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Risk ANALYSIS IN CAPITAL
BUDGETING (Oa
© The Institute of Chartered Accountants of India Plt FINANCIAL MANAGEMENT
Statistical Techniques Other techniques
+. Probab Conventional Techniques f
mee 1. Risk-adjusted ena
2. Variance or Standard En ae Analysis
Deviation 2. Scenari
2. Certainty Equivalent Analysis
3. Coefficient of Variation
7 8.1 INTRODUCTION TO RISK ANALYSIS IN
CAPITAL BUDGETING
While discussing the capital budgeting or investment evaluation techniques in
chapter 7, we have assumed that the investment proposals do not involve any risk
and cash flows of the project are known with certainty. This assumption was taken
to simplify the understanding of the capital budgeting techniques. However, in
practice, this assumption is not correct. In-fact, investment projects are exposed
to various degrees of risk.
There can be three types of decision making:
(Decision making under certainty: When cash flows are certait
(i) Decision making involving risk: When cash flows involves risk and probability
can be assigned.
(iii) Decision making under uncertainty: When the cash flows are uncertain and
probability cannot be assigned.
8.1.1 Risk and Uncertainty
Risk is the variability in terms of actual returns comparing with the estimated
returns, Most common techniques of risk measurement are Standard Deviation
and Coefficient of Variation. There is a thin difference between risk and
‘© The Institute of Chartered Accountants of India RISK ANALYSIS IN CAPITAL BUDGETING ‘]jC
uncertainty. In case of risk, probability distribution of cash flow is known. When
no information is known to formulate probability distribution of cash flows, the
situation is referred as uncertainty. However, these two terms are used
interchangeably.
8.1.2 Reasons for adjustment of Risk in Cay
| Budgeting decisions
Main reasons for considering risk in capital budgeting decisions are as follows
1. There is an opportunity cost involved while investing in a project for the level
of risk. Adjustment of risk is necessary to help make the decision as to whether
the returns out of the project are proportionate with the risks borne and
whether it is worth investing in the project over the other investment options
available.
2. Risk adjustment is required to know the real value of the Cash Inflows
Higher risk will lead to higher risk premium and also expectation of higher
return.
G 8.2 SOURCES OF RISK
Risk arises from different sources, depending on the type of investment being
considered, as well as the circumstances and the industry in which the organisation is
operating. Some of the sources of risk are as follows:
1. Project-specific risk: Risks which are related to a particular project and affects
the project's cash flows. It includes completion of the project in scheduled
time, error of estimation in resources and allocation, estimation of cash flows
etc. For example, a nuclear power project of a power generation company has
different risks than hydel projects.
2. Company-specific risk: Risk which arise due to company specific factors like
downgrading of credit rating, changes in key managerial persons, cases for
violation of intellectual property rights (IPR) and other laws and regulations,
dispute with workers etc. All these factors affect the cash flows of an entity and
access to funds for capital investments. For example, two banks have different
exposure to default risk
3. Industry-specific risk: These are the risks which effect the whole industry in
which the company operates. These risks include regulatory restrictions on
industry, changes in technologies etc. For example, regulatory restriction
imposed on leather and breweries industries.
‘© The Institute of Chartered Accountants of India Plt FINANCIAL MANAGEMENT
4, Market risk: The risk which arise due to market related conditions like entry of
substitute, changes in demand conditions, availability and access to resources
etc. For example, a thermal power project gets affected if the coal mines are
unable to supply coal requirements of a thermal power company etc.
5. Competition risk: These are risks related with competition in the market in
which a company operates. These risks are risk of entry of rival, product
dynamism and change in taste and preference of consumers etc.
6. Risk due to Economic conditions: These are the risks which are related with
macro-economic conditions like changes in monetary policies by central banks,
changes in fiscal policies like introduction of new taxes and cess, inflation,
changes in GDP, changes in savings and net disposable income etc.
7. International risk: These are risk which are related with conditions which are
caused by global economic conditions like restriction on free trade, restrictions on
market access, recessions, bilateral agreements, political and geographical
conditions etc. For example, restriction on outsourcing of jobs to overseas markets.
‘G 8.3 TECHNIQUES OF RISK ANALYSIS IN CAPITAL
BUDGETING
Techniques of risk analysis in capital budgeting can be classified as below:
Statistical
Techniques
Variance or Standard
Deviation
Coefficient of Variation
Risk-adjusted discount rate
Conventional
techniques
Certainty Equivalent
Sensitivity analysis
(Others techniques|
‘© The Institute of Chartered Accountants of India
Techniques of Risk Analysis. RISK ANALYSIS IN CAPITAL BUDGETING "(CS
G 8.4 STATISTICAL TECHNIQUES
8.4.1 Probabi
Probability is a measure about the chances that an event will occur. When an
event is certain to occur, probability will be 1 and when there is no chance of
happening an event, probability will be 0.
