Chapter Four: Risk Analysis for Single Investment

4.1. Sources, Measures and Perspectives on Risk

Sources of Risk:
Risk refers to the uncertainty that the actual return the investor realizes will differ from the
expected return. The sources of this variability in returns are often differentiated into two types
of risk: systematic and unsystematic risk.
Systematic risk refers to those factors that affect the returns on all comparable investments. For
example, when the market as a whole rises, the prices of most individual securities also rise.
There is a systematic relationship between the return on a specific asset and the return on all
other assets in its class (i.e., all other comparable assets). Because this systematic relationship
exists, diversifying the portfolio by acquiring comparable assets does not reduce this source of
risk; thus, systematic risk is often referred to as nondiversifiable risk. While constructing a
diversified portfolio has little impact on systematic risk, you should not conclude that this
nondiversifiable risk cannot be managed.
Unsystematic risk, which is also referred to as diversifiable risk, depends on factors that are
unique to the specific asset. For example, a firm’s earnings may decline because of a strike.
Other firms in the industry may not experience the same labor problem, and thus their earnings
may not be hurt or may even rise as customers divert purchases from the firm whose operations
are temporarily halted. In either case, the change in the firm’s earnings is independent of factors
that affect the industry, the market, or the economy in general. Because this source of risk
applies only to the specific firm, it may be reduced through the construction of a diversified
portfolio.
Therefore, the total risk the investor bears consists of unsystematic and systematic risk.
So, the total risk of investments can be measured with such common absolute measures used in
statistics as:
• Variance, and
• Standard deviation.

Investment Management: Chapter Four: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.
 Total    Risk

Unsystematic Risk Systematic Risk

(Diversifiable) (Nondiversifiable)

Busines Market Interest Reinvest Purchasing

Financial Exchang
s Risk Rate Risk ment Risk Power Risk
Risk Risk e Rate
Risk

Figure 4.1. Sources of risk

4.2. Techniques for Risk Analysis

You have learned the capital budgeting techniques in Financial Management assuming that the
proposed investment projects do not involve any risk. In real world situation, however, the firm
in general and its investment projects in particular are exposed to different degrees of risk. Risk
exists because of the inability of the decision-maker to make perfect forecasts. Forecasts cannot
be made with perfection or certainty since the future events on which they depend are uncertain.
An investment is not risky if, we can specify a unique sequence of cash flows for it. But the
whole trouble is that cash flows cannot be forecast accurately, and alternative sequence of cash
flows can occur depending on the future events. Thus, risk arises in investment evaluation
because we cannot anticipate the occurrence of the possible future events with certainty and
consequently, cannot make any correct prediction about the cash flow sequence. NPV
estimation depends on projected future cash flows. If there are errors in those projections, then
our estimated NPVs can be misleading. We called this possibility forecasting risk.

Risk analysis is one of the most complex and slippery aspects of investment. Many different
techniques have been suggested to handle risk in investment/ capital budgeting. Amongst the
techniques we are going to discuss on the following:
 Sensitivity Analysis

Investment Management: Chapter Four: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.
  Scenario Analysis
 Break-even Analysis
 Hiller Model
Sensitivity Analysis- A risk analysis technique in which key variables are changed one at a time
and the resulting changes in the NPV are observed. Or sensitivity analysis is a technique that
indicates how much NPV will change in response to a given change in an input variable, other
things held constant.

Sensitivity analysis begins with a base-case situation, which is developed using the expected
values for each input. In the evaluation of an investment project, we work with the forecast of
cash flows. Forecasted cash flows depend on the expected revenue and costs. Further, expected
revenue is a function of sales volume and unit selling price. Similarly, sales volume will depend
on the market size and the firm’s market share.

