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2.
3.
Risk
It s the difference between actual and expected cash flows. It is defined as the variability of the future actual cash flows against the expected cash flows of the proposal.
2. 3.
RADR
Difference between the discount rate applied to a riskless proposal and a risky proposal is known as risk premium. Ka = k + Where Ka = RADR K = Risk free discount rate = Risk Adjustment Premium Risk free Discount rate is described as the rate of return on the government securities As the risk increases, the risk premium also increases and therefore RADR also increases. RADR can be used to find out the risk adjusted NPV of the proposal. The only difference is that the rate of discount used in RADR i.e., ka is higher than original discount rate k.
Decision Rule
Accept the proposal if RANPV is positive or even zero. Reject the proposal if it is negative. Mutually Exclusive Proposals : Select the alternative which has highest RANPV.
Sensitivity Analysis
Value of NPV is sensitive to variables like sales revenue, input cost, competition etc. If any of these variables changes, value of NPV will also change. SA deals with consideration of sensitivity of NPV in relation to different variables contributing to NPV. It is a technique to evaluate the effect of changes in factors contributing to cash flows on the value of the NPV of the proposal.
Steps of S.A.
Based on future expectations, the cash flows are estimated in respect of the proposal. Identify the variables which have a bearing on the cash flows of a proposal. Establish relationship between these variables and the output value. Find out range of variations and the most likely value of each of these variables. Find out effect of change in any of these variables on the value of NPV. This exercise should be performed for all the factors individually.
S.A. Example
A company is evaluating two proposals A1 and A2 both having cash outflow of Rs.30,000 each. However, these alternative proposals may result in different cash inflows depending upon different economic condition i.e., good, average and poor. Following information is available : Evaluate proposals and advise firm given that minimum required rate of return of the firm is 10%
A1
Economic Life
A2
15 years
10 years
Solution
NPV of the proposal should also be calculated under all the three conditions. Cash Flows are in the form of annuity of 10 years for proposal A1 and for 15 years years for proposal A2. Relevant PVAF (10%,10) and PVAF (10%,15) are 6.145 and 7.606 respectively. Present Values of the cash flows may be calculated as follows :
Proposal A1 CF Good Condition Avg. Condition Poor Condition 8,000 6,000 4,500 PVAF 6.145 6.145 6.145 PV Proposal A2 CF 6,000 5,500 4,500 PVAF 7.606 7.606 7.606 PV
Proposal A2
PV
45,636
Outflow
NPV
Outflow
NPV
30,000
30,000
Avg. Condition
Poor Condition
Example
Following forecast are made about a proposal which is being evaluated by a firm. Initial Outlay : Rs.12,000 Life : 4 years PVAF (14,4) = 2.9137 Cash Inflows : Rs.4,500 (Annual) Kc = 14% PVAF (14,3) = 2.3216 Analyse the sensitivity of different variables with respect to the NPV.
Solution
A.
Sensitivity w.r.t. Initial Outlay : Outlay can increase from Rs.12,000 to Rs.13,112 before NPV becomes 0. So, There is a margin of --- % of initial outlay. B. Sensitivity w.r.t. payback period of the project : Payback period when NPV is 0. C. Sensitivity w.r.t. Annual Cash Inflows : 12,000 = Annual Inflows x 2.9137. So, Annual Inflows can decrease to --- from 4,500, So, annual cash inflows have a margin of ----% D. Sensitivity w.r.t. discount rate : The discount rate at which NPV is 0, is X. Therefore, 12,000 = 4,500 x X So, Discount rate can increase from 14% to ---% before NPV becomes negative. Therefore, there is a margin of ---% So, project is most sensitive to ________________
S.A. Limitations
1. S.A. is neither a risk measuring nor a risk reducing technique. It does not provide any clear cut decision rule. 2. Moreover, study of effect of variations in one variable by keeping other variables constant may not be very effective as the variable may be interdependent. 3. Analysis present results for a range of values, without providing any sense of the likelihood of these values occuring. 4. Subjective Use of the Analysis. Risk preference of decision makers may be different.
Evaluation of a project frequently requires a sequential decision making process where accept reject decision is made in several stages. Instead of taking a decision once for all, it is broken up into several parts and stages.
Decision Tree is a branching diagram representing a decision problem as a series of decisions to be taken under conditions of uncertainty. Here, project is broken down into clearly defined stages, and possible outcomes at each stage are listed along with the probabilities and cash flows effect of each outcome.
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3. 4. 5.
List all the possible outcomes at each stage. Specify probability of each outcome at each stage based on information available.
Specify the effect of each outcome on the expected cash flows from th project. Evaluate the optimal action to be taken at each stage, based on the outcome at the previous stage and its effect on cash flows. Estimate optimal action to be taken at the very first stage, based on the expected cash flows over the entire projects and all the likely outcomes of the cash flows.
Year 1
Year 2
8%
0.6
0.3 0.1
10% 0.2
0.5 0.3
125
0.1
0.2 0.7