Risk and uncertainty

methods
SRUJANA AK
 Probability Distribution Approach
• The probability distribution of cash flows over time provides valuable
information about the expected value of return and the dispersion of the
probability distribution of possible returns.
• The application of this theory in analyzing risk in capital budgeting
depends upon the behavior of the cash flows, from the point of view of
behavioral cash flows being (i) independent, or (ii) dependent.
• Dependent cash flows are cash flows in a period which depend upon the
cash flows in the preceding periods.
• Independent cash flows are cash flows not affected by cash flows in the
preceding or following years.
FORMULA

• Independent Cash Flows Over Time The mathematical formulation to

determine the expected values of the probability distribution of NPV
for any project is:

where CFt is the expected value of net CFAT in period t and i is the
riskless rate of interest. The standard deviation of the probability
distribution of NPV is equal to:
Cond…
• where is the standard deviation of the probability distribution of
expected cash flows for period t, would be calculated as follows:

The above calculations of the standard deviation and the NPV will
produce significant volume of information for evaluating the risk of the
investment proposal
 Example : 1
• Suppose there is a project which involves initial cost of Rs 20,000 (cost at t
= 0). It is expected to generate net cash flows during the first 3 years with
the probability. Risk free rate of return is 10 per cent.
Expected Cash Flows
 Solution:

Step 1: Expected Values: For the calculation of standard deviation for different
periods, the expected values are to be calculated first.
Step 2: The standard deviation of possible net cash flows is:

Step 3: calculation of NPV

Step 4: The standard deviation under the assumption of independence of cash flows
over time:
Step 1: calculation of expected values
 Step 2: The standard deviation of possible net cash flows

• When calculated on similar lines the standard deviations for periods 2 and
3 (s2 and s3) also work out to Rs 2,280
Step 3: calculation of NPV

Step 4: The standard deviation under the assumption of independence

of cash flows over time:
 Cont…
Assume that a project has a mean of Rs 40 and standard deviation of Rs
20.
The management wants to determine the probability of the NPV under the
following ranges: (i) Zero or less, (ii) Greater than zero, (iii) Between the
range of Rs 25 and Rs 45, (iv) Between the range of Rs 15 and Rs 30.
• (i) Zero or less
z= X –npv
sd
 Cond…

• NPV of 0 lies 2 standard deviation to the left of the expected value of the
probability distribution of possible NPV.
• Table Z indicates that the probability of the value within the range of 0 to
40 is 0.4772. Since the area of the left-hand side of the normal curve is
equal to 0.5, the probability of NPV being zero or less would be 0.0228,
that is, 0.5 – 0.4772.
• It means that there is 2.28 per cent probability that the NPV of the project
will be zero or less.
(ii) Greater than zero: The probability for the NPV being greater than zero
would be equal to 97.72 per cent, that is, 100 – 2.28 per cent probability of
NPV being zero or less
 Cond…
(iii) Between the range of Rs 25 and Rs 45:
• The first step is to calculate the value of Z for two ranges: (a) between Rs 25
and Rs 40, and (b) between Rs 40 and Rs 45. The second and the last step is
to sum up the probabilities obtained for these values of Z:

• The area as per Table Z for the respective values of –0.75 and 0.25 is 0.2734
and 0.0987 respectively. Summing up, we have 0.3721. In other words, there
is 37.21 per cent probability of NPV being within the range of Rs 25 and Rs
45. (It maybe noted that the negative signs for the value of Z in any way does
not affect the way Table Z is to be consulted. It simply reflects that the value
lies to the left of the mean value).
 Cond..

• (iv) Between the range of Rs 15 and Rs 30:

• According to Table Z, the area for respective values –1.25 and –0.5 is
0.3944 and 0.1915. The probability of having value between Rs 15 and 40
is 39.44 per cent, while the probability of having value between Rs 30 and
40 = 19.15 per cent.
 Example 2:

• (a) zero or less (assuming that the distribution is normal); (b) greater than
zero; and (c) at least equal to the mean; (iv) the profitability index of the
expected value; and (v) the probability that the profitability index will be
less than 1.
Decision-tree Approach
• Decision tree is a pictorial representation in tree form which indicates
the magnitude, probability and inter-relationships of all possible
outcomes.
• The Decision-tree Approach (DT) is another useful alternative for
evaluating risky investment proposals. The outstanding feature of this
method is that it takes into account the impact of all probabilistic
estimates of potential outcomes.
• In other words, every possible outcome is weighed in probabilistic terms
and then evaluated. The DT approach is especially useful for situations
in which decisions at one point of time also affect the decisions of the
firm at some later date. Another useful application of the DT approach is
for projects which require decisions to be made in sequential parts.
 Example 1
• Suppose a firm has an investment proposal, requiring an outlay of Rs 2,00,000 at present (t = 0). The
investment proposal is expected to have 2 years’ economic life with no salvage value. In year 1, there is
a 0.3 probability (30 per cent chance) that CFAT will be Rs 80,000; a 0.4 probability (40 per cent chance)
that CFAT will be Rs 1,10,000 and a 0.3 probability (30 per cent chance) that CFAT will be Rs 1,50,000.
• In year 2, the CFAT possibilities depend on the CFAT that occurs in year 1. That is, the CFAT for the year 2
are conditional on CFAT for the year 1. Accordingly, the probabilities assigned with the CFAT of the year 2
are conditional probabilities. The estimated conditional CFAT and their associated conditional
probabilities are as follows:

• the NPV at 8 per cent discount rate of each of the estimated CFATs
Example 2….

• A company is trying to decide whether to invest in a new project. Two mutually

exclusive projects are available, each requiring an investment of Rs 3,00,000.
Project A is expected to generate cash inflows of Rs 2,00,000 per year in the
next 2 years.
• It is estimated that the cash inflows associated with project B would either be
Rs 1,80,000, or Rs 2,20,000 (each with 0.5 probability of occurrence) next year.
If Rs 1,80,000 is received in the first year, the cash inflow for the second year is
likely to be Rs 1,50,000 (probability of 0.3), Rs 1,80,000 (probability of 0.4) and
Rs 2,00,000 (probability of 0.3). In case the first year’s cash inflow is Rs
2,20,000, the second year’s likely cash inflow would be Rs 1,80,000 and Rs
2,70,000 (each with 0.3 probability), and Rs 2,20,000 (probability 0.4).
• The firm uses a 14 per cent minimum required rate of return for deciding
whether to invest in projects comparable in risk to the ones under
consideration. (i) Calculate the risk adjusted expected NPV for projects A and B.
(ii) Which of the projects, if any, would you recommend? Why
Solution:
Example 3
• A company has the following estimates of the present values of the
future cash flows after taxes associated with the investment proposal,
concerned with expanding the plant capacity. It intends to use a
decision-tree approach to get a clear picture of the possible outcomes
of this investment. The plant expansion is expected to cost Rs
3,00,000. The respective PVs of future CFAT and probabilities are as
follows:
 Sensitivity Analysis
• One measure which expresses risk in more precise terms is sensitivity analysis.
• It 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.
• The analysis on these lines is important as the future is always uncertain and there
will always be estimation errors.
• Sensitivity analysis takes care of estimation errors by using a number of possible
outcomes in evaluating a project.
• The method adopted under sensitivity analysis is to evaluate a project using a number
of estimated cash flows to provide to the decision maker an insight into the variability
of the outcomes.
• Sensitivity analysis provides different cash flow estimates under three assumptions:
(i) the worst (i.e. the most pessimistic), (ii) the expected (i.e. the most likely), and (iii)
the best (i.e. the most optimistic) outcomes associated with the project.
Example 1

• From the undermentioned facts, compute the net present values

(NPVs) of the two projects for each of the possible cash flows, using
sensitivity analysis.
 solution

• The NPV of each project, assuming a 10 per cent required rate of return,
can be calculated for each of the possible cash flows. Table A-4 indicates
that the present value interest factor annuity (PVIFA) of Re 1 for 15 years at
10 per cent discount is 7.606. Multiplying each possible cash flow by PVIFA,
 Example 2

• A company has under consideration two mutually exclusive projects for

increasing its plant capacity. The management has developed pessimistic, most
likely and optimistic estimates of the annual cash flows associated with each
project. The estimates are as follows:

• (a) Determine the NPV associated with each estimate given for both the
projects. The projects have 20 year life each and the firm’s cost of capital, 10 per
cent.
• (b) Which project do you consider should be selected by the company and why?
 solution

