Risk Analysis in Capital Budgeting

Chapter 8
Risk Analysis in Capital Budgeting

1 ICAI Mat
Possible net cash flows of Projects A and B at the end of first year and their probabilities are
given as below. Discount rate is 10 per cent. For both the project initial investment is ` 10,000.
From the following information, CALCULATE the expected net present value for each project.
State which project is preferable?
Project A Project B
Possible Event
Cash Flow (`) Probability Cash Flow (`) Probability
A 8,000 0.10 24,000 0.10
B 10,000 0.20 20,000 0.15
C 12,000 0.40 16,000 0.50
D 14,000 0.20 12,000 0.15
E 16,000 0.10
T E
8 ,000 0.10

I T U
S T
Expected Net Present Value
C I N
SJ
Answer
Calculation of Expected Value for Project A and Project B
Project A Project B
Possible Net Cash Expected Expected
Probability Cash Flow(`) Probability
Event Flow(`) Value(`) Value(`)
A 8,000 0.10 800 24,000 0.10 2,400
B 10,000 0.20 2,000 20,000 0.15 3,000
C 12,000 0.40 4,800 16,000 0.50 8,000
D 14,000 0.20 2,800 12,000 0.15 1,800
E 16,000 0.10 1,600 8,000 0.10 800
ENCF 12,000 16,000

The net present value for Project A is (0.909 × ` 12,000 – ` 10,000) = ` 908
The net present value for Project B is (0.909 × ` 16,000 – `10,000) = ` 4,544.

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Risk Analysis in Capital Budgeting

2 ICAI Mat; MTP May 19

Probabilities for net cash flows for 3 years of a project are as follows:
Year 1 Year 2 Year 3
Cash Flow (`) Probability Cash Flow (`) Probability Cash Flow (`) Probability
2,000 0.1 2,000 0.2 2,000 0.3
4,000 0.2 4,000 0.3 4,000 0.4
6,000 0.3 6,000 0.4 6,000 0.2
8,000 0.4 8,000 0.1 8,000 0.1

CALCULATE the expected net cash flows. Also calculate net present value of the project using
expected cash flows using 10 per cent discount rate. Initial Investment is ` 10,000.

Expected Cash flows and Net Present

Value

T E
Answer
I T U
Year 1 Year 2
S T Year 3
Cash Expected
I
Cash
C N Expected Cash Expected

SJ
Flow Probability Value Flow Probability Value Flow Probability Value
(`) (`) (`) (`) (`) (`)
2,000 0.1 200 2,000 0.2 400 2,000 0.3 600
4,000 0.2 800 4,000 0.3 1200 4,000 0.4 1,600
6,000 0.3 1,800 6,000 0.4 2400 6,000 0.2 1,200
8,000 0.4 3,200 8,000 0.1 800 8,000 0.1 800
ENCF 6,000 4,800 4,200
The present value of the expected value of cash flow at 10 per cent discount rate has been
determined as follows:
ENCF1 ENCF2 ENCF3
Present Value of cash flow = ! !
"1! k # "1! k # "1! k #
1 2 3

6 , 000 4 , 800 4 , 200

= # #
!1.1" !1.1" !1.1"
1 2 3

= (6,000 × 0.909) + (4,800 × 0.826) + (4,200 + 0.751)

= 12,573
Expected Net Present value = Present Value of cash flow – Initial Investment
= ` 12,573 – ` 10,000 = ` 2,573.

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3 ICAI Mat
CALCULATE Variance and Standard Deviation on the basis of following information:
Project A Project B
Possible Event
Cash Flow (`) Probability Cash Flow (`) Probability
A 8,000 0.10 24,000 0.10
B 10,000 0.20 20,000 0.15
C 12,000 0.40 16,000 0.50
D 14,000 0.20 12,000 0.15
E 16,000 0.10 8,000 0.10

Variance and Standard Deviation

Answer
T E
T U
Calculation of Expected Value for Project A and Project B
I
Project A
S T Project B
Possible Net Cash
C I
ProbabilityN Expected
Cash Flow(`) Probability
Expected

SJ
Event Flow(`) Value(`) Value(`)
A 8,000 0.10 800 24,000 0.10 2,400
B 10,000 0.20 2,000 20,000 0.15 3,000
C 12,000 0.40 4,800 16,000 0.50 8,000
D 14,000 0.20 2,800 12,000 0.15 1,800
E 16,000 0.10 1,600 8,000 0.10 800
ENCF 12,000 16,000

Project A
Variance (σ2) = (8,000 – 12,000)2 × (0.1) + (10,000 -12,000)2 × (0.2) + (12,000 – 12000)2 × (0.4) +
(14,000 – 12,000)2 × (0.2) + (16000 – 12,000)2 × (0.1)
= 16,00,000 + 8,00,000 + 0 + 8,00,000 + 16,00,000 = 48,00,000

Standard Deviation (σ) ! Variance " $2 # ! 48 , 00 , 000 = 2,190.90

Project B:
Variance(σ2) = (24,000 – 16,000)2 × (0.1) + (20,000 – 16,000)2 × (0.15) + (16,000 – 16,000)2 ×(0.5)
+ (12,000 – 16,000)2 × (0.15) + (8,000 – 16,000)2 × (0.1)

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= 64,00,000 + 24,00,000 + 0 + 24,00,000 + 64,00,000 = 1,76,00,000

Standard Deviation (σ) = 1,76,00,000 = 4195.23

4 ICAI Mat
CALCULATE Coefficient of Variation based on the following information:
Project A Project B
Possible Event
Cash Flow (`) Probability Cash Flow (`) Probability
A 10000 0.10 26,000 0.10
B 12,000 0.20 22,000 0.15
C 14,000 0.40 18,000 0.50
D 16,000 0.20 14,000 0.15
E 18,000 0.10 10,000 0.10

Coefficient of Variation

T E
I T U
S T
Answer
C I N
SJ
Calculation of Expected Value for Project A and Project B
Project A Project B
Possible Net Cash Expected Cash Flow Expected Value
Probability Probability
Event Flow (`) Value (`) (`) (`)
A 10,000 0.10 1,000 26,000 0.10 2,600
B 12,000 0.20 2,400 22,000 0.15 3,300
C 14,000 0.40 5,600 18,000 0.50 9,000
D 16,000 0.20 3,200 14,000 0.15 2,100
E 18,000 0.10 1,800 10,000 0.10 1,000
ENCF 14,000 18,000

Project A
Variance (σ2) = (10,000 – 14,000)2 × (0.1) + (12,000 -14,000)2 × (0.2) + (14,000 – 14000)2 × (0.4) +
(16,000 – 14,000)2 × (0.2) + (18000 – 14,000)2 × (0.1)
= 16,00,000 + 8,00,000 + 0 + 8,00,000 + 16,00,000 = 48,00,000
Standard Deviation (σ) = Variance ( σ 2) = 48,00,000 = 2,190.90

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Project B:
Variance (σ2) = (26,000 – 18,000)2 × (0.1) + (22,000 – 18,000)2 × (0.15) + (18,000 – 18,000)2 × (0.5)
+ (14,000 – 18,000)2 × (0.15) + (10,000 – 18,000)2 × (0.1)
= 64,00,000 + 24,00,000 + 0 + 24,00,000 + 64,00,000 = 1,76,00,000
Standard Deviation (σ) = 1,76,00,000 = 4195.23
Projects Coefficient of variation Risk Expected Value
A 2,190.90 Less Less
= 0.1565
14,000
B 4,195.23 More More
= 0.2331
18,000

In project A risk per rupee of cash flow is ` 0.15 while in project B it is ` 0.23.Therefore Project A
is better than Project B.

5 ICAI Mat; MTP Aug 18; RTP May 19; RTP Nov 19
T E
An enterprise is investing ` 100 lakhs in a project. The risk-free rate of return is 7%. Risk premium

I T U
expected by the Management is 7%. The life of the project is 5 years. Following are the cash

S
flows that are estimated over the life of the project.T
Year
C I N Cash flows (` in lakhs)
1
2 SJ 25
60
3 75
4 80
5 65

CALCULATE Net Present Value of the project based on Risk free rate and also on the basis of
Risks adjusted discount rate.

Net Present Value based on Risk Free Rate

and Risk Adjusted Discount Rate

Answer
The Present Value of the Cash Flows for all the years by discounting the cash flow at 7% is
calculated as below:

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Present value of Cash

Year Cash flows (` in lakhs) Discounting Factor @7%
Flows ` In Lakhs
1 25 0.935 23.38
2 60 0.873 52.38
3 75 0.816 61.20
4 80 0.763 61.04
5 65 0.713 46.35
Total of present value of Cash flow 244.34
Less: Initial investment 100.00
Net Present Value (NPV) 144.34

Now when the risk-free rate is 7% and the risk premium expected by the Management is 7%. So
the risk adjusted discount rate is 7% + 7% =14%.
Discounting the above cash flows using the Risk Adjusted Discount Rate would be as
below:
Discounting Present Value of Cash
Year Cash flows` in Lakhs
Factor@14% Flows ` in lakhs

TE
1 25 0.877 21.93
2 60
I T U
0.769 46.14

ST
3 75 0.675 50.63
4
5
80
65
C I N 0.592
0.519
47.36
33.74

Initial investment
SJ
Total of present value of Cash flow 199.79
100.00
Net present value (NPV) 99.79

6 ICAI Mat
If Investment proposal is `45,00,000 and risk free rate is 5%, CALCULATE net present value
under certainty equivalent technique.
Year Expected cash flow (`) Certainty Equivalent coefficient
1 10,00,000 0.90
2 15,00,000 0.85
3 20,00,000 0.82
4 25,00,000 0.78

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Net Present Value based on Certainity

Equivalent Approach

Answer
10,00,000 × ( 0.90 ) 15,00,000 × ( 0.85 ) 20,00,000 × ( 0.82 ) 25,00,000 × ( 0.78 )
NPV = + + + - 45,00,000
(1.05) (1.05)2 (1.05)3 (1.05) 4
= ` 5,34,570

7 ICAI Mat
X Ltd is considering its New Product ‘with the following details
Sr. No. Particulars Figures
1 Initial capital cost ` 400 Cr

TE
2 Annual unit sales ` 5 Cr

ITU
3 Selling price per unit ` 100

ST
4 Variable cost per unit ` 50
5
6 Discount Rate
C I N
Fixed costs per year ` 50 Cr
6%

Required: SJ
1. CALCULATE the NPV of the project.
2. COMPUTE the impact on the project’s NPV of a 2.5 per cent adverse variance in each
variable. Which variable is having maximum effect .Consider Life of the project as 3 years.

