Risk Analysis In INVESTMENT

Risk Analysis In INVESTMENT

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Risk Riskis the potential of losing something of value, weighed against the potential to gain something of value

Financial riskThe probability that an actualreturnon aninvestmentwill be lower than theexpected return.

Risk analysisAlmost all sorts of large businesses require a minimum sort of risk analysis. For example, commercial banks need to properly hedge foreign exchange exposure of oversees loans while large department stores must factor in the possibility of reduced revenues due to a global recession. Risk analysis allows professionals to identify and mitigate risks, but not avoid them completely. Proper risk analysis often includes mathematical and statistical software programs.methods to perform a risk analysis in the computer field is calledfacilitated risk analysis process (FRAP).

Nature of RiskRisk exists because of the in ability of the decision maker to make perfect forecast. Forecast cannot be made on perfection coz the future event they depend are uncertain.For example, a company wants to produce and market a new product to their prospective customers. The demandis affectedby the general economic conditions. Demandmay bevery highif thecountry experiences highereconomic growth. Ontheotherhandeconomicevents like weakening of US dollar,sub prime crises may trigger economic slow down. This may create apessimistic demanddrastically y bringing downtheestimateofcashflows.

Factorsthataffect forecastsofinvestment,costandrevenue.The business isaffected bychanges in political situations, monetary policies, taxation, interest rates,policies of the central bank of the country on leading by banks etc.Industry specific factors influence the demand for the products of theindustry to which the firmbelongs.Company specific factors like change in management,wage negotiations with the workers, strikes or lockouts affect companys cost and revenue positions. Therefore,risk analysis in capital budgeting is part and parcel of enterprise risk management.

typeRisks ina projectaremany. Itis possibleto identify three separate and distinct type of risk in any project.1. Standalonerisk2. Portfoliorisk3. Marketor beta risk

Standalone risk is therisk ofaprojectwhen theprojectis consideredin isolation. Corporaterisk is theprojects risks to the riskof thefirm. Market riskis systematic risk.Themarketrisk isthemostimportantriskbecauseofthedirect influence ithas on stockprices.7

Sources of risk Project specific risk Competitive or Competition risk Industry specific risk International risk Market risk

1. Project specific risk: The sources of this risk could be traced to something quite specific to the project. Managerial deficiencies or error in estimation of cash flows or discount rate may lead to a situation of actual cash flows realised being less than that projected.2. Competitive risk or Competition risk: unanticipated actions of a firms competitors will materially affect the cash flows expected from a project. Because of this the actual cash flows from a project will be less than that of the forecast.3. Industry specific: industry specific risks are those that affect all the firms in the industry. It could be again grouped into technological risk, commodity risk and legal risk. All these risks will affect the earnings and cash flows of the project. The changes in technology affect all the firms not capable of adapting themselves to emerging new technology. The best example is the case of firms manufacturing motor cycles with two strokes engines. When technological innovations replaced the two stroke engines by the four stroke engines those firms which could not adapt to new technology had to shut down their operations. Commodity risk is the risk arising from the effect of price changes on goods produced and marketed. Legal risk arises from changes in laws and regulations applicable to the industry to which the firm belongs. The best example is the imposition of service tax on apartments by the Government of India when the total number of apartments built by a firm engaged in that industry exceeds a prescribed limit. Similarly changes in Import Export policy of the Government of India have led to the closure of some firms or sickness of some firms.4. International Risk: these types of risks are faced by firms whose business consists mainly of exports or those who procure their main raw material from international markets. For example, rupee dollar crisis affected the software and BPOs because it drastically reduced their profitability. Another best example is that of the textile units in Tirupur in Tamilnadu, exporting their major part of the garments produced. Rupee gaining and dollar Weakening reduced their competitiveness in the global markets. The surging Crude oil prices coupled with the governments delay in taking decision on pricing of petro products eroded the profitability of oil marketing Companies in public sector like Hindustan Petroleum Corporation Limited. Another example is the impact of US sub prime crisis on certain segments of Indianeconomy. The changes in international political scenario also affect the operations of certain firms.5. Market Risk: Factors like inflation, changes in interest rates, and changing general economic conditions affect all firms and all industries.

