Risk Analysis in Capital Budgeting Decisions

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Why do risks exist?

Risk exists because of the inability of the decision maker
to make perfect forecasts. It may arise due to:
Inaccurate
Inaccurate

cash flow forecasts

discounting rate or cost of capital calculation economic conditions

Rajasree, MBA, MS, CFA

Unfavourable

Sources of Risk: in a project

Project

Specific Risk: due to estimation error, quality of manpower,

unavailability of material etc

Competitive

Risk: unanticipated actions by competitors

Industry

Specific Risk: unexpected technological changes/

developments
Market

Risk: due to inflation, interest rate, growth rate etc Risk: exchange rate or political risk
Rajasree, MBA, MS, CFA

International

Nature of Risk
Risk exists because of the inability of the decision-maker to make perfect forecasts. An investment is not risky if we can specify a unique sequence of cash flows for it. However there are always uncertainties about cash flows which render risk to the capital investment proposals with regard to their acceptance.

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Concept of Probability
The concept of probability is fundamental to the use of risk analysis techniques. The probability estimate based on a very large number of observations is known as an objective probability. The probability estimates that are dependent on the state of belief of a person are called subjective probabilities.

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Statistical Techniques for Risk Analysis

Expected Net Present Value (ENPV) = The expected net present values can be found out by multiplying the monetary values of the possible events (cash flows) by their probabilities.

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Standard Deviation the absolute measure of risk

Variance of NCF = (NCF1 ENCF)2 * Prob1 + (NCF2 ENCF)2 * Prob2 + (NCFn ENCF)2 * Probn Standard Deviation = Root of variance. Coefficient of variation : it is the relative measure of risk. CV = Standard Deviation / Expected Net Cash Flow.

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Conventional Techniques of Risk Analysis

Risk-adjusted discount rate Certainty Equivalent Pay back period

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Risk-adjusted Discount rate

Risk-adjusted discount rate method uses a higher discount rate for more risky cash flows and lesser discount rate for less risky cash flows. Risk-adjusted discount rate = Risk-free rate + Premium for the risk

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Certainty Equivalent
Certainty Equivalent approach computes the NPV of the project by converting the risky cash flows into equivalent risk-free cash flows and discount them with risk free rate. The certainty equivalent coefficient can be calculated as : Certain net cash flow/Risky net cash flow. The certainty equivalent coefficient is always a value between 0 and 1.

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Pay back Period

The oldest and commonly used method of recognising risk associated with a capital budgeting proposal is pay back period. Under this method shorter period is given more preference than the longer periods

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Bindu Nair - IMM

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Sensitivity Analysis
Sensitivity Analysis is a way of analyzing change in the projects NPV or IRR for a given change in one of the variables. The following three steps are involved: 1. Identifying the variables which have an impact on the firms NPV 2. Defining the relationship between those variables 3. Analyzing the impact of each of those variables on the firms NPV.

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Scenario Analysis

Scenario Analysis measures the change in NPV of the project under different scenarios changing several variables at a time because of interrelationship of variables amongst themselves

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Decision Tree Analysis

A decision tree is a powerful tool of analyzing sequential decisions. It breaks up complex decisions into smaller decisions and calculate the NPV backwards to arrive at the most pragmatic decision based on maximization of NPV.

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