Risk Analysis in Capital

Investment Decisions
• Measurement of Risk
• Method of Incorporating Risk into
Capital Budgeting
 Measures of Risk
• Range
• Mean absolute Deviation
• Semi-Variance
• Coefficient of Variation
 example
NPV Probability

200 0.3

600 0.5

900 0.2
 For your Project

• Assign uneven probability for your cash

flow and calculate σ , variance and semi-
variance and coefficient of variation
Method of Incorporating Risk into
Capital Budgeting
• Certainty Equivalent Method
• Risk adjusted Discount Rate Method
-Perfectly Correlated cash
flows
-Uncorrelated cash flows
-Moderately correlated cash
flows
 Certainty Equivalent Method
• Utility of Decision Maker for the return
obtained by taking each additional unit of
risk
• Useful when the Decision maker’s risk-
return perception vary from one year to
another
 Certainty Equivalent Method
Outcome probability • Which alternative u
1000 0.30 will take?
• Find out Certainty
5000 0.70 Equivalent Coefficient
Expected Value=
Sure cash flow Rs 3000
Certainty Equivalent Coefficient
• =Sure Cash flow/Exp cash flow
• =3000/3800
• =0.79
• Shows the level of confidence of the top
mgt about the receipt of the cash flow from
the project.
 Example (’00 000)
Year Cash flow CEC

1 10 0.9

2 15 0.85

3 20 0.82

4 25 0.72

Find out CEC? And Comment on your findings, if

Initial investment is 45 lakhs; Rf=5%pa
Use formula for CEC in above
problem
n
α t At
NPV = ∑ −I
t =1 (1 + i )
t

α =CEC for the cash flow

A= the expected relevant cash flow
i=risk free rate
I=initial investment
 CEC
• Varies between 0-1
• Higher the CEC, higher the confidence of
the decision maker
• CEC=1 for T-bills & Risk free instruments
• If cash flows are highly correlated CEC will
be same in all the years
 Cash Flows as Random
Variables
• Risk is chance that a random variable will take
on a value significantly different from the
expected value
– In capital budgeting the estimate of each future
period's cash flow is a random variable
– The NPV and IRR of any project are random variables
with expected values and variances that reflect risk
• Thus, the actual value is likely to be different than the mean
• The amount the actual value is likely to differ from the
expected is related to the variance or standard deviation
The Probability Distribution of a Future
Cash Flow as a Random Variable
Risk in Estimated Cash Flows
 Risk Adjusted Discount Rate Method

Category of Investment Discount Rate

Replacement of Cost of capital +2%

Investments
New Projects Cost of capital +4%

R&D Investments Cost of capital +5%

 Calculation of SD of NPV

• Un-correlated cash flows- n

At
use Rf as discounting rate NP V = ∑ −I
t =1 (1 + i )
t
• expected NPV
• Expected cash flow
N P Vt
for year
• i = Rf
1/ 2
A outlay
• I=Initial  n
σt 
2

σ ( NPV ) = ∑ 2t 
 t =1 (1 + i ) 
 Example
Year 1 Year 2 Year 3

3000 0.3 2000 0.2 3000 0.3

5000 0.4 4000 0.6 5000 0.4

7000 0.3 6000 0.2 7000 0.3

Perfectly correlated cash flows

n
At
NP V = ∑ − I
t =1 (1 + i ) t

 n σt 
σ ( NPV ) = ∑ t 
 t =1 (1 + i ) 
 Example
• Work out previous Year Aver. Std Dev
one CF CF
• Next, see table; given
I=10,000 1 5000 1500

2 3000 1000

3 4000 2000

4 3000 1200
Moderately correlated cash flow
• Page 212
 Using probability table
• Given average NPV=96,000
• Dtd devn NPV = 60,000
• What is the probability that NPV will be
less than 0?
 steps
• Calculate z = (0-96000)/60000
• Z= -1.6
• So probability=
 Advanced Techniques in RA
• Sensitivity Analysis
• Scenario Analysis
• Simulation approach
• Decision Tree Analysis
 Sensitivity Analysis I

• Method
– Sensitivity analysis is a risk analysis technique that tells how
much NPV will change in response to given changes in one cash
flow factor with other factors held constant.
NPV ($)
NPV when unit sales price Unit sales price
goes up by 15%

NPV based on the originally

estimated unit sales price

$0
NPV when unit sales price
goes down by 20%

-20% -15% -10% -5% 0% 5% 10% 15% 20%

Deviation from Base-Case Value (%)
Based on: Financial Management, Eugene F. Brigham and Michael C. Ehrhardt, 2008
 Sensitivity Analysis II

• The slopes of the lines indicate how sensitive NPV is to changes in

each individual cash flow.
• Relatively small error in estimating individual cash flow with steeper
slope leads to a large error in estimating project’s NPV.
Unit sales price
NPV ($) Estimated values of cash Price growth rate
flow factors
Sales quantity

