FINANCIAL MANAGEMENT (ADDITIONAL LESSONS) V SEMESTER B.Com UNIVERSITY OF CALICUT SCHOOL OF DISTANCE EDUCATION STUDY MATERIAL Core Course B.Sc. COUNSELLING PSYCHOLOGY III Semester physiological psychology FINANCE SPECIALIZATION CORE COURSE (CUCBCSSS - 2014 Admission onwards) UNIVERSITY OF CALICUT SCHOOL OF DISTANCE EDUCATION Calicut university P.O, Malappuram Kerala, India 673 635. 311-B
UNIVERSITY OF CALICUT SCHOOL OF DISTANCE EDUCATION STUDY MATERIAL B.Com FINANCIAL MANAGEMENT V Semester Core Course FINANCE SPECILIZATION Prepared by: : Smt. Shyamala.M Assistant Professor PG Department of Commerce and Management Studies, NSS College, Nemmara, Palakkad. Layout & Settings: Computer Section, SDE Reserved 2
Risk Analysis in Capital Budgeting Capital budgeting is a process of identifying, analyzing and selecting investment to determine a firm's expenditures on assets whose cash flows are expected to extend beyond one year. Capital budgeting is used to ascertain the requirements of the long-term investments of a company. Examples of long-term investments are those required for replacement of equipments and machinery, purchase of new equipments and machinery, new products, and new business premises or factory buildings, as well as those required for R&D plans. The different techniques used for capital budgeting include: Profitability index Net present value Modified Internal Rate of Return Equivalent annuity Internal Rate of Return The different types of risks that are faced by entrepreneurs regarding capital budgeting are the following: Corporate risk,international risk, Stand-alone risk, Competitive risk, risk, Project specific risk, Industry specific risk The following methods are used for Risk Analysis in Capital Budgeting: Sensitivity Analysis: This is also known as a what if analysis. Because of the uncertainty of the future, if an entrepreneur wants to know about the feasibility of a project in variable quantities, for example investments or sales change from the anticipated value, sensitivity analysis can be a useful method. This is calculated in terms of NPV, or net present value. Scenario Analysis: In the case of scenario analysis, the focus is on the deviation of a number of interconnected variables. It is different from sensitivity analysis, which usually concentrates on the change in one particular variable at a specific point of time. Break Even Analysis: The Break Even Analysis allows a company to determine the minimum production and sales amounts for a project to avoid losing money. The lowest possible quantity at which no loss 3
occurs is called the break-even point. The break-even point can be delineated both in financial or accounting terms. Simulation Analysis: Simulation analysis is utilized for formulating the probability analysis for a criterion of merit with the help of random blending of variable values that carry a relationship with the selected criterion. Decision Tree Analysis: The principal steps of decision tree analysis are the definition of the decision tree and the assessment of the alternatives. Corporate Risk Analysis: Corporate risk analysis focuses on the analysis of risk that may influence the project in terms of the entire cash flow of the firm. The corporate risk of a project refers to its share of the total risk of a company. Risk Management: Risk management focuses on factors such as pricing strategy, fixed and variable costs, sequential investment, insurance, financial leverage, long term arrangements, derivatives, strategic alliance and improvement of information. Selection of project under risk: This involves procedures such as payback period requirement, risk adjusted discount rate, judgmental evaluation and certainty equivalent method. Practical Risk Analysis: The techniques involved include the Acceptable Overall Certainty Index, Margin of Safety in Cost Figures, Conservative Revenue Estimation, Flexible Investment Yardsticks and Judgment on Three Point Estimates. RISK ADJUSTED DISCOUNT RATE For a long time, economic theorists have assumed that, to allow for risk, the businessman required a premium over and above an alternative, which was risk-free. Accordingly, the more uncertain the returns in the future, the greater the risk and grater the premium required. Based on this reasoning, it is proposed that the risk premium be incorporated into the capital budgeting analysis through the discount rate. That is, if the time preference for money is to be recognized by discounting estimated future cash flows, at some risk free rate, to their present value, then, to allow for the riskiness, of those future cash flows a risk premium rate may be added to risk-free discount rate. Such a composite discount rate, called the risk-adjusted discount rate, will allow for both time preference and risk preference and will be a sum of the risk-free rate and riskpremium rate reflecting the investors attitude towards risk. The risk-adjusted discount rate method can be formally expressed as follows: Risk-adjusted discount rate = Risk free rate + Risk premium Under capital asset pricing model, the risk premium is the difference between the market rate of return and the risk free rate multiplied by the beta of the project. 4
