BFIN 332 RISK ANALYSIS IN CAPITAL BUDGETING -BASWETI

RISK ANALYSIS IN CAPITAL BUDGETING

SENSITIVITY ANALYSIS
In the evaluation of an investment project, we work with the forecasts of cash flows.
Forecasted cash flows depend on the expected revenue and costs. Further, expected revenue
is a function of sales volume and unit selling price. Similarly, sales volume will depend on
the market size and the firm's market share. Costs include variable costs, which depend on
sales volume, and unit variable cost and fixed costs. The net present value or the internal rate
of return of a project is determined by analyzing the after-tax cash flows arrived at by
combining forecasts of various variables. It is difficult to arrive at an accurate and unbiased
forecast of each variable. We can't be certain about the outcome of any of these variables. The
reliability of the NPV or IRR of the project will depend on the reliability of the forecasts of
variables underlying the estimates of net cash flows. To determine the reliability of the project's
NPV or IRR, we can work out how much difference it makes if any of these forecasts goes wrong. We
can change each of the forecast, one at a time, to at least three values: pessimistic, expected,
and optimistic. The NPV of the project is recalculated under these different assumptions.
This method of recalculating NPV or IRR by changing each forecast is called sensitivity
analysis.
Sensitivity, analysis is a way of analyzing change in the project's NPV (or IRR) for a given
change in one of the variables. It indicates how sensitive a project's NPV (or IRR) is to
changes in particular variables. The more sensitive the NPV, the more critical is the
variable.
The following three steps are involved in the use of sensitivity analysis:
1. Identification of all those variables, which have an influence on the project's 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 project's NPV.

The decision-maker, while performing sensitivity analysis, computes the project's NPV (or
IRR) for each forecast under three assumptions:
(a) Pessimistic,
(b) Expected, and
(c) Optimistic.
It allows him to ask "what if' questions. For example,

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1. What (is the NPV) if volume increase or decreases?

2. What (is the NPV) if variable cost or fixed cost increases or decreases?
3. What (is the NPV) if the selling price increases or decreases?
4. What (is the NPV) if the project is delayed or outlay escalates or the project's life is
more or less than anticipated?
A whole range of questions can be answered with the help of sensitivity analysis. It
examines the sensitivity of the variables underlying the computation of NPV or IRR,
rather than attempting to quantify risk. It can be applied to any variable, which is an input
for the after-tax cash flows. Let us consider an example.

Illustration 12.6: Sensitivity Analysis

The financial manager of XL Food Processing Company is considering the installation of a
plant costing Rs 10 million to increase its processing capacity. The expected values of the
underlying variables are given in Tables 12.4 and 12.5 provides the project's after-tax cash
flows over its expected life of 7 years. Salvage value is assumed to be zero.
Table 12.4: Expected Values of Variables

1 Investment (Rs'000) 10000

2 Sales volume (units'000) 1000
3 Unit selling price (Rs) 15
4 Unit variable cost (Rs) 675
5 Annual fixed costs (Rs'000) 4000
6 Depreciation (WDV) 25%
7 Corporate tax rate 35%
8 Discount rate 12%

The project's NPV at 12 per cent discount rate and IRR are as follows:
NPV = +4,973
IRR= 27.05%
Since NPV is positive (or IRR > discount rate), the project can be undertaken.
Recall:
NCF = (REV - EXP) (1 - T) + TDEP

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Table 12.5: Net Cash Flows of the Project

Year 0 1 2 3 4 5 6 7
1 Investment (10000)

2 Revenue=1k*15 15,000 15,000 15,000 15,000 15,000 15,000 15,000

3 Variable cost=1k*6.75 6,750 6,750 6,750 6,750 6,750 6,750 6,750

4 Fixed cost=4k 4,000 4,000 4,000 4,000 4,000 4,000 4,000

5 Depreciation=25%WDV 2,500 1,875 1,406 1,055 791 593 1,347**

6 EBIT=2-3-4-5 1,750 2,375 2,844 3,195 3,459 3,657 2,903

7 Tax@35% 613 831 995 1,118 1,211 1,280 1,016

8 PAT=6-7 1,138 1,544 1,848 2,077 2,248 2,377 1,887

9 NCF =1+5+8 -10000 3,638 3,419 3,255 3,132 3,039 2,970 3,234

** 415+902 =1,347
Note: Depreciation in the seventh year includes depreciation of the seventh year, Rs 445+++
and the present value of depreciation beyond seventh year, Rs 902 = [0.25/(0. 12 +0 .25)] *
Rs 1,335. Rs 1,335 @@ is the book value at the end of seventh year.