• (b) The calculations suggest that the projects are equally desirable on the basis of the most likely estimates
of their cash flows. However, Project A is riskier than Project B because the NPV can be negative by an
amount as high as Rs 19,783.
• On the other hand, in the case of Project B, there is no possibility of the firm incurring losses as the values
of NPV are positive under all expected cash flow situations.
• Since the projects are mutually exclusive, the actual selection will depend on the decision maker’s attitude
towards risk. If he is willing to take risk, he will select Project A, because it has also the possibility of
yielding a much higher amount of NPV as compared to Project B; if he is risk-averse, he will obviously select
Project B
 Example 3
• The Premier Ltd is considering a proposal to buy one of the two machines to
manufacture a new product. Each of these machines requires an investment of Rs
50,000, and is expected to provide benefits over a period of 12 years. The firm has
made pessimistic, most likely, and optimistic estimates of the returns associated with
each of these alternatives. These estimates are as
Monte Carlo Simulation Approach
• Monte Carlo Simulation is a mathematical technique that generates random variables for
modelling risk or uncertainty of a certain system.
• Monte Carlo simulation is a computerized mathematical technique to generate random
sample data based on some known distribution for numerical experiments.
• This method is applied to risk quantitative analysis and decision making problems.
• This method is used by the professionals of various profiles such as finance, project
management, energy, manufacturing, engineering, research & development, insurance, oil
& gas, transportation, etc.
• This method was first used by scientists working on the atom bomb in 1940. This method
can be used in those situations where we need to make an estimate and uncertain
decisions such as weather forecast predictions.
• They earn their name from the area of Monte Carlo in Monaco, famous for its high-end
casinos. Random outcomes are central to the technique, just as they are to roulette and
slot machines. 
Steps Monte Carlo Simulation Approach

• Step 1: Define the Problem

i)Identify clearly the objectives of the problem
ii) Identify factor which have the greatest effect on the objectives.

• Step 2: construct the model

i) specify variables and parameters

ii) formulate appropriate decision rules

iii) Identify the type of distribution to be used

iv) specify the manner in which time will change

v) define relationship between variables and parameters

• Step 3: Preparation of Model Experimentation

i) define starting condition for simulation
ii) Specify the number of runs for simulation

• Step 4 : Execute steps 1 to 3 and experiment with the model.

i) define a coding system and select a random
ii) create the random numbers to be used in simulation
 Cond…

• Step 5: summarize and examine the results of step 4

• Step 6: Evaluate the results of simulation and select the best course of
action.
Investment decisions under capital constraints
• Capital rationing is a strategy used by companies or
investors to limit the number of projects they take on at a 
time. If there is a pool of available investments that are all
expected to be profitable, capital rationing helps the investor
or business owner choose the most profitable ones to
pursue.
• Capital Rationing Example
• Capital rationing is about putting restrictions on investments
and projects taken on by a business.
• To illustrate this better, let’s consider the following example:
 Cond…
• XYZ LTD is looking at five possible projects to invest in, as shown below:

To determine which project offers the greatest potential profitability, we compute each project using
the following formula:
• Profitability =  NPV / Investment Capital

• Based on the table above, we can conclude that projects 1 and 2 offer the greatest potential profit. Therefore, XYZ
ltd will likely invest in those two projects.
Types of Capital Rationing

• There are two types of capital rationing – hard and soft rationing.

Hard capital rationing
• Hard capital rationing represents rationing that is being imposed on a company by
circumstances beyond its control. For example, a company may be restricted from borrowing
money to finance new projects because it has suffered a downgrade in its credit rating. Thus, it
may be difficult or effectively impossible for the company to secure financing, or it may only
be able to do so at exorbitant interest rates.

Soft capital rationing

• In contrast, soft capital rationing refers to a situation where a company has freely chosen to
impose some restrictions on its capital expenditures, even though it may have the ability to
make much higher capital investments than it chooses to. The company may choose from any
of a number of methods for imposing investment restrictions on itself.
• For example, it may temporarily require that a project offer a higher rate of return than is
usually required in order for the company to consider pursuing it. Or the company may simply
impose a limit on the number of new projects that it will take on during the next 12 months.
Reasons for Capital Rationing

• One big reason is that the potential project requires higher initial
investment which is not possible for the organization in the light of its
limited capital. So in such cases that potential project is rejected.
• There may be a lack of relevant human resources, talent, or knowledge
for the staring or operating of the new potential project. Even in such a
case, the company will not invest in that project.
• The fear of debt is another reason for the rejection of potential investment
options by companies. In Muslim countries, the interest paid on debt
(Riba) is considered as a major issue because of the religious constraint
for Muslims in the borrowing of money on interest. Therefore in many
Muslim countries, there is an ethical basis associated with capital
rationing. So the investors of such Muslim countries invest in equity
based projects where there is a risk of profit or loss.
Situations of capital rationing
• Single period constraints
• Multi period constraints

Single period constraints

situation 1: projects are divisible and constraints in a single period
Situation 2: projects are indivisible and constraints in single period
Multi period constraints
Situation 3: projects are divisible and constraints in multi-period
An unresolved problem