RISK ANALYSIS OF A PROJECT

 Sources, measures and perspectives on risk

 Sensitivity analysis
 Scenario analysis
 Break-even analysis
 Hillier model
 Simulation analysis
 Decision tree analysis
 How financial institutions analyse risk
4S

 SENSITIVITY ANALYSIS
 SCENARIO ANALYSIS
 SIMULATION ANALYSIS
 STRATEGIC ANALYSIS
 SOCIAL COSTS AND BENEFIT ANALYSIS
(SCBA)
SOURCES OF RISK

 Project-specific risk
 Competitive risk
 Industry-specific risk
 Market risk
 International risk
MEASURES OF RISK

 Range
 Standard deviation
 Variance
 Coefficient of variation
 Semi-variance
 Semi-standard deviation
Standard deviation
PERSPECTIVES ON RISK

 Stand-alone risk
 Firm risk
 Systematic risk

 Focus on stand-alone risk

 SENSITIVITY ANALYSIS
(r=12%) (Rs. In ‘000)
Year 0 Years 1-10
1. Investment (20,000)
2. Sales 18,000
3. Variable costs 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
SENSITIVITY ANALYSIS…………

 NPV positive for the expected values of the

underlying variables
 Which can vary widely
 Effect on NPV
 Do sensitivity analysis to variations in the
value of key variables
 Vary one variable at a time
 Define the optimistic and pessimistic
estimates for the underlying variables
 RS. IN
MILLION

range NPV

Key variable pessimistic expected optimistic pessimistic expected optimistic

INVESTMENT 24 20 18 -0.65 2.60 4.22

SALES 15 18 21 -1.17 2.60 6.40

VARIABLE 70 66.66 65 0.34 2.60 3.73

COSTS AS A
PERCENT OF
SALES

FIXED COSTS 1.3 1.0 0.8 1.47 2.60 3.33

EVALUATION OF SENSITIVITY
ANALYSIS
 Vulnerability analysis
 Critical analysis
 Intuitive articulation
 Likelihood of change
 Departs from reality
 Subjective analysis
SCENARIO ANALYSIS

 Underlying variables are interrelated

 Representation of scenarios reflecting

consistent combination of variables
PROCEDURE

 Factor selection- uncertainty

 Estimating the values of each of the variables
 Complete investment analysis
 Calculating NPV in each scenario
SCENARIOS

 Moderate appeal to customers across the

board
 Strong appeal to a large segment of the
market
 Appeal to a small segment of the market
 (Rs. In million)
Scenario 1 Scenario 2 Scenario 3
Initial investment 200 200 200
Unit selling price (in 25 15 40
rupees)
Demand (in units) 20 40 10
Revenues 500 600 400
Variable costs 240 480 120
Fixed costs 50 50 50
Depreciation 20 20 20
Pre-tax profit 190 50 210
Tax @ 50% 95 25 105
Profit after tax 95 25 105
Annual cash flow 115 45 125
Project life 10 years 10 years 10 years
Salvage value 0 0 0
Net present value 377.2 25.9 427.4
OBJECTIVE

 Best and worst case analysis

 Assessing the most favourable or the most
adverse configuration of key variables
 Internal consistency of such configurations
not given due importance
EVALUATION OF SCENARIO
ANALYSIS
 Improvement over sensitivity analysis
 Integration of number of variables
 Few well-delineated scenarios
 Information asymmetry from continuum to
discrete states
 Expanding the concept of estimating the
expected values
BREAK-EVEN ANALYSIS

 Quantum to be produced and sold at a

minimum
 Ensuring no “lose money”
 Defining break-even point in accounting
terms or financial terms
 ACCOUNTING BREAK-EVEN ANALYSIS
 (Rs. In ‘000)

Year 0 Years 1-10

1. Investment (20,000)

2. Sales 18,000

3. Variable costs 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

 RS. IN MILLION

SALES 9

VARIABLE COSTS 6

FIXED COSTS 1

DEPRECIATION 2

PROFIT BEFORE TAX 0

TAX 0

PROFIT AFTER TAX 0

ACCOUNTING BREAK-EVEN
ANALYSIS

 Stock that gives you return of zero per cent

 Getting back original investment
 Not compensated for time value of money
 Not compensated for that risk you bear
 Not compensated for forgoing the
opportunity cost of your capital
 Go for financial break-even analysis- NPV