The risk adjusted discount rate accounts for risk by varying the discount rate depending on the degree of risk of investment projects. A higher rate will be used for riskier projects and a lower rate for less risky projects. The net present value will decrease with increasing risk adjusted rate, indicating that the riskier a project is perceived, the less likely it will be accepted. If the risk free rate is assumed to be 10%, some rate would be added to it, say 5%, as compensation for the risk of the investment, and the composite 15% rate would be used to discount the cash flows. Advantages of risk adjusted discount rate It is simple and can be easily understood. It has a great deal of intuitive appeal for risk-averse businessman. It incorporates an attitude towards uncertainty. Disadvantages This approach, however, suffers from the following limitations: There is no easy way deriving a risk adjusted discount rate. Capital asset pricing model provides a basis of calculating the risk adjusted discount rate. Its use has yet to pick up in practice. It does not make any risk adjusted in the numerator for the cash flows that are forecast over the future years. It is based on the assumption that investor are risk-averse. Through it is generally true, there exists a category of risk seekers who do not demand premium for assuming risks; they are willing to pay premium to take risks. Accordingly, the composite discount rate would be reduced, not increased, as the level of risk increases. 1. The Beta company Ltd is considering the purchase of a new onvestment. Two alternative investments are available (A and B) each costing Rs.1,00,000. Cash inflows are expected to be as CASH INFLOWS Year Investment A Investment B 1 40,000 50,000 2 35,000 40,000 3 25,000 30,000 4 30,000 The company has a target return on capital of 10%. Risk premium rates are 2% and 8% respectively for investments A and B. Which investment should be preferred? 5
Solution: The profitability of the two investments can be compared on the basis of net present values of cash inflows adjusted for risk premium rates as follows: Investment A Year Discount factor @ 10%+2%=12% 1.893 2.797 3.712 4.635 Cash Inflows 40,000 35,000 25,000 Present 35,720 27,895 17,800 12,700 Investment B Discount factor @ 10%+8%=18%.847.718.609.516 Cash Inflows 50,000 40,000 30,000 30,000 Present 42,350 28,720 18,270 15,480 94,115 1,04,820 Net Present Investment A Rs.94,115-1,00,000 Rs. (-)5,885 Investment B 1,04,820-1,00,000 Rs. 4,820 As even at a higher discount rate investment B gives a higher net present value, Investment B should be preferred. II Certainty Equivalent Method for Risk Analysis Another common procedure for dealing with risk in capital budgeting is to reduce the forecasts of cash flows to some conservative levels. In formal way, the certainty equivalent approach may be expressed as: Net present value = (the risk adjusted factor X the forecasts of net cash flow) / (1 + Risk free rate) The certainty equivalent coefficient, the risk adjustment factor assumes a value between zero and one, and varies inversely with risk. A lower risk adjustment rate will be used if lower risk is anticipated. The decision maker subjectively or objectively establishes the coefficients. These coefficients reflect the decision makers confidence in obtaining a particular cash flow in period. For example, a cash flow of Rs. 20000 may be estimated in the next year, but if the investor feels that only 80% of it is a certain amount, then the certainty-equivalent coefficient will be 0.8. That is, he consider only Rs.16000 as the certain cash flow. Thus, to obtain certain cash flows, we will multiply estimated cash flows by the certainty-equivalent coefficients. 6