NPV and Sensitivity Analysis

Answer
1. Calculation of Net Cash Inflow per year:
Particulars Amount (`)
A Selling Price Per Unit (A) 100
B Variable Cost Per Unit (B) 50

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C Contribution Per Unit (C = A-B) 50

D Number of Units Sold Per Year 5 Cr.
E Total Contribution (E = C × D) ` 250 Cr.
F Fixed Cost Per Year ` 50 Cr.
G Net Cash Inflow Per Year (G = E - F) ` 200 Cr.

Calculation of Net Present Value (NPV) of the Project:

Year Year Cash Flow(` in Cr.) Discounting @ 6% Present Value (PV)(` in Cr.)
0 (400.00) 1.000 (400.00)
1 200.00 0.943 188.60
2 200.00 0.890 178.00
3 200.00 0.840 168.00
Net Present Value (188.60 + 178 + 168) - 400 134.60

Here NPV represent the most likely outcomes and not the actual outcomes. The actual
outcome can be lower or higher than the expected outcome.
2. Sensitivity Analysis considering 2.5 % Adverse Variance in each variable
Changes in variable Base
T E
Initial Cash Flow increased to ` 410 crore
I T U
Selling Price per Unit Reduced to ` 97.5
S T
I N
Variable Cost Per Unit increased to ` 51.25
C
SJ
Fixed Cost Per Unit increased to ` 51.2
Units sold per year reduced to 4.875 crore
Amount
Particulars Amount ` Amount ` Amount ` Amount ` Amount `
`
A Selling Price Per 100 100 97.5 100 100 100
Unit (A)
B Variable Cost Per 50 50 50 51.25 50 50
Unit (B)
C Contribution Per 50 50 47.5 48.75 50 50
Unit (C = A-B)
D Number of Units 5 5 5 5 5 4.875
Sold Per Year (in
Crores)
E Total Contribution 250 250 237.5 243.75 250 243.75
(E = C × D )
F Fixed Cost Per Year 50 50 50 50 51.25 50
(in Crores)

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G Net Cash Inflow Per 200 200 187.5 193.75 198.75 193.75
Year ( G = E - F)
H (G × 2.673) 534.60 534.60 501.19 517.89 531.26 517.89
I Initial Cash Flow 400 410 400 400 400 400
J NPV 134.60 124.60 101.19 117.89 131.26 117.89
K Percentage – 7.43% – 24.82% – 12.41% – 2.48% – 12.41%
Change in NPV

The above table shows that the by varying one variable at a time by 2.5% while keeping
the others constant, the impact in percentage terms on the NPV of the project. Thus it can
be seen that the change in selling price has the maximum effect on the NPV by 24.82 %.

8 ICAI Mat
XYZ Ltd. is considering a project “A” with an initial outlay of ` 14,00,000 and the possible three
cash inflow attached with the project as follows:
(` 000)

TE
Particular Year 1 Year 2 Year 3

ITU
Worst case 450 400 700
Most likely 550
S T 450 800
Best case

C
650
IN 500 900

S J
Assuming the cost of capital as 9%. Determine NPV in each scenario. If XYZ Ltd is certain
about the most likely result but uncertain about the third year’s cash flow, ANALYSE what will
be the NPV expecting worst scenario in the third year.

Scenario Analysis

Answer
The possible outcomes will be as follows:
Worst Case Most likely Best case
Year PVF @ 9% Cash Flow PV Cash Flow PV Cash Flow PV
` ‘000 ` ‘000 ` ‘000 ` ‘000 ` ‘000 ` ‘000
0 1 (1400) (1400) (1400) (1400) (1400) (1400)
1 0.917 450 412.65 550 504.35 650 596.05
2 0.842 400 336.80 450 378.90 500 421.00

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3 0.772 700 540.40 800 617.60 900 694.80

NPV -110.15 100.85 311.85

Now suppose that CEO of XYZ Ltd. is bit confident about the estimates in the first two years, but
not sure about the third year’s high cash inflow. He is interested in knowing what will happen
to traditional NPV if 3rd year turn out the bad contrary to his optimism.
The NPV in such case will be as follows:
5,50,000 4,50,000 7,00,000
= −- ` 14,00,000 + + +
(1+ 0.09) (1+0.09)2 (1+0.09)3
= − ` 14,00,000 + ` 5,04,587 + ` 3,78,756 + ` 5,40,528 = ` 23,871

9 ICAI Mat
Shivam Ltd. is considering two mutually exclusive projects A and B. Project A costs ` 36,000 and
project B ` 30,000. You have been given below the net present value probability distribution for
each project.
Project A Project B
NPV estimates (`) Probability
TE
NPV estimates (`)

U
Probability
15,000
12,000
0.2
0.3
T I T15,000
12,000
0.1
0.4
6,000
I
0.3
N S 6,000 0.4
3,000
SJ C
0.2 3,000 0.1

(i) COMPUTE the expected net present values of projects A and B.

(ii) COMPUTE the risk attached to each project i.e. standard deviation of each probability
distribution.
(iii) COMPUTE the profitability index of each project.
(iv) IDENTIFY which project do you recommend? State with reasons.

NPV,Standard Deviation and Profitability

index

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Answer
(i) Statement showing computation of expected net present value of Projects A and B:
Project A Project B
NPV Estimate Expected Expected
Probability NPV Estimate Probability
(`) Value Value
15,000 0.2 3,000 15,000 0.1 1,500
12,000 0.3 3,600 12,000 0.4 4,800
6,000 0.3 1,800 6,000 0.4 2,400
3,000 0.2 600 3,000 0.1 300
1.0 EV = 9,000 1.0 EV = 9,000

(ii) Computation of Standard deviation of each project

Project A
P X (X – EV) P (X- EV)²
0.2 15,000 6,000 72,00,000
0.3 12,000 3,000 27,00,000
0.3 6,000 – 3,000
T E 27,00,000
0.2 3,000 – 6,000
I T U 72,00,000

S T Variance = 1,98,00,000

Standard Deviation of Project A =

C I N 1,98,00,000 =` 4, 450

P
SJ X
Project B
(X – EV) P (X – EV)²
0.1 15,000 6,000 36,00,000
0.4 12,000 3,000 36,00,000
0.4 6,000 3,000 36,00,000
0.1 3,000 6,000 36,00,000
Variance = 1,44,00,000

Standard Deviation of Project B = 1, 44,00,000 =` 3,795

(iii) Computation of profitability of each project

Profitability index = Discount cash inflow / Initial outlay

In case of Project A: PI 9,000+36,000 45,000

PI == = = 1.25
36,000 36,000
9,000+30,000 39,000
In case of Project B: PI = = = 1.30
30,000 30,000

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(iv) In the selection of one of the two projects A and B, Project B is preferable because the
possible profit which may occur is subject to less variation (or dispersion). Much higher risk
is lying with project A.

10 ICAI Mat
From the following details relating to a project, analyse the sensitivity of the project to changes
in initial project cost, annual cash inflow and cost of capital:

Initial Project Cost (`) 1,20,000

Annual Cash Inflow (`) 45,000
Project Life (Years) 4
Cost of Capital 10%

IDENTIFY which of the three factors, the project is most sensitive if the variable is adversely
affected by 10%? (Use annuity factors: for 10% 3.169 and 11% ... 3.103).

Sensitivity Analysis
T E
I T U
S T
Answer
C I N
SJ
Calculation of NPV through Sensitivity Analysis
`
PV of cash inflows (` 45,000 × 3.169 ) 1,42,605
Initial Project Cost 1,20,000
NPV 22,605

Situation NPV Changes in NPV

Base (present) ` 22,605
If initial project cost is (` 1,42,605 – `1,32,000) = (` 22,605 – ` 10,605)/ ` 22,605
varied adversely by 10% `10,605 = (53.08%)
If annual cash inflow is [` 40,500 (revised cash flow) × (` 22,605 – ` 8,345) / ` 22,605
varied adversely by 10% 3.169) – (` 1,20,000)] = ` 8,345 = 63.08%
If cost of capital is varied (` 45,000 × 3.103) – ` 1,20,000 (` 22,605 – ` 19,635) / ` 22,605
adversely by 10% i.e. it = `19,635 = 13.14%
becomes 11%

Conclusion: Project is most sensitive to ‘annual cash inflow’

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11 RTP May 18
From the following details relating to a project, analyse the sensitivity of the project to changes
in initial project cost, annual cash inflow and cost of capital:
Initial Project Cost (`) 1,20,000
Annual Cash Inflow (`) 45,000
Project Life (Years) 4
Cost of Capital 10%
Required:
EXAMINE regarding which of the three factors, the project is most sensitive? (Use annuity
factors: for 10% 3.169 and 11% 3.103).

Sensitivity Analysis

T E
Answer
I T U
CALCULATION OF NET PRESENT VALUE
S T
C I N (`)

Initial Project Cost SJ

PV of Annual cash inflows (` 45,000 x 3.169) 1,42,605
1,20,000
NPV (PV of Cash flow – Initial Cost) 22,605
If initial project cost is varied adversely by 10%*
Initial Project Cost (1,20,000 x 110%) ` 1,32,000
NPV (Revised) (` 1,42,605 – ` 1,32,000 ) ` 10,605
Change in NPV (` 22,605 – ` 10,605)/ ` 22,605 i.e., 53.08%
If annual cash inflow is varied adversely by 10%*
Revised annual inflow (` 45,000 x 90%) ` 40,500
NPV (Revised) (` 40,500 x 3.169) – (` 1,20,000) (+) ` 8,345
Change in NPV (` 22,605 – ` 8,345) / ` 22,605 63.08%
If cost of capital is varied adversely by 10%*
NPV (Revised) (` 45,000 x 3.103) – ` 1,20,000 (+) ` 19,635
Change in NPV (` 22,605 – ` 19,635) / ` 22,605 13.14 %
Conclusion: Project is most sensitive to ‘annual cash inflows’
(*It is assumed that adverse variation is 10%)

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12 RTP Nov 18
Gauav Ltd. using certainty-equivalent approach in the evaluation of risky proposals. The
following information regarding a new project is as follows:
Year Expected Cash flow Certainty-equivalent quotient
0 (4,00,000) 1.0
1 3,20,000 0.8
2 2,80,000 0.7
3 2,60,000 0.6
4 2,40,000 0.4
5 1,60,000 0.3
Riskless rate of interest on the government securities is 6 per cent.

