session 11 risk analysis in cbgrd

8/13/2019 Session 11 Risk Analysis in CBgrd

1/37

Risk Analysis In Capital Budgeting


2/37

Findings from CFO Survey

Method % of companies rating it

as imp

Sensitivity analysis 90.10%

Scenario Analysis 61.60%

Risk Adjusted Discount Rate 31.70%

Decision Tree Analysis 12.20%Monte Carlo simulation 8.20%


3/37

Risk and Uncertainty

Risk is referred to a situation where the

probability distribution of the cash flow of an

investment proposal is known.

If no information is available to formulate a

probability distribution of the cash flows thesituation is known as uncertainty.

3


4/37

Sources and Perspective of Risk

Sources of Risk

Project-specific risk

Competitive risk

Industry-specific risk

Market risk International risk

Perspectives on Risk

Standalone risk

Firm risk

Market risk


5/37

Techniques For Risk Analysis

Techniques of risk

analysis

Analysis of stand-

alone risk

Analysis of

contextual risk

Sensitivity

analysis

Break-even

analysis

Simulation

analysis

Scenario

analysis

Corporate

risk analysis

Market risk

analysis

Decision tree

analysis


6/37

Certainty-Equivalent..Example If you invest in stock than there are two

possible outcomes: 0.6 probability of receiving 10,000

0.4 probability of receiving 5,000

If you keep money in fixed deposit 1.00probability of receiving 7000

Certainty equivalent is 7000/8000 = 0.875


7/37

Certainty-Equivalent

Reduce the forecasts of cash flows to some conservativelevels.The certainty-equivalent coefficient assumes a value

between 0 and 1, and varies inversely with risk. Decision-makersubjectively or objectively establishes the coefficients.

The certaintyequivalent coefficient can be determined as a

relationship between the certain cash flows and the risky cashflows.

7

=0

NCFNPV =

(1 )f

nt t

tt k

*NCF Certain net cash flow =

NCF Risky net cash flow

tt

t


8/37

Example

8


9/37

Risk-Adjusted Discount Rate Can we discount all kind of projects from same

discount rate (WACC) ?


10/37

Risk-Adjusted Discount Rate

Risk-adjusted discount rate, will allow for both timepreference and risk preference and will be a sum of the risk-free rate and the risk-premium rate reflecting the investorsattitude towards risk.

Under CAPM, the risk-premium is the difference between themarket rate of return and the risk-free rate multiplied by the

beta of the project.

10

= 0

NCFNPV =

(1 )

n t

t

t k

f rk = k + k


11/37

RADR in Practice..Example

Investment Category RADR

Replacement Investments WACC

Expansion Investments WACC + 3%

Investment in related lines WACC + 6%

Investment in new line WACC + 10%


12/37

Example

12


13/37

Example

13


14/37

Risk-adjusted Discount Rate: Merits

It is simple and can be easily understood.

It has a great deal of intuitive appeal for risk-aversebusinessman.

It incorporates an attitude (risk-aversion) towardsuncertainty.

14


15/37

Risk-adjusted Discount Rate: Limitations

There is no easy way of deriving a risk-adjusted discount rate.CAPM provides a basis of calculating the risk-adjusteddiscount rate.

It does not make any risk adjustment in the numerator for thecash flows that are forecast over the future years.

It is based on the assumption that investors are risk-averse.Though it is generally true, yet there exists a category of risk

seekers who do not demand premium for assuming risks; theyare willing to pay a premium to take risks.

15


16/37

Sensitivity Analysis

Sensitivity analysis is a way of analysingchange in the projectsNPV (or IRR) for agiven change in one of the variables.

The decision maker, while performingsensitivity analysis, computes the projectsNPV (or IRR) for each forecast under threeassumptions:

pessimistic, expected, and optimistic.

16


17/37


The following three steps are involved in the use ofsensitivity analysis:

1. Identification of all those variables, which have an

influence on the projects NPV (or IRR).2. Definition of the underlying (mathematical) relationship

between the variables.

3. Analysis of the impact of the change in each of thevariables on the projects NPV.

17



18/37

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 4,000

NPV = -20,000,000 + 4,000,000 (5.650) = 2,600,000 ( discount rate = 12 % )

RS. IN M IL LI ON

RANGE NPV

KEY VARIABLE PESSIM ISTIC EXPECTED OPTIM ISTIC PESSIM ISTIC EXPECTED OPTIMI STIC

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


19/37


20/37

Sensitivity Analysis: Pros and Cons

It does not provide clear-cut results. The termsoptimistic and pessimistic could mean differentthings to different persons in an organisation. Thus,the range of values suggested may be inconsistent.

It fails to focus on the interrelationship betweenvariables. For example, sale volume may be relatedto price and cost. A price cut may lead to high sales

and low operating cost.

