Financial Management I

11. Risk Analysis and Optimal Capital

Expenditure Decision

suresh.suralkar@gmail.com, Phone: 40434399

 Course Content - Syllabus


Sr Title ICMR Ch. PC Ch. IMP Ch.




1 Introduction to Financial Management 1* 1 1



2 Overview of Financial Markets 2* 2 -



3 Sources of Long-Term Finance 10* 17 20, 21



4 Raising Long-term Finance - 18* 20, 21, 23



5 Introduction to Risk and Return 4* 8, 9 4, 5



6 Time Value of Money 3* 6 2



7 Valuation of Securities 5* 7 3


8 Cost of Capital 11* 14 9



9 Basics of Capital Expenditure Decisions 18* 11 8



10 Analysis of Project Cash Flows - 12* 10, 11



11 Risk Analysis and Optimal Capital - 13* 11, 12



*Book preference
Expenditure Decision
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  Books


1. Financial Management, Prasanna Chandra, 7th Edition,

Chapter 13

2. Financial Management, I. M. Pandey, 9th Edition, Chapter

12

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  Syllabus – Risk Analysis and Optimal
Capital Expenditure Decision


1. Introduction to Project Risk

2. Stand-Alone Risk
3. Sensitivity
4. Scenario and Decision Tree Approach
5. The Impact of Abandonment on NPV and Stand-Alone
Risk
6. Risk Adjusted Discount Rate versus Certainty Equivalents
7. Incorporating Risk and Capital Structure into Capital
Expenditure Decisions
8. Optimal Capital Expenditure
9. Capital Rationing

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  1. Introduction to Project Risk


• Risk is inherent in almost every business decision. In

capital budgeting decisions (capital expenditure
decisions) as they involve costs and benefits extending
over a long period of time during which many things
can change. Every investment proposal might have
different risks involved. R&D project might be more
risky than an expansion project. In view of such
differences, variations in risk need to be considered in
capital investment appraisal.
• Risk analysis is most complex and slippery aspect of
capital budgeting. Many techniques have been
suggested for risk analysis. They fall into two broad
categories. 5 / 29
  1. Introduction to Project Risk


(i) Approaches that consider the stand-alone risk of a

project
(ii) Approaches that consider the risk of a project in the

context of the firm or in the context of the market.

A figure classifies various techniques as below.
Techniques of Risk Analysis


Analysis of Stand-alone Risk Analysis of Contextual Risk

Sensitivity Scenario
Analysis Analysis Corporate Risk Market Risk
Analysis Analysis
Break-even Hillier
Analysis Model

Simulation Decision Tree

Analysis Analysis
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  1. Introduction to Project Risk


There are several sources of risk in a project. Main risks are



as follows, which affect the earnings and cash flow of the

project.
1. Project-specific risk: Estimation error or some factors
specific to the project like quality of management.
2. Competitive risk: Unanticipated actions of competitors.
3. Industry-specific risk: Unexpected technological
developments, regulatory changes specific to the
industry
4. Market risk: Macroeconomic factors like GDP growth
rate, interest rate and inflation rate risk etc.
5. International risk: Exchange rate risk, political risk etc
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  2. Stand-Alone Risk


• Stand-alone risk: This represents the risk of a project

when it is viewed in isolation.
• It is the risk an asset would have if it were a firm’s only
risk.
• It is measured by the variability of the asset’s expected
returns.
•

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  3. Sensitivity Analysis


• Since the future is uncertain, you may like to know, what

will happen to the viability of the project when some
variables like sales or investment deviates from its
expected value. In other words, you may want to do
‘what if’ analysis, also called the sensitivity analysis.
• In sensitivity analysis, key variables are changed and the
resulting changes in the NPV and IRR are observed.
• Consider an example as below. Suppose you are a financial
manager of Naveen Flour Mills. Naveen is considering
setting up a new floor mill. The project staff has
developed the data as beow. Assumed cost of capital as
12%.
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  3. Sensitivity Analysis


 Cash Flow Forecast for Naveen’s Flour Mill Project

 Rs. in thousands
 Year 0 Year 1 - 10
1. Investment (20,000)
2. Sales 18,000
3. Variable costs (66⅔% of sales) 12,000
4. Fixed costs 1,000
5. Depreciation 2,000
6. Pre-tax profit 3,000
7. Taxes 1,000
8. Profit after taxes 2,000
9. Cash flow from operation 4,000
10. Net cash flow (20,000) 4,000

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  3. Sensitivity Analysis


 Since the cash flow from operations is an annuity, the NPV

of this project is
 -20,000,000 + 4,000,000 x PVIFA(12%, 10 years)
 = -20,000,000 + 4,000,000 x 5.65 = 2,600,000
The NPV based on the expected values looks positive. The

underlying variables can vary widely and we would like to

see the effect of such variations on the NPV. So we define
the optimistic and pessimistic estimates of the underlying
variables. These are shown in LHS column of the table
below. The NPV is calculated for the optimistic and
pessimistic values of the underlying variables. To do this,
vary one variable at a time.
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  3. Sensitivity Analysis


 Sensitivity of NPV to Variations in the Value of Key Variables

 Rs. in million

Range NPV

Key PessimistiExpectedOptimist PessimistiExpectedOptimist
Variable c ic

c ic
Investment 24 20 18
 -0.65 2.6 4.22
Sales 15 18 21
 -1.17 2.6 6.4
Variable 70 66.67 65

0.34 2.6 3.73
cost ascosts
Fixed
 a % 1.3 1 0.8 1.47 2.6 3.33
of sales

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  3. Sensitivity Analysis



Sales


NPV in Rs. millions


Investment
Variable costs

Fixed costs


0 Change from Base

Base

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  3. Sensitivity Analysis


Sensitivity analysis is a very popular method for assessing



risk. It has certain merits.

