11. risk analysis and optimal capital expenditure decision
TRANSCRIPT
Financial Management I
11. Risk Analysis and Optimal Capital Expenditure Decision
[email protected], Phone: 40434399
Course Content - Syllabus
*Book preference
Sr Title ICMR Ch. PC Ch. IMP Ch.
1 Introduction to Financial Management 1* 1 1
2 Overview of Financial Markets 2* 2 -
3 Sources of Long-Term Finance 10* 17 20, 21
4 Raising Long-term Finance - 18* 20, 21, 23
5 Introduction to Risk and Return 4* 8, 9 4, 5
6 Time Value of Money 3* 6 2
7 Valuation of Securities 5* 7 3
8 Cost of Capital 11* 14 9
9 Basics of Capital Expenditure Decisions 18* 11 8
10 Analysis of Project Cash Flows - 12* 10, 11
11 Risk Analysis and Optimal Capital Expenditure Decision - 13* 11, 12
2 / 53
4 / 29
Books
1. Financial Management, Prasanna Chandra, 7th Edition,
Chapter 13
2. Financial Management, I. M. Pandey, 9th Edition, Chapter
12
4 / 29
Syllabus – Risk Analysis and Optimal Capital Expenditure Decision
1. Introduction to Project Risk2. Stand-Alone Risk3. Sensitivity4. Scenario and Decision Tree Approach5. The Impact of Abandonment on NPV and Stand-Alone
Risk6. Risk Adjusted Discount Rate versus Certainty
Equivalents7. Incorporating Risk and Capital Structure into Capital
Expenditure Decisions8. Optimal Capital Expenditure9. Capital Rationing
5 / 29
1. Introduction to Project Risk
• Risk is inherent in almost every business decision. In
capital budgeting decisions (capital expenditure decisions)
as they involve costs and benefits extending over a long
period of time during which many things can change.
Every investment proposal might have different risks
involved. R&D project might be more risky than an
expansion project. In view of such differences, variations
in risk need to be considered in capital investment
appraisal.• Risk analysis is most complex and slippery aspect of
capital budgeting. Many techniques have been suggested
for risk analysis. They fall into two broad categories.
5 / 29
1. Introduction to Project Risk
(i) Approaches that consider the stand-alone risk of a project(ii) Approaches that consider the risk of a project in the
context of the firm or in the context of the market.A figure classifies various techniques as below.
Techniques of Risk Analysis
Analysis of Stand-alone Risk
SensitivityAnalysis
Analysis of Contextual Risk
Break-evenAnalysis
SimulationAnalysis
ScenarioAnalysis
HillierModel
Decision Tree Analysis
Corporate RiskAnalysis
Market RiskAnalysis
5 / 29
1. Introduction to Project Risk
There are several sources of risk in a project. Main risks are
as follows, which affect the earnings and cash flow of the
project.
1. Project-specific risk: Estimation error or some factors
specific to the project like quality of management.
2. Competitive risk: Unanticipated actions of competitors.
3. Industry-specific risk: Unexpected technological
developments, regulatory changes specific to the industry
4. Market risk: Macroeconomic factors like GDP growth
rate, interest rate and inflation rate risk etc.
5. International risk: Exchange rate risk, political risk etc
5 / 29
2. Stand-Alone Risk
• Stand-alone risk: This represents the risk of a project
when it is viewed in isolation.• It is the risk an asset would have if it were a firm’s only
risk.• It is measured by the variability of the asset’s expected
returns.
5 / 29
3. Sensitivity Analysis
• Since the future is uncertain, you may like to know, what
will happen to the viability of the project when some
variables like sales or investment deviates from its
expected value. In other words, you may want to do ‘what
if’ analysis, also called the sensitivity analysis.• In sensitivity analysis, key variables are changed and the
resulting changes in the NPV and IRR are observed. • Consider an example as below. Suppose you are a financial
manager of Naveen Flour Mills. Naveen is considering
setting up a new floor mill. The project staff has developed
the data as beow. Assumed cost of capital as 12%.
5 / 29
3. Sensitivity Analysis
Cash Flow Forecast for Naveen’s Flour Mill Project
Rs. in
thousands Year 0 Year 1 - 10
1. Investment (20,000)
2. Sales 18,000
3. Variable costs (66⅔% 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
5 / 29
3. Sensitivity Analysis
Since the cash flow from operations is an annuity, the NPV of
this project is
-20,000,000 + 4,000,000 x PVIFA(12%, 10 years)
= -20,000,000 + 4,000,000 x 5.65 = 2,600,000
The NPV based on the expected values looks positive. The
underlying variables can vary widely and we would like to
see the effect of such variations on the NPV. So we define
the optimistic and pessimistic estimates of the underlying
variables. These are shown in LHS column of the table
below. The NPV is calculated for the optimistic and
pessimistic values of the underlying variables. To do this,
vary one variable at a time.
