FINANCIAL

MANAGEMENT
RISK ANALYSIS IN CAPITAL BUDGETING
UNIT 5
RISK ANALYSIS
Risk is inherent in almost every business decision. More so in capital budgeting decisions as they
involve costs and benefits extending over a long period of time during which many things can
change in unanticipated ways.

▪ We assumed so far that all investments being considered for inclusion in the capital budget
had the same risk as those of the existing investments of the firm.

▪ Hence the average cost of capital was used for evaluating every project.

▪ Investment proposals, however, differ in risk.

▪ A research and development project may be more risky than an expansion project and
the latter tends to be more risky than a replacement project.

▪ In view of such differences, variations in risk need to be evaluated explicitly in capital

investment appraisal.
RISK ANALYSIS
Risk analysis is one of the most complex and slippery aspects of capital budgeting. Many different
techniques have been suggested and no single technique can be deemed as best in all situations.

The variety of techniques suggested to handle risk in capital budgeting fall into two broad
categories:

(i) Approaches that consider the stand-alone risk of a project.

(ii) Approaches that consider the risk of a project in the context of the firm or in the context of
the market
TECHNIQUES FOR RISK ANALYSIS
SOURCES AND PERSPECTIVES ON
RISK
Sources of Risk

There are several sources of risk in a project. The important ones are project-specific risk, competitive risk,
industry-specific risk, market risk, and international risk.

1. Project-specific risk The earnings and cash flows of the project may be lower than expected
because of estimation error or some factors specific to the project like the quality of management.

2. Competitive risk The earnings and cash flows of the project may be affected by unanticipated
actions of competitors.

3. Industry-specific risk Unexpected technological developments and regulatory changes, that are
specific to the industry to which the project belongs, will have an impact on the earnings and cash
flows of the project as well.

4. Market risk Unanticipated changes in macroeconomic factors like the GDP growth rate, interest
rate, and inflation have an impact on all projects, albeit in varying degrees.

5. International risk In the case of a foreign project, the earnings and cash flows may be different
than expected due to exchange rate risk or political risk.
SOURCES AND PERSPECTIVES ON
RISK
Perspectives on Risk

A project can be viewed from at least three different perspectives:

1. Stand-alone risk This represents the risk of a project when it is viewed in isolation.
2. Firm risk Also called corporate risk, this represents the contribution of a project to the risk
of the firm.
3. Market risk This represents the risk of a project from the point of view of a diversified
investor. It is also called systematic risk.

▪ Since the primary goal of the firm is to maximize shareholder value, what matters finally is the
risk that a project imposes on shareholders.

▪ If shareholders are well diversified, market risk is the most appropriate measure of risk.

▪ In practice, however, the project’s stand-alone risk as well as its corporate risk are also
considered important.
SENSITIVITY ANALYSIS
The future is uncertain, you may like to know what will happen to the viability of the project when
some variable like sales or investment deviates from its expected value. In other words, you may
want to do “what if” analysis or sensitivity analysis.

Illustration: The discount rate is 12% and Cash Flow for a Project is as given
SENSITIVITY ANALYSIS
Since the cash flow from operations is an annuity, the NPV of the project is:

The NPV based on the expected values of the underlying variables looks positive.

However, aware that the underlying variables can vary widely and hence you would like to explore
the effect of such variations on the NPV.

So you define the optimistic and pessimistic estimates for the underlying variables. These are
shown in the left hand columns of Exhibit. With this information, you can calculate the NPV for the
optimistic and pessimistic values of each of the underlying variables.
SENSITIVITY ANALYSIS
Sensitivity of NPV to Variations in the Value of Key Variables:

To do this, vary one variable at a time. For example, to study the effect of an adverse variation in sales
(from the expected ₹ 18 million to the pessimistic ₹ 15 million), you maintain the values of the other
underlying variables at their expected levels. (This means that the investment is held at ₹ 20 million,
variable costs as a proportion of sales are held at 66⅔ percent, fixed costs are held at ₹ 1 million, so on and
so forth).
SENSITIVITY ANALYSIS
Evaluation: Merits

A very popular method for assessing risk, sensitivity analysis has certain merits:

▪ It shows how robust or vulnerable a project is to changes in values of the underlying

variables.

