Final Project on Capital Budgeting & Different Risk

8/2/2019 Final Project on Capital Budgeting & Different Risk

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Name Roll No.sMilind Gala A015

Devavrat Lad A024Srijesh P A032

Gaurav Raval A037

Kshama Shukla A046

Mamta Tadi A049


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Capital Budgeting & Risk

CAPITAL BUDGETING = INVESTING in Long-term Assets.

Capital: Fixed assets used in production

Budget: Plan of in- and outflows during some period

Capital Budget: A list of planned investment (i.e., expenditures on fixed assets) outlays for different projects.

Capital Budgeting: Process of selecting viable investment

projects.


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RISK AND SENSITIVITY IN CAPITAL

BUDGETING RISK is a degree of uncertainty.

The cost of bearing risk is crucial concept for any corporation.

Uncertainty may arises due to:

Economic condition: Will consumer be spending or saving? Will the economy be ina recession?

Market Condition: Is market competitive? How much will raw material & laborcost in future?

Taxes: What will tax rates be? Will government alter the tax system

Interest rates: What will be the cost of raising capital in future years.

International condition: Will exchange rate between different countries currencies

changes?

These sources of uncertainty influence future cash flow. In evaluating a capitalproject, we are concerned with measuring its risk.


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Types of RISK

In the study of finance, there are a number of different types of risk the been identified.

It is important to remember, however, that all types of risks exhibit the same positive

risk-return relationship.

Default Risk

Interest Rate Risk

Price Risk :

Reinvestment Rate Risk :

Liquidity risk


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Project risk

Financial risk

Business risk

Foreign Exchange Risks

Translation Risks

Transactions Risks

Total Risk

Measures of Total Risk

Inflation Risk (Purchasing Power Risk)

Market risk

Firm specific risk

Types of RISK


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Causes Asset Risk

Fixed and Variable Cost

A simplifying assumption is to make variable costs a constant amount per unitof output ie

Variable cost = quantity x cost per unit

VC = Q x v

Fixed Cost (FC) Costs that are constant over a period regardless of level

of sales.

Total Cost (TC) the sum of fixed cost (FC) and variable cost (VC)

TC = FC + VC

TC = FC + (Q x V)

There is almost always some flexibility in production in deciding betweenfixed and variable cost. FC, generally magnify forecasting errors.


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Integrating Risk: Applying conservation of risk:

Brevenue = BFC PV (FC) / PV (rev) + Bvc PV (VC) / PV (rev) + Basset PV(asset) / PV (rev)

Now, BFC = 0 and BVC = B revenue as they should respond to the same underlying

variable, the rate of output. Thus

Basset = Brevenue PV (rev) PV (VC) / PV (asset) = Brevenue[1+PV(FC) / PV(asset)]

This formula shows the influence of FC, on the underlying asset

beta. In practice, one would have to iterate between finding thePV of the asset & discount rate until both were consistent.


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Risk Adjusted Discount Rates

There are two ways to take into account individual project risk.

1. Risk adjusted discount rates, divisional use of the CAPM.

2. Scenario analysis / simulation analysis to identify the sourcesof the risk.

This section of the note discusses risk adjusted discount rates

while Sections 4-5 discuss ways of quantifying the sources ofrisk.

We can identify situations which make one vs. the other

appropriate


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Risk adjusted Discount Rates (Cont.) Net Present Value (NPV) handles risk through adjusting the denominator used to

discount cash flows. Thus risky cash flows are discounted at a higher discount

rate - but only ifthey are systematic.

A higher discount rate comes from the firm having to offer a higher return tocompensate the firm for systematic risk.

Ideally, we would want to discount each project by the discount

rate appropriate for that level of systematic risk. Using one discount rate for allprojects incorrectly lumps them together. It is only appropriate when projectsexactly match the average risk of the firm

For Example:

An oil company worries about "the risk of a dry hole".

A pharmaceutical manufacturer worries about the "risk" that a new

drug which cures baldness many not be approved by the FDA.

The owner of a hotel in a politically unstable part of the world worries

about the "political risk" of expropriation


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Example: Problem

(A) A company is considering two mutually exclusive projects X and Y. Project X costs

Rs.30,000 and Project Y Rs. 36,000. You have been given below the net present value,

probability distribution for each project.

Project X Project Y

NPV Estimate (Rs) Probability NPV Estimate (Rs) Probability

3,000 0.1 3,000 0.2

6,000 0.4 6,000 0.3

12,000 0.4 12,000 0.3

15,000 0.1 15,000 0.2

(i) Compute the expected net present value of Projects X and Y.(ii) Compute the risk attached to each project i.e., Standard Deviation of each

probability distribution.