Costs include variable costs, which depend on sales volume, and unit variable cost and fixed
costs. The NPV or IRR of a project is determined by analyzing the after-tax cash flows arrived at
by combining forecasts of various variables. It is difficult to arrive at an accurate and unbiased
forecast of each variable. We can’t be certain about the outcome of any of these variables.
The reliability of the NPV or IRR of the project will depend on the reliability of the forecasts of
variables underlying the estimates of net cash flows. To determine the reliability of the project’s
NPV or IRR, we can work out how much difference it makes if any of these forecasts goes
wrong. We can change each of the forecasts, one at a time, to at least three values: Pessimistic,
Expected and Optimistic. The NPV of the project is recalculated under these different
assumptions. This method of recalculating NPV or IRR by changing each forecast is called
sensitivity analysis.
Sensitivity analysis is a way of analyzing change in the project’s NPV for a given change in one
of the variables. It indicates how sensitive a project’s NPV is to changes in particular variables.
The more sensitive the NPV, the more critical is the variable. The decision-maker, while
performing sensitivity analysis, computes the project’s NPV for each forecast under three
assumptions: Pessimistic, Expected and Optimistic. It allows him to ask “what if” questions.
For example, what is the NPV if investment increases or decrease? What is the NPV if volume of
sales increases or decrease? What is the NPV if variable cost or fixed cost increases or

Investment Management: Chapter Four: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.
decreases? A whole range of questions can be answered with the help of sensitivity analysis. It
examines the sensitivity of the variables underlying the computation of NPV or IRR, rather than
attempting to quantify risk.
Case - 1
You are the financial manager of ABC Flour Mills. ABC is planning to set up a new flour mill.
Your project staff has developed the following cash flow forecast for the new Flour Mill project.
(Note that the salvage value has been assumed to be nil).
Cash flow forecast for ABC’ s Flour Mill Project
($ in ‘000’)
Year 0 Years 1 - 10
Investment ………………………………………. ($20000)
Sales ………………………………………………………………. $18,000
Variable cost (66.67% of sales)…………………………………….. 12,000
Fixed cost …………………………… …………………………… …1,000
Depreciation …………………………………………………………. 2,000
Pre-tax profit ………………………………………………………. …3,000
Taxes ………………………………………………………………….1, 000
Profit after tax ……………………………………………………….. 2,000
Cash flow from operations …………………………………………... 4,000
Net cash flow ………………………………………………………… 4,000
What is the NPV of the new flour mill project? Assuming that the cost of capital is 12 percent.
The range of values that the underlying variables can take is shown below:
Underlying Variables Pessimistic Expected Optimistic
Investment……………... $24000 $20000 $18000
Sales …………………… 15000 18000 21000
VC as a % of sales………. 70 66.67 65
Fixed cost ………………. 1300 1000 800
Required: Calculate the sensitivity of NPV to variations in last
(a) Investment (b) Sales (c) Variable cost and (d) Fixed cost.

Investment Management: Chapter Four: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.
Scenario Analysis
A risk analysis technique in which “bad” and “good” sets of financial circumstances are
compared with a most likely, or base-case, situation. In sensitivity analysis, typically one
variable is varied at a time. In scenario analysis, several variables are varied simultaneously,
three scenarios are considered: Expected, Pessimistic, and Optimistic scenario.
Scenario analysis brings in the probabilities of changes in the key variables, and it allows us
to change more than one variable at a time. In a scenario analysis, the financial analyst begins
with the base case, or most likely set of values for the input variables. Then, he or she asks
marketing, engineering, and other operating managers to specify a worst-case scenario (low
unit sales, low sales price, high variable costs, and so on) and a best-case scenario (an
analysis in which all of the input variables are set at their best reasonably forecasted values).
Note: In the expected scenario, all variables assume their expected values; in the pessimistic
scenario, all variables assume their pessimistic values; and in the optimistic scenario all variables
assume their optimistic values.
Case-2: Required: - Calculate NPV of the project of ABC new flour mill under pessimistic,
expected and optimistic scenario by using the above case (case -1).
Break-even Analysis
In sensitivity analysis we ask what will happen to the project if sales decline or costs increase or
something else happens. As a financial manager, you will also be interested in knowing how
much should be produced and sold at a minimum to ensure that the project does not ‘lose
money’. Such an exercise is called break-even analysis and the minimum quantity at which loss
is avoided is called the break-even point.
The break-even point may be defined in accounting terms or financial terms.
Accounting Break-Even Point
The accounting break-even point is simply the sales level that results in a zero project net
income.
Cash Break-Even Point
The sales level that result in a zero operating cash flow.
Financial Break-Even Point
The sales level that result in a zero NPV.

