Capital Budgeting

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 Risk Analysis

02-Oct-09 Capital Budgeting 1

 Risk & Uncertainty
• Risk – The likelihood of occurrence of a known peril
(Insurance)
• Risk in capital budgeting is the possibility of
occurrence of a predicted variable when the
certainty of occurrence of an event is not known.
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02-Oct-09 Capital Budgeting 2

 Risks in Capital Budgeting
• Cash Flows subject to uncertainty & variations.
• All projects are based on assumptions that have
certain associated risks.
– Eg – Cash flow based on expected market
price/volume. What can happen if this changes?
– What will happen if government legislation makes
labor cost more expensive in a labor intensive
industry?
– What will happen if raw material prices vary from
projected costs?

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 Type of Risks
• Specific Project Related or Stand Alone Risks
– How does the variation in expected cash flow affect the
project?
• Corporate Risk
– How does the variation in cash flows affect all
projects?
• Market Risk
– What happens to the return to stakeholders/investors?
• Not all investors are sufficiently diversified.
• There are employees, suppliers, lenders who are not
guided by the portfolio theory.
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02-Oct-09 Capital Budgeting 4
 Tools For Analysis
1. Sensitivity Analysis
2. Probability
3. Important Statistical Tools
4. Scenario Analysis
5. Simulation
6. Risk Adjusted Discount Rate
7. Certainty Equivalent approach
8. Probability Distribution Approach
9. Normal Probability Distribution
10.Decision Tree Approach

02-Oct-09 Capital Budgeting 5

 Use of Risk Assessment Tools in the
Industry
• Most corporate firms use more than one tool.
• Sensitivity Analysis is most popular method used by more
than 91%.
• Scenario Analysis used by large corporate firms than
smaller ones.
• Risk Adjusted Rate of Return (RAR) used by 33% of
corporate firms.
• Simulation through Monte Carlo techniques and
Decision Tree methods – NOT USED by most
corporate firms.
• Most corporate firms also use Pay Back and Higher
Hurdle (Discount/WACC) rate for evaluation.
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 Risk Analysis – Sensitivity Analysis
• Simple but Very Useful Tool
• Cash Flows are projected based on certain key
parameters/inputs
– Selling Price
– Costs
– Volume of Output
– Overheads
• Examine the impact on NPV with changes in one or
more of the critical parameters.

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 Sensitivity Analysis
• Class Example & Class Work
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02-Oct-09 Capital Budgeting 8

 Probability Analysis
• The likelihood of the occurrence of an event in
quantitative terms.
• Types of Probabilities
– Objective Probability
• Based on a large number of independent and identical
observations.
– Subjective Probability
• Based on personal perceptions
• Also known as “Expert Opinion or Expert Knowledge”
• Capital budgeting uses subjective probability in most
cases.
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 Probability Analysis
• Estimate Expected Returns (Cash Flows)
• Estimate Probabilities
• Compute Expected Returns as
– (Estimated Expected Returns * Estimated Probability)
– NPV Prob. Expected NPV
– 5686 0.60 1612
– 9458 0.30 2837
– 15686 0.10 1569
• The mean of the Expected NPV will be the estimated
return from the project (ie 2006)

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 Statistical Tools
• Mean / Expected Value
• Standard Deviation of distributions
• Co-efficient of Variation (Std Deviation / Mean)
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• Example

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 Scenario Analysis
• Examines the project as a whole under different
economic conditions with many variables changing
at the same time instead of examining the impact of
variation of one or a few variables.
• Example
– What would happen in a situation of
• Economic Boom?
• Economic Depression?
• Stable Situation?
• Stagflation?

