Capital Budgeting

Risk & Uncertainty

Decision making process

1. Decision making process can be of three types : Decision making under Certainty : Situations when outcome of a particular decision can be ascertained with certainty. E.g., decision to buy machine X involve payment of the specific price of that machine. Situations when outcome of decision cannot be ascertained with certainty. Here, real outcome may be different from the expected one. When occurrence of an outcome can be ascertained some probability. E.g., expected sales. Risk is associated with decision making process when it is possible to quantify likelihood of future outcome.

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3.

Risk
It s the difference between actual and expected cash flows. It is defined as the variability of the future actual cash flows against the expected cash flows of the proposal.

Risk analysis in Capital Budgeting

Uncertainty of returns from the moment , the funds are invested until management and investor know how much the project has earned , is a primary determinant of a proposals risk.

Types and Sources of Risk in Capital Budgeting

1. Project specific risk : An individual project may have higher or lower cash flows than expected, either because of the wrong estimations or because of the factors specific to that project. Competition Risk : Cash Flow of a project are effected by the actions of the competitors. Industry Specific Risk : Risk which primarily affect the earnings and cash flows of a specific industry only. This risk may arise because of : technology, laws and regulation and commodity risk reflecting effects of price changes in G&S that are used or produced.

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Types & sources of Risk

4. International Risk : When projects outside the domestic market are taken up leading to exchange rate risk, political risk etc. 5. Market Risk : Factors that affect all companies and all projects, in varying degrees. E.g., changes in interest rate, inflation, economic condition etc.

Risk Adjusted Discount Rate (RADR)

Modify the rate of return to include a risk premium wherever needed. Greater the risk, higher should be the desired return from proposals. Premise : Riskiness of a proposal may be taken care of by adjusting the discount rate. Expected return is expressed in terms of discount rate which is also termed as the minimum required rate of return generated by a proposal if it is to be accepted. Therefore, there is a positive correlation between risk of a proposal and the discount rate.

RADR
Difference between the discount rate applied to a riskless proposal and a risky proposal is known as risk premium. Ka = k + Where Ka = RADR K = Risk free discount rate = Risk Adjustment Premium Risk free Discount rate is described as the rate of return on the government securities As the risk increases, the risk premium also increases and therefore RADR also increases. RADR can be used to find out the risk adjusted NPV of the proposal. The only difference is that the rate of discount used in RADR i.e., ka is higher than original discount rate k.

Decision Rule
Accept the proposal if RANPV is positive or even zero. Reject the proposal if it is negative. Mutually Exclusive Proposals : Select the alternative which has highest RANPV.

Sensitivity Analysis
Value of NPV is sensitive to variables like sales revenue, input cost, competition etc. If any of these variables changes, value of NPV will also change. SA deals with consideration of sensitivity of NPV in relation to different variables contributing to NPV. It is a technique to evaluate the effect of changes in factors contributing to cash flows on the value of the NPV of the proposal.

Steps of S.A.
Based on future expectations, the cash flows are estimated in respect of the proposal. Identify the variables which have a bearing on the cash flows of a proposal. Establish relationship between these variables and the output value. Find out range of variations and the most likely value of each of these variables. Find out effect of change in any of these variables on the value of NPV. This exercise should be performed for all the factors individually.

S.A. Example
A company is evaluating two proposals A1 and A2 both having cash outflow of Rs.30,000 each. However, these alternative proposals may result in different cash inflows depending upon different economic condition i.e., good, average and poor. Following information is available : Evaluate proposals and advise firm given that minimum required rate of return of the firm is 10%

A1
Economic Life

A2
15 years

10 years

Cash Inflows : (Annual)

Good Eco Condition
Avg. Eco Condition Poor Eco Condition

8,000 6,000 4,500

6,000 5,500 4,500

Solution
NPV of the proposal should also be calculated under all the three conditions. Cash Flows are in the form of annuity of 10 years for proposal A1 and for 15 years years for proposal A2. Relevant PVAF (10%,10) and PVAF (10%,15) are 6.145 and 7.606 respectively. Present Values of the cash flows may be calculated as follows :
Proposal A1 CF Good Condition Avg. Condition Poor Condition 8,000 6,000 4,500 PVAF 6.145 6.145 6.145 PV Proposal A2 CF 6,000 5,500 4,500 PVAF 7.606 7.606 7.606 PV

Calculation of NPV of Proposals

Proposal A1
PV
Good Condition
49,160

Proposal A2
PV
45,636

Outflow

NPV

Outflow

NPV

30,000

30,000

Avg. Condition
Poor Condition

Example
Following forecast are made about a proposal which is being evaluated by a firm. Initial Outlay : Rs.12,000 Life : 4 years PVAF (14,4) = 2.9137 Cash Inflows : Rs.4,500 (Annual) Kc = 14% PVAF (14,3) = 2.3216 Analyse the sensitivity of different variables with respect to the NPV.

