Nature of Risk

Risk exists because of the inability

of the decision-maker to make
perfect forecasts.
In formal terms, the risk associated
with an investment may be defined
as the variability that is likely to
occur in the future returns from the
investment.
Three broad categories of the
events influencing the investment
forecasts:
1

General economic conditions

SOURCES AND PERSPECTIVE OF RISK

Sources of Risk

Project-specific risk
Competitive risk
Industry-specific risk
Market risk
International risk
Perspectives on Risk

Standalone risk
Firm risk
Market risk

Risk-adjusted Discount Rate

Risk-adjusted
discount
rate
method:
NPV = NCFt / (1+k)t ,where k is a
risk-adjusted rate.
Risk-adjusted discount rate = Riskfree rate
+ Risk
premium
k = kf + kr

Capital budgeting and Risk

An investment project will cost Rs.50,000 initially, expected to
generate cash flows of Rs.25,000, Rs20,000, Rs.10,000 and
Rs.10,000 in next four years.
What is the project's NPV, if it is expected to generate certain cash
flows with 10 per cent risk-free rate.
Net present value using a 10 per cent risk-free discount rate, is:
NPV = -Rs.50,000 + Rs25,000/(1+0.1)+ Rs.20,000/(1+0.1) 2+
Rs.10,000/ (1+0.1)3 + Rs10,000/ (1+0.1)4 = +Rs.3,599
If the project is risky, then a higher rate should be used to
allow for the perceived risk. Assuming this rate to be 15 per
cent, the net present value of the project will be:
NPV = -Rs.50,000 + Rs25,000/(1+0.15)+ Rs.20,000/(1+0.15) 2
+ Rs.20,000/ (1+0.15)3+ Rs.10,000/ (1+0.15)4 = - Rs845

For a firm using IRR method IRR

for the project should be
compared
with
risk-adjusted
minimum required rate of return.
If IRR is higher than adjusted rate,
the project would be accepted,
otherwise rejected.

Certainty Equivalent
Certainty-equivalent approach involves
computing NPV as:
n

NPV =
t 0

(t NCFt ) /(1+kf)t

where, NCFt = the forecasts of net

cash flow without risk-adjustment
= the risk-adjustment factor or
the certainty-equivalent coefficient
kf = risk-free rate assumed to be
constant for all periods.

 Certainty-equivalent coefficients
can
be
determined
as
a
relationship
between
certain
cash flows and the risky cash
flows.
t = NCFt * /NCFt = Certain net
cash flow/ Risky net cash flow
If a risky cash flow of Rs.80,000
in period t and certain cash flow
of Rs.60,000 is equally desirable,
t = 60,000/80,000 =0.75

A project costs Rs.6,000 with cash

flows of Rs.4,000, Rs.3,000,
Rs.2,000 and Rs.1,000 in years 1
through 4. Associated t factors
are estimated to be: o = 1.00, l
= 0.90, 2 = 0.70, 3 = 0.50 and
4 = 0.30, and the risk-free
discount rate is 10 per cent.
NPV=1.0(-6,000) + 0.9(4,000) /
(1+0.10)
+
0.7
(3,000)
/
(1+0.10)2
+0.5(2,000)/
3

Sensitivity Analysis
Sensitivity analysis is analysing
change in projects NPV (or IRR) for
given change in one of the
variables.
It indicates how sensitive a
projects NPV (or IRR) is to changes
in particular variables. The more
sensitive the NPV, the more critical
is the variable.
Process:
Identification of all variables, which have
influence on projects NPV (or IRR).
Definition of underlying relationship between
the variables.
Analysis of impact of change in each of the

Modern Processing Company is considering

installation of a plant costing Rs10000 to increase its
processing capacity. Expected value of the
underlying variables and projects after-tax cash
flows over its expected life of 7 years are given
below. Salvage value is assumed to be zero.