Original NPV
value Asset beta
$0 Utility price

Input price
Operating costs
NPV breakeven Construction costs
analysis
Input price growth

-20% -15% -10% -5% 0% 5% 10% 15% 20%

Deviation from Base-Case Value (%)
Based on: Financial Management, Eugene F. Brigham and Michael C. Ehrhardt, 2008
 Sensitivity Analysis III
• Implication
– Sensitivity analysis is a powerful technique to understand which factors
need to be more accurately examined to reduce the entire credit risk.
• Weak Points
– Sensitivity analysis does not incorporate a concept of probability
– It can deal with only one cash flow for each analysis
• NPV Breakeven Analysis
– NPV breakeven analysis examines a value of each factor which makes
NPV exactly zero.

Based on: Financial Management, Eugene F. Brigham and Michael C. Ehrhardt, 2008
Sensitivity Analysis for your project
• Find what happens to your project’s NPV if
the cash flow affected by:
Increase/decrease in Initial Outlay
fall / rise in Sales
hike / dip in Variable Costs
up / down in Fixed Costs

Only one variable is varied at a time

Sensitivity Analysis for Your Project
Key variable Range
Pessimistic Expected Optimistic

Investment -20% Normal +20%

Sales Rs m -16% Normal +16%

Variable +10% Normal -5%

cost as % of
sales
Fixed costs +30% Normal -20%
 Advantages Vs Disadvantages
• How robust or • Nothing about the
vulnerable to changes likelihood of these
in underlying changes
variables • Specified variable
• Help explore where based
the vulnerability is • Inherently subjective
more
• Intuitively appealing
 Scenario Analysis
• A combination of changes in ‘n’ no. of
variables
• Choose the factor that is the source of
largest uncertainty and define the
scenarios
• Estimate values of each of the variable in
investment analysis for the separate
scenarios
• Find NPV in each scenario
 Scenario Analysis I
• Method
– Scenario analysis examines a set of scenarios under tha
assamption that each scenario occurs with a certain probability
• Example 1: sales price would drop by 6% with 25% probability for
worst case scenario.
• Example 2: operating cost would be reduced by 2% with 25%
probability for best case scenario.
– Then obtain base-case, best-case, and worst-case NPV and
calculate mean NPV and standard deviation to (roughly)
estimate the magnitude of the risk inherent to the project.
• Implication
– Scenario analysis is very useful technique to grasp the worst
case situation of the project (by assuming 1.0 correlation).

Based on: Financial Management, Eugene F. Brigham and Michael C. Ehrhardt, 2008
 Scenario Analysis II

• Simplified illustration of scenario analysis process

Expected NPV
Excel (mean value)
Sheet Standard Deviation
Slot in all base-, best-, of NPV
Base-, best-, and worst- and worst-case scenarios
case scenarios of each cash of each cash
flow

• Projected NPVs on the basis of the three scenarios

Probability (%)
50% FCF from base-
40% case scenario
30%
FCF from worst- 20% FCF from best-
case scenario 10% case scenario

$0 NPV ($)
Mean value
 Your Project’s Scenario Analysis
• Consider worst, normal, best scenario for
your project & work out scenario analysis
• All items in P&L undergo changes
 Monte Carlo Simulation

Technique for evaluation of

capital investments under
conditions of risk
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.
 Monte Carlo Simulation

• Simplified illustration of monte-carlo simulation process

NPVs probability
Distribution

Expected NPV
(mean value)

Standard Deviation
Probability distribution of each cash Randomly picking up of NPV
flow and correlations between them scenarios

• Simplified illustration of probability distribution of NPVs

Probability (%)

10%
8%
6%
4%
2%

$0 NPV ($)
 6 step process
• Define the problem
• Identify the fixed & variable factors
• Identify the alternatives available
• Construct a mathematical model
• Run the model & get results
• Decide best of the alternatives
 For Your Project
• Assign same probabilities as in the book
with respect to the three variables Cost of
the Project, Life of the project and annual
cash flows
• Your mathematical model could be NPV,
IRR
 example
Annual Cash Flow ######## Project life
Value Probability ######## 3 0.05
########
1000 0.02######## 4 0.10
1500 0.03######## 5 0.30
2000 0.15######## 6 0.25
########
2500 0.15######## 7 0.15
3000 0.30######## 8 0.10
3500 0.20######## 9 0.03
####
4000 0.15 10 0.02
 Initial Decisions
1. You want to set 10 runs of simulations
2. Exogenous variables identified are
Annual cash flows and Life of project
3. You want to use two-digit random
numbers only
4. Model applied is NPV
n
AnnualCash Flow
NPV = ∑ − InitialInvestment
t =1 (1 + Riskfreerate )
 Steps
1. assign two-digit random numbers range
from 0-99
2. Assign probabilities
 Set up correspondence between
Values of Exogenous variables & 2
digit random numbers
Annual cash flow Project Life
Value PROB CUM 2 DIGIT Value Yrs Prob Cum Prob 2 Digi
Rs. PROB RN RN

