Risk Analysis in Capital

Budgeting
Prof Ravichandran

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.
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Concept of Risk
Risk exists when there is a range of possible
outcomes associated with a decision and the
probabilities of those outcomes occurring are
known .
If those possibilities are not known, the decision
maker is said to face uncertainty.
A strategy is a plan or course of action designed
to achieve a management goal.

Concept of Risk
A state of nature refers to a condition that may exist
in the future that will have a significant effect on the
success of a strategy.
An outcome is the gain or loss associated with a
particular combination of strategy and state of
nature.
A payoff matrix lists the outcomes associated with
each strategy-state of nature combination

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

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
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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.
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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.
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Example
Suppose an investment project has a life of three
years, and it would involve an initial cost of Rs 10,000.
Expected Cash Flow

If the discount rate is 15 per cent, calculate the

expected NPV.

Example

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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

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Variance or Standard Deviation

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

Standard deviation

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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.

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Risk Analysis in Practice

Most companies 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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Risk Analysis in Practice

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.

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Other Methods
for Incorporating Risk
Certainty equivalent: a certain (risk-free)
cash flow that would be acceptable as
opposed to the expected value of a risky
cash flow
With the certainty equivalent method, the
risk adjustment is made in the numerator
of the present-value calculation.

Sensitivity and
Scenario Analysis
Sensitivity analysis: a method for
estimating project risk that involves
changing a key variable to evaluate the
impact the change will have on the results
Scenario analysis: similar to sensitivity
analysis, but takes into consideration the
changes of several important variables
simultaneously

Simulation
Simulation analysis: a method for
estimating project risk that assigns a
probability distribution to each of the key
variables
Uses random numbers to simulate a set of
possible outcomes to arrive at an expected
value and dispersion

Decision Trees
Decision tree: a diagram that points out
graphically the order in which decisions must
be made and compares the value of the
various actions that can be undertaken
Decision points are designated with squares
on a decision tree. Chance events are
designated with circles and are assigned
certain probabilities.

Real Options in
Capital Budgeting
Real option: an opportunity to make
changes in some aspects of the project while
it is in progress or to make adjustments even
before the project is started
Value of the project = NPV + option value

Summary
Capital budgeting involves the evaluation of projects in
which initial expenditures provide streams of cash inflows
over a significant period of time.
Two methods are recommended for evaluating capital
budgeting proposalsNPV and IRR. If there is a conflict,
NPV is the theoretically preferred measure.
Capital budgeting decisions are subject to risk.

Summary
Expected value and standard deviation are
used to describe the attributes of capital
budgeting for risky projects.
Risk adjusted discount rates and certainty
equivalents are used to incorporate risk
into the capital budgeting process.
Sensitivity analysis and scenario analysis
are used by firms to analyze risk.