Risk Analysis

RISK RISK ANAL ANALYSIS YSIS

Presented By:GIRISH ARORA 74 Sec-B PGDM 2009-2011

Risk is a possibility of incurring loss or misfortune. Every project is linked with certain amount of risk. Research and development project is more risky than an expansion project. Thus a need arises for the calculation of the amount of risk concerned with the projects. Risk analysis comprises of various tools for determining determining the risk associated associated with project. No single technique or tool may be suggested as the best tool.

Risk is a possibility of incurring loss or misfortune. Every project is linked with certain amount of risk. Research and development project is more risky than an expansion project. Thus a need arises for the calculation of the amount of risk concerned with the projects. Risk analysis comprises of various tools for determining determining the risk associated associated with project. No single technique or tool may be suggested as the best tool.

The two broad categories of techniques used for risk analysis: ±

±

Technique considering considering stand alone risk of a project. project . Technique that considers co nsiders the risk of project in context to the firm and market.

Stand-Alone risk of project Various

techniques that consider stand alone risk of project are:±

Sensitivity analysis

±

Scenario analysis

±

Break-Even Break-Even analysis analys is

±

Hillier model

±

Simulation analysis

±

Decision tree analysis

SENSITIVITY ANALYSIS Future is uncertain, this leads to risk with a project. What a manager wants to know? ±

Manager wants to know the viability of the project when some variables like sales or investment deviates from their expected values.

Sensitivity analysis is thus a technique of systematically changing parameters in a model to determine the effect of such changes. This method is part of capital budgeting decisions.

Example solved 11.2 Prasanna chandra 6 th edition Financial manager of Naveen flour mills considers of setting up of new floor mill in Bangalore. The project staff has developed the following figures of cash flows. Determine the NPV of the project and find out the sensitivity analysis with the deviations in key variables from the expected values.

Sensitivity of NPV to variations RANGE(Rs in µ000) K ey Variable

Pessimistic

Expected

Optimistic

Investment

24000

20000

18000

Sales

15000

18000

21000

Variable Costs 70 as percent of  sales

66.66

65

Fixed Costs

1000

80

1300

Discounting Rate=12%, n=10

Solution

RANGE(Rs in µ000) K ey Variable

Pessimistic

Expected

Optimistic

Investment

24000

20000

18000

Sales

15000

18000

21000

Variable Costs 70 as percent of  sales

66.66

65

Fixed Costs

1000

80

Consider

1300

the case when Investment occurs in pessimistic time. Thus more investment would be required then the expected value. Now we change the value of investment to 24000 then 20000 keeping the other variables constant and determine the change in NPV of the project.

NPV= -24000000+4133000*5.65 NPV= -648550 Similarly, we calculate NPV when the investment is done under  optimistic time and so on.

RANGE(Rs in µ000)

NPV

K ey Variabl e

Pessimisti c

Expected Optimis Pessimist Expecte Optimis tic ic d tic

Invest ment

24000

20000

18000

-648550

Sales

15000

18000

21000

-1166290 2600000 6367420

66.66

65

340452

Variabl 70 e Costs as percent of sales

2600000 4223936

2600000 3730621

Fixed 1300 1000 80 1470000 2600000 3353936 Costs Thus the effect, of varying the key variables, on NPV can be easily assessed. The financial manager thus gets to know whether to carry on with the project under different circumstances.

Example: unsolved question No. 1 prasanna chandra 6th edition you are financial manager of HEPL. HEPL is planning to set up an extrusion plant at Indore. Your project staff has developed the following cash flow forecast for the project.

Determine the NPV of the project and calculate the effect of variations in the values of underlying variables on NPV.

RANGE(Rs in million) Underlying Variable

Pessimistic

Expected

Optimistic

Investment

300

250

200

Sales

150

200

275

Variable Costs 65 as percent of  sales

60

56

Fixed Costs

20

15

30

Cost of Capital=13%, n=10

Solution

NPV= -250+50*5.426 NPV= 21.312

RANGE(Rs in µ000)

NPV

K ey Variabl e

Pessimisti c

Expected Optimis Pessimist Expecte Optimis tic ic d tic

Invest ment

300

250

200

-20.95

21.31

63.55

Sales

150

200

275

-56.21

21.31

137.58

Variabl 65 e Costs as percent of sales

60

56

-17.46

21.31

52.31

Fixed Costs

20

15

-17.46

21.31

40.68

30

Thus it can be determined that situations with negative NPV are unfavorable situations for carrying out the project further.

Merits and Demerits of Sensitivity Analysis Merits ±

±

±

It shows the robustness of project to changes in underlying key variables. It indicates whether to carry on with the project. If the NPV is highly sensitive to changes then manager can explore the variability of key variable.

Demerits or shortcomings ±

±

Sensitivity analysis considers change in only one variable whereas in reality variables move together. It shows the effect on variable with change in key variable but does not depict the likely change in the variable.

SCENARIO ANALYSIS Sensitivity analysis assumes that variables are independent of each other. Whereas, variables are interrelated and they may change in combination. To examine the risk of investment one can analyze the impact of  alternative combinations of variables, called Scenarios. Consider the following example where, Zen enterprises is evaluating a project for introducing a new product. Depending on the response of market, firm has formulated 3 scenarios, Scenario1: The product will have moderate appeal to customers at a moderate price. Scenario2: The product will have strong appeal to large segment which is highly price sensitive. Scenario3: The product appeals small segment which is willing to pay high for the product.

Consider the following example in which the initial investment is Rs 200 million, The 3 scenarios are considered as:Scenario1 Moderate demand of 20 million units and moderate selling price of product being Rs 25 per unit. Scenario2 High demand of 40 million units and low selling price of Rs 15 per unit, Scenario3 Low demand 0f 10 million units for a highly priced product of Rs 40 per unit.

