The risk of the project varies according to the nature of the investment of the project. The variety of techniques suggested to handle risk in capital budgeting falls into two broad categories,
(i) Stand-Alone risk of the project
(ii) Risk of the project in the context of the market.
RISK ANALYSIS TECHNIQUES OF CAPITAL BUDGETING
The risk of the project is analyzed using various techniques to take the suitable decision, some of the techniques are as follows,
- Sensitivity Analysis
- Scenario Analysis
- Break-Even Analysis
- Simulation Analysis
- Decision Tree Analysis
- Hiller Model
# Sensitivity Analysis
It is a technique that measures the change in the profitability of a project caused by the changes in the factors that affect the cash inflows of the project. It is also called as ‘What-If Analysis’. If a small change in one factor leads to a major change in the profitability of the proposed investment, the project is considered to be more sensitive to the factor. A project that is less sensitive is preferable to projects that are more sensible.
# Scenario Analysis
The scenario analysis is a method applied to determine the feasibility of the project in terms of the change in the underlying variables simultaneously. In scenario analysis, not only the sensitivity of the NPV is evaluated in terms of the change in the underlying variables but also the probabilities are assigned to each variable on the basis of risk inherent in the project.
# Break-Even Analysis
Break Even point is the point where there is no profit and no loss. Here the time value of money is considered. This method is used to identify the sales at NPV=0. The finding out of the B.E.P using fixed costs, depreciation is called as Break-Even Analysis.
# Simulation Analysis
Sensitivity Analysis indicates the sensitivity of one variable for the other variable. Such information through useful amongst the adequate decision making, the decision maker would also like to know the likelihood of such occurrences. This information can be generated by simulation analysis which may be used for developing the profitability profile criterion by randomly combining the values and variables which have a bearing on chosen criteria.
# Decision Tree Analysis
In modern business, there are complex business decisions which involve a sequence of decision over time, such sequential decisions can be handled by plotting decision tree. A decision tree is a graphical representation of the relationship between a present decision and future events, future decisions and their consequences. This sequence of events is mapped out over time in a format resembling branches of a tree and hence the analysis is known as decision- tree analysis.
# Hiller Model
According to Hiller Model, the risk associated with the project can be assessed through the standard deviation of expected cash flows. In other words, determining the variability of the project through calculating the deviations in the cash flows from the mean of the expected cash flows. Thus, the Hiller Model asserts that the computation of standard deviation of several ranges of cash flows enables a firm to determine the uncertainty involved in the future projects.