Risk Analysis and Capital Budgeting

Exercise problems
Q1
The beta company ltd is considering the purchase of a new investment. Two alternative investment
are available (A and B) each costing Rs 1,00,000. Cash inflow are expected to be as follows:
Cash inflow
Years Investment A Investment B
1 40,000 50,000
2 35,000 40,000
3 25,000 30,000
4 20,000 30,000
The company has a target return on capital of 10%. Risk premium rates are 2% and 8%
respectively for investment A and B. which investment should be preferred?

Q2

An enterprise is investing ` 100 lakhs in a project. The risk-free rate of return is 7%. Risk premium
expected by the Management is 7%. The life of the project is 5 years. Following are the cash flows
that are estimated over the life of the project.

Year Cash flows (` in lakhs)

1 25

2 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.
Q3

PQR LTD. is considering a project in U.S.A., which will involve an initial investment of US$
1,40,00,000. The project will have 5 years of life. Current spot exchange rate is `60.30
per US $. The risk-free rate in USA is 7% and the same in India is 8%. Cash inflows from the
project are as follows:
Years 1 2 3 4 5
Cash inflows (US $) 18,00,000 24,00,000 30,00,000 50,00,000 60,00,000

Calculate the NPV of the Project using foreign currency approach. Required rate of return on
the Project is 15%.
Q4

A project involves an outlay of Rs 1,00,000. Its expected cash flow at the end of year 1 is
Rs40,000. There after it decreases every year by Rs 2000. It has an economic life of 6 years. The
certainty equivalent factor is 1-0.05. calculate the net present value of the project if the risk free
rate of return is 10%. Suggest which of the two project should be preferred.

Q5

Due to a considerable risk inherent in a project costing an initial cash flow of Rs 20,000 a firm decides
to use certainty equivalents to evaluate the project. The certainty equivalents have been estimated
to be 0.8, 0.7, 0.6, 0.5, 0.4 in a period of 5 years. The risk- free rate of interest is 10%. The expected
values of cash inflows are given below:

Years Cash inflow

1 5,000

2 8,000

3 4,000

4 6,000
5 12,000

You are required to advice the firm whether its management should accept the project.

Ans: NPV -3,103: project be rejected because NPV is negative

Q6

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 0.786

Q7

There are two projects X and Y. Each involves an investment of Rs 40,000. The expected cash
inflow and the certainty coefficient are as under:
year Project X Project Y
Cash inflow certainty Cash inflow certainty
coefficient coefficient
1 25,000 .8 20,000 .9
2 20,000 .7 30,000 .8
3 20,000 .9 20,000 .7

Risk free cut off rate is 10%. Suggest which of the two projects should be preferred.

Q8
Q8

X Ltd is considering its New Product ‘with the following details

Sr. No. Particulars Figures
1 Initial capital cost 400 Cr
2 Annual unit sales 5 Cr
3 Selling price per unit 100
4 Variable cost per unit 50
5 Fixed costs per year 50 Cr
6 Discount Rate 6%
Required:
CALCULATE the NPV of the project.
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.
Q9
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).
Q10

Ajit corporation is considering the risk characteristics of a certain project. The firm has identified the
following factors, with their respective expected values, have a bearing on the NPV of this project.
Initial investment Rs 30,000
Cost of capital 10%
Quantity manufactured unsold annually 1400
Price for unit Rs 30
Variable cost per unit Rs 20
Fixed cost Rs 3,000
Depreciation Rs2,000
Tax rate 50%
Life of the project 5 years
Net salvage value Nil
Assume that the following underline variables can take the values as shown below
Underline variable Pessimistic Optimistic
Quantity manufacture and sold 800 1800
Price per unit 20 50
Variable cost per unit 40 15
Calculate the sensitivity of net present value to variations in quantity manufactured
Q11
Mr Risky is considering to mutually exclusive projects A and B. You are required to advise him about
the acceptability of the project from the following information:
Project A Project B
Cost of the investment 50,000 50,000
Forecast cash flow per annum for 5 years
Optimistic 30,000 40,000
Most likely 20,000 40,000
Pessimistic 15000 5,000
The cutoff rate maybe assume to be 15%
Q12
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 NPV estimates (`) Probability
15,000 0.2 15,000 0.1
12,000 0.3 12,000 0.4
6,000 0.3 6,000 0.4
3,000 0.2 3,000 0.1
COMPUTE the expected net present values of projects A and B.
COMPUTE the risk attached to each project i.e. standard deviation of each probability distribution.
COMPUTE the profitability index of each project.
IDENTIFY which project do you recommend? State with reasons.
Q13

Two mutually exclusive investment proposals are being considered. The following information is
available:

PROJECT X PROJECT Y

Cost Rs 6,000 Rs 6,000

Cash flow

year RS probability RS probability

1 4,000 0.2 8,000 0.2

2 8,000 0.6 9,000 0.6

3 12,000 0.2 9,000 0.2

Assuming cost of capital at 10% advise the selection of the project.

