Risk Analysis in Capital

Budgeting
 Why the concept of risk arises?
 Capital budgeting requires the projection of
cash inflow and outflow of the future.
 The future in always uncertain, estimate of
demand, production, selling price, cost etc.,
Cannot be exact.
 For example: The product at any time it
become obsolete therefore, the future in
unexpected, where the concept of risk arises.
 The following are the methods used for
accounting of risk in capital budgeting.
 Incorporating Risk into
Capital Budgeting
Methods:
 Risk-Adjusted Discount Rate
 Certainty Equivalent Approach
 Sensitivity technique
 Probability technique
 Standard deviation method
 Decision tree analysis
 How can we adjust this model to
take risk into account?
n


ACFt
NPV = - Co
(1 + k) t
t=1
 How can we adjust this model to
take risk into account?
n


ACFt
NPV = - IO
(1 + k) t
t=1
 Adjust the discount rate (k).
 The Ramakrishna Ltd., in considering the purchase
of a new investment. Two alternative investments are
available (X and Y) each costing Rs. 150000. Cash
inflows are expected to be as follows:
Year Investment X Investment Y

1 60,000 65,000
2 45,000 55,000
3 35,000 40,000
4 30,000 40,000
 The company has a target return on capital of 10%.
Risk premium rate are 2% and 8% respectively for
investment X and Y. Which investment should be
preferred?
 Certainty Equivalent Approach
 Adjusts the risky after-tax cash flows
to certain cash flows.
 The idea:

Risky Certainty Certain

Cash X Equivalent = Cash
Flow Factor (a) Flow
 Certainly equivalent method
Certainty Equivalent Approach

 simplest method
 Reduces the risk and uncertainty in
decision making by employing only
certain cash flows through certainty
equivalent coefficient factor.
= certain cash flows / expected
cash flows
 Sensitivity technique

 When cash inflows are sensitive under different

circumstances more than one forecast of the future
cash inflows may be made.
 These inflows may be regarded on ‘Optimistic’,
‘most likely’ and ‘pessimistic’. Further cash inflows
may be discounted to find out the net present values
under these three different situations.
 If the net present values under the three situations
differ widely it implies that there is a great risk in the
project and the investor’s is decision to accept or
reject a project will depend upon his risk bearing
activities.
 Mr. Selva is considering two mutually exclusive project
‘X’ and ‘Y’. You are required to advise him about the
acceptability of the projects from the following
information.
 Probability Technique
 refers to the each event of future happenings are
assigned with relative frequency probability.
 Probability means the likelihood of future event.
 Expected cash inflow * probability = Actual cash
flows
 Actual cash flows are discounted .
 Out of all available projects, the project with
higher net present value may be accepted.
 Two mutually exclusive investment proposals
are being considered. The following information
in available. Cost of each project is Rs 10,000/-
 Standard Deviation

 Two Projects have the same cash outflow and

their net values are also the same,
 standard deviation of the expected cash
inflows of the two Projects may be calculated
to measure the comparative and risk of the
Projects.
 The project having a higher standard deviation
in said to be more risky as compared to the
other.
 Decision Tree analysis
 It is helpful for taking risky and complex decisions
 Because it consider all the possible outcomes and each
possible outcomes are assigned with the probability.
 Project requires decisions to be made in sequential parts.

Construction of Decision Tree

 1. Define the problem
 2. Evaluate the different alternatives
 3. Indicating the decision points
 4. Assign the probabilities of the monetary values
 5. Analysis the alternatives.
 Accept/Reject criteria: If the net present values are positive
the project may be accepted otherwise it is rejected.