UNIT 2

RISK ANALYSIS IN CAPITAL BUDGETING

Meaning:

Capital budgeting:
A capital budget is a long term plan that outlines the financial demands of an
investment, development, or major purchase. Capital Budgeting is defined as the process by
which a business determines which fixed asset purchases or project investments are acceptable
and which are not. Capital budgeting is the process to identify analysis and select investment
projects, whose returns (cash flows) are expected to extend beyond one year.

Risk:

Risk is expressed differently by different people. To some, it is the chance or possibility of

loss, to others, it may be uncertain situations.

The word risk has been derived from Latin word “resecare” where “re” means “against” and
“secare” means “to cut”. It means to cut against or the part that is cut off or lost. Thus risk is
losing something or suffering loss due to future uncertainties.

Definitions:
Irving Fisher: Risk may be defined as combinations of hazards measured by probability.

Blomkvist: Defined risk as “the possible loss of something of value”.

Merkhofer: “Risk allows for a number of possible outcomes, not all of which are bad”.

Adams: “Risk is defined, by most of those who seek to measure it, as the product of the
probability and utility of some future event”.

Ballard: “Risk = Frequency x Consequences”

Beck and Bernstein: “the perception of risk from chance of loss into opportunity for gain”.

UNCERTAINTY:
Uncertainty involves a situation, about which the likelihood of possible outcome is not
known. Uncertainty cannot be quantified whereas risk can be quantified of the likelihood of
future outcomes. The degree of risk depends upon the features of assets, investment,
instruments, mode of investment etc. It implies a lack of information or a high level of
unpredictability.

RISK VS UNCERTAINITY:

Risk and uncertainty are two concepts commonly encountered in various fields, including
finance, business, and decision-making. While often used interchangeably, they represent
distinct concepts with different implications. The main difference between Risk & Uncertainty
are as follows:
SI.no Risk Uncertainty
1 Relates to known and measurable Involves unknown probabilities and
probabilities unpredictable outcomes
2 Can be quantified and assessed objectively Difficult to quantify or assess due to
lack of information
3 Arises from identifiable events or situations Arises from ambiguity and lack of
information
4 Involves known potential outcomes and Involves unknown potential outcomes
their likelihoods and their probabilities
5 Allows for calculation of expected values Does not allow for precise calculations
and probabilities or predictions
6 Can be managed and mitigated through risk Cannot be fully managed or eliminated
management strategies
7 Provides a basis for decision-making and Requires adaptive and flexible
planning approaches
8 Involves both positive and negative Can lead to both opportunities and
consequences threats
9 Frequently encountered in structured and Common in dynamic and complex
well-defined environments environments
10 Associated with potential losses or gains Associated with ambiguity and limited
information

CAUSES OF RISK:

1. Wrong method of investment

2. Wrong timing of investment
3. Wrong quantity of investment
4. Interest rate risk.
5. Nature of investment instruments.
6. Nature of industry in which the company is operating
7. Creditworthiness of the issuer
8. Maturity period or length of investment
9. Terms of lending
10. National and international factors
11. Natural calamities etc.
Types of Risk:

I. Systematic Risk:

Systematic risk is due to the influence of external factors on an organization. Such factors are
normally uncontrollable from an organization's point of view. It is a macro in nature as it
affects a large number of organizations operating under a similar stream or same domain. It
cannot be planned by the organization.

The types of systematic risk are depicted and listed below:

1. Interest rate risk:

Interest-rate risk arises due to variability in the interest rates from time to time. It particularly
affects debt securities as they carry the fixed rate of interest. The types of interest-rate risk are
depicted and listed below:
The meaning of price and reinvestment rate risk is as follows:

a. Price risk arises due to the possibility that the price of the shares, commodity,
investment, etc. may decline or fall in the future.

b. Reinvestment rate risk results from fact that the interest or dividend earned
from an investment can't be reinvested with the same rate of return as it was
acquiring earlier.

