Capital Budgeting and Analysis of Risk
Capital budgeting process involves forecasting of expected
cash inflows which will be realized by the company over the
undertaken investment. But future is quite uncertain. Therefore
risk is involved in estimation of future cash inflows. It is difficult
to forecast the exact amount of cash inflow which will be
realized by the company in series of years.
In finance, risk is defined variability in rate of return which
company realized over period of time.
Total Risk
Systematic Risk Unsystematic Risk
Systematic Risk-Systematic risk refers to the variation in
returns of the company due to systematic factors like,
industrial production, GDP, Inflation, Forex Rate, Interest
Rate. Impact of systematic risk can not be diversified.
Unsystematic Risk-Unsystematic risk refers to the variation in
returns of the company due to Company specific factors like
dividends, capital structure, management etc.
Risk Analysis
Factors which influence the forecast of
future cash inflows.
[Link] Economic Conditions-
[Link] Factors-
[Link] Factors-
Techniques of Analysis and Managing
of Risk
[Link] Techniques-
1. Payback Method-
2. Risk adjusted discount rate-
3. Certainty equivalent
2. Sensitivity Analysis-
3. Statistical Techniques-
1. Beta-
2. Standard deviation-
3. Coefficient of variation-
Risk adjusted Discount Rate
Under this method, for normal projects simple discount
rate is used in order to calculate the present value of cash
inflows.
In case of risky projects, comparatively higher discount
rate is used to calculate the present value of cash inflows.
For example-
Banks charge normal lending rate over the loans extended
to prime borrowers.
On the other hands, Banks charge comparatively higher
lending rate over the loans extended to sub prime
borrowers.
Risk Adjusted Discount Rate
For Normal Project- Net present value of a cash inflows of
a projects will be calculated by the following formula.
C1 C2 C3 Cn
NPV ........ n
C0
(1 Kf ) (1 Kf ) (1 Kf ) (1 Kf )
2 3
For Risky Project- Net present value of a cash inflows of a
projects will be calculated by the following formula.
K Kf Kr
C1 C2 C3 Cn
NPV ........ n
C0
(1 K ) (1 K ) (1 K ) (1 K )
2 3
Risk Adjusted Discount Rate
A Project will cost Rs. 50,000, and it is expected to generate
cash inflows Rs. 25,000, Rs. 20,000, Rs. 10,000, Rs. 10,000
in next four years. Assume a 10 percent required rate of
return.
25000 20000 10000 10000
NPV 50000 Rs3599 /
4
(1 0.10) (1 0.10) (1 0.10) (1 0.10)
2 3
If the project is risky than a higher discount rate should be used
to calculate the net present value of the cash inflows.
K=10%+5%=15%
25000 20000 10000 10000
NPV 50000 Rs845 /
4
(1 0.15) (1 0.15) (1 0.15) (1 0.15)
2 3
Certainty Equivalent Method
This method involves assigning a probability to the
incurring of cash inflows which will be generated over
the project.
-Where, a is probability of cash
[Link]
NPV inflow,
(1 K ) t -K is discount rate,
-CF is cash inflow
A lower probability (a) is used if higher risk is perceived in
generating of cash inflow.
A higher probability (a) is used if lower risk is perceived in
generating of cash inflow.
Certainty Equivalent Method
A projects costs Rs. 6000, it expects to generate cash inflows
Rs. 4000, Rs. 3000, Rs. 2000 and Rs. 1000 in next four years.
Assume the probability of getting the cash inflows are
a1=90%, a1=70%, a3=50%, a4=30%, and risk free discount
rate is 10%.
0.90(4000) 0.70(3000) 0.50(2000) 0.30(1000)
NPV 1(6000) Rs37 /
4
(1 0.10) (1 0.10) (1 0.10) (1 0.10)
2 3
Statistical Techniques
Statistical techniques provide how cash
inflows are sensitive to economic and
other factors of the company.
Beta Analysis
Beta is the measurement of how much one variable is
sensitive to another.
For example how much sale of a company depends upon
industry sale or economic growth.
Y X
Where, Y is company sale, X is economic growth rate, α minimum sale, β
sensitiveness of company sale to economic growth rate.
A high beta is the index of high risk, i.e, sale of company
largely depends upon economic growth rate.
A low beta value is the index of low risk, i.e. sale of
company very less depends upon economic growth rate.
Beta Analysis
For example,
beta of consumer durable company will be very high.
It is because the sale of consumer products are
directly hit by economic growth rate.
beta of pharma company company will be very less. It
is because the sale of consumer products are directly
hit by economic growth rate.
Standard Deviation
Standard deviation is the measurement of variation in company
cash inflows, which company will realize over the series of
years.
A projects cost is Rs. 2,00,000, it is expected to generate
following cash inflows in next five year.
Year 1 2 3 4 5
Cash inf Rs. 20,000 Rs. 30000 Rs. 50000 Rs. 70000 Rs 80000
Value of Total cash inflows=Rs. 250000
Standard Deviation =25495
A projects cost is Rs. 2,00,000, it is expected to generate
following cash inflows in next five year.
Year 1 2 3 4 5
Cash inf Rs. 45,000 Rs. 47000 Rs. 48000 Rs. 50000 Rs 60000
Value of Total cash inflows=Rs. 250000
Standard Deviation =5873
Coefficient of Variation
A relative measure of risk is the coefficient of variation.
AverageVal ue
C.V .
S tan dardDeviation
A high coefficient of variation is the indication of high fluctuations in
cash inflows .i.e. project is risky.
A low coefficient of variation is the indication of low fluctuations in cash
inflows .i.e. project is safe.
Sensitivity Analysis
Sale Volume
Expected
Revenue
Cash Inflows Unit Cost
Cost
NPV
Discount
Rate
Sensitivity analysis is a way of analysis change in project NPV or
IRR for a given change in one of the variables. The more
sensitive the variables the more sensitive will be the NPV of the
Project.
Sensitivity Analysis
Steps in Sensitive Analysis-
1. Indemnification of variables having influence on project
NPV.
2. Defining Relationship in variables.
3. Analysis of the impact of change in each of the
variables.
Forecast Under different Assumptions-
1. Expected value of variables.
2. Optimistic Value of variables.
3. Pessimistic Value variables.
Acceptance or Rejection of Project-
1. Expected NPV.
2. Optimistic NPV.
3. Pessimistic NPV.
