must be the largest source of uncertainty
for the success of the project. It may be the state of the
economy or interest rate or technological development or
response of the market.
2. Estimate the values of each of the variables in investment
analysis ( investment outlay, revenues, costs, project life,
and so on) for each scenario.
3. Calculate the NPV and/or IRR under each scenario.
Illustration
ABC co. is evaluating a project for introducing a new
product. The management of the firm has identified
three scenarios:
1) Moderate appeal to customers at a modest price.
2) Strong appeal to large segment of the market which is
highly price-sensitive
3) Appeal to a small segment willing to pay a high price.
NPV calculation for three scenarios.
( Rs. in million)
Scenario I II III
Initial investment 200 200 200
Unit selling price 25 15 40
Demand (in units) 20 40 10
Revenues 500 600 400
Variable costs ( R s. 12 per unit ) 240 480 120
Fixed costs 50 50 50
Depreciation 20 20 20
PBT 190 50 210
Tax @ 50% 95 25 105
PAT 95 25 105
Annual cash flow 115 45 125
Project life 10 years 10 years 10 years
NPV 377.2 25.9 427.4
( at a discount rate of 15% )
In the above illustration, an attempt has been made to develop scenarios
in which the values of the variables are internally inconsistent.
The objective of such a scenario analysis is to get a feel of what happens
under the most favorable or the most adverse configuration.
1.5 Break Even Analysis
A financial manager is always desires to know how much
should be produced and sold at a minimum to ensure that
the project does not lose money. Such an exercise is called
break even analysis and the minimum quantity at which loss
is avoided is called the break even point. The BEP may be
defined in accounting or financial terms.
The following example explains the concept of both types of
BEP.
XYZ is a highly profitable company. XYZ is planning to set
up an extrusion plant. The following cash flow fore cast has
been developed.
(a) What is the NPV of the project? Assume that the cost of
capital is 13%. The range of values that the underlying
variables can take is also shown separately.
(b) Calculate the effect of variations in the values of
variables on NPV.
(c) Calculate the accounting and financial BEP.
Rs. in million
Year 0 Years 1-10
Investment (250)
Sales 200
Variable costs(60% of Sales) 120
Fixed costs 20
Depreciation 25
PBT 35
Taxes 10
PAT 25
Cash flow from operations 50

Underlying variable Pessimistic Expected Optimistic


Investment 300 250 200
Sales 150 200 275
Variable costs (%) 65 60 56
Fixed costs 30 20 15
Cost of capital 14 13 12
Solution
a) Calculation of NPV
NPV = C1 + C2 + C3 +----------+ C10 - Initial Investment
1.13 (1.13)² (1.13)³ (1.13)¹º
= (50 x 5.42624) – 250 = 271.32 – 250 = 21.32
Accounting BEP:
BEP = Fixed Costs +Depreciation = 20 +25 = 112.50
(sales) Contribution Ratio (200-120)/200
or 546.25 % of sales value
Financial BEP:
PV ( cash flows) = 271.32 = 1.356 (sales)
When PV ( cash flows ) equals initial investment, it is called
financial BEP.
Therefore, 1.356 ( sales ) = 250
Sales = 250 = 184.36 or 92 % of sales value
1.356
1.6 How Financial Institutions Analyze Risk
Financial institutions calculate several indicators for
evaluating the risk being BEP, the DSCR, and fixed assets
coverage ratio in addition to sensitivity analysis.
BEP: It is calculated with reference to the year when the
project is expected to reach its target level of capacity
utilization, which is usually the third or the fourth year.
It is calculated in terms of capacity utilization. So it is
called break-even capacity utilization (BEPCU).
Illustration:
Capacity: 2680 tonnes, Year : third
Capacity Utilization: 70 % or 2016 tonnes
A. Variable Costs ( Rs. in million)
R. M. & Consumables 137.2
Power & fuel 24.7
Selling expenses 19.2
Interest on W. C. 10.8
Other variable expenses 5.0
Total 196.9
B. Fixed Costs:
Salaries & wages 22.0
Repairs & maintenance 2.0
Admn. Expenses 2.5
Fixed selling expenses 6.3
Fixed royalty 3.0
Interest on term loans 12.0
Depreciation & amortization 7.5
Total 55.3
C. Sales realization 265.6
D. Contribution 68.7

BEPCU = Fixed costs x % capacity utilization


Contribution
= 55.3 x 70 % = 56.3 %
68.7
The cash BEPCU is calculated using the above formula without
including depreciation and amortization as part of the fixed costs.

