CH 12. Risk Evaluation in Capital Budgeting

Chapter 12: Risk Evaluation in
Capital Budgeting
Definition of Risk
Risk refers to the variability in the actual
returns vis--vis the estimated returns, in terms
of cash flows.
Risk involved in capital budgeting can be
measured in absolute as well as relative terms.
The absolute measures of risk include
sensitivity analysis, simulation and standard
deviation.
The coefficient of variation is a relative
measure of risk.
Compiled by: Prof. Rajsee Joshi
Nature of Risk
Risk exists because of the inability of the
decision-maker to make perfect forecasts.

In formal terms, the risk associated with an
investment may be defined as the
variability that is likely to occur in the
future returns from the investment.
Three broad categories of the events
influencing the investment forecasts:
General economic conditions
Industry factors
Company factors
Statistical Techniques for Risk

Analysis
Probability
Variance or Standard Deviation
Coefficient of Variation
1. Probability
A typical forecast for a period. This is referred
to as best estimate or most likely forecast:

A forecaster should not give just one estimate,
but a range of associated probabilitya
probability distribution.
Probability may be described as a measure of
someones opinion about the likelihood that an
event will occur.
Assigning Probability
The probability estimate, which is based on
a very large number of observations, is

known as an objective probability.
Probability assignments that reflect the
state of belief of a person rather than the
objective evidence of a large number of
trials are called personal or subjective
probabilities.
Expected Net Present Value

Once the probability assignments have
been made to the future cash flows the

next step is to find out the expected
net present value.
Expected net present value = Sum of
present values of expected net cash
flows.
2. Variance or Standard Deviation

Simply stated,
variance measures
the deviation about
expected cash flow
n
2
of each of the
(NCF) = (NCFj ENCF) 2 Pj
j =1
possible cash flows.
Standard deviation
is the square root of
variance.
Absolute Measure
of Risk.
3. Coefficient of Variation
Relative Measure of Risk
It is derived as the standard deviation of the
probability distribution divided by its

expected value
The coefficient of variation is a useful
measure of risk when we are comparing the
projects which have
(i) same standard deviations but different
expected values, or
(ii) different standard deviations but same
expected values, or
(iii) different standard deviations and different
expected values.
CONVENTIONAL TECHNIQUES FOR RISK

EVALUATION
Payback
Risk-Adjusted Discount Rate
Certainty Equivalent
COMPILED BY: PROF. RAJSEE JOSHI
1. Payback
This method, answers the duration within
which the initial investment is recovered

The merit of payback
Its simplicity
Focusing attention on the near term future and
thereby emphasising the liquidity of the firm through

recovery of capital.
Favouring short term projects over what may be
riskier, longer term projects.
It ignores the time value of cash flows.
2. Risk-Adjusted Discount Rate

Risk-adjusted discount rate, will allow for
both time preference and risk preference

and will be a sum of the risk-free rate and
the risk-premium rate reflecting the
investors attitude towards risk.
n
NCFt
NPV =
t
(1
k
)
t =0
k = kf + kr
Evaluation of Risk-adjusted
Discount Rate
Advantages :
It is simple and can be easily understood.
It has a great deal of intuitive appeal for risk-
averse businessman.
It incorporates an attitude (risk-aversion)
towards uncertainty.
Limitations:
There is no easy way of deriving a risk-adjusted
discount rate.
It does not make any risk adjustment in the
numerator for the cash flows that are forecast
over the future years.
It is based on the assumption that investors are
risk-averse. Though it is generally true, there
exists
Compiled
a category
by: Prof. Rajsee
of risk
Joshi seekers who do not
demand premium for assuming risks; they are
3. CertaintyEquivalent
Reduce the forecasts of
cash flows to some

n
t NCFt
conservative levels.
NPV =
t
The certaintyequivalent
t = 0 (1 kf )
coefficient assumes a
value between 0 and 1,
and varies inversely with
*
NCF
Certain net cash flow
t
risk.
t
=
NCFt
Risky net cash flow
Decision-maker
subjectively or
objectively establishes
the coefficients.
The certaintyequivalent
coefficient can be
determined as a
relationship between the
certain cash flowsCompiled
and by: Prof. Rajsee Joshi
Evaluation of Certainty
Equivalent
This method suffers from many dangers in
a large enterprise:
First, the forecaster, expecting the reduction
that will be made in his forecasts, may inflate

them in anticipation.
Second, if forecasts have to pass through
several layers of management, the effect
may be to greatly exaggerate the original
forecast or to make it ultra-conservative.
Risk-adjusted Discount Rate