DETERMINE whether the project should be accepted?

Certainity Equivalent Approach

T E
I T U
S T
Answer
C I N
SJ
Determination of Net Present Value (NPV)
Adjusted Cash
Expected Cash Certainty- PV factor (at
Year flow (Cash flow Total PV (`)
flow (`) equivalent (CE) 0.06)
x CE) (`)
0 (4,00,000) 1.0 (4,00,000) 1.000 (4,00,000)
1 3,20,000 0.8 2,56,000 0.943 2,41,408
2 2,80,000 0.7 1,96,000 0.890 1,74,440
3 2,60,000 0.6 1,56,000 0.840 1,31,040
4 2,40,000 0.4 96,000 0.792 76,032
5 1,60,000 0.3 48,000 0.747 35,856
NPV = (6,58,776 - 4,00,000) 2,58,776
As the Net Present Value is positive the project should be accepted.

13 Nov 18
From the following details relating to a project, analyse the sensitivity of the project to changes
in the Initial Project Cost, Annual Cash Inflow and Cost of Capital :

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Risk Analysis in Capital Budgeting

Particulars
Initial Project Cost ` 2,00,00,000
Annual Cash Inflow ` 60,00,000
Project Life 5 years
Cost of Capital 10%
To which of the 3 factors, the project is most sensitive if the variable is adversely affected by 10 ?
Cumulative Present Value Factor for 5 years for 10% is 3.791 and for 11% is 3.696.

Sensitivity Analysis

Answer
Calculation of NPV through Sensitivity Analysis

T E `
PV of cash inflows (` 60,00,000 × 3.791)
I T U
2,27,46,000
Initial Project Cost
NPV S T 2,00,00,000
27,46,000

C I N
SJ
Situation NPV Changes in NPV
Base (present) ` 27,46,000
If initial project cost is varied (` 2,27,46,000 – ` 27,46,000 − ` 7,46,000
adversely by 10% ` 2,20,00,000*) = ` 7,46,000 ` 27,46,000

= (72.83%)
If annual cash inflow is varied [` 54,00,000 (revised ` 27,46,000 − ` 4,71,400
adversely by 10% cash flow) ** × 3.791) – ` 27,46,000
(` 2,00,00,000)] = 82.83%
= ` 4,71,400
If cost of capital is varied (` 60,00,000 × 3.696)– ` 27,46,000 - ` 21,76,400
adversely by 10% i.e. it ` 2,00,00,000 ` 27,46,000
becomes 11%
= ` 21,76,000 = 20.76%

*Revised initial project Cost = 2,00,00,000 × 110% = 2,20,00,000

**Revised Cash Flow = ` 60,00,000 x (100 – 10) % = ` 54,00,000
Conclusion: Project is most sensitive to ‘annual cash inflow’

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14 MTP May 19
Determine the risk adjusted net present value of the following projects:
X Y Z
Net cash outlays (`) 2,10,000 1,20,000 1,00,000
Project life 5 years 5 years 5 years
Annual Cash inflow (`) 70,000 42,000 30,000
Coefficient of variation 1.2 0.8 0.4

The Company selects the risk-adjusted rate of discount on the basis of the coefficient of variation:
P.V. Factor 1 to 5 years At risk
Coefficient of Variation Risk-Adjusted Rate of Return
adjusted rate of discount
0.0 10% 3.791
0.4 12% 3.605
0.8 14% 3.433
1.2 16% 3.274
1.6 18% 3.127
2.0 22%
T E 2.864
More than 2.0 25%
I T U 2.689

S T
C I N (5 Marks)

SJ
NPV based on Risk Adjusted Discounting
Rate using Coefficient of Variation

Answer
Statement showing the determination of the risk adjusted net present value
Risk
Net Coefficient Annual PV Discounted Net
adjusted
Projects cash of cash factor cash present
discount
outlays variation inflow 1-5 years inflow value
rate
(`) (`) (`) (`)
(vii) = (v)
(i) (ii) (iii) (iv) (v) (vi) (viii) = (vii) – (ii)
× (vi)
X 2,10,000 1.20 16% 70,000 3.274 2,29,180 19,180
Y 1,20,000 0.80 14% 42,000 3.433 1,44,186 24,186
Z 1,00,000 0.40 12% 30,000 3.605 1,08,150 8,150

8.16 |CA Inter FM

Divya Jadi Booti
Contact: 033-4059-3800 Website: sjc.co.in
Risk Analysis in Capital Budgeting

15 MTP May 19
Probabilities for net cash flows for 3 years of a project of Ganesh Ltd are as follows:
Year 1 Year 2 Year 3
Cash Flow Cash Flow Cash Flow
Probability Probability Probability
(`) (`) (`)
2,000 0.1 2,000 0.2 2,000 0.3
4,000 0.2 4,000 0.3 4,000 0.4
6,000 0.3 6,000 0.4 6,000 0.2
8,000 0.4 8,000 0.1 8,000 0.1

CALCULATE the expected net cash flows and the present value of the expected cash flow, using
10 per cent discount rate. Initial Investment is ` 10,000 (5 Marks)

PV of expected cash flows

T E
I T U
Answer
S T
Year 1
C I N Year 2 Year 3

Cash
Flow Probability ValueSJ
Expected Cash
Flow Probability
Expected
Value
Cash
Flow Probability
Expected
Value
(`) (`) (`) (`) (`) (`)

2,000 0.1 200 2,000 0.2 400 2,000 0.3 600

4,000 0.2 800 4,000 0.3 1200 4,000 0.4 1,600
6,000 0.3 1,800 6,000 0.4 2400 6,000 0.2 1,200
8,000 0.4 3,200 8,000 0.1 800 8,000 0.1 800
ENCF 6,000 4,800 4,200

The present value of the expected value of cash flow at 10 per cent discount rate has been
determined as follows:
ENCF1 ENCF2 ENCF3
Present Value of cash flow = + +
(1+k)1 (1+k)2 (1+k)3

= 6,0001 + 4,8002 + 4,2003

(1.1) (1.1) (1.1)
= (6,000 × 0.909) + (4,800 × 0.826) + (4,200 + 0.751)
= 12,573

CA Inter FM
| 8.17
Divya Jadi Booti
Contact: 033-4059-3800 Website: sjc.co.in
Risk Analysis in Capital Budgeting

Expected Net Present value = Present Value of cash flow - Initial Investment
= ` 12,573 – ` 10,000 = ` 2,573.

16 MTP May 19
Invest Corporation Ltd. adjusts risk through discount rates by adding various risk premiums to
the risk free rate. Depending on the resultant rate, the proposed project is judged to be a low,
medium or high risk project.
Risk level Risk free rate (%) Risk Premium (%)
Low 8 4
Medium 8 7
High 8 10

DEMONSTRATE the acceptability of the project on the basis of Risk Adjusted rate. (4 Marks)

Acceptability of Project based on Risk

Adjusted Rate
T E
I T U
S T
Answer
C I N
SJ
Calculation of Risk Adjusted rate
Risk level Risk free rate (%) Risk Premium (%) Risk adjusted rate (%)
Low 8 4 12
Medium 8 7 15
High 8 10 18

The cash flows of the project considered are as following:

Point in time (yearly intervals) 0 1 2
Cash flow (` in crore) (100) 45 80

If the project is judged to be Low risk

Years 0 1 2
PV (` in crore) (100) 45
= 40.18 80
1+ 0.12 = 63.78
(1+ 0.12)2

8.18 |CA Inter FM

Divya Jadi Booti
Contact: 033-4059-3800 Website: sjc.co.in
Risk Analysis in Capital Budgeting

NPV = 40.18 + 63.78 – 100 = 3.96 : Accept

If the project is judged to be Medium risk
Years 0 1 2
PV (` in crore) (100) 45
= 39.13 80
= 60.49
1+ 0.15 (1+ 0.15)2

NPV = 39.13 + 60.49 – 100 = (0.38) : Reject

If the project is judged to be High risk
Years 0 1 2
PV (` in crore) (100) 45
= 38.14 80
= 57.45
1+ 0.18 (1+ 0.18)2

NPV = 38.14 + 57.45 – 100 = (4.41) : Reject

TE
17 May 19

T U
Kanoria Enterprises wishes to evaluate two mutually exclusive projects X and Y.
I
The particulars are as under :

I N ST
Initial Investment
SJ C Project X (`)
1,20,000
Project Y (`)
1,20,000
Estimated cash inflows (per annum for 8 years)
Pessimistic 26,000 12,000
Most Likely 28,000 28,000
Optimistic 36,000 52,000

The cut off rate is 14%. The discount factor at 14% are :
Year 1 2 3 4 5 6 7 8 9
Discount factor 0.877 0.769 0.675 0.592 0.519 0.456 0.400 0.351 0.308

Advise management about the acceptability of projects X and Y.