++That’s 7th year Depreciation amount = 0.25 * (10,000- 2,500-1,875-1,406-1,055-791-593)

= 0.25* (10,000 – 8,220 ##)
= 0.25 (1,780) = 445
# # 8,220 is the accumulated depreciation up to the end of the sixth year
@@- WDV at end of the seventh year = 10,000- 8,220 - 445 = 1,335
C1
RECALL - Present Value of a perpetuity (PV)=
K

Or
d 0.25
PVD= * WDV  *1,335  Rs 902
d + k  (0.25  0.12)

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Where d= Depreciation rate i.e. 25%

K = Discount rate i.e. 12%
WDV = Book value at end of the seventh year i.e. 1,335

Total depreciation =445 + 902 = 1,347

NCF PVIF@12%,n PV
1 3,638 0.8929 3,247.77
2 3,419 0.7972 2,725.41
3 3,255 0.7118 2,316.62
4 3,132 0.6355 1,990.21
5 3,039 0.5674 1,724.61
6 2,970 0.5066 1,504.77
7 3,234 0.4523 1,462.87
LESS IO - 10,000.00
NPV 4,972.26

IRR-USE TRIAL AND ERROR METHOD

TRY 27.05%
NCF PVIF@27.05%,n PV
1 3,638 0.7871 2863.0460
2 3,419 0.6195 2117.9612
3 3,255 0.4876 1587.0306
4 3,132 0.3838 1201.9136
5 3,039 0.3021 918.1384
6 2,970 0.2378 706.2023
7 3,234 0.1871 605.2163
LESS IO -10,000.0000
NPV -0.4916

TRY 27%
NCF PVIF@27%,n PV
1 3638 0.7874 2864.1732
2 3419 0.6200 2119.6292
3 3255 0.4882 1588.9057
4 3132 0.3844 1203.8075
5 3039 0.3027 919.9472
6 2970 0.2383 707.8722
7 3234 0.1877 606.8862
LESS IO -10000.0000
NPV 11.2212

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We then interpolate between 27% and 27.05%

11.2212  0
IRR =27 + * 27.05  27   27.04790
11.2212  (0.4916)

How confident is the financial manager about his forecasts of various variables? Before he takes
a decision, he may like to know whether the NPV changes, if any, of the forecasts goes wrong. A
sensitivity analysis can be conducted with regard to volume, price, costs etc. In order to do
so, we must obtain pessimistic and optimistic estimates of the underlying variables. Let us
assume the pessimistic and the optimistic values for volume, price and costs as shown in
Table 12.6.
Table 12.6: Forecasts Under Different Assumptions
VARIABLE PESSIMISTIC EXPECTED OPTIMISTIC
Volume (units ‘000’ 750 1,000 1,250
Unit selling price (Rs) 12.75 15.00 16.50
Unit variable cost (Rs) 7.425 6.75 6.075
Annual fixed costs (Rs'000) 4,800 4,000 3,200

If we change each variable (others holding constant), the project's NPVs are recalculated in
Table 12.7 (detailed calculations not shown).
Table 12.7: Sensitivity Analysis Under Different Assumptions

VARIABLE PESSIMISTIC EXPECTED OPTIMISTIC

Volume (units ‘000’ -1,146 4,973 10,091
Unit selling price (Rs) -1,702 4,973 9,422
Unit variable cost (Rs) 2,970 4,973 6,975
Annual fixed costs (Rs'000) 2,599 4,973 7,346

UNDER PESSIMISTIC- VOLUME 750

EX
VOL 750 12.6 PANDEY
Year 0 1 2 3 4 5 6 7
1 Investment -10000

2 Revenue=750*15 11,250 11,250 11,250 11,250 11,250 11,250 11,250

3 Variable cost=750*6.75 5,063 5,063 5,063 5,063 5,063 5,063 5,063

4 Fixed cost=4k 4,000 4,000 4,000 4,000 4,000 4,000 4,000

5 Depreciation=25%WDV 1,055

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2,500 1,875 1,406 791 593 1,347

-
6 EBIT=2-3-4-5 313 313 781 1,133 1,396 1,594 841
-
7 Tax@35% 109 109 273 396 489 558 294
-
8 PAT=6-7 203 203 508 736 908 1,036 546

9 NCF =1+5+8 -10000 2,297 2,078 1,914 1,791 1,699 1,630 1,893

EX 12.6
NCF PVIF@12%,n PV
1 2,297 0.8929 2,050.78
2 2,078 0.7972 1,656.67
3 1,914 0.7118 1,362.39
4 1,791 0.6355 1,138.22
5 1,699 0.5674 963.91
6 1,630 0.5066 825.56
7 1,893 0.4523 856.44
LESS IO - 10,000.00
NPV - 1,146.02

UNDER OPTIMISTIC –UNIT SELLING PRICE-Rs 16.50

SP=16.50 OPT EX 12.6

Year 0 1 2 3 4 5 6 7
1 Investment (10000)

