Perspectives on Risk Standalone risk Firm risk Market risk

Techniques for Risk Analysis

Techniques for Risk Analysis

Analysis of StandAlone Risk

Analysis of Contextual Risk

Sensitivity Analysis

Scenario Analysis

Corporate Risk Analysis

Market Risk Analysis

Break-even Analysis

Simulation Analysis

Decision tree Analysis

Measures of Risk
Risk refers to variability. It is a complex and multi-faceted phenomenon. A variety of measures have been used to capture different facets of risk. The more important ones are: Range Standard deviation

Coefficient of variation

Sensitivity Analysis
(000)
YEAR 0 YEARS 1 - 10

1. INVESTMENT 2. SALES

(20,000) 18,000 12,000 1,000

3. VARIABLE COSTS (66 2/3 % OF SALES) 4. FIXED COSTS

5. DEPRECIATION
6. PRE-TAX PROFIT 7. TAXES 8. PROFIT AFTER TAXES 9. CASH FLOW FROM OPERATIO 10. NET CASH FLOW (20,000)

2,000
3,000 1,000 2,000 4,000 4,000

NPV = -20,000,000 + 4,000,000 (5.650) = 2,600,000

Cost of capital = 12%, PVIFA at 10 years, 12% is 5.650

Sensitivity Analysis
RS. IN MILLION RANGE
KEY VARIABLE PESSIMISTIC EXPECTED OPTIMISTIC PESSIMISTIC

NPV
EXPECTED OPTIMISTIC

INVESTMENT (RS. IN MILLION) SALES (RS. IN MILLION) VARIABLE COSTS AS A PERCENT OF SALES FIXED COSTS

24 15 70

20 18 66.66

18 21 65

-0.65 -1.17 0.34

2.60 2.60 2.60

4.22 6.40 3.73

1.3

1.0

0.8

1.47

2.60

3.33

Scenario Analysis
Procedure 1. Select the factor around which scenarios will be built. 2. Estimate values of each of the variables for each Scenario

3. Calculate NPV / IRR under each scenario

NET PRESENT VALUE FOR THREE SCENARIOS
(RS. IN MILLION) SCENARIO 1
INITIAL INVESTMENT 200

SCENARIO 2
200

SCENARIO 3
200

UNIT SELLING PRICE (IN RUPEES)

DEMAND (IN UNITS) REVENUES VARIABLE COSTS FIXED COSTS DEPRECIATION

25
20 500 240 50 20

15
40 600 480 50 20

40
10 400 120 50 20

PRE-TAX PROFIT
TAX @ 50% PROFIT AFTER TAX ANNUAL CASH FLOW PROJECT LIFE SALVAGE VALUE

190
95 95 115 10 YEARS 0

50
25 25 45 10 YEARS 0

210
105 105 125 10 YEARS 0

NET PRESENT VALUE (AT A DISCOUNT

RATE OF 15 PERCENT)

377.2

25.9

427.4

Break-Even Analysis
Accounting Break Even Analysis
Fixed Costs + Depreciation = Contribution margin ratio 0.333 1+2 = Rs. 9 million

Cash flow forecast for Naveens flour mill project

(000) Year 1 - 10 18,000 12,000 1,000 2,000 3,000 1,000 2,000 4,000 4,000

1. Investment 2. Sales 3. Variable costs (66 2/3% of sales) 4. Fixed costs 5. Depreciation 6. Pre-tax profit 7. Taxes 8. Profit after taxes 9. Cash flow from operation 10. Net cash flow

Year 0 (20,000)

(20,000)

Cash Break-Even Analysis : When NPV is 0. Find Sales ?

Simulation Analysis
Procedure
1. Choose variables whose expected values will be replaced with distributions 2. Specify the probability distributions of these variables 3. Draw values at random and calculate NPV

4. Repeat 3 many times and plot distribution

5. Evaluate the results

Decision Tree Analysis

Decision tree analysis is a tool for analysing situations where sequential decision making in face of risk is involved. The key steps in decision tree analysis are: 1. 2. Identifying the problem and alternatives Delineating the decision tree

3.

Specifying probabilities and monetary

outcomes

4.

Evaluating various decision alternatives

Vigyanik case
The scientists at Vigyanik 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 six months. Management believes that there is a 70 percent chance that the pilot production and test marketing will be successful. In case of success, Vigyanik can build a plant costing Rs.150 million. The plant will generate an annual cash inflow of Rs.30 million for 20 years if the demand is high or an annual cash inflow of Rs.20 million if the demand is moderate. High demand has a probability of 0.6; Moderate demand has a probability of 0.4. To analyse such situations where sequential decision making is involved decision tree analysis is helpful.

Vigyanik Case
C21 : High demand Annual cash flow Probability 30 million : 0.6 D21:Invest -Rs 150 million C11 : Success D11: Carry out pilot production and market test -Rs 20 million Probability : 0.7

c2
C22 : Moderate Annual demand cash flow Probability 20 million : 0.4

D2
D22: Stop

c1

C12 : Failure Probability : 0.3

D1
D12:Do nothing

D3

D31: Stop

Vigyanik Case
The alternatives in the decision tree shown are evaluated as follows: 1. Start at the right-hand end of the tree and calculate the EMV at chance point C2 that comes first as we proceed leftward. EMV(C2) = 0.6 [30xPVIFA (20, 12%)] + 0.4 [20 x PVIFA (20, 12%)] = Rs.194.2 million

2.

Evaluate the EMV of the decision alternatives at D2 the last stage decision point. Alternative EMV D21 (Invest Rs.150 million) Rs.44.2 million D22 (Stop) 0
Select D21 and truncate D22 as EMV(D21) > EMV(D22).

3.

Vigyanik Case
4. Calculate the EMV at chance point C1 that comes next as we roll backwards. EMV (C1) = 0.7 [44.2] + 0.3 [0] = Rs.30.9 million Evaluate the EMV of the decision alternatives at D1 the first stage decision point : Alternative EMV D11 (Carry out pilot production and market test at a cost of Rs.20 million) Rs.10.9 million D12 (Do nothing) 0 Based on the above evaluation, we find that the optimal decision strategy is as follows : Choose D11 (carry out pilot production and market test) at the decision point D1 and wait for the outcome at the chance point C1. If the outcome at C1 is C11 (success), invest Rs.150 million; if the outcome at C1 is C12 (failure) stop.

5.

Project Selection Under Risk

Judgmental Evaluation
Payback Period Requirement Risk Adjusted Discount Rate

Certainty Equivalent Method

Relative Importance of Various Methods of

Assessing Project Risk

A survey of corporate finance practices in India found the relative importance of various methods of assessing project risk to be as follows:
% of companies rating it as very important or important Sensitivity analysis Scenario analysis Risk-adjusted discount rate Decision tree analysis Monte Carlo simulation 90.10 61.60 31.70 12.20 8.20