RISK ANALYSIS

IN CAPITAL BUDGETING
Discuss the concept of risk in investment decisions.
Understand some commonly used techniques, i.e., payback,
certainty equivalent and risk-adjusted discount rate, of risk
analysis in capital budgeting.
Focus on the need and mechanics of sensitivity analysis and
scenario analysis.
Highlight the utility and methodology simulation analysis.
Explain the decision tree approach in sequential investment
decisions.
Focus on the relationship between utility theory and capital
budgeting decisions.
1
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:
General economic conditions
I ndustry factors
Company factors
2
TECHNIQUES FOR RISK ANALYSIS
Techniques of risk
analysis
Analysis of stand-
alone risk
Analysis of
contextual risk
Sensitivity
analysis
Break-even
analysis
Simulation
analysis
Scenario
analysis
Corporate
risk analysis
Market risk
analysis
Hillier
model
Decision tree
analysis
Techniques for Risk
Analysis
Statistical Techniques for Risk Analysis
Probability
Variance or Standard Deviation
Coefficient of Variation
Conventional Techniques of Risk Analysis
Payback
Risk-adjusted discount rate
Certainty equivalent
4
Probability
A typical forecast is single figure for a period. This is referred to
as best estimate or most likely forecast:
Firstly, we do not know the chances of this figure actually occurring, i.e.,
the uncertainty surrounding this figure.
Secondly, the meaning of best estimates or most likely is not very clear. It
is not known whether it is mean, median or mode.

For these reasons, a forecaster should not give just one estimate,
but a range of associated probabilitya probability distribution.

Probability may be described as a measure of someones
opinion about the likelihood that an event will occur.
5
Assigning Probability
The probability estimate, which is based on a very
large number of observations, is known as an
objective probability.
Such probability assignments that reflect the state of
belief of a person rather than the objective evidence
of a large number of trials are called personal or
subjective probabilities.
6
Risk and Uncertainty
Risk is referred to a situation where the probability
distribution of the cash flow of an investment
proposal is known.

If no information is available to formulate a
probability distribution of the cash flows the
situation is known as uncertainty.
7
Expected Net Present Value
Once the probability assignments have been made to
the future cash flows the next step is to find out the
expected net present value.



Expected net present value = Sum of present values
of expected net cash flows.
8
=0
ENPV =
(1 )
n
t
t
ENCF
k +

ENCF = NCF t jt jt
P
Example
Suppose an investment project has a life of three
years, and it would involve an initial cost of Rs
10,000.





If the discount rate is 15 per cent, calculate the
expected NPV.
9
Expected Cash Flow
Example
10
Variance or Standard
Deviation
Variance measures the deviation about expected cash
flow of each of the possible cash flows.

Standard deviation is the square root of variance.



Absolute Measure of Risk.
11
2 2

=1
(NCF) = (NCF ENCF)
n
j j
j
P o

Coefficient of Variation
Coefficient of variation is relative Measure of Risk.

It is defined as the standard deviation of the
probability distribution divided by its expected value:
12
Expected value
Cofficient of variation = CV =
Standard deviation
Coefficient of Variation
The coefficient of variation is a useful measure of
risk when we are comparing the projects which have

same standard deviations but different expected values, or
different standard deviations but same expected values, or
different standard deviations and different expected values.
13
Exercise
14
The following information is available regarding the expected cash flows
generated, and their probability for company X. What is the expected return on
the project? Assuming 10 per cent as the discount rate, find out the present
values of the expected monetary values.
Year 1 Year 2 Year 3
Cash flows Probability Cash flows Probability Cash flows Probability
Rs 3,000
6,000
8,000
0.25
0.50
0.25
Rs 3,000
6,000
8,000
0.50
0.25
0.25
Rs 3,000
6,000
8,000
0.25
0.25
0.50
Solution
15
TABLE 3 (i) Calculation of Expected Monetary Values
Year 1 Year 2 Year 3
Cash
flows
Proba
bility
Monetary
values
Cash
flows
Probabi
lity
values
Monetary Cash
flows
Probab
ility
values
Moneta
ry
Rs 3,000
6,000
8,000
Total
0.25
0.50
0.25
Rs 750
3,000
2,000
5,750
Rs 3,000
6,000
8,000
0.50
0.25
0.25
Rs 1,500
1,500
2,000
5,000
Rs 3,000
6,000
8,000
0.25
0.25
0.50
Rs
750
1,500
4,000
6,250
(ii) Calculation of Present Values
Year 1 Rs 5,750 0.909 = Rs 5,226.75
Year 2 5,000 0.826 4,130.00
Year 3 6,250 0.751 4,693.75
Total 14,050.50
HILLIER MODEL
Uncorrelated Cash Flows
n C
t
NPV = I
t = 1 (1 + i)
t

n o
t
2

o (NPV) =
t = 1 (1 + i)
2t
Perfectly Correlated Cash Flows
n C
t
NPV = I
t = 1 (1 + i)
t
n o
t
o (NPV) =
t = 1 (1 + i)
t
HILLIER MODEL
Independent Cash Flows Over Time The mathematical formulation to determine the
expected values of the probability distribution of NPV for any project is:
The above calculations of the standard deviation and the NPV will produce
significant volume of information for evaluating the risk of the investment proposal.
The calculations are illustrated in Example 6.
( )
( )
( )
(8)
m
1 j
jt
.P
2
t
CF
jt
CF
t