2 Revenue=1k*16.5 16,500 16,500 16,500 16,500 16,500 16,500 16,500

3 Variable cost=1k*6.75 6,750 6,750 6,750 6,750 6,750 6,750 6,750

4 Fixed cost=4k 4,000 4,000 4,000 4,000 4,000 4,000 4,000

5 Depreciation=25%WDV 2,500 1,875 1,406 1,055 791 593 1,347

6 EBIT=2-3-4-5 3,250 3,875 4,344 4,695 4,959 5,157 4,403

7 Tax@35% 1,138 1,356 1,520 1,643 1,736 1,805 1,541

8 PAT=6-7 2,113 2,519 2,823 3,052 3,223 3,352 2,862

9 NCF =1+5+8 (10000) 4,613 4,394 4,230 4,107 4,014 3,945 4,209

SP=16.50 EX 12.6
NCF PVIF@12%,n PV
1 4,613 0.8929 4,118.30
2 4,394 0.7972 3,502.67
3 4,230 0.7118 3,010.61

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4 4,107 0.6355 2,609.84

5 4,014 0.5674 2,277.85
6 3,945 0.5066 1,998.73
7 4,209 0.4523 1,903.92
LESS IO - 10,000.00
NPV 9,421.93

FC 4,800 PESSIMISTIC EX 12.6

Year 0 1 2 3 4 5 6 7
1 Investment -10000

2 Revenue=1k*15 15,000 15,000 15,000 15,000 15,000 15,000 15,000

3 Variable cost=1k*6.75 6,750 6,750 6,750 6,750 6,750 6,750 6,750

4 Fixed cost=4800 4,800 4,800 4,800 4,800 4,800 4,800 4,800

5 Depreciation=25%WDV 2,500 1,875 1,406 1,055 791 593 1,347

6 EBIT=2-3-4-5 950 1,575 2,044 2,395 2,659 2,857 2,103

7 Tax@35% 333 551 715 838 931 1,000 736

8 PAT=6-7 618 1,024 1,328 1,557 1,728 1,857 1,367

9 NCF =1+5+8 -10000 3,118 2,899 2,735 2,612 2,519 2,450 2,714

FC 4,800 PESS EX 12.6

NCF PVIF@12%,n PV
1 3,118 0.8929 2,783.48
2 2,899 0.7972 2,310.87
3 2,735 0.7118 1,946.50
4 2,612 0.6355 1,659.74
5 2,519 0.5674 1,429.55
6 2,450 0.5066 1,241.32
7 2,714 0.4523 1,227.65
LESS IO - 10,000.00
NPV 2,599.11

Table 12.7 shows the project's NPV when each variable is set to its pessimistic, expected
and optimistic values. The most critical variables are sales volume and unit selling price.
If the volume declines by 25 per cent (to 750,000 units) i.e. (1k-750)/1k*100=25%, NPV of
the project becomes negative (- Rs 1,146,000). Similarly, if the unit selling price falls by 15

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per cent (to Rs 12.75), NPV is minus Rs 1,702,000 i.e.(15-12.75)/15*100 = 15%

DCF Break-even Analysis

Sensitivity analysis is a variation of the break-even analysis.1. What you are asking is:
what shall be the consequences if volume or price or cost changes? You can ask this
question differently: How much lower can the sales volume become before the project
becomes unprofitable? What you are asking for is the breakeven point. Let us work with
the expected values of the variables in Illustration 12.6. We can measure the after-tax cash
flows as follows (assuming revenues and expenses are entirely on cash basis):

NCF = (REV - EXP) (1 - T) + TDEP

Note that we are working with the expected values

In our example, the first part of the right-hand expression is an annuity:
[1000 (15 - 6.75) - 4000] (1 - 0.35) = Rs 2,763
and its present value at 12 per cent discount rate is:
PV of an annuity amount (C) = C* PVIFA, n, k%
= 2,763 * PVIFA, 7, 12%
= 2,763 x 4.5638 = 12,610
The salvage value is zero. Under the gross block of assets method, the depreciation tax
shield is available for ever (until the block of assets is sold). Hence, assuming indefinite
period of time, the present value of depreciation tax shield (PVDTS) on plant of Rs 10,000
is as follows:
Td 0.35 * 0.25
PVDTS = * OV  *10,000  Rs 2,365
d + k  0.25  0.12
Where T = Corporate tax rate i.e. 35%
d= Depreciation rate i.e. 25%
K = Discount rate i.e. 12%
Ov = plant value i.e. 10,000
Here by the break-even point we mean that point where NPV is zero. We can use the
following expression to determine break-even point:
NCF = (REV - EXP) (1 - T) + TDEP
NPV = PV of NCF – Investment =0

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NPV = 0
NPV = Q (S-V) – F}(1-T) * PVIFA, K%, n + PVDTS – IO = 0

NPV = [ { V (15 – 6.75 ) – 4,000} (1-0.35) * 4.5638 + 2,365] – 10,000 = 0 ……….(12)

Where v = sales volume in units

n = number of years i.e. 7
K% = discount rate i.e. 12%
PVIFA, 12%, 7 = 4.5638
IO = Investment i.e. 10,000
PVDTS = present value of depreciation tax shield i.e. 2,365
T = corporate tax rate i.e. 35%

Where Vis the sales volume, 4.5638 is the present value factor of a 7-year annuity (at 12 per
cent) and Rs 2,365 is the present value of the series of depreciation tax shield.
We can solve Equation (12) as follows:
NPV = [ { V (15 – 6.75 ) – 4,000} 0.65 * 4.5638 + 2,365] – 10,000 = 0 ……….(12)

NPV = [ { (15V – 6.75V ) – 4,000} 2.96647 + 2,365] – 10,000 = 0

NPV = [ {8.25V – 4,000} 2.96647 +2,365] – 10,000 = 0
24.4733775V – 11,865.88 + 2,365 – 10,000 = 0
24.4733775V = 10,000 + 11,865.88 - 2,365
24.4733775V = 19,500
19,500
V=  796.8201365 =797
24.4733775