Solution

A.

NPV of the project is = -12,000 + 4,500 x (2.9137) = Rs.1,112

Sensitivity w.r.t. Initial Outlay : Outlay can increase from Rs.12,000 to Rs.13,112 before NPV becomes 0. So, There is a margin of --- % of initial outlay. B. Sensitivity w.r.t. payback period of the project : Payback period when NPV is 0. C. Sensitivity w.r.t. Annual Cash Inflows : 12,000 = Annual Inflows x 2.9137. So, Annual Inflows can decrease to --- from 4,500, So, annual cash inflows have a margin of ----% D. Sensitivity w.r.t. discount rate : The discount rate at which NPV is 0, is X. Therefore, 12,000 = 4,500 x X So, Discount rate can increase from 14% to ---% before NPV becomes negative. Therefore, there is a margin of ---% So, project is most sensitive to ________________

S.A. Limitations
1. S.A. is neither a risk measuring nor a risk reducing technique. It does not provide any clear cut decision rule. 2. Moreover, study of effect of variations in one variable by keeping other variables constant may not be very effective as the variable may be interdependent. 3. Analysis present results for a range of values, without providing any sense of the likelihood of these values occuring. 4. Subjective Use of the Analysis. Risk preference of decision makers may be different.

Decision Tree Approach

Valid in Sequential decisions.
Present decision is affected by the decisions taken in the past or it affects the future decisions of the same firm.

Evaluation of a project frequently requires a sequential decision making process where accept reject decision is made in several stages. Instead of taking a decision once for all, it is broken up into several parts and stages.
Decision Tree is a branching diagram representing a decision problem as a series of decisions to be taken under conditions of uncertainty. Here, project is broken down into clearly defined stages, and possible outcomes at each stage are listed along with the probabilities and cash flows effect of each outcome.

Steps in Decision Tree

1. Break the project into clearly defined stages.

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List all the possible outcomes at each stage. Specify probability of each outcome at each stage based on information available.
Specify the effect of each outcome on the expected cash flows from th project. Evaluate the optimal action to be taken at each stage, based on the outcome at the previous stage and its effect on cash flows. Estimate optimal action to be taken at the very first stage, based on the expected cash flows over the entire projects and all the likely outcomes of the cash flows.

Decision Tree problem 1

A Company has funds of Rs.2,00,000 which expectedly are not required for the next few years and can hence be deposited in a bank @15% interest payable annually. Alternatively, funds can be used to install a new machine for the production of a new item. For this, the firm has two options before it : (i) Machine 1 costing Rs. 1,80,000 which is expected to give annual cash inflows of Rs.1,00,000, Rs.1,20,000 and Rs.40,000 respectively for the next three years. (ii) Machine 2 costing Rs.1,90,000 which is expected to give annual cash inflows of Rs.1,00,000, Rs.1,00,000 and Rs.50,000 respectively for next three years. Present the decision situation in a decision tree and evaluate the options.

PVF @ 15% : 1 year : 0.870 2 year : 0.756 3 year : 0.658

Decision Tree Problem 2

A firm of investment consultants has been asked by one of its clients w.r.t. investment of a sum of rs.1,00,000 for a period of 2 years. After a thorough analysis of different opportunities, option A and B have been shortlisted. Option A will lead to a return of 8%, 10% or 12% in the first year, but due to the nature of the option, there is a correlation between the returns of year 1 and year 2. the returns of year 1 and the probabilities of the same return in year 2 are as follows : The three different returns in Year 1 are equally likely. Option B has a certain return of 9.5% per year.

Year 1

Year 2

8%

0.6

0.3 0.1

10% 0.2

0.5 0.3

125

0.1

0.2 0.7

Evaluation of Decision Tree

It allows firm to deal with uncertainties in the projects by considering the project in stages, and decision at any stage depends upon the outcome of the previous stage. It is a useful technique in case of sequential decision process. It helps in visualising different alternatives in more explicit form i.e., the graphic presentation. It provides a wealth of information but also requires a wealth of information. Requirement that the project be broken down into several stages and that the outcomes be discrete at every stage, reduces the number of projects for which decision tree can be applied. Approach becomes complicated as the number of stages of the decision making are incorporated. It may fail to incorporate too many independent variables.