Risk in Capital Budgeting

• Risk-adjusted Discount Rate

• Certainty Equivalent
• Sensitivity Analysis
• Scenario Analysis
• You are considering construction of an office building that you plan
to sell after one year for Rs4,00,000.
• Since the cash flow is uncertain, you discount at the risk-adjusted
discount rate of 12 percent rather than the 7 percent risk-free rate of
interest.
• This gives a present value of 400,000/1.12 = Rs357,143.
• Suppose a government department approaches and offers to fix the
price at which it will buy the building from you at the end of the year.
This guarantee would remove any uncertainty about the payoff on
your investment. So you would accept a lower figure than the
uncertain payoff of Rs400,000.
• But how much less?
• If the building has a present value of Rs357,143 and
the risk-free interest rate is 7 percent, then
• PV = Certain cash flow / 1.07 = Rs357,143
• Or, Certain cash flow = Rs382,143
• In other words, a certain cash flow of RsRs382,143
has exactly the same present value as an expected
but uncertain cash flow of Rs400,000.
• The cash flow of Rs382,143 is therefore known as
the certainty-equivalent cash flow.
• The above example illustrates two ways to value a risky
cash flow C1:
• Method 1: Discount the risky cash flow at the risk-
adjusted rate k* that is greater than rf. This method is
called as risk-adjusted discounted rate method.
• Method 2: Find the certainty equivalent cash flow and
discount the same using the risk-free interest rate rf.
When you use this method, you need to ask, What is the
smallest certain payoff for which I would exchange the
risky cash flow C1? This method is known as Certainty-
equivalent approach.
 Risk-adjusted Discount Rate

• The risk-adjusted discount rate method can be

formally expressed as follows:
• NPV = ∑ NCFt / (1+k)t
• where k is a risk-adjusted rate.
• That is:
• Risk-adjusted discount rate = Risk-free rate + Risk
premium
• k = kf + k r
• 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.
 ILLUSTRATION 12.
• An investment project will cost Rs.50,000 initially
and it is expected to generate cash flows in
years one through four of Rs.25,000, Rs20,000,
Rs.10,000 and Rs.10,000. What is the project's
NPV, if it is expected to generate certain cash
flows? Assume a 10 per cent risk-free rate. The
net present value for the project, using a 10 per
cent risk-free discount rate, is:
• NPV = -Rs.50,000 + Rs25,000/(1+0.1)+ Rs.20,000/(1+0.1)2+
Rs.10,000/ (1+0.1)3 + Rs10,000/ (1+0.1)4 = +Rs.3,599

• If the project is risky, then a higher rate should be used to allow for
the perceived risk. Assuming this rate to be 15 per cent, the net
present value of the project will be:

• NPV = -Rs.50,000 + Rs25,000/(1+0.15)+ Rs.20,000/(1+0.15)2+

Rs.20,000/ (1+0.15)3+ Rs.10,000/ (1+0.15)4 = - Rs845
• If a firm uses the IRR method, then to
allow for perceived risk of an investment
project, the IRR for the project should be
compared with the risk-adjusted minimum
required rate of return. If the IRR is higher
than this adjusted rate, the project would
be accepted, otherwise it should be
rejected.
 Certainty Equivalent
• The certainty-equivalent approach may be expressed as:
n
• NPV =
 (αt NCFt ) /(1+kf)t
t 0
…..(10)

• where, NCFt = the forecasts of net cash flow without

risk-adjustment
• α = the risk-adjustment factor or the certainty-equivalent
coefficient
• kf = risk-free rate assumed to be constant for all periods.
• The certainty-equivalent coefficient can be
determined as a relationship between the certain
cash flows and the risky cash flows. That is:

• αt = NCFt * /NCFt
• = Certain net cash flow / Risky net cash flow
• For example, if one expects a risky cash flow of
Rs.80,000 in period t and considers a certain
cash flow of Rs.60,000 equally desirable, then
αt, will be 0.75 = 60,000/80,000.
• ILLUSTRATION 13: A project costs Rs.6,000 and it has cash flows
of Rs.4,000, Rs.3,000, Rs.2,000 and Rs.1,000 in years 1 through 4.
Assume that the associated αt factors are estimated to be: αo = 1.00,
αl = 0.90, α2 = 0.70, α3 = 0.50 and α4 = 0.30, and the risk-free
discount rate is 10 per cent. The net present value will be:
• NPV=1.0(-6,000) + 0.9(4,000) / (1+0.10) + 0.7 (3,000) / (1+0.10)2
• +0.5(2,000) / (1+0.10)3 + 0.3(1,000) / (1+0.10)4
• = -Rs37
• If the IRR method is used, we will calculate that
rate of discount which equates the PV of
certainty-equivalent cash inflows with the PV of
certainty-equivalent cash outflows. The rate so
found will be compared with the minimum
required risk-free rate. Project will be accepted if
the IRR is higher than the minimum rate;
otherwise it will be rejected.
 Sensitivity Analysis