Expected values of Variables

Variables
Investment (Rs)
Sales volume (unit)
Unit selling price (Rs)
Unit variable cost (Rs)
Annual Fixed costs (Rs)
Depreciation (WDV)
Corporate tax rate
Discount rate

Value
10,000
1,000
15
6.75
4,000
25%
35%
12%

Net Cash Flows of the project

C0

C1

Investment -10,000
Revenue
variable cost
Fixed costs
Depreciation
EBIT
Tax
PAT
NCF -10,000

15,000
6,750
4,000
2,500
1,750
613
1,138
3,638

C2

C3

15,000 15,000
6,750 6,750
4,000 4,000
1,875 1,406
2,375 2,844
831
995
1,544 1,848
3,419 3,255

C4

C5

15,000 15,000
6,750 6,750
4,000 4,000
1,055
791
3,195 3,459
1,118 1,211
2,077 2,248
3,132 3,039

C6

C7

15,000 15,000
6,750 6,750
4,000 4,000
593
1780
3,657
2470
1,280
865
2,377
1605
2,970
3385

Projects NPV at 12 percent

discount rate and IRR are as
follows:
NPV = +4973
IRR = 27.05%
Since NPV is positive (or IRR >
discount rate), the project can
be undertaken.
Let us assume the pessimistic and
the optimistic values for volume,
price and cost.

Forecasts Under Different Assumptions

Variable
Pessimistic
Volume (unit)
750
Unit selling price (Rs)
12.75
Unit variable cost (Rs)
7.425
Annual fixed costs
4,800

Expected
1,000
15
6.75
4,000

Optimistic
1,250
16.50
6.075
3,200

If we change each variable (others holding constant), the projects NPVs

are recalculated
Variable Sensitivity
NPVAnalysis
(Pessimistic)Under
NPVDifferent
(Expected) Assumptions
NPV (Optimistic)
Volume
Unit selling price
Unit variable cost
Annual fixed costs

-1,146
-1,702
2,970
2,599

4,973
4,973
4,973
4,973

10,000
9,422
6,975
7,346

The most critical variables are sales volume and unit selling
price.
If the volume declines by 25%, NPV becomes negative (Rs1146).
Similarly if the net selling price falls by 15%, NPV is minus
Rs1,702

SCENARIO ANALYSIS
Scenario Analysis: Summary Report
Scenario summary

Variable combinations:
Sales volume (unit)
Selling price / unit (Rs)
Variable cost/unit (Rs)
Fixed cost
Results:
NPV (Rs)

Base
values

Pessimistic

Optimistic

Expected

1,000
15.00
6.75
4,000

750
12.75
7.43
4,800

1,250
16.50
6.75
3,200

1,250
13.50
7.10
4,400

4,972

-10,038

19,026

3,044

Total
Total Risk
Risk (Discrete
(Discrete
Distribution)
Distribution)
ANNUAL CASH FLOWS: YEAR 1
PROPOSAL A
State

Probability

Deep Recession
.05
Mild Recession
.25
Normal
.40
Minor Boom
.25
Major Boom
.05

Cash Flow
Rs -3,000
1,000
5,000
9,000
13,000

Probability
Distribution of Year
1 Cash Flows
Proposal A

Probability

.40

.25

.05
-3,000

1,000

5,000

9,000

Cash Flow (Rs)

13,000

Expected Value of Year

1 Cash Flows
(Proposal A)
CF1
Rs -3,000
1,000
5,000
9,000
13,000

=1.00

P1
.05
.25
.40
.25
.05

(CF1)(P1)
Rs

-150
250
2,000
2,250
650

CF1 = Rs5,000

Variance of Year 1
Cash Flows (Proposal
A)
(CF1)(P1)
Rs -150
250
2,000
2,250
650
Rs5,000

(CF1 - CF1)2(P1)
( -3,000 - 5,000)2 (.05)
( 1,000 - 5,000)2 (.25)
( 5,000 - 5,000)2 (.40)
( 9,000 - 5,000)2 (.25)
(13,000 - 5,000)2 (.05)

