# session 4 risk - Risk Analysis in Capital Budgeting Nature...

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Risk Analysis in Capital Budgeting

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Nature of Risk 2 Risk exists because of the inability of the decision- maker to make perfect forecasts. In formal terms, the risk associated with an investment may be defined as the variability that is likely to occur in the future returns from the investment. Three broad categories of the events influencing the investment forecasts: General economic conditions Industry factors Company factors
Techniques for Risk Analysis 3 Statistical Techniques for Risk Analysis Probability Variance or Standard Deviation Coefficient of Variation Conventional Techniques of Risk Analysis Payback Risk-adjusted discount rate Certainty equivalent

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Probability 4 A typical forecast is single figure for a period. This is referred to as “best estimate” or “most likely” forecast: Firstly, we do not know the chances of this figure actually occurring, i.e ., the uncertainty surrounding this figure. Secondly, the meaning of best estimates or most likely is not very clear. It is not known whether it is mean, median or mode. For these reasons, a forecaster should not give just one estimate, but a range of associated probability–a probability distribution. Probability may be described as a measure of someone’s opinion about the likelihood that an event will occur.
Assigning Probability 5 The probability estimate, which is based on a very large number of observations, is known as an objective probability . Such probability assignments that reflect the state of belief of a person rather than the objective evidence of a large number of trials are called personal or subjective probabilities .

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Expected Net Present Value Once the probability assignments have been made to the future cash flows the next step is to find out the expected net present value. Expected net present value = Sum of present values of expected net cash flows. 6 =0 ENPV = (1 ) n t t ENCF k + ENCF = NCF × t jt jt P
Variance or Standard Deviation Simply stated, variance measures the deviation about expected cash flow of each of the possible cash flows. Standard deviation is the square root of variance. Absolute Measure of Risk. 7 2 2 =1 (NCF) = (NCF – ENCF) n j j j P σ

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Coefficient of Variation Relative Measure of Risk It is defined as the standard deviation of the probability distribution divided by its expected value:c Coeff of variation = standard deviation / expected value 8
Coefficient of Variation 9 The coefficient of variation is a useful measure of risk when we are comparing the projects which have ( i ) same standard deviations but different expected values, or ( ii ) different standard deviations but same expected values, or ( iii ) different standard deviations and different expected values.

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Risk Analysis in Practice 10 Most companies in India account for risk while evaluating their capital expenditure decisions. The following factors are considered to influence the riskiness of investment projects:
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## This note was uploaded on 03/03/2011 for the course MARKETING 101 taught by Professor Singh during the Spring '11 term at Management Development Institute.

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session 4 risk - Risk Analysis in Capital Budgeting Nature...

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