Scenario Analysis - pessimistic, optimistic,

most likely view

CA Inter FM
Divya Jadi Booti | 8.19
Contact: 033-4059-3800 Website: sjc.co.in
Risk Analysis in Capital Budgeting

Answer
The possible outcomes of Project x and Project y are as follows
Project X Project Y
Estimated PVF@ Estimated PVF@
PV of PV of
Estimates Annual 14% Annual 14%
Cash NPV Cash NPV
Cash for Cash for
flow (`) flow (`)
inflows 8 inflows 8
(`) (`)
(`) years (`) years
Pessimistic 26,000 4.639 1,20,614 614 12,000 4.639 55,668 (– 64,332)
Most likely 28,000 4.639 1,29,892 9,892 28,000 4.639 1,29,892 9,892
Optimistic 36,000 4.639 2,41,228 47,004 52,000 4.639 2,41,228 1,21,228

In pessimistic situation project X will be better as it gives low but positive NPV whereas Project
Y yield highly negative NPV under this situation. In most likely situation both the project will
give same result. However, in optimistic situation Project Y will be better as it will gives very
high NPV. So, project X is a risk less project as it gives positive NPV in all the situation whereas
Y is a risky project as it will result into negative NPV in pessimistic situation and highly positive
NPV in optimistic situation. So acceptability of project will largely depend on the risk taking
capacity (Risk seeking/ Risk aversion) of the management
T E
I T U
18
S T MTP Nov 19
I N
CALCULATE Variance and Standard Deviation on the basis of following information:
C
Possible Event SJ
Cash Flow (`)
Project A
Probability Cash Flow (`)
Project B
Probability
A 80,000 0.10 2,40,000 0.10
B 1,00,000 0.20 2,00,000 0.15
C 1,20,000 0.40 1,60,000 0.50
D 1,40,000 0.20 1,20,000 0.15
E 1,60,000 0.10 80,000 0.10
(8 Marks)

Variance and Standard Deviation

8.20 |CA Inter FM

Divya Jadi Booti
Contact: 033-4059-3800 Website: sjc.co.in
Risk Analysis in Capital Budgeting

Answer
Calculation of Expected Value for Project A and Project B
Project A Project B
Possible Net Cash Flow Expected Expected
Probability Cash Flow (`) Probability
Event (`) Value (`) Value (`)
A 80,000 0.10 8,000 2,40,000 0.10 24,000
B 1,00,000 0.20 20,000 2,00,000 0.15 30,000
C 1,20,000 0.40 48,000 1,60,000 0.50 80,000
D 1,40,000 0.20 28,000 1,20,000 0.15 18,000
E 1,60,000 0.10 16,000 80,000 0.10 8,000
ENCF 1,20,000 1,60,000

Project A
Variance (σ2) = (80,000 – 1,20,000)2 × (0.1) + (1,00,000 – 1,20,000)2 × (0.2) + (1,20,000 – 1,20,000)2
× (0.4) + (1,40,000 – 1,20,000)2 × (0.2) + (1,60,000 – 1,20,000)2 × (0.1)
= 16,00,00,000 + 8,00,00,000 + 0 + 8,00,00,000 + 16,00,00,000
= 48,00,00,000
T E
Standard Deviation (σ) =
I T U
Variance ( σ ) = 48,00,00,000 = 21,908.90
2

Project B:
S T
C I N
Variance (σ2) = (2,40,000 – 1,60,000)2 × (0.1) + (2,00,000 – 1,60,000)2 × (0.15) + (1,60,000 –

SJ
1,60,000)2 ×(0.5) + (1,20,000 – 1,60,000)2 × (0.15) + (80,000 – 1,60,000)2 × (0.1)
= 64,00,00,000 + 24,00,00,000 + 0 + 24,00,00,000 + 64,00,00,000
= 1,76,00,00,000
Standard Deviation (σ) = 1,76,00,00,000 = 41,952.35

19 Nov 19
Door Ltd. is considering an investment of ` 4,00,000. This investment is expected to generate
substantial cash inflows over the next five years. Unfortunately, the annual cash flows from this
investment is uncertain, and the following profitability distribution has been established.
Annual Cash Flow (`) Probability
50,000 0.3
1,00,000 0.3
1,50,000 0.4

At the end of its 5 years life, the investment is expected to have a residual value of ` 40,000. The
cost of capital is 5%

CA Inter FM
| 8.21
Divya Jadi Booti
Contact: 033-4059-3800 Website: sjc.co.in
Risk Analysis in Capital Budgeting

(i) Calculate NPV under the three different scenarios.

(ii) Calculate Expected Net Present Value.
(iii) Advise Door Ltd. on whether the investment is to be undertaken.
Year 1 2 3 4 5
DF @ 5% 0.952 0.907 0.864 0.823 0.784

Answer
(i) Calculation of NPV under three different scenarios (Amount in `)
Particulars 1st Scenario 2nd Scenario 3rd Scenario
Annual Cash Flow 50,000 1,00,000 1,50,000
PV of cash inflows (Annual Cash Flow × 4.33*) 2,16,500 4,33,000 6,49,500
PV of Residual Value (` 40,000 × 0.784) 31,360 31,360 31,360
Total PV of Cash Inflow 2,47,860 4,64,360 6,80,860
Initial investment 4,00,000 4,00,000 4,00,000
NPV (1,52,140) 64,360 2,80,860
* .952 + .907 + .864 + .823 + .784 = 4.33
T E
I T U
(ii) Calculation of Expected Net present Value under three different scenarios
Particulars
S T
1st Scenario 2nd Scenario 3rd Scenario Total (`)
Annual Cash Flow
C I N` 50,000 ` 1,00,000 ` 1,50,000
Probability
Expected Value SJ 0.3
` 15,000
0.3
` 30,000
0.4
` 60,000 1,05,000
PV of Expected value (1,05,000 × 4.33) 4,54,650
PV of Residual Value (40,000 × 0.784) 31,360
Total PV of Cash Inflow 4,86,010
Initial investment 4,00,000
Expected Net Present Value 86,010

(iii) Since the expected net present value of the Investment is positive, the Investment should
be undertaken.

20 RTP May 20
G Ltd. using certainty-equivalent approach in the evaluation of risky proposals. The following
information regarding a new project is as follows:
Year Expected Cash flow Certainty-equivalent quotient
0 (8,00,000) 1.0
1 6,40,000 0.8

8.22 |CA Inter FM

Divya Jadi Booti
Contact: 033-4059-3800 Website: sjc.co.in
Risk Analysis in Capital Budgeting

2 5,60,000 0.7
3 5,20,000 0.6
4 4,80,000 0.4

Riskless rate of interest on the government securities is 6 per cent. DETERMINE whether the
project should be accepted?

Certainity Equivalent Approach

Answer
Determination of Net Present Value (NPV)
Adjusted Cash
Expected Cash flow Certainty- PV factor
Year flow (Cash flow x Total PV (`)
(`) equivalent (CE) (at 0.06)
CE) (`)
T E
0 (8,00,000) 1.0
I U
(8,00,000)
T 1.000 (8,00,000)
1 6,40,000 0.8
S T 5,12,000 0.943 4,82,816
2
3
5,60,000
5,20,000
C I N 0.7
0.6
3,92,000
3,12,000
0.890
0.840
3,48,880
2,62,080
4
5
SJ
4,80,000
3,20,000
0.4
0.3
1,92,000
96,000
0.792
0.747
1,52,064
71,712
NPV = (13,17,552 - 8,00,000) 5,17,552
As the Net Present Value is positive the project should be accepted.

21 MTP May 20
A&R Ltd. has undertaken a project which has an initial investment of `2,000 lakhs in plant &
machinery and `800 lakhs for working capital. The plant & machinery would have a salvage
value of ` 474.61 lakhs at the end of the fifth year. The plant & machinery would depreciate at
the rate of 25% p.a. on WDV method. The other details of the project for the five year period are
as follows:

Sales 10,00,000 units p.a.

Selling price per unit `500
Variable cost 50% of selling price
Fixed overheads (excluding depreciation) `300 lakh p.a.

CA Inter FM
Divya Jadi Booti| 8.23
Contact: 033-4059-3800 Website: sjc.co.in
Risk Analysis in Capital Budgeting

Corporate tax rate 35%

Rate of interest on bank loan 12%
After tax required rate of return 15%

Required:
(i) CALCULATE net present value (NPV) of the project and DETERMINE the viability of the
project.
(ii) DETERMINE the sensitivity of project’s NPV under each of the following condition:
a. Decrease in selling price by 10%;
b. Increase in cost of plant & machinery by 10%.
PV factor Year-1 Year-2 Year-3 Year-4 Year-5
12% 0.892 0.797 0.711 0.635 0.567
15% 0.869 0.756 0.657 0.571 0.497
(10 Marks)

NPV and Sensitivity Analysis

T E
I T U
S T
Answer
C I N
SJ
(i) Calculation of Net Present Value (NPV):
Year-1 Year-2 Year-3 Year-4 Year-5
Sales volume (Qty. in lakh) 10 10 10 10 10
Contribution per unit (`) 250 250 250 250 250
(Selling price – variable cost)
Total contribution (`in lakh) 2,500 2,500 2,500 2,500 2,500
Less: Fixed overheads (` In lakh) 300 300 300 300 300
PBDT 2,200 2,200 2,200 2,200 2,200
Less: Depreciation (` in lakh) 500 375 281.25 210.94 158.20
(Working note-1)
PBT 1,700 1,825 1,918.75 1,989.06 2,041.80
Less: Tax @ 35% 595 638.75 671.56 696.17 714.63
PAT 1,105 1,186.25 1,247.19 1,292.89 1,327.17
Add: Depreciation 500 375 281.25 210.94 158.20
Add: Salvage value of plant - - - - 474.61
& machinery
Add: Working capital - - - - 800

8.24 |CA Inter FM

Divya Jadi Booti
Contact: 033-4059-3800 Website: sjc.co.in
Risk Analysis in Capital Budgeting

Net Cash inflow 1,605 1,561.25 1,528.44 1,503.83 2,759.98

P.V factor @15% 0.869 0.756 0.657 0.571 0.497
P.V of cash inflows 1,394.74 1,180.31 1,004.18 858.68 1,371.71

Net Present Value = P.V of cash inflows – P.V of cash outflows

= ` (1,394.74 + 1,180.31 + 1,004.18 + 858.68 + 1,371.71) – (` 2,000 + ` 800)
= ` 3,009.62 lakh
The NPV of the project is positive, hence, the project is viable.
Working note-1:
Year 1 Year 2 Year 3 Year 4 Year 5
Opening balance 2,000 1,500 1,125 843.75 632.81
Depreciation @25% 500 375 281.25 210.94 158.20
Closing WDV 1,500 1,125 843.75 632.81 474.61

