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Slm Unit 09 Mbf201

Oct 24, 2014

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Financial Management

Unit 9

Unit 9

Risk Analysis in Capital Budgeting

Structure: 9.1 Introduction Learning objectives 9.2 Types and Sources of Risk in Capital Budgeting Sources of risk Conventional techniques 9.3 Risk Adjusted Discount Rate Evaluation of risk adjusted discount rate 9.4 Certainty Equivalent Evaluation of certainty equivalent 9.5 Sensitivity Analysis 9.6 Probability Distribution Approach Variance 9.7 Decision Tree Approach Evaluation of decision tree approach 9.8 Summary 9.9 Terminal Questions 9.10 Answers to SAQs and TQs

9.1 IntroductionCapital budgeting decisions typically involve forecasting the future operating cash flows. Forecasting involves making certain assumptions about the future behaviour of costs and revenues. Such forecasting, however, suffers from uncertainty because the future is highly uncertain. Assumptions made about the future behaviour of costs and revenues may change and can significantly alter the fortunes of a company. The process is thereby inherently risky. Analysing the risks to reduce the element of uncertainty has therefore become an essential aspect of todays corporate project management. This unit will help you understand the various types of risks involved in capital budgeting decisions. In this unit, you will study how sensitivity analysis is used to determine the most critical uncertainties in theSikkim Manipal University Page No. 186

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estimation. You will also study the pitfalls of using uncertain single-point estimates for the cash flows associated with the project. This unit will help the capital budget decision-makers to avoid costly mistakes.9.1.1 Learning Objectives After studying this unit, you should be able to:

Define risk in capital budgeting Examine the importance of risk analysis in capital budgeting Determine the methods of incorporating the risk factor in capital budgeting decision Understand the types and sources of risk in capital budgeting decision

9.1.2 Definition of Risk Before we start to discuss about risk analysis in capital budgeting, let us first understand what risk in capital budgeting means. Risk in capital budgeting may be defined as the variation of actual cash flows from the expected cash flows. Every business decision involves risk. Risk exists on account of the inability of a firm to make perfect forecasts of cash flows. The inability can be attributed to factors that affect forecasts of investment, cost and revenue. Some of these are as follows: The business is affected by changes in political situations, monetary policies, taxation, interest rates and policies of the central bank of the country on lending by banks Industry specific factors influence the demand for the products of the industry to which the firm belongs Company specific factors like change in management, wage negotiations with the workers, strikes or lockouts affect companys cost and revenue positions Let us see a case explaining why making a perfect forecast of cash flows is difficult.

Sikkim Manipal University

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Caselet A company wants to produce and market a new product to their prospective customers and the demand is affected by the general economic conditions. Demand may be very high if the country experiences higher economic growth. On the other hand economic events like weakening of US dollar and sub-prime crises may trigger economic slow-down. This may create a pessimistic demand drastically bringing down the estimate of cash flows.

9.2 Types and Sources of Risk in Capital BudgetingHaving understood what risk in capital budgeting means, let us now understand the types of risk and their sources. Capital budgeting involves four types of risks in a project stand-alone risk, portfolio risk, market risk and corporate risk (see figure 9.1)

Figure 9.1: Types of risks

Stand-alone risk Stand alone risk of a project is considered when the project is in isolation. Stand-alone risk is measured by the variability of expected returns of the project.

Sikkim Manipal University

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Portfolio risk A firm can be viewed as portfolio of projects having a certain degree of risk. When new project is added to the existing portfolio of project, the risk profile of the firm will alter. The degree of the change in the risk depends on: The co-variance of return from the new project The return from the existing portfolio of the projects If the return from the new project is negatively correlated with the return from portfolio, the risk of the firm will be further diversified. Market risk Market risk is defined as the measure of the unpredictability of a given stock value. However, market risk is also referred to as systematic risk. The market risk has a direct influence on stock prices. Market risk is measured by the effect of the project on the beta of the firm. The market risk for a project is difficult to estimate. Corporate risk Corporate risk focuses on the analysis of the risk that might influence the project in terms of entire cash flow of the firms. Corporate risk is the projects risks of the firm. 9.2.1 Sources of risk The five different sources of risk are: Project specific risk Competitive or Competition risk Industry specific risk International risk Market risk Project-specific risk Project-specific risk could be traced to something quite specific to the project. Managerial deficiencies or error in estimation of cash flows or discount rate may lead to a situation of actual cash flows realised being less than the projected. Competitive or Competition risk Unanticipated actions of a firms competitors will materially affect the cash flows expected from a project. As a result of this, the actual cash flows from a project will be less than that of the forecast.Sikkim Manipal University Page No. 189

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Industry-specific risk Industry-specific risks are those that affect all the industrial firms. Industryspecific risk could be again grouped into technological risk, commodity risk and legal risk. All these risks will affect the earnings and cash flows of the project. Technological risk The changes in technology affect all the firms not capable of adapting themselves in emerging into a new technology. Example The best example is the case of firms manufacturing motor cycles with two stroke engines. When technological innovations replaced the two stroke engines by the four stroke engines, those firms which could not adapt to new technology had to shut down their operations. Commodity risk Commodity risk is the risk arising from the effect of price-changes on goods produced and marketed. Legal risk Legal risk arises from changes in laws and regulations applicable to the industry to which the firm belongs. Example The imposition of service tax on apartments by the Government of India, when the total number of apartments built by a firm engaged in that industry exceeds a prescribed limit. Similarly changes in Import-Export policy of the Government of India have led to the closure of some firms or sickness of some firms.

International risk These types of risks are faced by firms whose business consists mainly of exports or those who procure their main raw material from international markets.

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Let us now look at the firms facing such kind of risk: The rupee-dollar crisis affected the software and BPOs because it drastically reduced their profitability. Another example is that of the textile units in Tirupur in Tamil Nadu, which exports the major part of the garments produced. Rupee gaining and dollar weakening reduced their competitiveness in the global markets. The surging Crude oil prices coupled with the governments delay in taking decision on pricing of petro products, eroded the profitability of oil marketing companies in public sector like Hindustan Petroleum Corporation Limited. Another example is the impact of US sub-prime crisis on certain segments of Indian economy. The changes in international political scenario also affected the operations of certain firms. Market risk Factors like inflation, changes in interest rates, and changing general economic conditions affect all firms and all industries. Firms cannot diversify this risk in the normal course of business. There are many techniques of incorporation of risk perceived in the evaluation of capital budgeting proposals. They differ in their approach and methodology as far as incorporation of risk in the evaluation process is concerned. 9.2.2 Techniques for incorporation of risk factor in capital budgeting The techniques for incorporation of risk factor in capital budgeting decisions could be grouped into conventional and statistical techniques. In this chapter, we are going to discuss mainly the conventional techniques pay-back period. Pay-back period The oldest and the most commonly used method of recognising risk associated with a capital budgeting proposal is pay-back period. Pay-back period is defined as the length of time required to recover the initial cash out-lay. Pay-back period ignores time value of money (cash flows).

Sikkim Manipal University

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Pay-back period prefers projects of short term pay backs to that of longterm pay backs. The emphasis is on the liquidity of the firm through recovery of capital. Traditionally, Indian business community employs this technique in evaluating projects with very high level of uncertainty. The changing trends in fashion, makes the fashion business risky and therefore, pay-back period has been endorsed as a tradition in India to take dec