Capital Budgeting under Risk and Uncertainties^133
as best in all situations. The variety of techniques suggested to handle risk in capital
budgeting fall into two broad categories: (i) Approaches that consider the stand-alone
risk of a project; (ii) Approaches that consider the risk of a project in the context of
the firm or in the context of the market. Exhibit 6.2 classifies various techniques into
these two broad categories.
This chapter discusses different techniques of risk analysis (except market risk analysis
which is covered in the chapter on Cost of Capital), explores various approaches to
project selection under risk, and describes risk analysis in practice. It is divided into nine
sections as follows:
l Sensitivity analysis
l Scenario analysis
l Break-even analysis
l Hillier model
l Simulation analysis
l Decision tree analysis
l Corporate risk analysis
Project selection under risk. Risk analysis in practice.Figure 6.2: Techniques of Risk Analysis
Sensitivity Analysis
Since future is uncertain, you may like to know what happens to the viability of a
project when some variable like sales or investment deviates from its expected value.
In other words, you would like to do sensitivity analysis. Also called ìwhat ifí analysis
it answers questions like:
What happens to net present value (or some other criterion of merit) if sales are only
60,000 units rather than the expected 75,000 units9 What happens to net present value
if the life or the project turns out to be only 8 years, rather than the expected 10 years?Techniques of Risk AnalysisAnalysis of
Contextual RiskAnalysis of Stand
alone RiskSensiivity
AnalysisScenario
AnalysisCorporate
Risk AnalysisMarket Risk
Analysis
Break Even
AnalysisHillier
Model
Simulation
AnalysisDecision Tree
Analysis