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TechniquesConventional techniquesPaybackRisk-adjusted discount rateCertainty evaluationSensitivity AnalysisStatistical TechniquesProbability Distribution ApproachVariance

There are many techniques of incorporation of risk perceived in the evaluation of capital budgeting proposals. They differ in their approach and methodology so far as incorporation of risk in the evaluation process is concerned.9

PaybackThe oldest and commonly used method of recognizing risk associated with a capital budgeting proposal is pay back period.Under this method, shorter pay back period is given preference to longer ones.Firms establish guidelines for acceptance or rejections of projects based on standards of pay back periods.Payback period prefers projects of short term pay backs to that of long term pay backs.Traditionally Indian business community employs this technique in evaluating projects with very high level of uncertainty.Pay back period ignores time value of many (cash flows).

exampleParticularsProject A (Rs) Project B (Rs)

Initial cash outlay 10 lakhs 10 lakhs

Cash flowsYear 15 lakhs 2 lakhs Year 23 lakhs2 lakhsYear 31 lakhs3 lakhsYear 41 lakhs3 lakhs

Both the projects have a pay back period of 4 years. The project B is riskier than the Project A because Project A recovers 80% of initial cash outlay in the first two years of its operation where as Project B generates higher Cash inflows only in the latter half of the payback period. This undermines the utility of payback period as a technique of incorporating risk in project evaluation. This method considers only time related risks and ignores all other risks of the project under consideration.

Risk-adjusted discount rateThe basis of this approach is that there should be adequate reward in the form of return to firms which decide to execute risky business projects.To motivate firms to take up risky projects returns expected from the project shall have to be adequate, keeping in view the expectations of the investors. Therefore risk premium need to be incorporated in discount rate in the evaluation of risky project proposals.

Risk free rate is computed based on the return on government securities.Risk premium is the additional return that investors require as compensation for assuming the additional risk associated with the project to be taken up for execution.12

ContTherefore the discount rate for appraisal of projects has two components.Those components areRisk free rate and risk premiumRisk Adjusted Discount rate = Risk free rate + Risk premiumThe more uncertain the returns of the project the higher the risk. Higher the risk greater the premium. Therefore, risk adjusted Discount rate is a composite rate of risk free rate and risk premium of the project.

exampleAn investment will have an initial outlay of Rs 100,000. It is expected to generate cash inflows as under:

YearCash in flow140,000250,000315,000430,000

Risk free rate of interest is 10%. Risk premium is 10% (the risk characterizing the project)(a) compute the NPV using risk free rate(b) Compute NPV using risk adjusted discount rate

solution(a) using risk free rateYearCash in flows Rs PV factor at 10% PV of cash inflows140,0000.90936,360250,0000.82641,300315,0000.75111,265430,0000.68320,490PV of cash in flows1,09,415PV of Cash outflows1,00,000NPV9,415

(b) Using risk adjusted discount rateYearCash in flows Rs PV factor at 20% PV of cash inflows140,0000.83333,320250,0000.69434,700315,0000.5798,685430,0000.48214,460PV of cash in flows91,165PV of Cash outflows1,00,000NPV(8,835)

The project would be acceptable when no allowance is made for risk.But it will not be acceptable if risk premium is added to the risk free rate. It moves from positive NPV to negative NPV.If the firm were to use the internal rate of return, then the project would be accepted when IRR is greater than the risk adjusted discount rate.

Evaluation of Risk adjusted discount rate:Advantages:1. It is simple and easy to understand.2. Risk premium takes care of the risk element in future cash flows.3. It satisfies the businessmen who are risk averse.Limitations:1. There are no objective bases of arriving at the risk premium. In this process the premium rates computed become arbitrary.2. The assumption that investors are risk averse may not be true in respect of certain investors who are willing to take risks. To such investors, as the level of risk increases, the discount rate would be reduced.3. Cash flows are not adapted to incorporate the risk adjustment for net cash in flows.