Q14
 Two mutually exclusive investment proposals are being considered. The following
information is available:
Project A Project B
Cost 12,000 12,000
Life 2yrs 2yrs
Cash flow each year 8,000 8,000
Salvage value Nil Nil
Upon the further analysis it was found that cost of the project is a certain amount and so is
the life of the project. However, the probabilities of cash inflow each for projects A & B are as
follows:
Project A possible Probabilities Project B possible Probabilities
cash inflow cash inflow
4,000 0.2 7,000 0.2
8,000 0.6 8,000 0.6
12,000 0.2 9,000 0.2
Assuming cost of capital at 10%, advise the selection of the project.
( ANS both project has negative NPV so both should be rejected Project A = - 5506, Project B = -
5410)

Q15
From the following information, ascertain which project is more risky on the basis of
standard deviation:
Project A Project B
Cash inflow Probability Cash inflow Probability
2,000 0.2 2,000 0.1
4,000 0.3 4,000 0.4
6,000 0.3 6,000 0.4
8,000 0.2 8,000 0.1
Q16
CALCULATE Variance and Standard Deviation on the basis of following information:
Possible Event Project A Project B
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
Q17
From the following information given below, find out which project is more risky
State of market Probability of occurrence Project A Project B
High 0.2 1000 1200
Normal 0.6 800 800
Medium 0.2 600 400
( ANS SD project A = 126.5: B=252.5 : project B is more risky)
Q18
CALCULATE Coefficient of Variation based on the following information:
Possible Event Project A Project B
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
Q19
Company is considering two mutually exclusive projects X and Y project X cost Rs 30,000 and
project Y Rs 36,000. You are being given below the net present value probability distribution
for each project:
Project X Project Y
NPV estimated Probability NPV estimated Probability
3000 .1 3000 .2
6000 .4 6000 .3
12000 .4 12000 .3
15000 .1 15000 .2
• Compute the expected net present value of project X and Y
• Compute risk attached to each project I,e. standard deviation of each probably
distribution
• Compute the Co efficient of variation. Which project do you consider more risky and
why?
• Compute the probability index of each project.
Q20
A company is considering two mutually exclusive projects X and Y. Project X costs Rs`3,00,000
and Project Y Rs`3,60,000. You have been given below the NPV and probability distribution for
each project:

Project X Project Y
NPV Estimate (`) Probability NPV Estimate (`) Probability
30,000 0.1 30,000 0.2
60,000 0.4 60,000 0.3
1,20,000 0.4 1,20,000 0.3
 1,50,000 0.1 1,50,000 0.2
Required:
• Compute the expected Net Present Value (NPV) of Projects X and Y.
• Compute the risk attached to each project i.e. Standard Deviation of each probability
distribution.
• Which Project do you consider more risky?
• Compute the Profitability Index of each Project.

Q21
Mr. wise is considering an investment proposal of Rs 20,00. The expected returns during the
life of the investment are as under:
Cash inflow in year 1
Event Cash inflow Probability
I 8,000 .3
II 12,000 .5
III 10,000 .2
 If cash flow in year 2 are:
Event 8,000 12,000 10,000
Cash in flow probability Cash in flow probability Cash in flow probability

I 15,000 .2 20,000 .1 25,000 .2

II 20,000 .6 30000 .8 40,000 .5
III 25,000 .2 40000 .1 60,000 .3
Using 10% as cost of capital, advise about the acceptability of the proposal. Construct the
decision tree for the proposed investment.

