1. Capital Budgeting

2. Risk analysis in Capital Budgeting
The uncertainty of returns from the moment, the funds are invested until management and investor know how much the projects has earned, is a primary determinant of a proposal's risk.
The estimates used to evaluate the capital budgeting proposals are the projections of future conditions and involve risk because of uncertainties surrounding the key variables involved in the evaluation procedure.

3. Project Specific Risk:
an individual project may have higher or lower cash flows than expected, either because of the wrong estimation or because of factors specific to that project..
2. Competition Risk:
cash flows of a project are affected by the actions of the competitors..
3. Industry Specific Risk:
technology risk,
legal risk,
commodity risk - effects of price changes in goods and services that are used or produced.
4. International Risk:
A firm faces this type of risk when it takes on projects outside its domestic market. the earnings and cash flows might be different than expected owing to exchange rate movements or political changes.
5. Market Risk:
The last type of risk arises by the factors that affect essentially all companies and all projects. For example, changes in interest rate structure will affect the projects already taken as well as those yet to be taken, both directly through the discount rate and indirectly through cash flows.

4. Sensitivity Analysis
Deals with the consideration of sensitivity of the NPV in relation to different variables contributing to the NPV.
Indicates how much the NPV will change in response to a given change in an input variable
change one variable at a time
answers “what if” questions
start with base-case which uses expected values

5. Steps
A) Based on the expectations for the future, the cash flows are estimated in respect of the proposal.
B) To identify the variables which have a bearing on the cash flows of a proposal. For example, some of these variables may be the selling price, cost of inputs, market share, market growth rate etc.,
C) To establish the relationship, between these variables and the output value i.e., the effect of these variables on the value of NPV of the proposal.
D) To find out the range of variations and the most likely value of each of these variables, and
E) To find out the effect of change in any of these variables on the value of NPV. This exercise should be performed for all the factors individually. For example, in case of a project involving .the product sale, the effect of change in different variables such as number of units sold, selling price, discount rate etc., can be taken up on the NPV or IRR of the project. This information can be used in conjunction with the basic capital budgeting analysis to decide whether or not to take up the project.

6. Example
Xyz ltd is evaluating two proposals a1 and a2 having cash outflow of rs 30,000. These alternative proposals may result in different cash inflows different economic conditions. Evaluate the proposals and advice the firm given that the minimum required rate of return of the firm is 10% a1 a2
10years
15years
Cash Inflows (annual)
good eco codn
rs 8000
6000
average eco condition
5500
bad economic condition
4500

7. Proposal a1 CF
PV(6.145)
Outflow
NPV
GOOD
8000
49160
30000
19160
AVG
6000
36870
6870
POOR
4500
27653
-2347

8. Proposal a2 CF
PV(6.145)
Outflow
NPV
GOOD
6000
45636
30000
15636
AVG
5500
41833
11833
POOR
4500
34227
4227

9. Simulation Analysis
Computerized analysis which uses continuous probability distributions
generation of values of cash flows using predetermined-probability distribution and the random numbers. The different components of cash flows are placed in relation to one another in a mathematical model. The process of generating the values of cash flows is repeated numerous times to result in a probability distribution of cash flows.
Steps
Computer program selects values for each variable based on its assumed distribution
NPV/IRR are calculated
Process is repeated many (1000+) times
End result is a probability distribution of NPV based on the simulated values

10. Decision Tree Analysis
Decision trees are a behavioral approach that uses diagrams to map the various investment decision alternatives and payoffs as their probabilities of occurrence
Steps In Decision Tree Analysis
Identifying The Problem and alternatives
Delineating The decision Tree
Specifying probalities and monetary outcomes
Evaluating various decision alternatives