Certainty EquivalentUnder this method the risking uncertain, expected future cash flows are converted into cash flows with certainty. Here we multiply uncertain future cash flows by the certainty equivalent coefficient to convert uncertain cash flows into certain cash flows. The certainty equivalent coefficient is also known as the risk adjustment factor.Risk adjustment factor is normally denoted by t (Alpha). It is the ratio of certain net cash flow to risky net cash flow = Certainty Equivalent = Certain Cash flow Risky Cash flowCertainty equivalent coefficient is between 0 and 1. This risk adjustment factor varies inversely with risk. If risk is high a lower value is used for risk adjustment.If risk is low a higher coefficient of certainty equivalent is used

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exampleA project costs Rs 50,000. It is expected to generate cash inflows as underYearCash in FlowsCertainty Equivalent132,0000.9227,0000.6320,0000.5410,0000.3

solutionYearUncertain cash in flowsC.E.Certain cash flowsPV Factor at10%PV of certain cash inflows132,0000.928,8000.90926,179227,0000.616,2000.82613,381320,0000.510,0000.7517,510410,0000.33,0000.6832,049PV of certain cash inflows49,119Initial cash out lay50,000NPV(881)

The project has a negative NPV.Therefore, it is rejected.If IRR is used the rate of discount at which NPV is equal to zero is computed and then compared with the minimum (required) risk free rate.If IRR is greater than specified minimum risk free rate, the project is accepted, other wise rejected.

Sensitivity AnalysisAnalysing the change in the projects NPV or IRR on account of a given change in one of the variables is called Sensitivity Analysis.It is a technique that shows the change in NPV given a change in one of the variables that determine cash flows of a project. It measures the sensitivity of NPV of a project in respect to a change in one of the input variables of NPV.The reliability of the NPV depends on the reliability of cash flows. If fore casts go wrong on account of changes in assumed economic environments, reliability of NPV & IRR is lost.Therefore, forecasts are made under different economic conditions viz pessimistic, expected and optimistic. NPV is arrived at for all the three assumptions.

There are many variables like sales, cost of sales, investments, tax rates etc which affect the NPV and IRR of a project.22

Following steps are involved in Sensitivity analysis:1. Identification of variables that influence the NPV & IRR of the project.2. Examining and defining the mathematical relationship between the variables.3. Analysis of the effect of the change in each of the variables on the NPV of the project.

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exampleA company has two mutually exclusive projects under consideration viz project A & project B.Each project requires an initial cash outlay of Rs 3,00,000 and has an effective life of 10 years.The companys cost of capital is 12%. The following fore cast of cash flows are made by the management.EconomicProject AProject BEnvironmentAnnual cash inflowsAnnual cash in flowsPessimistic65,00025,000Expected75,00075,000Optimistic90,0001,00,000

What is the NPV of the project?Which project should the management consider?Given PVIFA = 5.650

Present Value Interest Factor Of Annuity

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SolutionsNPV of project AEconomicProjectPVIFAPV of cash inflowNPVEnvironmentCash inflowsAt 12% (10 years)Pessimistic65,0005.6503,67,25067,250Expected75,0005.6504,23,7501,23,750Optimistic90,0005.6505,08,5002,08,500

NPV of project BPessimistic25,0005.6501,41,250(1,58,750)Expected75,0005.6504,23,7501,23,750Optimistic1,00,0005.6505,65,0002,65,000

DecisionUnder pessimistic conditions project A gives a positive NPV of Rs 67,250 and Project B has a negative NPV of Rs 1,58,750 Project A is accepted.Under expected conditions, both gave some positive NPV of Rs 1,23,000. Any one of two may be accepted.Under optimistic conditions Project B has a higher NPV of Rs 2,65,000 compared to that of As NPV of Rs 2,08,500.Difference between optimistic and pessimistic NPV for Project A is Rs 1,41,250 and for Project B the difference is Rs 4,23,750.Project B is risky compared to Project A because the NPV range is of large differences.

Statistical TechniquesStatistical techniques use analytical tools for assessing risks of investments

Probability Distribution ApproachWhen we incorporate the chances of occurrences of various economic environments computed NPV becomes more reliable. The chances of occurrences are expressed in the form of probability. Probability is the likelihood of occurrence of a particular economic environment. After assigning probabilities to future cash flows expected net present value is computed.

exampleA company has identified a project with an initial cash outlay of Rs 50,000. The following distribution of cash flow is given below for the life of the project of 3 years.Year 1Year 2Year 3Cash in flowProbabilityCash in flowProbabilityCash in flowProbability15,0000.220,0000.325,0000.418,0000.115,0000.220,0000.335,0000.430,0000.340,0000.232,0000.330,0000.245,0000.1

