RISK ANALYSIS

What Is Risk Analysis?

Risk Analysis is a process that helps you identify and manage potential
problems that could undermine key business initiatives or projects.
To carry out a Risk Analysis, you must first identify the possible threats
that you face, and then estimate the likelihood that these threats will
materialize.Risk Analysis can be complex, as you'll need to draw on
detailed information such as project plans, financial data, security
protocols, marketing forecasts, and other relevant information. However,
it's an essential planning tool, and one that could save time, money, and
reputations.

Risk is a possibility of incurring loss or misfortune.

Every project is linked with certain amount of risk.
Research and development project is more risky than an
expansion project.
Thus a need arises for the calculation of the amount of risk
concerned with the projects.
Risk analysis comprises of various tools for determining the
risk associated with project.
No single technique or tool may be suggested as the best tool.
 When to Use Risk Analysis

Risk analysis is useful in many situations:

When you're planning projects, to help you anticipate and
neutralize possible problems.
When you're deciding whether or not to move forward
with a project.
When you're improving safety and managing potential risks
in the workplace.
When you're preparing for events such as equipment or
technology failure, theft, staff sickness, or natural disasters.
When you're planning for changes in your environment,
such as new competitors coming into the market, or
changes to government policy.
 Sources and Perspective of Risk
Sources of Risk
Project-specific risk
Competitive risk
Industry-specific risk
Market risk
International risk
Perspectives on Risk

Like anything, projects do have risks. There are three types of project risks associated with
capital budgeting:
1. Stand-Alone Risk-This risk assumes the project a company intends to pursue is a single asset
that is separate from the company's other assets. It is measured by the variability of the single
project alone. Stand-alone risk does not take into account how the risk of a single asset will
affect the overall corporate risk.
2. Corporate Risk- This risk assumes the project a company intends to pursue is not a single
asset but incorporated with a company's other assets. As such, the risk of a project could be
diversified away by the company's other assets. It is measured by the potential impact a project
may have on the company's earnings.
3. Market Risk- This looks at the risk of a project through the eyes of the stockholder. It looks at
the project not only from a company's perspective, but from the stockholder's overall portfolio.
It is measured by the effect the project may have on the company's beta.
 How to Use Risk Analysis
To carry out a risk analysis, follow these steps:

1. Identify Threats
The first step in Risk Analysis is to identify the existing and
possible threats that you might face. These can come from
many different sources. For instance, they could be:
Human Illness, death, injury, or other loss of a key
individual.
Operational Disruption to supplies and operations, loss of
access to essential assets, or failures in distribution.
Reputational Loss of customer or employee confidence,
or damage to market reputation.
Procedural Failures of accountability, internal systems, or
controls, or from fraud.
Project Going over budget, taking too long on key tasks,
or experiencing issues with product or service quality.
Financial Business failure, stock market fluctuations,
interest rate changes, or non-availability of funding.
 Technical Advances in technology, or from technical failure.
Natural Weather, natural disasters, or disease.
Political Changes in tax, public opinion, government policy, or
foreign influence.
Structural Dangerous chemicals, poor lighting, falling boxes, or
any situation where staff, products, or technology can be harmed.
You can use a number of different approaches to carry out a
thorough analysis:
Run through a list such as the one above to see if any of these
threats are relevant.
Think about the systems, processes, or structures that you use, and
analyze risks to any part of these. What vulnerabilities can you spot
within them?
Ask others who might have different perspectives. If you're leading
a team, ask for input from your people, and consult others in your
organization, or those who have run similar projects.
Tools such as SWOT Analysis
and Failure Mode and Effects Analysis can also help you uncover
threats, while Scenario Analysis helps you explore possible future
threats.
 2. Estimate Risk
Once you've identified the threats you're facing, you need to
calculate out both the likelihood of these threats being realized,
and their possible impact.
One way of doing this is to make your best estimate of the
probability of the event occurring, and then to multiply this by the
amount it will cost you to set things right if it happens. This gives
you a value for the risk:
Risk Value = Probability of Event x Cost of Event
As a simple example, imagine that you've identified a risk that your
rent may increase substantially.
You think that there's an 80 percent chance of this happening
within the next year, because your landlord has recently increased
rents for other businesses. If this happens, it will cost your business
an extra $500,000 over the next year.
So the risk value of the rent increase is:
0.80 (Probability of Event) x $500,000 (Cost of Event) = $400,000
(Risk Value)
You can also use a Risk Impact/Probability Chart
to assess risk. This will help you to identify which risks you need to
focus on.
 The two broad categories of techniques used for risk
analysis:
Technique considering stand alone risk of a project.
Technique that considers the risk of project in context
to the firm and market.
 Techniques for Risk Analysis

