CH 12

Chapter - 12
Risk Analysis in Capital Budgeting
Chapter Objectives
Discuss the concept of risk in investment decisions. Understand some commonly used techniques, i.e.,
payback, certainty equivalent and risk-adjusted discount rate, of risk analysis in capital budgeting. Focus on the need and mechanics of sensitivity analysis and scenario analysis. Highlight the utility and methodology simulation analysis. Explain the decision tree approach in sequential investment decisions. Focus on the relationship between utility theory and capital budgeting decisions.
Financial Management, Ninth Edition I M Pandey Vikas Publishing House Pvt. Ltd. 2
Nature of Risk
Risk exists because of the inability of the
decision-maker to make perfect forecasts. In formal terms, the risk associated with an investment may be defined as the variability that is likely to occur in the future returns from the investment. Three broad categories of the events influencing the investment forecasts:

General economic conditions Industry factors Company factors
Financial Management, Ninth Edition I M Pandey Vikas Publishing House Pvt. Ltd.
Techniques for Risk Analysis

Statistical Techniques for Risk Analysis Probability Variance or Standard Deviation Coefficient of Variation
Conventional Techniques of Risk Analysis Payback Risk-adjusted discount rate Certainty equivalent
Probability
A typical forecast is single figure for a period. This is

referred to as best estimate or most likely forecast:

Firstly, we do not know the chances of this figure actually occurring, i.e., the uncertainty surrounding this figure. Secondly, the meaning of best estimates or most likely is not very clear. It is not known whether it is mean, median or mode.
For these reasons, a forecaster should not give just
one estimate, but a range of associated probabilitya probability distribution. Probability may be described as a measure of someones opinion about the likelihood that an event will occur.
Assigning Probability
The probability estimate, which is based on a
very large number of observations, is known as an objective probability. Such probability assignments that reflect the state of belief of a person rather than the objective evidence of a large number of trials are called personal or subjective probabilities.
Expected Net Present Value

Once the probability
assignments have been made to the future cash flows the next step is to find out the expected net present value. Expected net present value = Sum of present values of expected net cash flows.
ENPV =
t =0
ENCF t (1 k )
ENCFt = NCFjt Pjt
Variance or Standard Deviation

Simply stated,
variance measures the deviation about expected cash flow of each of the possible cash flows. Standard deviation is the square root of variance. Absolute Measure of Risk.
(NCF) =
2
(NCF
j =1
ENCF) 2 Pj
Coefficient of Variation
Relative Measure of Risk
It is defined as the standard deviation of the
probability distribution divided by its expected value:

Cofficient of variation = CV = Expected value Standard deviation
Coefficient of Variation
The coefficient of variation is a useful
measure of risk when we are comparing the projects which have

(i) same standard deviations but different expected values, or (ii) different standard deviations but same expected values, or (iii) different standard deviations and different expected values.
10
Risk Analysis in Practice
Most companies in India account for risk while evaluating their capital expenditure decisions. The following factors are considered to influence the riskiness of investment projects:
price of raw material and other inputs price of product product demand government policies technological changes project life inflation
Out of these factors, four factors thought to be contributing most to the project riskiness are: selling price, product demand, technical changes and government policies. The most commonly used methods of risk analysis in practice are:

sensitivity analysis conservative forecasts
Sensitivity analysis allows to see the impact of the change in the behaviour of critical variables on the project profitability. Conservative forecasts include using short payback or higher discount rate for discounting cash flows. Except a very few companies most companies do not use the statistical and other sophisticated techniques for analysing risk in investment decisions.
Payback
This method, as applied in practice, is more an
attempt to allow for risk in capital budgeting decision rather than a method to measure profitability. The merit of payback
Its simplicity. Focusing attention on the near term future and thereby emphasising the liquidity of the firm through recovery of capital. Favouring short term projects over what may be riskier, longer term projects.
Even as a method for allowing risks of time nature, it
ignores the time value of cash flows.

