SV NOTES

DEPARTMENT OF COMMERCE
STUDY MATERIAL

For

III BCOM VI SEMESTER

ADVANCED FINANCIAL MANAGEMENT

(AS PER NEP SYLLABUS)

Module No. 2: Risk Analysis in Capital Budgeting

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 Module No. 2: Risk Analysis in Capital Budgeting
Risk Analysis – Types of Risks – Risk and Uncertainty – Techniques of SAGARA VANA.S
Measuring Risks– Risk adjusted Discount Rate Approach – Certainty Lecturer in commerce
Equivalent Approach – Sensitivity Analysis -Probability Approach - Mob:99866-36693
Standard Deviation and Co-efficient of Variation –Decision Tree
Analysis – Problems.

Risk Analysis in Capital Budgeting

Capital budgeting decisions are based on estimations of future cash flows.Such estimations cannot be
made with 100% certainty. Therefore, uncertainty is associated with such estimations. Such
uncertainty leads to risk. Capital Budgeting decisions are based on the existence of risk and
uncertainty.

The risk can be broken up into three types

1. Certainty: It is a situation where the returns are assured and no variability likely to occur in future
returns. For example investment in Government bonds. fixed deposits in a nationalized bank.
2. Uncertainty: It is a situation where infinite number of outcomes are possible and probabilities can
not be assigned. ' ,
3. Risk: Risk is the variability that is likely, occur in future returns from the investment. In other
words, risk is a situation in which the probabilities of future cash flows occurring are known.

Types of Risks
➢ Markey risk
➢ Project specific risk
➢ Company specific risk
➢ Competition risk
➢ Interest rate risk
➢ Inflation risk
➢ Technology risk
➢ Regulatory and legal risk

Risk analysis
Risk analysis is the process of identifying and analyzing potential issues that could negatively impact
key business initiatives or projects. This process is done to help organizations avoid or mitigate those
risks.

Risk and Uncertainty

Capital Budgeting under risk and uncertainty refers to the process of making investment decisions
that involve an element of risk or uncertainty in the cash flows or the timing of the cash flows. In such
a scenario, traditional capital budgeting techniques such as payback period, accounting rate of return
(ARR), net present value (NPV), and internal rate of return (IRR) may not be sufficient to evaluate the
investment proposal. Therefore, capital budgeting under risk and uncertainty requires the use of more
sophisticated techniques that consider the probability of various outcomes and the impact of risk on
the investment decision

Techniques for Risk Analysis in Capital Budgeting

I. Statistical techniques of Risk Analysis
1. Probability Approach -
2. Standard Deviation
3. Coefficient of Variation
4. Decision Tree Analysis –

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 II. Conventional Techniques of Risk Analysis
5. Payback Period
6. Risk adjusted Discount Rate Approach –
7. Certainty Equivalent Approach –
III. Other techniques of Risk Analysis
8. Sensitivity Analysis -
9. Scenario Analysis

Techniques of Measuring Risks as per syllabus

1. Risk adjusted Discount Rate Approach –
2. Certainty Equivalent Approach –
3. Sensitivity Analysis -
4. Probability Approach -
5. Standard Deviation and
6. Co-efficient of Variation –
7. Decision Tree Analysis – Problems

Risk Adjusted Discount Rate/ cut off rate (RADR)

Risk Adjusted Discount Rate is based on the same logic as the net present value method. Under this
method, discount rate is adjusted in accordance with the degree of risk. That is, a risk discount factor
(known as risk-premium rate) is determined and added to the discount factor (risk free rate)
otherwise used for calculating net present value. For example, the rate of interest (r) employed in the
discounting is10 per cent and the risk discount factor or degrees of risk (d) are 2, 4 and 5 per cent for
mildly risky, moderately risky and high risk (or speculative) projects respectively then the total rate of
discount (D) would respectively be 12 per cent, 14 per cent and 15 .per cent.

PROBLEMS ON RISK ADJUSTED DISCOUNT RATE

1. From the following data, state which project is better?
Cash in flow
Year
Project: G Project: H
0 -20,000 -20,000
1 8,000 10,000
2 8,000 12,000
3 4,000 6,000
Risk less discount rate is 5%. Project G is less risky as compared to Project H. The management
considers risk premium rates at 5% and 10% respectively. Which project should be selected? Dr.VR
PALANIVELU

2. The Beta Company Ltd. is considering the purchase of a new investment. Two alternative
investments are available (A and B) each costing Rs. 1,00,000. Cash inflows are expected to be
as follows:
Cash in flow
Year
Investment A Investment B
1 40,000 50,000
2 35,000 40,000
3 25,000 30,000
4 20,000 30,000