Techniques for Risk

Analysis

Analysis of Stand- Analysis of

Alone Risk Contextual Risk

Sensitivity Scenario Corporate Market Risk

Analysis Analysis Risk Analysis Analysis

Break-even
Analysis

Hiller Decision tree

Model Analysis
 Stand-Alone risk of project
Various techniques that consider stand alone
risk of project are:-
Sensitivity analysis
Scenario analysis
Break-Even analysis
Hillier model
Decision tree analysis
 SENSITIVITY ANALYSIS
Future is uncertain, this leads to risk with a project.
What a manager wants to know?
Manager wants to know the viability of the project when some variables
like sales or investment deviates from their expected values.
Sensitivity analysis is thus a technique of systematically changing
parameters in a model to determine the effect of such changes.
This method is part of capital budgeting decisions.
Sensitivity analysis is simply the method for determining how
sensitive our NPV analysis is to changes in our variable
assumptions. To begin a sensitivity analysis, we must first come up
with a base-case scenario. This is typically the NPV using
assumptions we believe are most accurate. From there, we can
change various assumptions we had initially made based on other
potential assumptions. NPV is then recalculated, and the
sensitivity of the NPV based on the change in assumptions is
determined. Depending on our confidence in our assumptions, we
can determine how potentially risky a project can be.
 Example solved 11.2 Prasanna chandra 6th edition
Financial manager of Naveen flour mills considers of setting up of new
floor mill in Bangalore. The project staff has developed the following
figures of cash flows. Determine the NPV of the project and find out the
sensitivity analysis with the deviations in key variables from the
expected values.
 Sensitivity of NPV to variations
RANGE(Rs in 000)
Key Variable Pessimistic Expected Optimistic
Investment 24000 20000 18000
Sales 15000 18000 21000

Variable Costs 70 66.66 65

as percent of
sales
Fixed Costs 1300 1000 80

Discounting Rate=12%, n=10

 Solution
Calculation of NPV

= Co
1+
=1
 NPV=-20000000+4000000*PVIFA
since the cash flow occurs as annuities hence the use of PVIFA for
calculation of present value of annuities.
1+ 1
=
1+

PVIFA=5.650
NPV= -20000000+4000000*5.650
NPV=2600000

To analyze the sensitivity of the NPV to variations in key

variables, we vary one variable at a time keeping the other
variables constant.
 RANGE(Rs in 000)
Key Variable Pessimistic Expected Optimistic
Investment 24000 20000 18000
Sales 15000 18000 21000
Variable Costs 70 66.66 65
as percent of
sales
Fixed Costs 1300 1000 80
Consider the case when Investment occurs in pessimistic time. Thus
more investment would be required then the expected value.
Now we change the value of investment to 24000 then 20000
keeping the other variables constant and determine the change in
NPV of the project.
NPV= -24000000+4133000*5.65
NPV= -648550

Similarly, we calculate NPV when the investment is done under

optimistic time and so on.
 RANGE(Rs in 000) NPV
Key Pessimisti Expected Optimis Pessimist Expecte Optimis
Variabl c tic ic d tic
e
Invest 24000 20000 18000 -648550 2600000 4223936
ment
Sales 15000 18000 21000 -1166290 2600000 6367420
Variabl 70 66.66 65 340452 2600000 3730621
e Costs
as
percent
of sales
Fixed 1300 1000 80 1470000 2600000 3353936
Costs
Thus the effect, of varying the key variables, on NPV can be easily
assessed. The financial manager thus gets to know whether to carry on
with the project under different circumstances.
 Example: unsolved question No. 1 prasanna chandra 6th edition
you are financial manager of HEPL. HEPL is planning to set up an extrusion plant
at Indore. Your project staff has developed the following cash flow forecast for the
project.

