Module 2

Risk analysis in capital budgeting

RISK
Introduction:
Every business involves risk. In fact, risk is the characteristic inherent in every business.
Similarly, investment in securities also involves risk. In business, investment is made
with the expectation of earning income in the form of regular cash inflows. But the cash
inflows may not be regular as expected. That means, risk may be present in business.
Meaning of Risk:
In the general sense, risk may be defined as the difference between the expected return
on an investment and the actual return. In other words, risk is the variability which may
arise in future between the estimated or expected return and the actual return. In short,
risk is the variability of returns from those that are expected.
Risk arises in situations in which probabilities of a particular event which occurs are
known, i.e., the chance of future loss can be foreseen. In the case of risk, an estimate
can be made about the degree of happening of the future loss.
Definition of risk:
In the words of Hampton John, J, "Risk is the chance of future loss that can be foreseen."
Emmett J. Vaughan," Risk is a condition in which there is a possibility of an adverse
deviation from a desired outcome that is expected or hoped so far."
Uncertainty:
In the context of the study of risk, it is necessary to have some idea about uncertainty.
In the words of Hampton John, J. "Uncertainty is the unforeseen chance for future loss
or danger."
Technically, risk and uncertainty are different terms.
Risk refers to a situation where the degree of probability of the outcome of a future
event is known. But uncertainty refers to a situation when the degree of probability of
outcome of a future event is not known.
Further, the variability or deviation is less in the case of risk, whereas it is more in the
case of uncertainty.
Again, business decisions made under risk are less vulnerable as compared to business
decisions made under uncertainty.
It is true that, technically, risk differs from uncertainty. But, often. both the terms are
used interchangeably.

Risk and uncertainty

A risk refers to a situation where there is possibility of loss. Uncertainty, on the
other hand, refers to a situation where the outcome is not certain or is unknown.
There is lack of knowledge about what will happen or may not happen.
Uncertainty is just opposite of certainty where one is sure of the outcome.
Decision making under uncertain situations is difficult. It is the understanding of
the situation, skill and judgement of the decision maker which helps in taking
decisions.

Classification of Risks or Types of Risks:

Risks can be broadly classified into two categories. They are:
1. Systematic Risks
2. Unsystematic Risks
1. Systematic Risks:
Systematic risk is that part of the total risk that results from the tendency of stock prices
to move together with the general market. Systematic risks refer to risks which affect
the overall market, and consequently, cannot be reduced through diversification.
Systematic risks arise out of external and uncontrollable factors, such as the state of the
economy, tax reforms, energy situation and a number of other factors.
Examples of systematic risks are:
(i) The change in the interest rate policy effected by the Government.
(ii) Increase in the corporate tax rate by the Government.
(iii) Massive deficit financing resorted to by the Government.
(iv) Increase in the inflation rate.
(v) Restrictive credit policy promulgated by the Reserve Bank of India.
(vi) Relaxation of the foreign exchange controls, and announcement of full
convertibility of Indian rupee by the Government.
(vii) Withdrawal by the Government of tax on dividend payments by companies.
(viii) Elimination or reduction of capital gains tax.
Systematic risks include:
(a) market risk
(b) interest rate risk and
(c) purchasing power risk or inflation risk.
(a) Market risk: refers to risk arising out of changes in demand and supply pressures
or forces in the markets, following the changing flow of information and expectations
of investors. The investors attitude and expectations are the chief forces affecting
market risk. Marke risks include such factors as business recessions, depressions and
long-term changes in consumption in the economy.
Market risks cannot be eliminated. Through diversification, market risks can be
reduced, but cannot be completely eliminated, because price of all securities move
together, and any equity stock investor will have face the risk of downward market and
decline in security prices. Investor can try to reduce market risks by being conservative
in framing their investment portfolio, timing their stock purchases, and by choosing
growth stock.
(b) Interest rate risk: refers to risk that arises from the changes in the market rates of
interest from time to time. The prices of all securities rise or fall depending on the
change in interest rates. The longer the maturity period of a security, the higher will be
the yield on investment, and lower will be the fluctuations in prices. Short-term interest
rates fluctuate at a greater speed and are more volatile than long-term interest rates.
Interest rates change continuously for debentures and bonds.
Interest rate risk can be reduced by diversifying investment in various kinds of
securities, buying securities of different maturities and by analyzing the different kinds
of securities available for investment.
(c) Purchasing power risk or inflation risk: refers to risk that arises out of fall in the
purchasing power of money or rise in the prices of goods and services. Purchasing
power risk covers both inflation risks and deflation risks. Purchasing power risk is
inherent in all investments, and cannot be controlled.
(2) Unsystematic Risks:
Unsystematic risks are risks which are unique to a firm or to an industry. They do not
affect the overall market. Unsystematic risks arise out of the known and controllable
factors.
Unsystematic risks arise out of the uncertainties surrounding a particular firm or
industry due to factors like labor strike, irregular disorganized management policies and
consumer preferences, which are independent of the price mechanism operating in the
securities market. By diversification, unsystematic risks can be reduced, and even
eliminated, if diversification is effective.
Examples of unsystematic risks are:
(1) Declaration of strike by the company workers.
(ii) The R & D expert leaving the company.
(iii) A formidable competitor entering the market.
(iv) The company losing a big contract in a bid.
(v) The company making a breakthrough in process innovation.
(vi) The Government increasing customs duty on the materials by the company.
(vii) Inability of the company to obtain adequate quantity of raw materials.
(viii) Increase in input cost.
(ix) Specific tax incidence.
(x) Change in management.
(xi) Supply position in input.

