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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

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

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

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.

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

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

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.

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