Example:
Best guess 3,00,000 03
High guess 2,00,000 06
Low guess 1,20,000 04
In the above example chances that cash flow will be % 3,00,000, % 2,00,000 and
% 1,00,000 are 30%, 60% and 10% respectively.
() Expected Net Cash Flows
Expected Net Cash flows are calculated as the sum of the likely Cash flows of
the Project multiplied by the probability of cash flows. Expected Cash flows are
calculated as below:
E(R)/ENCF
Where, E(R)/ENCF
Pi
Expected Net Cash flows
Probability of Cash flows
Net Cash flows
3,00,000 3,00,000 x 0.3 = 90,000
Best guess
High guess 2,00,000 06 2,00,000 x 0.6 = 1,20,000
‘© The Institute of Chartered Accountants of India Plt FINANCIAL MANAGEMENT
Low guess 1,20,000 0.1 1,20,000 x 0.1 = 12,000
Expected Net cash flow (ENCF) 222,000
) Expected Net Present Value
Expected net present value =
ENPV <> ENCF
*S¥(T+ky
Where, ENPV = Expected Net Present Value
ENCF = Expected Net Cash Flows(including both inflows and outflows)
t= Period
k = Discount rate.
(a) Expected Net Present Value - Single period
Let us understand the calculation of Expected Net Present Value (ENPV) for a
single period through an illustration as follows:
Possible net cash flows of Projects A and B at the end of first year and their
probabilities are given below. Discount rate is 10 per cent. For both the projects,
initial investment is % 10,000. CALCULATE the expected net present value for each
project. STATE which project is preferable?
A 8,000 0.10 24,000 0.10
B 10,000 0.20 20,000 0.15
c 12,000 0.40 16,000 0.50
D 14,000 0.20 12,000 0.15
E 16,000 0.10 8,000 0.10
‘© The Institute of Chartered Accountants of India RISK ANALYSIS IN CAPITAL BUDGETING (CS Si
Calculation of Expected Value for Project A and Project B
A 8,000 0.10 800 | 24,000 0.10 2,400
8 10,000 0.20 2,000 | 20,000] 0.15 3,000
c 12,000 0.40 4,800 | 16,000] 0.50 8,000
D__| 14,000 0.20 2,800 | 12,000] 0.15 1,800
E 16,000 0.10 1,600 | 8,000 | 0.10 800
ENCF 12,000 16,000
The Net Present Value for Project A is (0.909 x % 12,000 - % 10,000) = = 908
The Net Present Value for Project B is (0.909 x % 16,000 - 10,000) = % 4,544.
(b) Expected Net Present Value- Multiple period
Let us understand the calculation of Expected Net Present Value (ENPV) for
multiple periods through an illustration as follows:
Probabilities for net cash flows for 3 years of a project are as follows:
2,000 01 2,000 02 2,000 03
4,000 02 4,000 0.3, 4,000 04
6,000 03 6,000 04 6,000 02
8,000 04 8,000 01 8,000 on
CALCULATE the expected net present value of the project using 10 per cent discount
rate if the initial investment of the project is # 10,000.
‘© The Institute of Chartered Accountants of India FINANCIAL MANAGEMENT
Calculation of Expected Val
2,000 | 0.1 200 2000 | 02 | 400 | 2000 | o3 | 600
4000 | 02 | 800 4000 | 03 | 1200 | 4000 | o4 | 1,600
6000 | 03 | 1800 | 6000 | o4 | 2400 | 6000 | o2 | 1,200
000 | 04 | 3200 | 8000 | 01 | 800 | 8000| o1 | 800
ENCF 6,000 4,800 4,200
‘The present value of the expected value of cash flow at 10 per cent discount rate
has been determined as follows:
— ENCF, , ENCE, , ENCE,
Ce UFR FWY
6,006 1,800 4,200
a 1 (1.1
(6,000 x 0.909) + (4,800 x 0.826) + (4,200 x 0.751)
12,573
Present Value of cash flow
Expected Net Present value =
resent Value of cash flow - Initial Investment
12,573 - 10,000 = % 2,573.
