RISK ANALYSIS IN

CAPITAL BUDGETING
 THE VARIETY OF TECHNIQUES USED TO
HANDLE RISK IN CAPITAL BUDGETING:

1. Approaches that consider the stand-alone risk of project

(sensitivity-analysis, scenario analysis, break-even analysis,
Hiller mode, simulation analysis, and decision tree
analysis).

2. Approaches that consider the contextual risk of a project

(corporate risk analysis and market risk analysis).
SENSITIVITY ANALYSIS

Sensitivity analysis or “what if” analysis answers

questions like: “what happens to NPV or IRR if
sales decline by 5 percent or 10 percent from their
expected levels?”
Sensitivity analysis
NPV = En t=1 [Q ( P-V) – F- D] (1- T ) +D + S -I
(1+ r) t (1+ r) n
NPV= net present value of the project
Q = no. of units sold annually
P = selling price per unit
V = variable cost per unit
F = total fixed cost, excluding depreciation and interest
D = annual depreciation charge
T = income tax rate
r = cost of capital
n = project life in years
S = net salvage value
I = initial cost
Procedure
1. Set up the relationship between the basic underlying
factors (like the quantity sold, unit selling price, life of the
project, etc.) and net present value (or some other criterion
of merit).
2. Estimate the range of variation and the most likely value of
each of the basic underlying factors.
3. Study the effect on net present value of variations in the
basic variables. (typically one factor is varied at a time).
MERITS OF SENTIVITY ANALYSIS
1. It forces management to identify the underlying variables
and their inter-relationships.
2. It shows how robust or vulnerable a project it to changes in
the underlying variables.
3. It indicates the need for further work. If the net present
value or internal rate of return is highly sensitive to
changes in some variables, it is desirable to gather further
information about that variable.
SCENERIO ANALYSIS
PROCEDURE:
1. Select the factor around which scenarios will be built. The
factor chosen must be the largest source of uncertainty for the
success of the project. It may be the state of the economy or
interest rate or technological development or response of the
market.
2. Estimate the values of each of the variables in investment
analysis (investment outlay, revenues, costs, project life, and
so on ) for each scenario.
3. Calculate the net present value and/or the internal rate of
return under each scenario.
Best and worst case analysis
Best 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.

Worst scenario: low demand, low selling price, high

variable cost, and so on.
 LIMITATIONS:
1. It is based on assumptions that there are few well-delineated
scenarios. This may not be true in many cases. For example,
the economy does not necessarily lie in three discrete states,
viz., recession, stability and boom.
2. Scenario analysis expands the concept of estimating the
expected values. Thus, in a case where there are 10 inputs the
analyst has to estimate 30 expected values (3*10) to do the
scenario analysis.
 BREAK-EVEN ANALYSIS
The break-even point for a product is the point where total
revenue received equals the total costs associated with the sale of
the product (TR=TC). A break-even point is typically calculated
in order for businesses to determine if it would be profitable to
sell a proposed product, as opposed to attempting to modify an
existing product instead so it can be made lucrative. Break-Even
Analysis can also be used to analyze the potential profitability of
an expenditure in a sales-based business.
Break even analysis is a special application of sensitivity
analysis. It aims at finding the value of individual variables at
which the project’s NPV is zero. In common with sensitivity
analysis, variables selected for the break even analysis can be
tested only one at a time.

The break even analysis results can be used to decide abandon of

the project if forecasts show that below break even values are
likely to occur.
HILLIER MODEL
Under certain circumstances, the expected NPV and
the standard deviation of the NPV may be obtained
through analytical derivation. Two cases of such
analysis are :
(i) No correlation among cash flows
(ii) Perfect correlation among cash flows
 SIMULATION ANALYSIS
PROCEDURE:

1. Model the project. The model of the project shows how the NPV is
related to the parameters and the exogenous variables. (parameters
are input variables specified by the decision maker and held constant
over all simulation runs. Exogenous variables are input variables
which are stochastic in nature and outside the control of the decision
maker).
2. Specify the values of parameters and the probability distributions of
the exogenous variables.
3. Select a value, at random, from the probability distributions of each
of the exogenous variables.
 Continued…

4. Determine the NPV corresponding to the randomly generated

values of exogenous variables and pre-specified parameter
values.

5. Repeat steps 3 and 4 a number of times to get a large number of

simulated NPV’s.