▪ It indicates where further work may be done. If the net present value is highly sensitive to
changes in some factor, it may be worthwhile to explore how the variability of that critical
factor may be contained.

▪ It is intuitively very appealing as it articulates the concerns that project evaluators normally
have.
SENSITIVITY ANALYSIS
Evaluation: Demerits

Notwithstanding its appeal and popularity, sensitivity analysis suffers from several shortcomings:

▪ It merely shows what happens to NPV when there is a change in some variable, without
providing any idea of how likely that change will be.

▪ Typically, in sensitivity analysis only one 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.
SCENARIO ANALYSIS
In sensitivity analysis, typically one variable is varied at a time. In scenario analysis, several
variables are varied simultaneously.

Most commonly, three scenarios are considered: expected (or normal) scenario, pessimistic
scenario, and optimistic scenario.

▪ In the normal scenario, all variables assume their expected (or normal values);

▪ in the pessimistic scenario, all variables assume their pessimistic values; and

▪ in the optimistic scenario all variables assume their optimistic values.

SCENARIO ANALYSIS
Illustration: Pessimistic, Normal and Optimistic Scenario is as given
SCENARIO ANALYSIS
Illustration: Pessimistic, Normal and Optimistic Scenario Analysis using Spreadsheet
SCENARIO ANALYSIS
Evaluation

Scenario analysis may be regarded as an improvement over sensitivity analysis because it considers
variations in several variables together.

However, scenario analysis has its own limitations:

▪ It is based on the assumption that there are a 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. It can in fact be anywhere on the
continuum between the extremes. When a continuum is converted into three discrete
states some information is lost.

▪ 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 (3x10) to do
the scenario analysis.
BREAK-EVEN ANALYSIS
In sensitivity analysis we ask what will happen to the project if sales decline or costs increase or
something else happens.

▪ As a financial manager, you will also be interested in knowing how much should be produced
and sold at a minimum to ensure that the project does not ‘lose money’.

▪ Such an exercise is called break-even analysis and the minimum quantity at which loss is
avoided is called the break-even point.

▪ The break-even point may be defined in accounting terms or financial terms.

BREAK-EVEN ANALYSIS
Accounting Break-even Analysis Note that the ratio of variable costs to sales is 0.667 (12/18). This
means that every rupee of sales makes a contribution of ₹ 0.333. Put differently, the contribution
margin ratio is 0.333. Hence the break-even level of sales will be:

By way of confirmation, you

can verify that the break-
even level of sales is indeed
₹ 9 million.
BREAK-EVEN ANALYSIS
Financial Break-even Analysis: The focus of financial break-even analysis is on NPV and not
accounting profit. At what level of sales will the project have a zero NPV?

To illustrate how the financial break-even level of sales is calculated. The annual cash flow of the
project depends on sales as follows:
1. Variable costs : 66.67 percent of sales

2. Contribution : 33.33 percent of sales

3. Fixed costs : ₹ 1 million

4. Depreciation : ₹ 2 million
5. Pre-tax profit : (0.333 × Sales) − ₹ 3 million
6. Tax (at 33.333%) : 0.333(0.333 Sales − ₹ 3 million)

7. Profit after tax : 0.667 (0.333 × Sales − ₹ 3 million)

8. Cash flow (4+7) : ₹ 2 million + 0.667 (0.333 × Sales − ₹ 3 million) = 0.222 Sales
BREAK-EVEN ANALYSIS
Since the cash flow lasts for 10 years, its present value at a discount rate of 12 percent is:
PV(cash flows) = 0.222 Sales × PVIFA (10 years, 12%)
= 0.222 Sales × 5.650

= 1.254 Sales

The project breaks even in NPV terms when the present value of these cash flows equals the
initial investment of ₹ 20 million. Hence, the financial break-even occurs when

PV (cash flows) = Investment

1.254 Sales = ₹ 20 million
Sales = ₹ 15.95 million

Thus, the sales for the project must be ₹ 15.95 million per year for the investment to have a zero
NPV. Note that this is significantly higher than ₹ 9 million which represents the accounting break-
even sales.
SIMULATION ANALYSIS
Sensitivity analysis indicates the sensitivity of the criterion of merit (NPV, IRR, or any other) to
variations in basic factors. Such information, though useful, may not be adequate for decision
making. The decision maker would also like to know the likelihood of such occurrences.
Simulation analysis is a tool for doing that.

