Project Appraisal Risk Analysis

Risk Analysis of Single Investments 1.1 Sources of Risk There are several sources of risks in a project. The important ones are: Project-specific Risk The earnings and cash flows of the project may be lower than expected because of an estimation error or due to some other factors specific to the project like quality of management. Competitive Risk The earnings and cash flows of the project may be affected by the unanticipated actions of competitors Industry-specific Risk Unexpected technological developments and regulatory changes, that are specific to the industry to which the project belongs, will have an impact on the earnings and cash flows of the project as well Market Risk Unanticipated changes in macroeconomic factors like GDP growth rate, interest rate, and inflation have an impact on all projects, albeit in varying degrees.

International Risk In the case of a foreign project, the earnings and cash flows may be different than expected due to the exchange rate risk or political risk. 1.2 Measures of Risk Risk refers to variability. It is a complex and multi-faceted phenomenon. A variety of measures have been used to capture different facets of risk. The more important are: Range, Standard deviation, Coefficient of variation, and semi-variance. Perspectives on Risk: Regardless of the risk measure employed, there are different perspectives on risk, which are:Stand-alone risk This represents the risk of a project when it is viewed in isolation Firm risk Also called corporate risk, this reflects the contribution of a project to the risk of the firm. Systemic risk/ market risk This represents the risk of a project from the point of view of a diversified investor.

The varieties of techniques developed to handle risk in capital budgeting fall into two broad categories: (i) Approaches that consider the stand-alone risk of a project( sensitivity analysis, scenario analysis, breakeven analysis, Hillier model, simulation analysis, and decision tree analysis ). (ii) Approaches that consider the contextual risk of a project (corporate risk analysis and market risk analysis). 1.3 Sensitivity Analysis Since future is uncertain, what will happen to the viability of the project when some variable like sales or investment deviates from its expected value. This type of analysis is called sensitivity or “what if” analysis. This is popular method for assessing risk. Sensitivity has certain merits: • It shows how robust or vulnerable a project is to changes in values of the underlying variables.

• It indicates where further work may be done. • It is intuitively a very appealing as it articulates the concerns that project evaluators normally have. Shortcomings: • It merely shows what happens to NPV when there is a change in some variable, without providing ant idea of how likely that change will be. • In sensitivity analysis only one variable is changed at a time. • It is inherently a very subjective analysis. Illustration ( Rs. in’000) Year 0 Years 1-10 1. Investment (20,000) 2. Sales 18,000 3. Variable costs 12,000 (66 2/3 % of sales ) 4. Fixed costs 1,000 5. Depreciation 2,000 6. PBT 3,000 7. Taxes 1,000

PAT 2,000 Cash flow from operation 4,000 NPV = -20,000,000 + 4,000,000 x PVIFA ( r = 12% and n= 10) = -20,000,000 + 4,000,000 x 5.650 = 2,600,000 Let us define the optimistic and pessimistic estimates for the underlying variables. ( Rs. in million) Range NPV Key variable Investment24 Sales Variable costs as (% of Sales) Fixed costs

Pessimistic Expected Optimistic 20 18 -1.40 15 18 21 70 66.66 65

Pessimistic Expected Optimistic 2.60 4.60 -1.17 2.60 4.93 0.34 2.60 3.73

1.3

1.47

1.0

0.8

2.60

3.33

1.4 Scenario Analysis In sensitivity analysis, typically one variable is varied at a time. If variables are interrelated, as they are most likely to be, it will be helpful to look at some plausible scenarios, each scenario representing a consistent combination of variables.

Procedure: 1. Select the factor around which scenarios will be built. The factor chosen must be the largest source of uncertainty for the success of the project. It may be the state of the economy or interest rate or technological development or response of the market. 2. Estimate the values of each of the variables in investment analysis ( investment outlay, revenues, costs, project life, and so on) for each scenario. 3. Calculate the NPV and/or IRR under each scenario. Illustration ABC co. is evaluating a project for introducing a new product. The management of the firm has identified three scenarios: 1) Moderate appeal to customers at a modest price. 2) Strong appeal to large segment of the market which is highly price-sensitive 3) Appeal to a small segment willing to pay a high price.