6. Plot the frequency distribution of the NPV.

 DECISION TREE ANALYSIS
A useful tool for analyzing sequential decisions in the face of risk.

STEPS IN DECISION TREE ANALYSIS:

1. Identify the problem and alternatives.

2. Delineating the decision tree
3. Specifying probabilities and monetary outcomes
4. Evaluating various decision outcomes
 CORPORATE RISK ANALYSIS

A projects corporate risks is its contribution to the

overall risk of the firm. Put differently, it is reflects
the impact of the project on the risk profile of the
firm’s total cash flows. On a stand-alone basis a
project may be very risky but if its returns are not
highly correlated- or, even better, negatively
correlated-with the returns on the other projects of
the firm, its corporate risk tends to be low.
 PROJECT SELECTION UNDER RISK
 In many situations companies use NPV or IRR as the
principal selection criterion, but apply a pay back period
requirement to control for risk. If an investment is considered
more risky, a shorter pay back period is required.

 Under the risk profile method, the probability distribution of

NPV, an absolute measure, is transformed into the probability
distribution of profitability index, a relative measure. Then,
the dispersion of the profitability index is compared with the
maximum risk profile acceptable to management for the
expected profitability index of the project.
 Continued…

The risk-adjusted discount rate method calls for adjusting the

discount rate to reflect project risk. If the project risk is same
as the risk of the existing investments of the firm, the discount
rate used is the WACC of the firm; if the project risk is greater
(lesser) than the existing investments of the firm, the discount
rate is used is higher (lower) than the WACC of the firm.
Under the certainty equivalent method, the expected cash
flows of the project are converted into their certainty
equivalents by applying suitable certainty equivalent
coefficients. Then, the risk-free rate is applied for discounting
purposes.
Methods of risk analysis

(i) Conservative estimation of revenues

(ii) Safety margins in cost figures
(iii) Flexible investment yardsticks
(iv) Acceptable overall certainty index
(v) Judgment on three-point estimates
CAPITAL BUDGETING:
EXTENSIONS
CHOICES BETWEEN PROJECTS OF UNEQUAL LIFE:

For this we have to look at the equivalent annual cost

(EAC) figure. The EAC is a function of the present values
of costs, the life of the asset, and the discount rate.

EAC = PVC cost

PVIFA r, n
 INTERRELATIONSHIP BETWEEN INVESTMENT AND
FINANCING ASPECT

When investment and financing aspects of a project are inter-

related, the financing impact of investment decision must be
considered. This can be done by calculating the adjusted NPV
which is defined as:

Base case NPV (NPV under assumption that the project is all-
equity financed) + NPV of financing decisions associated with
the project
The following procedure may be used
for selecting the set of investments
under capital rationing:
(i) Define all combinations of projects which are
feasible, given the capital budget restrictions
and project interdependence.
(ii) Choose the feasible combination that has the
highest NPV.
Capital budgeting under constraints

Feasible combination approach

Linear programming model
Integer programming model
 VALUE OF OPTIONS
IDENTIFY OPTIONS:
 INCREMENTAL OPTION provides the firm with opportunities to make profitable
investments in future.
 FLEXIBILITY OPTION: gives a firm a wider latitude in manufacturing so that it
can cope better with opportunities that come its way.

ANALYZE ENVIORNMENTAL UNCERTAINTY:

VALUE OPTIONS:
The greater the uncertainty characterizing a project, the higher the value of the
options embedded in the project. The longer the duration of the project, the higher
the value of the options inherent in it.
 Entry barriers that result in positive NPV of a
project:

Economies of scale
Product differentiation
Cost advantage
Marketing research
Technological edge
Governmental policy
QUALITATIVE INFLUENCES
Intuition
Vision
Superstition
Politics
Sponsorship
Intangible benefits
ORGANIZATIONAL CONSIDERATION
In order to be meaningful and viable, the capital
budget of a firm must satisfy some conditions:

 It must be compatible with the resources of the firm

 It must be controllable
 It must be endorsed by the executive management
To ensure that corporate strategy and long range
plans firmly undergird the capital budgeting
process, the following ought to be done:

(i) Long-range planning should precede capital budgeting

(ii) Long-range plans should be formalized and communicated
to all persons involved in the process of capital budgeting
(iii) During the capital budgeting exercise, investment
proposals should be viewed in the context of critical
premises of business plans
THANK YOU!!