Procedure

The steps involved in simulation analysis are as follows:

1. Model the project. The model of the project shows how the net present value 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.
SIMULATION ANALYSIS
3. Select a value, at random, from the probability distributions of each of the exogenous
variables.

4. Determine the net present value 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 net present
values.

6. Plot the frequency distribution of the net present value.

Illustration In real life situations, simulation is done only on the computer because of the
computational tedium involved.
SIMULATION ANALYSIS
Evaluation

An increasingly popular tool of risk analysis, simulation offers certain advantages:

▪ Its principal strength lies in its versatility. It can handle problems characterized by

(a) numerous exogenous variables following any kind of distribution, and

(b) complex interrelationships among parameters, exogenous variables, and endogenous

variables. Such problems often defy the capabilities of analytical methods.

▪ It compels the decision maker to explicitly consider the interdependencies and uncertainties
characterizing the project.
SIMULATION ANALYSIS
Simulation, however, is a controversial tool which suffers from several shortcomings.

▪ It is difficult to model the project and specify the probability distributions of exogenous
variables.

▪ Simulation is inherently imprecise. It provides a rough approximation of the probability

distribution of net present value (or any other criterion of merit). Due to its imprecision, the
simulated probability distribution may be misleading when a tail of the distribution is
critical.

▪ A realistic simulation model, likely to be complex, would most probably be constructed by a

management scientist, not the decision maker. The decision maker, lacking understanding of
the model, may not use it.

▪ To determine the net present value in a simulation run the risk-free discount rate is used.
This is done to avoid prejudging risk which is supposed to be reflected in the dispersion of
the distribution of net present value.
DECISION TREE ANALYSIS
To analyze sequential decision making the decision tree analysis is helpful.

Steps in Decision Tree Analysis

The key steps in decision tree analysis are as follows:

▪ Delineate the decision tree

▪ Evaluate the alternatives

1. Delineate the Decision Tree Exhibiting the anatomy of the decision situation, the decision
tree shows:

▪ The decision points (typically represented by squares), the alternative options available
for experimentation and action at these points, and the investment outlays associated
with these options.

▪ The chance points (typically represented by circles) where outcomes are dependent on
the chance process, the likely outcomes at these points along with the probabilities
thereof, and the monetary values associated with them.
DECISION TREE ANALYSIS
2. Evaluate the Alternatives Once the decision tree is delineated and data about outcomes
and probabilities gathered, decision alternatives may be evaluated as follows:

1) Start at the right-hand end of the tree and calculate the NPV at various chance points
that come first as you proceed leftward.

2) Given the NPVs of chance points in step 1, evaluate the alternatives at the final stage
decision points in terms of their NPVs.

3) At each final stage decision point, select the alternative which has the highest NPV and
truncate the other alternatives. Each decision point is assigned a value equal to the NPV
of the alternative selected at that decision point.

4) Proceed backward (leftward) in the same manner, calculating the NPV at chance points,
selecting the decision alternative which has the highest NPV at various decision points,
truncating inferior decision alternatives, and assigning NPVs to decision points, till the
first decision point is reached.
DECISION TREE ANALYSIS
Analysis of Decision Tree:

Illustration:

The scientists at Vigyanik have come up with an electric moped. The firm is ready for pilot
production and test marketing. This will cost ₹ 20 million and take six months.
Management believes that there is a 70 percent chance that the pilot production and test
marketing will be successful. In case of success, Vigyanik can build a plant costing ₹ 150
million. The plant will generate an annual cash inflow of ₹ 30 million for 20 years if the
demand is high or an annual cash inflow of ₹ 20 million if the demand is moderate. High
demand has a probability of 0.6; moderate demand has a probability of 0.4. The discount
rate is 12%.
DECISION TREE ANALYSIS
Decision Tree:
DECISION TREE ANALYSIS
The alternatives in the decision tree are evaluated as follows:

1. Start at the right-hand end of the tree and calculate the NPV at chance point C2 that comes
first as we proceed leftward.