5 / 29
3. Sensitivity Analysis
Sensitivity of NPV to Variations in the Value of Key Variables
Rs. in
millionRange NPV
Key Variable Pessimistic Expected Optimistic Pessimistic Expected Optimistic
Investment 24 20 18 -0.65 2.6 4.22
Sales 15 18 21 -1.17 2.6 6.4
Variable cost
as a % of sales
70 66.67 65 0.34 2.6 3.73
Fixed costs 1.3 1 0.8 1.47 2.6 3.33
5 / 29
3. Sensitivity Analysis
-2
-1
0
1
2
3
4
5
6
7
NP
V in
Rs.
mil
lion
s
0Base
Change from Base
Sales
InvestmentVariable costsFixed costs
5 / 29
3. Sensitivity Analysis
Sensitivity analysis is a very popular method for assessing
risk. It has certain merits.• It shows how robust or vulnerable a project is to the
changes in values of the underlying variables.• It indicates where further work may be done. If the NPV is
highly sensitive to changes in some factor, it may be
worthwhile to explore how the variability of that critical
factor may be contained.• It is intuitively very appealing as it articulates the
concerns that project evaluators normally have.
5 / 29
3. Sensitivity Analysis
Sensitivity analysis also have some shortcomings.• It merely shows what happens to NPV when there is a
change in some variable, without providing any idea of
how likely that change will be.• Typically, in sensitivity analysis, only one variable is
changed at a time. In the real world, however, variables
tend to move together.• It is inherently a very subjective analysis. The same
sensitivity analysis may lead one decision maker to accept
the project while another may reject it.
5 / 29
4. Scenario Analysis
• In Scenario Analysis, several variables are varied
simultaneously (whereas in sensitivity analysis, one
variable is varied at a time). Most commonly, three
scenarios are considered: expected (or normal) scenario,
pessimistic scenario and optimistic scenario.• In normal scenario, all variables assume their expected (or
normal values). In the pessimistic scenario, all variables
assume their pessimistic values and in the optimistic
scenario, all variables assume their optimistic values.
The NPVs of the project of Naveen Flour Mills under three
scenarios are calculated as below.
5 / 29
4. Scenario Analysis
Pessimistic, Normal and Optimistic Scenario Rs. in
millionPessimistic Scenario
Expected Scenario
Optimistic Scenario
1. Investment 24 20 182. Sales 15 18 213. Variable costs 105 (70%) 12 (66⅔%) 13.65 (65%)4. Fixed costs 1.3 1 0.85. Depreciation 2.4 2 1.86. Pre-tax profit 0.8 3 4.757. Taxes 0.27 1 1.588. Profit after taxes 0.53 2 3.179. Annual cash flow from operation 2.93 4 4.9710. NPV = (9) x PVIFA(12%, 10yrs) - (1)
(7.45) 2.6 10.06
5 / 29
4. Scenario Analysis
Scenario Analysis may be regarded as an improvement over sensitivity analysis, however it has some limitations.
• It is based on the assumption that there are few well-delineated scenarios. This may not be true in many cases. For example, the economy does not necessarily lie in three discrete states, namely, recession, stability and boom. In fact, it can be anywhere on the continuum between the extremes. When a continuum is converted into three discrete states some information is lost.
• Scenario analysis expands the concept of estimating the expected values. Thus in a case where there are 10 inputs, the analyst has to estimate 30 expected values to do the scenario analysis.
5 / 29
4. Decision Tree Approach
Decision tree approach is based on the concept of tree and branches and to take a better decision.
Steps in Decision Tree Analysis• Delineate (draw) the Decision Tree• Evaluate the alternativesDelineate the Decision Tree• Draw the decision points (typically represented by
squares), the alternative options available for experimentation and action at these points and the investment outlays associated with these options.
• Draw the chance points (typically represented by circles) where outcomes are dependent on the chance process, the likely outcomes at these points along with the probabilities and the monetary values associated with them.
5 / 29
4. Decision Tree Approach
Evaluate the Alternatives• Start at the right hand end of the tree and calculate the
NPV at various chance points that come first as you
proceed leftward.• Given the NPVs of chance points in step above, evaluate
the alternatives at the final stage decision points in terms
of their NPVs.• At each final stage decision point, select the alternative
which has the highest NPV and truncate the other
alternatives. Each decision point is assigned a value equal
to the NPV of the alternative selected at that decision
point.
5 / 29
4. Decision Tree Approach
• Proceed backward (leftward) in the same manner,
calculating the NPV at chance points, selecting the
decision alternative which has the highest NPV at various
decision points, truncating inferior decision alternatives
and assigning NPVs to decision points, till the first
decision point is reached.
5 / 29
4. Decision Tree Approach
Decision Tree
D1
C1
-Rs. 20 million
D2
C1
P=0.6
P=0.4
30 million
40 million
5 / 29
6. Risk Adjusted Discount Rate versus Certainty Equivalents
• Most firms use Risk-Adjusted Discount Rate. • It is a discount rate that applies to particularly risky
stream of income.• It is equal to the risk-free rate of interest plus a risk
premium.
5 / 29
9. Capital Rationing
• A situation in which a constraint is placed on the total size
of the firm’s capital investment.