: follows as calculated be would

t
t, period for flows cash expected of on distributi y probabilit the of deviation standard the is
t
where
(7)
n
1 t
2t
i 1

2
t
NPV
to equal is NPV of on distributi y probabilit the of deviation standard The
interest. of rate riskless the is i and t period in CFAT net of value expected the is CF where
(6)
n
1 t
CO
t
i 1
t
CF
NPV

=
=

=
+
=

=

+
=
|
.
|

\
|
Example 6
Suppose there is a project which involves initial cost of Rs 20,000 (cost at t =
0). It is expected to generate net cash flows during the first 3 years with the
probability as shown in Table 7.
TABLE 7 Expected Cash Flows
Year 1 Year 2 Year 3
Probability Net cash
flows
Probability Net cash
flows
Probability Net cash
flows
0.10 Rs 6,000 0.10 Rs 4,000 0.10 Rs 2,000
0.25 8,000 0.25 6,000 0.25 4,000
0.30 10,000 0.30 8,000 0.30 6,000
0.25 12,000 0.25 10,000 0.25 8,000
0.10 14,000 0.10 12,000 0.10 10,000
Solution
1 . Expected Values: For the calculation of standard deviation for
different periods, the expected values are to be calculated first. These
are calculated in Table 8.
(3) NPV= Rs 10,000 (0.909) + Rs 8,000 (0.826) + Rs 6,000 (0.751) Rs
20,000 = Rs 204.
( )
( ) ( ) ( )
( ) ( )
2,280. Rs to out work also ) and ( 3 and 2 periods for deviations standard the lines similar on calculated When
Rs2,280 ] 10,000 14,000 0.10 10,000 12,000 0.25
10,000 10,000 0.30 10,000 8,000 0.25 10,000 6,000 [0.10

: is 1 period for deviation standard the Thus,

.P CF CF
: is flow cash net posible of deviation standard The (ii)
3 2
2 2
2 2 2
1
m
1 j
jt
2
t jt t
= +
+ + +
=
=

=
Calculation of Expected Values of Each Period
Time
period

Probability
(1)
Net cash flow
(2)
Expected value (1 2)
(3)


Year 1





Year 2





Year 3
0.10
0.25
0.30
0.25
0.10

0.10
0.25
0.30
0.25
0.10

0.10
0.25
0.30
0.25
0.10
Rs 6,000
8,000
10,000
12,000
14,000

4,000
6,000
8,000
10,000
12,000

2,000
4,000
6,000
8,000
10,000



Rs 600
2,000
3,000
3,000
1,400
= 10,000
400
1,500
2,400
2,500
1,200
= 8,000
200
1,000
1,800
2,000
1,000
= 6,000
1
CF
2
CF
3
CF
( )
( )
( )
( )
( )
( )
( )
3,283 Rs
1.10
2,280 Rs
1.10
2,280 Rs
1.10
2,280 Rs
i 1

: time over flows cash of ce independen of assumption the under deviation standard (iv)The
6
2
4
2
2
2
n
1 t
2t
2
t
= + + =
+
=

=
Normal Probability Distribution
We can make use of the normal probability distribution to further analyze the element of
risk in capital budgeting. The use of the normal probability distribution will enable the
decision maker to have an idea of the probability of different expected values of NPV,
that is, the probability of NPV having the value of zero or less; greater than zero and
within the range of two values, say, Rs 1,000 and Rs 1,500 and so on.
The normal probability distribution as shown in Figure has a number of useful
properties.
The area under the normal curve, representing the normal probability distribution, is
equal to 1 (0.5 on either side of the mean). The curve has its maximum height at its
expected value (mean). The distribution (curve) theoretically runs from minus infinity to
plus infinity. The probability of occurrence beyond 3
s
is very near zero (0.26 per cent).
-3 -2 -1 X +1 +2 +3
99.74%
95.46%
Normal Curve
68.26%
Example
Assume that a project has a mean of Rs 40 and standard deviation of Rs 20. The
management wants to determine the probability of the NPV under the following
ranges: (i) Zero or less, (ii) Greater than zero, (iii) Between the range of Rs 25 and
Rs 45, (iv) Between the range of Rs 15 and Rs 30.
Solution
(i) Zero or less: The first step is to determine the difference between the expected
outcome X and the expected net present value. The second step is to standardize
the difference (as obtained in the first step) by the standard deviation of the
possible net present values. Then, the resultant quotient is to be seen in statistical
tables of the area under the normal curve. Such a table (Table Z) is given at the end
of the book. The table contains values for various standard normal distribution
functions. Z is the value which we obtain through the first two steps, that is:

