Financial Management

BITS Pilani
Work Integrated Learning
Programmes Division
 BITS Pilani
Work Integrated Learning
Programmes Division

Risk Analysis in Capital Budgeting

Risk Analysis in Capital Budgeting

• Risk is inherent in almost every business decision

• Capital budgeting decisions involve costs and benefits extending over a long
period of time during which many things can change in unanticipated way.
• R & D projects are more riskier than the expansion project and the latter
tends to be more riskier than a replacement project.
• Therefore, risk need to be evaluated explicitly in capital budgeting decision.
• This is called Risk Analysis in Capital Budgeting.
• Large corporations often use very sophisticated methods to incorporate risk
into capital budgeting, but every business needs to know a few basic
techniques for evaluating uncertainty.

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Risk Analysis Techniques

1. Sensitivity Analysis
2. Scenario Analysis
3. Break-even Analysis
4. Decision Tree Analysis

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Sensitivity Analysis

• Also known as ‘what if’ analysis

• It is a way of analysing 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 change in
particular variable.
• The more sensitive the NPV or IRR, the more critical is the variable.
For example, what will happen to the viability of the project when
some variable like sales or investment deviates from its expected
value?

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Steps for 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 or IRR

While performing sensitivity analysis, decision maker computes the project’s

NPV or IRR for each forecast under three assumptions:
a. Pessimistic,
b. Expected, and
c. Optimistic

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Sensitivity Analysis: Illustration 1

The financial manager of a food processing company is considering the installation of a plant
cost Rs. 1 crore to increase its processing capacity. The expected values of the underlying
variables are given as follow. Life of project is 7 yrs.

Sr. No. Particulars Amount/units

1 Investment (Rs.’000) 10000
2 Sales volume (units ‘000) 1000
3 Unit selling price (Rs.) 15
4 Unit variable cost (Rs.) 6.75
5 Annual fixed costs (Rs.’000) 4000
6 Depreciation (%) (WDM) 25%
7 Corporate tax rate (%) 35%
8 Discount rate (%) 12%

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Sensitivity Analysis: Illustration
Calculation of Net Cash Flows

Cash flows (Rs. '000)

Year/Particulars 0 1 2 3 4 5 6 7
Investment -10000
Revenue 15000 15000 15000 15000 15000 15000 15000
Variable Cost 6750 6750 6750 6750 6750 6750 6750
Fixed Costs 4000 4000 4000 4000 4000 4000 4000
Depreciation 2500 1875 1406 1055 791 593 445
Pre-tax profit 1750 2375 2844 3195 3459 3657 3805
Taxes @35% 613 831 995 1118 1211 1280 1332
Profit After Taxes 1138 1544 1849 2077 2248 2377 2473

Net Cash flow -10000 3638 3419 3255 3132 3039 2970 2918
The project’s NPV at 12% is
NPV = 4829 >0
Accept the project
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Sensitivity Analysis: Illustration
Forecast under different assumptions
Variables Pessimistic Expected Optimistic % Change
1 Sales Volume (unit'000) 750 1000 1250 25%
2 Units selling price 12.75 15 16.5 15%
3 Units variable cost 7.425 6.75 6.075 10%
4 Annual fixed cost (Rs.'000) 4800 4000 3200 20%

Now, project’s NPV are recalculated as below (We are changing one value at a
time, not all). This table has done CF calculation 8 times for 8 results here.
Variables Pessimistic Expected Optimistic
1Sales Volume (unit'000) -1289 4829 10948
2Units selling price -1845 4829 9279
3Units variable cost 2827 4829 6832
4Annual fixed cost (Rs.'000) 2456 4829 7203

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Sensitivity Analysis: Illustration

• The above NPV calculation under different assumption shows project’s

sensitivity
• The project does not seem to be that attractive with change in assumptions.
• The most critical variable is sales volume, followed by the units selling price.
• If volume decline by 25%, NPV of the project becomes negative. Similarly, if
the unit selling price falls by 15%, NPV is negative.