The project will start losing money if the sales volume goes below 797,000 units (i.e., if the
sales decline by more than 20 per cent). Let us verify if NPV is zero at this sales volume:
NPV = [(797(15 - 6.75) - 4,000) 0.65 x 4.5638 + 2,365]-10,000
NPV = 7,639 + 2,365-10,000 = 0

We can similarly work out the lowest selling price (P). Given other assumptions, how low
the units selling price can go before the project's NPV becomes negative? We can solve the
following equations:
NPV = [(1000(P - 6.75) - 4,000)0.65 * 4.5638 + 2,365]-10,000 = 0
= [(1000P – 6,750) - 4,000) 0.65 * 4.5638 + 2,365]-10,000 = 0
= [(1000P – 6,750) - 4,000) 2.96647 + 2,365]-10,000 = 0

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= 2,966.47 P - 20,023.6725 -11,865.88 + 2,365 -10,000 = 0

= 2,966.47P-39,524.5525=0
P = 39,524.4425/2,966.47 = 13.32

Let us verify: NPV=[(1000(13.32-6.75)-4,000)0.65 *4.5638 + 2,365] -10,000

= 7,625 + 2,365-10,000 = 0
You should note that the DCF break-even point is different from the accounting break-
even point. The accounting breakeven 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). Thus, you may be operating
above the accounting break-even point but still losing money because you have ignored the
opportunity cost of capital.

Pros and Cons of Sensitivity Analysis

Sensitivity analysis has the following advantages1
1. 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.
2. 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.
3. It helps to expose inappropriate forecasts, and thus guide; the decision-maker to
concentrate on relevant variables.

Let us emphasize that sensitivity analysis is not a panacea for a project's all uncertainties. It
helps a decision-maker to understand the project better.
It has the following limitations2
1. It does not provide clear-cut results. The terms ‘optimistic’ and ‘pessimistic could mean
different things to different persons in an organization. Thus, the range of value suggested
may be inconsistent.
2. It fails to focus on the interrelationship between variable? For example, sale volume may
be related to price and cor. A price cut may lead to high sales and low operating cost.

Scenario Analysis

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The simple sensitivity analysis assumes that variables are independent of each other. In
practice, the variables will be interrelated and they may change in combination. One way
to examine the risk of investment is to analyze the impact of alternative combinations of
variables, called scenarios, on the project's NPV (or IRR). The decision-maker can develop
some plausible scenarios for this purpose. For instance, in our example we can consider
three scenarios: pessimistic, optimistic and expected.
In the expected scenario, it may be possible to increase base volume of 1,000,000 units to
1,250,000 units (25 per cent increase) if the company reduces selling price from Rs 15 Rs
13.50 (10 per cent reduction), resorts to aggressive advertisement campaign, thereby
increasing unit variable cost to Rs 7.10 (5 per cent increase) and fixed cost to Rs
4,400,000 (10 per cent increase). Table 12.8 shows that this scenario generates a positive
NPV of Rs 3,044,000. NPVs under other scenarios are also shown in Table 12.8. More
plausible scenarios could be thought out and analyzed to arrive at a final judgment about the
project.

Table 12.8: Scenario Analysis: Summary Report

Scenario Summary Base Values Pessimistic Optimistic Expected

Variables combinations:

Sales volume (units '000) 1,000 750 1,250 1,250

Selling price/unit (Rs) 15.00 12.75 16.50 13.50

Variable cost/unit (Rs) 6.75 7.43 6.75 7.10

Fixed cost (Rs '000) 4,000 4,800 3,200 4,400

Result:

NPV (Rs '000) 4,972** -10,038 19,026 3,044

4,972** = as computed earlier

Note: NPV calculation for the expected scenario:

Recall from previous calculation:

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Td 0.35 * 0.25
PVDTS = * OV  *10,000  Rs 2,365
d + k  0.25  0.12
For the expected scenario we note the following variable
Q = sales volume in units i.e. 1,250
n = number of years i.e. 7
K% = discount rate i.e. 12%
PVIFA, 12%, 7 = 4.5638
IO = Investment i.e. 10,000
d = Depreciation rate i.e. 25%
PVDTS = present value of depreciation tax shield i.e. 2,365
T = corporate tax rate i.e. 35%
S= Unit selling price per unit i.e. 13.5
V = variable cost per unit i.e. 7.1
F = fixed cost i.e. Rs 4,400
NCF = (REV - EXP) (1 - T) + TDEP
NPV = PV of NCF – Investment
NPV = Q (S-V) – F}(1-T) * PVIFA, K%, n + PVDTS – IO
NPV = [(1250 (13.5-7.1)-4400) 0.65 x 4.5638 + 2,365]-10,000
= 10,679 + 2,222 - 10,000 = Rs 3,044

The present value of the written-down value depreciation tax shield is Rs 2,365.

