Risk Analysis in Capital Budgeting | Financial Management & Economics Finance: CA Intermediate (Old Scheme) PDF Download

 Page 1


 
LEARNING OUTCOMES 
 
 
 
 RISK ANALYSIS IN CAPITAL 
 BUDGETING  
 
 
? Discuss the concept of risk and uncertainty in capital 
budgeting. 
? Discuss the sources of risks 
? Understand reasons for adjusting risk in capital budgeting 
? Understand various techniques used in Risk Analysis. 
? Discuss concepts, advantages and limitations of various 
techniques of risk analysis in capital budgeting. 
  
CHAPTER 
8 
CHAPTER 
8 
Page 2


 
LEARNING OUTCOMES 
 
 
 
 RISK ANALYSIS IN CAPITAL 
 BUDGETING  
 
 
? Discuss the concept of risk and uncertainty in capital 
budgeting. 
? Discuss the sources of risks 
? Understand reasons for adjusting risk in capital budgeting 
? Understand various techniques used in Risk Analysis. 
? Discuss concepts, advantages and limitations of various 
techniques of risk analysis in capital budgeting. 
  
CHAPTER 
8 
CHAPTER 
8 
 
 
8.2 FINANCIAL MANAGEMENT  
 
 8.1 INTRODUCTION TO RISK ANALYSIS IN 
CAPITAL BUDGETING 
While discussing the capital budgeting techniques in chapter 7, we have assumed 
that the investment proposals do not involve any risk and cash flows of the 
project are known with certainty. This assumption was taken to simplify the 
understanding of the capital budgeting techniques. However, in practice, this 
assumption is not correct. Infact, investment projects are exposed to various 
degrees of risk. There can be three types of decision making: 
(i)  Decision making under certainty: When cash flows are certain 
(ii)  Decision making involving risk: When cash flows involve risk and probability 
can be assigned. 
(iii)  Decision making under uncertainty: When the cash flows are uncertain and 
probability cannot be assigned. 
8.1.1 Risk and Uncertainty 
Risk is the variability in terms of actual returns comparing with the estimated 
returns. Most common techniques of risk measurement are Standard Deviation 
and Coefficient of variations. There is a thin difference between risk and 
uncertainty. In case of risk, probability distribution of cash flow is known. When 
no information is known to formulate probability distribution of cash flows, the 
Techniques of Risk Analysis in Capital 
Budgeting
Statistical Techniques
1. Probability
2. Variance or Standard
Deviation
3. Coefficient of Varition 
Conventional Techniques
1. Risk-adjusted
discount rate
2. Certainty equivalents
Other techniques
1. Sensitivity
Analysis
2. Scenario
Analysis
 
Page 3


 
LEARNING OUTCOMES 
 
 
 
 RISK ANALYSIS IN CAPITAL 
 BUDGETING  
 
 
? Discuss the concept of risk and uncertainty in capital 
budgeting. 
? Discuss the sources of risks 
? Understand reasons for adjusting risk in capital budgeting 
? Understand various techniques used in Risk Analysis. 
? Discuss concepts, advantages and limitations of various 
techniques of risk analysis in capital budgeting. 
  
CHAPTER 
8 
CHAPTER 
8 
 
 
8.2 FINANCIAL MANAGEMENT  
 
 8.1 INTRODUCTION TO RISK ANALYSIS IN 
CAPITAL BUDGETING 
While discussing the capital budgeting techniques in chapter 7, we have assumed 
that the investment proposals do not involve any risk and cash flows of the 
project are known with certainty. This assumption was taken to simplify the 
understanding of the capital budgeting techniques. However, in practice, this 
assumption is not correct. Infact, investment projects are exposed to various 
degrees of risk. There can be three types of decision making: 
(i)  Decision making under certainty: When cash flows are certain 
(ii)  Decision making involving risk: When cash flows involve risk and probability 
can be assigned. 
(iii)  Decision making under uncertainty: When the cash flows are uncertain and 
probability cannot be assigned. 
8.1.1 Risk and Uncertainty 
Risk is the variability in terms of actual returns comparing with the estimated 
returns. Most common techniques of risk measurement are Standard Deviation 
and Coefficient of variations. There is a thin difference between risk and 
uncertainty. In case of risk, probability distribution of cash flow is known. When 
no information is known to formulate probability distribution of cash flows, the 
Techniques of Risk Analysis in Capital 
Budgeting
Statistical Techniques
1. Probability
2. Variance or Standard
Deviation
3. Coefficient of Varition 
Conventional Techniques
1. Risk-adjusted
discount rate
2. Certainty equivalents
Other techniques
1. Sensitivity
Analysis
2. Scenario
Analysis
 