8.4.2 Variance
Variance is a measurement of the degree of jon between numbers in a
data set from its average. In very simple words, variance is the measurement of
difference between the average of the data set from every number of the data
AB
Where, NCF, = Net Cash Flow
ENCF = Expected Net Cash Flow
P, = Probability
‘© The Institute of Chartered Accountants of India RISK ANALYSIS IN CAPITAL BUDGETING ‘(CY Si
Variance measures the uncertainty of a value from its average. Thus, variance
helps an organization to understand the level of risk it might face on investing in
a project. A variance value of zero would indicate that the cash flows that would
be generated over the life of the project would be same. This might happen in a
case where the company has entered into a contract of providing services in
return of a specific sum. A large variance indicates that there will be a large
variability between the cash flows of the different years. This can happen in a case
where the project being undertaken is very innovative and would require a certain
time frame to market the product and enable to develop a customer base and
generate revenues. A small variance would indicate that the cash flows would be
somewhat stable throughout the life of the project. This is possible in case of
products which already have an established market.
8.4.3 Standard Devi
ion
Standard Deviation (SD) is a degree of variation of individual items of a set of
data from its average. The square root of variance is called Standard Deviation.
For Capital Budgeting decisions, Standard Deviation is used to calculate the risk
associated with the estimated cash flows from the project.
Importance of Variance and Standard Deviation in Capital Budgeting:
For making capital budgeting decisions, these two concepts are important to
measure the volatility in estimated cash flows and profitability in an investment
proposal. Both the concepts measures the difference between the expected cash
flows and estimated cash flows (mean or average). Variance measures the range
of variability (difference) in cash flows data while Standard deviation determines
risk in an investment proposal. An investment proposal in which expected cash
flows are close to the estimated net cash flow are seen as less risky and has the
potential to make profit.
Standard deviation and Variance are two different statistical concepts but are
closely interrelated. Standard deviation is calculated as square root of variance,
hence, variance is prerequisite for calculation of SD.
‘© The Institute of Chartered Accountants of India Pt FINANCIAL MANAGEMENT
CALCULATE Variance and Standard Deviation of Project A and Project B on the
basis of following information:
A 8,000 0.10 24,000 0.10
B 10,000 0.20 20,000 0.15
c 12,000 0.40 16,000 0.50
D 14,000 0.20 12,000 0.15
E 16,000 0.10 8,000 0.10
ct A and Project B
A 800 2,400
B 2,000 | 20,000 3,000
c 12,000 4,800 | 16,000 8,000
D 14,000 2,800 | 12,000 1,800
E 16,000 1,600 | 8,000 800
ENCE 12,000 16,000
Project A
Variance (0°) = (8,000 ~ 12,000)? x (0.1) + (10,000 - 12,000)* x (0.2) + (12,000 -
12000)? x (0.4) + (14,000 ~ 12,000)* x (0.2) + (16000 - 12,000)* x (0.1)
= 16,00,000 + 8,00,000 + 0 + 8,00,000 + 16,00,000 = 48,00,000
Standard Deviation (0) = /Variance(a*) = /48,00,000 = 2,190.90
Project B:
Variance(a” = (24,000 - 16,000)? x (0.1) + (20,000 - 16,000)? x (0.15) + (16,000 -
16,000)? x(0.5) + (12,000 - 16,000)* x (0.15) + (8,000 - 16,000)? x (0.1)
= 64,00,000 + 24,00,000 + 0 + 24,00,000 + 64,00,000 = 1,76,00,000
Standard Deviation (a) = /Variance(o*) = J1,76,00,000 = 4195.23
‘© The Institute of Chartered Accountants of India RISK ANALYSIS IN CAPITAL BUDGETING "AC,
8.4.4 The Coefficient of Va
The standard deviation is a useful measure of calculating the risk associated with
the estimated cash inflows from an Investment. However, in Capital Budgeting
decisions, the management is several times faced with choosing between many
investments’ avenues. Under such situations, it becomes difficult for the
management to compare the risk associated with different projects using
Standard Deviation as each project has different estimated cash flow values. In
such cases, the Coefficient of Variation becomes useful
The Coefficient of Variation calculates the risk borne for every percent of
expected return. It is calculated as:
Coefficient of vi n
Expected Return/Expected Cash Flow
The Coefficient of Variation enables the management to calculate the risk borne
by the concern for every unit of estimated return from a particular investment.
Simply put, the investment avenue which has a lower ratio of standard
deviation to expected return will provide a better risk - return trade off. Thus,
when a selection has to be made between two projects, the management would
select a project which has a lower Coefficient of Variation.