NPV calculation for three scenarios. ( Rs. in million) II III 200 200 15 40 40 10 600 400 480 120 50 50 20 20 50 210 25 105 25 105 45 125 10 years 10 years 25.9 427.4

Scenario I Initial investment 200 Unit selling price 25 Demand (in units) 20 Revenues 500 Variable costs ( R s. 12 per unit ) 240 Fixed costs 50 Depreciation 20 PBT 190 Tax @ 50% 95 PAT 95 Annual cash flow 115 Project life 10 years NPV 377.2 ( at a discount rate of 15% ) In the above illustration, an attempt has been made to develop scenarios in which the values of the variables are internally inconsistent. The objective of such a scenario analysis is to get a feel of what happens under the most favorable or the most adverse configuration.

1.5 Break Even Analysis A financial manager is always desires to know how much should be produced and sold at a minimum to ensure that the project does not lose money. Such an exercise is called break even analysis and the minimum quantity at which loss is avoided is called the break even point. The BEP may be defined in accounting or financial terms. The following example explains the concept of both types of BEP. XYZ is a highly profitable company. XYZ is planning to set up an extrusion plant. The following cash flow fore cast has been developed. (a) What is the NPV of the project? Assume that the cost of capital is 13%. The range of values that the underlying variables can take is also shown separately. (b) Calculate the effect of variations in the values of variables on NPV. (c) Calculate the accounting and financial BEP.

Investment Sales Variable costs(60% of Sales) Fixed costs Depreciation PBT Taxes PAT Cash flow from operations Underlying variable Investment Sales Variable costs (%) Fixed costs Cost of capital

14

Year 0 (250)

Rs. in million Years 1-10 200 120 20 25 35 10 25 50

Pessimistic 300 150 65 30 13

Expected 250 200 60 20 12

Optimistic 200 275 56 15

Solution a) Calculation of NPV NPV = C1 + C2 + C3 +----------+ C10 - Initial Investment 1.13 (1.13)² (1.13)³ (1.13)¹º = (50 x 5.42624) – 250 = 271.32 – 250 = 21.32 Accounting BEP: BEP = Fixed Costs +Depreciation = 20 +25 = 112.50 (sales) Contribution Ratio (200-120)/200 or 546.25 % of sales value Financial BEP: PV ( cash flows) = 271.32 = 1.356 (sales) When PV ( cash flows ) equals initial investment, it is called financial BEP. Therefore, 1.356 ( sales ) = 250 Sales = 250 = 184.36 or 92 % of sales value 1.356

1.6 How Financial Institutions Analyze Risk Financial institutions calculate several indicators for evaluating the risk being BEP, the DSCR, and fixed assets coverage ratio in addition to sensitivity analysis. BEP: It is calculated with reference to the year when the project is expected to reach its target level of capacity utilization, which is usually the third or the fourth year. It is calculated in terms of capacity utilization. So it is called break-even capacity utilization (BEPCU). Illustration: Capacity: 2680 tonnes, Year : third Capacity Utilization: 70 % or 2016 tonnes A. Variable Costs R. M. & Consumables Power & fuel Selling expenses Interest on W. C. 10.8 Other variable expenses Total

( Rs. in million) 137.2 24.7 19.2 5.0 196.9

B. Fixed Costs: Salaries & wages Repairs & maintenance Admn. Expenses Fixed selling expenses Fixed royalty Interest on term loans Depreciation & amortization Total C. Sales realization D. Contribution

22.0 2.0 2.5 6.3 3.0 12.0 7.5 55.3 265.6 68.7

BEPCU = Fixed costs x % capacity utilization Contribution = 55.3 x 70 % = 56.3 % 68.7 The cash BEPCU is calculated using the above formula without including depreciation and amortization as part of the fixed costs. Cash BEPCU = 47.8 x 70 % = 48.7% 68.7

Debt Service Coverage Ratio DSCR = PAT +Depreciation + Lease rental amortization + Interest on term loans Repayment of tern loans + Interest on term loans +Lease rental

The average DSCR is computed by taking the total of all values of numerator and denominator for the entire period of the proposed term loans, commencing from the year in which commercial production starts and not taking the DSCRs for each year. Average DSCR = Total cash accruals over the repayment period Total debt service burden over the same period Sensitivity Analysis Financial institutions carry out sensitivity analysis to asses the impact of adverse changes in the operating conditions of the project on its viability. The standard sensitivity analysis involves assessing the impact of 10 % adverse variation in selling price, quantity, and operating costs on the internal rate of return (IRR), DSCR, and BEPCU %.