 8.3 
RISK ANALYSIS IN CAPITAL BUDGETING  
situation is referred as uncertainty. However, these two terms are used 
interchangeably. 
8.1.2 Reasons for adjustment of Risk in Capital Budgeting decisions 
Main reasons for considering risk in capital budgeting decisions are as follows 
1.  There is an opportunity cost involved while investing in a project for the level 
of risk. Adjustment of risk is necessary to help make the decision as to whether 
the returns out of the project are proportionate with the risks borne and 
whether it is worth investing in the project over the other investment options 
available. 
2.  Risk adjustment is required to know the real value of the Cash Inflows. 
Higher risk will lead to higher risk premium and also expectation of higher 
return. 
 8.2 SOURCES OF RISK  
Risk arises from different sources, depending on the type of investment being 
considered, as well as the circumstances and the industry in which the organisation is 
operating. Some of the sources of risk are as follows 
1.  Project-specific risk- Risks which are related to a particular project and affects 
the project’s cash flows. It includes completion of the project in scheduled 
time, error of estimation in resources and allocation, estimation of cash flows 
etc. For example, a nuclear power project of a power generation company has 
different risks than hydel projects. 
2.  Company specific risk- Risk which arise due to company specific factors like 
downgrading of credit rating, changes in key managerial persons, cases for 
violation of intellectual property rights (IPR) and other laws and regulations, 
dispute with workers etc. All these factors affect the cash flows of an entity and 
access to funds for capital investments. For example, two banks have different 
exposure to default risk.  
3.  Industry-specific risk- These are the risks which effect the whole industry in 
which the company operates. The risks include regulatory restrictions on 
industry, changes in technologies etc. For example, regulatory restriction 
imposed on leather and breweries industries. 
4.  Market risk – The risk which arise due to market related conditions like entry 
of substitute, changes in demand conditions, availability and access to 
Page 4


 
LEARNING OUTCOMES 
 
 
 
 RISK ANALYSIS IN CAPITAL 
 BUDGETING  
 
 
? Discuss the concept of risk and uncertainty in capital 
budgeting. 
? Discuss the sources of risks 
? Understand reasons for adjusting risk in capital budgeting 
? Understand various techniques used in Risk Analysis. 
? Discuss concepts, advantages and limitations of various 
techniques of risk analysis in capital budgeting. 
  
CHAPTER 
8 
CHAPTER 
8 
 
 
8.2 FINANCIAL MANAGEMENT  
 
 8.1 INTRODUCTION TO RISK ANALYSIS IN 
CAPITAL BUDGETING 
While discussing the capital budgeting techniques in chapter 7, we have assumed 
that the investment proposals do not involve any risk and cash flows of the 
project are known with certainty. This assumption was taken to simplify the 
understanding of the capital budgeting techniques. However, in practice, this 
assumption is not correct. Infact, investment projects are exposed to various 
degrees of risk. There can be three types of decision making: 
(i)  Decision making under certainty: When cash flows are certain 
(ii)  Decision making involving risk: When cash flows involve risk and probability 
can be assigned. 
(iii)  Decision making under uncertainty: When the cash flows are uncertain and 
probability cannot be assigned. 
8.1.1 Risk and Uncertainty 
Risk is the variability in terms of actual returns comparing with the estimated 
returns. Most common techniques of risk measurement are Standard Deviation 
and Coefficient of variations. There is a thin difference between risk and 
uncertainty. In case of risk, probability distribution of cash flow is known. When 
no information is known to formulate probability distribution of cash flows, the 
Techniques of Risk Analysis in Capital 
Budgeting
Statistical Techniques
1. Probability
2. Variance or Standard
Deviation
3. Coefficient of Varition 
Conventional Techniques
1. Risk-adjusted
discount rate
2. Certainty equivalents
Other techniques
1. Sensitivity
Analysis
2. Scenario
Analysis
 
