RISK AND

UNCERTAINITY IN
CAPITAL
BUDGETING
SUBMITTED TO: SUBMITTED BY:
MS. ANKITA TURKA ANJALI DHIMAN (3)
ANUSHKA MADAN (4)
MUSKAN (15)
PRACHI SHARMA (18)
 CAPITAL BUDGETING

• CAPITAL : Operating assets used for production.

• BUDGET : A plant that details projected cash flow during
some period.
• CAPITAL BUDGETING : Process of analysing projects and
deciding which ones to includes in capital budget.
• ACCORDING TO R.N.ANTHONY “any investment
involving commitment of funds now with the expectation
of earning a satisfactory return on these funds over the
period of time in future.
 RISK
• Risk is the variability in the actual returns in relation to the

estimated return.
• Risk exists when the decision maker is in a position to

assign probabilities to various outcome.

• Risk situation is one in which the probabilities of

occurrence of a particular event are known.

 UNCERTAINTY

• Uncertainty refers to the outcomes of given event which are

too unsure to be assigned probabilities.

• Uncertainty exists when the decision maker has no

historical data from which to develop a probability

distribution and must make intelligent guesses in order to

develop a subjective probability distribution.

 RISK AND RETURN

• Greater the risk grater the return.

• A risk without return is suicide.

• Risk can be minimized but

cannot be eliminated.
MEASUREMENT OF RISK

Behavioural Statistical

Sensitivity Standard
Analysis Deviation

Probability Coefficient
Distribution of Variation
 BEHAVIOURAL

The behavioural view of risk can be obtained by using:

1. Sensitivity Analysis
2. Probability Distribution
Sensitivity Analysis:
Sensitivity analysis helps a business estimate what will happen to the project if the
assumptions and estimates turn out to be unreliable.
It takes into account a number of possible outcomes/ returns estimates while
evaluating an asset.
 SENSITIVITY ANALYSIS

Sensitivity analysis provides a better understanding of the risks associated with a

project.
In order to have a sense of the variability among return estimates, a possible
approach is to estimate:
Worst (Pessimistic)
Expected (Most Likely)
Best (Optimistic)
The difference between the optimistic and the pessimist outcomes is the Range,
which, according to the sensitive analysis is the basic measure of Risk.
 SENSITIVITY ANALYSIS

The greater the range, the more the variability (risk) the asset is said to have.
On the basis of the range of annual returns, asset Y is more risky.
 SENSITIVITY ANALYSIS

LIMITATION:
The sensitivity analysis provides more than one estimate of the
future return of a project. It is, therefore, superior to single- figure
forecast bas it gives a more precise idea regarding the variability of
the returns. But it has a limitation in that it does not disclose the
chances of occurrence of these variations. So, to overcome this, we
have another method known as probability distribution.
 PROBABILITY DISTRIBUTION

The concept of probability provide a more precise measure of the

variability of cashflows.
The concept of probability is helpful as it indicates the percentage chance
of occurrence of each possible cash inflow.
For example, if some expected cash flow has 0.6 probability of occurrence,
it means that the given cash inflow is likely to be obtained in 6 out of 10
times. Likewise, if a cash flow has a probability of 1, it is certain to occur.
With zero probability, it will never occur.
The probability of obtaining particular cash flow estimates would be
between zero and one.
 PROBABILITY DISTRIBUTION

It involves two steps:

1. Depending on the chance of occurrence of a particular cash flow
estimate, probabilities are assigned. The probabilities can be subjective
or objective.
2. To estimate the expected return on the project. The returns are
expressed in terms of expected monetary values. The expected value of
a project is a weighted average return, where the weights are the
probabilities assigned to the various expected events, that is, the
expected monetary values of the estimated cash flows multiplied by the
probabilities.
PROBABILITY DISTRIBUTION
PROBABILITY DISTRIBUTION
 SCENARIO ANALYSIS
It is just like sensitivity analysis but broader in scope.

Unlike sensitivity analysis which analyses the impact of only one variable at a time, the
scenario analysis evaluates the impact on the project’s profitability of simultaneous
changes in more than one variable at a time, such as cash inflows, cash outflows and
cost of capital

The decision maker evaluates case under three scenario—

Best scenario
Most-likely
Worst scenario

its usefulness is limited in that it considers only a few discreet outcomes.

 STATISTICAL
It is more precise measure of risk.
The statistical view of risk can be obtained by using:
1. Standard Deviation
2. Coefficient of variation
These two measures tell us about the variability associated with the
expected cash flow in terms of degree of risk.
Standard deviation is an absolute measure which can be applied when the
projects involve the same outlay.
If the projects to be compared involve different outlays, the coefficient of
variation is the correct choice being a relative measure.
 STANDARD DEVIATION
Absolute measure of risk
In statistical terms, standard deviation is defined as the square root of the
mean of the squared deviation, where deviation being the difference
between the outcome and the expected mean value of all outcomes.
To calculate the value of standard deviation, we provide weights to the
square of each deviation by its probability of occurrence.
 STANDARD DEVIATION
Assume there are n possible levels of cash flows which are signified as CF1,
CF2…….CFn. The mean of these cash flows equals CF(BAR)
The probability of any Cfi is signified as Pi
For example the probability of CF4 is P4 and so on.