Measures of Risk Risk refers to variability. It is a complex and multi-faceted phenomenon. A variety of measures have been used to capture different facets of risk. They are: 1. Range, Mean Absolute Deviation (MAD) 2. Standard Deviation 3. Coefficient of variation 4. Semi-variance To illustrate the calculation of these measures, consider a capital investment whose NPV has the distribution as: NPV Probability 200 0.3 600 0.5 900 0.2 The expected NPV works out to: 3

E (NPV) =Σ Pi NPVi i=1

= 0.3 x 200 + 0.5 x 600 + 0.2 x 900 = 540 1.Range: The simplest measure of risk, the range of a distribution is the difference between the highest value and the lowest value. The range is: 900 – 200 = 700 n MAD = Σ Pi [(Ri – R )] i=1 Where Pi = the probability associated with the ith possible value Ri = the ith possible value of the variable R = the mean of the distribution n = no.of values that can be taken by the variable The MAD shows that the variability of the values without regard to the sign of variation. MAD = 0.3( 200 – 540 ) + 0.5 (600 – 540) + 0.2 ( 900 - 540) = 102 + 30 + 72 = 204

2.Standard Deviation: It is obtained as under:σ = [ Σpi (Xi – X’)² ]½ Where σ = standard deviation pi = probability associated with the ith value Xi = ith value X’ = expected value So , σ = [ 0.3 ( 200 – 540 )² + 0.5 ( 600 – 540 )²+ (90 – 540 )²]½ = [ 62500]½ = 250 Variance:The square of standard deviation is called variance. Variance = 62,500 3. Coefficient of Variation:The coefficient of variation (CV) adjusts standard deviation for scale. It is defined as: CV = Standard Deviation Expected value The coefficient of variation for the investment is: CV = 250 / 540 = 0.46

4. Semi-Variance: There is a problem with SD. It considers all deviations, positive as well as negative, from the expected value in the same way. Since investors are concerned about only negative deviations, semi-variance seem to be a more suitable measure of risk. The semi-variance is computed the way the variance is computed, except that only outcomes below the expected value are taken into account.It is defined as: SV = Σ pi di’² Where di’ is equal to di, if di < 0 and equal to 0 if di > 0 The semi-variance for the investment is: SV = 0.3 ( 20 –540 )² = 34,680 The semi- standard deviation is the square root of semi-variance. The semi-standard deviation for the investment is:√(Semi-variance) = √( 34680) = 186.2

What is risk? Risk is a situation where the possible events are known, but which of those will actually happen is not known. But, the probability of their occurrence can be determined. The term“RISK” is used to mean that though it is known how much the cash flows are likely to be, we can express realizability only through a probability distribution. Types of Risk: Business Risk: It can be defined as the variability of the earnings due to changes in the firm’s normal operating conditions. It has its origin in the impact of the changing economic environment on the firm’s activities and the management’s decisions on the capital intensity of the operations. Business risk is the variability of the EBIT and is therefore unconnected to the financial risk. In other words, business risk can be expressed as the possibility that the firm may not be able to compete in the market as effectively as planned to with the assets available with it.

Sub-types of business risk: 1. Investment Risk: It is the variability in the earning due to variations in cash in flows and out flows resulting from the capital investments made by the firm. 2. Portfolio Risk: It is also variation of the earnings but from a completely different perspective. As for example, the variability of the earnings caused by the diversification, acquisition, merger etc. Financial Risk: Variability of the after tax earning or the EPS of the firm caused by the financial structure, or precisely, the debt content in the capital structure. It is the impact of the efficient or otherwise use made by the firm to its long-term capital on the earnings of the firm.