Alternatively
Expected scenario EX 12.8 PANDEY
Year 0 1 2 3 4 5 6 7
1 Investment -10000

2 Revenue=1250*13.50 16,875 16,875 16,875 16,875 16,875 16,875 16,875

3 Variable cost=1250*7.10 8,875 8,875 8,875 8,875 8,875 8,875 8,875

4 Fixed cost=4400 4,400 4,400 4,400 4,400 4,400 4,400 4,400

5 Depreciation=25%WDV 2,500 1,875 1,406 1,055 791 593 1,347

6 EBIT=2-3-4-5 1,100 1,725 2,194 2,545 2,809 3,007 2,253

7 Tax@35% 385 604 768 891 983 1,052 789

8 PAT=6-7 715 1,121 1,426 1,654 1,826 1,954 1,464

9 NCF =1+5+8 -10000 3,215 2,996 2,832 2,709 2,617 2,548 2,811

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Expected scenario EX 12.8

NCF PVIF@12%,n PV
1 3,215 0.8929 2,870.54
2 2,996 0.7972 2,388.59
3 2,832 0.7118 2,015.90
4 2,709 0.6355 1,721.71
5 2,617 0.5674 1,484.87
6 2,548 0.5066 1,290.71
7 2,811 0.4523 1,271.76
LESS IO - 10,000.00
NPV 3,044.08

NPV calculation for the pessimistic scenario:

NPV = Q (S-V) – F}(1-T) * PVIFA, K%, n + PVDTS – IO
NPV = [(750 (12.75-7.43) - 4800) 0.65 x 4.5638 + 2,365]-10,000
NPV = -10,037.8407
Or
Pessimistic scenario EX 12.8 PANDEY
Year 0 1 2 3 4 5 6 7
1 Investment -10000

2 Revenue=750*12.75 9,563 9,563 9,563 9,563 9,563 9,563 9,563

3 Variable cost=750*7.43 5,573 5,573 5,573 5,573 5,573 5,573 5,573

4 Fixed cost=4800 4,800 4,800 4,800 4,800 4,800 4,800 4,800

5 Depreciation=25%WDV 2,500 1,875 1,406 1,055 791 593 1,347

- - - - -
6 EBIT=2-3-4-5 3,310 - 2,685 2,216 1,865 1,601 1,403 - 2,157
- - - - -
7 Tax@35% 1,159 - 940 776 653 560 491 - 755
- - - - -
8 PAT=6-7 2,152 - 1,745 1,441 1,212 1,041 912 - 1,402
-
9 NCF =1+5+8 -10000 349 130 - 34 - 157 250 - 319 - 55

Pessimistic scenario EX 12.8

NCF PVIF@12%,n PV
1 349 0.8929 311.16
2 130 0.7972 103.44
3 - 34 0.7118 - 24.42

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4 - 157 0.6355 - 100.00

5 - 250 0.5674 - 141.66
6 - 319 0.5066 - 161.54
7 - 55 0.4523 - 24.90
LESS IO - 10,000.00
NPV - 10,037.93

NPV calculation for the optimistic scenario:

NPV = Q (S-V) – F}(1-T) * PVIFA, K%, n + PVDTS – IO
NPV = [(1,250 (16.50 – 6.75) – 3,200) 0.65 x 4.5638 + 2,365]-10,000
NPV = 19,026.1491
Or

Optimistic scenario EX 12.8 PANDEY

Year 0 1 2 3 4 5 6 7
1 Investment -10000

2 Revenue=1250*16.50 20,625 20,625 20,625 20,625 20,625 20,625 20,625

3 Variable cost=1250*6.75 8,438 8,438 8,438 8,438 8,438 8,438 8,438

4 Fixed cost=3200 3,200 3,200 3,200 3,200 3,200 3,200 3,200

5 Depreciation=25%WDV 2,500 1,875 1,406 1,055 791 593 1,347

6 EBIT=2-3-4-5 6,488 7,113 7,581 7,933 8,196 8,394 7,641

7 Tax@35% 2,271 2,489 2,653 2,776 2,869 2,938 2,674

8 PAT=6-7 4,217 4,623 4,928 5,156 5,328 5,456 4,966

9 NCF =1+5+8 -10000 6,717 6,498 6,334 6,211 6,119 6,050 6,313

Optimistic scenario EX 12.8

NCF PVIF@12%,n PV
1 6,717 0.8929 5,997.21
2 6,498 0.7972 5,180.27
3 6,334 0.7118 4,508.46
4 6,211 0.6355 3,947.21
5 6,119 0.5674 3,471.93
6 6,050 0.5066 3,064.87
7 6,313 0.4523 2,855.83
LESS IO - 10,000.00
NPV 19,025.78