The formula to calculate the standard deviation:

 STANDARD DEVIATION

The greater the standard deviation of a probability distribution, the greater

is the dispersion of outcomes around the expected value.
It is a measure that indicates the degree of uncertainty (or dispersion) of
cash flow and is one precise measure of risk.
If two projects have same expected value ( mean) , then one which has
greater SD will be said to have higher degree of uncertainty or risk.
STANDARD DEVIATION (EXAMPLE)
Following table shows calculations of standard deviations for two projects.
STANDARD DEVIATION
The standard deviation of project X is smaller than project Y . Therefore it
can be concluded that project X is less risky than project Y.
The conclusion regarding the superiority of project X over project Y would
hold because both the projects have an equal outlay.
However, if the size of the projects outlay differ, the decision maker should
make use of the coefficient of variation to judge the riskiness of the
projects.
 Coefficient of variation

Relative measure of risk

Standard deviation can be misleading in comparing the uncertainty of
alternative projects, if they differ in size.
The coefficient of variation is correct technique in such cases.
It is calculated as:
 Coefficient of variation

Taking the previous example:

The coefficient of variation for
Project X – 0.516 (Rs10756.4 ÷ Rs20848)
Project Y – 2.06 (Rs43026 ÷ Rs20848)
The higher the coefficient, the more risky is the project.
Project Y is more risky than project X
Coefficient of variation(v)
However the real utility of V is apparent when we compare the projects
having different expected values.

On the basis of SD alone, project B would be labelled as a more risky

project than A but on the basis of V, project B would be considered less
risky
CONTINUED….
We can therefore conclude that the coefficient of variation is a better
measure of the uncertainty of cash flow returns than the standard deviation.
This is because the coefficient of variation adjusts for the size of the cash
flow, whereas the standard deviation does not.
Risk adjusted discount rate

This rate is based on the concept that investor demands higher returns from
the risky project

Risky projects - High Discount rates

Less Risky Projects - Low Discount Rates

E.g lower RAD for running business

Higher RAD for new product or to new type of customers

BASICALLY IT USED BY INVESTORS IN COMPENSATION TO THEIR HIGHER

INVESTMENT AND ADDITIONAL RISK AND TIME INVOLVED
 Risk-adjusted
Risk-adjusted discount
discount rate = rate = Risk-free
Risk-free interest
interest rate rate + risk
+ Expected
Expected risk premium premium
 Solution Now, the risk-adjusted discount rate for each project will
Solution
Project B = 2% + 5% = 7%
Project C = 1.2% + 4% = 5.2%
Project D = 3% + 7% = 10%
we need to calculate the PV of cash flows for each project using the above
RADR. Following is the NPV of the three projects:
Project B – $53,103 Project C – $71,400 Project D – $75,522
Now, to decide on the most profitable project, we need to deduct the initial
cash outflow from the PV to get the NPV.
Project B = $53,103 – $56,000 = -$2,897
Project C = $71,400 – $68, 000 = $3,400
Project D = $75,552 – $85,000 = -$9,448
Since Project C has a positive NPV, so Company A should invest in
Project C.
Certainity equivalent approach
This approach is an alternate to risk adjusted rate method which over comes the
limitations of radr under this method the destination of the project is eliminated by
adjusting the cash flows instead of discount rate
Certainty equivalent is quite a popular method among risk-averse investors. These
investors do not want to invest in high-return but risky investments. Instead, they
forgo higher returns for the lesser amount of income
For example, let’s suppose that a government bond offers a 3% return on
investments. There is another bond that offers 7% returns, but it is not guaranteed
as in the case of the government bond. In such circumstances, a risk-averse investor
will go for the government bond rather than going for the high-return bond.
The concept of certainty equivalent is instrumental in evaluating risk. It depends on
the risk tolerance of an individual and hence differs from person to person. For
example, investors nearing their retirement would be high certainty equivalent, as
they do not wish to take increased risks on their investments.
Question

Solution
Probability distribution approach

This approach provides valuable information about the expected value of

Return and the Dispersion of probability distribution of the possible
Returns
The theory of this approach depends upon the behaviour of cash flows
1. Independent cash flows
2. Depdndent cash flows
Decision tree
approach
DECESION TREE APPROACH

A capital budgeting decision tree shows the cash flows and net
present value of the project under differing possible
circumstances.
Illustration: A company has made following estimates if the
CFAT of the proposed project. The company. use decision tree
analysis to get clear picture of project's cash inflow.
Descesion tree Approach

This is a pictorial representation in tree form which indicates the

magnitude and Probability and inter relationship of all possible outcomes
This is basically a picture form of presentation in tree formatted lingerie
about relationships of probability of outcomes and their weights
Basically all possible values are weighted in their probabilistic terms and
then evaluated and analyzed
A picture format is used for better understanding the data
Decesion Tree
Approach