The certainty-equivalent coefficient can be determined as a relationship between the certain cash flows and the risky cash flows. That is: Risk adjustment factor = certain net cash flow / Risky net cash flow For example, if one expected a risky cash flow of Rs. 80000 in period and certain cash flow of Rs. 60000 equally desirable, then risk adjustment factor will be 0.75 = 60000/80000. If the internal rate of return method is used, we will calculate that rate of discount, which equates the present value of certainty equivalent cash outflows. The rate so found will be compared with the minimum required risk free rate. Project will be accepted if the internal rate is higher than the minimum rate; otherwise it will be unacceptable. Evaluation of certainty equivalent The certainty equivalent approach explicitly recognizes risk, but the procedure for reducing the forecasts of cash flows is implicit and is likely to be inconsistent from one investment to another. Further, this method suffers from many dangers in a large enterprise. First, the forecaster, expecting the reduction that will be made in his forecasts, may inflate them in anticipation. This will no longer give forecasts according to best estimate. Second, if forecasts have to pass through several layers of management, the effect may be to greatly exaggerate the original forecast or to make it ultra conservative. Third, by focusing explicit attention only on the gloomy outcomes, chances are increased for passing by some good investments. II. There are two projects X and Y. Each involves an investment of Rs.40,000. The expected cash inflows and the certainty coefficients are as under: PROJECT X Year Cash inflow Certainty Coefficient 1 25,000.8 2.7 3.9 PROJECT Y Cash Inflow Certainty Coefficient.9 30,000.8.7 Risk free cut off rate is 10%. Suggest which of the two projects should be preferred. SOLUTION Year 1 2 3 Cash Inflow 25,000 Calculation of Cash Inflows with Certainity Project X Certain Cash Certainty Cash Inflow Coefficient Inflow.8.7.9 14,000 18,000 30,000 Project Y Certainty coefficient.9.8.7 Certain Cash Inflow 18,000 24,000 14,000 7
Calculations of Present of Cash inflows Year Discount Project X Project Y Factor @10% Cash inflows Present values Cash inflows Present values 1.909 20000 18,180 18,000 2.826 14000 11,564 24,000 3.751 18000 13,518 14,000 TOTAL 43,262 46,700 NET PRESENT VALUE PROJECT X 43262-40,000 = Rs.3,262 PROJECT Y 46,700-40,000 = Rs.6,700 As the net present value of project Y is more than that of Project X, Project Y should be preferred. III. SENSITIVITY TECHNIQUE In the evaluation of an investment project, we work with the forecasts of cash flows. Fore casted cash flows depend on the expected revenue and costs. Further, expected revenue is a function of sales volume and unit selling price. Similarly, sales volume will depend on the market size and firms market share. Costs include variable costs, which depend on sales volume, and unit variable cost and fixed costs. The net present value or the internal rate of return of a project is determined by analyzing the after tax cash flows arrived at by combining forecasts of various variables. It is different to arrive at an accurate and unbiased forecast of each variable. We can t be certain about the outcomes of any of these variables. The reliability of the net present value or internal rate of return of the project will depend on the reliability of the forecasts of each variable underlying the estimates of net cash flows. To determine the reliability of the projects net present value or internal rate of return, we can work out how much difference it makes if any of these forecasts goes wrong. We can change each of the forecasts, one at a time, to at least three values, expected, and optimistic. The net present value of the project is recalculated under these different assumptions. This method of recalculating net present value or internal rate of return by changing each forecast is called sensitivity analysis. Sensitivity analysis is a way of analyzing change in the projects values for a given change in one of the variables. It indicates how sensitive a projects value is to changes in particular variables. The more sensitivity of the value, the more critical is the variable. The following three steps are involved in the use of sensitivity analysis: Identification of all those variables, which have an influence on the projects value Definition of the underlying (mathematical) relationship between the variables Analysis of the impact of the change in each of the variables on the projects value 8
The decision maker, while performing sensitivity analysis computes the projects net present value or internal rate of return for each forecast under three assumptions. Pessimistic, Expected, Optimistic. It all allows him to ask what if. For example, what if volume increase or decreases? What if variable cost or fixed cost increases or decreases? What if the selling price increase or decreases? What if the project is delayed or outlay escalates or the projects life is more or less than anticipated? A whole range of questions can be answered with the help of sensitivity analysis. It examines the sensitivity of the variables underlying the computation of net present value or internal rate of return, rater than attempting to quantify risk. It can be applied to any variable, which