The variable costs on three scenarios are 48%, 80%, 30% respectively. Taxes are paid at a rate of 50% Depreciation occurs at 10% and project life cycle is of 10 years and salvage value is 0. It is also given that the Discounting Rate is15%.

Scenario 1

Scenario 2

Scenario 3

Initial Investment Unit S.P(Rs) Demand(in units)

200 25 20

200 15 40

200 40 10

Revenues

500

600

400

Variable

240 (48% of sales)

480(80%)

120(30%)

Fixed costs

50

50

50

Depreciation(10%)

20

20

20

Pre-Tax profit

190

15

210

Tax@50%

95

25

105

Profit after Tax

95

25

105

Annual Cash flow

115

45

125

Net Present Value

377.2

25.9

427.4

costs

Thus scenario analysis helps to understand the effect on NPV when the variables change in correlation.

BEST AND WORST CASE ANALYSIS The scenarios developed in previous example are most commonly occurring situations where high selling price and low demand go hand in hand. But managers try another kinds of scenario analysis called the best and worst case analysis. These scenarios are as: Best Scenario: Best scenario is considered when the product has high demand, high selling price, low variable cost etc. Average scenario: has average demand, average selling price, average variable cost. Worst Scenario: The scenario is considered worst when the product has low demand, low selling price, high variable costs.

The objective of such scenario analysis is to determine what would happen if situation is most favorable and if the adverse situation arises.

Merits and Demerits of Scenario Analysis Merits: It is an improvement to Sensitivity analysis because it considers variations in several variables together as it happens in reality.

Demerits: It is based on assumption that there are few linear scenarios. If there are many changing key variables then it would be difficult to analyze a number of scenarios.

BREAK -EVEN ANALYSIS This method helps in determining how much should be produced and sold at the minimum to ensure no loss situation. The minimum quantity at which loss is avoided is called a Break-Even point. It is a no profit-no loss situation. Since profits are linked with cost and volumes. Hence, it is the cost-volume-profit relationship analysis.

The project breaks even in NPV terms when the present value of cash flows is equal to the initial investment. Formulas used for the calculation of Break Even sales: Contribution Margin=Total Sales-Total Variable Costs

Consider the previous example of Naveen Flour mills. Financial manager  of the firm wants to know the break even sales.

Solution

For the project to break even, PV of cash flows should be equal to initial investment or NPV should be zero. Hence, 1.254*sales= 20 million Break Even Sales=Rs 15.95 million This implies that for the project to have a zero NP V, sales of the flour mill should be equal to 15.95 million.

Example: unsolved question No. 1 prasanna chandra 6th edition you are financial manager of HEPL. HEPL is planning to set up an extrusion plant at Indore. Your project staff has developed the following cash flow forecast for the project.

Determine the financial break even point of sales.

Solution

For the project to break even, PV of cash flows should be equal to initial investment or NPV should be zero. Hence, 1.614*sales-40.36 million= 250 million Break Even Sales= Rs 180 million

HILLIER MODEL F.S. Hillier analyzed that the expected cash flows have standard deviations. The more the certainty of cash flow less is the standard deviation. There are two cases for which analysis is done ±

There is no correlation among cash flows,

±

Cash

flows are perfectly correlated.

The cash flows for the project involving outlay of Rs 10000 are as follows: Year 1 Year 2 Year3 Net cash flow

Probabilit y

Net cash flow

Probabilit y

Net cash flow

Probabilit y

Rs 3000

.3

2000

.2

3000

.3

5000

.4

4000

.6

5000

.4

7000

.3

6000

.2

7000

.3

Calculate the NPV and (NPV) for the project when the risk free interest rate i=6%

Year 1

Year 2

Year3

Net cash flow

Probabilit y

Net cash flow

Probabilit y

Net cash flow

Probabilit y

Rs 3000

.3

2000

.2

3000

.3

5000

.4

4000

.6

5000

.4

7000

.3

6000

.2

7000

.3

At

5000

At

4000

At

5000

Question No. 3 unsolved exercise Prasanna chandra 6 th edition(projects) A project involving an initial outlay of Rs 10 million has the following benefits associated with it:

Year 1

Year 2

Year3

Net cash flow (Rs in mln)

Probabilit y

Net cash flow

Probabilit y

Net cash flow

Probabilit y

4

.4

5

.4

3

.3

5

.5

6

.4

4

.5

6

.1

7

.2

5

.2

Assume that the cash flows are independent. Calculate the expected NPV and standard deviation of NPV. Risk free interest rate=10%

Solution Year 1

Year 2

Year3

Net cash flow (Rs in mln)

Probabilit y

Net cash flow

Probabilit y

Net cash flow

Probabilit y

4

.4

5

.4

3

.3

5

.5

6

.4

4

.5

6

.1

7

.2

5

.2

At

4.7

At

5.8

At

3.9

The investment project has an initial outlay of Rs 10000. The mean and standard deviation of cash flows which are perfectly correlated are as,

Year

At

t

1

5000

1500

2

3000

1000

3

4000

2000

4

3000

1200

Determine the NPV and (NPV) of the project when the risk free interest rate=6%.

Example unsolved question No. 4 prasanna chandra 6 th edition ch. 11 Janakiram is considering an investment which requires a current outlay of Rs 25000. the expected value of cash flows and standard deviations of  cash flows are:

Year

At

t

1

12000

5000

2

10000

6000

3

9000

5000

4

8000

6000

The cash flows are perfectly correlated. Calculate the expected value of  NPV and standard deviation of NPV of this investment. Risk free interest rate is 8%.