Vs. CertaintyEquivalent
The certaintyequivalent approach recognises
risk in capital budgeting analysis by adjusting

estimated cash flows and employs risk-free rate
to discount the adjusted cash flows.
On the other hand, the risk-adjusted discount
rate adjusts for risk by adjusting the discount
rate. It has been suggested that the certainty
equivalent approach is theoretically a superior
technique.
Sensitivity Analysis
Sensitivity analysis is a way of analysing
change in the projects NPV (or IRR) for a given

change in one of the variables.
The following three steps are involved in the
use of sensitivity analysis:
Identification of all those variables, which have an
influence on the projects NPV (or IRR).

Definition of the underlying (mathematical)
relationship between the variables.
Analysis of the impact of the change in each of the
variables on the projects NPV.
The decision maker, while performing
sensitivity analysis, computes the projects NPV

(or IRR) for each forecast under three
assumptions: (a) pessimistic, (b) expected, and
(c) optimistic.
DCF Break-even Analysis

Sensitivity analysis is a variation of the break-
even analysis.
What shall be the consequences if volume or
price or cost changes (Sensitivity analysis)? You
can ask this question differently: How much
lower can the sales volume become before the
project becomes unprofitable? What you are
asking for is the break-even point.
DCF break-even point is different from the
accounting break-even point. The accounting
break-even point is estimated as fixed costs
divided by the contribution ratio. It does not
account for the opportunity cost of capital, and
fixed costs include both cash plus non-cash
costs (such as depreciation).
Scenario Analysis
One way to examine the risk of investment
is to analyse the impact of alternative

combinations of variables, called
scenarios, on the projects NPV (or IRR).
The decision-maker can develop some
plausible scenarios for this purpose. For
instance, we can consider three scenarios:
pessimistic, optimistic and expected.
Simulation Analysis
The Monte Carlo simulation or simply the
simulation analysis considers the interactions

among variables and probabilities of the change
in variables. It computes the probability
distribution of NPV. The simulation analysis
involves the following steps:
First, you should identify variables that
influence cash inflows and outflows.
Second, specify the formulae that relate
variables.
Third, indicate the probability distribution for
each variable.
Fourth, develop a computer programme that
randomly
Compiled selects
by: Prof. Rajsee
one
Joshivalue from the
probability distribution of each variable and
Shortcomings
The model becomes quite complex to use.
It does not indicate whether or not the
project should be accepted.

Simulation analysis, like sensitivity or
scenario analysis, considers the risk of any
project in isolation of other projects. i.e It
does not make comparisons between two
projects
Decision Trees for

Sequential Investment
Investment expenditures are not an isolated
Decisions
period commitments, but as links in a chain
of present and future commitments.
An analytical technique to handle the
sequential decisions is to employ decision
trees.
Usefulness of Decision Tree

Approach
The merits of the decision tree approach are:
It clearly brings out the implicit assumptions and
calculations for all to see, question and revise.
It allows a decision maker to visualise assumptions
and alternatives in graphic form, which is usually
much easier to understand than the more abstract,
analytical form.
The demerits of the decision tree approach are:
The decision tree diagrams can become more and
more complicated as the decision maker decides to
include more alternatives and more variables and to
look farther and farther in time.
It is complicated even further if the analysis is
extended to include interdependent alternatives and
variables that are dependent upon one another.
Utility Theory and Capital