The company has a target return on capital of 10%. Risk premium rates are 2% and 8% respectively
for investments A and B. Which investment should be preferred? SHASHI K GUPTA
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 3. A firm has two investment opportunity each costing ₹ 1,00,000 and each having the expected
profits as shown below:

Year Project A Project B

1 50,000 20,000
2 40,000 40,000
3 30,000 50,000
4 10,000 60,000

After giving due consideration to the risk factor in each project, the management is decided that
Project A should be evaluated at 10% cost of capital and Project B a risky project with 15% cost of
capital.
Compare the net present values and suggest the course of action for the management if:
A. Both the projects are independent
B. Both are projects are mutually exclusive

4. A company is considering a proposal to buy a machine for 35.000. The expected cash inflows
from the machine for a period of three consecutive years are 20,000 each. After the expiry of
the useful life of the machine, the estimated scrap value is 2,000. The firm's cost of capital is
10% and risk adjusted discount rate is 18%. Should the company accept the proposal of
purchasing the machine?

5. An enterprise is investing Rs.100, 000 in a project. The risk free rate of the project is 9%. the
risk premium expected by the management is 5%. The life of the project is 5 years following
are the cash flows that are estimated over the life of the project.

Year Cash flows

1 25,000
2 60,000
3 75,000
4 80,000
5 65,000

Calculate net present value of the activity based on the risk free rate & Risk adjusted discount rate
6. An enterprise is investing 100 lakhs in a project. The risk-free rate of return is 7%. Risk
premium expected by the Management is 7%. The life of the project is 5 years. Following are
the cash flows that are estimated over the life of the project:

Year Cash flows (in lakhs)

1 25
2 60
3 75
4 80
5 65

Calculate Net Present Value of the project based on Risk free rate and also on the basis of Risks
adjusted discount rate. ICAI

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Certainty-Equivalent Coefficient Approach
In this method, uncertain cash inflow are converted into certain cash inflow with the help of the
Certainty Equivalent co-efficient factor since certain cash inflow do not bear any risk , we use risk free
rate of discounting.

7. There are two projects X and Y. Each involves an investment of Rs. 40.000. The expected cash
inflows and the certainty coefficients are as under:
Year Project x Project y
Cash inflow Certainty coefficient Cash inflow Certainty coefficient
1 25,000 0.8 20,000 0.9
2 20,000 0.7 30,000 0.8
3 20,000 0.9 20,000 0.7

Risk-free cut off rate is 10%. Suggest which of the two projects should be preferred. SHASHI K GUPTA
/ Dr.VR PALANIVELU

8. If investment proposal cost Rs 45,00,000 and risk free rate is 5% calculate net present value
under certainty equivalent technique
Year Expected cash flows Certainty equivalent coefficient
1 10,00,000 0.90
2 15,00,000 0.85
3 20,00,000 0.82
4 25,00,000 0.78
ICAI

9. A project costs Rs. 6,000 and it has cash flow of Rs. 4,000, Rs. 3,000, Rs. 2,000 and Rs. 1,000 in 1
to 4 years. Assumed that the associated certainty equivalent coefficient factors (α) are,
estimated to be α0 = 1.00, α1 = 0.90, α2 = 0.70, α3 = 0.50, and α4= 0.30 and the risk free discount
rate is 10 1 percent. calculate net present value under certainty equivalent technique .Acharya
Nagarjuna University

10. A company employs certainty equivalent approach in the evaluation of risky projects. The
capital budgeting department of the company has estimated the following cash flows regarding
the new project.
Year Expected Cash Inflow Certainty Equivalent Co-efficient
1 90,000 0.8
2 80,000 0.6
3 70,000 0.7
4 65,000 0.8
5 45,000 0.9

The firm has the initial investment of₹ 1,10.000. The cost of equity capital of the company is 14%. The
cost of debt is 10% and the risk free rate of return is 7%. Should the project be accepted?

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 11. M/s Alpha Corporation is considering an investment in one of the two mutually proposal
Project A, which includes an initial outlay of ₹ 2,00,000 and Project B which has an outlay of
₹2,25,000. The certainty equivalent approach is employed in evaluating risky investments. The
current yield on treasury bills is 5% and the company uses risk free rate. The expected value of
net cash flows with their respective certainty equivalent are: -

Year Project -A Project -B

Cash Certainty Equivalent Cash Certainty Equivalent
inflow Co-efficient inflow Co-efficient
1 1,00,000 0.8 1,00,000 0.9
2 1,20,000 0.7 1,20,000 0.8
3 1,50,000 0.9 2,00,000 0.7

A. Which project should be accepted by the company?

B. Which project is more risky?

Sensitivity Analysis

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