Unsystematic risks include:

(a) business risk
(b) financial risk
(c) default or insolvency risk
(a) Business risk: implies uncertainty regarding operating profit (i.e., excess of
operating revenues over operating expenses). Business risk relates to the variability of
the business sales, income, profits, etc. which, in tum, depend on the market conditions,
product mix, input supplies, strength of the competitors, etc.
Business risk may be external risk or internal risk. The business risk is sometimes
external to the company due to changes in Government policy or strategy of competitors
or unforeseen market conditions. The business risks may be internal due to fall in
production, labor problems, raw materials problem or inadequate supply of electricity.
The internal business risks lead to fall in revenues and in profit of the company, and
they can be corrected by certain changes in the company's policies.
(b) Financial risk: refers to risk related to the financial structure of the company. In
other words, it is the risk associated with the debt-equity mix, short-term liquidity
problem, fall in current assets or rise in current liabilities.
Financial risks lead to fluctuations in earnings, profits and dividends to shareholders.
Financial risks are avoidable or controllable through proper financial planning. They
can be completely avoided, if a company does not resort to debt financing in capital
structure. But, then, the equity shareholders will be deprived of the benefit of trading
on equity and increase in earnings per share.
(c) Default or insolvency risk: refers to risk that arises out of default or insolvency on
the part of the issuer of securities. The borrower or issuer of securities may become
insolvent or may default or delay the payment of interest or principal amount.

Techniques of risk analysis in capital budgeting

Ⅰ. STATISTICAL TECHNIQUES
1. Probability: Probability is a measure about the chances that an event will occur.
When an event is certain to occur, probability will be 1 and when there is no
chance of happening an event probability will be 0.
2. Variance: is a measurement of the degree of dispersion between numbers in a
data set from its average. In very simple words, variance is the measurement of
difference between the average of the data set from every number of the data set.
Variance measures the uncertainty of a value from its average. Thus, variance
helps an organization to understand the level of risk it might face on investing in
a project. A variance value of zero would indicate that the cash flows that would
be generated over the life of the project would be same. This might happen in a
case where the company has entered into a contract of providing services in
return of a specific sum. A large variance indicates that there will be a large
variability between the cash flows of the different years. This can happen in a
case where the project being undertaken is very innovative and would require a
certain time frame to market the product and enable to develop a customer base
and generate revenues. A small variance would indicate that the cash flows
would be somewhat stable throughout the life of the project. This is possible in
case of products which already have an established market.
3. Standard deviation : 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.
4. The Coefficient of Variation: 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.
Ⅱ. CONVENTIONAL TECHNIQUES
1. Risk Adjusted Discount Rate: The use of risk adjusted discount rate (RADR)
is based on the concept that investors demands higher returns from the risky
projects. The required rate of return on any investment should include
compensation for delaying consumption plus compensation for inflation equal to
risk free rate of return, plus compensation for any kind of risk taken. If the risk
associated with any investment project is higher than risk involved in a similar
kind of project, discount rate is adjusted upward in order to compensate this
additional risk borne.
2. risk adjusted discount rate: A risk adjusted discount rate is a sum of risk-free
rate and risk premium. The Risk Premium depends on the perception of risk by
the investor of a particular investment and risk aversion of the Investor.
So, Risks adjusted discount rate = Risk free rate+ Risk premium
Risk Free Rate: It is the rate of return on Investments that bear no risk. For e.g.,
Government securities yield a return of 6 % and bear no risk. In such case, 6 % is
the risk-free rate.
Risk Premium: It is the rate of return over and above the risk-free rate, expected by
the Investors as a reward for bearing extra risk. For high risk project, the risk
premium will be high and for low risk projects, the risk premium would be lower.
3. Certainty Equivalent (CE) Method for Risk Analysis: Certainty equivalent
method –Definition: As per CIMA terminology, “An approach to dealing with
risk in a capital budgeting context. It involves expressing risky future cash flows
in terms of the certain cashflow which would be considered, by the decision
maker, as their equivalent, that is the decision maker would be indifferent
between the risky amount and the (lower) riskless amount considered to be its
equivalent”. The certainty equivalent is a guaranteed return that the management
would accept rather than accepting a higher but uncertain return. This approach
allows the decision maker to incorporate his or her utility function into the
analysis. In this approach a set of risk less cash flow is generated in place of the
original cash flows.

Ⅲ. Other techniques
1. Sensitivity analysis
Sensitivity analysis is defined as systematically varying one or more parameters in
a decision model over a specified range and recalculating the expected utility of the
model for each value. Sensitivity analysis examines the stability of a decision tree's
output by systematically varying input parameters.
2. Decision tree analysis
A decision tree is a tree-like model that acts as a decision support tool, visually
displaying decisions and their potential outcomes, consequences, and costs. From
there, the “branches” can easily be evaluated and compared in order to select the
best courses of action.