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Evaluation of Sensitivity Analysis
Merits:
• It shows how robust or vulnerable a project is to changes in the values of the underlying variables
• It indicates where further work may be done. If the NPV is highly sensitive to changes in some
factor, it may be worthwhile to explore how the variability of the that critical factor may be
contained.

Demerits:
• It merely shows what happens to NPV when there is a change in some variables, without
providing any idea of how likely (probability) that change will be.
• Typically, in sensitivity analysis only on variable is changed at a time. in the real world, however,
variables tend to move together.
• It is inherently a very subjective analysis. The same sensitivity analysis may lead one decision
maker to accept the project while another may reject it.

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Example: Sensitivity Analysis
• Sensitive Controls Limited have a project on hand costing Rs.20
crore with a life of 10 years. The expected revenue is Rs.21 crore
per annum with variable cost estimated at 50%. The fixed cost are
Rs 5 crore while depreciation is on the basis of SLM. The tax rate is
40% and the cost of capital for the firm is 14%.
• The management of the Sensitive Controls Limited is apprehensive
of the cash flow estimates. The apprehension emanates from
uncertainty of revenue and the proportion of the variable cost. Due
to inherent risk in the projections the management also believes
that the suppliers of capital for the project may not be very
comfortable with the returns equal to the current cost of capital.

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Find out the following: (Refer to Excel)
i) The estimated annual cash flows of the project.
ii) Assuming uniform cash flows of the project for entire life and current cost of
capital as appropriate discount rate find the net present value of the project.
iii) Find out the NPV of the project assuming the revenues can change from 70% to
130% of the expected revenue and plot the NPV with respect to the level of
revenue. Find out from the plot the approximate minimum revenue that the project
must generate so as to keep the NPV positive.
iv) Find out the NPV of the project assuming that the variable cost can change from
35% to 65% of the expected revenue and plot the NPV with respect to the variable
cost as proportion of expected revenue. What is the maximum proportion of
variable cost the project can afford?
v) Find out the NPV of eth project for cost of capital ranging between 11% and 17% and
plot the NPV with respect to cost of capital. What is the maximum cost of capital
that would keep the project acceptable?
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Scenario Analysis
• Scenario analysis is a crucial risk assessment technique used in capital budgeting to
evaluate the potential outcomes of an investment project under different sets of future
conditions (Scenarios).
• Unlike traditional single-point forecasts or sensitivity analysis (which typically changes
one variable at a time), scenario analysis considers how a project's financial viability
might change if several key variables shift simultaneously in a plausible manner.
• This provides a more comprehensive understanding of the risks and opportunities
associated with a capital expenditure.
• Various Variables (Sales, output, costs) are interrelated. Therefore, it looks at the
plausible scenarios, representing a consistent combination of variables.
• For eg. a project may be evaluated under three different scenarios:
1. The base case scenario where the demand and price are expected to be normal
2. The scenario where the demand is high, but the price is low.
3. The scenario where the demand is low, but the price high.

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Scenario Analysis…

Firm often do a different kind of scenario analysis in which the following

scenarios are considered.

• Optimistic scenario: High demand, high selling price, low variable cost, and
so on.
• Normal scenario: Average demand, average selling price, average variable
cost, and so on.
• Pessimistic scenario: Low demand, low selling price, high variable cost,
and so on.

 Scenario analysis, if extended, becomes Simulation Analysis (which is not

covered in this course).

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Scenario Analysis: Advantages

• Comprehensive View: Provides a more holistic view of risk by considering

multiple variables changing simultaneously, which is more realistic than
sensitivity analysis.
• Better Preparedness: Encourages managers to think proactively about
potential future events and prepare contingency plans.
• Highlights Interdependencies: Illustrates how different variables interact
and jointly impact project outcomes.
• Improved Communication: The structured scenarios can facilitate clearer
discussions among stakeholders about risks and opportunities.
• Avoids "Single-Point Failure": Reduces reliance on a single forecast,
which is often inherently uncertain.