Discount rate is 10%

solutionYear 1 = 15,000 x 0.2 + 18,000 x 0.1 + 35,000 x 0.4 + 32,000 x 0.300 = 3,000 + 1,800 + 14,000 + 9,600 = 28,400Year 2 = 20,000 x 0.3 + 15,000 x 0.2 + 30,000 x 0.3 + 30,000 x 0.2 = 6,000 + 3,000 + 9,000 + 6,000 = 24,000Year 3 = 25,000 x 0.4 + 20,000 x 0.3 + 40,000 x 0.2 + 5,000 x 0.1 = 10,000 + 6,000 + 8,000 + 4,500 == 28,500YearExpected cash inflowsPV factor at 10%PV of expectedcash in flows128,4000.90925,816224,0000.82619,824328,5000.75121,403PV of expected cash in flows67,043PV of initial cash out lay50,000Expected NPV17,043

VarianceA study of dispersion of cash flows of projects will help the management in assessing the risk associated with the investment proposal.Dispersion is computed by variance or standard deviation. Variance measures the deviation of each possible cash flow from the expected.Square root of variance is standard deviation.

ExampleFollowing details are available in respect of a project which requires an initial cost of Rs 5,00,000.YearEconomic ConditionCash flowsProbability1High growth2,00,0000.3Average growth1,50,0000.6No growth40,0000.12High growth3,00,0000.3Average growth2,00,0000.5No growth5,00,0000.23High growth4,00,0000.2Average growth2,50,0000.6No growth30,0000.2

SolutionYear 2Year 1Year 3Economic ConditionCash in FlowProbabilityExpected value of Cash in flow123High growth2,00,0000.360,000Average growth1,50,0000.690,000No growth40,0000.14,000Expected Value1,54,000

Economic ConditionCash in FlowProbabilityExpected value of Cash in flowHigh growth3,00,0000.390,000Average growth2,00,0000.51,00,000No growth50,0000.210,000Expected Value2,00,000

Economic ConditionCash in FlowProbabilityExpected value of Cash in flowHigh growth4,00,0000.280,000Average growth2,50,0000.61,50,000No growth30,0000.26,000Expected Value2,36,000

Expected NPV =1,54,000 + 2,00,000 + 2,36,000 5,00,000 1.10 (1.10)^2 (1.10)^3 = 1,40,000 + 1,65,289 + 1,77,310 -5,00,000 =(17,401) negative NPV

Standard Deviation for I yearCash in flowCExpected ValueE(C E)^2(C E)^2 x prob2,00,0001,54,000(46,000)^2(46,000)^2 x 0.3 = 634800 0001,50,0001,54,000(4000)^2(4,000)^2 x 0.3 = 9600 00040,0001,54,000( 1,14,000)^2(1,14,000)^2 x 0.3 = 12996 00 000Total1944 000 000

Variance of Cash flows for 1st year = 1944 000 000Standard Deviation of cash flows for 1st year = 44091

Standard Deviation for II yearCash in flowCExpected ValueE(C E)^2(C E)^2 x prob3,00,0002,00,000(1,00,000)^2(1,00,000)^2 x 0.3 = 3000 000 0002,00,0002,00,000(0)^2(0)^2 x 0.5 = 050,0002,00,000( -1,50,000)^2(1,50,000)^2 x 0.2 = 45 00 000 000Total7500 00 000

Variance of Cash flows for 2nd year = 7500 00 000Standard Deviation of cash flows for 2nd year =8660

Standard Deviation for II yearCash in flowCExpected ValueE(C E)^2(C E)^2 x prob4,00,0002,36,000(1,64,000)^2(1,64,000)^2 x 0.2 = 53792 00 0002,50,0002,36,000(14000)^2(14,000)^2 x 0.6 = 1176 00 00036,0002,36,000( 2,00,000)^2(2,00,000)^2 x 0.2 = 8000 000 000Total13496800 000

Variance of Cash flows for 3rd year = 13496800 000Standard Deviation of cash flows for 3rd year = 116175

Standard Deviation of NPV

the assumption is that there is no relationship between cash flows from one period to another. Under this assumption the standard deviation of NPV is Rs 96,314.On the other hand, if cash flows are perfectly correlated, cash flows of all years have linear correlation to one another, then

The standard deviation of NPV when cash flows are perfectly correlated will be higher than that under the situation of independent cash flows.