This is also illustrated in Fig. 3.
The figure of 2 indicates that a NPV of 0 lies 2 standard deviation to the left of the
expected value of the probability distribution of possible NPV. Table Z indicates that
the probability of the value within the range of 0 to 40 is 0.4772. Since the area of
the left-hand side of the normal curve is equal to 0.5, the probability of NPV being
zero or less would be 0.0228, that is, 0.5 0.4772. It means that there is 2.28 per
cent probability that the NPV of the project will be zero or less.
0 . 2
20 Rs
40 Rs 0
Z =

=
-20
Figure 3
Expected Outcomes (X Values)
0 +20 +40 +60 +80 +100
C
o
n
t
i
n
u
o
u
s

P
r
o
b
a
b
i
l
i
t
y

d
i
s
t
r
i
b
u
t
i
o
n





Exercise
The Cautious Ltd is considering a proposal for the purchase of a new machine
requiring an outlay of Rs 1,500 lakh. Its estimate of the cash flow distribution
for the three-year life of the machine is given below (amount in Rs lakh):
Period 1 Period 2 Period 3
Cash flows Probability Cash flows Probability Cash flows Probability
Rs 800 0.1 Rs 800 0.1 Rs 1,200 0.2
600 0.2 700 0.3 900 0.5
400 0.4 600 0.4 600 0.2
200 0.3 500 0.2 300 0.1
The probability distribution is assumed to be independent. Risk-free rate of
interest is 5 per cent. From the above information, determine the following: (i)
the expected NPV of the project; (ii) the standard deviation of the probability
distribution of NPV; (iii) the probability that the NPV will be (a) zero or less
(assuming that the distribution is normal); (b) greater than zero; and (c) at
least equal to the mean; (iv) the profitability index of the expected value; and
(v) the probability that the profitability index will be less than 1.
Table 9 Determination of Expected NPV (Rs lakh)
Period 1 Period 2 Period 3
CF Pj Cash flow CF Pj Cash flow CF Pj Cash flow
(CF Pj) (CF Pj) (CF Pj)
800 0.1 80 800 0.1 80 1,200 0.2 240
600 0.2 120 700 0.3 210 900 0.5 450
400 0.4 160 600 0.4 240 600 0.2 120
200 0.3 60 500 0.2 100 300 0.1 30
Mean ( ) 420 Mean ( ) 630 Mean ( ) 840
NPV = Rs 420 (0.952) + Rs 630 (0.907) + Rs 840 (0.864) Rs 1,500 = Rs 197 lakh.
1
CF
2
CF
3
CF
12 -
26
188 35,600
1

35,600
j1
P
2
)
1
CF -
j1
(CF
14,520 0.3 x 48,400
160 0.4 x 400
6,480 0.2 x 32,400
14,440 Rs 0.1 x 1,44,400 Rs
j1
P
2
)
1
CF -
j1
(CF
j1
(x)P
2
)
1
CF
j1
(CF
: t Period, for flow Cash Expected of Deviation Standard (ii)
= =
=
=
=
=
=
= 1 Period
90 8,100
2

8,100
j2
P
2
)
2
CF -
j2
(CF
3,380 0.2 x 16,900 x 900
1,470 0.3 x 4,900
2,890 Rs 0.1 x 28,900 Rs
j2
P
2
)
2
CF -
j2
(CF
j2
(x)P
2
)
2
CF -
j2
(CF
= =
=
=
=
=
= 2 Period
262 68400
3

68400
j3
P
2
)
3
CF -
j3
(CF
29,160 0.1 x 2,91,600
11,520 0.2 x 57,600
1,800 0.5 x 3,600
25,920 Rs 0.2 x 1,29,600 Rs
j3
P
2
)
3
CF -
j3
(CF
j3
(x)P
2
)
3
CF -
j3
(CF
= =
=
=
=
=
=
= 3 Period
( )
( ) ( ) ( )
300 Rs
1.340
68,400 Rs
1.216
Rs81,00
1.102
35,520 Rs
6
0.05) (1
2
262 Rs
4
0.05) (1
2
90 Rs
2
0.05) (1
2
188 Rs
n
1 t
2t
i 1
2t
(NPV)
: NPV about deviation standard of n Calculatio
= + + =
+
+
+
+
+
=