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Scenario Analysis: Disadvantages

• Subjectivity: Defining scenarios and assigning probabilities (if used) can be

subjective and rely on management judgment, which can introduce bias.
• Limited Number of Scenarios: It's impractical to analyze every conceivable
scenario, so some possibilities might be overlooked.
• Complexity: Can be time-consuming and complex, especially for projects
with many interrelated variables.
• Assumptions are Critical: The validity of the analysis heavily depends on
the realism and accuracy of the assumptions made for each scenario. If the
defined scenarios do not reflect actual potential futures, the analysis will be
misleading.
• Not a Prediction Tool: It doesn't predict the future but rather explores a
range of plausible futures.

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Scenario Analysis: Illustration 1 extended

In our previous example, it may be possible to

• Increase sales volume to 12,50,000 units (25% increase) if the company
reduces unit selling price to Rs. 13.50 (10 % reduction), resorts to aggressive
advertisement campaign, thereby increasing unit variable cost to Rs.7.10 (5
% increase) and fixed cost to Rs. 44,00,000 (10 percent increase).
• This scenario generates positive NPV as shown below

Variables Expected Scenario Assumptions

1Sales Volume (unit'000) 1000 1250
2Units selling price 15 13.5
3Units variable cost 6.75 7.1
4Annual fixed cost (Rs.'000) 4000 4400

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Scenario Analysis: Illustration

NPV Calculations at 12% for Scenario:

Cash flows (Rs. '000)
Year/Particulars 0 1 2 3 4 5 6 7
1 Investment -10000
2 Revenue 16875 16875 16875 16875 16875 16875 16875
3 Variable Cost 8875 8875 8875 8875 8875 8875 8875
4 Fixed Costs 4400 4400 4400 4400 4400 4400 4400
5 Depreciation 2500 1875 1406 1055 791 593 445
6 Pre-tax profit 1100 1725 2194 2545 2809 3007 3155
7 Taxes @35% 385 604 768 891 983 1052 1104
8 Profit After Taxes 715 1121 1426 1654 1826 1955 2051
9 Net Cash flow -10000 3215 2996 2832 2709 2617 2548 2496
PVIF @ 12% 0.893 0.797 0.712 0.636 0.567 0.507 0.452
PV of Cash Flow 2871 2388 2016 1723 1484 1292 1128
Total of PV of Cash Flow 12902
Initial Cash Outlay (Co) -10000
NPV 2902>0

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Example: Scenario (Refer to Excel)
• A firm is considering a capital investment of Rs 40 lacs for a project that has life of 5 years. The
cash flows are dependent upon the general economic conditions. The project team has
considered 4 different scenarios of poor, average, good and excellent with respective
probabilities of 20%, 30%, 30% and 20% respectively. The cash flows from three years under 4
different scenarios are given below:

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Example: Scenario… (Refer to Excel)

i) The NPV of the project under different scenarios of poor, average, good
and excellent.
ii) The expected NPV of the project.
iii) Risk as assessed from standard deviation and co-efficient of variation.
iv) Find out the probabilities of NPV being
a) negative b) 80%, c) 90%, d) 100%, e) 110% and f) 120% of the
expected NPV.
v) The management does not accept any proposal that has more than 20%
chance of providing negative NPV. Under such condition what is your
recommendation regarding acceptance of the project?

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Solution: (Refer to Excel)

Explain Normal distribution…Next PPT

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Solution in detail
• Normal Distribution: Calculating Probabilities/Areas (z-table) (Play in class)
• Understand Normal distribution, Standard normal distribution, Z-score, area under the
curve.
• Now compute for all values by explain on diagram and using tables online
• To calculate the probabilities of the Net Present Value (NPV) being at certain levels, we
will use the concept of the Z-score and the standard normal distribution. This approach
assumes that the NPV is normally distributed.
• Given: Expected NPV (Mean, μ) = 16.26; Standard Deviation (σ) = 16.71. The Z-score
formula is: Z= (X−μ)/σ​. Where: X is the specific NPV value we are interested in, μ is the
expected NPV, σ is the standard deviation of NPV.
• For each case, we will calculate the Z-score and then find the corresponding cumulative
probability (P(NPV≤X)) from the standard normal distribution table or calculator.
• a) Probability of NPV being negative (P(NPV<0)) Here, X=0. Z= (0−16.26)/16.71​ =
≈−0.9730. Using a standard normal distribution table or calculator, the probability
corresponding to Z=−0.9730 is approximately 0.1653 or 16.53%. Similarly compute for
others.