2. Market risk:

Market risk is associated with consistent fluctuations seen in the trading price of any
particular shares or securities. That is, it arises due to rise or fall in the trading price of listed
shares or securities in the stock market.

The types of market risk are depicted and listed below:

The meaning of different types of market risk is as follows:

a. Absolute risk is without any content. For e.g., if a coin is tossed, there is
fifty percentage chance of getting a head and vice-versa.
b. Relative risk is the assessment or evaluation of risk at different levels of business
functions. For e.g. a relative-risk from a foreign exchange fluctuation may be
higher if the maximum sales accounted by an organization are of export sales.
c. Directional risks are those risks where the loss arises from an exposure to the
particular assets of a market. For e.g. an investor holding some shares
experience a loss when the market price of those shares falls down.
d. Non-Directional risk arises where the method of trading is not consistently
followed by the trader. For e.g. the dealer will buy and sell the share
simultaneously to mitigate the risk.
e. Basis risk is due to the possibility of loss arising from imperfectly matched risks.
For e.g. the risks which are in offsetting positions in two related but non-identical
markets.
f. Volatility risk is of a change in the price of securities as a result of changes in the
volatility of a risk-factor. For e.g. it applies to the portfolios of derivative
instruments, where the volatility of its underlying is a major influence of prices
3. Purchasing power or inflationary risk:

Purchasing power risk is also known as inflation risk. It is so, since it emanates (originates)
from the fact that it affects a purchasing power adversely. It is not desirable to invest in
securities during an inflationary period.

The types of power or inflationary risk are depicted and listed below.

The meaning of demand and cost inflation risk is as follows:

a. Demand inflation risk arises due to increase in price, which result from
an excess of demand over supply. It occurs when supply fails to cope
with the demand and hence cannot expand anymore. In other words,
demand inflation occurs when production factors are under maximum
utilization.
b. Cost inflation risk arises due to sustained increase in the prices of goods
and services. It is actually caused by higher production cost. A high cost
of production inflates the final price of finished goods consumed by
people.

II. Unsystematic Risk:

Unsystematic risk is due to the influence of internal factors prevailing within an organization.
Such factors are normally controllable from an organization's point of view. It is a micro in
nature as it affects only a particular organization. It can be planned, so that necessary actions
can be taken by the organization to mitigate (reduce the effect of) the risk.

The types of unsystematic risk are depicted and listed below:

1. Business or liquidity risk:

Business risk is also known as liquidity risk. It is so, since it emanates (originates) from the
sale and purchase of securities affected by business cycles, technological changes, etc.

The types of business or liquidity risk are depicted and listed below:
The meaning of asset and funding liquidity risk is as follows:

• Asset liquidity risk is due to losses arising from an inability to sell or pledge assets at,
or near, their carrying value when needed. For e.g. assets sold at a lesser value than
their book value.
• Funding liquidity risk exists for not having an access to the sufficient-funds to make a
payment on time. For e.g. when commitments made to customers are not fulfilled as
discussed in the SLA (service level agreements).

2. Financial or credit risk:

Financial risk is also known as credit risk. It arises due to change in the capital structure of
the organization. The capital structure mainly comprises of three ways by which funds are
sourced for the projects. These are as follows:

• Owned funds. For e.g. share capital

• Borrowed funds. For e.g. loan funds.
• Retained earnings. For e.g. reserve and surplus.

The meaning of types of financial or credit risk is as follows:

• Exchange rate risk; is also called as exposure rate risk. It is a form of financial risk
that arises from a potential change seen in the exchange rate of one country's currency
in relation to another country's currency and vice-versa. For e.g. investors or
businesses face it either when they have assets or operations across national borders,
or if they have loans or borrowings in a foreign currency.
• Recovery rate risk; is an often neglected aspect of a credit-risk analysis. The
recovery rate is normally needed to be evaluated. For e.g. the expected recovery rate
of the funds tendered (given) as a loan to the customers by banks, non-banking
financial companies (NBFC), etc.
• Sovereign risk; is associated with the government. Here, a government is unable to
meet its loan obligations, reneging (to break a promise) on loans it guarantees, etc.
 • Settlement risk; exists when counterparty does not deliver a security or its value in
cash as per the agreement of trade or business.