is an input for the after tax cash flows. III. Mr.Siva is considering two mutually exclusive projects A and B. You are required to advise him about the acceptability of the projects from the following information. Cost of the investment Forecast cash Inflows per annum for 5 years Optimistic Most Likely Pessimistic (The Cut off rate may be assumed to be 15%) SOLUTION Optimistic Most Likely Pessimistic Annual Cash inflow PROJECT A 50,000 30,000 15,000 Calculations of Net Present of Cash Inflows at a Discount Rate of 15% (Annuity of Re.1 for 5 Years) Project A Project B Discount Present Net Annual Discount Factor Present Cash Factor @15% Inflow @15% 30,000 15,000 3.3522 3.3522 3.3522 1,00,566 67,014 50,283 50,566 17,044 283 40,000 5,000 3.3522 3.3522 3.3522 PROJECT B 50,000 40,000 5,000 Present 1,34,088 67,044 16,761 Net Present 84,088 17,044 33,239 The net present values calculated above indicate that Project B is more risky as compared to Project A. But at the same time during favorable conditions, it is more profitable also. The acceptability of the project will depend upon Mr. Siva s attitude towards risk. If he could afford to take higher risk, Project B is more profitable. IV. PROBABILITY TECHNIQUE Statistical techniques are analytical tools for handling risky investments. These techniques, drawing from the fields of mathematics, logic, economics and psychology, enable the decision- 9
maker to make decisions under risk or uncertainty. The concept of probability is fundamental to the use of the risk analysis techniques. Hoe is probability defined? How are probabilities estimated? How are they used in the risk analysis techniques? Probability may be described as a measure of someone s option about the likelihood that an event will occur. If an event is certain to occur, we say that it has a probability of one of occurring. If an event is certain not to occur, we say that its probability of occurring is zero. Thus, probability of all events to occur lies between zero and one. A probability distribution may consist of a number of estimates. But in the simple form it may consist of only a few estimates. One commonly used form employs only the high, low and best guess estimates, or the optimistic, most likely and pessimistic estimates. The classical concept of objective probability is of little use in analyzing investment decision because these decisions are non-respective and hardly made under independent identical conditions over time. As a result, some people opine that it is not very useful to express the forecaster s estimates in terms of probability. However, in recent years another view of probability has revived, that is, thepersonal view, which holds that it makes a great deal of sense to talk about the probability of a single event, without reference to the repeatability, long run frequency concept. 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. When future estimates of cash inflows have different probabilities the expected monetary values may be computed by multiplying cash inflow with the probability assigned. The monetary values of the inflows may further be discounted to find out the present values. The project that gives higher net present value may be accepted. IV. Two Mutually exclusive investment proposals are being considered. The following information is available: Cost Project X Rs.6,000 Project Y Rs. 6,000 CASH INFLOWS year Rs Probability Rs Probability 1 4,000.2 8,000.2 2 8,000.6 9,000.6 3 12,000.2 9,000.2 Assuming cost of capital at 10%, advice the selection of the project. 10
SOLUTION; Yea r PV factor @10 % Calculation of Net Present s of the Two Projects Project X Project Y Cash inflow s probabilit y Monetar y Presen t Cash inflow s probabil ity Monetary Present 1.909 4,000.2 800 727 7,000.2 1,400 1,273 2.826 8,000.6 4,800 3,965 8,000.6 4,800 3,965 3.751 12,000.2 2,400 1,802 9,000.2 1,800 1,352 Total Present value 6,494 6,590 Less: Cost of investment 6,000 6,000 Net present value 494 590 As the net present value of project y is more than that of Project X after taki9ng into consideration the probabilities of cash inflows, Project Y is more profitable. V. STANDARD DEVIATION METHOD: If two projects have the same cost and their net present values are also same, standard deviations of the expected cash inflows of the two 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 the other. From the following information, ascertain which project is more risky on the basis of standard deviation: PROJECT A PROJECT B Cash Inflow Probability Cash inflow Probability 2,000.2 2,000.1 4,000.3 4,000.4 6,000.3 6,000.4 8,000.2 8,000.1 11