CALCULATE Coefficient of Variation of Project A and Project B based on the
following information:
A 10000 0.10 26,000 0.10
B 12,000 0.20 22,000 0.15
c 14,000 0.40 18,000 0.50
D 16,000 0.20 14,000 0.15
E 18,000 0.10 10,000 0.10
‘© The Institute of Chartered Accountants of India Pte FINANCIAL MANAGEMENT
Calculation of Expected Value for Project A and Project B
A 10,000 | 0.10 1,000 | 26,000] 0.10 2,600
B 12,000 | 0.20 2,400 |22,000| 0.15 3,300
c 14,000 | 0.40 5,600 |18,000| 0.50 9,000
D 16,000 | 0.20 3,200 |14,000| 0.15 2,100
E 18,000 | 0.10 1,800 | 10,000] 0.10 1,000
ENCF 14,000) 18,000|
Project A
Variance (a*) = (10,000 - 14,000)? x (0.1) + (12,000 - 14,000)? x (0.2) + (14,000 -
14000)? x (0.4) + (16,000 ~ 14,000)* x (0.2) + (18000 - 14,000)? x (0.1)
= 16,00,000 + 8,00,000 + 0 + 8,00,000 + 16,00,000 = 48,00,000
Standard Deviation (0) = Variance(o*) = /48,00,000 =
Project B:
Variance(a = (26,000 - 18,000)? x (0.1) + (22,000 - 18,000)? x (0.15) + (18,000 -
18,000)? x (0.5) + (14,000 ~ 18,000)? x (0.15) + (10,000 ~ 18,000)? x (0.1)
= 64,00,000 + 24,00,000 + 0 + 24,00,000 + 64,00,000 = 1,76,00,000
190,90
Standard Deviation (a) = \Variance(a”) ,76,00,000 195.23
A een Less Less
B 4,195.23 More More
7a000 702331
‘© The Institute of Chartered Accountants of India RISK ANALYSIS IN CAPITAL BUDGETING "ACS
In project A, risk per rupee of cash flow is € 0.15 while in project B, it is % 0.23.
Therefore, Project A is better than Project B.
8.5 CONVENTIONAL TECHNIQUES
8.5.1 Risk Adjusted Discount Rate
The use of risk adjusted discount rate (RADR) is based on the concept that
investors demand higher returns from the risky projects. The required rate of
return on any investment should include compensation for delaying consumption
plus compensation for inflation equal to risk free rate of return, plus
compensation for any kind of risk taken. If the risk associated with any investment
project is higher than risk involved in a similar kind of project, discount rate is
adjusted upward in order to compensate this additional risk borne. Under this
method, NPV is calculated as follows:
Where, NCF, = Net cash flow
k = Risk adjusted discount rate (RADR)
' = Initial Investment
t = Period
‘A risk adjusted discount rate is a sum of risk free rate and risk premium. The
Risk Premium depends on the perception of risk by the investor of a particular
investment and risk aversion of the Investor.
So,
Risk adjusted discount rate (RADR) = Risk free rate + Risk premium
isk Free Rate: It is the rate of return on Investments that bear no risk. For e.g.
Government securities yield a return of 6% and bear no risk. In such case, 6% is
the risk-free rate.
Risk Premium: It is the rate of return over and above the risk free rate, expected
by the Investors as a reward for bearing extra risk. For high risk projects, the risk
premium will be high and for low risk projects, the risk premium would be lower.
‘© The Institute of Chartered Accountants of India Pts FINANCIAL MANAGEMENT
An enterprise is investing ¢ 100 lakhs in a project. The risk-free rate of return is 7%
Risk premium expected by the Management is 7%. The life of the project is 5 years.
Following are the cash flows that are estimated over the life of the project:
1 25
2 60
3 75
4 80
5 65
CALCULATE Net Present Value of the project based on Risk free rate and also on the
basis of Risks adjusted discount rate.
The Present Value of the Cash Flows for all the years by discounting the cash flow
at 7% is calculated as below:
1 0.935 23.38
2 60 0.873 52.38
3 7S 0.816 61.20
4 80 0.763 61.04
5 65 0.713 46.35
Total of Present value of Cash flows 244.34
Less: Initial investment 100.00
Net Present Value (NPV) 144.34
Now, when the risk-free rate is 7% and the risk premium expected by the
Management is 7%, then risk adjusted discount rate is 7% + 7% = 14%.
