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Risk Analysis: Presented By:-Girish Arora 74 Sec-B PGDM 2009-2011
Risk Analysis: Presented By:-Girish Arora 74 Sec-B PGDM 2009-2011
Presented By:-
GIRISH ARORA
74
Sec-B
PGDM 2009-2011
• Risk is a possibility of incurring loss or misfortune.
• Every project is linked with certain amount of risk.
• Research and development project is more risky than
an expansion project.
• Thus a need arises for the calculation of the amount
of risk concerned with the projects.
• Risk analysis comprises of various tools for
determining the risk associated with project.
• No single technique or tool may be suggested as the
best tool.
• The two broad categories of techniques used for risk
analysis:
– Technique considering stand alone risk of a project.
– Technique that considers the risk of project in context
to the firm and market.
Stand-Alone risk of project
• Various techniques that consider stand alone
risk of project are:-
– Sensitivity analysis
– Scenario analysis
– Break-Even analysis
– Hillier model
– Simulation analysis
– Decision tree analysis
SENSITIVITY ANALYSIS
• Future is uncertain, this leads to risk with a
project.
• What a manager wants to know?
– Manager wants to know the viability of the project when
some variables like sales or investment deviates from their
expected values.
Sensitivity analysis is thus a technique of systematically
changing parameters in a model to determine the effect of such
changes.
This method is part of capital budgeting decisions.
• Example solved 11.2 Prasanna chandra 6th edition
Financial manager of Naveen flour mills considers of setting up of new
floor mill in Bangalore. The project staff has developed the following
figures of cash flows. Determine the NPV of the project and find out the
sensitivity analysis with the deviations in key variables from the
expected values.
Figure in Rs ‘000
Year 0 Year 1-10
Investment (20000)
Sales 18000
Variable costs(200/3 % of sales) 12000
Fixed costs 1000
Depreciation 2000
Pre-Tax Profit 3000
Taxes 1000
Profit after taxes 2000
Net cash flow (20000) 4000
• Sensitivity of NPV to variations
RANGE(Rs in ‘000)
Key Variable Pessimistic Expected Optimistic
Investment 24000 20000 18000
Sales 15000 18000 21000
PVIFA=5.650
NPV= -20000000+4000000*5.650
NPV=2600000
NPV= -24000000+4133000*5.65
NPV= -648550
Thus the effect, of varying the key variables, on NPV can be easily
assessed. The financial manager thus gets to know whether to carry on
with the project under different circumstances.
• Example: unsolved question No. 1 prasanna chandra 6th edition
you are financial manager of HEPL. HEPL is planning to set up an extrusion plant
at Indore. Your project staff has developed the following cash flow forecast for the
project. Rs in million
Year 0 Year 1-10
Investment (250)
Sales 200
Variable costs(60 % of sales) 120
Fixed costs 20
Depreciation 25
Pre-Tax Profit 35
Taxes 10
Profit after taxes 25
Net cash flow (250) 50
Determine the NPV of the project and calculate the effect of variations
in the values of underlying variables on NPV.
RANGE(Rs in million)
Underlying Pessimistic Expected Optimistic
Variable
Investment 300 250 200
Sales 150 200 275
Variable Costs 65 60 56
as percent of
sales
Fixed Costs 30 20 15
NPV= -250+50*5.426
NPV= 21.312
RANGE(Rs in ‘000) NPV
Key Pessimisti Expected Optimis Pessimist Expecte Optimis
Variabl c tic ic d tic
e
Invest 300 250 200 -20.95 21.31 63.55
ment
Sales 150 200 275 -56.21 21.31 137.58
Variabl 65 60 56 -17.46 21.31 52.31
e Costs
as
percent
of sales
Fixed 30 20 15 -17.46 21.31 40.68
Costs
The variable costs on three scenarios are 48%, 80%, 30% respectively.
Taxes are paid at a rate of 50%
Depreciation occurs at 10% and project life cycle is of 10 years and
salvage value is 0.
It is also given that the Discounting Rate is15%.
Scenario 1 Scenario 2 Scenario 3
Initial Investment 200 200 200
Unit S.P(Rs) 25 15 40
Demand(in units) 20 40 10
Revenues 500 600 400
Variable costs 240 (48% of sales) 480(80%) 120(30%)
Fixed costs 50 50 50
Depreciation(10%) 20 20 20
Pre-Tax profit 190 15 210
Tax@50% 95 25 105
Profit after Tax 95 25 105
Annual Cash flow 115 45 125
Net Present Value 377.2 25.9 427.4
Thus scenario analysis helps to understand the effect on NPV when the
variables change in correlation.
BEST AND WORST CASE ANALYSIS
The scenarios developed in previous example are most commonly
occurring situations where high selling price and low demand go hand in
hand. But managers try another kinds of scenario analysis called the best
and worst case analysis.
Worst Scenario: The scenario is considered worst when the product has
low demand, low selling price, high variable costs.
Where,
is expected cash flow for year t,
i is risk-free interest rate,
I is initial outlay
The cash flows for the project involving outlay of Rs 10000 are as
follows: Year 1 Year 2 Year3
Net cash Probabilit Net cash Probabilit Net cash Probabilit
flow y flow y flow y
Rs 3000 .3 2000 .2 3000 .3
Calculate the NPV and σ(NPV) for the project when the risk free interest
rate i=6%
We
know,
NPV
σ(NPV)=
1/2
σ(NPV)=
1/2
σ(NPV)= = Rs 2258
Question No. 3 unsolved exercise Prasanna chandra 6th edition(projects)
A project involving an initial outlay of Rs 10 million has the following
benefits associated with it:
Year 1 Year 2 Year3
Net cash Probabilit Net cash Probabilit Net cash Probabilit
flow (Rs y flow y flow y
in mln)
4 .4 5 .4 3 .3
5 .5 6 .4 4 .5
6 .1 7 .2 5 .2
Assume that the cash flows are independent. Calculate the expected NPV
and standard deviation of NPV. Risk free interest rate=10%
Solution
Year 1 Year 2 Year3
Net cash Probabilit Net cash Probabilit Net cash Probabilit
flow (Rs y flow y flow y
in mln)
4 .4 5 .4 3 .3
5 .5 6 .4 4 .5
6 .1 7 .2 5 .2
At 4.7 At 5.8 At 3.9
The NPV
NPV+
NPV= Rs 2 million
σ(NPV)=
σ(NPV)=
σ(NPV)= Rs 1 million
Correlated cash flows
σ(NPV)=
Where,
is expected cash flow for year t,
I is risk-free interest rate,
I is initial outlay
The investment project has an initial outlay of Rs 10000. The mean and
standard deviation of cash flows which are perfectly correlated are as,
Year At σt
1 5000 1500
2 3000 1000
3 4000 2000
4 3000 1200
Determine the NPV and σ(NPV) of the project when the risk free interest
rate=6%.
The NPV
NPV=+
NPV=Rs 3121
σ(NPV)=
σ(NPV)=++
σ(NPV)=Rs 4935
Example unsolved question No. 4 prasanna chandra 6th edition ch. 11
Janakiram is considering an investment which requires a current outlay
of Rs 25000. the expected value of cash flows and standard deviations of
cash flows are:
Year At σt
1 12000 5000
2 10000 6000
3 9000 5000
4 8000 6000
The cash flows are perfectly correlated. Calculate the expected value of
NPV and standard deviation of NPV of this investment. Risk free interest
rate is 8%.
Solution
The NPV
NPV=+
NPV=32709-25000
NPV=Rs 7709
σ(NPV)=
σ(NPV)=++
σ(NPV)=Rs 18153