=
+
=
(iii) (a) Calculation of Probability of the NPV Being Zero or Less: Z = [(0-
197)/300]=-.6567
According to Table Z, the probability of the NPV being zero is = 0.2454, that is,
24.54 per cent. Therefore, the probability of the NPV being zero or less would
be 0.5 0.2454 = 0.2546 or 25.46 per cent.
(b)The probability of the NPV being greater than zero would be 1 0.2546 =
0.7454 or 74.54 per cent
(c)At least equal to mean: Z = [(197-197)/300] = 0
Reading from the normal distribution table, we get the probability
corresponding to 0 as 0. Therefore, the probability of having NPV at least
equal to mean would be equivalent to the area to the right of the curve, that is,
0.5 = 50 per cent.
(iv) Profitability Index: (PV of cash inflows/PV of cash outflows) = [(Rs 197 +
Rs 1,500) / Rs 1,500] = 1.13
(v) The probability of the index being less than 1: For the index to be 1 or less,
the NPV would have to be zero or negative. Thus, the probability would be
equal to 25.46 per cent as calculated in part (iii) (a) of the answer.
Decision-tree Approach
Decision tree is a pictorial representation in tree from which indicates the
magnitude, probability and inter-relationships of all possible outcomes.
Example: Suppose a firm has an investment proposal, requiring an outlay of
Rs 2,00,000 at present (t = 0). The investment proposal is expected to have 2
years economic life with no salvage value. In year 1, there is a 0.3 probability
(30 per cent chance) that CFAT will be Rs 80,000; a 0.4 probability (40 per cent
chance) that CFAT will be Rs 1,10,000 and a 0.3 probability (30 per cent chance)
that CFAT will be Rs 1,50,000. In year 2, the CFAT possibilities depend on the
CFAT that occurs in year 1. That is, the CFAT for the year 2 are conditional on
CFAT for the year 1. Accordingly, the probabilities assigned with the CFAT of
the year 2 are conditional probabilities. The estimated conditional CFAT and
their associated conditional probabilities are as follows:
If CFAT1 = Rs 80,000 If CFAT1 = Rs 1,10,000 If CFAT1 = Rs 1,50,000
CFAT2 Probability CFAT2 Probability CFAT2 Probability
Rs 40,000 0.2 Rs 1,30,000 0.3 Rs 1,60,000 0.1
1,00,000 0.6 1,50,000 0.4 2,00,000 0.8
1,50,000 0.2 1,60,000 0.3 2,40,000 0.1
12 -
30
Solution The estimated values have been portrayed in Fig. 4.



Time: 0
Path Expected NPV
at 8% rate of
discount
Joint
Probability
(Pj)**
Expected NPV
NPV () Pj
Year 1

Year 2
Probabi
lities
CFAT Probabi
lities
CFAT








Cash
Outlays
Rs 2,00,000

0.3





0.4





0.3



Rs 80,000





1,10,000





1,50,000
0.2

0.6

0.2

0.3

0.4

0.3

0.1

0.8

0.1

Rs 40,000

1,00,000

1,50,000

1,30,000

1,50,000

1,60,000

1,60,000

2,00,000

2,40,000

1

2

3

4

5

6

7

8

9

Rs ( 91,640)

(40,220)

(2,630)

13,270

30,410

38,980

76,020

1,10,300

1,44,580

0.06

0.18

0.06

0.12

0.16

0.12

0.03

0.24

0.03
1.00

Rs ( 5,498.4)

(7,239.6)

(157.8)

1,592.4

4,865.6

4,677.6

2,280.6

26,472.0

4,337.4
31,329.8
* PV factors for years 1 and 2 at 8% discount rate as per Table A-3 are 0.926 and 0.857 respectively. Multiply CFAT1 by
0.926 and CFAT2 by 0.857; summing up, we get total PV for individual possible CFAT; substracting Rs. 2,00,000 (CO),
we get the NPV.
** Product of probabilities of CFAT for years 1 and 2.
Figure 4: Decision Tree
The DT shows 9 distinct possibilities, the project could assume if accepted. For
example, one possibility is that the CFAT for the year one may amount to Rs 80,000 and
for the year 2 Rs 40,000. A close perusal of Fig. 4 would also indicate that this is the
worst event that could happen. Assuming a 8 per cent risk free/discount rate for the
project, the NPV would be negative. Likewise, the best outcome that could occur is
CFAT1 = Rs 1,50,000 and CFAT2 = Rs 2,40,000. The NPV would be the highest among all
the 9 possible combinations. Figure 4 shows the NPV at 8 per cent discount rate of each
of the estimated CFATs.
The expected NPV of the project is given by the following mathematical formulation:

where P
j
=The probability of the jth path occurring which is equal to the joint probability
along the path;
NPV
j
= NPV of the j th path occurring.
In our example, the joint probability, P
j
for the worst path is 0.06 (0.3 0.2) and for the
best path is 0.03 (0.3 0.1). The sum of all these joint probabilities must be equal to 1.
The last column shows the expected NPV, which is obtained by summing up the product
of NPV of jth path and the corresponding probability of jth path (EP
j
NPV
j
). The sum of
these weighted NPVs is positive and, therefore, the project should be accepted.
This approach has the advantage of exhibiting a birds eye view of all the possibilities
associated with the proposed project.