Investment Management: Chapter Four: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.
Case-3: Required: - Calculate the accounting breakeven point and financial break-even point
referring to the case study – 1.
Hiller Model
The probability distribution of cash flows over time provides valuable information about the
expected value of return and the dispersion (standard deviation) of the probability distribution of
possible return.
The expected NPV and the standard deviation of NPV can be described about the riskiness of an
investment project. Under certain circumstances, the expected NPV and the standard deviation
of NPV may be obtained through analytical derivation as suggested by F.S. Hiller. Two cases of
such analysis are discussed here:
1. No correlation among cash flows, and
2. Perfect correlation among cash flows.
Once this analysis is completed by developing relevant information about the expected value
and dispersion of the probability distribution of possible return, the decision-maker will make
accept-reject decision. This he/she would do by obtaining a trade-off between risk and return.
He/ She would select those projects which yield the highest expected return, but at the same time
minimize risk to the firm.
Uncorrelated cash flows: (Independent) When cash flows of different years are uncorrelated,
the cash flow for year‘t’ is independent of the cash flow for year t - n. Put differently, there is no
relationship between cash flows from one period to another. In this case the expected NPV and
standard deviation of NPV are defined as follows:
NPV =
Perfect correlated cash flows: (Dependent) if cash flows are perfectly correlated, the behavior
of cash flows in all periods is alike.
This means that if the actual cash flow in one year is α standard deviations to the left of its
expected value, cash flows in other years will also be α standard deviations to the left of their
respective expected values. Put in other words, Cash flows of all years are linearly related to one
another.
The expected value and the standard deviation of net present value, when cash flows are
perfectly correlated, are as follows:
NPV=

Investment Management: Chapter Four: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.
Case – 4
A project involving an outlay of $10,000 has the following benefits associated with it.
Year – 1 Year – 2 Year – 3
Cash flow Probability Cash flow Probability Cash flow Probability
$3,000 0.3 $2,000 0.2 $3,000 0.3
5,000 0.4 4,000 0.6 5,000 0.4
7,000 0.3 6,000 0.2 7,000 0.3
Assume that the cash flows are independent and also assume that risk-free interest rate is to be 6
percent.
Required: - Calculate the expected net present value and the standard deviation of net present
value.
Case-5
An investment project involves a current outlay of $10,000. The mean and standard deviation of
cash flows, which are perfectly correlated, are as follows:
Year Expected cash flows Standard deviation of cash flows
1 $5,000 1,500
2 3,000 1,000
3 4,000 2,000
4 3,000 1,200
Assuming a risk-free interest rate of 6 percent.
Required: - Calculate the expected net present value and the standard deviation of net present
value.
4.3. Managing Risk
Managers are not merely content with measuring risk. They want to explore ways and means of
mitigating risk. Some of the ways of doing this are discussed below. These risk reduction
strategies have a cost associated with them whether they are profitable in a given situation will
depend on circumstances.
 Fixed and variable costs

 Pricing strategy

 Sequential investment

 Improving information

Investment Management: Chapter Four: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.
  Financial leverage

 Insurance

 Long-term arrangements

 Strategic alliance

 Derivatives

Investment Management: Chapter Four: DBU, CBE, Dep’t of Accounting & Finance, By Mamaru G.