Page 202 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes 9.8 Statistical Techniques to Handle Risk

The estimates of cash inflows and outflows may be termed as probability estimates i.e., they
represent only likely happenings.
The uncertainty about future leads to variations in returns. Risk is perceived to be variability of
actual returns from the estimated returns. For example, if two projects are considered, one with
a NPV of 100 with probability I and other project with two possible outcomes.
NPV Probability
200 0.5

0 0.5
Both the projects have the same NPV of 100. However, the risk profile of second project is
different from the first. The returns on the first project do not vary or are certain while in the
second project the returns can vary anywhere between 0 to 200 around its expected mean of 100.
Thus, the certainty of getting returns of 100 is much lesser in the second project as compared to
the first project making it more risky.
Actually, if risk and uncertainty factors are not taken into account there is always a danger that
capital expenditure evaluation may produce misleading results.

Method of Accounting for Risk
Having established the need for taking into account the risk involved in a capital expenditure
proposal, the different measures to quantity the risk in more precise terms are given below:

1. Sensitivity Analysis: Sensitivity Analysis provides information as to how sensitive the
estimated project parameters, namely the expected cash flow, the discount rate and the
project life are to estimation errors by considering a number of possible outcomes. It
provides different cash flow estimates under three assumptions:
The worst (i.e. the, most pessimistic), the expected (i.e., the most likely) and the best
(i.e., the most optimistic) outcomes associated with the project.

Example:
Project X Project Y
Initial cash outlays – 80,000 – 80,000
Cash flow estimates (1 – 15 years) worst 12,000 0
Most likely 16,000 16,000
Best 20,000 32,000
Required rate of return 10% 10%
Economic life 15 years 15 years

Solution:

Project X Project Y
PV NPV PV NPV
( ) ( ) ( ) ( )
Worst 91,272 11,272 NIL – 80,000
Most likely 1,21,696 41,696 1,21,696 41,696
Best 1,52,120 72,120 2,43,392 1,63,392

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