=
=
m
1 j
j j
) 9 ( NPV P NPV
CONVENTIONAL TECHNIQUES
OF RISK ANALYSIS
Payback
Risk-adjusted discount rate
Certainty equivalent
32
Risk Analysis in Practice
Most companies in India account for risk while
evaluating their capital expenditure decisions.
The following factors are considered to influence the
riskiness of investment projects:
price of raw material and other inputs
price of product
product demand
government policies
technological changes
project life
inflation

33
Risk Analysis in Practice
Four factors thought to be contributing most to the
project riskiness are:
selling price
product demand
technical changes
government policies

Methods of risk analysis in practice are:
sensitivity analysis
conservative forecasts

34
Sensitivity Analysis &
Conservative Forecasts
Sensitivity analysis allows to see the impact of the
change in the behaviour of critical variables on the
project profitability.

Conservative forecasts include using short payback
or higher discount rate for discounting cash flows.

Except a very few companies most companies do
not use the statistical and other sophisticated
techniques for analysing risk in investment
decisions.
35
Payback
This method, as applied in practice, is more an attempt to
allow for risk in capital budgeting decision rather than a
method to measure profitability.
The merit of payback
Its simplicity.
Focusing attention on the near term future and thereby emphasising
the liquidity of the firm through recovery of capital.
Favouring short term projects over what may be riskier, longer term
projects.
Even as a method for allowing risks of time nature, it
ignores the time value of cash flows.
36
Risk-Adjusted Discount
Rate
Risk-adjusted discount rate, will allow for both time
preference and risk preference and will be a sum of the risk-
free rate and the risk-premium rate reflecting the investors
attitude towards risk.



Under CAPM, the risk-premium is the difference between the
market rate of return and the risk-free rate multiplied by the
beta of the project.

37
=0
NCF
NPV =
(1 )
n
t
t
t
k +

f r
k = k + k
We shall be using the following equation for the purpose of determining NPV under
the RAD method.
where CFAT
t
= expected CFAT in year t, K
r
= risk-adjusted discount rate, CO =
cash outflows.
Thus, projects are evaluated on the basis of future cash flow projections and an
appropriate discount rate. Example 5 clarifies how the K
r
can be used to evaluate
capital budgeting projects.
( )

=

+
=
n
1 t
t
r
t
(3) CO
k 1
CFAT
NPV
Example
Cash outlays (Rs 1,00,000)
50,000
60,000
40,000
CFAT Year 1
Year 2
Year 3
Riskless rate of return = 6 per cent
Risk-adjusted rate of return for the current project = 20 per cent
Solution
( ) ( ) ( )
6,410 Rs (0.579)] 40,000 [Rs (0.694)] 60,000 [Rs (0.833)] 50,000 [Rs
1,00,000 Rs
.20 1
40,000 Rs
.20 1
60,000 Rs
.20 1
50,000 Rs
1,00,000) (Rs NPV
3 2
= + +
+ =
+
+
+
+
+
+ =
Risk-adjusted Discount
Rate: Merits
It is simple and can be easily understood.
It has a great deal of intuitive appeal for risk-averse
businessman.
It incorporates an attitude (risk-aversion) towards
uncertainty.

39
Risk-adjusted Discount Rate:
Limitations
There is no easy way of deriving a risk-adjusted discount rate.
CAPM provides a basis of calculating the risk-adjusted
discount rate.

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

It is based on the assumption that investors are risk-averse.
Though it is generally true, yet there exists a category of risk
seekers who do not demand premium for assuming risks; they
are willing to pay a premium to take risks.

40
Example
41
Example
42
Certainty-Equivalent
Reduce the forecasts of cash flows to some conservative
levels.The certainty-equivalent coefficient assumes a value
between 0 and 1, and varies inversely with risk. Decision-
maker subjectively or objectively establishes the
coefficients.



The certaintyequivalent coefficient can be determined as
a relationship between the certain cash flows and the risky
cash flows.