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• b) Probability of NPV being 80% of the expected NPV
(P(NPV≤0.80×16.26)). X=0.80×16.26=13.008;
Z=(13.008−16.26)/16.71​≈−0.1946. Using a standard normal distribution table
or calculator, the probability corresponding to Z=−0.1946 is approximately
0.4228 or 42.28%.
• Similarly, Do it for others and match with the solutions.

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Break-Even Analysis

• How much should be produced and sold at a minimum to ensure that the project
does not lose money.
• This is called break-even analysis and the minimum quantity at which loss is
avoided is called the break-even point.
• Most popular way is financial break-even analysis
• For example, imagine a project that has a fixed cost of $100,000 and earns on net
$4 (contribution) per unit sold. You expect to sell 35,000 units, which generates a
profit of $40,000 (35,000*$4 - $100,000 = $40,000). The break even-point is 25,000
units (25,000*4 - $100,000=0).
• You might be wrong about selling 35,000 units, but if you know that the project will
sell at least 25,000 units then you know you won’t lose money, and would feel more
confident about going ahead with the project.

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Example: BEP (Refer to Excel)

• The upfront cost of a project is $100,000. Sales are for five years, starting next year.
The company earns $0.50 per sale, and expects to sell 60,000 units per year.
• If the interest rate (cost of capital) is 5%, the NPV is -100,000 +129,884 = 29,884
(Refer to Excel).
• At what level of sales does the project break even in terms of NPV?
• Set PV = -100,000 (so that NPV = 0) and find the amount of sales per year (Use
Goal seek in Excel). Explain in detail
• The answer is sales in dollars = 23,097 so that sales in units = 46,194 (23097/0.5).

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Probability Approach to NPV (Students
do it in class)
• National Paper Mills is considering expansion into manufacture of glazed paper or craft paper. Though
both the projects can be undertaken but due to capital constraints only one of them can be
implemented now. The glazed paper project involves an outlay of Rs 25 crore while craft paper project
can be implemented with Rs 20 crore. The markets are uncertain and the estimates of NPV for both the
projects with corresponding probabilities are as below:

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Example: Probability (Refer to Excel)

i) What is the expected NPV of each project?

ii) What is the risk of each project, as measured from standard
deviation and co-efficient of variation
iii) What is the profitability index of each project?
iv) What conclusion would you draw based on expected NPV, its
standard deviation, and co-efficient of variation?
v) If firm faces constraint of capital which project should be
undertaken

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Decision Tree Analysis

• Employ to take the sequential investment decisions

• While constructing and using a decision tree, following steps to be
considered.
1. Define investment
2. Identify decision alternatives
3. Draw a decision tree (using probability distribution)
4. Analyse data

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Example: Decision Tree
• Apollo Hospital is in the business of developing Hospitals and has identified to set up a
new hospital / new treatment center (Apollo Clinic) in J&K with a life of 2 - 3 years.
The capital investment is Rs. 275 lakhs. During the first year Apollo Hospital expects
the post tax cash inflows of Rs. 150 lakhs with probability of 60% or Rs. 180 lacs with
probability of 40% depending upon the demand for the service by J&K people. During
the second year the probabilities of demand being low, medium and high are 40%, 40%
and 20% respectively. If initial demand during first year is high then the second year
cash flows are expected to be Rs. 200 lakhs, Rs. 240 lakhs and Rs. 290 lakhs
respectively. However, if initial demand during first year is low then the second year
cash flows are expected to be Rs.160 lacs, Rs. 200 lakhs and Rs. 250 lakhs respectively.
Assume cost of capital for Apollo Hospital is 15%. Advise whether Apollo Hospital should
go ahead with the investment.
• Estimate riskiness of the proposed project and decide whether you can accept the
project or not.

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Solution

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Solution

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Solution

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 THANK YOU!!!

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