Risk Analysis

Suppose you have a choice between two projects, both of which require the same initial investment, have identical net present values, and require the same yearly cash inflows to break even. If the cash inflow of the first investment has a probability of occurrence of 95% and that of the second investment is 70%, then risk analysis would indicate that the first investment is better.

Risk analysis refers to the chance that the selection of this project will prove to be unacceptable. In capital budgeting, risk analysis is almost entirely based upon how well we can predict cash inflows since the initial investment is usually known with some degree of certainty. The inflows, of course, are based upon sales projections, taxes, cost of raw materials, labor rates, and general economic conditions.

TABLE 14-19. SENSITIVITY ANALYSIS

Project A Project B

Initial Investment $10,000 $10,000

Annual Cash Inflows optimistic most likely pessimistic range

Net Present Values optimistic most likely pessimistic range

Sensitivity analysis is a simple way of assessing risk. A common approach is to estimate NPV based upon an optimistic (best case) approach, most likely (expected) approach, and pessimistic (worst case) approach. This can be illustrated using the table below. Both Projects A and B require the same initial investment of $10,000, with a cost of capital of 10%, and with expected five-year annual cash inflows of $5,000/year.

In Table 14-19, the range for Project A's NPV is substantially less than that of Project B, thus implying that Project A is less risky. A risk lover might select Project B because of the potential reward of $27,908, whereas a risk avoider would select Project A, which offers perhaps no chance for loss.

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