1000 0.02 0.02 00-01 3 0.05 0.05 00-04

1500 0.03 0.05 02-04 4 0.10 0.15 05-14
2000 0.15 0.20 05-19 5 0.30 0.45 15-44
2500 0.15 0.35 20-34 6 0.25 0.70 45-69
3000 0.30 0.65 35-64 7 0.15 0.85 70-84
3500 0.20 0.85 65-84 8 0.10 0.95 85-94
4000 0.15 1.00 86-99 9 0.03 0.98 95-97
10 0.02 1.00 98-99
 Choosing the Probability
distribution for basic variables
• Portrait Approach - like police
• Building Block approach – expert divide
the data according to pattern & arrive at
 Trapezoidal Distribution
Uniform Dist

Normal

Step Rectangular
Distbn
 What to use when
• Uniform Distribution : safe limits
• Trapezoidal : data in a small range around its
best estimate – large class of subjective
judgments satisfactorily
• Step Rectangular : divides data into ranges &
assign different probability to each
• Normal – where no statistical errors or random
disturbances affect the data
 Simulation results
Run RN Rs CF R N Yrs NPV
1 53 3000 97 9 4277
2 66 3500 99 10 8506
3 30 2500 81 7 (829)
4 19 2000 09 4 (7660)
5 31 2500 67 6 (2112)
6 81 3500 70 7 4039
7 38 3000 75 7 1605
8 48 3000 83 7 1605
9 90 4000 33 5 2163
10 58 3000 52 6 66
Advantages Vs. Disadvantages
• Versatility • Difficult o model &
• Compels the decision specify the probability
maker to explicitly distbn
consider • Imprecision – rpugh
interdependencies apprxmn
• Enormous complexity
• Rf is used as
discounting rate
 World Bank
• Powerful technique
• Efficient medium of communication
• Not replacing skilled judgment; more
judgment than traditional analysis
• Treatment of correlations between
variables can be completely misleading if
correlations are not handled properly
 Decision Tree Analysis
• Decision Tree analysis lets us approximate the NPV
distribution if we can estimate the probability of certain
events within the project
• A decision tree is an expanded time line which branches
into alternate paths whenever an event can turn out
more than one way
– The place at which branches separate is called a node
– Any number of branches can emanate from a node but the
probabilities must sum to 1.0 (or 100%)
– A path represents following the tree along a branch
• Evaluating a project involves calculating NPVs along all possible
paths and developing a probability distribution
 Decision tree analysis
• Identify the problem
• Delineate the decision tree
• Specify probability & monetary outcomes
• Evaluate the decision alternatives
 Decision Tree Analysis—
Example 1
Q: The Wing Foot Shoe Company is considering a three-year project
to market a running shoe based on new technology. Success
depends on how well consumers accept the new idea and demand
the product. Demand can vary from great to terrible, but for
planning purposes management has collapsed that variation into
just two possibilities, good and poor. A market study indicates a
Example

60% probability that demand will be good and a 40% chance that it
will be poor.

It will cost Rs5M to bring the new shoe to market. Cash flow
estimates indicate inflows of Rs3M per year for three years at full
manufacturing capacity if demand is good, but just Rs1.5M per year
if it’s poor. Wing Foot’s cost of capital is 10%. Analyze the project
and develop a rough probability distribution for NPV.
 Decision Tree Analysis—
Example
A: First, draw a decision tree diagram for the project. Then calculate
the NPV along each path.

0 1 2 3 NPV
P = .6 Rs3M Rs3M Rs3M Rs2.461M
(Rs5M) Rs-
Example

P = .4Rs1.5M Rs1.5M Rs1.5M 1.270M

Then calculate the weighted NPV for the tree. The decision
tree explicitly
Demand NPV Probability Product calls out the fact
Good 2.641M 60% Rs1.585M that a big loss is
quite possible,
Poor -1.270M 40% Rs-.508M although the
expected NPV
Expected Rs1.077M is positive.
NPV =
 Example 2
• The scientists at Spectrum have come up
with an electric moped. The firm is ready
for pilot production and test marketing .
This will cost Rs. 20 million and take 6
months. Mgt believes that there is 70%
chance that the pilot production and test
marketing will be successful. In the case
of success , they can build the plant
costing Rs 150m.
 - cont’d
• The plant will generate an annual cash
inflow of Rs.30m for 20 yrs if the demand
is high or an annual cash inflow of Rs.20m
if the demand is low. High demand has a
probability 0.6; low demand 0.4; pl advise
the co using decision tree analysis
Example 3- Expected Value &
Decision Tree

Decision
Expected Value
Decision Tree