Summary one – Risk analysis in capital budgeting

- Risk arises in the investment evaluation because the forecasts of cash flows can go wrong. Risk can be defined as variability of returns of an investment project. Standard deviation is a commonly used measure of variability.• Statistical techniques are used to measured and incorporate risk in capital budgeting. Two important statistics in this regard are the expected monetary value and standard deviation. The decision maker instead of working with one single forecast can work with a range of values and their associated probabilities. The expected monetary value is the weighted average of returns where probabilities of possible outcomes are used as weights.
- Decision maker in practice may handle risk in conventional ways. For example, they may use a shorter payback period, or use conservative forecasts of cash flows, or discounted net cash flows at the risk adjusted discount rates.
- A more useful technique is the sensitivity analysis. It is a method of analyzing change in the projects net present value for a given change in one variable at a time. It helps in asking what if questions and calculates net present value under different assumptions.
- Scenario analysis is the extension of sensitivity. It considers a few combinations of variables and calculates net present value for each of them. It is a usual practice to calculate net present value for each of them. It is a usual practice to calculate net present value under normal, optimistic pessimistic scenario.
- Sensitivity or scenario analysis forces the decision maker to identify underlying variables, indicates critical variables and helps in strengthening the project by pointing out its weak links. Its limitations are that it cannot handle a large number of interdependent variables and at times, fails to give unambiguous results.

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