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What is Risk and Uncertainty in Capital Budgeting?


Risk: It is variability between actual return and estimated return in a certain future. The decision maker draws a probability of certain return based on historical data.

Uncertainty: The decision makers are not able to draw probability of an outcome in uncertain future. The facts are unknown in uncertain future.

Risks associated with Projects are:
Stand-Alone risk: It is a risk associated with single project alone.
Corporate risk: It is a risk of a choosing a project which effects the overall company profits or positions.
Market risk: It is a risk of choosing a project which effects the shareholders position         in company.
Liquidity risk: To face difficulty in converting an investment into cash. It means investors are not able to get fair value on selling its investment when they need cash immediately.
Inflation risk: It is a loss of purchasing power. It means the quantity of goods you bought in Rs. 5 now you can buy in Rs.8. Due to the time variation the value of  money decrease this is known as inflation.

Methods to calculate Risk and Uncertainty in Capital Budgeting:
·         Sensitivity
·         Simulation
·         Scenario Analysis
·         Break Even Analysis
·         Decision Tree
·         Risk-Adjusted Discount Rate
·         Probability Distribution Approach
·         Certainty Equivalent

Sensitivity analysis:  It gives answer of “what if” question. It means how change in one variable affect the outcome of a project if other things remain same. It shows how sensitive NPV is if we change one variable (like sale value) then it affects the NPV value.

Example: There are 3 projects A, B and C and the required rate of return is 9% per annum. The expected cash inflows in different cases are as follows:


Particulars
Project A
Project B
Project C
Initial Cash Flows
(20,000)
(20,000)
(20,000)
Worst
18,000
14,000
16,000
Most Likely
32,000
36,000
32,000
Best
40,000
42,000
35,000
Project Period
5
5
5

Particulars
Cash Inflows
Discount rate 9%
Present Value
NPV
Worst
18,000
1.538
11703.51
-8296.48
Most likely
32,000
1.538
20806.24
806.24
Best
40,000
1.538
26007.80
6007.80

Particulars
Cash Inflows
Discount rate 9%
Present Value
NPV
Worst
14,000
1.538
9102.73
-10897.26
Most Likely
31,000
1.538
20156.04
156.04
Best
42,000
1.538
27308.19
7308.19

Particulars
Cash Inflows
Discount rate 9%
Present Value
NPV
Worst
16,000
1.538
10403.12
-9596.87
Most Likely
32,000
1.538
20806.24
806.24
Best
35,000
1.538
22756.82
2756.82








Find out which project is better among these three projects with the help of NPV sensitivity analysis method.
Project A: Cash Outflow = Rs. 20, 000
Project B: Cash Outflow = Rs. 20,000
Project C: Cash Outflow = Rs. 20,000

Observations of above tables are as follows:

1) In worst case project A is better than project B and C according to NPV.
2) In most likely case project A and C provide same NPV Rs.806.24. Any one of two can accepted.
3) In best case project B NPV Rs.7308.19 is better than project A and C in which NPV is Rs.6007.80 and Rs.2756.82 respectively and project A is better than C.

Therefore, according to the above observations if decision maker is risk taker project B is good and if conservative project A is good. Project C is better only in most likely case.

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