20


21/37

Scenario Analysis

One way to examine the risk of investment isto analyse the impact of alternativecombinations of variables, called scenarios,on

theprojectsNPV (or IRR).

The decision-maker can develop some

plausible scenarios for this purpose. Forinstance, we can consider three scenarios:pessimistic, optimistic and expected.

21


22/37

Pessimistic, Normal And Optimistic Scenario

PessimisticScenario

ExpectedScenario

OptimisticScenario

1. Investment 24 20 18

2. Sales 15 18 21

3. Variable costs 10.5 (70%) 12 (66.7%) 13.65 (65%)4. Fixed costs 1.3 1.0 0.8

5. Depreciation 2.4 2.0 1.8

6. Pre-tax profit 0.8 3.0 4.75

7. Tax 0.27 1.0 1.588. Profit after tax 0.53 2.0 3.17

9. Annual cash flow from operations 2.93 4.0 4.97

10. Net present value

(9) x PVIFA (12%, 10 yrs)(1)

(7.45) 2.60 10.06


23/37

Simulation Analysis

The Monte Carlosimulation or simply the simulation analysisconsiders the interactions among variables and probabilities ofthe change in variables. It computes the probability distributionof NPV.

The simulation analysis involves the following steps:

First, you should identify variables that influence cash inflows andoutflows.

Second, specify the formulae that relate variables.

Third, indicate the probability distribution for each variable.

Fourth, develop a computer programme that randomly selects one valuefrom the probability distribution of each variable and uses these values tocalculate theprojectsNPV.

23


24/37

Simulation Analysis: Shortcomings

The model becomes quite complex to use.

It does not indicate whether or not the

project should be accepted.

Simulation analysis, like sensitivity or

scenario analysis, considers the risk of any

project in isolation of other projects.

24

B k A l i


25/37

Break-even Analysis

Accounting Break-even Analysis

FIXED COSTS + DEPRECIATION 1 + 2

= = RS. 9 MILLIONCONTRIBUTION MARGIN RATIO 0.333

CASH FLOW FORECAST FOR NAVEENS FLOUR MILL PROJECT

(000)YEAR 0 YEAR 1 - 10

1. INVESTMENT (20,000)

2. SALES 18,000

3. VARIABLE COSTS (662/3% 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 (20,000) 4,000

Cash Break-even Analysis


26/37

DCF Break-even Analysis

Sensitivity analysis is a variation of the break-evenanalysis.

DCF break-even point is different from the accounting

break-even point. The accounting break-even point isestimated as fixed costs divided by the contribution ratio. Itdoes not account for the opportunity cost of capital, andfixed costs include both cash plus non-cash costs (such asdepreciation).

26


27/37

Simulation Analysis

Procedure

1. Choose variables whose expected values will be replaced withdistributions

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


28/37

Decision Trees for Sequential Investment Decisions

Investment expenditures are not an isolatedperiod commitments, but as links in a chain ofpresent and future commitments.

An analytical technique to handle the sequentialdecisions is to employ decision trees.

28


29/37

Steps In Decision Tree Approach

Define investment

Identify decision alternatives

Draw a decision tree

decision points chance events

Analyse data

29


30/37

Electric Bike Project

An automobile company is planning to develop anew product electric bike. Project will cost Rs. 20

million and will take 6 months. 70% chance that

in pilot production and testing product will be

successful. The company require to invest Rs. 150

million to built a new plant and plant will generate

Rs. 30 million for 20 years, if demand is high. If

demand is moderate than project will generate Rs.20 million. Probability of high demand is 0.4. The

discount rate is 12%.

Decision Tree Analysis


31/37

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

A l i


32/37

Analysis

1. Start at thee right hand end of the tree and

calculate the NPV at chance point C2 thatcomes first as we proceed left


33/37

Usefulness of Decision Tree Approach

Clarity: It clearly brings out the implicitassumptions and calculations for all to see,question and revise.

Graphic visualization: It allows a decisionmaker to visualise assumptions andalternatives in graphic form, which is

usually much easier to understand than themore abstract, analytical form.

33


34/37

Decision Tree Approach: Limitations

The decision tree diagrams can become moreand more complicated as the decision makerdecides to include more alternatives and morevariables and to look farther and farther intime.

It is complicated even further if the analysis is

extended to include interdependentalternatives and variables that are dependentupon one another.

34


35/37

Risk Analysis in Practice

Most companies in India account for risk whileevaluating their capital expenditure decisions.

The following factors are considered to influence

the riskiness of investment projects: price of raw material and other inputs

price of product

product demand

government policies

technological changes

project life

inflation

35


36/37

Risk Analysis in Practice

Four factors thought to be contributing most tothe project riskiness are: selling price

product demand

technical changes

government policies

Methods of risk analysis in practice are: sensitivity analysis

conservative forecasts

36


37/37

Case Exercises

Richa Foods Limited

Weston Plastic

Airways Limited

session 11 risk analysis in cbgrd

Documents