(ii) Determination of sensitivity of NPV w.r.t.

a. Decrease in selling price by 10%
Year 1 Year 2
U TE
Year 3 Year 4 Year 5
Sales volume (Qty. in lakh) 10
T I T 10 10 10 10
New Selling price
Variable cost
I N S 450
250
450
250
450
250
450
250
450
250

SJ
Contribution per unit (`) C
(Selling price – variable cost)
200 200 200 200 200

Total contribution (`in lakh) 2,000 2,000 2,000 2,000 2,000

Less: Fixed overheads (` In lakh) 300 300 300 300 300
PBDT 1,700 1,700 1,700 1,700 1,700
Less: Depreciation (` in lakh) 500 375 281.25 210.94 158.20
(Working note-1)
PBT 1,200 1,325 1,418.75 1,489.06 1,541.80
Less: Tax @ 35% 420 463.75 496.56 521.17 539.63
PAT 780 861.25 922.19 967.89 1,002.17
Add: Depreciation 500 375 281.25 210.94 158.20
Add: Salvage value of plant - - - - 474.61
& machinery
Add: Working capital - - - - 800
Net Cash inflow 1,280 1,236.25 1,203.44 1,178.83 2,434.98
P.V factor @15% 0.869 0.756 0.657 0.571 0.497
P.V of cash inflows 1,112.32 934.61 790.66 673.11 1,210.18

CA Inter FM
Divya Jadi Booti| 8.25
Contact: 033-4059-3800 Website: sjc.co.in
Risk Analysis in Capital Budgeting

NPV = ` (1,112.32+934.61+790.66+673.11+1,210.18) – (` 2,000 + ` 800)

= ` 4,720.88 – ` 2,800 = 1,920.88 lakh
10% reduction in selling price reduces the NPV by 36.18% (3,009.62-1,920.88/3,009.62)
b. Increase in project cost by 10%
Year 1 Year 2 Year 3 Year 4 Year 5
PBDT 2,200 2,200 2,200 2,200 2,200
Less: Depreciation (` in lakh) 550 412.5 309.37 232.03 174.03
(Working note-2)
PBT 1,650 1,787.50 1,890.63 1,967.97 2,025.97
Less: Tax @ 35% 577.50 625.63 661.72 688.79 709.09
PAT 1072.50 1,161.87 1,228.91 1,279.18 1,316.88
Add: Depreciation 550 412.5 309.37 232.03 174.03
Add: Salvage value of plant - - - - 474.61
& machinery
Add: Working capital - - - - 800
Net Cash inflow 1,622.50 1,574.37 1,538.28 1,511.21 2,765.52
P.V factor @15% 0.869 0.756
T E
0.657 0.571 0.497
P.V of cash inflows 1,409.95 1,190.22
I T U1,010.65 862.90 1,374.46

NPV
S T
= ` (1,409.95 + 1,190.22 + 1,010.65 + 862.90 + 1,374.46) – (` 2,200 + ` 800)
I N
= ` 5,848.18 – ` 3,000 = ` 2,848.18 lakh
C
SJ
10% increase in project cost reduces the NPV only by 5.36% (3,009.62 – 2,848.18/3,009.62)
Working note-2:
Year-1 Year-2 Year-3 Year-4 Year-5
Opening balance 2,200 1,650 1,237.50 928.13 696.10
Depreciation @25% 550 412.5 309.37 232.03 174.03
Closing WDV 1,650 1,237.50 928.13 696.10 522.07

22 RTP Nov 20; RTP May 21

A&R Ltd. is considering one of two mutually exclusive proposals, Projects- X and Y, which
require cash outlays of ` 42,50,000 and ` 41,25,000 respectively. The certainty-equivalent (C.E)
approach is used in incorporating risk in capital budgeting decisions. The current yield on
government bonds is 5.5% and this is used as the risk-free rate. The expected net cash flows
and their certainty equivalents are as follows:

8.26 |CA Inter FM

Divya Jadi Booti
Contact: 033-4059-3800 Website: sjc.co.in
Risk Analysis in Capital Budgeting

Project X Project Y
Year-end Cash Flow (`) C.E. Cash Flow (`) C.E.
1 16,50,000 0.8 16,50,000 0.9
2 15,00,000 0.7 16,50,000 0.8
3 15,00,000 0.5 15,00,000 0.7
4 20,00,000 0.4 10,00,000 0.8
5 21,00,000 0.6 8,00,000 0.9
The Present value (PV) factor @ 5.5% is as follows:
Project Y 0 1 2 3 4 5
PV factor 1 0.947 0.898 0.851 0.807 0.765

Required:
DETERMINE the project that should be accepted?

Answer
Calculation of Net Present Value (NPV) of Project X
Adjusted Cash Present value Total Present
Year end
Cash Flow (`)
(a)
C.E. (b) flow (`)
T E
factor at 6% value (`)
(c) = (a) x (b)
I T U (d) (e) = (c) x (d)
1 16,50,000 0.8
T
13,20,000
S
0.947 12,50,040
2
3
15,00,000
15,00,000
0.7
0.5
C I N 10,50,000
7,50,000
0.898
0.851
9,42,900
6,38,250
4
5
20,00,000
21,00,000
SJ
0.4
0.6
8,00,000
12,60,000
0.807
0.765
6,45,600
9,63,900
PV of total cash inflows 44,40,690
Less: Initial Investment (42,50,000)
Net Present Value 1,90,690
Calculation of Net Present Value (NPV) of Project Y
Adjusted Cash Present value Total Present
Cash Flow (`)
Year end C.E. (b) flow (`) factor at 6% value (`)
(a)
(c) = (a) x (b) (d) (e) = (c) x (d)
1 16,50,000 0.9 14,85,000 0.947 14,06,295
2 16,50,000 0.8 13,20,000 0.898 11,85,360
3 15,00,000 0.7 10,50,000 0.851 8,93,550
4 10,00,000 0.8 8,00,000 0.807 6,45,600
5 8,00,000 0.9 7,20,000 0.765 5,50,800
PV of total cash inflows 46,81,605
Less: Initial Investment (41,25,000)
Net Present Value 5,56,605

CA Inter FM
| 8.27
Divya Jadi Booti
Contact: 033-4059-3800 Website: sjc.co.in
Risk Analysis in Capital Budgeting

Project Y has NPV of ` 5,56,605/- which is higher than the NPV of Project X. Thus, A & R Ltd.
should accept Project Y.

23 MTP Nov 20
ABC Ltd. is considering a project “X” with an initial outlay of ` 16,00,000 and the possible three
cash inflow attached with the project is as follows:
(Amount in ` ‘000)
Particular Year 1 Year 2 Year 3
Scenario 1 550 500 800
Scenario 2 650 550 900
Scenario 3 750 600 1000

Assuming the cost of capital as 9%.

(i) DETERMINE NPV in each scenario.
(ii) If ABC Ltd. is certain about the 1st and 2nd year’s results in scenario 2 but uncertain
about the third year’s cash flow, DETERMINE NPV expecting scenario 1 in the third year.

T E
Year
DF @ 9%
1
0.917
I T U 2
0.842
3
0.772

S T
C I N (5 Marks)

SJ
Net preset value based on scenarios

Answer
(i) The possible outcomes under different scenario will be as follows:
(Amount in ` ‘000)
Scenario 1 Scenario 2 Scenario 3
Year PVF @ 9%
Cash Flow PV Cash Flow PV Cash Flow PV
0 1.000 (1600) (1600) (1600) (1600) (1600) (1600)
1 0.917 550.00 504.35 650.00 596.05 750.00 687.75
2 0.842 500.00 421.00 550.00 463.10 600.00 505.20
3 0.772 800.00 617.60 900.00 694.80 1000.00 772.00
NPV (57.05) 153.95 364.95

8.28 |CA Inter FM

Divya Jadi Booti
Contact: 033-4059-3800 Website: sjc.co.in
Risk Analysis in Capital Budgeting

(ii) The company is bit confident about the estimates in the first two years, but not sure
about the third year’s cash inflow, the NPV in such case expecting scenario 1 in the
third year will be as follows:
= – 16,00,000 + (6,50,000 x 0.917 + 5,50,000 x 0.842 + 8,00,000 x 0.772)
= – 16,00,000 + (5,96,050 + 4,63,100 + 6,17,600)
= ` 76,750

24 Nov 20
A Ltd. is considering two mutually exclusive projects X and Y.
You have been given below the Net Cash flow probability distribution of each project:
Project-X Project-Y
Net Cash Flow (`) Probability Net Cash Flow (`) Probability
50,000 0.30 1,30,000 0.20
60,000 0.30 1,10,000 0.30
70,000 0.40 90,000 0.50
(i) Compute the following :
T E
(a) Expected Net Cash Flow of each project.
I T U
(b) Variance of each project.
S T
I N
(c) Standard Deviation of each project.
C
SJ
(d) Coefficient of Variation of each project.
(ii) Identify which project do you recommend ? Give reason. (10 Marks)

Expected Net Cash Flow, Variance,

Standard Deviation, Coeffecient of
Variation

Answer
(i) (a) Calculation of Expected Net Cash Flow (ENCF) of Project X and Project Y
Project X Project Y
Net Cash Expected Net Net Cash Expected Net
Probability Probability
Flow (`) Cash Flow (`) Flow (`) Cash Flow (`)
50,000 0.30 15,000 1,30,000 0.20 26,000
60,000 0.30 18,000 1,10,000 0.30 33,000
70,000 0.40 28,000 90,000 0.50 45,000
ENCF 61,000 1,04,000

CA Inter FM
| 8.29
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Risk Analysis in Capital Budgeting

(b) Variance of Projects

Project X
Variance (σ2) = (50,000 – 61,000)2 × (0.3) + (60,000 – 61,000)2 × (0.3) + (70,000 – 61,000)2
× (0.4)
= 3,63,00,000 + 3,00,000 + 3,24,00,000 = 6,90,00,000
Project Y
Variance(σ2) = (1,30,000 – 1,04,000)2 × (0.2) + (1,10,000 – 1,04,000)2 × (0.3) + (90,000 –
1,04,000)2 × (0.5)
= 13,52,00,000 + 1,08,00,000 + 9,80,00,000 = 24,40,00,000
(c) Standard Deviation of Projects
Project X

Standard Deviation (σ) = Variance " !2 # $ 6 , 90 , 00 , 000 = 8,306.624

Project Y

Standard Deviation (σ) = Variance " !2 # $ 24 , 40 , 00 , 000 = 15,620.499

(d) Coefficient of Variation of Projects

T E
I
Coefficient of variation
T U
Projects
S T
! Standard Deviation $ Risk
Expected Net
#
I N &
" Expected Net Cash Flow %

C
Cash Flow

X SJ8 , 306.24
61, 000
= 0.136 or 13.60% Less Less

15, 620.499
Y = 0.150 or 15.00% More More
1, 04 , 000

(ii) In project X risk per rupee of cash flow is 0.136 (approx.) while in project Y it is 0.15 (approx.).
Therefore, Project X is better than Project Y.