 8.3 
RISK ANALYSIS IN CAPITAL BUDGETING  
situation is referred as uncertainty. However, these two terms are used 
interchangeably. 
8.1.2 Reasons for adjustment of Risk in Capital Budgeting decisions 
Main reasons for considering risk in capital budgeting decisions are as follows 
1.  There is an opportunity cost involved while investing in a project for the level 
of risk. Adjustment of risk is necessary to help make the decision as to whether 
the returns out of the project are proportionate with the risks borne and 
whether it is worth investing in the project over the other investment options 
available. 
2.  Risk adjustment is required to know the real value of the Cash Inflows. 
Higher risk will lead to higher risk premium and also expectation of higher 
return. 
 8.2 SOURCES OF RISK  
Risk arises from different sources, depending on the type of investment being 
considered, as well as the circumstances and the industry in which the organisation is 
operating. Some of the sources of risk are as follows 
1.  Project-specific risk- Risks which are related to a particular project and affects 
the project’s cash flows. It includes completion of the project in scheduled 
time, error of estimation in resources and allocation, estimation of cash flows 
etc. For example, a nuclear power project of a power generation company has 
different risks than hydel projects. 
2.  Company specific risk- Risk which arise due to company specific factors like 
downgrading of credit rating, changes in key managerial persons, cases for 
violation of intellectual property rights (IPR) and other laws and regulations, 
dispute with workers etc. All these factors affect the cash flows of an entity and 
access to funds for capital investments. For example, two banks have different 
exposure to default risk.  
3.  Industry-specific risk- These are the risks which effect the whole industry in 
which the company operates. The risks include regulatory restrictions on 
industry, changes in technologies etc. For example, regulatory restriction 
imposed on leather and breweries industries. 
4.  Market risk – The risk which arise due to market related conditions like entry 
of substitute, changes in demand conditions, availability and access to 
 
 
8.4 FINANCIAL MANAGEMENT  
resources etc. For example, a thermal power project gets affected if the coal 
mines are unable to supply coal requirements of a thermal power company etc.  
5.  Competition risk- These are risks related with competition in the market in 
which a company operates. These risks are risk of entry of rival, product 
dynamism and change in taste and preference of consumers etc.   
6.  Risk due to Economic conditions – These are the risks which are related with 
macro-economic conditions like changes in monetary policies by central banks, 
changes in fiscal policies like introduction of new taxes and cess, inflation, 
changes in GDP, changes in savings and net disposable income etc.  
7.  International risk – These are risk which are related with conditions which are 
caused by global economic conditions like restriction on free trade, restrictions on 
market access, recessions, bilateral agreements, political and geographical 
conditions etc. For example, restriction on outsourcing of jobs to overseas markets.  
 8.3 TECHNIQUES OF RISK ANALYSIS IN CAPITAL 
BUDGETING 
Techniques of risk analysis in capital budgeting can be classified as below: 
 
Techniques of Risk Analysis
Statistical 
Techniques
Probability
Variance or Standard 
Deviation
Coefficient of Variation
Conventional 
techniques
Risk-adjusted discount   rate
Certainty equivalents
Others techniques
Sensitivity analysis
Scenario analysis
Page 5


 
LEARNING OUTCOMES 
 
 
 
 RISK ANALYSIS IN CAPITAL 
 BUDGETING  
 
 
? Discuss the concept of risk and uncertainty in capital 
budgeting. 
? Discuss the sources of risks 
? Understand reasons for adjusting risk in capital budgeting 
? Understand various techniques used in Risk Analysis. 
? Discuss concepts, advantages and limitations of various 
techniques of risk analysis in capital budgeting. 
  
CHAPTER 
8 
CHAPTER 
8 
 
 
8.2 FINANCIAL MANAGEMENT  
 
 8.1 INTRODUCTION TO RISK ANALYSIS IN 
CAPITAL BUDGETING 
While discussing the capital budgeting techniques in chapter 7, we have assumed 
that the investment proposals do not involve any risk and cash flows of the 
project are known with certainty. This assumption was taken to simplify the 
understanding of the capital budgeting techniques. However, in practice, this 
assumption is not correct. Infact, investment projects are exposed to various 
degrees of risk. There can be three types of decision making: 
(i)  Decision making under certainty: When cash flows are certain 
(ii)  Decision making involving risk: When cash flows involve risk and probability 
can be assigned. 
(iii)  Decision making under uncertainty: When the cash flows are uncertain and 
probability cannot be assigned. 
8.1.1 Risk and Uncertainty 
Risk is the variability in terms of actual returns comparing with the estimated 
returns. Most common techniques of risk measurement are Standard Deviation 
and Coefficient of variations. There is a thin difference between risk and 
uncertainty. In case of risk, probability distribution of cash flow is known. When 
no information is known to formulate probability distribution of cash flows, the 
Techniques of Risk Analysis in Capital 
Budgeting
Statistical Techniques
1. Probability
2. Variance or Standard
Deviation
3. Coefficient of Varition 
Conventional Techniques
1. Risk-adjusted
discount rate
2. Certainty equivalents
Other techniques
1. Sensitivity
Analysis
2. Scenario
Analysis
 