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 Scenario Analysis
• The projections under different conditions are
aggregated and evaluated and
• Statistical measures applied to compute a likely
scenario
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• Class Exercise
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02-Oct-09 Capital Budgeting 13

 Simulation
• An attempt to replicate a real life situation by
assigning values to key variables like selling price,
variable costs, sales volumes etc..
• Uses random numbers.
• A few thousand iterations are needed to arrive at a
meaningful distribution
• Needs the aid of electronic data processing for
meaningful interpretation.
• Not a very popular technique

02-Oct-09 Capital Budgeting 14

 Simulation – Monte Carlo
1. Identify the exogenous variables
– Sales – Volume, Price
– Variable Costs
– Fixed Costs
– Tax Rate
2. Specify the probability distribution for each of the
exogenous variables.
3. Compute the cumulative probability for each
exogenous variable.
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02-Oct-09 Capital Budgeting 15
 Simulation – Monte Carlo - contd
4. Compute the cumulative probability of each of he
distributions.
5. Allocate RANDOM NUMBERS to all possible
values of each variable in proportion to the
cumulative probabilities.
6. Select corresponding random number values for each
variable and their corresponding key factor values
7. Obtain the NPV

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 Simulation – Monte Carlo – (contd.)
• Perform many iterations
– In real life this would be a few thousands.
• Evaluate for the distribution
– Mean,
– Standard Deviation and
– Coefficient of Variation for the distributions
• Example
• Class Work

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 Risk Adjusted Discount Rate (RADR)
• Risk associated with projects has two dimensions
– Risks may vary with projects within the same
organization
– The same project may experience different risks at
different time periods.
• Rationale for RAD
– Shareholders have “Opportunity costs”.
– These costs are directly proportionate to risk.
– The RAD is therefore the premium expected over the
risk free return
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02-Oct-09 – Capital Budgeting 18
 Risk Adjusted Discount Rate (RADR
• Used on the same principle as IRR & NPV using the
same Accept-Reject criterion with the exception
that
– The hurdle rate is the RADR – not MCC.
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– [CFATi/ (1+Kr) ] - CO
• The RADR can also use different rates for periods
with a higher risk.
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 Risk Adjusted Discount Rate (RADR)
• Example
• Cash Flows in
– Year 0 Rs 1,00,000 (Outflow)
– Year 1 Rs. 50,000
– Year 2 Rs. 60,000
– Year 3 Rs. 40,000
– Riskless rate of return is 6%. RADR = 20%
– Part A – Compute NPV
– Part B – What would the answer be if the RADR is
25%, 26% & 28% in Years 1, 2 and 3 respectively?
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02-Oct-09 Capital Budgeting 20
 Risk Adjusted Discount Rate (RADR)

• NPV – Part A
– {(50,000/(1.20)1 ) + (60,000/(1.20)2 ) + (40,000/(1.20)3 ) } –
100,000
– = {41,667 + 41,667 + 23,148} – 100,000
– = 6,482
• NPV – Part B
– {(50,000/(1.25)1 ) + (60,000/(1.26)2 ) + (40,000/(1.28)3 ) } –
100,000
– = {40,000 + 37,793 + 19,073} – 100,000
– = - 3,134
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• Class Example
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 RADR - Evaluation
• Simple to use.
• Practical as MCC at varying rates can be applied for
different projects
• Disadvantages
– Determination of RADR arbitrary and error prone
– Adjustment of risk should be on the cash flow not the
RADR.
– Compounding of risk over time implies that risk
increases over time. May not be always true. Eg.
Teak Plantations

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 Certainty Equivalent Approach
• An alternative to RADR.
• Adjusts cash flows and NOT the hurdle rate.
• The Certainty Equivalent Coefficient
– Risk Free Cash Flow / Risk Prone Cash Flow
• Use the Co-efficient to Generate Certainty Equivalent
Cash Flows (CE-Cash Flow)
• Discount the CE-Cash Flows by the Risk Free rate.
• Perform the standard NPV test
• Example
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 Certainty Equivalent Approach
• Evaluation
– Simple to compute
– Modifies cash flows – not the discount rate.
– Issues With the Approach
• A Subjective estimate
• Does not directly use the probability distribution

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 Capital Budgeting - Risk
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• END

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