Risk-Adjusted Discount Rate

Risk-adjusted discount rate,
will allow for both time preference and risk preference and will be a sum of the risk-free rate and the risk-premium rate reflecting the investors attitude towards risk.
Under CAPM, the risk-
NPV =
t =0
NCFt t (1 k )
premium is the difference between the market rate of return and the risk-free rate multiplied by the beta of the project.
k = kf + kr
13
The following are the advantages of risk-adjusted discount
Evaluation of Risk-adjusted Discount Rate

rate method:

It is simple and can be easily understood. It has a great deal of intuitive appeal for risk-averse businessman. It incorporates an attitude (risk-aversion) towards uncertainty.
This approach, however, suffers from the following
limitations:
There is no easy way of deriving a risk-adjusted discount rate. As discussed earlier, CAPM provides for a basis of calculating the riskadjusted discount rate. Its use has yet to pick up in practice. It does not make any risk adjustment in the numerator for the cash flows that are forecast over the future years. It is based on the assumption that investors are risk-averse. Though it is generally true, there exists a category of risk seekers who do not demand premium for assuming risks; they are willing to pay a premium to take risks.
CertaintyEquivalent
Reduce the forecasts of cash
flows to some conservative n t NCFt levels. NPV = t The certaintyequivalent t = 0 (1 kf ) coefficient assumes a value between 0 and 1, and varies inversely with risk. Decision-maker subjectively or objectively establishes the coefficients. The certaintyequivalent coefficient can be * NCF Certain net cash flow t determined as a relationship t = between the certain cash NCFt Risky net cash flow flows and the risky cash flows.
15
Evaluation of CertaintyEquivalent
This method suffers from many dangers in a
large enterprise:
First, the forecaster, expecting the reduction that will be made in his forecasts, may inflate them in anticipation. Second, if forecasts have to pass through several layers of management, the effect may be to greatly exaggerate the original forecast or to make it ultra-conservative. Third, by focusing explicit attention only on the gloomy outcomes, chances are increased for passing by some good investments.
Risk-adjusted Discount Rate Vs. CertaintyEquivalent

The certaintyequivalent approach recognises risk in
capital budgeting analysis by adjusting estimated cash flows and employs risk-free rate to discount the adjusted cash flows. On the other hand, the riskadjusted discount rate adjusts for risk by adjusting the discount rate. It has been suggested that the certaintyequivalent approach is theoretically a superior technique. The risk-adjusted discount rate approach will yield the same result as the certaintyequivalent approach if the risk-free rate is constant and the risk-adjusted discount rate is the same for all future periods.
Sensitivity Analysis
Sensitivity analysis is a way of analysing change in
the projects NPV (or IRR) for a given change in one of the variables. The following three steps are involved in the use of sensitivity analysis:

Identification of all those variables, which have an influence on the projects NPV (or IRR). Definition of the underlying (mathematical) relationship between the variables. Analysis of the impact of the change in each of the variables on the projects NPV.
The decision maker, while performing sensitivity
analysis, computes the projects NPV (or IRR) for each forecast under three assumptions: (a) pessimistic, (b) expected, and (c) optimistic.
DCF Break-even Analysis

Sensitivity analysis is a variation of the break-even
analysis. What shall be the consequences if volume or price or cost changes (Sensitivity analysis)? You can ask this question differently: How much lower can the sales volume become before the project becomes unprofitable? What you are asking for is the breakeven point. DCF break-even point is different from the accounting break-even point. The accounting breakeven point is estimated as fixed costs divided by the contribution ratio. It does not account for the opportunity cost of capital, and fixed costs include both cash plus non-cash costs (such as depreciation).
Pros and Cons of Sensitivity Analysis

Sensitivity analysis has the following advantages:
It compels the decision-maker to identify the variables, which affect the cash flow forecasts. This helps him in understanding the investment project in totality. It indicates the critical variables for which additional information may be obtained. The decision-maker can consider actions, which may help in strengthening the weak spots in the project. It helps to expose inappropriate forecasts, and thus guides the decision-maker to concentrate on relevant variables. It does not provide clear-cut results. The terms optimistic and pessimistic could mean different things to different persons in an organisation. Thus, the range of values suggested may be inconsistent. It fails to focus on the interrelationship between variables. For example, sale volume may be related to price and cost. A price cut may lead to high sales and low operating cost.
It has the following limitations:
20
Scenario Analysis
One way to examine the risk of investment is
to analyse the impact of alternative combinations of variables, called scenarios, on the projects NPV (or IRR). The decision-maker can develop some plausible scenarios for this purpose. For instance, we can consider three scenarios: pessimistic, optimistic and expected.
21
Simulation Analysis
The Monte Carlo simulation or simply the
simulation analysis considers the interactions among variables and probabilities of the change in variables. It computes the probability distribution of NPV. The simulation analysis involves the following steps:
First, you should identify variables that influence cash inflows and outflows. Second, specify the formulae that relate variables. Third, indicate the probability distribution for each variable. Fourth, develop a computer programme that randomly selects one value from the probability distribution of each variable and uses these values to calculate the projects NPV.
Shortcomings
The model becomes quite complex to use.
It does not indicate whether or not the project
should be accepted. Simulation analysis, like sensitivity or scenario analysis, considers the risk of any project in isolation of other projects.
23
Decision Trees for Sequential Investment Decisions

