“DISCUSS THE TECHNIQUES OF PROJECT RISK ANALYSIS IN

DETAILS WITH ILLUSTRATIVE EXAMPLES ALSO LIST OUT THE

MERITS AND DEMERITS OF THESE TECHNIQUES”

SUBMITTED TO:
DR. BHARGAV PANDYA

Presented By
NAME : VADHAVI JIGAR P.
Roll No.: 64 MBA Batch (2017-19)

M.S. PATEL INSTITUTE OF MANAGEMENT STUDIES

FACULTY OF MANAGEMEN STUDIES

The Maharaja Sayajirao University Of Baroda

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 Brief Overview
The risk varies according to the nature of investments. A research and
development project can be much riskier than the expansion project
while; the expansion project can be much riskier than the replacement
project. Hence, the firm must evaluate the risk before employing its
resources in any long-term investment project.
 Risk is referred to a situation where the probability distribution
of the cash flow of an investment proposal is known.
 If no information is available to formulate a probability
distribution of the cash flows the situation is known as uncertainty

 The firms apply several techniques to handle the risk associated with the
capital budgeting decisions and are grouped into two broad categories:

1. An approach to handling stand-alone risk of a project

2. An approach to handling the risk associated with the firm and with the market
(Contextual Risk)

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 1. SENSTIVITY ANALYSIS :-
 A sensitivity analysis determines how different values of an independent variable
affect a particular dependent variable under a given set of assumptions. This
technique is used within specific boundaries that depend on one or more input
variables.
 Sensitivity analysis can be used to help make predictions in the share prices of
public companies. Some of the variables that affect stock prices include company
earnings, the number of shares outstanding, the debt-to-equity ratios (D/E), and the
number of competitors in the industry. The analysis can be refined about future
stock prices by making different assumptions or adding different variables. This
model can also be used to determine the effect that changes in interest rates have on
bond prices. In this case, the interest rates are the independent variable, while bond
prices are the dependent variable.

MERITS :-

 It shows how robust or vulnerable a project is to changes in values of the underlying variables
 Help in decision making
 Helps in identifying how dependent the output is on a particular input value. Analyses if the
dependency in turn helps in assessing the risk associated
 Aids searching for errors in the model

DEMERITS
 It merely shows what happens to NPV when there is a change in some variable, without
providing any idea of how likely that change will be.
 Typically, in sensitivity analysis only one variable is changed at a time.
 The interpretation of result is subjective.

Example:-

NPV = F / [ (1 + i)^n ]

Where,

PV = Present Value
F = Future payment (cash flow)
i = Discount rate (or interest rate)
n = the number of periods in the future the cash flow is

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 Pessimistic Expected Optimistic

Investment 300 250 200

Sales 150 200 275

Variable costs 97.5 120 154

Fixed costs 30 20 15

Depreciation 30 25 20

Pretax profit - 7.5 35 86

Tax @ 28.57% - 2.14 10 24.57

Profit after tax - 5.36 25 61.43

Net cash flow 24.64 50 81.43

Cost of capital 14% 13% 12%

NPV - 171.47 21.31 260.10

NPV of the project = -250 + 50 x PVIFA (r=13,n=10)

= Rs.21.31 million

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 2. SCENARIO ANALYSIS :-
 Scenario analysis is conducted, to analyze the impacts of possible future
events on the system performance by taking into account several alternative
outcomes, i.e., scenarios, and to present different options for future
development paths resulting in varying outcomes and corresponding
implications.
 Scenario analysis is the process of forecasting the expected value of a
performance indicator, given a time period, occurrence of different
situations, and related changes in the values of system parameters under an
uncertain environment. Scenario analysis can be used to estimate the
behavior of the system in response to an unexpected event, and may be
utilized to explore the changes in system performance, in a theoretical best-
case (optimistic) or worst-case (pessimistic) scenario

MERITS:-
 helps you understand the possible implications and benefits of different approaches
 Having all the potential outcomes laid out in front of you can help you make the best decision

DEMERITS:-
 It is based on the assumption that there are few well-delineated scenarios.
 The main drawback of this method lies in the interpretation of its results: how do you decide
which scenario is preferable? In addition, the two parameters (uncertainty and impact) can be
highly subjective and very difficult to measure
 This analysis Expands the concept of estimating the expected values.

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 3. BREAK-EVEN ANALYSIS :-
 Break-even analysis is a technique widely used by production
management and management accountants. It is based on
categorising production costs between those which are "variable"
(costs that change when the production output changes) and those
that are "fixed" (costs not directly related to the volume of
production).
 Total variable and fixed costs are compared with sales revenue in
order to determine the level of sales volume, sales value or production
at which the business makes neither a profit nor a loss (the "break-
even point").
The Break-Even Chart:- In its simplest form, the break-even chart is a graphical representation of
costs at various levels of activity shown on the same chart as the variation of income (or sales,
revenue) with the same variation in activity. The point at which neither profit nor loss is made is
known as the "break-even point" and is represented on the chart below by the intersection of the
two lines:

MERITS:-

 Measure profit and losses at different levels of production and sales.