• Sensitivity analysis is a way of analysing change in the project’s

NPV (or IRR) for a given change in one of the variables. It indicates
how sensitive a project’s NPV (or IRR) is to changes in particular
variables. The more sensitive the NPV, the more critical is the
variable. The following three steps are involved in the use of
sensitivity analysis:
• (1)Identification of all those variables, which have an influence on
• the project’s NPV (or IRR).
• (2) Definition of the uderlying relationship between the variables.
• (3)Analysis of the impact of the change in each of the variables on
• the project’s NPV.
 Illustration

• The finance manager of XL Food Processing

Company is considering the installation of a
plant costing Rs10000 to increase its processing
capacity. The expected values of the underlying
variables are given in Table 1 and Table 2
provides the project’s after-tax cash flows over
its expected life of 7 years. Salvage value is
assumed to be zero.
 Table 1: Expected values of Variables

Variables
Investment (Rs) 10,000
Sales volume (unit) 1,000
Unit selling price (Rs) 15
Unit variable cost (Rs) 6.75
Annual Fixed costs (Rs) 4,000
Depreciation (WDV) 25%
Corporate tax rate 35%
Discount rate 12%
 Table 2: Net Cash Flows of the project

C0 C1 C2 C3 C4 C5 C6 C7

Investment -10,000
Revenue 15,000 15,000 15,000 15,000 15,000 15,000 15,000
variable cost 6,750 6,750 6,750 6,750 6,750 6,750 6,750
Fixed costs 4,000 4,000 4,000 4,000 4,000 4,000 4,000
Depreciation 2,500 1,875 1,406 1,055 791 593 1780
EBIT 1,750 2,375 2,844 3,195 3,459 3,657 2470
Tax 613 831 995 1,118 1,211 1,280 865
PAT 1,138 1,544 1,848 2,077 2,248 2,377 1605
NCF -10,000 3,638 3,419 3,255 3,132 3,039 2,970 3385
• The project’s NPV at 12 percent discount rate and IRR are as
follows:
• NPV = +4973
• IRR = 27.05%
• Since NPV is positive (or IRR > discount rate), the project can be
undertaken.

• Let us assume the pessimistic and the optimistic values for volume,
price and cost as shown in Table 3.
 Table 3: Forecasts Under Different Assumptions

Variable Pessimistic Expected Optimistic

Volume (unit) 750 1,000 1,250
Unit selling price (Rs) 12.75 15 16.50
Unit variable cost (Rs) 7.425 6.75 6.075
Annual fixed costs 4,800 4,000 3,200
• If we change each variable (others holding constant), the project’s NPVs are
recalculated in Table 4

• Table 4: Sensitivity Analysis Under Different Assumptions

Variable NPV (Pessimistic) NPV (Expected) NPV (Optimistic)

Volume Unit -1,146 4,973 10,000

selling price -1,702 4,973 9,422
Unit variable cost 2,970 4,973 6,975
Annual fixed costs 2,599 4,973 7,346

• The most critical variables are sales volume and unit selling price.
• If the volume declines by 25%, NPV becomes negative (-Rs1146).
• Similarly if the net selling price falls by 15%, NPV is minus Rs1,702
 SCENARIO ANALYSIS

• Table 5: Scenario Analysis: Summary Report

Scenario summary Base Pessimistic Optimistic Expected
values

Variable combinations:
Sales volume (unit) 1,000 750 1,250 1,250
Selling price / unit (Rs) 15.00 12.75 16.50 13.50
Variable cost/unit (Rs) 6.75 7.43 6.75 7.10
Fixed cost 4,000 4,800 3,200 4,400
Results:
NPV (Rs) 4,972 -10,038 19,026 3,044