Budgeting
Utility theory aims at incorporation of
decision-makers risk preference explicitly

into the decision procedure.
As regards the attitude of individual
investors towards risk, they can be
classified in three categories:
Risk-averse
Risk-neutral
Risk-seeking
Individuals are generally risk averters and
demonstrate a decreasing marginal utility

for money function.
Example
Let us assume that the
owner of a firm is
considering an investment
project, which has 60 per
cent of probability of yielding
a net present value of Rs 10
lakh and 40 per cent
probability of a loss of net
present value of Rs 10 lakh.
ENPV = 10 0.6 + (10) 0.4 = Rs 2 lakh
Project has a positive
expected NPV of Rs 2 lakh.
However, the owner may be
risk averse, and he may
consider the gain in utility
arising from the positive
outcome (positive PV of Rs
10 lakh) less than the loss in
utility as a result of the
negative outcome (negative
PV of Rs 10 lakh).
The owner may rejectCompiled
the by: Prof. Rajsee Joshi
Benefits and Limitations of

Utility Theory
It suffers from a few advantages:
First, the risk preferences of the decision-maker are
directly incorporated in the capital budgeting analysis.
Second, it facilitates the process of delegating the
authority for decision.
It suffers from a few limitations:
First, in practice, difficulties are encountered in
specifying a utility function.
Second, even if the owners or a dominant
shareholders utility function be used as a guide, the
derived utility function at a point of time is valid only
for that one point of time.
Third, it is quite difficult to specify the utility function if
the decision is taken by a group of persons.
Risk Analysis in Practice

Most companies in India account for risk while
evaluating their capital expenditure decisions.

The following factors are considered to influence
the riskiness of investment projects:
price of raw material and other inputs
price of product
product demand
government policies
technological changes
project life
inflation
Out of these factors, four factors thought to be
contributing most to the project riskiness are:
selling price, product demand, technical changes
and government policies.
RISK ANALYSIS IN PRACTICE

The most commonly used methods of risk analysis in
practice are:
sensitivity analysis
conservative forecasts
Sensitivity analysis allows to see the impact of the
change in the behaviour of critical variables on the

project profitability. Conservative forecasts include
using short payback or higher discount rate for
discounting cash flows.
Except a very few companies most companies do not
use the statistical and other sophisticated techniques
for analysing risk in investment decisions.
COMPILED BY: PROF. RAJSEE JOSHI
Thank You

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Chapter 12: Risk Evaluation in

decision-maker to make perfect forecasts.

Compiled by: Prof. Rajsee Joshi

Statistical Techniques for Risk

Compiled by: Prof. Rajsee Joshi

to as best estimate or most likely forecast:

Compiled by: Prof. Rajsee Joshi

a very large number of observations, is

Compiled by: Prof. Rajsee Joshi

Expected Net Present Value

been made to the future cash flows the

Compiled by: Prof. Rajsee Joshi

2. Variance or Standard Deviation

probability distribution divided by its

CONVENTIONAL TECHNIQUES FOR RISK

COMPILED BY: PROF. RAJSEE JOSHI

which the initial investment is recovered

thereby emphasising the liquidity of the firm through

It ignores the time value of cash flows.

Compiled by: Prof. Rajsee Joshi

2. Risk-Adjusted Discount Rate

both time preference and risk preference

Compiled by: Prof. Rajsee Joshi

Reduce the forecasts of

cash flows to some

First, the forecaster, expecting the reduction

that will be made in his forecasts, may inflate

Compiled by: Prof. Rajsee Joshi

Risk-adjusted Discount Rate

risk in capital budgeting analysis by adjusting

Compiled by: Prof. Rajsee Joshi

change in the projects NPV (or IRR) for a given

influence on the projects NPV (or IRR).

The decision maker, while performing

sensitivity analysis, computes the projects NPV

DCF Break-even Analysis

is to analyse the impact of alternative

Compiled by: Prof. Rajsee Joshi

simulation analysis considers the interactions

project should be accepted.

Compiled by: Prof. Rajsee Joshi

Decision Trees for

Compiled by: Prof. Rajsee Joshi

Usefulness of Decision Tree

Utility Theory and Capital

decision-makers risk preference explicitly

Individuals are generally risk averters and

demonstrate a decreasing marginal utility

Let us assume that the

Benefits and Limitations of

Risk Analysis in Practice

evaluating their capital expenditure decisions.

RISK ANALYSIS IN PRACTICE

Sensitivity analysis allows to see the impact of the

change in the behaviour of critical variables on the

Compiled by: Prof. Rajsee Joshi

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