Q22
A firm has an investment proposal requiring an outlay of Rs 40,000. The investment proposal is
expected to have 2 years economic life with no salvage value. In year 1 there is a 0.4 probability
that cash inflow after tax will be Rs 25,000 and 0.6 probability that cash inflow after tax will be Rs
30,000. The probability assigned to cash inflow tax the year 2 are as follows:
The cash inflow year 1 25,000 30,000
The cash Probability The cash Probability
inflow year 2 inflow year 2
12000 .2 20000 .4
16000 .3 25000 .5
22000 .5 30000 .1
The firm uses 10% discount rate for this type of investment. Construct the decision tree for
the proposed investment.
ANS EXPECTED NPV IS 3111.88. PROJECT IS ACCEPTED

Q23
A large steel manufacturing company has three options with regard to
production:
(i) produce commercially, (ii) build pilot plant, (iii) stop producing steel.

• The management has estimated that their pilot plant, if built, has 80%
chances of high yield and 20% chance of low yield.
• If pilot plant does show a high yield, management assigns a probability of
0.75 that the commercial plant will also have a high yield.
• If pilot plant shows a low yield, there is only a 0.1 chance that the
commercial plant will show a high yield.
• Finally, management's best assessment of the yield on a commercial-size
plant without building a pilot plant first has a 0.6 chance of high yield.
• A pilot plant will cost Rs 3,00,000/-. The profits earned under high and low
yield conditions are Rs 1,20,00,000/- and -Rs 12,00,000/-respectively.

Find the optimum decision of the company.

Step-by-step explanation:

The decision tree diagram has been represented in the figure.

EMV of chance node C will be = Rs. [0.75(1,20,00,000)-0.25(12,00,000)]

= Rs. 87,00,000

EMV of chance node D will be = Rs. [0.1(1,20,00,000)-0.9(12,00,000)]

= Rs. 1,20,000

EMV of decision node 2 is = Rs. 87,00,000

EMV of decision node 3 is = Rs. 1,20,000

EMV of chance node A will be = Rs. [0.8(87,00,000)-0.2(1,20,000)]

= Rs. 69,36,000

The EMV of decision node 1 if pilot plant is built:

= Rs. [69,36,000-3,00,000]

= Rs. 66,36,000

EMV of chance node B will be:

= Rs. [0.6(1,20,00,000)-0.4(12,00,000)]

= Rs. 67,20,000

So, EMV of decision node 1 for alternative 'produce commercially' will be:

= Rs. 67,20,000

Therefore, the optimum decision for the company will be that the company should not
build the pilot plant but should produce commercially.

Q24

/
Q10 Solved in class- Version 2
Ajit corporation is considering the risk characteristics of a certain project. The firm has identified the
following factors, with their respective expected values, have a bearing on the NPV of this project.
Calculate the sensitivity of net present value to variations in Quantity manufactured, Price per unit
and VC per unit

Initial investment Rs 30,000

Cost of capital 0.10

Quantity manufactured sold annually 1400.00

Price for unit ₹ 30.00

Variable cost per unit ₹ 20.00
Fixed cost ₹ 3,000.00
Depreciation ₹ 2,000.00
Tax rate 0.50
Life of the project 5 years
Net salvage value Nil

Assume that the following underline variables can take the values as shown below
Underline variable Pessimistic Optimistic
Quantity manufacture and sold 800 1800.00
Price per unit 20 50.00
Variable cost per unit 40 15.00
Calculate the sensitivity of net present value to variations in quantity manufactured, Price per
unit and VC per unit.

Solution:

CF Calculation under CF Calculation under CF Calculation under

Most likey scenario Pessimistic Scenario Optimistic Scenario
Sales 42000 Sales 16000 Sales 90000
VC 28000 VC 32000 VC 27000
Contributio 14000 Contributio -16000 Contributio 63000
less FC ₹ 3,000.00 less FC ₹ 3,000.00 less FC ₹ 3,000.00
EBDT ₹ 11,000.00 EBDT -₹ 19,000.00 EBDT ₹ 60,000.00
Less depri 2000 Less depri 2000 Less depri 2000
EADBT 9000 EADBT -₹ 21,000.00 EADBT ₹ 58,000.00
less tax 4500 less tax -₹ 10,500.00 less tax ₹ 29,000.00
EAT 4500 EAT -₹ 10,500.00 EAT ₹ 29,000.00
Add depre 2000 Add depre 2000 Add depre 2000
CFAT 6500 CFAT -₹ 8,500.00 CFAT ₹ 31,000.00

CFAT PVIFA 10%,5 years sum of PVCIF NPV

Most
Likely 6500 3.79 24640.2 -5359.8
-₹
Pessimistic 8,500.00 3.79 -32221.8 -62221.8
optimistic 31000 3.79 117514.8 87514.8