25 RTP May 21
X Ltd is considering installation of new machine with the following details:
Sr. No. Particulars Figures
1 Initial Investment ` 1400 Crore
2 Annual unit sales 100 Crore
3 Selling price per unit ` 40
4 Variable cost per unit ` 20
5 Annual Fixed costs ` 500 Crore

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6 Depreciation ` 200 Crore

7 Discount Rate 12%
8 Tax rate 30%
Consider Life of the project as 4 years with no salvage value.
Required:
(i) CALCULATE the expected NPV of the project.
(ii) COMPUTE the impact on the project’s NPV if change in variables is as under and also
compute which variable is having maximum impact on NPV.
Sr.
Variable Figures
No.
1 Unit sold per year 85 Crore
2 Selling price per unit ` 39
3 Variable cost per unit ` 22
4 Annual Fixed costs ` 575 Crore
PV factor at 12% are as follows:

TE
Year 1 2 3 4

ITU
PV factor 0.893 0.797 0.712 0.636

S T
C
Expected NPV and sensititvity analysis IN
S J
Answer
(i) Calculation of Net Cash Inflow per year:
Particulars Amount (`)
A Selling Price Per Unit (A) 40
B Variable Cost Per Unit (B) 20
C Contribution Per Unit (C = A - B) 20
D Number of Units Sold Per Year 100 Crore
E Total Contribution (E = C × D) 2,000 Crore
F Annual Fixed costs 500 Crore
G Depreciation 200 Crore
H Net Profit before taxes (H = E - F - G) 1,300 Crore
I Tax @ 30% of H 390 Crore
J Net Cash Inflow Per Year (J = H - I + G) 910 Crore

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Calculation of expected Net Present Value (NPV) of the Project:

Year Year Cash Flow PVAF @ 12% Present Value (PV)
(` in Crore) (` in Crore)
0 (1400.00) 1.000 (1400.00)
1-4 910.00 3.038 2,764.58
Net Present Value 1,364.58
(ii) Sensitivity Analysis under variable different value:
Changes in variable Base Units sold Selling Variable Annual Fixed
per year is price per cost per costs is ` 575
85 Crore unit is ` 39 unit is ` 22 Crore
Particulars (`) (`) (`) (`) (`)
A Selling Price Per Unit 40 40 39 40 40
B Variable Cost Per Unit 20 20 20 22 20
C Contribution Per Unit 20 20 19 18 20
(C = A - B)
D Number of Units Sold 100 85 100 100 100
Per Year (in Crores)
E Total Contribution 2,000 1,700
T E
1,900 1,800 2,000
(E = C × D)
I T U
F Annual Fixed Cost (in 500
S T500 500 500 575
Crores)
G Depreciation (in
C I
200 N 200 200 200 200
Crores)
SJ
H Net Profit before taxes 1,300 1,000 1,200 1,100 1,225
(H = E - F - G)
I Tax @ 30% of H 390 300 360 330 367.50
J Net Cash Inflow Per 910 700 840 770 857.50
Year (J = H - I + G)
K (J × 3.038) 2,764.58 2,126.60 2,551.92 2,339.26 2,605.09
L Initial Cash Flow 1400 1400 1400 1400 1400
M NPV (K - L) 1,364.58 726.60 1,151.92 939.26 1205.09
N Change in NPV - (637.98) (212.66) (425.32) (159.49)
O Percentage Change in - -46.75% -15.58% -31.17% -11.69%
NPV
The above table shows that by varying one variable at a time while keeping the others
constant, the impact in percentage terms on the NPV of the project. Thus, it can be seen
that the change in units sold per year has the maximum effect on the NPV by 46.75%.

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Risk Analysis in Capital Budgeting

26 Jan 21
A project requires an initial outlay of ` 3,00,000.
The company uses certainty equivalent method approach to evaluate the project. The risk free
rate is 7%. Following information is available :
CFAT CE
Year (Cash Flow After Tax) (Certainty Equivalent
(`) Coefficient)
1. 1,00,000 0.90
2. 1,50,000 0.80
3. 1,15,000 0.60
4. 1,00,000 0.55
5. 50,000 0.50
PV Factor at 7%
Year 1 2 3 4 5
PV Factor 0.935 0.873 0.816 0.763 0.713
Evaluate the above. Is investment in the project beneficial ?
U TE (5 Marks)

I T
Certainity Equivalent Approach
I N ST
SJ C
Answer
Statement Showing the Net Present Value of Project
CFAT (₹) C.E. Adjusted Cash Present value Total Present
Year end flow (₹) factor @ 7% value (₹)
(a) (b) (c) = (a) × (b) (d) (e) = (c) × (d)
1 1,00,000 0.90 90,000 0.935 84,150
2 1,50,000 0.80 1,20,000 0.873 1,04,760
3 1,15,000 0.60 69,000 0.816 56,304
4 1,00,000 0.55 55,000 0.763 41,965
5 50,000 0.50 25,000 0.713 17,825
PV of Cash Inflow 3,05,004
Less: Initial Investment (3,00,000)
Net Present Value 5,004
Since the NPV of the project is positive, it is beneficial to invest in the project.

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27 MTP May 21
SG Ltd. is considering a project “Z” with an initial outlay of ` 7,50,000 and life of 5 years. The
estimates of project are as follows:
Lower Estimates Base Upper Estimates
Sales (units) 4,500 5,000 5,500
(`) (`) (`)
Selling Price p.u. 175 200 225
Variable cost p.u. 100 125 150
Fixed Cost 50,000 75,000 1,00,000
Depreciation included in Fixed cost is ` 35,000 and corporate tax is 25%.
Assuming the cost of capital as 15%, Determine NPV in three scenarios i.e worst, base and best
case scenario.
PV factor for 5 years at 15% are as follows:
Years 1 2 3 4 5
P.V. factor 0.870 0.756 0.658 0.572 0.497

T E
I T U (7 Marks)

S T
Scenario Analysis
C I N
SJ
Answer
(i) Calculation of Yearly Cash Inflow
In worst case: High costs and Low price (Selling price) and volume (Sales units) are taken.
In best case: Low costs and High price (Selling price) and volume (Sales units) are taken.
Worst Case Base Best Case
Sales (units) (A) 4,500 5,000 5,500
(`) (`) (`)
Selling Price p.u. 175 200 225
Less: Variable cost p.u. 150 125 100
Contribution p.u. (B) 25 75 125
Total Contribution (A x B) 1,12,500 3,75,000 6,87,500
Less: Fixed Cost 1,00,000 75,000 50,000
EBT 12,500 3,00,000 6,37,500

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Less: Tax @ 25% 3,125 75,000 1,59,375

EAT 9,375 2,25,000 4,78,125
Add: Depreciation 35,000 35,000 35,000
Cash Inflow 44,375 2,60,000 5,13,125
(ii) Calculation of NPV in different scenarios
Worst Case Base Best Case
Initial outlay (A) (`) 7,50,000 7,50,000 7,50,000
Cash Inflow (c) (`) 44,375 2,60,000 5,13,125
Cumulative PVF @ 15% (d) 3.353 3.353 3.353
PV of Cash Inflow (B = c x d) (`) 1,48,789.38 8,71,780 17,20,508.13
NPV (B - A) (`) (6,01,210.62) 1,21,780 9,70,508.13

28 ICAI Mat
PNR Ltd. is considering a project with the following Cash flows:
Years Cost of Plant (₹)
E
Running Cost (₹)
T
Savings (₹)
0
1
12,00,00,000
I T U
4,00,00,000 12,00,00,000
2
S T 5,00,00,000 14,00,00,000
3
C I N 6,00,00,000 11,00,00,000

SJ
The cost of capital is 12%. Measure the sensitivity of the project to changes in the levels of plant
cost, running cost and savings (considering each factor at a time) such that the NPV becomes
zero. The P.V. factors at 12% are as under:
Year 0 1 2 3
PV factor @12% 1 0.892 0.797 0.711
DETERMINE the factor which is the most sensitive to affect the acceptability of the project?