Investment expenditures are not an
isolated period commitments, but as links in a chain of present and future commitments. An analytical technique to handle the sequential decisions is to employ decision trees.
Steps in Decision Tree Approach Define investment Identify decision alternatives Draw a decision tree

decision points chance events

Analyse data
Usefulness of Decision Tree Approach

The merits of the decision tree approach are:

It clearly brings out the implicit assumptions and calculations for all to see, question and revise. It allows a decision maker to visualise assumptions and alternatives in graphic form, which is usually much easier to understand than the more abstract, analytical form.
The demerits of the decision tree approach are:
The decision tree diagrams can become more and more complicated as the decision maker decides to include more alternatives and more variables and to look farther and farther in time. It is complicated even further if the analysis is extended to include interdependent alternatives and variables that are dependent upon one another.
25
Utility Theory and Capital Budgeting

Utility theory aims at incorporation of
decision-makers risk preference explicitly into the decision procedure. As regards the attitude of individual investors towards risk, they can be classified in three categories:

Risk-averse Risk-neutral Risk-seeking
Individuals are generally risk averters and
demonstrate a decreasing marginal utility for money function.

Let us assume that the owner of
a firm is considering an investment project, which has 60 per cent of probability of yielding a net present value of Rs 10 lakh and 40 per cent probability of a loss of net present value of Rs 10 lakh. Project has a positive expected NPV of Rs 2 lakh. However, the owner may be risk averse, and he may consider the gain in utility arising from the positive outcome (positive PV of Rs 10 lakh) less than the loss in utility as a result of the negative outcome (negative PV of Rs 10 lakh). Tthe owner may reject the project in spite of its positive ENPV.
ENPV = 10 0.6 + (10) 0.4 = Rs 2 lakh
27
Benefits and Limitations of Utility Theory

It suffers from a few advantages:

First, the risk preferences of the decision-maker are directly incorporated in the capital budgeting analysis. Second, it facilitates the process of delegating the authority for decision. First, in practice, difficulties are encountered in specifying a utility function. Second, even if the owners or a dominant shareholders utility function be used as a guide, the derived utility function at a point of time is valid only for that one point of time. Third, it is quite difficult to specify the utility function if the decision is taken by a group of persons.
It suffers from a few limitations:
28

CH 12

Încărcat de

Informații document

Titlu original

Drepturi de autor

Formate disponibile

Partajați acest document

Partajați sau inserați document

Opțiuni de partajare

Vi se pare util acest document?

Este necorespunzător acest conținut?

Drepturi de autor:

Formate disponibile

CH 12

Încărcat de

Drepturi de autor:

Formate disponibile

Chapter - 12

Risk Analysis in Capital Budgeting

General economic conditions Industry factors Company factors

Techniques for Risk Analysis

referred to as best estimate or most likely forecast:

For these reasons, a forecaster should not give just

Expected Net Present Value

ENCFt = NCFjt Pjt

Variance or Standard Deviation

It is defined as the standard deviation of the

probability distribution divided by its expected value:

measure of risk when we are comparing the projects which have

Risk Analysis in Practice

sensitivity analysis conservative forecasts

Even as a method for allowing risks of time nature, it

ignores the time value of cash flows.

Risk-Adjusted Discount Rate

The following are the advantages of risk-adjusted discount

Evaluation of Risk-adjusted Discount Rate

This approach, however, suffers from the following

Risk-adjusted Discount Rate Vs. CertaintyEquivalent

The decision maker, while performing sensitivity

DCF Break-even Analysis

Pros and Cons of Sensitivity Analysis

It has the following limitations:

Decision Trees for Sequential Investment Decisions

decision points chance events

Usefulness of Decision Tree Approach

The demerits of the decision tree approach are:

Utility Theory and Capital Budgeting

Risk-averse Risk-neutral Risk-seeking

Individuals are generally risk averters and

demonstrate a decreasing marginal utility for money function.

Let us assume that the owner of

ENPV = 10 0.6 + (10) 0.4 = Rs 2 lakh

Benefits and Limitations of Utility Theory

It suffers from a few limitations:

S-ar putea să vă placă și