# risk_in_CB - Risk Analysis in Capital Budgeting Why the...

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Unformatted text preview: Risk Analysis in Capital Budgeting Why the concept of risk arises? Capital budgeting requires the projection of cash inflow and outflow of the future. The future in always uncertain, estimate of demand, production, selling price, cost etc., Cannot be exact. For example: The product at any time it become obsolete therefore, the future in unexpected, where the concept of risk arises. The following are the methods used for accounting of risk in capital budgeting. Incorporating Risk into Capital Budgeting Methods: Risk-Adjusted Discount Rate Certainty Equivalent Approach Sensitivity technique Probability technique Standard deviation method Decision tree analysis How can we adjust this model to take risk into account? n NPV = t=1 ACFt (1 + k) t - Co How can we adjust this model to take risk into account? n NPV = t=1 ACFt (1 + k) t Adjust the discount rate (k). - IO The Ramakrishna Ltd., in considering the purchase of a new investment. Two alternative investments are available (X and Y) each costing Rs. 150000. Cash inflows are expected to be as follows: Year Investment X Investment Y 1 2 3 4 60,000 45,000 35,000 30,000 65,000 55,000 40,000 40,000 The company has a target return on capital of 10%. Risk premium rate are 2% and 8% respectively for investment X and Y. Which investment should be preferred? Certainty Equivalent Approach Adjusts the risky after-tax cash flows to certain cash flows. The idea: Risky Cash X Flow Certainty Equivalent Factor (a) = Certain Cash Flow Certainly equivalent method Certainty Equivalent Approach simplest method Reduces the risk and uncertainty in decision making by employing only certain cash flows through certainty equivalent coefficient factor. = certain cash flows / expected cash flows Sensitivity technique When cash inflows are sensitive under different circumstances more than one forecast of the future cash inflows may be made. These inflows may be regarded on ‘Optimistic’, ‘most likely’ and ‘pessimistic’. Further cash inflows may be discounted to find out the net present values under these three different situations. If the net present values under the three situations differ widely it implies that there is a great risk in the project and the investor’s is decision to accept or reject a project will depend upon his risk bearing activities. Mr. Selva is considering two mutually exclusive project ‘X’ and ‘Y’. You are required to advise him about the acceptability of the projects from the following information. Probability Technique refers to the each event of future happenings are assigned with relative frequency probability. Probability means the likelihood of future event. Expected cash inflow * probability = Actual cash flows Actual cash flows are discounted . Out of all available projects, the project with higher net present value may be accepted. Two mutually exclusive investment proposals are being considered. The following information in available. Cost of each project is Rs 10,000/- Standard Deviation Two Projects have the same cash outflow and their net values are also the same, standard deviation of the expected cash inflows of the two Projects may be calculated to measure the comparative and risk of the Projects. The project having a higher standard deviation in said to be more risky as compared to the other. Decision Tree analysis It is helpful for taking risky and complex decisions Because it consider all the possible event’s and each possible events are assigned with the probability. Construction of Decision Tree 1. Define the problem 2. Evaluate the different alternatives 3. Indicating the decision points 4. Assign the probabilities of the monetary values 5. Analysis the alternatives. Accept/Reject criteria: If the net present values are positive the project may be accepted otherwise it is rejected. ...
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• Spring '17
• Net Present Value, net present values, certain cash flows, Certainty Equivalent Approach

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