Cash BEPCU = 47.8 x 70 % = 48.7%


68.7
Debt Service Coverage Ratio
DSCR = PAT +Depreciation + Lease rental amortization + Interest on term loans
Repayment of tern loans + Interest on term loans +Lease rental

The average DSCR is computed by taking the total of all


values of numerator and denominator for the entire period
of the proposed term loans, commencing from the year in
which commercial production starts and not taking the
DSCRs for each year.
Average DSCR = Total cash accruals over the repayment period
Total debt service burden over the same period
Sensitivity Analysis
Financial institutions carry out sensitivity analysis to asses
the impact of adverse changes in the operating conditions of
the project on its viability. The standard sensitivity analysis
involves assessing the impact of 10 % adverse variation in
selling price, quantity, and operating costs on the internal
rate of return (IRR), DSCR, and BEPCU %.
Measures of Risk
Risk refers to variability. It is a complex and multi-faceted
phenomenon. A variety of measures have been used to
capture different facets of risk. They are:
1. Range, Mean Absolute Deviation (MAD)
2. Standard Deviation
3. Coefficient of variation
4. Semi-variance
To illustrate the calculation of these measures, consider a
capital investment whose NPV has the distribution as:
NPV Probability
200 0.3
600 0.5
900 0.2
The expected NPV works out to:
3
E (NPV) =Σ Pi NPVi
i=1
= 0.3 x 200 + 0.5 x 600 + 0.2 x 900 = 540
1.Range: The simplest measure of risk, the range of a distribution
is the difference between the highest value and the
lowest value. The range is: 900 – 200 = 700
n
MAD = Σ Pi [(Ri – R )]
i=1
Where Pi = the probability associated with the ith possible value
Ri = the ith possible value of the variable
R = the mean of the distribution
n = no.of values that can be taken by the variable

The MAD shows that the variability of the values without


regard to the sign of variation.
MAD = 0.3( 200 – 540 ) + 0.5 (600 – 540) + 0.2 ( 900 - 540)
= 102 + 30 + 72
= 204
2.Standard Deviation: It is obtained as under:-
σ = [ Σpi (Xi – X’)² ]½
Where σ = standard deviation
pi = probability associated with the ith value
Xi = ith value
X’ = expected value
So , σ = [ 0.3 ( 200 – 540 )² + 0.5 ( 600 – 540 )²+ (90 – 540 )²]½
= [ 62500]½ = 250
Variance:The square of standard deviation is called variance.
Variance = 62,500
3. Coefficient of Variation:The coefficient of variation (CV)
adjusts standard deviation for scale. It is defined as:
CV = Standard Deviation
Expected value
The coefficient of variation for the investment is:
CV = 250 / 540 = 0.46
4. Semi-Variance:
There is a problem with SD. It considers all deviations,
positive as well as negative, from the expected value in the same
way. Since investors are concerned about only negative deviations,
semi-variance seem to be a more suitable measure of risk.
The semi-variance is computed the way the variance is
computed, except that only outcomes below the expected value are
taken into account.It is defined as:
SV = Σ pi di’²
Where di’ is equal to di, if di < 0 and equal to 0 if di > 0
The semi-variance for the investment is:
SV = 0.3 ( 20 –540 )² = 34,680
The semi- standard deviation is the square root of semi-variance.
The semi-standard deviation for the investment is:√(Semi-variance)
= √( 34680)
= 186.2
What is risk?
Risk is a situation where the possible events are known, but
which of those will actually happen is not known. But, the
probability of their occurrence can be determined. The
term“RISK” is used to mean that though it is known how
much the cash flows are likely to be, we can express
realizability only through a probability distribution.
Types of Risk:
Business Risk: It can be defined as the variability of the
earnings due to changes in the firm’s normal operating
conditions. It has its origin in the impact of the changing
economic environment on the firm’s activities and the
management’s decisions on the capital intensity of the
operations. Business risk is the variability of the EBIT and
is therefore unconnected to the financial risk. In other
words, business risk can be expressed as the possibility
that the firm may not be able to compete in the market
as effectively as planned to with the assets available with it.
Sub-types of business risk:
1. Investment Risk: It is the variability in the earning due
to variations in cash in flows and out flows resulting
from the capital investments made by the firm.
2. Portfolio Risk: It is also variation of the earnings but
from a completely different perspective. As for
example, the variability of the earnings caused by the
diversification, acquisition, merger etc.
Financial Risk:
Variability of the after tax earning or the EPS of the firm
caused by the financial structure, or precisely, the debt
content in the capital structure. It is the impact of the
efficient or otherwise use made by the firm to its long-term
capital on the earnings of the firm.