Certified Finance Specialist

Class 2 : Project Appraisal

Sensitivity Analysis and Capital Rationing

1 What is risk and uncertainty

and why does it arise?

Risk:

several possible outcomes

Based on past relevant experiences

Quantifiable

Example: A risky situation there is a 70% probability that returns from a

project will be in excess of $100,000 but a 30% probability that returns will be
less than $100,000.

Uncertainty:

several possible outcomes

little past experience

difficult to quantify its likely effects

Example: no information can be provided on the returns from the project, we

are faced with an uncertain situation.

Future cannot be predicted accurately

Sensitivity of:

Initial Investment:

Sales Volume:

PV of net cash flow / PV of cash inflows x 100%

Variable costs:

PV of net cash flow / PV (cash inflows variable costs) x 100%

Selling price:

PV of net cash flow / PV of initial investment x 100%.

PV of net cash flow / PV of variable costs x 100%

Cost of capital:

IRR

Sensitivity: Difference between COC & IRR

Example 1

A company is considering a project with the following cash

flows.

Example 2

Step 1

Year

PV of initial
investment
(7,000)

PV of variable
costs

PV of cash
inflows

(7000 * 1)

PV of net
cash flow
(7,000)

6,500 * 0.926
1

[2000 * 0.926]
[2,000 * 0.857]

(7,000)

(1,852)

6,019

4,167

6,500 * 0.857
(1,714)

5,571

3,857

(3,566)

11,590

1,024

Step 2
Cash flows

Formula

Initial
investment

PV of net cash flow

x 100%
PV of initial investment .

Sales volume
Selling price
Variable costs

Cost of capital

PV of net cash flow

100%
PV (cash inflows variable costs)

PV of net cash flow

x 100%
PV of cash inflows
PV of net cash flow
x 100%
PV of cash inflows

Sensitivity
1,024/7,000 100% = 14.6%.
($1,024/$8,024) 100% = 12.8%
($1,024/$11,590) 100% = 8.8%.
($1,024/$3,566) 100% = 28.7%
The cost of capital can therefore
increase from 8% to over 18%
before the NPV becomes
negative

Weaknesses of
Sensitivity Analysis

Changes in two or more variables can not be analysed

as each key variable are isolated.

Unrealistic since they are often interdependent.

Sensitivity analysis does not examine the probability

that any particular variation in costs or revenues
might occur.

Critical factors may not be controlled by managers

Parameters defining acceptability must be laid down

by managers thus in itself it does not provide any
decision rule.

Risk and scenario

analysis

Stages involved in company specific risk analysis:

1.

Risk identification specific to the project

2.

Risk analysis frequency; consequences of occurrence

3.

Risk mitigation reducing frequency, adverse consequences, costs

of possible mitigation. Selection of best combination

4.

Residual risk accept; include in final report

Risk and scenario

analysis
Controlling Residual risks
MEASURES:

Appointment of risk custodians

Plans for dealing with foreseeable and unforeseeable

crises

Regular monitoring of the risks

Regular management reviews

Identifying risks
Risk matrix
Inherent risks
/risk factors
Promotion of concept
Design
Failure to meet
specified
standards
Professional
negligence
Contract negotiations,
Project approval,
Raising of capital,
Construction
Operation and
maintenance
Receiving revenues

Politi
cal

Business

Economic

Project

Natural

Financial

Crime

Identifying risks Risk matrix

Risk and scenario

analysis

Risk and scenario analysis

Decision
Scenario
Various
NPV
consequences
combinations
analysis
tree

NC

PO

Sa

NC

Risk
Nature:
Discrete

NC

Sa

PO

Sa

NC=
NPV
consequen
ces
PO=

PO

Occurrence

Scenario
Analysis

Decision
tree

Probability of

ds
o
th
Me

Risk Nature:
Continuous

computer
based
stochastic
modeling
1

Distribution of
possible NPVs

Pitfalls of building a stochastic

model despite superior than
scenario analysis1

Many assumptions

Difficult to understand

Costs involved

Confusions from output

Loose sight of key factors

SUMMARY

Project analysis

Decision
tree

Appraisal methods

Scenario analysis

Probability distribution
of NPVs

Stochastic
modeling

Transfe
r

Sales

Profitabil
ity
Etcs

Risk
mitigatio
ns
Avoi
d

NPVS

Costs

Accept /
Retentio
n

Redu
ce

Risk Mitigation (TARA)

Transfer:

To 3rd party

Contractually (e.g. Insurance)

Hedging (offsetting derivative positions)

Avoid:

Terminate project

E.g. contracts with several contingencies; not buying

businesses potential tax consequences

Potential return / profit lost

Risk Mitigation (TARA)

Reduction:

Undertake projects

Reduce risk to acceptable limit (risk appetite)

Establishment of systems (ABB, ABC, etcs.)

E.g. fire alarms, sprinkler systems, etcs.

Accept / retention:

Cannot be avoided/transfer

E.g. insurance cost high | loss from risk low

Uninsurable risks during war, earthquake, accidents

Should be low risk | low return

Cost is higher than overall losses

Contingency planning to mitigate effects

Result of risk Mitigation

Reduce adverse NPV effect of any downside risk

Reduce the overall NPV as a result of the costs of any

mitigation measures

Distribution of NPVs get narrowed

Lower mean | lower return

All risks mitigated only risk free return

Residual risks

Fully identify

Analyse

Specify method of project finance

Report showing likely impact on investors

Price inflation

Borrowing

Tax

Etcs

Causes of a shortage of
capital
Allocation of

capital available
most effectively.

When capital rationing is necessary?

Situation: Insufficient capital to undertake project(s)

with positive NPVs

Profitability index:

Ranks divisible projects

Capital rationing

Single period

Selection crieteria: Highest profitability indices

Reasons for capital

rationing

Soft capital rationing

Reasons for capital

rationing

Soft capital rationing

Reasons:
5.

Unwillingness to raise capital through issuing new shares

(loose control)

6.

Unwillingness to issue additional share capital if it will

lead to a short-term dilution in earnings per share.

7.

do not wish to be committed to large fixed interest

payments (additional debt capital)

8.

Only retained profits as a sole capital financing

9.

Capital expenditure budgeting

Profitability Index
PV of future cash flows (excluding capital investment)

PV of capital investment

Or,

NPV
Investment

Example 1

Suppose,

Project A has investment of $10,000, present value cash

inflows of $11,240.

Project B has investment of $40,000, present value of

cash inflows $43,801.

Decision?

Project B has higher NPV ($3,801 compared with $1,240)

Project A has higher PI (1.12 compared with 1.10)

Example 2 (divisible)

Example 2 (Nondivisible)

Example 2 (Nondivisible)

Capital rationing example :

single period capital rationing

Problems of PI

Opportunity to undertake project lost if not taken

during capital rationing period

Ignore that projects could be deferred and

undertaken at later date

Project have to be divisible

Ignore strategic value1

Ignore cash flow patterns

Ignore project sizes