Risk analysis in Capital 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 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.
Example • 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%
Simulation 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 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 Analysis • Identifying The Problem and alternatives • Delineating The decision Tree • Specifying probalities and monetary outcomes • Evaluating various decision alternatives