Discounting the above cash flows using the Risk Adjusted Discount Rate would be
as below:
‘© The Institute of Chartered Accountants of India RISK ANALYSIS IN CAPITAL BUDGETING "CS
1 25 0.877 21.93
2 60 0.769 46.14
3 15 0.675 50.63
4 80 0.592 47.36
5 65 0.519 33.74
Total of Present value of Cash flows 199.79
Less: Initial investment 100.00
Net present value (NPV) 99.79
Advantages of Risk-adjusted discount rate
1) _ Itis easy to understand.
2) Itincorporates risk premium in the discounting factor.
Limitations of Risk-adjusted discount rate
1) _ Difficulty in finding risk premium and risk-adjusted discount rate.
2) Though NPV can be calculated but it is not possible to calculate Standard
Deviation of a given project.
8.5.2 Certainty Equivalent (CE)
As per CIMA terminology, “Certainty Equivalent is an approach dealing with risk in
a capital budgeting context, It involves expressing risky future cash flows
terms of the certain cashflow which would be considered, by the decision
maker, as their equivalent, that is the decision maker would be indifferent
between the risky amount and the (lower) riskless amount considered to be its
equivalent.”
The certainty equivalent is a guaranteed return that the management would
accept rather than accepting a higher but uncertain return. This approach allows
the decision maker to incorporate his or her utility function into the analysis. In
this approach a set of risk less cash flow is generated in place of the original cash
flows
‘© The Institute of Chartered Accountants of India Steps in the Certainty Equivalent (CE) approach
Step 1: Remove risks by substituting equivalent certain cash flows from risky cash
flows. This can be done by multiplying each risky cash flow by the appropriate a,
value (CE coefficient)
( Certain cash flow
~ Risky or expected cashflow,
Suppose on tossing out a coin, if it comes head, you will win
% 10,000 and if it comes out to be tail, you will win nothing. Thus, you have 50%
chance of winning and expected value is ® 5,000 (& 10,000 x 0.50) . In such case, if
you are indifferent at receiving 3,000 for a certain amount and not playing then
% 3,000 will be certainty equivalent and 0.3 (i.e. = 3,000/% 10,000) will be certainty
equivalent coefficient.
Step 2: Discounted value of cash flow is obtained by applying risk less rate of
interest. Since you have already accounted for risk in the numerator using CE
coefficient, using the cost of capital to discount cash flows will tantamount to
double counting of risk.
Step 3: After that, normal capital budgeting method is applied except in case of
IRR method, where IRR is compared with risk free rate of interest rather than the
firm's required rate of return.
Certainty Equivalent Coefficient transforms expected values of uncertain flows
into their Certainty Equivalents. It is important to note that the value of Certainty
Equivalent Coefficient lies between 0 & 1. Certainty Equivalent Coefficient 1
indicates that the cash flow is certain or management is risk neutral. In industrial
situation, cash flows are generally uncertain and managements are usually risk
averse. Under this method, NPV is calculated as follows:
Where,
on = Risk-adjustment factor or the certainly equivalent coefficient
NCR: = Forecasts of net cash flow for year ‘t’ without risk-adjustment
k = Risk free rate assumed to be constant for all periods
' = Initial Investment
‘© The Institute of Chartered Accountants of India RISK ANALYSIS IN CAPITAL BUDGETING "(AC
If Investment proposal costs % 45,00,000 and risk free rate is 5%, CALCULATE net
present value under certainty equivalent technique.
1 10,00,000 0.90
2 15,00,000 0.85
3 20,00,000 0.82
4 25,00,000 0.78
= 1000,000%(0.80) ,15,00,000(0.85) , 20,00,000%(0.82) , 25,00,000%10.78)_ 45 49,o99
(1.05) (1.05)2 (1.05)3 (1.05)4 o
NPV
= %5,34,570
Advantages of Certainty Equivalent Method
1, The certainty equivalent method is simple and easy to understand and apply.
2. It can easily be calculated for different risk levels applicable to different cash
flows. For example, if in a particular year, a higher risk is associated with the
cash flow, it can be easily adjusted and the NPV can be recalculated
accordingly.
advantages of Certainty Equivalent Method
1. There is mo objective or mathematical method to estimate certainty
equivalents. Certainty Equivalents are subjective and vary as per each
individual's estimate.
2. Certainty equivalents are decided by the management based on their
perception of risk. However, the risk perception of the shareholders who are
the money lenders for the project is ignored. Hence, it is not used often in
corporate decision making,
Risk-adjusted Discount Rate Vs. Certainty-Equivalent
Certainty Equivalent Method is superior to Risk Adjusted Discount Rate Method
as it does not assume that risk increases with time at constant rate. Each year's,
Certainty Equivalent Coefficient is based on level of risk impacting its cash flow.
