Risk Analysis in Capital Investment (CI) Decisions

In capital budgeting, the basic assumption is that the proposals do not involve any risk (business risk), but it seldom happens. Decisions are made on the basis of forecasts which depend upon events whose occurrence can not be anticipated with absolute certainty because of economic, social, fiscal, political and other reasons. The risk is linked with business decisions.

Def. of Risk:
Risk is the variability that is likely to occur in future between the estimated and actual returns.

Risk and Uncertainty:

A Risk situation is one in which the probabilities of particular event occurring are known. An Uncertainty Situation is one where these possibilities are not known. Investment Appraisal is a methodology for calculating the expected returns based on cash flow forecasts of many project variables, often inter-related. Risk emanates from the uncertainty encompassing these project variables. The evaluation of risk depends upon:(i) Our ability to identify and understand the nature of uncertainty surrounding the key project variables. (ii) Having tools and methodology to process its risk implications on the returns of the project.
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Risk is a situation where the possible events are known, but which of those will actually happen is not known. However, the probability of their occurrence can be determined. In capital investment decisions, we can express the realizability of cash flows only through a probability distribution.

Types of Risks in CI Decisions:

A. Business Risk: It is the variability of the earnings

due to changes in the firms normal operating conditions. It has its origin in the impact of the changing economic environment on the firms activities and the managements decisions on the capital intensity of the operations. Business Risk is the variability of the EBIT and is unconnected to the financial risk. Business Risk can be sub-divided into 2 types of risks viz.

(i) Investment Risk: It is the variability in the

earnings due to variations in inflows and outflows of cash resulting from the capital investments made by the firm. These variations arise due to errors in the judgment of or unexpected changes in the market acceptance of the product or service of the firm, unforeseen technological changes and changes in the cost structure.

(ii) Portfolio Risk: It is the measure of the variability

of the earnings caused by the diversification achieved by the firm in its operations and asset portfolio. This can be reduced by investing in the projects or acquiring other firms which have negative correlation with the earnings of the firm.

B. Financial Risk: It is the variability of the after tax

earnings or the EPS of the firm caused by the financial structure or more precisely, the debt content in the capital structure. It is the impact of the efficient use of the long-term capital on the earnings of the firm.

Measures of Risk:
The statistical measures of dispersion are the most useful ones to gauge the extent of variation in the cash flows. There are basically two types of such measures: A. General Techniques: 1. Risk Adjusted Discount Rate (RADR) 2. Certainty Equivalent Co-efficient (CEC) B. Quantitative Techniques: 1. Range 2. Mean Absolute Deviation (MAD) 3. Variance / Standard Deviation (SD) 4. Co-efficient of Variation (COV) 5. Sensitivity Analysis (SA) 6. Simulation Analysis(SIA) 7. Scenario Analysis (SCA) 8. Decision Tree Analysis (DTA)

A. General Techniques:
1. Risk Adjusted Discount Rate (RADR) This is based on the assumption that investors expect a high rate of return on risky projects compared to less risky projects.

Procedure: Determine the risk free rate (This is the rate at which future cash flows should be discounted had there been no risk. Find risk premium (extra return expected over normal returns) Find NPV with composite discount rate (normal rate plus risk premium) which takes into account both time and risk factors. A higher discount rate will be used for more risky projects and lower discount rate for less risky projects. At NPV = ------------, t t=1 (1+k)
n

t=1,2,3,..n.
At = Cash flows without risk adjustment

k = Risk adjusted discount rate and k= i+p, where, i = risk-free rate and p=Premium This method incorporates the risk averse attitude of the investors. But the determination of appropriate discount rate is arbitrary. It is adjusted and not the required rate of return. It results in compounding of risk over time, since premium is added to discount rate. It assumes that investors are averse to risk. But there are some risk seekers also.

2. Certainty Equivalent Co-efficient (CEC)

In this method, the estimated cash flows are reduced to conservative level by applying a correction factor termed as CEC.

Risk-less Cash flows (Certain cash flows) CEC = ------------------------------------------------------Risky cash flows (Uncertain cash flows) Risk-less cash flows are which management is ready to accept if no risk is involved. Exp. Management expects a cash flow of Rs.20,000. The project is risky, but it expects at least a cash flow of Rs.12,000. It means CEC = 12000/20000 = 0.6. Here, t At NPV = ------------, t t=1 (1+i)
n

t=1,2,3,..n.
At = Cash flows without risk adjustment

t = CEC or risk adjustment factor i = Risk-free rate assumed to be constant for all periods.

