Capital Capital Budgeting Budgeting

Risk analysis in Capital Risk analysis in Capital Budgeting Budgeting

• The uncertainty of returns from the moment, the funds are invested until management and investor know how much the projects has earned, is a primary determinant of a proposal's risk.

• The estimates used to evaluate the capital budgeting proposals are the projections of future conditions and involve risk because of uncertainties surrounding the key variables involved in the evaluation procedure.

• Project Specific Risk: • an individual project may have higher or lower cash flows than expected, either

because of the wrong estimation or because of factors specific to that project.. • 2. Competition Risk: cash flows of a project are affected by the actions of the competitors.. • 3. Industry Specific Risk: technology risk, legal risk, commodity risk - effects of price changes in goods and services that are used or

produced. • 4. International Risk: • A firm faces this type of risk when it takes on projects outside its domestic market.

the earnings and cash flows might be different than expected owing to exchange rate movements or political changes.

• 5. Market Risk: • The last type of risk arises by the factors that affect essentially all companies and

all projects. For example, changes in interest rate structure will affect the projects already taken as well as those yet to be taken, both directly through the discount rate and indirectly through cash flows.

Sensitivity AnalysisSensitivity Analysis• Deals with the consideration of sensitivity

of the NPV in relation to different variables contributing to the NPV.

• Indicates how much the NPV will change in response to a given change in an input variable– change one variable at a time– answers “what if” questions– start with base-case which uses expected

values

Steps • A) Based on the expectations for the future, the cash flows are

estimated in respect of the proposal. • B) To identify the variables which have a bearing on the cash

flows of a proposal. For example, some of these variables may be the selling price, cost of inputs, market share, market growth rate etc.,

• C) To establish the relationship, between these variables and the output value i.e., the effect of these variables on the value of NPV of the proposal.

• D) To find out the range of variations and the most likely value of each of these variables, and

• E) To find out the effect of change in any of these variables on the value of NPV. This exercise should be performed for all the factors individually. For example, in case of a project involving .the product sale, the effect of change in different variables such as number of units sold, selling price, discount rate etc., can be taken up on the NPV or IRR of the project. This information can be used in conjunction with the basic capital budgeting analysis to decide whether or not to take up the project.

ExampleExample• Xyz ltd is evaluating

two proposals a1 and a2 having cash outflow of rs 30,000. These alternative proposals may result in different cash inflows different economic conditions. Evaluate the proposals and advice the firm given that the minimum required rate of return of the firm is 10%

  a1 a2

 10year

s15year

s

Cash Inflows (annual)    

good eco codn

rs 8000 6000

average eco condition 6000 5500

bad economic condition 4500 4500

  Proposal a1      

  CF PV(6.145) Outflow NPV

GOOD 8000 49160 30000 19160

AVG 6000 36870 30000 6870

POOR 4500 27653 30000 -2347

  Proposal a2      

  CF PV(6.145) Outflow NPV

GOOD 6000 45636 30000 15636

AVG 5500 41833 30000 11833

POOR 4500 34227 30000 4227

Simulation AnalysisSimulation Analysis• Computerized analysis which uses continuous probability distributions

• generation of values of cash flows using predetermined-probability distribution and the random numbers. The different components of cash flows are placed in relation to one another in a mathematical model. The process of generating the values of cash flows is repeated numerous times to result in a probability distribution of cash flows.

• Steps– Computer program selects values for each variable based on its

assumed distribution– NPV/IRR are calculated– Process is repeated many (1000+) times– End result is a probability distribution of NPV based on the simulated

values

Decision Tree AnalysisDecision Tree Analysis• Decision trees are a behavioral approach

that uses diagrams to map the various investment decision alternatives and payoffs as their probabilities of occurrence

• Steps In Decision Tree Analysis1. Identifying The Problem and alternatives2. Delineating The decision Tree3. Specifying probalities and monetary

outcomes4. Evaluating various decision alternatives