‘© The Institute of Chartered Accountants of India Despite its soundness, it is not preferable like Risk Adjusted Discount Rate
Method. It is difficult to specify a series of Certainty Equivalent Coefficients but
simple to adjust discount rates.
G 8.6 OTHER TECHNIQUES
8.6.1 Sensitivity Analysis
As per CIMA terminology, "Sensitivity Analysis a modeling and risk assessment
procedure in which changes are made to significant variables in order to
determine the effect of these changes on the planned outcome. Particular
attention is thereafter paid to variables identifies as being of special significance”.
Sensitivity analysis put in simple terms is a modeling technique which is used in
Capital Budgeting decisions, to study the impact of changes in the variables on
the outcome of the project. In a project, several variables like weighted average
cost of capital, consumer demand, price of the product, cost price per unit etc.
operate simultaneously. The changes in these variables impact the outcome of the
project. Therefore, it becomes very difficult to assess, change in which variable
impacts the project outcome in a significant way. In Sensitivity Analysis, the project
outcome is studied after taking into change in only one variable. The more
sensitive is the NPV (or IRR), the more critical is that variable. So, Sensitivity analysis.
is a way of finding impact on the project's NPV (or IRR) for a given change in one of
the variables.
Steps involved in Sensitivity Analysis
Sensitivity Analysis is conducted by following the steps as below:
1. Finding variables, which have an influence on the NPV (or IRR) of the project.
2. Establist
\g mathematical relationship between the variables.
Analysing the effect of the change in each of the variables on the NPV (or IRR)
of the project.
X Ltd. is considering its new project with the following details:
1 Initial capital cost 400 Cr.
2 Annual unit sales 5 Cr.
‘© The Institute of Chartered Accountants of India RISK ANALYSIS IN CAPITAL BUDGETING "CS
3 _| Selling price per unit 100
4 _| Variable cost per unit 750
5__| Fixed costs per year 50 Cr.
6 _| Discount Rate 6%
Required:
1. CALCULATE the NPV of the project.
2. COMPUTE the impact on the project's NPV considering a 2.5 per cent adverse
variance in each variable. Which variable is having maximum effect?
Consider Life of the project as 3 years.
1. Calculation of Net Cash Inflow per year
A_| Selling price per unit 100
B_| Variable cost per unit 50
C_| Contribution per unit (A - B) 50
D_| Number of units sold per year 5Cr.
E_| Total Contribution (C x D) 250 Cr.
F_| Fixed cost per year = 50 Cr.
G_| Net cash inflow per year (E - F) % 200 Cr,
Calculation of Net Present Value (NPV) of the Project
0 (400.00) 1.000 (400.00)
1 200.00 0.943 188.60
2 200.00 0.890 178.00
3 200.00 0.840 168.00
Net Present Value 134.60
Here, NPV represent the most likely outcomes and not the actual outcomes.
The actual outcome can be lower or higher than the expected outcome.
‘© The Institute of Chartered Accountants of India Pt FINANCIAL MANAGEMENT
2. Sensitivity Analysis considering 2.5 % Adverse Variance in each variable
selling price per 975|
lunit
8 |Variable cost per 50] 50] 50] 51.25] 50] 50]
lunit
C [Contribution per 50] 50] 475] 4875| 50] 50]
lunit (A - 8)
D [Number of units 5 5 5 5 s| 4875)
sold per year
(units in Crores)
E [Total 250] 250[237s| 243,75 250) 24375
Contribution
(cx)
F |Fixed cost per 50] 50] 50] sof 51.25] 50]
lyear
G |Net Cash inflow 200] 2o0[1e75| 19375) 19875] 193.75}
lper year
\e-F)
HpvotNet cash | 53460[ 53460[ 50119] 51789) $37.26) 517.80]
inflow per year (G|
x 2.673)
1 [inital capital cost | 400] 410] 400] 400] 400] 400]
J [NPV HD 73460|12460[101.19| 11789] 13126] 117.89)
K [Percentage “| -Ta3%| -2482%| -12a1%]—-248%|-12.41%|
|change in NPV
The above table shows that by changing one variable at a time by 2.5% (adverse)
while keeping the others constant, the impact in percentage terms on the NPV of
the project can be calculated. Thus, it can be seen that the change in selling price
has the maximum effect on the NPV by 24.82%.
