Risk In Capital Budgeting

Prepared by Sumit Goyal- LPU

LEARNING 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.

Prepared by Sumit Goyal- LPU

Risk Meaning is capital budgeting

Capital budgeting exercise is based on the future cash
flows that are estimated which are uncertain.
Capital budgeting exercise assumes the cash flows to
be certain and hence the decision made is correct.
Capital budgeting decision must incorporate the risk
emanating from the changes in the cash flows.
There are various ways to assess risk in capital
budgeting decisions.

Prepared by Sumit Goyal- LPU

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
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Sensitivity Analysis
Sensitivity analysis relates to finding out the critical
variables in the assumptions of cash flow.
Then find the change in NPV of the project with a given
change in the each of the critical variables.
More often than not the critical determinants of the cash
flows are
selling price and
proportions of variable cost.

Only one variable is assumed to change at a time.

Prepared by Sumit Goyal- LPU

Example
A company is considering a project costing Rs
8000 with a useful life of ten years to
manufacture. It makes certain assumptions for
projecting the operational cash flows. It expects
to sell 3000 units per annum at selling price of
3.20 with variable cost of 1.80 per unit. The fixed
cost, which includes selling expenses are
expected to be 1200. Depreciation charge is Rs
1200. with no interest and after tax of 40% it
expects cash inflows of 2280 for the next ten
years.
Prepared by Sumit Goyal- LPU

 The NPV of the project at 15% is 3443.

However the manager feels that the price is
taken at higher level that may not be
sustainable. They would to analyse the project
with the change in selling price and a fall is
expected anywhere between 5 to 20%.

Prepared by Sumit Goyal- LPU

Selling price
falls by
Units

3000

5%

10%

15%

20%

3000

3000

3000

3000

Calculate the cash inflows with the change in selling price

and discount it 15% then calculate the NPV.

Prepared by Sumit Goyal- LPU

Calculate the NPV of the project.

Normal

Initial cost
increase by
10%.

Cost of
capital
increase by
10%

Prepared by Sumit Goyal- LPU

Variable
cost
increase by
10%

Fixed cost
increase by
10%.

Scenario Analysis
Scenario analysis is similar to sensitivity analysis in
approach.
It recognises that because of the interrelationships
several variables change simultaneously.
Each case classified as scenario, we find the change
in NPV for simultaneous change in several variables.

Prepared by Sumit Goyal- LPU

Scenario Analysis
Each scenario is assigned a probability.
NPV is calculated for all scenarios and we arrive at
expected NPV,

This forms the basis of decision making.

Risk assessment is not done on a single variable
basis.

Prepared by Sumit Goyal- LPU

SCENARIO ANALYSIS
The decision-maker can develop some
plausible scenarios for this purpose. For
instance, we can consider three scenarios:
pessimistic, optimistic and expected.

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Example
Excellent

Good

Normal

Bad

worst

Demand
Level

+10%

+5%

3000

-5%

-10%

Selling price

+5%

Same

3.2

-5%

-10%

Variable cost +10%

Same

5400

Same

+10%

Overheads

+5%

-5%

1200

+10%

+20%

Probability

15%

20%

30%

20%

15%

Prepared by Sumit Goyal- LPU

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.

Prepared by Sumit Goyal- LPU

Simulation

Scenario analysis suffers from disadvantage that

sufficiently large scenarios may not be available
for reliable decision making

Simulation overcomes the problem of scenario

analysis

It is possible to simulate large number of

scenarios and find out the NPVs under each so
as to make statistical data dependable and
relevant for decision making.
Prepared by Sumit Goyal- LPU

SIMULATION ANALYSIS
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.

Prepared by Sumit Goyal- LPU

Demand
Level

Selling price

Variable
cost

Value

Probability

Value

Probability

Value

Probability

2600

0.10

2.75

0.20

1.70

0.20

2700

0.20

2.85

0.25

1.80

0.60

Prepared by Sumit Goyal- LPU

Prepared by Sumit Goyal- LPU