43

=0
NCF
NPV =
(1 )
f
n
t t
t
t k
o
+

*
NCF Certain net cash flow
=
NCF Risky net cash flow
t
t
t
o =
We illustrate below the certainty-equivalent approach to adjust risk to capital
budgeting analysis on the basis of Previous Example.
Year Coefficient
1
2
3
0.90
0.70
0.60
The certainty-equivalent cash inflows would be as follows:
Year 1 = Rs 45,000 (coefficient 0.9 Rs 50,000, the expected cash inflows)
Year 2 = Rs 42,000 (0.70 Rs 60,000)
Year 3 = Rs 24,000 (0.60 Rs 40,000)
This would be discounted by the riskless rate of return, which is, 6 per cent.
Substituting the value in Equation (5),
Since the NPV is negative, the project should be rejected. This decision is in
conflict with the decision using the risk-adjusted discount rate where K = 20
per cent. Thus, both these methods may not yield identical results.
( ) ( ) ( )
( ) ( ) ( ) 25 Rs 1,00,000 Rs 0.840 24,000 Rs 0.890 42,000 Rs (0.943) 45,000 Rs
1,00,000 Rs
0.06 1
24,000 Rs
0.06 1
42,000 Rs
0.06 1
45,000 Rs
NPV
3 2 1
= + + =

+
+
+
+
+
=
Certainty-Equivalent:
Evaluation
First, the forecaster, expecting the reduction that will be
made in his forecasts, may inflate them in anticipation.

Second, 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.

Third, by focusing explicit attention only on the gloomy
outcomes, chances are increased for passing by some good
investments.
45
Example
46
Risk-adjusted Discount Rate
Vs. Certainty-Equivalent
The certainty-equivalent approach recognises risk in capital
budgeting analysis by adjusting estimated cash flows and
employs risk-free rate to discount the adjusted cash flows.
On the other hand, the risk-adjusted discount rate adjusts for
risk by adjusting the discount rate. It has been suggested that
the certainty-equivalent approach is theoretically a superior
technique.
The risk-adjusted discount rate approach will yield the
same result as the certainty-equivalent approach if the
risk-free rate is constant and the risk-adjusted discount
rate is the same for all future periods.
47
SENSITIVITY ANALYSIS
Sensitivity analysis is a way of analysing
change in the projects NPV (or IRR) for a given
change in one of the variables.

The decision maker, while performing sensitivity
analysis, computes the projects NPV (or IRR)
for each forecast under three assumptions:
pessimistic,
expected, and
optimistic.
48
SENSITIVITY ANALYSIS
The following three steps are involved in the use of
sensitivity analysis:

1. Identification of all those variables, which have an
influence on the projects NPV (or IRR).
2. Definition of the underlying (mathematical) relationship
between the variables.
3. Analysis of the impact of the change in each of the
variables on the projects NPV.

49

SENSITIVITY ANALYSIS
(000)
YEAR 0 YEAR 1 - 10
1. INVESTMENT (20,000)
2. SALES 18,000
3. VARIABLE COSTS (66 2/3 % OF SALES) 12,000
4. FIXED COSTS 1,000
5. DEPRECIATION 2,000
6. PRE-TAX PROFIT 3,000
7. TAXES 1,000
8. PROFIT AFTER TAXES 2,000
9. CASH FLOW FROM OPERATION 4,000
10. NET CASH FLOW 4,000

NPV = -20,000,000 + 4,000,000 (5.650) = 2,600,000 ( discount rate = 12 % )




RS. IN MILLION
RANGE NPV
KEY VARIABLE PESSIMISTIC EXPECTED OPTIMISTIC PESSIMISTIC EXPECTED OPTIMISTIC
INVESTMENT (RS. IN MILLION) 24 20 18 -0.65 2.60 4.22
SALES (RS. IN MILLION) 15 18 21 -1.17 2.60 6.40
VARIABLE COSTS AS A 70 66.66 65 0.34 2.60 3.73
PERCENT OF SALES
FIXED COSTS 1.3 1.0 0.8 1.47 2.60 3.33

DCF Break-even Analysis
Sensitivity analysis is a variation of the break-even
analysis.

DCF break-even point is different from the accounting
break-even point. The accounting break-even point is
estimated as fixed costs divided by the contribution ratio. It
does not account for the opportunity cost of capital, and
fixed costs include both cash plus non-cash costs (such as
depreciation).
51
BREAK-EVEN ANALYSIS
ACCOUNTING BREAK-EVEN ANALYSIS
FIXED COSTS + DEPRECIATION 1 + 2
= = RS. 9 MILLION
CONTRIBUTION MARGIN RATIO 0.333

CASH FLOW FORECAST FOR NAVEENS FLOUR MILL PROJECT
(000)
YEAR 0 YEAR 1 - 10
1. INVESTMENT (20,000)
2. SALES 18,000
3. VARIABLE COSTS (66
2
/
3
% OF SALES) 12,000
4. FIXED COSTS 1,000
5. DEPRECIATION 2,000
6. PRE-TAX PROFIT 3,000
7. TAXES 1,000
8. PROFIT AFTER TAXES 2,000
9. CASH FLOW FROM OPERATION 4,000
10. NET CASH FLOW (20,000) 4,000

CASH BREAK-EVEN ANALYSIS
Sensitivity Analysis: Pros
and Cons
It compels the decision-maker to identify the variables, which
affect the cash flow forecasts. This helps him in understanding
the investment project in totality.