Variance of Year 1
Cash Flows (Proposal
A)
(CF1)(P1)
Rs -150
250
2,000
2,250
650

Rs5,000

(CF1 - CF1)2*(P1)
3,200,000
4,000,000
0
4,000,000
3,200,000

14,400,000

Summary of Proposal A
The standard deviation = SQRT (14,400,000)
Rs3,795
The expected cash flow

= Rs5,000

Coefficient of Variation (CV) = Rs3,795 / Rs5,000

= 0.759

CV is a measure of relative risk and is the

ratio of standard deviation to the mean of
the distribution.

An Illustration of Total
Risk (Discrete
Distribution)
ANNUAL CASH FLOWS: YEAR 1
PROPOSAL B
State

Probability

Deep Recession
.05
Mild Recession
.25
Normal
.40
Minor Boom
.25
Major Boom
.05

Cash Flow
Rs -1,000
2,000
5,000
8,000
11,000

Probability
Distribution of Year
1 Cash Flows
Proposal B

Probability

.40

.25

.05
-3,000

1,000

5,000

9,000

Cash Flow (Rs)

13,000

Expected Value of Year

1 Cash Flows
(Proposal B)
CF1

P1

Rs -1,000
.05
2,000
.25
5,000
.40
8,000
.25
11,000
.05
=1.00

(CF1)(P1)
Rs -50
500
2,000
2,000
550
CF1=Rs5,000

Variance of Year 1
Cash Flows (Proposal
B)
(CF1)(P1)
Rs

-50
500
2,000
2,000
550

Rs5,000

(CF1 - CF1)2(P1)

( -1,000 - 5,000)2 (.05)

( 2,000 - 5,000)2 (.25)
( 5,000 - 5,000)2 (.40)
( 8,000 - 5,000)2 (.25)
(11,000 - 5,000)2 (.05)

Variance of Year 1
Cash Flows (Proposal
B)
(CF1)(P1)
Rs -50
500
2,000
2,000
550
Rs5,000

(CF1 - CF1)2(P1)

1,800,000
2,250,000
0
2,250,000
1,800,000
8,100,000

Summary of Proposal B
The standard deviation = SQRT (8,100,000)
= Rs2,846
The expected cash flow = Rs5,000
Coefficient of Variation (CV) = Rs2,846 / Rs5,000 = 0.569

The standard deviation of B < A (Rs2,846< Rs3,795),

so B is less risky than A.
The coefficient of variation of B < A (0.569<0.759),
so B has less relative risk than A.

Probability Tree
Approach
A graphic or tabular approach
for organizing the possible
cash-flow streams generated
by an investment. The
presentation resembles the
branches of a tree. Each
complete branch represents
one possible cash-flow

Probability Tree
Approach
Yami Basket is examining a
project that will have an
initial cost today of Rs900 .
Uncertainty surrounding the
first year cash flows creates
three possible cash-flow
scenarios in Year 1.
Rs in 000

Probability Tree
Approach
(.20) Rs1,200

-Rs900

(.60)

Rs450

(.20)

-Rs600

Year 1

Node 1: 20% chance of a

Rs1,200 cash-flow.
Node 2: 60% chance of a
Rs450 cash-flow.
Node 3: 20% chance of a
-Rs600 cash-flow.

Probability Tree
Approach
(.10) Rs2,200

(.20) Rs1,200

(.60) Rs1,200
(.30) Rs 900
(.35) Rs 900

-Rs900

(.60)

Rs450

(.40) Rs 600
(.25) Rs 300
(.10) Rs 500

(.20)

-Rs600

Year 1

(.50) -Rs 100

(.40) -Rs 700
Year 2

Each node in
Year 2
represents a
branch of
probability
tree.
The
probabilities
are said to be
conditional
probabilities.