Sensitivity Analysis

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Answer
Present value (PV) of Cash Flows
Year 0 1 2 3 Total
Cost of Plant (12,00,00,000)
Running cost 0 (4,00,00,000) (5,00,00,000) (6,00,00,000)
Savings 0 12,00,00,000 14,00,00,000 11,00,00,000
Net cash inflow (12,00,00,000) 8,00,00,000 9,00,00,000 5,00,00,000
PV factor 1 0.892 0.797 0.711
NPV (12,00,00,000) 7,13,60,000 7,17,30,000 3,55,50,000 5,86,40,000
Determination of the most Sensitive factor:
(i) Sensitivity Analysis w.r.t. Plant cost:
NPV of the project would be zero when the cost of the plant is increased by ₹ 5,86,40,000
` 5, 86 , 40 , 000
∴ Percentage change in the cost = × 100 = 48.87%
` 12, 00 , 00 , 000
(ii) Sensitivity Analysis w.r.t. Running cost:

E
NPV of the project would be zero when the Running cost is increased by ₹ 5,86,40,000
T
∴ Percentage change in the cost
I T U
!
` 5, 86 , 40 , 000T
S$# " 100
I N
# 0.892 " 4 , 00, 00, 000 $ % # 0.797 " 5, 00, 00, 000
C
% 0.711" 6 , 00 , 00 , 000 $

! SJ
` 5, 86 , 40 , 000
3, 56 , 80 , 000 " 3, 98 , 50 , 000 " 4 , 26 , 60 , 000
# 100 !
` 5, 86 , 40 , 000
` 11, 81, 90 , 000
# 100 ! 49.61%

(iii) Sensitivity Analysis w.r.t. Savings:

NPV of the project would be zero when the savings decreased by ₹ 5,86,40,000
∴ Percentage change in the savings
` 5, 86 , 40 , 000
! " 100
# 0.892 " 12, 00, 00, 000 $ % # 0.797 " 14 , 00, 00, 000 $ % # 0.711" 11, 00, 00, 000 $
` 5, 86 , 40 , 000 ` 5,8
86 , 40 , 000
! # 100 ! # 100 ! 19.75%
10 , 70 , 40 , 000 " 1115
, , 80 , 000 " 7, 82,10 , 000 29 , 68 , 30 , 000
The Savings factor is the most sensitive as only a change beyond 19.75% in savings makes
the project unacceptable.

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Risk Analysis in Capital Budgeting

29 ICAI Mat
The Textile Manufacturing Company Ltd., is considering one of two mutually exclusive propos-
als, Projects M and N, which require cash outlays of ₹ 8,50,000 and ₹ 8,25,000 respectively. The
certainty-equivalent (C.E) approach is used in incorporating risk in capital budgeting decisions.
The current yield on government bonds is 6% and this is used as the risk free rate. The expected
net cash flows and their certainty equivalents are as follows:
Project M Project N
Year-end Cash Flow (₹) C.E. Cash Flow (₹) C.E.
1 4,50,000 0.8 4,50,000 0.9
2 5,00,000 0.7 4,50,000 0.8
3 5,00,000 0.5 5,00,000 0.7
Present value factors of ₹ 1 discounted at 6% at the end of year 1, 2 and 3 are 0.943, 0.890 and
0.840 respectively.
Required:
(i) ANALYSE which project should be accepted?
(ii) If risk adjusted discount rate method is used, IDENTIFY which project would be appraised
with a higher rate and why?
T E
I T U
Risk Adjusted Discount Rate S T
C I N
SJ
Answer
(i) Statement Showing the Net Present Value of Project M
Adjusted Cash Present value Total Present
Cash Flow (₹) C.E.
Year end flow (₹) factor at 6% value (₹)
(a) (b)
(c) = (a) × (b) (d) (e) = (c) × (d)
1 4,50,000 0.8 3,60,000 0.943 3,39,480
2 5,00,000 0.7 3,50,000 0.890 3,11,500
3 5,00,000 0.5 2,50,000 0.840 2,10,000
8,60,980
Less: Initial Investment 8,50,000
Net Present Value 10,980

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Statement Showing the Net Present Value of Project N

C.E. Adjusted Cash Present value Total Present
Cash Flow (₹)
Year end flow (₹) factor value (₹)
(a)
(b) (c) = (a) × (b) (d) (e) = (c) × (d)
1 4,50,000 0.9 4,05,000 0.943 3,81,915
2 4,50,000 0.8 3,60,000 0.890 3,20,400
3 5,00,000 0.7 3,50,000 0.840 2,94,000
9,96,315
Less: Initial Investment 8,25,000
Net Present Value 1,71,315
Decision : Since the net present value of Project N is higher, so the project N should be
accepted.
(ii) Certainty - Equivalent (C.E.) Co-efficient of Project M (2.0) is lower than Project N (2.4). This
means Project M is riskier than Project N as “higher the riskiness of a cash flow, the lower
will be the CE factor”. If risk adjusted discount rate (RADR) method is used, Project M would
be analysed with a higher rate.

30 T E ICAI Mat
I T U
T
A&R Ltd. has under its consideration a project with an initial investment of ₹ 90,00,000. Three
S
below:
C I N
probable cash inflow scenarios with their probabilities of occurrence have been estimated as

SJ
Annual cash inflow (₹)
Probability
20,00,000
0.2
30,00,000
0.7
40,00,000
0.1
The project life is 5 years and the desired rate of return is 18%. The estimated terminal values
for the project assets under the three probability alternatives, respectively, are ₹ 0, ₹ 20,00,000
and ₹ 30,00,000.
You are required to:
(i) CALCULATE the probable NPV;
(ii) CALCULATE the worst-case NPV and the best-case NPV; and
(iii) STATE the probability occurrence of the worst case, if the cash flows are perfectly positively
correlated over time.

Scenario Analysis

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Answer
(i) Calculation of Net Present Value (NPV)
Year Prob. = 0.2 Prob. = 0.7 Prob. = 0.1
PV of
Probable Probable Probable Total Cash PVF@
Cash flow Cash flow Cash flow Total cash
cash flow cash flow cash flow flow 18%
flow
0 (90,00,000) 1.000 (90,00,000)
1 20,00,000 4,00,000 30,00,000 21,00,000 40,00,000 4,00,000 29,00,000 0.847 24,56,300
2 20,00,000 4,00,000 30,00,000 21,00,000 40,00,000 4,00,000 29,00,000 0.718 20,82,200
3 20,00,000 4,00,000 30,00,000 21,00,000 40,00,000 4,00,000 29,00,000 0.608 17,63,200
4 20,00,000 4,00,000 30,00,000 21,00,000 40,00,000 4,00,000 29,00,000 0.515 14,93,500
5 20,00,000 4,00,000 30,00,000 21,00,000 40,00,000 4,00,000 29,00,000 0.437 12,67,300
5 0 0 20,00,000 14,00,000 30,00,000 3,00,000 17,00,000 0.437 7,42,900
Net Present Value (NPV) 8,05,400

(ii) Worst and Best case is the case where expected annual cash inflows are minimum
and maximum respectively.
Calculation of Worst Case and Best Case NPV:
Worst case
TE Best Case

ITU
Year PVF@ 18% PV of Cash PV of Cash
Cash flows Cash flows

S T flows flows
0
1
1.000

C
0.847 IN
(90,00,000)
20,00,000
(90,00,000)
16,94,000
(90,00,000)
40,00,000
(90,00,000)
33,88,000
2
S J 0.718 20,00,000 14,36,000 40,00,000 28,72,000
3 0.608 20,00,000 12,16,000 40,00,000 24,32,000
4 0.515 20,00,000 10,30,000 40,00,000 20,60,000
5 0.437 20,00,000 8,74,000 40,00,000 17,48,000
5 0.437 0 0 30,00,000 13,11,000
NPV (27,50,000) 48,11,000
Worst case NPV = ₹ (27,50,000)
Best Case NPV = ₹ 48,11,000
(iii) The cash flows are perfectly positively correlated over time means cash flow in first year
will be cash flows in subsequent years. The cash flow of ₹ 20,00,000 is the worst case cash
flow and its probability is 20%, thus, possibility of worst case is 20% or 0.2.

31 Jul’21
K.P. Ltd. is investing ₹ 50 lakhs in a project. The life of the project is 4 years. Risk free rate of return
is 6% and risk premium is 6%, other information is as under:

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Risk Analysis in Capital Budgeting

Sales of 1st year ₹ 50 lakhs

Sales of 2nd year ₹ 60 lakhs
Sales of 3rd year ₹ 70 lakhs
Sales of 4th year ₹ 80 lakhs
P/V Ratio (same in all the years) 50%
Fixed Cost (Excluding Depreciation) of 1st year ₹ 10 lakhs
Fixed Cost (Excluding Depreciation) of 2nd year ₹ 12 lakhs
Fixed Cost (Excluding Depreciation) of 3rd year ₹ 14 lakhs
Fixed Cost (Excluding Depreciation) of 4th year ₹ 16 lakhs
Ignore interest and taxes
You are required to calculate NPV of given project on the basis of Risk Adjusted Discount Rate.
Discount factor @ 6% and 12% are as under: [5]
Year 1 2 3 4
Discount Factor @ 6% 0.943 0.890 0.840 0.792
Discount Factor@ 12% 0.893 0.797 0.712 0.636

T E
Risk Adjusted Discounting Rate
I T U
S T
C I N
Answer
Calculation of Cash Flow
SJ
Sales Contribution Fixed Cost Cash Flows
P/V ratio
Year (₹ in Lakhs) (₹ in Lakhs) (₹ in Lakhs) (₹ in lakhs)
(B)
(A) (C) = (A x B) (D) (E) = (C – D)
1 50 50% 25 10 15
2 60 50% 30 12 18
3 70 50% 35 14 21
4 80 50% 40 16 24
When risk-free rate is 6% and the risk premium expected is 6%, then risk adjusted discount rate
would be 6% + 6% =12%.
Calculation of NPV using Risk Adjusted Discount Rate (@ 12%)
Cash flows Discounting Factor @ Present Value of Cash Flows
Year
(₹ in Lakhs) 12% (₹ in lakhs)
1 15 0.893 13.395
2 18 0.797 14.346

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3 21 0.712 14.952
4 24 0.636 15.264
Total of present value of Cash flow 57.957
Less: Initial Investment 50.000
Net Present value (NPV) 7.957

32 ICAI Mat
Shivam Ltd. is considering two mutually exclusive projects A and B. Project A costs ` 12,000 and
project B ` 11,000. You have been given below the net cash flow (NCF) probability distribution
for each project.
Project A Project B
NCF estimates (`) Probability NCF estimates (`) Probability
15,000 0.4 15,000 0.3
12,000 0.3 12,000 0.5
10,000 0.2 10,000 0.1
8,000 0.1 8,000
T E 0.1
Required:
I T U
(i)
S T
COMPUTE the expected net cash flows (ENCF) of projects A and B.

I N
(ii) COMPUTE the risk attached to each project i.e. standard deviation of each probability
C
SJ
distribution.
(iii) COMPUTE the profitability index of each project.
(iv) IDENTIFY which project do you recommend? State with reasons.