Determine the NPV of the project and calculate the effect of variations
in the values of underlying variables on NPV.
 RANGE(Rs in million)
Underlying Pessimistic Expected Optimistic
Variable
Investment 300 250 200
Sales 150 200 275
Variable Costs 65 60 56
as percent of
sales
Fixed Costs 30 20 15

Cost of Capital=13%, n=10

 Solution

NPV= -250+50*5.426
NPV= 21.312
 RANGE(Rs in 000) NPV
Key Pessimisti Expected Optimis Pessimist Expecte Optimis
Variabl c tic ic d tic
e
Invest 300 250 200 -20.95 21.31 63.55
ment
Sales 150 200 275 -56.21 21.31 137.58
Variabl 65 60 56 -17.46 21.31 52.31
e Costs
as
percent
of sales
Fixed 30 20 15 -17.46 21.31 40.68
Costs
Thus it can be determined that situations with negative NPV are
unfavorable situations for carrying out the project further.
 Merits and Demerits of Sensitivity
Analysis
Merits
It shows the robustness of project to changes in underlying key
variables.
It indicates whether to carry on with the project.
If the NPV is highly sensitive to changes then manager can explore
the variability of key variable.
Demerits or shortcomings
Sensitivity analysis considers change in only one variable
whereas in reality variables move together.
It shows the effect on variable with change in key variable but
does not depict the likely change in the variable.
 SCENARIO ANALYSIS
Sensitivity analysis assumes that variables are independent of each
other. Whereas, variables are interrelated and they may change in
combination.
To examine the risk of investment one can analyze the impact of
alternative combinations of variables, called Scenarios.

Consider the following example where,

Zen enterprises is evaluating a project for introducing a new product.
Depending on the response of market, firm has formulated 3 scenarios,
Scenario1: The product will have moderate appeal to customers at a
moderate price.
Scenario2: The product will have strong appeal to large segment which
is highly price sensitive.
Scenario3: The product appeals small segment which is willing to pay
high for the product.
Consider the following example in which the initial investment is Rs 200
million,
The 3 scenarios are considered as:-
Scenario1 Moderate demand of 20 million units and moderate selling
price of product being Rs 25 per unit.

Scenario2 High demand of 40 million units and low selling price of Rs

15 per unit,

Scenario3 Low demand 0f 10 million units for a highly priced product

of Rs 40 per unit.

The variable costs on three scenarios are 48%, 80%, 30% respectively.
Taxes are paid at a rate of 50%
Depreciation occurs at 10% and project life cycle is of 10 years and
salvage value is 0.
It is also given that the Discounting Rate is15%.
 Scenario 1 Scenario 2 Scenario 3

Initial Investment 200 200 200

Unit S.P(Rs) 25 15 40
Demand(in units) 20 40 10
Revenues 500 600 400
Variable costs 240 (48% of sales) 480(80%) 120(30%)
Fixed costs 50 50 50
Depreciation(10%) 20 20 20
Pre-Tax profit 190 15 210
Tax@50% 95 25 105
Profit after Tax 95 25 105
Annual Cash flow 115 45 125
Net Present Value 377.2 25.9 427.4

Thus scenario analysis helps to understand the effect on NPV when the
variables change in correlation.
BEST AND WORST CASE ANALYSIS
The scenarios developed in previous example are most commonly
occurring situations where high selling price and low demand go hand in
hand. But managers try another kinds of scenario analysis called the best
and worst case analysis.

These scenarios are as:

Best Scenario: Best scenario is considered when the product has high
demand, high selling price, low variable cost etc.

