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1. Risk and Uncertainty Analysis in Capital Budgeting Presented by: Parul Kaundal & Rajwinder Singh

2. Meaning of Risk 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 Scenario Traditional Capital Budgeting Techniques Such As: Payback Period Accounting Rate Of Return Net Present Value Internal Rate Of Return may not be sufficient to evaluate the Investment Proposals.

3. KEY REASONS: It Requires The Use Of More Sophisticated Techniques That Consider The Probability Of Various Outcomes And The Impact Of Risk On The Investment Decisions There Are Several Methods Of Capital Budgeting Under Risk And Uncertainty Some Of Which Are Discussed Below Capital Budgeting Requires The Projection Of Cash Inflow And Outflow Of The Future The Future Is Always Uncertain, Estimate Of Demand, Production, Selling Price, Cost Etc. Cannot Be Exact.

4. FOR EXAMPLE: The product at any time it become obsolete. Therefore the Future is Unexpected, So, Some Methods For Considering The Accounting Of Risk In Capital Budgeting Various Evaluation Methods Are Used For Risk And Uncertainty In Capital Budgeting

5. METHODS RISK ADJUSTED CUTOFF RATE CERTAINTY EQUIVALENT METHOD SENSITIVITY TECHNIQUE PROBABILITY TECHNIQUE STANDARD DEVIATION METHOD COEFFICIENT OF VARIATION METHOD DECISION TREE ANALYSIS MONTE CARLO SIMULATION SCENARIO ANALYSIS PAYBACK

6. STATISTICAL TECHNIQUES: Probability Variance or Standard Deviation Coefficient of Variation

7. PROBABILITY Probability may be described as a measure of someone’s opinion about the likelihood that an event will occur. A typical forecast is single figure for a period. This is referred to as “best estimate” or “most likely” forecast: Probability For these reasons, a forecaster should not give just one estimate, but a range of associated probability–a probability distribution. .

8. Assigning Probability The probability estimate, which is based on a very large number of observations, is known as an objective probability. Such probability assignments that reflect the state of belief of a person rather than the objective evidence of a large number of trials are called personal or subjective probabilities.

9. Expected Net Present Value Once the probability assignments have been made to the future cash flows the next step is to find out the expected net present value. Expected net present value = Sum of present values of expected net cash flows.

10. VARIANCE OR STANDARD DEVIATION Variance measures the deviation about expected cash flow of each of the possible cash flows. Standard deviation is the square root of variance.

11. COEFFICIENT OF VARIATION Coefficient of Variation It is defined as the standard deviation of the probability distribution divided by its expected value: Coefficient of variation(CV)= Expected value/Standard Deviation

12. Risk Analysis in Practice Companies in India account for risk while evaluating their capital expenditure decisions. The following factors are considered : –price of raw material and other inputs –price of product –product demand –government policies –technological changes –project life –inflation

13. CONVENTIONAL TECHNIQUES: Payback Technique Risk Adjusted Discount Rate Certainty Equivalents

14. PAYBACK TECHNIQUE Payback is one of the oldest and most common procedures used and the explicit recognition of risk in the project with an investment. This method, applied in practice, as is an attempt to measure the risk assessment in investment decision as a possible method Profitability. The payback method is the amount of time required for a firm to recover its initial investment in a project, as calculated from cash inflows.

15. DECISION CRITERIA: The length of the maximum acceptable payback period is determined by management. If the payback period is less than the maximum acceptable payback period, accept the project. If the payback period is greater than the maximum acceptable payback period, reject the project.

16. PROS AND CONS OF PAYBACK ANALYSIS Pros : The payback method is widely used by large firms to evaluate small projects and by small firms to evaluate most projects. Its popularity results from its computational simplicity and intuitive appeal. By measuring how quickly the firm recovers its initial investment, the payback period also gives implicit consideration to the timing of cash flows and therefore to the time value of money. Because it can be viewed as a measure of risk exposure, many firms use the payback period as a decision criterion or as a supplement to other decision techniques.

17. Cons : The major weakness of the payback period is that the appropriate payback period is merely a subjectively determined number. It cannot be specified in light of the wealth maximization goal because it is not based on discounting cash flows to determine whether they add to the firm’s value. A second weakness is that this approach fails to take fully into account the time factor in the value of money. A third weakness of payback is its failure to recognize cash flows that occur after the payback period.