Joint Probabilities
[P(1,2)]
(.10) Rs2,200

(.20) Rs1,200

(.60) Rs1,200
(.30) Rs 900
(.35) Rs 900

-Rs900

(.60)

Rs450

(.40) Rs 600
(.25) Rs 300
(.10) Rs 500

(.20)

-Rs600

Year 1

(.50) -Rs 100

(.40) -Rs 700
Year 2

.02 Branch
1
.12 Branch
2
.06 Branch
3
.21 Branch
4
.24 Branch
5
.15 Branch
6

Project NPV Based on

Probability Tree Usage
z

The probability
tree accounts
for the
distribution of
cash flows.
Therefore,
discount all
cash flows at
only the riskfree rate of
return.

NPV = (NPVi)(Pi)
i=1

The NPV for branch i of

the probability tree for
two years of cash flows is

CF1
CF2
NPVi =
+
(1 + Rf )1 (1 + Rf )2
- ICO

NPV for Each Cash-Flow

Stream at 5% Risk-Free
Rate
(.10) Rs2,200

(.20) Rs1,200

(.60) Rs1,200
(.30) Rs 900
(.35) Rs 900

-Rs900

(.60)

Rs450

(.40) Rs 600
(.25) Rs 300
(.10) Rs 500

(.20)

-Rs600

Year 1

(.50) -Rs 100

(.40) -Rs 700
Year 2

Rs
2,238.32
Rs
1,331.29
Rs
1,059.18
Rs
344.90
Rs
72.79
-Rs
199.32

Calculating the
Expected Net Present
Value (NPV)
Branch
NPVi
Branch 1
Rs 2,238.32
Branch 2
Rs 1,331.29
Branch 3
Rs 1,059.18
Branch 4
Rs 344.90
Branch 5
Rs
72.79
Branch 6
-Rs 199.32
Branch 7
-Rs 1,017.91
Branch 8-Rs 1,562.13
Branch 9
-Rs 2,106.35

P(1,2)
.02
.12
.06
.21
.24
.15
.02
.10
.08

NPVi * P(1,2)
Rs 44.77
Rs159.75
Rs 63.55
Rs 72.43
Rs 17.47
-Rs 29.90
-Rs 20.36
-Rs156.21
-Rs168.51

Expected Net Present Value = -Rs 17.01

Calculating the
Variance of the Net
Present Value
NPVi
Rs 2,238.32
Rs 1,331.29
Rs 1,059.18
Rs 344.90
Rs
72.79
-Rs 199.32
-Rs 1,017.91
-Rs 1,562.13
-Rs 2,106.35

P(1,2)
.02
.12
.06
.21
.24
.15
.02
.10
.08

(NPVi - NPV )2[P(1,2)]

Rs 101,730.27
Rs 218,149.55
Rs 69,491.09
Rs 27,505.56
Rs
1,935.37
Rs
4,985.54
Rs 20,036.02
Rs 238,739.58
Rs 349,227.33

Variance = Rs1,031,800.31

Summary of the
Decision Tree
Analysis
The standard deviation = SQRT
(Rs1,031,800)
= Rs1,015.78
The expected NPV

= -Rs

17.01

Simulation Approach
An approach that allows
us to test the possible
results of an investment
proposal before it is
accepted. Testing is
based on a model
coupled with

Simulation Approach
Factors we might consider in a
Market analysis
model:

Market size, selling price,

market
growth rate, and market share
Investment cost analysis
Investment required, useful life
of facilities, and residual value
Operating and fixed costs
Operating costs and fixed costs

Simulation Approach
Each variable is assigned an appropriate probability
distribution. The distribution for the selling price of
baskets created by Yami Basket looks like:

Rs20

Rs25

Rs30

Rs35

.02

.08

.22

.36

Rs40

.22

Rs45

.08

Rs50

.02

The resulting proposal value is dependent on the

distribution and interaction of EVERY variable listed
on earlier slide

Simulation Approach

PROBABILITY
OF OCCURRENCE

Each proposal will generate an internal rate

of return. The process of generating many,
many simulations results in a large set of
internal rates of return. The distribution
might look like the following:

INTERNAL RATE OF RETURN (%)

Contribution
Contribution to
to Total
Total Firm
Firm
Risk:
Risk: Firm-Portfolio
Firm-Portfolio
Approach
Approach
Proposal B

Combination of
Proposals A and B

CASH FLOW

Proposal A

TIME

TIME

TIME

Combining projects in this manner reduces

the firm risk due to diversification.