(iii) Which project do you consider more risky and why?

(iv) Compute the profitability index of each project.


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(b) Determine the risk adjusted net present value of the following projects:

A B C

Net cash outlays (Rs.) 1,00,000 1,20,000 2,10,000

Project life 5 years 5 years 5 yearsAnnual cash inflow (Rs.) 30,000 42,000 70,000

Coefficient of variation 0.4 0.8 1.2

The company selects the risk-adjusted rate of discount on the basis of the co-

efficient of variation:

Coefficient of variation Risk adjusted rate of discount Present value factor 1 to 5

yrs at risk adjusted rate of disc

0.0 10% 3.791

0.4 12% 3.605

0.8 14% 3.4331.2 16% 3.274

1.6 18% 3.127

2.0 22% 2.864

More than 2.0 25% 2.689


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Solution:

(a) Project X

NPV Estimate

(Rs)

Probability NPV Estimate

x Probability

(Rs)

Deviation

from Expected

NPV i.e. Rs.

9,000

Square of the

Deviation

(Rs)

Square of the

deviationx

Probability

(Rs)

3,000 0.1 300 6,000 3,60,00,000 36,00,000

6,000 0.4 2,400 3,000 90,00,000 36,00,000

12,000 0.4 4,800 - 3,000 90,00,000 36,00,000

15,000 0.1 1,500 - 6,000 3,60,00,000 36,00,000

Expected NPV 9,000 1,44,00,000


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Solution:

Project Y

NPV Estimate

(Rs)

Probability NPV Estimate

x Probability

(Rs)

Deviation

from ExpectedNPV i.e. Rs.

9,000

Square of the

Deviation

(Rs)

Square of the

deviationxProbability

(Rs)

3,000 0.2 600 6,000 3,60,00,000 72,00,000

6,000 0.3 1,800 3,000 90,00,000 27,00,00012,000 0.3 3,600 - 3,000 90,00,000 27,00,000

15,000 0.2 3,000 - 6,000 3,60,00,000 72,00,000

Expected NPV 9,000 1,98,00,000

(i) The expected net present value of Projects X and Y is Rs. 9,000 each.

(ii) Standard Deviation = yprobabilitxdeviationtheofSquare


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In case of Project X : Standard Deviation = Rs.

= Rs. 3,795

In case of Project Y : Standard Deviation = Rs.

= Rs. 4,450

(iii) Coefficient of variation = Standard deviation / Expected net present value

In case of Project X : Coefficient of variation = 3,795 / 9,000 = 0.42

In case of Project Y : Coefficient of variation = 4,450 / 9,000 = 0.49 or 0.50

Project Y is riskier since it has a higher coefficient of variation.

(iv) Profitability index = Discounted cash inflow / Discounted cash outflow

In case of Project X : Profitability Index = 9,000 + 30,000 / 30,000 = 1.30

In case of Project Y : Profitability Index = 9,000 + 36,000 / 36,000 = 1.25

01,44,00,00

01,98,00,00


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(b) Statement showing the determination of the risk adjusted net present value

Projects Net

cashOutlays

(Rs)

Coefficie

ntof

Variation

Risk

adjusteddiscount

Rate

Annual

cashInflow

(Rs)

PV factor

1-5 yearsat risk

adjusted

rate of

Discount

(Rs)

Discount

edcash

inflow

(Rs)

Net

presentValue

(Rs)

(I) (ii) (iii) (iv) (v) (vi) (vii) =

(v) X (vi)

(viii) =

(vii) - (ii)

A 1,00,000 0.4 12% 30,000 3.605 1,08,150 8,150

B 1,20,000 0.8 14% 42,000 3.433 1,44,186 24,186

C 2,10,000 1.20 16% 70,000 3.274 2,29,180 19,180


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Summary Risk is typically figured into our decision making by using a cost of capital

that reflects the project risk.

The relevant risk for evaluation of project is the projects market risk,which is also referred as the asset beta. This risk can be estimated by

looking at the market risk of companies in a single line of business similar

to that of project, a pure-play.

An alternative to finding a pure-play is to classify projects according to the

type of project (eg expansion) & assign costs of capital to each projecttype according to subjective judgment of risk.

Most companies adjust for risk on their assessment of the attractiveness

for projects. However, this adjustment is typically done by evaluating risk

subjectively & ad hoc adjustments to the companys cost of capital to

arrive at a cost of capital for a particular project.


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Prof. Chandan Das Gupta

Final Project on Capital Budgeting & Different Risk

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