Corporate Finance

Risk Analysis in Capital Investments 
 233

Thus, the discount rate for an Indian company that pays 3 percent over treasuries, when at home, for a
project in UK:

= Rate at which the Indian government borrows from UK + 3 percent premium.

IN CONCLUSION

The riskiness of a project can be captured either by adjusting the cash flow or the discount rate. The dis-
count rate should be adjusted if the risk is systematic in nature. The pure play technique might be employed to
estimate the project discount rate. In any case, the corporate cost of capital should not be applied indis-
criminately to all projects. There are three principal methods for risk analysis. They are: sensitivity analysis,
simulation and best case–worst case analysis. An analyst has the freedom to choose from these methods.

Exhibit 11.7 Modified decision trees

Rs 1 lac p.a., 10 years, Probability = 0.3

Rs 10 lac per year, 10 years, Probability = 0.6

Rs 10 lac for 2 years, Rs 1 lac for 8 years

Probability = 0.1

Build big plant
I = Rs 0 lac

Build small plant
I = Rs 13 lac

Rs 50000 p.a., 8 years

Probabilty = 0.14

Rs 4 lac p.a., 8 years

P = 0.14

Rs 4.5 lac p.a.

P = 0.7

EXPAND

I = Rs 22 lac

NO

CHANGE

Rs 7 lac p.a., 8 years

Probability = 0.86

Rs 3 lac p.a., 8 years

P = 0.86

Rs 4 lac p.a., 10 years, P = 0.3