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SIMULATION ANALYSIS
We have explained in the previous sections that sensitivity and scenario analyses are quite
useful to understand the uncertainty of the investment projects. But both approaches
suffer from certain weaknesses. As we have discussed, they do not consider the
interactions between variables and also, they do not reflect on the probability of the
change in variables.
The Monte Carlo simulation or simply the simulation analysis considers the interactions
among variables and probabilities of the change in variables (Hertz 1968)1 It does not
give the project's NPV as a single number rather it computes the probability distribution of
NPV. The simulation analysis is an extension of scenario analysis. In simulation analysis a
computer generates a very large number of scenarios according to the probability
distributions of the variables. The simulation analysis involves the following steps:
1. First, you should identify variables that influence cash inflows and outflows. For
example, when a firm introduces a new product in the market these variables are initial
investment, market size, market growth, market share, price, variable costs, fixed costs,
product life cycle, and terminal value.
2. Second, specify the formulae that relate variables. For example, revenue depends on sales
volume and price; sales volume is given by market size, market share, and market growth.
Similarly, operating expenses depend on production, sales and variable and fixed costs.
3. Third, indicate the probability distribution for each variable. Some variables will have
more uncertainty than others. For example, it is quite difficult to predict price or market
growth with confidence.
4. Fourth, develop a computer programme that randomly selects one value from the
probability distribution of each variable and uses these values to calculate the project's
NPV. The computer generates a large number of such scenarios, calculates NPVs and
stores them. The stored values are printed as a probability distribution of the project's
NPVs along with the expected NPV and its standard deviation. The risk-free rate should
be used as the discount rate to compute the project's NPV. Since simulation is performed
to account for the risk of the project's cash flows, the discount rate should reflect only the
time value of money.

Simulation analysis is a very useful technique for risk analysis. Unfortunately, its practical
use is limited because of a number of shortcomings.

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Limitations of Simulation analysis

First, the model becomes quite complex to use because the variables are interrelated with
each other, and each variable depends on its values in the previous periods as well.
Identifying all possible relationships and estimating probability distribution is a difficult task;
its time consuming as well as expensive.
Second, the model helps in generating a probability distribution of the project's NPVs. But it
does not indicate whether or not the project should be accepted.
Third, simulation analysis, like sensitivity or scenario analysis, considers the risk of any
project in isolation of other projects. We know that if we consider the portfolio of projects,
the unsystematic risk can be diversified. A risky project may have a negative correlation
with the firm's other projects, and therefore, accepting the project may reduce the overall risk
of the firm.

DECISION TREES FOR SEQUENTIAL INVESTMENT DECISIONS

We have so far discussed simple accept or reject decisions, which view current investments
in isolation of subsequent decisions. But in practice, the present investment decisions
may have implications for future investment decisions, and may affect future events and
decisions. Such complex investment decisions involve a sequence of decisions over time.
It is argued that 'since present choices modify future alternatives, industrial activity cannot
be reduced to a single decision and must be viewed as a sequence of decisions extending
from the present time into the future’ (Masse & Pierre 1962).1 If this notion of industrial
activity as a sequence of decisions is accepted, we must view investment expenditures not as
isolated period commitments, but as links in a chain of present and future commitments (Mao
& James, C.T.1969).2 An analytical technique to handle the sequential decisions is to
employ decision trees (Magee 1964).3 In this section, we shall illustrate the use of decision
trees in analyzing and evaluating the sequential investments.
Steps in Decision Tree Approach
A present decision depends upon future events, and the alternatives of a whole sequence of
decisions in future are affected by the present decision as well as future events. Thus, the
consequence of each decision is influenced by the outcome of a chance event. At the time of
taking decisions, the outcome of the chance event is not known, but a probability distribution
can be assigned to it.
A decision tree is a graphic display of the relationship between a present decision and future
events, future decisions and their consequences.

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The sequence of events is mapped out over time in a format similar to the branches of a tree.
While constructing and using a decision tree, some important steps should be considered:
1. Define investment- The investment proposal should be defined. Marketing, production or
any other department may sponsor the proposal. It may be either to enter a new market or
to produce a new product.
2. Identify decision alternatives- The decision alternatives should be clearly identified. For
example, if a company is thinking of building a plant to produce a new product, it may
construct a large plant, a medium-sized plant, or a small plant initially and expand it later
on or construct no plant. Each alternative will have different consequences.
3. Draw a decision tree- The decision tree should be graphed indicating the decision
points, chance events and other data. The relevant data such as the projected cash flows,
probability distributions, the expected present value etc, should be located on the decision
tree branches.
4. Analyze data- The results should be analyzed and the best alternative should be selected.

Illustration 12.7: Decision Tree Analysis: Water Purity Limited

Water Purity Limited has developed a scientifically more effective water filter than the ones
currently available in the market. One option before the company is to start production on a
large scale by installing a large plant costing Rs 50 lakh. Alternatively, it can initially install
a small plant at a cash outlay of Rs 10 lakh and then decide to expand the capacity after a
year at a cost of Rs 45 lakh if the initial demand is high. There is a 50-50 chance that the
initial demand will be high or low. If it is high, then there is a 70 per cent chance that
demand in the subsequent years will be high. If it turns out to be low, it is expected to remain
low in subsequent years also.
The large plant is likely to generate net cash flow of Rs 10 lakh in year 1 if demand is high
and Rs 7 lakh if demand is low. With a high in demand, net cash flows are expected to be
Rs 16 lakh in perpetuity if the subsequent demand is high and Rs 10 lakh if the
subsequent demand is low. The subsequent demand will remain low if the initial demand is
low and the expected cash flow in perpetuity will be Rs 7 lakh.
The small plant is estimated to yield net cash flows of Rs 4 lakh in year 1 if demand is high
and Rs 2 lakh if demand is low. If the initial demand is high, the company will expand its
capacity and it is expected to generate net cash flows of Rs 20 lakh in perpetuity if the
subsequent demand is high and Rs 8 lakh if the subsequent demand is low. If the initial
demand is low, the subsequent demand will be low, and the expected net cash flow is Rs 2

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lakh in perpetuity. What should Water Purity Limited do?

