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Risk Analysis In Capital Budgeting

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%

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 the situation is known as uncertainty.

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

Techniques For Risk Analysis

Techniques of risk analysis

Analysis of contextual risk

Sensitivity analysis

Scenario analysis

Market risk analysis

Break-even analysis

Simulation analysis

Decision tree analysis

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 1.00 probability of receiving 7000 Certainty equivalent is 7000/8000 = 0.875

Certainty-Equivalent
Reduce the forecasts of cash flows to some conservative levels.The certainty-equivalent coefficient assumes a value between 0 and 1, and varies inversely with risk. Decision-maker subjectively or objectively establishes the coefficients.
NPV =
t =0 n

t NCFt
(1 kf )
t

The certaintyequivalent coefficient can be determined as a relationship between the certain cash flows and the risky cash flows.
NCF* Certain net cash flow t t = NCFt Risky net cash flow
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Example

Can we discount all kind of projects from same discount rate (WACC) ?

Risk-adjusted discount rate, will allow for both time preference and risk preference and will be a sum of the riskfree rate and the risk-premium rate reflecting the investors attitude towards risk.
NCFt NPV = t (1 k ) t =0
n

Under CAPM, the risk-premium is the difference between the market rate of return and the risk-free rate multiplied by the beta of the project.

k = kf + kr
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Investment Category Replacement Investments Expansion Investments Investment in related lines RADR WACC WACC + 3% WACC + 6%

Investment in new line

WACC + 10%

Example

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Example

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It is simple and can be easily understood. It has a great deal of intuitive appeal for risk-averse businessman. It incorporates an attitude (risk-aversion) towards uncertainty.

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There is no easy way of deriving a risk-adjusted discount rate. CAPM provides a basis of calculating the risk-adjusted discount rate. It does not make any risk adjustment in the numerator for the cash 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; they are willing to pay a premium to take risks.

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Sensitivity Analysis
Sensitivity analysis is a way of analysing change in the projects NPV (or IRR) for a given change in one of the variables. The decision maker, while performing sensitivity analysis, computes the projects NPV (or IRR) for each forecast under three assumptions:
pessimistic, expected, and optimistic.

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Sensitivity Analysis
The following three steps are involved in the use of sensitivity 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 the variables on the projects NPV.

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Sensitivity Analysis
(000)
YEAR 0 1. INVESTMENT 2. SALES 3. VARIABLE COSTS (66 2/3 % OF SALES) 4. FIXED COSTS 5. DEPRECIATION 6. PRE-TAX PROFIT 7. TAXES 8. PROFIT AFTER TAXES 9. CASH FLOW FROM OPERATION 10. NET CASH FLOW (20,000) 18,000 12,000 1,000 2,000 3,000 1,000 2,000 4,000 4,000 YEAR 1 - 10

( discount rate = 12 % ) RS. IN MILLION

RANGE
KEY VARIABLE PESSIMISTIC EXPECTED OPTIMISTIC PESSIMISTIC

NPV
EXPECTED OPTIMISTIC

INVESTMENT (RS. IN MILLION) SALES (RS. IN MILLION) VARIABLE COSTS AS A PERCENT OF SALES FIXED COSTS

24 15 70

20 18 66.66

18 21 65

1.3

1.0

0.8

1.47

2.60

3.33

Sensitivity Analysis: Pros And Cons

It compels the decision-maker to identify the variables, which affect the cash flow forecasts. This helps him in understanding the investment project in totality.
It indicates the critical variables for which additional information may be obtained. The decision-maker can consider actions, which may help in strengthening the weak spots in the project.

It helps to expose inappropriate forecasts, and thus guides the decision-maker to concentrate on relevant variables.

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Sensitivity Analysis: Pros and Cons

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

It fails to focus on the interrelationship between variables. For example, sale volume may be related to price and cost. A price cut may lead to high sales and low operating cost.