3. Operational risk:

Operational risks are the business process risks failing due to human errors. This risk will
change from industry to industry. It occurs due to breakdowns in the internal procedures,
people, policies and systems.

The types of operational risk are depicted and listed below:

The meaning of types of operational risk is as follows:

1. Model risk: is involved in using various models to value financial securities. It is due
to probability of loss resulting from the weaknesses in the financial-model used in
assessing and managing a risk.
2. People risk; arises when people do not follow the organization’s procedures,
practices and/or rules. That is, they deviate from their expected behaviour.
3. Legal risk; arises when parties are not lawfully competent to enter an agreement
among themselves. Furthermore, this relates to the regulatory-risk, where a
transaction could conflict with a government policy or particular legislation (law)
might be amended in the future with retrospective effect.
4. Political risk; occurs due to changes in government policies. Such changes may have
an unfavourable impact on an investor. It is especially prevalent in the third-world
countries.

Techniques of measuring risks in capital budgeting:

• Risk adjusted cut off rate or method of varying discount rate: There are 2 types
of returns associated with the business namely; risk free return and risk adjusted of
return. risk free return is one which the business firms comfortably earn sufficient
profits without assuming the risking given situation, the anticipated cash flows are
earned by the project, risk adjusted cut off rate method is certain percentage of
discount factor will be added to the risk free return and such risk adjusted rate of
return will be used to find the present value of cash inflows. It is with reason this
method is called as risk adjusted rate of return where in both time preferences and
risk preference will be reflected together.
A Risk Adjusted Discount Rate (RADR) is a rate that adds a risk premium to the risk-free
rate to take into account the risk associated with future cash flows the firm expects from an
investment project

Risk-Adjusted Discount Rate = Risk-free Rate of Interest + Risk Premium

RADR=RF+R RF= Risk free return

R=Risky return or risk premium

• Certainty Equivalent Method: Certainty equivalent is the amount of cash an investor

would accept today than going for a larger amount of cash tomorrow. Investors often
use this to deny the risk. It helps investors earn a guaranteed income on their
investment rather than going for increased risk on their investment portfolios. The
certainty-equivalent method shows an amount of investment in the future an investor
will forego for a lesser amount of money now. That may happen because the future is
uncertain and higher levels of risks are associated with a higher potential of losses.
Therefore, risk-averse investors tend to use this method to avoid unnecessary risks in
the investments.
Certainty Equivalent = Expected Value – Risk Premium

Or

𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰
Certainty equivalent =
𝐑𝐢𝐬𝐤𝐲 𝐜𝐚𝐬𝐡 𝐟𝐥𝐨𝐰

• Sensitivity analysis: cash inflows are very sensitive to the business situations.
Every products sales is influenced by many factors viz., seasons and situations in the
economy some products are demand in a particular season, some products are not
preferred in certain situation etc, when the sales of the products are more in a
particular situation. Cash inflow during such period will be high. The overall situation
of the business or economy will be grouped into 3 categories optimistic. During
optimistic situation, sales of the company will be high, in most likely situation the
sales of the company will be normal accordingly cash flow of the project will be
moderate. In pessimistic situation, sales of the company will be less, accordingly the
cash flow generated during the period will also be less. Sensitivity analysis
determines how different values of an independent variable affect a particular
dependent variable under a given set of assumptions. This approach helps to take
decisions of accepting or rejecting a project through the estimation of Net Present
Value. Sensitivity analysis are also evaluated in conditions of finding out about a
project when there is a change in one of the variables by analyzing after tax cash
flows of combined forecast the variables.