Project A cash inflows Calculation of standard deviation Square of Deviation form Deviations (d2) Probability Mean (d) (5,000) 1 2 3 4 5 2,000 4,000 6,000 8,000-3,000-1,000 +1,000 +3,000 90,00,000 10,00,000 10,00,000 90,00,000.2.3.3.3 N=1 Weighted Sq.Deviations (fd2) 18,00,000 3,00,000 3,00,000 18,00,000 (fd2) = 42,00,000 Standard deviation fd2/n 4,/1 = 2.050 1 2 3 4 5 2,000 4,000 6,000 8,000-3,000-1,000 +1,000 +3,000 90,00,000 10,00,000 10,00,000 90,00,000.1.4.4.1 N=1 9,00,000 4,00,000 4,00,000 9,00,000 (fd2) = 26,00,000 fd2/n =1.612 26, 00,000/1 12
As the standard deviation of Project A is more than that of Project B, A is more risky. VI. Coefficient of variation method Coefficient of variation is a relative measure of dispersion. If the projects have the same cost but different net present values, relative measures, ie, coefficient of variation should be computed to judge the relative position of risk involved. It can be calculated as Coefficient of variation = standard deviation/meanx100 Using figures of above question compute coefficient of variation and suggest which proposal should be accepted. SOLUTION; Coefficient of variation = Standard deviation X100 Mean For Project B = 1,612 X100 = 32.24% 5,000 VII. DECISION TREE ANALYSIS For Project A = 2,050 X100 = 41% 5,000 In modern business There are complex investment decisions which involve a sequence of decisions over time. Such sequential decisions can be handles by plotting decisions trees. A decision tree is a graphic representation of the relationship between a present decision and future events, future decisions and their consequences. The sequence of events is mapped out over time in a format resembling branches of a tree and hence the analysis is known as decision tree analysis. The various steps involved are: 1. Identification of the problem 2. Finding out the alternatives 3. Exhibiting the decision tree indicating the decision points, chance events, and other relevant data 4. Specification of probabilities and monetary values for cash inflows and 5. Analysis of the alternatives. Conventional Techniques of Risk Analysis in capital budgeting A number of techniques to handle risk are used by managers in practice. They range from simple rules of thumb to sophisticated statistical techniques. The following are the popular, non- 13
conventional techniques of handling risk in capital budgeting. Payback Risk-adjusted discount rate Certainty equivalent These methods, as discussed below about payback first, but all of them are simple, familiar and partially defensible on theoretical grounds. However, they are based on highly simplified and at times, unrealistic assumptions. They fail to take account of whole range of the effect of risky factors on the investment decision-making. Payback Payback is one of the oldest and commonly used methods or explicitly recognizing risk associated with an investment project. This method, as applied in practice, is more an attempt to allow for risk in capital budgeting decision rather than a method to measure profitability. Business firms using this method usually prefer short payback to longer ones, and often establish guidelines that a firm should accept investments with some maximum payback period, say three or five years. The merit of payback is its simplicity. Also payback makes an allowance for risk by focusing attention on the near term future and thereby emphasizing the liquidity of the firm through recovery of capital, and by favoring short term projects over what may be riskier, longer term projects. It should be realized, however, that the payback period, as a method of risk analysis, is useful only in allowing for a special type of risk, the risk that a project will go exactly as planned for a certain period and will then suddenly cease altogether and be worth nothing. It is essentially suited to the assessment of risks of time nature. Once a payback period has been calculated, the decision-maker would compare it with his own assessment of the projects likely, and if the letter exceeds the former, he would accept the project. This is a useful procedure, economic only if the forecasts of cash flows associated with the project are likely to be unimpaired for a certain period. The risk that a project will suddenly cease altogether after a certain period life may arise due to reasons such as civil war in a country, closure of the business due to an indefinite strike by the workers, introduction of a new product but a competitor which captures the whole market and nature disasters such as flood or fire. Such risks undoubtedly exist but they, by no means, constitute a large proportion of the commonly encountered business risks. The usual risk in business is not that a project will go as forecast for a period and then collapse altogether; rather the normal business risk is that the forecasts of cash flows will go wrong due to lower sales, higher cost. 14