59107462 risk analysis in capital budgeting decisions

8/2/2019 59107462 Risk Analysis in Capital Budgeting Decisions

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Risk Analysis in Capital BudgetingDecisions


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Risk exists because of the inability of the decision maker

to make perfect forecasts.

It may arise due to:

Inaccurate cash flow forecasts

Inaccurate discounting rate or cost of capital calculation

Unfavourable economic conditionsRajasree, MBA, MS, CFA

Why do risks exist?


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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

International Risk: exchange rate or political risk

Rajasree, MBA, MS, CFA

Sources of Risk: in a project


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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 Deviationthe absolute

measure of risk

Variance of NCF = (NCF1ENCF)2 * Prob1 +

(NCF2ENCF)2 * Prob2 + (NCFnENCF)

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 theNPV of the project by converting the riskycash flows into equivalent risk-free cash flows

and discount them with riskfree rate. The certainty equivalent coefficient can be

calculated as : Certain net cash flow/Risky netcash flow.

The certainty equivalent coefficient is always avalue between 0 and 1.


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Pay back Period

The oldest and commonly used method ofrecognising risk associated with a capitalbudgeting proposal is pay back period.

Under this method shorter period is givenmore preference than the longer periods

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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 variables3. 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.

59107462 risk analysis in capital budgeting decisions

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