 8.3 
RISK ANALYSIS IN CAPITAL BUDGETING  
situation is referred as uncertainty. However, these two terms are used 
interchangeably. 
8.1.2 Reasons for adjustment of Risk in Capital Budgeting decisions 
Main reasons for considering risk in capital budgeting decisions are as follows 
1.  There is an opportunity cost involved while investing in a project for the level 
of risk. Adjustment of risk is necessary to help make the decision as to whether 
the returns out of the project are proportionate with the risks borne and 
whether it is worth investing in the project over the other investment options 
available. 
2.  Risk adjustment is required to know the real value of the Cash Inflows. 
Higher risk will lead to higher risk premium and also expectation of higher 
return. 
 8.2 SOURCES OF RISK  
Risk arises from different sources, depending on the type of investment being 
considered, as well as the circumstances and the industry in which the organisation is 
operating. Some of the sources of risk are as follows 
1.  Project-specific risk- Risks which are related to a particular project and affects 
the project’s cash flows. It includes completion of the project in scheduled 
time, error of estimation in resources and allocation, estimation of cash flows 
etc. For example, a nuclear power project of a power generation company has 
different risks than hydel projects. 
2.  Company specific risk- Risk which arise due to company specific factors like 
downgrading of credit rating, changes in key managerial persons, cases for 
violation of intellectual property rights (IPR) and other laws and regulations, 
dispute with workers etc. All these factors affect the cash flows of an entity and 
access to funds for capital investments. For example, two banks have different 
exposure to default risk.  
3.  Industry-specific risk- These are the risks which effect the whole industry in 
which the company operates. The risks include regulatory restrictions on 
industry, changes in technologies etc. For example, regulatory restriction 
imposed on leather and breweries industries. 
4.  Market risk – The risk which arise due to market related conditions like entry 
of substitute, changes in demand conditions, availability and access to 
 
 
8.4 FINANCIAL MANAGEMENT  
resources etc. For example, a thermal power project gets affected if the coal 
mines are unable to supply coal requirements of a thermal power company etc.  
5.  Competition risk- These are risks related with competition in the market in 
which a company operates. These risks are risk of entry of rival, product 
dynamism and change in taste and preference of consumers etc.   
6.  Risk due to Economic conditions – These are the risks which are related with 
macro-economic conditions like changes in monetary policies by central banks, 
changes in fiscal policies like introduction of new taxes and cess, inflation, 
changes in GDP, changes in savings and net disposable income etc.  
7.  International risk – These are risk which are related with conditions which are 
caused by global economic conditions like restriction on free trade, restrictions on 
market access, recessions, bilateral agreements, political and geographical 
conditions etc. For example, restriction on outsourcing of jobs to overseas markets.  
 8.3 TECHNIQUES OF RISK ANALYSIS IN CAPITAL 
BUDGETING 
Techniques of risk analysis in capital budgeting can be classified as below: 
 
Techniques of Risk Analysis
Statistical 
Techniques
Probability
Variance or Standard 
Deviation
Coefficient of Variation
Conventional 
techniques
Risk-adjusted discount   rate
Certainty equivalents
Others techniques
Sensitivity analysis
Scenario analysis
 8.5 
RISK ANALYSIS IN CAPITAL BUDGETING  
 8.4 STATISTICAL TECHNIQUES 
8.4.1 Probability
Meaning: Probability is a measure about the chances that an event will occur. 
When an event is certain to occur, probability will be 1 and when there is no 
chance of happening an event probability will be 0. 
Example: 
Assumption Cash Flows (`) Probability 
Best guess 3,00,000 0.3 
High guess 2,00,000 0.6 
Low guess 1,20,000 0.1 
In the above example chances that cash flow will be 3,00,000, 2,00,00 and 1,00,00 
are 30%,60% and 10% respectively. 
(i) Expected Net Cash Flows 
Expected Cash flows are calculated as the sum of the likely Cash flows of the 
Project multiplied by the probability of cash flows. Expected Cash flows are 
calculated as below: 
E (R)/ENCF=  ENCF = ? NCF
i
×P
i
n
i= 1
 
Where, E (R)/ENCF = Expected Cash flows 
Pi = Probability of Cash flow 
NCFi = Cash flows 
Example: 
Assumption (1) Cash Flows (`) 
(2) 
Probability 
(3) 
Expected cash flow 
(2×3) (`) 
Best guess 3,00,000 0.3 3,00,000×0.3 = 90,000 
High guess 2,00,000 0.6 2,00,000×0.6 =1,20,000 
Low guess 1,20,000 0.1 1,20,000×0.1 =12,000 
Expected Net cash flow (ENCF)                   2,22,000