The steps for analyzing sensitivity analysis are:

Identify the variables, which have an influence on the NPV or IRR of a proposal; the
mathematical relationship of the variable should be defined; an analysis of changes in the
variable is made through the NPV; and on the basis of the results the proposal may be
accepted or rejected.
New Output = Base Output x (1 + Change in Input)
New Profit = Base Profit x (1 + 10%) = Base Profit x 1.10

• Probability approach; Capital budgeting decisions are made by forecasting

future cash flows. There are uncertainties in assigning these cash flows. Where cash
flows are independent in nature and the cash flows receipt in the current year do not
have any relationship with the next year, probabilities can be assigned to the cash
flows. Probability is a measure, which is related to the likelihood of the occurrence
of an event. If a probability certainly occurs it is said that there is the probability of
one, but when it is not certain the probability of occurring of the event is zero. Thus
probabilities lie between 0 and 1. A probability distribution consists of many
estimates but usually firms/companies have three or four estimates.

The expected rate of return for any asset is the weighted average of all possible returns
multiplied by their respective probabilities. This can be represented as below,

Where, E(R) =Expected return,

n=Number of possible outcomes

Pi=Possibilities associated with ith possible outcome

Ri= Rate of return for the ith possible outcome.

• Standard deviation method: if two projects have the same cost and their net
present values are also the same, standard deviation of the expected cash flows of the
2 projects may be calculated to judge the comparative risk of the projects. The
project having a higher standard deviation is said to be more risky as compared to
others.

Standard Deviation is a degree of variation of individual items of a set of data from its
average. The square root of variance is called Standard Deviation. For Capital Budgeting
decisions, Standard Deviation is used to calculate the risk associated with the estimated cash
flows from the project. In this method the deviations are squared making all values positive.
Then the weighted average of these figures is taken, using probabilities on weights. The result
is termed as variance it is converted to the original units by taking the square root. The result
is termed as standard deviation,

Symbolically,
𝑛
σ = √∑𝑖=1[𝑅𝑖 − 𝐸(𝑅)]2 X Pi
Where, σ = Standard deviation
n = number of possible outcomes
𝑅𝑖 = Rate of return from the ith possible outcomes
𝐸(𝑅) = Expected return
Pi = Possibility associated with the ith possible outcome

• The Coefficient of Variation method; the standard deviation is a useful

measure of calculating the risk associated with the estimated cash inflows from an
Investment. However, in Capital Budgeting decisions, the management is several
times faced with choosing between many investments avenues. Under such
situations, it becomes difficult for the management to compare the risk associated
with different projects using Standard Deviation as each project has different estimated
cash flow values.
 In such cases, the Coefficient of Variation becomes useful. The Coefficient of Variation
calculates the risk borne for every percent of expected return. Coefficient of variation is a
relative of dispersion in which risk per unit of expected return is calculate

𝐒𝐭𝐚𝐧𝐝𝐚𝐫𝐝 𝐃𝐞𝐯𝐢𝐚𝐭𝐢𝐨𝐧 𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐑𝐞𝐭𝐮𝐫𝐧

Coefficient of variation =
𝐄𝐱𝐩𝐞𝐜𝐭𝐞𝐝 𝐂𝐚𝐬𝐡 𝐅𝐥𝐨𝐰

• Decision-Tree Analysis: A Decision Tree is a graphical chart and tool to help

people make better decisions. It is a risk analysis method. Basically, it is a graphical
presentation of all the possible options or solutions (alternative solutions and possible
choices) to the problem at hand. The name decision tree comes from the fact that the
final form of any decision tree must resemble a tree with roots and leaves. In place of
roots and leaves in a real tree, a decision tree has options and solutions. For any
executive, it is very important to know decision tree analysis, including how to use it,
its pros and cons, and related terminologies. A decision tree is a diagrammatic
representation of a multi-decision problem, where all possible courses of action are
represented, and every possible outcome of each course of action is shown.

Decision trees should be used where a problem involves a series of decisions being made
and several outcomes arise during the decision-making process. Decision trees force the
decision maker to consider the logical sequence of events. A complex problem is broken down
into smaller, easier to handle sections. The financial outcomes and probabilities are shown
separately, and the decision tree is 'rolled back' by calculating expected values and making
decisions.