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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
Break-even
Analysis
= 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
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
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.
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
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.
Worst Scenario: The scenario is considered worst when the product has
low demand, low selling price, high variable costs.
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.
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,
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
Calculate the NPV and (NPV) for the project when the risk free interest
rate i=6%
We know,
NPV= =1 I
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+
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+
NPV=Rs 3121
(NPV)= =1
1+
(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+
NPV=32709-25000
NPV=Rs 7709
(NPV)= =1
1+
(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
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
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 =