risk analysis in capital budgeting
TRANSCRIPT
Analysis of Risk and Uncertainity
Chap-12
• Description ,measurement and types of risk• Methods for Incorporating risk factor in the
analysis of capital budgeting
Sources of Risk
• Project Specific Risk• Competitive Risk• Industry Specific Risk• Market Risk• International Risk
Different Perspectives of Risk
• Stand-alone Risk: The risk of a firm in investing in one and only one project.
• Firm Risk : Project’s risk to the company.• Market Risk: Systematic Risk
Measures of Risk
• Standard Deviation• Coefficient of Variation
Measures to quantify Risk
• Sensitivity Analysis• Scenario Analysis• Simulation• Decision-tree Approach
Incorporation of Risk into Capital Budgeting
• RADR(Risk-adjusted Discount Rate Approach)• Certainty-Equivalent Approach• Probability Distribution Approach
DECISION TREE ANALYSIS
STEPS• DELINEATE THE DECISION TREE
• EVALUATE THE ALTERNATIVESC21 : HD ANNUAL CASH FLOW
0.6 30 MILLION
D21 : INV
C2 EMV (C2) = RS.194.2 m
150 m
C11 : S
D2 EMV (D2) = RS.44. 2 m C22 : LD ANNUAL CASH FLOW
p : 0.7 0.4 20 MILLION
D11 : PILOT PROD
C1 EMV (C1) = RS.30. 9 m D22 : STOP
& TEST MKTG
- RS.20 m C12 : F
D1 EMV (D1) = RS.10. 9 m D3 D31 : STOP
p : 0.3
D12 : DO NOTHING
Techniques to handle risk in Capital Budgeting
Sensitivity Analysis : One variable is changed at a time.(“What if “ analysis)
Scenario Analysis: Several variables are changed at a time.(“What if “ analysis)
Simulation analysis : For developing the probability profile of a criterion of merit by randomly combining values of variables that bear on the chosen criterion.
Sensitivity Analysis
Evaluation:• Shows how vulnerable a project is to changes
in values of the underlying variables.• Indicates where further work to be done.Limitations:• Only one variable is changed at a time.• Subjective Analysis
Sensitivity Analysis
Assume that you are the financial manager of Gopal Flour Mills. Gopal is considering setting up a new flour mill near Bangalore. Based on Gopal’s previous experience, the project staff of Gopal has developed the figures
Note : Salvage value has been assumed to be nil and the straight line method of depreciation is used .
Cash Flow forecast for Gopal’s Flour Mill ProjectYear 0 Year 1-10
INVESTMENT (20,000)
• SALES 18,000
• VARIABLE COSTS (66 2/3 % OF SALES) 12,000
• FIXED COSTS 1,000
DEPRECIATION 2,000
• PBT(PRE-TAX PROFIT) 3,000
• TAXES 1,000
• PROFIT AFTER TAXES 2,000
• CASH FLOW FROM OPERATION 4,000
• NET CASH FLOW 4,000
NPV = -20,000,000 + 4,000,000 (5.650) = 2,600,000
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 4,000
10. NET CASH FLOW 4,000NPV = -20,000,000 + 4,000,000 (5.650) = 2,600,000
RS. IN MILLION
RANGE NPV NPV
KEY VARIABLE PESSIMISTIC EXPECTED OPTIMISTIC PESSIMISTIC EXPECTED OPTIMISTIC
INVESTMENT (RS. IN MILLION) 24 20 18 -0.65 2.60 4.22
SALES (RS. IN MILLION) 15 18 21 -1.17 2.60 6.40
VARIABLE COSTS AS A 70 66.66 65 0.34 2.60 3.73 PERCENT OF SALES FIXED COSTS 1.3 1.0 0.8 1.47 2.60 3.33
Scenario Analysis
Three Scenarios are considered.• Expected(normal)Scenario• Pessimistic Scenario• Optimistic Scenario
The NPV of the Project of Gopal Flour Mills will be calculated in the three scenarios.
SCENARIO ANALYSISPROCEDURE1. SELECT THE FACTOR AROUND WHICH SCENARIOS WILL BE BUILT2. ESTIMATE VALUES OF EACH OF THE VARIABLES FOR EACH SCENARIO3. CALCULATE NPV / IRR UNDER EACH SCENARIO
NET PRESENT VALUE FOR THREE SCENARIOS(RS. IN MILLION)
SCENARIO 1 SCENARIO 2 SCENARIO 3INITIAL INVESTMENT 200 200 200UNIT SELLING PRICE (IN RUPEES) 25 15 40DEMAND (IN UNITS) 20 40 10 REVENUES 500 600 400VARIABLE COSTS 240 480 120FIXED COSTS 50 50 50DEPRECIATION 20 20 20PRE-TAX PROFIT 190 50 210TAX @ 50% 95 25 105PROFIT AFTER TAX 95 25 105ANNUAL CASH FLOW 115 45 125PROJECT LIFE 10 YEARS 10 YEARS 10 YEARSSALVAGE VALUE 0 0 0NET PRESENT VALUE (AT A DISCOUNT 377.2 25.9 427.4RATE OF 15 PERCENT)
SIMULATION ANALYSIS
PROCEDURE
1. CHOOSE VARIABLES WHOSE EXPECTED VALUES WILL BE REPLACED WITH DISTRIBUTIONS
2. SPECIFY THE PROBABILITY DISTRIBUTIONS OF THESE VARIABLES
3. DRAW VALUES AT RANDOM AND CALCULATE NPV
4. REPEAT 3 MANY TIMES AND PLOT DISTRIBUTION
5. EVALUATE THE RESULTS
PROJECT SELECTION UNDER RISK
• Judgmental Evaluation
• Payback Period Requirement
• Risk Adjusted Discount Rate
• Certainty Equivalent Method
Relative Importance of Various Methods of Assessing Project Risk
Technique % of companies rating it as very important or important
Sensitivity Analysis 90.10
Scenario Analysis 61.60
RADR 31.70
Decision tree Analysis 12.20
Monte Carlo Simulation 8.20
Break-Even Analysis
Accounting BEP:Fixed costs +DepreciationContribution margin ratioFinancial BEPNPV=0i.e. PV of Cash inflows=PV of cash outflows
Real Options
• Real Options: Opportunities to respond to changing market
conditions and influence the outcomes of a project.
Types of Options:• Growth Option• Abandonment Option• Timing Option
Value
• Project worth = NPV(traditional) + Option valueOr
• Value of the option=NPV(traditional)-NPV of the Option
• The option value will depend on the number of options available, the greater the number of options the greater is the option value and the greater is the project’s worth.
LIMITATIONS
SENSITIVITY ANALYSIS • NO IDEA OF LIKELIHOOD
• ONE FACTOR IS VARIED AT A TIME
SCENARIO ANALYSIS • SCENARIOS MAY NOT BE CLEARLY DELINEATED
SIMULATION ANALYSIS • DEFINING THE DISTRIBUTIONS IS DIFFICULT
• TRADITIONAL SIMULATION ANALYSIS DOESN’T PERMIT
INTERACTIONS AMONG VARIABLE
• BUSINESS AS USUAL ASSUMPTIONS
DECISION TREE ANALYSIS • STAGES MAY NOT BE CLEARLY DEFINED
• OUTCOMES MAY NOT BE CLASSIFIED INTO BROAD CLASSES
• PROBABILITIES & CASH FLOWS ARE DIFFICULT TO DEFINE
Mini Case
• Airways ltd Case -to be discussed in class( Financial Management(Prasanna Chandra)
• (Page no.342)• Southern Air ways Case-Assignment(Page No.359)