Managerial (Real)
Options
Management flexibility to
make future decisions that
affect a projects expected
cash flows, life, or future
acceptance.
Project Worth = NPV + Option(s)
Value

Managerial (Real)
Options
Expand (or contract)
Allows the firm to expand (contract)
production if conditions become favorable
(unfavorable).

Abandon
Allows the project to be terminated early.

Postpone
Allows the firm to delay undertaking a
project (reduces uncertainty via new
information).

Previous Example with

Project Abandonment
(.10) Rs2,200
(.20) Rs1,200

(.60) Rs1,200
(.30) Rs 900
(.35) Rs 900

-Rs900

(.60)

Rs450

(.40) Rs 600
(.25) Rs 300
(.10) Rs 500

(.20)

-Rs600

Year 1

(.50) -Rs 100

(.40) -Rs 700
Year 2

Assume that
this project
can be
abandoned
at the end of
the first year
for Rs200.
What is the
project
worth?

Project Abandonment
(.10) Rs2,200
(.20) Rs1,200

(.60) Rs1,200
(.30) Rs 900
(.35) Rs 900

-Rs900

(.60)

Rs450

(.40) Rs 600
(.25) Rs 300
(.10) Rs 500

(.20)

-Rs600

Year 1

(.50) -Rs 100

(.40) -Rs 700
Year 2

Node 3:
(500/1.05)(.1)+
(-100/1.05)
(.5)+ (700/1.05)(.4)=
(Rs476.19)
(.1)+ -(Rs
95.24)(.5)+ (Rs666.67)(.4)=
-(Rs266.67)

Project Abandonment
(.10) Rs2,200
(.20) Rs1,200

(.60) Rs1,200
(.30) Rs 900
(.35) Rs 900

-Rs900

(.60)

Rs450

(.40) Rs 600
(.25) Rs 300
(.10) Rs 500

(.20)

-Rs600

Year 1

(.50) -Rs 100

(.40) -Rs 700
Year 2

The optimal
decision at the
end of Year 1 is
to abandon the
project for
Rs200.
Rs200 >
-(Rs266.67)
What is the
new project
value?

Project Abandonment
(.10) Rs2,200
(.20) Rs1,200

(.60) Rs1,200
(.30) Rs 900
(.35) Rs 900

-Rs900

(.60)

Rs450

(.40) Rs 600
(.25) Rs 300

Rs
2,238.32
Rs
1,331.29
Rs
1,059.18

Rs
344.90
(.20) -Rs400*
(1.0) Rs
0
Rs
3
*-Rs600 + Rs200 abandonment 72.79
-Rs
Year 1
Year 2
199.32

Summary of the Addition

of the Abandonment
Option

The standard deviation* = SQRT

(740,326)
= Rs857.56
The expected NPV*
= Rs 71.88
NPV* = Original NPV +
Abandonment Option
Thus, Rs71.88 = -Rs17.01 +
Option
Abandonment Option
= Rs 88.89

* For True Project considering abandonment option

CORPORATE RISK ANALYSIS

A projects corporate
contribution to the

risk

is

its

overall risk of the firm

On a stand-alone basis a project may be
very risky but
if its returns are not highly correlated
or, even better,
negatively correlated with the returns
on the other
projects of the firm, its corporate risk

RISK ANALYSIS IN PRACTICE

Conservative Estimation of Revenues
Safety Margin in Cost Figures
Flexible Investment Yardsticks
Acceptable Overall Certainty Index
Judgment on Three Point Estimates