It indicates the critical variables for which additional
information may be obtained. The decision-maker can consider
actions, which may help in strengthening the weak spots in
the project.

It helps to expose inappropriate forecasts, and thus guides the
decision-maker to concentrate on relevant variables.
53
Sensitivity Analysis: Pros and
Cons
It does not provide clear-cut results. The terms
optimistic and pessimistic could mean different
things to different persons in an organisation. Thus,
the range of values suggested may be inconsistent.

It fails to focus on the interrelationship between
variables. For example, sale volume may be related
to price and cost. A price cut may lead to high sales
and low operating cost.

54
SCENARIO ANALYSIS
One way to examine the risk of investment is to
analyse the impact of alternative combinations of
variables, called scenarios, on the projects NPV (or
IRR).

The decision-maker can develop some plausible
scenarios for this purpose. For instance, we can
consider three scenarios: pessimistic, optimistic and
expected.
55
SCENARIO ANALYSIS
PESSIMISTIC, NORMAL AND OPTIMISTIC
Pessimistic
Scenario
Expected
Scenario
Optimistic
Scenario
1. Investment 24 20 18
2. Sales 15 18 21
3. Variable costs 10.5 (70%) 12 (66.7%) 13.65 (65%)
4. Fixed costs 1.3 1.0 0.8
5. Depreciation 2.4 2.0 1.8
6. Pre-tax profit 0.8 3.0 4.75
7. Tax 0.27 1.0 1.58
8. Profit after tax 0.53 2.0 3.17
9. Annual cash flow from operations 2.93 4.0 4.97
10. Net present value
(9) x PVIFA (12%, 10 yrs) (1)
(7.45) 2.60 10.06
SIMULATION ANALYSIS
The Monte Carlo simulation or simply the simulation
analysis considers the interactions among variables and
probabilities of the change in variables. It computes the
probability distribution of NPV.

The simulation analysis involves the following steps:
First, you should identify variables that influence cash inflows and
outflows.
Second, specify the formulae that relate variables.
Third, indicate the probability distribution for each variable.
Fourth, develop a computer programme that randomly selects one
value from the probability distribution of each variable and uses
these values to calculate the projects NPV.
57
Simulation Analysis:
Shortcomings
The model becomes quite complex to use.
It does not indicate whether or not the project
should be accepted.
Simulation analysis, like sensitivity or scenario
analysis, considers the risk of any project in
isolation of other projects.
58
Decision Trees for Sequential
Investment Decisions
Investment expenditures are not an isolated
period commitments, but as links in a chain of
present and future commitments.

An analytical technique to handle the sequential
decisions is to employ decision trees.
59
Steps in Decision Tree
Approach
Define investment
Identify decision alternatives
Draw a decision tree
decision points
chance events
Analyse data

60
Usefulness of Decision Tree
Approach
Clarity: It clearly brings out the implicit
assumptions and calculations for all to see,
question and revise.

Graphic visualization: It allows a decision
maker to visualise assumptions and alternatives
in graphic form, which is usually much easier to
understand than the more abstract, analytical
form.

61
Decision Tree Approach:
Limitations
The decision tree diagrams can become more and
more complicated as the decision maker decides to
include more alternatives and more variables and to
look farther and farther in time.

It is complicated even further if the analysis is
extended to include interdependent alternatives and
variables that are dependent upon one another.