18. RISK-ADJUSTED DISCOUNT RATE An estimation of the present value of cash for high risk investments is known as risk-adjusted discount rate. The risk adjusted discount rate approaches attempts to handle the problem of risk and uncertainty in a more direct and thoughtful way. As we know investors are risk averse and so requires a reward for undertaking a risky investment, the greater must be its expected return.

19. The Greater The Project Perceived Level Of Risk, The Greater Is The Risk Premium Risk adjusted discount rate = risk free rate + risk premium

20. ADVANTAGES AND DISADVANTAGES OF RISK ADJUSTED DISCOUNT RATE Advantages :- It is simple and can be easily understood. It has a great deal of intuitive appeal for risk-averse businessman. It incorporates an attitude towards uncertainty.

21. Disadvantages :- There is no easy way deriving a risk adjusted discount rate. Capital asset pricing model provides a basis of calculating the risk adjusted discount rate. Its use has yet to pick up in practice. It does not make any risk adjusted in the numerator for the cash flows that are forecast over the future years.

22. CERTAINTY EQUIVALENT Under this techniques, the estimated cash flows are adjusted by using risk free rate to ascertain risk free cash flow The expected cash flows of the project are converted in to equivalent riskless amount The smaller certainty equivalent will be used in the case of an expected cash inflows and the larger certainty equivalent used for payment. For example, if an investor, according to his “best estimate” expects a cash flow of Rs. 60000 next year, he will apply an intuitive correction factor and may work with Rs. 40000 to be on safe side. There is a certainty- equivalent cash flow

23. EVALUATION OF CERTAINTY EQUIVALENT The certainty equivalent approach explicitly recognizes risk, but the procedure for reducing the forecasts of cash flows is implicit and is likely to be in consistent from one investment to another

24. DRAWBACKS OF CERTAINTY EQUIVALENT the forecaster, expecting the reduction that will be made in his forecasts, may inflate them in anticipation. This will no longer give furcated according to best estimate. if forecasts have to pass through several layers of management, the effect may be to greatly exaggerate the original forecast or to make it ultra conservative. by focusing explicit attention only on the gloomy out comes, chances are increased for passing by some good investments.

25. OTHER TECHNIQUES: Sensitivity Analysis Monte Carlo Simulation Scenario Analysis Decision Tree Approach

26. SENSITIVITY ANALYSIS Sensitivity analysis is a technique used to measure the impact of changes in input variables such as sales costs or interest rates on the outcome of investment season the technique involves changing in one output variables at a time and observing the effect on the investment seasons Sensitivity analysis is a simple and easy to use technique but it has a limitation in that it assumes that the input variables are independent and do not interact with each other.

27. MONTE CARLO SIMULATION Simulation is a statistically based behavioral approach that applies predetermined probability distributions and random numbers to estimate risky outcomes. By tying the various cash flow components together in a mathematical model and repeating the process, the financial manager can develop a probability distribution of projected return.

28. A Monte Carlo simulation is defined as a computational technique that uses random sampling to model and analyze complex systems or processes.

29. SCENARIO ANALYSIS The simple sensitivity analysis assumes that variable are independent of each other. In reality the variable will be interrelated and they may change in combination. One way to examine the risk on investment is to analyze the impact of alternative combination of variable, called scenario analysis.

30. It analyse decisions by considering alternative possible outcomes. Three scenarios: Base case/Normal or Expected scenario Worst case/Pessimistic scenario Best case/Optimistic scenario Utilized for the evaluation of combined effect of different variable.

31. DECISION TREE APPROACH Decision Trees are a graphical representation of the possible outcomes of the investment decisions. Tree like structure that shows the possible outcomes of the investment decisions at each decision point . The technique considers the probability of each outcome and the cost of each disease enabling the decision maker to choose the most optimal decision. Steps in Decision Tree Approach Define investment Identify decision alternatives Draw a decision tree - decision point ,chance events Assign the Probability Analyse data

32. Accept or Reject C riteria If the net present values are in positive the project may be accepted otherwise it is rejected

33. Usefulness of Decision Tree Approach The Merits of the decision tree approach are: It clearly brings out the implicit assumptions and calculations for all to see, question and revise. It allows a decision maker to visualise assumptions and alternatives in graphic form, which is usually much easier to understand than the more abstract, analytical form.

34. The Demerits of the decision tree approach are: The decision tree diagrams can become more and more complicated as the decision maker decides to include more alternatives and more variables and to look farther and farther in time. It is complicated even further if the analysis is extended to include interdependent alternatives and variables that are dependent upon one another .

35. Thanks !