‘© The Institute of Chartered Accountants of India RISK ANALYSIS IN CAPITAL BUDGETING ‘(Ce hi
Advantages of Sensitivity Analysis:
Following are the main advantages of Sensitivity Analysis:
(1) Critical Issues: This analysis identifies critical factors that impinge on a
project's success or failure.
(2) Simplicity: It is a simple technique.
Disadvantage of Sensitivity Analysis
Following are the main disadvantages of Sensitivity Analysis:
(1) Assumption of Independence: This analysis assumes that all variables are
independent ie. they are not related to each other, which is unlikely in real life.
(2) Ignore probability: This analysis does not look to the probability of changes in
the variables.
8.6.2 Scenario Analysis
Although sensitivity analysis is probably the most widely used risk analysis
technique, it does have limitations. Therefore, we need to extend sensitivity
analysis to deal with the probability distributions of the inputs. In addition, it
would be useful to vary more than one variable at a time so we could see the
combined effects of changes in the variables.
Scenario analysis provides answer to these situations of extensions. This analysis
brings in the probabilities of changes in key variables and also allows us to
change more than one variable at a time.
This analysis begins with base case or most likely set of values for the input
variables. Then, go for worst case scenario (low unit sales, low sale price, high
variable cost, etc.) and best case scenario (high unit sales, high sale price, low
variable cost, etc.). Alternatively, Scenarios analysis is possible where some factors
are changed positively and some factors are changed negatively.
So, in a nutshell Scenario analysis examine the risk of investment, to analyse the
impact of alternative combinations of variables, on the project’s NPV (or IRR).
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XYZ Ltd, is considering a project "A" with an initial outlay of ® 14,00,000 and the
possible three cash inflow attached with the project as follows:
s aoo
Worst case 450 400 700
Most likely 550 450 800
Best case 650 500 900
Assuming the cost of capital as 9%, DETERMINE NPV in each scenario. If XYZ Ltd is
certain about the most likely result in first two years but uncertain about the third
year's cash flow, ANALYSE what will be the NPV expecting worst scenario in the
third year.
The possible outcomes will be as follows:
1_| (1,400) | (1,400) _[ (7,400) | (1,400) | (1,400) | (1,400)
0.917 | 450 41265 | 550 | 50435 | 650 | 596.05
0.842 | 400 336.80 | 450 | 37890 | 500 | 421.00
3 [0772| 700 540.40 | 800 | 617.60 | 900 | 694.80
NPV -110.15, 100.85 311.85
If XYZ Ltd. is certain about the most likely result in first two years but uncertain
about the third year's cash flow, then, NPV expecting worst case scenario is
expected in the third year will be as follows:
%5,50,000 | % 4,50,000 | % 7,00,000
(10.09) * (1+0.09) (140.09
% 14,00,000 + % 5,04,587 + 2 3,78,756 + % 5,40,528 = % 23,871
Scenario Analysis Vs Sensitivity Anal
inu|alo
= - % 14,00,000+
Sensitivity analysis and Scenario analysis both help to understand the impact of
the change in input variable on the outcome of the project. However, there are
certain basic differences between the two.
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Sensitivity analysis calculates the impact of the change of a single input variable on
the outcome of the project viz, NPV or IRR. The sensitivity analysis thus enables to
identify that single critical variable which can impact the outcome in a huge way and
the range of outcomes of the project given the change in the input variable.
Scenario analysis, on the other hand, is based on a scenario. The scenario may be
recession or a boom wherein depending on the scenario, all input variables change.
Scenario Analysis calculates the outcome of the project considering this scenario where
the variables have changed simultaneously. Similarly, the outcome of the project would
also be considered for the normal and recessionary situation. The variability in the
outcome under the three different scenarios would help the management to assess the
risk a project carries. Higher deviation in the outcome can be assessed as higher risk
and lower to medium deviation can be assessed accordingly.
Scenario analysis is far more complex than sensitivity analysis because in scenario
analysis all inputs are changed simultaneously, considering the situation in hand
while in sensitivity analysis, only one input is changed and others are kept
constant.
Miscellaneous Illustrations
Shivam Ltd. is considering two mutually exclusive projects A and B. Project A costs
12,000 and project 8 * 17,000. You have been given below the net cash flow (NCF)
probability distribution for each project.
15,000 0.4 15,000 0.3
12,000 03 12,000 05
10,000 0.2 10,000 01
8,000 01 8,000 0.1
(COMPUTE the expected net cash flows (ENCF) of projects A and B.