NPV(C2) = 0.6[30 x PVIFA(20, 12%)] + 0.4[20 x PVIFA(20, 12%)]

= 194.2 Million

2. Evaluate the NPV of the decision alternatives at D2 the last stage decision point:

Alternative NPV

D21 (Invest ₹ 150 million) ₹ 44.2 million

D22 (Stop) 0

3. Select D21 and truncate D22 as NPV(D21) > NPV(D22).

DECISION TREE ANALYSIS
4. Calculate the NPV at chance point C1 that comes next as we roll backwards.

NPV (C1) = 0.7 [44.2] + 0.3 [0] = ₹ 30.9 million

5. Evaluate the NPV of the decision alternatives at D1 the first stage decision point:

Alternative NPV
D11 (Carry out pilot production and ₹ 10.9 million
market test at a cost of ₹ 20 million)
D12 (Do nothing) 0

Based on the above evaluation, we find that the optimal decision strategy is as follows: Choose
D11 (carry out pilot production and market test) at the decision point D1 and wait for the
outcome at the chance point C1. If the outcome at C1 is C11 (success), invest ₹ 150 million; if the
outcome at C1 is C12 (failure) stop.
CORPORATE ANALYSIS
A project’s corporate risk is its contribution to the overall risk of the firm. Put differently, it reflects
the impact of the project on the risk profile of the firm’s total cash flows.

Aware of the benefits of portfolio diversification, many firms consciously pursue a strategy of
diversification.

For example, Hindustan Unilever Limited, has a diversified portfolio comprising, in the main, of the
following businesses: soaps and detergents, personal care products, edible oil, and tea.

▪ The proponents of diversification argue that it helps in reducing the firm’s overall risk
exposure.

▪ As most businesses are characterized by cyclicality, it seems desirable that there are at least
two to three different lines of business in a firm’s portfolio.
MANAGING RISKS
Managers are not merely content with measuring risk. They want to explore ways and means of
mitigating risk. These risk reduction strategies have a cost associated with them, and whether they
are profitable in a given situation will depend on circumstances.

1. Fixed and Variable Costs A common way to modify the risk of an investment is to change
the proportions of fixed and variable costs. For example, in the early 1980s Ford Motor
Company restructured its operations. Essentially, it decided to buy most of its components
from outside suppliers instead of manufacturing them in-house. This decreased its fixed
costs and increased its variable costs.

2. Pricing Strategy Pricing strategy is used by many firms to manage risk. A lower price
increases potential demand, but also raises the breakeven level.

3. Sequential Investment If you are not sure about the market response to your product or
service, you may start small and later expand as the market grows. This strategy may entail
higher capital cost per unit because capacity is created in stages. However, it reduces risk
exposure.
MANAGING RISKS
4. Improving Information You may like to gather more information about the market and
technology before taking the plunge. Additional study often improves the quality of
forecasts but involves direct costs (the cost of the study) as well as opportunity costs of
delayed action. You have to weigh the costs and benefits of further study and decide how
much of additional information should be gathered.

5. Financial Leverage How reducing the proportion of fixed operating costs lowers risk.
Likewise reducing the dependence on debt lowers risk. Remember that debt entails a
definite contractual commitment whereas equity carries no fixed burden. Hence if the
operating risk of the project is high, it makes sense to go for a low level of financial
leverage.