Average scenario: has average demand, average selling price, average

variable cost.

Worst Scenario: The scenario is considered worst when the product has
low demand, low selling price, high variable costs.

The objective of such scenario analysis is to determine what would

happen if situation is most favorable and if the adverse situation arises.
Merits and Demerits of Scenario Analysis
Merits:
It is an improvement to Sensitivity analysis because it
considers variations in several variables together as it
happens in reality.
Demerits:
It is based on assumption that there are few linear scenarios.
If there are many changing key variables then it would be
difficult to analyze a number of scenarios.
 BREAK-EVEN ANALYSIS
This method helps in determining how much should
be produced and sold at the minimum to ensure no
loss situation.
The minimum quantity at which loss is avoided is
called a Break-Even point.
It is a no profit-no loss situation.
Since profits are linked with cost and volumes.
Hence, it is the cost-volume-profit relationship
analysis.
The project breaks even in NPV terms when the present value of cash
flows is equal to the initial investment.

Formulas used for the calculation of Break Even sales:

Contribution Margin=Total Sales-Total Variable Costs

Consider the previous example of Naveen Flour mills. Financial manager
of the firm wants to know the break even sales.
Solution

1+ 1

1+
For the project to break even, PV of cash flows should
be equal to initial investment or NPV should be zero.
Hence,
1.254*sales= 20 million
Break Even Sales=Rs 15.95 million
This implies that for the project to have a zero NPV,
sales of the flour mill should be equal to 15.95
million.
 Example: unsolved question No. 1 prasanna chandra 6th edition
you are financial manager of HEPL. HEPL is planning to set up an extrusion plant
at Indore. Your project staff has developed the following cash flow forecast for the
project.

Determine the financial break even point of sales.

Solution

1+ 1

1+
For the project to break even, PV of cash flows should be
equal to initial investment or NPV should be zero.
Hence,

1.614*sales-40.36 million= 250 million

Break Even Sales= Rs 180 million

 HILLIER MODEL
F.S. Hillier analyzed that the expected cash flows
have standard deviations.
The more the certainty of cash flow less is the
standard deviation.
There are two cases for which analysis is done
There is no correlation among cash flows,
Cash flows are perfectly correlated.
Uncorrelated cash flows
When there is no correlation among cash flows i.e. cash flow
for year 2 is independent of cash flow for year1 and they
deviate independently, the expected NPV and standard
deviation of NPV are as:

NPV= =1 I
1+ 1
2

(NPV)= =1 2
2
1+

Where,
is expected cash flow for year t,
i is risk-free interest rate,
I is initial outlay
The cash flows for the project involving outlay of Rs 10000 are as
follows: Year 1 Year 2 Year3
Net cash Probabilit Net cash Probabilit Net cash Probabilit
flow y flow y flow y
Rs 3000 .3 2000 .2 3000 .3

5000 .4 4000 .6 5000 .4

7000 .3 6000 .2 7000 .3

Calculate the NPV and (NPV) for the project when the risk free interest
rate i=6%
We know,

NPV= =1 I
1+

Where I=10000, i=6%, t=3

Year 1 Year 2 Year3

Net cash Probabilit Net cash Probabilit Net cash Probabilit
flow y flow y flow y
Rs 3000 .3 2000 .2 3000 .3
5000 .4 4000 .6 5000 .4
7000 .3 6000 .2 7000 .3
At 5000 At 4000 At 5000
Hence,
5000 4000 5000
The NPV= + 2+ 3-10000
1.06 1.06 1.06
NPV= Rs 2475 and,
1
2

(NPV)=
=1 2
2
1+

2 2 2
50003000 .3+ 50005000 .4+ 50007000 .3
2 +
1.06
2 2 2 1/2
40002000 .2+ 40004000 .6+ 40006000 .2
(NPV)= 1.06
4 +
2 2 2
50003000 .3+ 50005000 .4+ 50007000 .3
2
1.06