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Scenario Analysis
One way to examine the risk of investment is to analyse the impact of alternative combinations of variables, called scenarios, on the projects NPV (or IRR). The decision-maker can develop some plausible scenarios for this purpose. For instance, we can consider three scenarios: pessimistic, optimistic and expected.
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Pessimistic, Normal And Optimistic Scenario

Pessimistic Scenario 1. Investment 2. Sales 3. Variable costs 4. Fixed costs 5. Depreciation 6. Pre-tax profit 24 15 10.5 (70%) 1.3 2.4 0.8

Optimistic Scenario 18 21 13.65 (65%) 0.8 1.8 4.75

7. Tax
8. Profit after tax

0.27
0.53

1.0
2.0

1.58
3.17

9. Annual cash flow from operations

10. Net present value (9) x PVIFA (12%, 10 yrs) (1)

2.93
(7.45)

4.0
2.60

4.97
10.06

Simulation Analysis
The Monte Carlo simulation or simply the simulation analysis considers the interactions among variables and probabilities of the change in variables. It computes the probability distribution of NPV. The simulation analysis involves the following steps:
First, you should identify variables that influence cash inflows and outflows. Second, specify the formulae that relate variables. Third, indicate the probability distribution for each variable. Fourth, develop a computer programme that randomly selects one value from the probability distribution of each variable and uses these values to calculate the projects NPV.
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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.

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Break-even Analysis
Accounting Break-even Analysis
FIXED COSTS + DEPRECIATION = CONTRIBUTION MARGIN RATIO 0.333 1+2 = RS. 9 MILLION

CASH FLOW FORECAST FOR NAVEENS FLOUR MILL PROJECT

(000) YEAR 1 - 10 18,000 12,000 1,000 2,000 3,000 1,000 2,000 4,000 4,000

1. INVESTMENT 2. SALES 3. VARIABLE COSTS (66 2/3% OF SALES) 4. FIXED COSTS 5. DEPRECIATION 6. PRE-TAX PROFIT 7. TAXES 8. PROFIT AFTER TAXES 9. CASH FLOW FROM OPERATION 10. NET CASH FLOW

YEAR 0 (20,000)

(20,000)

DCF Break-even Analysis

Sensitivity analysis is a variation of the break-even analysis. DCF break-even point is different from the accounting break-even point. The accounting break-even point is estimated as fixed costs divided by the contribution ratio. It does not account for the opportunity cost of capital, and fixed costs include both cash plus non-cash costs (such as depreciation).

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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

Decision Trees for Sequential Investment Decisions

Investment expenditures are not an isolated period commitments, but as links in a chain of present and future commitments. An analytical technique to handle the sequential decisions is to employ decision trees.

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Steps In Decision Tree Approach

Define investment Identify decision alternatives Draw a decision tree
decision points chance events

Analyse data

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Electric Bike Project

An automobile company is planning to develop a new 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

STEPS
DELINEATE THE DECISION TREE EVALUATE THE ALTERNATIVES
C21 : HD ANNUAL CASH FLOW 0.6 30 MILLION

D21 : INV C2 150 m C11 : S D2 p : 0.7 D11 : PILOT PROD C1 EMV (C1) = RS.30. 9 m & TEST MKTG D22 : STOP EMV (D2) = RS.44. 2 m C22 : LD 0.4 ANNUAL CASH FLOW 20 MILLION EMV (C2) = RS.194.2 m

- RS.20 m
D1 EMV (D1) = RS.10. 9 m

C12 : F
D3 p : 0.3 D31 : STOP

D12 : DO NOTHING

Analysis
1. Start at thee right hand end of the tree and calculate the NPV at chance point C2 that comes first as we proceed left

Usefulness of Decision Tree Approach

Clarity: It clearly brings out the implicit assumptions and calculations for all to see, question and revise.
Graphic visualization: It allows a decision maker to visualise assumptions and alternatives in graphic form, which is usually much easier to understand than the more abstract, analytical form.

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Decision Tree Approach: Limitations

The decision tree diagrams can become more and more complicated as the decision maker decides to include more alternatives and more variables and to look farther and farther in time. It is complicated even further if the analysis is extended to include interdependent alternatives and variables that are dependent upon one another.
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Risk Analysis in Practice

Most companies in India account for risk while evaluating their capital expenditure decisions. The following factors are considered to influence the riskiness of investment projects:

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price of raw material and other inputs price of product product demand government policies technological changes project life inflation

Risk Analysis in Practice

Four factors thought to be contributing most to the project riskiness are:
selling price product demand technical changes government policies

Methods of risk analysis in practice are:

sensitivity analysis conservative forecasts
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Case Exercises
Richa Foods Limited Weston Plastic Airways Limited