6. Insurance You can get an insurance cover against a variety of risks like physical damage,
theft, loss of key person, and so on. Insurance is a pure antidote for such risks. Of course,
to protect yourself against such risks you have to pay insurance premium.
MANAGING RISKS
7. Strategic Alliance When the resources required for a project or the risks inherent in a
project are beyond the capacity of a single company, strategic alliance may be the way out.
A strategic alliance, also referred to as a joint venture, represents a partnership between
two or more independent companies which join hands to achieve a common purpose. It is
usually organized as a newly created company, though the partners may choose any other
form of organization.

8. Shorter Time to Market One way to reduce uncertainty is to cut the time to market.
Researchers at Harvard Business School found in the early 1990s that Japanese automakers
were designing and launching new car models in about two years when their American
counterparts took about four years.

9. Contingency Planning Apart from taking steps to reduce risk to the extent it is practical
and feasible, well managed companies prepare for the worst. This means listing the things
that could go wrong with a decision and then identifying the actions that would be taken to
cope with those adverse developments.
PROJECT SELECTION UNDER RISKS
Once information about expected return (measured as net present value, or internal rate of return or
some other criterion of merit) and variability of return (measured in terms of range or standard
deviation or some other risk index) has been gathered, the next question is: Should the project be
accepted or rejected? There are several ways of incorporating risk in the decision process:
judgmental evaluation, payback period requirement, risk adjusted discount rate, and certainty
equivalent.

1. Judgmental Evaluation Often managers look at the risk and return characteristics of a
project and decide judgmentally whether the project should be accepted or rejected,
without using any formal method for incorporating risk in the decision making process.

2. Payback Period Requirement In many situations companies use NPV or IRR as the principal
selection criterion, but apply a payback period requirement to control for risk. Typically, if
an investment is considered more risky, a shorter payback period is required even if the
NPV is positive or IRR exceeds the hurdle rate. This approach assumes that risk is a
function of time.
PROJECT SELECTION UNDER RISKS
3. Risk Adjusted Discount Rate The risk adjusted discount rate method calls for adjusting
the discount rate to reflect project risk. If the risk of the project is equal to the risk of the
existing investments of the firm, the discount rate used is the average cost of capital of the
firm; if the risk of the project is greater than the risk of the existing investments of the
firm, the discount rate used is higher than the average cost of capital of the firm; if the risk
of the project is less than the risk of the existing investments of the firm, the discount rate
used is less than the average cost of capital of the firm.

4. Certainty Equivalent Method The certainty equivalent method is conceptually superior to

the risk adjusted discount rate method because it does not assume that risk increases with
time at a constant rate. Each year’s certainty equivalent coefficient is based on the level of
risk characterizing its cash flow. Despite its conceptual soundness it is not as popular as
the risk-adjusted discount rate method. This is perhaps because it is inconvenient and
difficult to specify a series of certainty equivalent coefficients but seemingly simple to
adjust the discount rate.
RISK ANALYSIS IN PRACTICE
Several methods to incorporate the risk factor into capital expenditure analysis are used in practice.

1. Conservative Estimation of Revenues In many cases the revenues expected from a project
are conservatively estimated to ensure that the viability of the projects is not easily
threatened by unfavorable circumstances. The capital budgeting systems often have built-in
devices for conservative estimation.

2. Safety Margin in Cost Figures A margin of safety is generally included in estimating cost
figures. This varies between 10 percent and 30 percent of what is deemed as normal cost.
The size of the margin depends on what management feels about the likely variation in
cost.

3. Flexible Investment Yardsticks The cut-off point on an investment varies according to the
judgement of management about the riskiness of the project. In one company replacement
investments are okayed if the expected post-tax return exceeds 15 percent but new
investments are undertaken only if the expected post-tax return is greater than 20 percent.
Another company employs a short payback period of three years for new investments.
RISK ANALYSIS IN PRACTICE
4. Sensitivity Analysis It is a common practice to judge how robust or vulnerable a project is
to adverse variations in the values of the underlying variables like selling price, raw material
cost, and quantity sold.

5. Scenario Analysis Companies often look at a few scenarios and the top management or the
board of directors decides on the basis of such information.
END OF UNIT V