1/2
2400000 1600000 2400000
(NPV)= 2 + 4 + 6 = Rs 2258
1.06 1.06 1.06
Question No. 3 unsolved exercise Prasanna chandra 6th edition(projects)
A project involving an initial outlay of Rs 10 million has the following
benefits associated with it:
Year 1 Year 2 Year3
Net cash Probabilit Net cash Probabilit Net cash Probabilit
flow (Rs y flow y flow y
in mln)
4 .4 5 .4 3 .3
5 .5 6 .4 4 .5
6 .1 7 .2 5 .2

Assume that the cash flows are independent. Calculate the expected NPV
and standard deviation of NPV. Risk free interest rate=10%
 Solution
Year 1 Year 2 Year3
Net cash Probabilit Net cash Probabilit Net cash Probabilit
flow (Rs y flow y flow y
in mln)
4 .4 5 .4 3 .3
5 .5 6 .4 4 .5
6 .1 7 .2 5 .2
At 4.7 At 5.8 At 3.9

The NPV= =1 I
1+

4.7 5.8 3.9

NPV= + 2+ 3 10
1.1 1.1 1.1
NPV= Rs 2 million
 2 1
2
(NPV)= =1 2
1+
2 2 2
4.74 .4+ 4.75 .5+ 4.76 .1
2 +
1.1
2 2 2 1
5.85 .4+ 5.86 .4+ 5.87 .2
(NPV)= 1.1
4 + 2

2 2 2
3.93 .3+ 3.94 .5+ 3.95 .2
6
1.1

(NPV)= Rs 1 million
Correlated cash flows
When there perfect correlation among cash flows i.e. if cash
flow of year1 deviates by a value ,say x, then the cash flow of
year 2 will also deviate by a value x. Thus the cash flows have
standard deviation in linearly related to each other, the
expected NPV and standard deviation of NPV in this case are
as:


NPV= =1 I
1+

(NPV)= =1
1+

Where,
is expected cash flow for year t,
I is risk-free interest rate,
I is initial outlay
The investment project has an initial outlay of Rs 10000. The mean and
standard deviation of cash flows which are perfectly correlated are as,

Year At t
1 5000 1500

2 3000 1000

3 4000 2000

4 3000 1200

Determine the NPV and (NPV) of the project when the risk free interest
rate=6%.

The NPV= =1 I
1+

5000 3000 4000 3000

NPV= + 2 + 3+ 4 10000
1.06 1.06 1.06 1.06

NPV=Rs 3121

(NPV)= =1
1+

1500 1000 2000 1200

(NPV)= + 2+ 3 + 4
1.06 1.06 1.06 1.06

(NPV)=Rs 4935
Example unsolved question No. 4 prasanna chandra 6th edition ch. 11
Janakiram is considering an investment which requires a current outlay
of Rs 25000. the expected value of cash flows and standard deviations of
cash flows are:
Year At t
1 12000 5000

2 10000 6000

3 9000 5000

4 8000 6000

The cash flows are perfectly correlated. Calculate the expected value of
NPV and standard deviation of NPV of this investment. Risk free interest
rate is 8%.
 Solution

The NPV= =1 I
1+

12000 10000 9000 8000

NPV= + 2 + 3+ 4 25000
1.08 1.08 1.08 1.08

NPV=32709-25000
NPV=Rs 7709

(NPV)= =1
1+

5000 6000 5000 6000

(NPV)= + 2+ 3 + 4
1.08 1.08 1.08 1.08

(NPV)=Rs 18153
 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 AnalysisExample 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 60% probability that demand will be
Example

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 its poor. Wing
Foots cost of capital is 10%. Analyze the project and develop a rough
probability distribution for NPV.
 Decision Tree AnalysisExample
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)
Example

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

Then calculate the weighted NPV for the tree. The decision tree
explicitly calls out
Demand NPV Probability Product the fact that a big
Good 2.641M 60% Rs1.585M loss is quite
possible,
Poor -1.270M 40% Rs-.508M although the
expected NPV is
Expected Rs1.077M positive.
NPV =