 Predict the effect of changes in sales prices.
 Analyze the relationship between fixed and variable costs.
 Predict the effect of cost and efficiency changes on profitability.

DEMERITS:-

 Assumes that sales prices are constant at all levels of output.

 Assumes production and sales are the same.
 Break even charts may be time consuming to prepare.
 It can only apply to a single product or single mix of products.

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 EXAMPLE:-

Pessimistic

Initial investment 30000

Sale revenue 42000

Variable costs 56000

Fixed costs 3000

Depreciation 2000

Profit before tax -11000

Tax -5500

Profit after tax -5500

Net cash flow -3500

NPV F / [ (1 + i)^n ] -43268

Accounting break-even point

i. Fixed costs + depreciation = Rs.5000

ii. Contribution margin ratio = 10 / 30 = 0.3333

iii. Break-even level of sales = 5000 / 0.3333

= Rs.15000

Financial break-even point

i. Annual cash flow = 0.5 x (0.3333 Sales – 5000) = 2000

ii. PV of annual cash flow = (i) x PVIFA (10,5)

= 0.6318 sales – 1896

iii. Initial investment = 30000

iv. Break-even level of sales = 31896 / 0.6318 = Rs.50484

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 4. HILLIER MODEL :-
According to the Hillier model, the risk associated with the project can
be assessed through the standard deviation of expected cash flows. In
other words, determining the viability of the project through
calculating the deviations in the cash flows from the mean of expected
cash flows
 Thus, Hillier model asserts that the computation of standard
deviations of several ranges of cash flows enables a firm to determine
the uncertainty involved in the future projects
 This model was proposed by F.S. Hillier and according to him, the expected Net Present
Value and the standard deviation of the Net present value of the project can be
determined through analytical derivations. Under this model, there are two cases of
analysis:

 When there is no correlation among the cash flows

 When there is a perfect correlation among the cash flows.

 When the cash flows of different years are uncorrelated, then the cash flow in the year “t”
is independent of the cash flow in the year “t-n”. Whereas, if the cash flows of different
years are perfectly correlated, then the cash flows in each period will be alike

The formula to compute the Net present Value and the standard deviation under both the cases is
given below:

Uncorrelated Cash Flows

NPV = n∑t=1 [Ct / (1+i)t] – I

∂ (NPV) = n∑t=1 [∂t2/ (1+i)2t]1/2

Correlated Cash Flows

NPV = n∑t=1 [Ct / (1+i)t] – I

∂(NPV) = n∑t=1[ ∂t/ (1+t)t]

EXAMPLES:-

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 MERITS :-
 Assumption of Reinvestment.
 Accepts Conventional Cash Flow Pattern.
 Consideration of all Cash Flows.
 Good Measure of Profitability.

DEMERITS:-
 Factors Risks.
 Estimation of Opportunity Cost.
 Ignoring Sunk Cost
 Difficulty in Determining the Required Rate of Return

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5. SIMULATION ANALYSIS
The Simulation Analysis is a method, wherein the infinite calculations are made
to obtain the possible outcomes and probabilities for any choice of action.
 The concept of simulation analysis can be further comprehended through the
following steps:
1. First, you should identify variables that influence cash inflows and outflows.
2. Second, specify the formulae that relate variables.
3. Third, indicate the probability distribution for each variable.
4. Fourth, develop a computer programme that randomly selects one value from the
probability distribution of each variable and uses these values to calculate the
project’s NP.

This whole process of simulation analysis compels the decision maker to

consider all the interdependencies and uncertainties characterizing the
project. Thus, the viability of the project is determined on the basis of
number of outcomes and the probabilities realized through a series of actions
performed during the simulation analysis

MERITS:-
 Determine NPV in simulation run, with risk free discount rate
 Simulation is inherently imprecise
 Difficult to model the project and specify probability distribution of exogenous variables

DEMERITS:-
 The model becomes quite complex to use
 It does not indicate whether or not the project should be accepte
 Simulation analysis, like sensitivity or scenario analysis, considers the risk of any
project in isolation of other projects

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EXAMPLE:-
QUANTITY (Q) PRICE (P)
VARIABLE COST (V) NPV
Ru Random Correp Random Corres- Randm Corres- 1.8955 Q(P-V)-
n Number onding Number ponding Numbe ponding 31,895.5
Value value r value