(i) COMPUTE the risk attached to each project ie. standard deviation of each
probability distribution.
(i) COMPUTE the profitability index of each project.
(iv) IDENTIFY which project do you recommend? State with reasons.
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Computation of expected net cash flow of Projects A and B
15,000 6,000 15,000 4,500)
12,000 = 3,600] 12,000 ag 6,000
10,000) 02 2,000) 10,000 o1 1,000)
8,000] 0.1 800 8,000] 0.1 800
ENCF 12,400 12,300)
(i) Computation of Standard deviation of each project
Project A
12,400 15,000 2,600 27,04,000
03 | 12,400 12,000 -400 48,000
02 | 12,400 10,000 2,400 11,52,000
O14 12,400 8,000 -4,400 19,36,000
Variance 58,40,000
Standard Deviation of Project A = #5840 000 = 2416.61
12,300 15,000 21,87,000
05 12,300 12,000 45,000
O14 12,300 10,000 5,29,000
O14 12,300 8,000 18,49,000
Variance 46,10,000
Standard Deviation of Project B = v46,10,000 = 2147.09
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Computation of profitability index of each project
Proftabilty index = Discounted cash inflows
Cash outlay
Project A
12,400
Pl= So90 = 1033
Project B
12300 _
Pl= Topp = 1118
(iv) Recommendation of the project
ENCF of both the projects is almost same but Standard deviation (risk) is lower
in Project B as compared to Project A. Also, profitability index of Project B is
higher than that of Project A. So, Project B is preferable because of lower risk
and higher profitability index.
From the following details relating to a project, ANALYSE the sensitivity of the
project to changes in initial project cost, annual cash inflow and cost of capital:
Initial Project Cost (3 1,20,000
Annual Cash Inflow (2) 45,000
Project Life (Years) 4
Cost of Capital 10%
IDENTIFY which of the three factors, the project is most sensitive, if the variable is
adversely affected by 10%? (Use annuity factors: 10% = 3.169 and 11% = 3.103).
Calculation of NPV through Sensitivity Analysis
PV of cash inflows (& 45,000 3.169) 1,42,605
Initial Project Cost (1,20,000)
NPV 22,605
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Base (present) 22,605
If initial project cost is varied | (@ 1,42,605 - | (© 22,605-€ 10,605)/
adversely by 10% . it | 1,32,000) % 22,605
becomes % 1,32,000 ( 1,20,000 | = % 10,605. = (53.08%)
x1.10).
If annual cash inflow is varied | (€ 40,500 x 3.169) — | (€ 22,605 - € 8,345) /
adversely by 10% ie. it | (@ 1,20,000)] 22,605
becomes & 40,500 (% 45,000 x | = %8,345 = 63.08%
0.9).
If cost of capital is varied | (@ 45,000 x 3.103) - | (® 22,605 19,635) /
adversely by 10% ie. it | €1,20,000 % 22,605
becomes 11%. = 719,635 = 13.14%
Conclusion: Project is most sensitive to ‘annual cash inflow’.
PNR Ltd. is considering a project with the following Cash flows:
0 12,00,00,000 : :
1 - 4,00,00,000 12,00,00,000
2 - 5,00,00,000 14,00,00,000
3 - 6,00,00,000 11,00,00,000
The cost of capital is 12%. Measure the sensitivity of the project to changes in the
levels of plant cost, running cost and savings (considering each factor at a time)
such that the NPV becomes zero. The P.V. factors at 12% are as under:
PV factor @12% 1 0.892 | 0.797 | 0711
DETERMINE the factor which is the most sensitive to affect the acceptability of the project?
Calculation of Net Present value (NPV)
Cost of Plant (12,00,00,000) : : 5
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Running cost : (4,00,00,000) | (5,00,00,000) | (6,00,00,000)
Savings : 12,00,00,000 | 14,00,00,000 | 11,00,00,000
Net cash inflow | (12,00,00,000) | _8,00,00,000 | 9,00,00,000 | _5,00,00,000
PV factor 1 0.892 0.797 071
PV of Cash Flows | (12,00,00,000) | 7,13,60,000 | 7,17,30,000 | _3,55,50,000
NPV
% (- 12,00,00,000 + 7,13,60,000 + 7,17,30,000 + 3,55,50,000)
% 5,86,40,000
Determination of the most Sensitive factor:
(Sensitivity Analysis w.r-t. Plant cost:
NPV of the project would be zero when the cost of the plant is increased by
5,86,40,000.
75,86, 40,000
Percentage change in the plant cost =
