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# Risk analysis in capital budgeting

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### Risk analysis in capital budgeting

1. 1.  Nitheesh chandran 1316098  Nuthan 13160100  Nichelle 1316097  Nizamuddin Hussain 1316099  Nandkumar 1316092
2. 2. 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). RISK The potential that a chosen action or activity (including the choice of inaction) will lead to a loss (an undesirable outcome). Nandkumar
3. 3. BEHAVIORAL APPROACHES FOR DEALING WITH RISK  Sensitivity Analysis  Simulation  International Risk Considerations Nandkumar
4. 4. 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
5. 5. 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
6. 6. 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
7. 7. 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
8. 8. 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
9. 9. CONVENTIONAL TECHNIQUES TO HANDLE RISK There are mainly three popular conventional techniques they are  Pay back technique  Risk adjusted discount rate  Certainty equivalent Nichelle
10. 10. 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
11. 11. 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
12. 12. 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
13. 13. 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
14. 14. 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
15. 15.  The Greater The Project Perceived Level Of Risk, The Greater Is The Risk Premium  Risk adjusted discount rate = risk free rate + risk premium Nithesh
16. 16. 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
17. 17. 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
18. 18. 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
19. 19. 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
20. 20. 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
21. 21. 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
22. 22. 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
23. 23. 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
24. 24.  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
25. 25. 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
26. 26. There are 3 types of options 1 .option to delay the project 2. Option to expand the project 3.Option to abandon the project Nizamuddin