Group 5

Risk analysis in

capital budgeting

Nitheesh chandran 1316098

Nuthan 13160100

Nichelle 1316097

Nizamuddin Hussain 1316099

Nandkumar 1316092

Group members

Capital budgeting  it is the planning process used to

determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structure (debt, equity or retained earnings).RISKThe potential that a chosen action or activity (including the choice of inaction) will lead to a loss (an undesirable outcome).

RISK IN CAPITAL BUDGETING

Nandkumar

BEHAVIORAL APPROACHES FOR DEALING WITH RISK 

Sensitivity Analysis Simulation International Risk Considerations

Nandkumar

SENSITIVITY ANALYSIS

Sensitivity analysis is the way of analyzing change in the project’s NPV or IRR for a given change in one of the variable. It indicates how sensitive a project’s NPV and IRR is to change in the particular variables.

The more sensitive is the NPV, the more critical is the variable

Nandkumar

THREE STEP IN THE SENSITIVITY ANALYSIS

Identification of all those variables, which have an influence on project’s NPV or IRR

Definition of the underlying quantitative relationship between the variables

Analysis of the impact of the change in each of the variables on the project’s NPV

Nandkumar

SIMULATION Simulation is a statistically based behavioral

approach that applies predetermined probability distributions and random numbers to estimate risky outcomes.

By tying the various cash flow components together in a mathematical model and repeating the process, the financial manager can develop a probability distribution of projected returns

Nandkumar

STEPS IN SIMULATION Define the problem precisely Introduce the variables associated with the

problems Construct a numerical model Set up possible course of action for testing Run the experiment Consider the result and the possibilities to

modify the model or change data in puts Decide what course of action to take

Nandkumar

INTERNATIONAL RISK CONSIDERATIONS

Political risk is much more difficult to protect against.

Therefore, it is important for managers to account for this risk before making an investment by adjusting project cash inflows or using risk-adjusted discount rates. 

Other considerations in international capital budgeting include taxes and transfer pricing.

Finally, it is important that firms view international investments from a strategic view, rather than from a strictly financial perspective.

Nichelle

CONVENTIONAL TECHNIQUES TO HANDLE RISK

There are mainly three popular conventional techniques they are

Pay back technique Risk adjusted discount rate Certainty equivalent

Nichelle

PAY BACK TECHNIQUE

Payback is one of the oldest and most common procedures used and the explicit recognition of risk in the project with an investment. This method, applied in practice, as is an attempt to measure the risk assessment in investment decision as a possible method Profitability.

The payback method is the amount of time required for a firm to recover its initial investment in a project, as calculated from cash inflows.

Nichelle

Decision criteria:

The length of the maximum acceptable payback period is determined by management.

If the payback period is less than the maximum acceptable payback period, accept the project.

If the payback period is greater than the maximum acceptable payback period, reject the project.

Nichelle

PAYBACK PERIOD: PROS AND CONS OF PAYBACK ANALYSIS

Pros The payback method is widely used by large firms to evaluate small

projects and by small firms to evaluate most projects. Its popularity results from its computational simplicity and intuitive

appeal. By measuring how quickly the firm recovers its initial investment,

the payback period also gives implicit consideration to the timing of cash flows and therefore to the time value of money.

Because it can be viewed as a measure of risk exposure, many firms use the payback period as a decision criterion or as a supplement to other decision techniques.

Nichelle

Cons The major weakness of the payback period is that the

appropriate payback period is merely a subjectively determined number. It cannot be specified in light of the wealth maximization

goal because it is not based on discounting cash flows to determine whether they add to the firm’s value.

A second weakness is that this approach fails to take fully into account the time factor in the value of money.

A third weakness of payback is its failure to recognize cash flows that occur after the payback period.

Nichelle

RISK ADJUSTED DISCOUNT RATE

An estimation of the present value of cash for high risk investments is known as risk-adjusted discount rate. 

The risk adjusted discount rate approaches attempts to handle the problem of risk and uncertainty in a more direct and thoughtful way. As we know investors are risk averse and so requires a reward for under taking a risky investment, the greater must be its expected return.

Nithesh

The Greater The Project Perceived Level Of Risk, The Greater Is The Risk Premium

Risk adjusted discount rate = risk free rate + risk premium

Nithesh

ADVANTAGES AND DISADVANTAGES OF RISK ADJUSTED DISCOUNT RATE 

disadvantages There is no easy way deriving a risk adjusted

discount rate. Capital asset pricing model provides a basis of calculating the risk adjusted discount rate. Its use has yet to pick up in practice.

It does not make any risk adjusted in the numerator for the cash flows that are forecast over the future years.

advantage It is simple and can be easily understood. It has a great deal of intuitive appeal for risk-averse

businessman. It incorporates an attitude towards uncertainty.

Nithesh

CERTAINTY EQUIVALENT

Under this techniques, the estimated cash flows are adjusted by using risk free rate to assertain risk free cash flow

The expected cash flows of the project are converted in to equivalent riskless amount

The smaller certainty equivalent will be used in the case of an expected cash inflows and the larger certainty equivalent used for payment

 For example, if an investor, according to his “best estimate” expects a cash flow of 60000$ next year, he will apply an intuitive correction factor and may work with 40000$ to be on safe side. There is a certainty-equivalent cash flow.

Nithesh

EVALUATION OF CERTAINTY EQUIVALENT

The certainty equivalent approach explicitly recognizes risk, but the procedure for reducing the forecasts of cash flows is implicit and is likely to be in consistent from one investment to another

Nuthan

DRAW BACKS OF CERTAINTY EQUIVALENT 1. the forecaster, expecting the reduction

that will be made in his forecasts, may inflate them in anticipation. This will no longer give furcated according to best estimate.

2. 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.

3. by focusing explicit attention only on the gloomy out comes, chances are increased for passing by some good investments.

Nuthan

SCENARIO ANALYSIS

The simple sensitivity analysis assumes that variable are independent of each other. In reality the variable will be interrelated and they may change in combination.

one way to examine the risk on investment is to analyze the impact of alternative combination of variable, called scenario analysis.

Nuthan

INFLATION AND CAPITAL BUDGETING.

There are two parameters entering the process of capital budgeting- the cash flows over the life of the project discount rate .They need to be consistent. The problem of consistency of the cash flow and discount rate may arise from inflation.

Nuthan

COMPARING PROJECTS WITH UNEQUAL LIVES

Many a times firms are required to choose between two or more alternative technologies to manufacture the same product.The selection of one model from the two short listed is a situation that is analogous to mutually exclusive projects, but these have different lives.

Nizamuddin

Making a choice between two technologies is difficult because the evaluation cannot be compared purely on the basis of NPV or IRR for the reason that they have different lives.Here two issues must be emphasized. We must reiterate here that normally we are

looking at the most cost effective options in such evaluation.Therefore the perspective is to select a technology that has least NPV of costs.

Nizamuddin

consistent with the going concern concept we assume that the technology is required indefinitely irrespective of which one is chosen and therefore,would need to be replaced at the end of the useful life.

Nizamuddin

REAL OPTIONS

Real options are the opportunities that are embedded in capital projects that eneble managers to alter their cash flows and risks in a way that affect project acceptability (NPV).

Nizamuddin

There are 3 types of options1 .option to delay the project2. Option to expand the project 3.Option to abandon the project

Nizamuddin