Figure 12.1: Water Purity Ltd.: Decision tree approach

The problem of water filter in Illustration 12.7 is a sequential decision, and can be
depicted as a decision tree as shown in Figure 12.1. We may notice the following in Figure
12.1:
1. Decision points shown by squares
2. Chance events shown by circles
The decision points faced by the company are represented by squares. The company has to
first decide whether a large plant or a small plant should be built. After one year, it has to
decide whether the capacity should be expanded if the initial choice was to build a small
plant. The chances of initial and subsequent demand being high and low are shown by
circles, and are known as chance events. The expected net cash flows with associated

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probabilities are shown on the branches of tree. The probabilities of demand after year 1
depend on the demand conditions in year 1. For example, there is a 70 per cent probability
that the subsequent demand will be high if demand in year 1 is high. What is the probability
that demand will be high in the first year as well as the subsequent years? This is given
by the joint probability of occurrences of high demand, i.e., 0.5 x 0.7 = 0.35.
In order to decide whether the company should build a large plant or a small plant, we should
first analyze the problem of plant expansion after the first year. This is called the method
of backward induction or rolling back. If the initial demand is high and the company
expands its plant, the expected net cash flow (ENCF) is:

ENCF2 = 0.7 x 20 + 0.3 x 8 = Rs 16.4 lakh

To calculate the net present value of the expected net cash flow, we need a discount rate. Let
us assume that Water Purity Limited has an opportunity cost of capital of 20 per cent. Thus
the expected net present value (ENPV) of expansion costing Rs 45 lakh at the end of year 1
is:
16.4
ENPV1 =  45  37 = Rs 37 lakh
0.2

Note that ENCF of Rs 16.4 is perpetuity, and its value is found by simply dividing it by the

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discount rate.

What will be ENPV in year 1 if the company decides not to expand that plant? In our
illustration this is possible only if the initial demand is low. The expected net cash flow will
remain Rs 2 lakh in perpetuity. Thus ENPV in year 1 is:
2
ENPV1 =  0  10 = Rs 10 lakh
0.2

and ENPV0 today is the same because 2 lakh is a perpetuity from year 1 onwards:
2  10
 0  10 = Rs 10 lakh
1.2
ENPV0 = 1

We may note that when the initial demand is low no future decision is involved since the
company will not expand. We could directly calculate ENPV as follows:
2
ENPV0 =  10  0
0.2

Since ENCF of Rs 2 lakh is a perpetuity from the beginning.

Expansion is expected to yield a higher expected net present value if the initial demand is
high. What is ENPV today if the company decides in favour of expansion?
The company will have to incur an initial cost of Rs 10 lakh. The expected net cash flow in
year 1 will be Rs 4 + Rs 37 = Rs41 lakh if demand is high and Rs 2 + Rs 10 = Rs 12 lakh if
demand is low. Thus ENCF today is:

ENCF1 = 0.5 x 41 + 0.5 x 12 = Rs 26.5 lakh

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and ENPV for a small plant today is:

26.5
ENPV0 =  10   12.08 lakh
1.2

Building a large plant

Instead of building a small plant and then expanding later on, the company has the option of
building a large plant today. What is ENPV today if Water Purity Limited decides to
build a large plant?
The present value of ENCF in year 1 with high initial demand is:
0.7 * 16  0.3 * 10 14.2
NPV=   71 lakh
0.2 0.2

and with low initial demand:

1.0 * 7
NPV =  35 lakh
0.2

Thus the net cash flow in year 1 is Rs 10 + Rs 71 = Rs 81 lakh if demand is high and Rs 7 +
Rs 35 lakh = Rs 42 lakh if demand is low. Thus, ENCF today is:
ENCF = 0.5 x 81 + 0.5 x 42 = Rs 61.5 lakh

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and ENPV for the large plant today is:

61.5
ENPV =  50   1.25 = Rs 1.25 lakh
1.2 1

In fact, there is no need to perform backward calculation in case of the large plant since no
future decision is involved. We can calculate ENPV today as follows:
0.5 * 10  0.5 * 7 0.50.7 * 16  0.3 *10  0.51 * 7 
ENPV=  50  
1.2 1
0.2 1.21

8.5 7 .1  3 .5
ENPV=  50  
1.2 1
0 .2 1.2 1

ENPV= -50 +7.08333 + 44.1667 =1.2499 = + Rs 1.25 lakh

Given ENPV calculations, the best alternative for Water Purity Limited seems to build a
small plant (ENPV = Rs 12.08 lakh) today and expand it after a year if the initial demand is
high. This alternative yields a higher ENPV than the other alternative.
Let us consider another example of sequential investment decision-making.

