210 Corporate Finance
chance of running over schedule, costing you Rs 100 out of your own pocket, that might be a risk you are
willing to take. But if you have a 5 percent chance of running over schedule, knowing that there is a penalty
of Rs 10,000, you might be less willing to take that risk.
Firms worry about the absolute level of cash flow because it affects their ability to service debt, invest
and grow. To measure risk a firm has to forecast the distribution of cash flows. A firm can set a threshold
below which it will experience financial distress, and use the cumulative distribution of cash flows to find
out the probability of a cash flow below this level. The cash flow shortfall corresponding to the probability
level, chosen by the firm, is called cash flow at risk at that probability level.^1 A cash flow at risk of Rs 200
crore at 5 percent means that there is a probability of 5 percent that the firm’s cash flow will be lower than
its expected cash flow by at least Rs 200 crore. If there is a probability that the level of cash flow will be less
than the threshold, the company should take actions to reduce the risk of cash flow and ensure that it earns
the cash flow corresponding to the threshold level 95 percent of the time.
There are two approaches to incorporating risk in capital budgeting. The first approach is to estimate the
changes in decision criteria like NPV and IRR to changes in underlying business drivers like sales growth,
market-share, etc. The second approach is to adjust the cash flows or discount rate for riskiness of the pro-
ject. Before we go on to measurement of risk a brief description of risks is in order. There are essentially two
types of risk—diversifiable and non-diversifiable. Risks can also be classified as business and financial.
Some of the risks that affect a project are: completion risk, raw material supply risk, technological risk,
economic risk, financial risk, currency risk and political risk. Executives commonly make ad hoc adjustments
to cash flows and discount rates to account for the unique risks in the project. Modern finance theory
hypothesizes that only systematic risk is rewarded in stock markets and project specific risk is not relevant
as investors can diversify their portfolio. In a CAPM universe, only systematic factors like changes in inflation,
interest rates, etc. are relevant. But this does not mean that managers should not manage unsystematic or
project specific risk because systematic risk is a function of total risk.^2 In the following sections, some
methods of assessing risk are described.
BEST CASE–WORST CASE ANALYSIS
A popular way of assessing risk is to assume conservative, most likely and optimistic values for key drivers
of NPV like sales growth rate, operating profit margin and incremental investment in fixed assets and working
capital during the project life, and compute NPV. The range of NPV represents the riskiness of the project.
The most likely, pessimistic and optimistic values of key variables for a hypothetical project are shown
here: Cash flows are estimated for pessimistic, most likely and optimistic scenarios. The NPV is computed
for the three scenarios, say, (50,000), 100,000, and 400,000. The limitation of the ‘best case–worst case’
analysis is that what constitutes the worst case remains subjective. In real life situations, worst case estimates
tend to be optimistic because of executives’ faith in the business and strategy. So the usefulness of the tool is
limited.
(^1) This concept is similar to Value at Risk for financial firms. A good book on the subject is: Philipe Jorion (1997). Value at
Risk: The New Benchmark for Controlling Derivatives Risk, McGraw-Hill, New York.
(^2) Remember the formula for beta?