RISK ANALYSIS IN CAPITAL BUDGETING
Every project is analyzed based on a set of input variables as follows:
Project life (n)
Cash flow
Initial investment
Discount rate
Where these variables are known with certainty, then the decision criteria is established using the
normal procedures depending on the method chosen.
Example-NPV:
NPV = (PV x CF)-I
Decision rule:
For independent projects, accept all projects that generate a + NPV.
For mutually exclusive projects, accept only the project with the highest +ve NPV.
Whenever any of the variables is uncertain, then there will be need to compute the expected
value as well as its standard deviation.
EXPECTED MONETARY VALUE
A project has the following possible NPVs:
NPV Prob.
140,000 0.25
280,000 0.45
330,000 0.30
Required:
Calculate the expected monetary value (EMV)
Illustration-1
A project has an initial investment of ksh 22,500,000 and promises to generate uncertain cash
flows as follows:
Cash Inflow Prob.
8,000,000 0.15
11,500,000 0.25
21,800,000 0.20
25,000,000 0.20
6,000,000 0.15
3,000,000 0.05
The discount rate applicable to this project is 10%.
Required:
Calculate the expected monetary value of the NPV
SIMULATION
Simulation is a method of incorporating risk in capital budgeting by use of random numbers.
Illustration-1
A company is considering purchasing a new machine at a cost of ksh. 76 million. The machine is
expected to generate cash flows in four years according to the following probability distribution:
Year-1 Year-2 Year-3 Year-4
Cash flow Prob. Cash flow Prob. Cash flow Prob. Cash flow Prob.
(ksh. ‘000’) (ksh. ‘000’) (ksh. ‘000’) (ksh. ‘000’)
22,000 0.40 18,000 0.50 45,000 0.30 23,000 0.25
39,000 0.40 29,000 0.30 47,000 0.40 23,000 0.25
26,000 0.20 43,000 0.10 (4,000) 0.30 23,000 0.25
8,000 0.10 23,000 0.25
The cash flows are independent of each other. The company’s cost of capital is 14%.
Required:
a) Calculate the NPV of the project using expected cash flows
b) Simulate the cash flows and advise on the viability of the investment in the machine
using NPV approach.
Perform six (6) trials using the following set of random numbers:
45,35,18,72 12,85,74,26 96,45,64,37 58,49,37,61 67,31,29,81 75,60,48,43
CERTAINTY EQUIVALENTS APPROACH
Under this method, the cash flows are reduced to their certainty risk equivalents before
calculating the NPV using risk-free rate of interest as the discount rate.
Illustration-1
A company has given a schedule of expected cash flows for its project along with the certainty
equivalent factors for each stream of cash flows as follows:
Year Expected Net CF Certainty Equivalent factor (α)
(ksh. ‘000’)
0 -10,000 1.0
1 5,000 0.9
2 6,000 0.8
3 7,000 0.7
4 4,000 0.6
5 3,000 0.4
The risk-free rate of interest is 8% pa.
Required:
Calculate the certainty equivalent NPV for the project and advise on its viability.
RISK-ADJUSTED DISCOUNT RATE APPROACH
The (RADR) method escalates the discount rate rather than adjusting the cash flows downwards.
Suppose the firm that’s evaluating a project has a corporate cost of capital of 15%. Then, all
average-risk projects would be evaluated using a discount rate of 15%. Now assume that a risk
analysis of a particular project is above-average risk, then the company may choose a higher cost
of capital of say 22% to be used in evaluating that project.
Illustration-1
A company is considering a project that will cost ksh. 20,000,000 in initial investment and will
generate cash flows of ksh. 6,000,000 per year in years 1-5. All the company’s projects are
discounted at a WACC of 12% since they are deemed to be average risk projects. However, this
particular project is considered to be riskier than the average and the company is considering a
4% risk premium for its cash flows.
Required:
a) Determine the project’s NPV using the WACC of the company for all average-risk projects.
Is the project viable?
b) Calculate the projects NPV using the Risk-Adjusted-Discount rate.
c) Would you change your decision in (a) above? Explain.
SENSITIVITY ANALYSIS
1.1 Sensitivity Analysis
Sensitivity analysis examines how sensitive a decision rule (like NPV, IRR, etc.) is to variables
affecting a project’s outcome.
For instance, the variables influencing the decision rule in a project appraisal situation may be;
Project life;
Cost of Capital;
Amount of net cash flow etc.
If any one of these variables is changed, then there is bound to be an impact on the NPV or the
IRR as the case may be. Analyzing this impact is referred to as sensitivity analysis.
The Purpose of Sensitivity Analysis
The purpose of sensitivity analysis is:
To help identify the key variables which influence the project cost and benefit streams
To investigate the consequences of likely adverse changes in these key variables
To assess whether project decisions are likely to be affected by such changes
To identify actions that could mitigate possible adverse effects on the project.
The steps in performing sensitivity analysis:
i) Perform a base case analysis, based on expectations about the future.
ii) Identify key assumptions in the base case analysis - these could be firm specific (revenue
levels, operating costs, etc.) or macroeconomic (tax rates, inflation, etc.).
iii) Change one key assumption at a time, and estimate the decision criterion (NPV, IRR,
etc.) - summarize the impact of changing the key assumption on the decision criterion in
the form of a table or graph.
iv) Decide whether to take the project based on the risk of changes in the key assumptions.
v) Set control limits for each of the variables being changed
Illustration-1:
The finance director of Unilever ltd is considering a project proposal to make and sell units of
one of their main products over the next five years:
Initial capital cost ksh. 4,000,000
Annual unit sales 10,000 units
Selling price per unit ksh. 600
Variable cost per unit ksh. 350
Fixed costs per year ksh. 1,200,000
The discount rate applicable to this project is 16% and the following cash flows are expected:
Year Cash flow
0 (4,000,000)
1 1,300,000
2 1,300,000
3 1,300,000
4 1,300,000
5 1,300,000
Ignore taxation.
Required:
a) Evaluate the viability of the above project based on NPV criterion.
b) Suppose there are three alternative outcomes for the annual unit sales as follows:
Worst outcome 9,000 units
Most likely outcome 10,000 units
Best outcome 11,000 units
i) Determine how sensitive the project is to changes in the annual unit sales
ii) Draw a graph showing the project’s NPV on the vertical axis and annual unit sales in the
horizontal axis to represent the sensitivity in b (i) above.