Illustration 12.8: Decision Tree Analysis: Supreme Engineering Limited

Supreme Engineering Limited (SEL) has developed a new product which has a 10 year
expected life. A market study conducted by the company has revealed that a domestic as well
as an export market exists for the product. It is also indicated that a small plant will suffice
to cater to the domestic demand. However, a large plant will have to be built if export
demand also has to be met. The exact magnitude of the export market is not known. The
company has the option of building a small plant today, and then, after three years decide
to expand. The company may decide to expand if the initial demand consisting of both
domestic and export is high.
Further, the company has two options vis-a-vis its decision to expand: the small plant could
be expanded to a large size or a small size The market study indicates that the chance that the
initial demand will be high is 0.60 and low 0.40. Given a high initial demand, there is 0.80
probability that demand will be high in the subsequent years and 0.20 probability of demand

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being low. Table 12.9 summarizes the relevant data for various options. SEL uses a 10 per
cent discount rate for evaluating its investment proposals.

Table 12.9: Data for Alternative investment options

Initial (1-3 years Subsequent (4-10 years)
Plant size Cash Demand Prob. NCF Demand Prob. NCF
outlay
Large 50 H 0.6 10 H 0.8 12
L 0.2 10
L 0.4 8 H 0.2 8
L 0.8 6
Small 20 H 0.6 4 H 0.8 4
L 0.2 3
L 0.4 3 H 0.2 3
L 0.8 2
Expansion:
Large 30 H 0.8 13
L 0.2 9
Small 10 H 0.8 7
L 0.2 5

The data contained in Table 12.9 is shown in the form of a decision tree in Figure 12.2. In
order to select the best alternative, we start at the last chronological decision on the tree.
Figure 12.2: Decision tree

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At decision point 2 three options are involved: either the firm expands to a large size and
incurs an outlay of Rs 30 lakh or expands to a small size and incurs an outlay of Rs 10 lakh or
does not expand even if the initial demand is high. Let us consider expansion to large size
first. The annual expected net cash flow foe seven years

ENCF = 0.8 * 13 + 0.2 *x 9 = Rs 12.2

and ENPV is:

ENPV = - 30 + 12.2 * PVAF at 10% for 7 years
= - 30 + 12.2 * 4.868 = + Rs 29.39 lakh

For expansion to a small size, ENCF is:

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ENCF = 0.8 * 7 + 0.2 * 5 = Rs 6.6 lakh

and ENPV is:

ENPV = - 10 + 6.6 * PVAF at 10% for 7 years
= - 10 + 6.6 x 4.868 = + Rs 22.13 lakh

What will be ENPV if the initial demand is high and the firm does not want to expand? For
this option, ENCF at the end of year 3 is:
ENCF = 0.8*4 + 0.2*3 = Rs3.8 LAKH … a small size

AND ENPV

ENPV = -0+3.8*PVAF AT 10% FOR 7 Years

=-0+ (3.8* 4.868 = Rs 18.50 lakh

If the initial demand is low, the firm (… a small size) will not expand. ENCF at the end of 3
is:
ENCF = 0.2*3 +0. 8*2 = Rs 2.2 Lakh

And ENPV is:

ENPV = -0 +2.2 * 4.686 = Rs 10.71 lakh

The optimum decision at point 2 is to expand the small plant to a large size since ENPV is the
highest. All other alternatives at decision point 2 can be eliminated and replaced by ENPV of
Rs 29.39 lakh. We can now roll back to decision point 1. If the initial demand is high, the
firm is expected to receive net cash flow of Rs 4 lakh each for year 1 and 2 and Rs 4 + Rs
29.39 = Rs 33.39 lakh in year 3. On the other hand if the initial demand is low, net cash flow
will be Rs 3 lakh each year for year 1 and 2 and rs 3 +Rs 10.71 (i.e., present value of ENCF
if demand low and the firm does not expand) = Rs 13.71 lakh in year 3. Thus ENCF will be:

Year 1 & 2 0.6 * 4 + 0.4 * 3 = Rs 3.6 lakh

Year 3 0.6 * 33.39 + 0.4 *13.71 = Rs 25.52 lakh

And ENPV is:

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3.6 3.6 25.52

ENPV =  20   
1.1 1.1 1.1
1 2 3

= -20 + 3.6 * 0.909 + 3.6 * 0.826 + 25.52 * 0.751

ENPV = -20 + 27.75 = Rs 5.41 lakh

USEFULNESSS OF DECISION TREE APPROACH (DTA)

The DTA) is extremely useful in handling the sequential investments. Working backwards –
from future to present – we are able to eliminate unprofitable branches and determine
optimum decision at various decision points.
The merits of (DTA)
1. Clarity – it clearly brings out the implicit assumptions and calculations for all to see and
revise.
2. Graphic visualization – it allows a decision maker to visualize assumptions and
alternatives in graphic form, which is usually much easier to understand than the more
abstract, analytical form

Demerits of (DTA)
1. 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; for
example, sales volume depends on market share which depends on promotion expenses,
etc.
2. The diagram itself quickly becomes cumbersome and calculations become very time
consuming or almost impossible.

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