• It shows how robust or vulnerable a project is to the
changes in values of the underlying variables.
• It indicates where further work may be done. If the NPV is
highly sensitive to changes in some factor, it may be
worthwhile to explore how the variability of that critical
factor may be contained.
• It is intuitively very appealing as it articulates the
concerns that project evaluators normally have.

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  3. Sensitivity Analysis


Sensitivity analysis also have some shortcomings.



• It merely shows what happens to NPV when there is a

change in some variable, without providing any idea of
how likely that change will be.
• Typically, in sensitivity analysis, only one variable is
changed at a time. In the real world, however, variables
tend to move together.
• It is inherently a very subjective analysis. The same
sensitivity analysis may lead one decision maker to
accept the project while another may reject it.

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  4. Scenario Analysis


• In Scenario Analysis, several variables are varied

simultaneously (whereas in sensitivity analysis, one
variable is varied at a time). Most commonly, three
scenarios are considered: expected (or normal) scenario,
pessimistic scenario and optimistic scenario.
• In normal scenario, all variables assume their expected (or
normal values). In the pessimistic scenario, all variables
assume their pessimistic values and in the optimistic
scenario, all variables assume their optimistic values.
The NPVs of the project of Naveen Flour Mills under three

scenarios are calculated as below.

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  4. Scenario Analysis


 Pessimistic, Normal and Optimistic Scenario

 Rs. in million
Pessimistic
 Expected Optimistic
1. Investment Scenario
24 Scenario
20 Scenario
18
2. Sales 15 18 21
3. Variable costs 105 (70%) 12 (66⅔%) 13.65 (65%)
4. Fixed costs 1.3 1 0.8
5. Depreciation 2.4 2 1.8
6. Pre-tax profit 0.8 3 4.75
7. Taxes 0.27 1 1.58
8. Profit after taxes 0.53 2 3.17
9. Annual cash flow from operation 2.93 4 4.97
10. NPV (7.45) 2.6 10.06
= (9) x PVIFA(12%, 10yrs) - (1)

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  4. Scenario Analysis


Scenario Analysis may be regarded as an improvement over



sensitivity analysis, however it has some limitations.

• It is based on the assumption that there are few well-
delineated scenarios. This may not be true in many
cases. For example, the economy does not necessarily lie
in three discrete states, namely, recession, stability and
boom. In fact, it can be anywhere on the continuum
between the extremes. When a continuum is converted
into three discrete states some information is lost.
• Scenario analysis expands the concept of estimating the
expected values. Thus in a case where there are 10
inputs, the analyst has to estimate 30 expected values to
do the scenario analysis.
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  4. Decision Tree Approach


Decision tree approach is based on the concept of tree and

branches and to take a better decision.
Steps in Decision Tree Analysis

• Delineate (draw) the Decision Tree

• Evaluate the alternatives
Delineate the Decision Tree

• Draw the decision points (typically represented by

squares), the alternative options available for
experimentation and action at these points and the
investment outlays associated with these options.
• Draw the chance points (typically represented by circles)
where outcomes are dependent on the chance process,
the likely outcomes at these points along with the
probabilities and the monetary values associated with
them. 5 / 29
  4. Decision Tree Approach


Evaluate the Alternatives



• Start at the right hand end of the tree and calculate the
NPV at various chance points that come first as you
proceed leftward.
• Given the NPVs of chance points in step above, evaluate
the alternatives at the final stage decision points in
terms of their NPVs.
• At each final stage decision point, select the alternative
which has the highest NPV and truncate the other
alternatives. Each decision point is assigned a value
equal to the NPV of the alternative selected at that
decision point.
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  4. Decision Tree Approach


• Proceed backward (leftward) in the same manner,

calculating the NPV at chance points, selecting the
decision alternative which has the highest NPV at
various decision points, truncating inferior decision
alternatives and assigning NPVs to decision points, till
the first decision point is reached.

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  4. Decision Tree Approach


 Decision Tree

30 million
P=0.6

C1

D2 40 million
P=0.4
C1

-Rs. 20
D1 million

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 6. Risk Adjusted Discount Rate versus
Certainty Equivalents


• Most firms use Risk-Adjusted Discount Rate.

• It is a discount rate that applies to particularly risky
stream of income.
• It is equal to the risk-free rate of interest plus a risk
premium.
•

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  9. Capital Rationing


• A situation in which a constraint is placed on the total size

of the firm’s capital investment.
•

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