62
12 - 63
SOLVED PROBLEMS
12 -
64
Consumer demand for a new
toy
Probability of
occurrence
Estimated sales in year
(Rs in lakh)
1 2 3
Above average 0.30 12 25 6
Average 0.60 7 17 4
Below average 0.10 2 9 1.5
SOLVED PROBLEM 1
Toy Enterprises Ltd designs and manufactures toys. Past experience
indicates that the product life of a toy is 3 years. Promotional advertising
produces an increase in sales in the early years, but there is a substantial
sales decline in the final year of a toys life.
Consumer demand for new toys placed on the market tends to fall into three
classes. About 30 per cent of the new toys sell well above expectations, 60
per cent sell as anticipated, and 10 per cent have poor consumer acceptance.
A new toy has been developed. The following sales projections were made by
carefully evaluating the consumer demand.
12 -
65
Variable costs are estimated at 30 per cent of the selling price. Special
machinery must be purchased at a cost of Rs 8,60,000 which will be installed
in an unused portion of the factory. The company has been trying
unsuccessfully for several years to rent out the vacant portion at Rs 50,000
per year. Fixed expenses (excluding depreciation) are estimated at Rs 50,000
per year. The new machinery will be depreciated by the written down value
method @ 25 per cent with an estimated value of Rs 1,10,000 at the end of the
third year. Assume this is the only asset in the block. Advertising and
promotional expenses will be incurred uniformly, and will total Rs 1,00,000 in
the first year, Rs 1,50,000 in the second year, and Rs 50,000 in the third year.
The company is subject to a corporate tax rate of 35 per cent. Its cost of
capital is 10 per cent.
(i) Prepare a schedule computing the probable sales of this new toy in each of
the three years. Also, determine the NPV of the proposal.
(ii) Assuming that cash flows occur uniformly throughout each year,
determine the NPV of the proposal. The present value of Re 1 earned
uniformly throughout the year discounted at 10 per cent is as follows:
12 -
66
Solution
(i) Schedule showing probable sales of the new toy, years 13
(Rs in lakh)
Consumer
demand
for new toy
Probability of
occurrence
(Pj )
Years (estimated
sales)
Probable sales
per year
1 2 3 1 2 3
Above average 0.30 12 25 6 3.6 7.5 1.80
Average 0.60 7 17 4 4.2 10.2 2.40
Below average 0.10 2 9 1.5 0.2 0.9 0.15
8.0 18.6 4.35
Year Discount factor
1 0.95
2 0.86
3 0.78
(iii) Give your recommendations in both the situations.
12 -
67
Determination of CFAT
Particulars Years
1 2 3
Probable sales revenue Rs
8,00,000
Rs
18,60,000
Rs
4,35,000
Less: Variable costs (0.30) 2,40,000 5,58,000 1,30,500
Less: Depreciation 2,15,000 1,61,250 Nil*
Cash fixed costs 50,000 50,000 50,000
Advertising expenses 1,00,000 1,50,000 50,000
EBT 1,95,000 9,40,750 2,04,500
Less: Taxes (0.35) 68,250 3,29,263 71,575
EAT 1,26,750 6,11,487 1,32,925
CFAT (EAT + Depreciation) 3,41,750 7,72,737 1,32,925
Add: Salvage value 1,10,000
Add: Tax savings on short-term capital
loss**
1,30,812
3,41,750 7,72,737 3,73,737
* No depreciation in terminal year.
** (Rs 3,73,750 0.35)
12 -
68
(ii) Determination of NPV assuming CFAT occurs uniformly throughout the year
Year CFAT PV factor
(0.10)
Total PV
1 Rs 3,41,750 0.95 Rs 3,24,662
2 7,27,737 0.86 6,25,854
3 1,32,925 0.78 1,03,681
3 1,10,000 (salvage value) 0.751 82,610
3 1,32,812 (tax savings on short-term capital loss) 0.751 98,240
Total present value 12,35,047
Less: Cash outflows 8,60,000
NPV 3,75,047
(iii) Recommendation The project should be accepted in both the situations.
Determination of NPV
Year CFAT PV factor (0.10) Total PV
1 Rs 3,41,750 0.909 Rs 3,10,651
2 7,27,737 0.826 6,01,111
3 3,73,737 0.751 2,80,676
Total present value 11,92,438
Less: Cash outflows 8,60,000
NPV 3,32,438
12 -
69
SOLVED PROBLEM 2
A company has the following estimates of the present values of the future
cash flows after taxes associated with the investment proposal, concerned
with expanding the plant capacity. It intends to use a decision-tree approach to
get a clear picture of the possible outcomes of this investment. The plant
expansion is expected to cost Rs 3,00,000. The respective PVs of future CFAT
and probabilities are as follows:
PV of future CFAT
With expansion Without expansion Probabilities
Rs 3,00,000 Rs 2,00,000 0.2
5,00,000 2,00,000 0.4
9,00,000 3,50,000 0.4
Advise the company regarding the financial feasibility of the project.
12 -
70
Solution
The relevant computation are depicted below
Decision Tree
Time:0 Year 1
Probabil
ities (P
i
)
PV of CFAT Expected PV
(CFAT) x (P
i
)
0.2 Rs 3,00,000 Rs 60,000
0.4 5,00,000 2,00,000
0.4 9,00,000 3,60,000
6,20,000
Less: Cash Outflows - 3,00,000
NPV 3,20,000
0.2 2,00,000 40,000
0.4 2,00,000 80,000
0.4 3,50,000 1,40,000
2,60,000
Less: Cash outflows Nil
NPV 2,60,000
The expected NPV with plant expansion and without expansion is Rs 3,20,000 and Rs 2,60,000 respectively.
Therefore, the company is advised to expand the plant capacity
Cash outlays
Nil
Cash outlays
Rs 3,00,000
Do not
expand plant
Expand plant
Decision
tree