1 03 800 38 20 17 15 -24,314

2 32 1,200 69 30 24 15 2,224

3 61 1,400 30 20 03 15 -18,627

4 48 1,400 60 30 83 40 -58,433

5 32 1,200 19 20 11 15 -20,523

6 31 1,200 88 40 30 20 13,597

7 22 1,200 78 30 41 20 -9,150

8 46 1,400 11 20 52 20 -31,896

9 57 1,400 20 20 15 15 -18,627

10 92 1,800 77 30 38 20 2,224

11 25 1,200 65 30 36 20 -9,150

12 64 1,400 04 20 83 40 -84,970

13 14 1,000 51 30 72 20 -12,941

14 05 800 39 20 81 40 -62,224

15 07 800 90 50 40 20 13,597

16 34 1,200 63 30 67 20 -9,150

17 79 1,600 91 50 99 40 -1,568

18 55 1,400 54 30 64 20 -5,359

19 57 1,400 12 20 19 15 -18,627

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20 53 1,400 78 30 22 15 7,910

21 36 1,200 79 30 96 40 -54,642

22 32 1,200 22 20 75 20 -31,896

23 49 1,400 93 50 88 40 -5,359

24 21 1,200 84 40 35 20 13,597

25 08 .800 70 30 27 15 -9,150

26 85 1,600 63 30 69 20 -1,568

27 61 1,400 68 30 16 15 7,910

28 25 1,200 81 40 39 20 13,597

29 51 1,400 76 30 38 20 -5,359

30 32 1,200 47 30 46 20 -9,150

31 52 1,400 61 30 58 20 -5,359

32 76 1,600 18 20 41 20 -31,896

33 43 1,400 04 20 49 20 -31,896

34 70 1,600 11 20 59 20 -31,896

35 67 1,400 35 20 26 15 -18,627

36 26 1,200 63 30 22 15 2,224

37 89 1,600 86 40 59 20 28,761

38 94 1,800 00 20 25 15 -14,836

39 09 .800 15 20 29 15 -24,314

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40 44 1,400 84 40 21 15 34,447

41 98 1,800 23 20 79 20 -31,896

42 10 1,000 53 30 77 20 -12,941

43 38 1,200 44 30 31 20 -9,150

44 83 1,600 30 20 10 15 -16,732

45 54 1,400 71 30 52 20 -5,359

46 16 1,000 70 30 19 15 -3,463

47 20 1,200 65 30 87 40 -54,642

48 61 1,400 61 30 70 20 -5,359

49 82 1,600 48 30 97 40 -62,224

50 90 1,800 50 30 43 20 2,224

Expected NPV = NPV

50

= 1/ 50 NPVi

i=1

= 1/50 (-7,20,961)
= 14,419

50

Variance of NPV = 1/50 NPVi – NPV)2

i=1

= 1/50 [27,474.047 x 106]

= 549.481 x 106

Standard deviation of NPV = 549.481 x 106 = 23,441

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6.DECISION –TREE ANALYSIS:-
The Decision Tree Analysis is a schematic representation of several
decisions followed by different chances of the occurrence. Simply, a tree-
shaped graphical representation of decisions related to the investments and
the chance points that help to investigate the possible outcomes is called as a
decision tree analysis.

 The decision tree shows Decision Points, represented by squares, are the alternative
actions along with the investment outlays, that can be undertaken for the experimentation.
These decisions are followed by the chance points, represented by circles, are the
uncertain points, where the outcomes are dependent on the chance process. Thus, the
probability of occurrence is assigned to each chance point.

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Once the decision tree is described precisely, and the data about outcomes along with their
probabilities is gathered, the decision alternatives can be evaluated as follows:

1. Start from the extreme right-hand end of the tree and start calculating NPV for each
chance points as you proceed leftward.
2. Once the NPVs are calculated for each chance point, evaluate the alternatives at the final
stage decision points in terms of their NPV.
3. Select the alternative which has the highest NPV and cut the branch of inferior decision
alternative. Assign value to each decision point equivalent to the NPV of the alternative
selected.
4. Again, repeat the process, proceed leftward, recalculate NPV for each chance point,
select the decision alternative which has the highest NPV value and then cut the branch
of the inferior decision alternative. Assign the value to each point equivalent to the NPV
of selected alternative and repeat this process again and again until a final decision point
is reached.

Thus, decision tree analysis helps the decision maker to take all the possible outcomes into the
consideration before reaching a final investment decision

MERITS:-
 It clearly brings out the implicit assumptions and calculations for all to see, question and
revise
 It allows a decision maker to visualise assumptions and alternatives in graphic form,
which is usually much easier to understand than the more abstract, analytical form.
DEMERITS :-
 The decision tree diagrams can become more and more complicated as the decision maker
decides to include more alternatives and more variables and to look farther and farther in time
 It is complicated even further if the analysis is extended to include interdependent alternatives
and variables that are dependent upon one another

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