Expected Net Cash Flows, Standard

Deviation and Profitability Index

Answer
(i) Computation of expected net cash flow of Projects A and B
Project A Project B
NCF Probability ENCF NCF Estimate Probability ENCF
Estimate (`) (`) (`) (`)
15,000 0.4 6,000 15,000 0.3 4,500
12,000 0.3 3,600 12,000 0.5 6,000

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10,000 0.2 2,000 10,000 0.1 1,000

8,000 0.1 800 8,000 0.1 800
ENCF 12,400 12,300
(ii) Computation of Standard deviation of each project
Project A
P ENCF NCF (NCF – ENCF) P (NCF – ENCF)²
0.4 12,400 15,000 2,600 27,04,000
0.3 12,400 12,000 -400 48,000
0.2 12,400 10,000 -2,400 11,52,000
0.1 12,400 8,000 -4,400 19,36,000
Variance 58,40,000
Standard Deviation of Project A = 58 , 40 , 000 = 2416.61
Project B
P ENCF NCF (NCF – ENCF) P (NCF – ENCF)²
0.3 12,300 15,000 2,700 21,87,000
0.5 12,300 12,000
T E -300 45,000
0.1 12,300
T
10,000
I U -2,300 5,29,000
0.1 12,300
S T
8,000 -4,300 18,49,000
Variance

C I N 46,10,000

SJ
Standard Deviation of Project B = 46 ,10 , 000 = 2147.09
(iii) Computation of profitability index of each project
Discounted cash inflows
Profitability index =
Cash outlay
Project A
12,400
PI = = 1.033
12,000
Project B
12,300
PI = = 1.118
11,000
(iv) Recommendation of the project
ENCF of both the projects is almost same but Standard deviation (risk) is lower in Project B
as compared to Project A. Also, profitability index of Project B is higher than that of Project
A. So, Project B is preferable because of lower risk and higher profitability index.

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Risk Analysis in Capital Budgeting

33 ICAI Mat
New Projects Ltd. is evaluating 3 projects, P-I, P-II, P-III. Following information is available in
respect of these projects:
P-I P-II P-III
Cost ` 15,00,000 ` 11,00,000 ` 19,00,000
Inflows-Year 1 6,00,000 6,00,000 4,00,000
Year 2 6,00,000 4,00,000 6,00,000
Year 3 6,00,000 5,00,000 8,00,000
Year 4 6,00,000 2,00,000 12,00,000
Risk Index 1.80 1.00 0.60
Minimum required rate of return of the firm is 15% and applicable tax rate is 40%. The risk free
interest rate is 10%.
Required:
(i) Find out the risk-adjusted discount rate (RADR) for these projects.
(ii) Which project is the best?

T E
I T U
Risk Adjusted Discount Rate
S T
C I N
Answer
SJ
(i) The risk free rate of interest and risk factor for each of the projects are given. The risk
adjusted discount rate (RADR) for different projects can be found on the basis of CAPM as
follows:
Required Rate of Return = IRf + (ke – IRF) Risk Factor
For P-I : RADR = 0.10 + (0.15 – 0.10 ) 1.80 = 19%
For P-II : RADR = 0.10 + (0.15 – 0.10 ) 1.00 = 15 %
For P-III : RADR = 0.10 + (0.15 – 0.10) 0.60 = 13 %
(ii) The three projects can now be evaluated at 19%, 15% and 13% discount rate as follows:
Project P-I
Annual Inflows ` 6,00,000
PVAF (19 %, 4) 2.639
PV of Inflows (` 6,00,000 × 2.639 ) ` 15,83,400

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Risk Analysis in Capital Budgeting

Less: Cost of Investment ` 15,00,000

Net Present Value ` 83,400
Project P-II
Year Cash Inflow (`) PVF (15%,n) PV (`)
1 6,00,000 0.870 5,22,000
2 4,00,000 0.756 3,02,400
3 5,00,000 0.658 3,29,000
4 2,00,000 0.572 1,14,400
Total Present Value 12,67,800
Less: Cost of Investment 11,00,000
Net Present Value 1,67,800
Project P-III
Year Cash Inflow (`) PVF (13%,n) PV (`)
1 4,00,000 0.885 3,54,000
2 6,00,000 0.783 4,69,800
3 8,00,000
T E 0.693 5,54,400
4
Total Present Value
I T U
12,00,000 0.613 7,35,600
21,13,800
Less: Cost of Investment
S T 19,00,000
Net Present Value
C I N 2,13,800

SJ
∴ Project P-III has highest NPV. So, it should be accepted by the firm.

34 RTP Nov'22
Consider the below mentioned table for the risk premium and the coefficient of variation
Co-efficient of Variation Risk Premium
0 0
0 to 0.25 2%
0.25 to 0.50 3%
0.50 to 0.75 4%
0.75 to 1 6%
A company is evaluating two projects with an initial investment of ₹ 1,50,000 for each project
with cash inflows from them occurring at the end of 5th Year which depends on possible
scenarios prevailing during the investment period. The details of the same are as follows:

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Divya Jadi Booti
Contact: 033-4059-3800 Website: sjc.co.in
Risk Analysis in Capital Budgeting

Scenario Project X Project Y

Cash Flow (₹) Probability Cash Flow (₹) Probability
Superb 5,00,000 0.20 4,00,000 0.30
Better 3,00,000 0.30 3,50,000 0.20
Moderate 1,50,000 0.15 2,50,000 0.20
Bad 50,000 0.20 75,000 0.20
Worse 10,000 0.15 5,000 0.10
If the ongoing government bond yield is 6%, identify WHICH project to be undertaken.

Evaluation of Project

Answer
Calculation of Expected Cash Flow, Standard Deviation & Co-efficient of variation
(a) Project X
T E
Probability (P) Cash Flows (x) P.x
I T P.x2 U
0.20 5,00,000
S T
1,00,000 50,00,00,00,000
0.30 3,00,000
C I N 90,000 27,00,00,00,000

SJ
0.15 1,50,000 22,500 3,37,50,00,000
0.20 50,000 10,000 50,00,00,000
0.15 10,000 1,500 1,50,00,000
2,24,000 80,89,00,00,000
Expected Cash flow = ∑ P.x = 2,24,000 = X

!P.x 2 " # !P.x $

2
Standard Deviation =

80 , 89 , 00 , 00 , 000 ! " 2, 24 , 000 #

2
=

= 30 , 71, 40 , 00 , 000

sx = 1,75,254
sx
Co-efficient of variation =
X
1, 75, 254
=
2, 24 , 000
COVx = 0.7824

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Risk Analysis in Capital Budgeting

(b) Project Y
Probability (P) Cash Flows (y) P.y P.y2
0.3 4,00,000 1,20,000 48,00,00,00,000
0.2 3,50,000 70,000 24,50,00,00,000
0.2 2,50,000 50,000 12,50,00,00,000
0.2 75,000 15,000 1,12,50,00,000
0.1 5,000 500 25,00,000
2,55,500 86,12,75,00,000
Expected Cash flow = ∑ P.y = y = 2,55,500

!P.y 2 " # !P.y $

2
Standard Deviation =

86 ,12, 75, 00 , 000 ! " 2, 55, 500 #

2
=

sy = 1,44,386
sy
Co-efficient of variation =
Y
T E
=
1, 44 , 386
2, 55, 500
I T U
S T
COVY
I
= 0.5651

C N
SJ
B. Calculation of Risk Adjusted Discount Rate
Project COV Risk Premium RADR
X 0.7824 6% 6% + 6% = 12%
Y 0.5651 4% 6% + 4% = 10%
C. Calculation of NPV
Year Project X Project Y
Cash Flows PVF @ 12% PV Cash Flows PVF @ 10% PV
0 (1,50,000) 1 (1,50,000) (1,50,000) 1 (1,50,000)
5 2,24,000 0.5674 1,27,098 2,55,500 0.6209 1,58,640
NPV (22,902) 8,640
NPV of project Y is higher, Project Y should be selected.

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Divya Jadi Booti
Contact: 033-4059-3800 Website: sjc.co.in
Risk Analysis in Capital Budgeting

35 May’22
P Ltd. is considering a project with the following details:
Initial Project Cost ₹ 1,00,000
Annual Cash Inflow (₹) 1 2 3 4
30,000 40,000 50,000 60,000
Project Life (Years) 4
Cost of Capital 10%
(i) MEASURE the sensitivity of the project to change in initial project cost and Annual cash
inflows (considering each factor at a time) such that NPV become zero.
(ii) IDENTIFY which of the two factors; the project is most sensitive to affect the acceptability
of the project?
Year 1 2 3 4 5
PVIF0.10, t 0.909 0.826 0.751 0.683 0.621

Sensitivity Analysis
T E
I T U
S T
C I N
Answer
SJ
Computation of Net Present Value (NPV):
Year PVF @ 10% Original Cash Flows PV PV
(₹) (₹) (₹)
0 1 (1,00,000) (1,00,000)
1 0.909 30,000 27,270
2 0.826 40,000 33,040
3 0.751 50,000 37,550
4 0.683 60,000 40,980 1,38,840
NPV 38,840
Determination of the most Sensitive factor:
(i) Sensitivity Analysis w.r.t. Initial Project cost (such that NPV becomes zero):
NPV of the project would be zero when the initial project cost is increased by
` 38 , 840
∴ Percentage change in Initial project cost = × 100 = 38.84%
` 1, 00 , 000

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Contact: 033-4059-3800 Website: sjc.co.in
Risk Analysis in Capital Budgeting

(ii) Sensitivity Analysis w.r.t. Annual Cash inflows (such that NPV becomes zero):
NPV of the project would be zero when the Annual cash inflows is decreased by ₹ 38,840.
` 38 , 840
∴ Percentage change in the Annual cash inflows = × 100 = 27.97%
` 1, 38 , 840

Conclusion: Annual cash inflows factor is the most sensitive as only a change beyond
27.97% in savings makes the project unacceptable.

T E
I T U
S T
C I N
SJ

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Divya Jadi Booti
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