This method explicitly recognizes risk. But the procedure for reducing cash flows is implicit and inconsistent from investment to investment. Forecaster may inflate in anticipation of reduction. By focusing on gloomy outcomes, some good investments may be ignored. B. Quantitative Techniques:
(i) Range (Rg): Rh Rl,
Where, Rh = Highest value of Distribution Rl = Lowest value of the Distribution

It measures the variation between the highest and the lowest value of the distribution and is a rough measure of variability.

(ii)

Mean Absolute Deviation (MAD): n _ MAD = Pi RiR ,

i=1

Pi = Probability of i th value Ri = i th value of variable _ R = Arithmetic Mean MAD shows the variability of the values without regard to the sign of variation. (iii) Variance and Standard Deviation: The square root of variance is called the standard deviation (SD). These are the measures of how well the expected values or mean returns represent the distribution. The higher the SD, lower is the utility of the mean as high SD indicates the value scattered in a greater area around the mean. _ Variance = Pi ( Ri R)2 ,
n i=1 n i=1
_
2

Where,

1/2

SD = [ Pi ( Ri R) ] 4. Coefficient of Variation (COV): It measures the risk borne per unit of return. That is, the amount of risk as represented by the standard deviation for each unit of expected return. It is a relative measure and is given by:

Standard Deviation COV = --------------------------Mean 5. Sensitivity Analysis (SA): In SA, the factors that are likely to change during the life of the project are first identified and the extent of change in the NPV or other criterion is chosen for evaluation with change in the factors. The changes are measured in percentages. SA provides information on the extent to which the project remains viable under different situations, or, the extent of change in the variables that will be tolerated by the project. This answers questions like What will be NPV if sales drop to 50000 units compared to 70000 units? What will be NPV if economic life of project is only 5 instead of 7 years? Sometimes it provides cash flows under 3 assumptions; (i) Pessimistic; (ii) Most likely; ad (iii) Optimistic. It explains how sensitive the cash flows are under these 3 different situations. The larger the difference between the pessimistic and optimistic cash flows, the more risky is the project. The limitation is that this method does not provide chances of occurrence of each of these estimates. Procedure: 1. Set a relationship between basic factors like quantity sold, unit price, life of project, etc. and NPV 2. Estimate range of variation - say 5% or10%. 3. Study the effect of variation on NPV in the basic variables.
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6. Simulation Approach (SIMU): In SA, the impact on NPV of change in one of the variables is examined. For studying the impact of each variable, all other factors have either been assumed to be constant, or their expected values have been used. If the decision maker wants to know the expected value of NPV taking into account each possible value of all the factors that affect it, SA method would not work. Simulation is an imitation of a real world system using a mathematical model that captures the characteristic features of the system as it encounters random events in time. It is method of solving decision making problems by designing, constructing, and operating a model of the real system. Procedure: 1. Specify parameters 2. Select values at random (Random Number Tables) 3. Determine NPV corresponding to random values 4. Repeat for simulated NPVs 5. Plot frequency distribution 6. Interpret the results 7. Scenario Analysis (SCA): In Sensitivity Analysis (SA), we study the changes in the criterion of merit (NPV) with changes in one of the variables. But if two or more inter-related variables change simultaneously at the same time, SCA helps in dealing with such scenario. In SCA, different scenarios are generated and the desirability of the project is studied in each scenario.

8. Decision Tree Analysis (DTA): DTA helps in tackling risky capital investment proposals. DTA is a graphic display of relationships between a present decision and possible future events, future decisions and their consequences. The sequence of events is mapped out over time in a flow resembling branches of a tree. Thus, it is a pictorial representation in the form of a tree which indicates the magnitude, probabilities and inter-relationships of all possible outcomes. It gives an overall view of all possibilities associated with the project. But it is an unwieldy and complex method with increasing life and possible outcomes. Constructing a Decision Tree: Definition of the proposal Identification of alternatives (Purchase a plant, not to purchase a plant, a big one, or a small one, etc.) Graphing the decision tree (Shows decision points i.e. cash outlays, decision branches alternatives) Forecasting cash flows (Cash flows, probabilities, and expected values displayed) Evaluating the results (The firm may proceed with the alternatives which are profitable)

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