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Risk Analysis

Risk Analysis is one of the most complexand slippery aspect of capital Budgeting.

Techniques suggested to handle risk incapital budgeting fall into two broadcategories:

• Techniques that consider the stand alonerisk of a project

• Techniques that consider the risk of aproject in the context of firm and in thecontext of market.

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Sources of Risk

There are Several Sources of risk in aproject. The important ones are:

• Project Specific risk

• Competitive risk

• Industry specific risk

•

Market risk • International risk

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Sensitivity Risk

Since the future is uncertain you may like toknow that what will happen to the viability of the project when some variables like

sales or investment deviates from itsexpected value.

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Example of Sensitivity analysis

Project A Project BInvestment 50,000 50,000

Cash inflow for 5 years

• Optimistic 30,000 40,000

• Expected/ Most Likely 20,000 20,000

• Pessimistic 15,000 5,000

The cut-off/ Discount Rate is 15%

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Strategies for responding to Risk

Avoid Risk

Transfer Risk

Mitigate Risk Accept Risk

Research Risk

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Technical Analysis

For manufacturing a product/ services oftentwo or more alternatives technologies areavailable.

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Choice of Technology

The choice of technology is influenced by a variety of factors:

• Plant Capacity

• Principal inputs

• Investment outlay

• Product Mix

• Latest development

• Ease of Absorption

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Appropriateness of Technology

Appropriateness refers to technology suitable to local economic, social andcultural conditions. The technology

should:

• Utilizes local Raw material

• Utilizes local man power

• Product according to Mkt.

• Maintain ecological balance

•

Suitable to social and cultural conditions.

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Material input and utilities

Another important aspect of technicalanalysis is concerned with defining thematerial and utilities required, qualities of

material, supply etc.

(1) Material can classified into four broadparts:

• Agricultural Products

• Mineral Products

• Live stocks and forest Product

•

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(2). Processed Industrial material andcomponents.

(3). Factory supplies

(4). Utilities

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Product Mix

The choice of product mix is guided by mktdemand/requirements: i.e ready madegarments of different sizes, Soaps etc.

Market Pattern

Pattern of Mkt segmentation

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Plant Capacity

Plant capacity refers to production capacity,mean the volume or number of units thatcan be manufactured during a given

periods.

Following factors have to be considered todecide plant capacity:

• Technological requirement

• Input constraints

• Investment cost

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• Resources of the firms

• Market conditions

• Govt. Policies

Schedule of Project implementation As a part of the technical analysis, a project

implementation schedule is also usually

prepared. For this we need followinginformation:……………..

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Need for considering Alternatives

Nature of Project

Production Process

Product Quality Location

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Location and site

The location and site depends upon thedemand, input, size of the plant and many more factors. The terms are used in

similar way but they are different to eachother.

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The decision of Location and site is basedupon following factors:

• Proximity of raw material and Market

• Availability of Infrastructure

• Labour situation

• Govt. Policies

•

Other factors ( Climate conditions,General living conditions)

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Project Charts and Layout

Once the data is available on the principaldimensions of project, Project Chart andlayout may be prepared.

The Important Charts and layouts are:

•

General Functional layout• Material flow diagram

• Transport layout

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• Utility consumption layout

•

Communication layout• Organizational layout

• Plant layout (Concerned with the physical

layout of the factory)

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Capital Budgeting/ Investment Criteria

It is the process of making investmentdecision in capital expenditures. CapitalInvestment decisions are known as long

term investment decision. Foe example:• Cost of acquisition of permanent assets

• Cost of additional expansion, improvement

• Cost of replacement of permanent assets

• R&D project cost , Etc.

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Need and Importance of CB

Large Investment

Long term commitment of funds

Irreversible natureLong term effect on profitability

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Capital Budgeting Process

Identification of Investment proposals

Screening the Proposal

Evaluation of various proposalsFixing priorities

Final approval

Implementing ProposalPerformance review

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Kinds of Capital Budgeting Decisions

Accept Reject decisions

Mutually Exclusive Project Decisions

Capital Rationing Decisions

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Evaluation of Investment Decisions

Traditional Methods:

Pay Back Period Method

Post pay back Profitability MethodPost Pay back Period Method

Discounted Pay Back Method

Avg Rate of return method

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Time adjusted or discounted Methods

• Net Present Value Method

•

Internal Rate of Return Method• Profitability Index Method

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Network Technique

Project is a word with which we are familiar. Itrefers to a group of activities and events havingsystematic relationship.

A network is a graphic or diagrammaticrepresentation of various activities and events of a project.

With the help of network we can come to know how the different activities and events are interrelated and how much resources needed by each

activity.

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Techniques of Network

Network analysis is an operation researchtechnique which uses two methodologiesnamely:

PERT: Programme Evaluation and Review Technique.

CPM: Critical Path Method

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Fundamentals of Network Analysis

Activity: A project consists of many activities, which

have systematic relationship with eachothers.

Activity is representation by an arrow.

Length of arrow is of no significance and isnot related with time of activity.

Activity flow from left to right. ( May be

upward or downward)

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Predecessor Activity

Successor Activity

Concurrent Activity

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Event:

Event denotes a point of time when anactivity begins or ends. It is shown by O. An Activity is represented by two Events.

Events are numbered by 1,2,3…..

1. Merger Event

2. Burst Event

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Interdependency:

An activity is called independent if it is notdependents on any earlier activity otherwise it is called dependent activity.

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Drawing a Network

It is the first step in network analysis.

Mr. X has a project of writing a book. Various activitiesinvolved are:

Activity Name Time(Weeks)

Extensive Reading A 3

After A Write manuscript B 4

After B Type the manuscript C 5 After C Book is printed D 6

After D Book is binded E 3

Project Completion time is the Total duration of activities

21 Weeks

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Rules for drawing a Network

• One activity will have only one arrow.

• One activity will be shown by two events only.

• Number of preceding event is always less than

the succeeding event.• Two events cant have same number.

• Length of arrow does not show its duration.

• Normally crossing of arrow is not allowed.• Every event must have at least one activity

preceding and succeeding it, except the startingand ending event.

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Errors in Network

Dangling: When an activity except thefirst and last does not have a succeedingevent.

Looping: While drawing a network aproject may create the cycling situation which is known as looping. Its seemsproject is not going to end.

Parallel activity: Between two events

without any interception events are notallowed in network diagram. (Dummy)

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Draw a network based on following events.

Activities Time(weeks)1-2 5

1-3 3

2-4 4

3-5 6

3-6 2

4-7 4

5-7 6

6-8 47-9 3

8-9 4

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Draw a network based on following activities.

Activity Immediate Predecessor

A -B A

C A

D B,CE C

F D

G EH F,G

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CRITICAL PATH METHOD

It was developed in 1956 for planning andscheduling the construction work. Twotimes and costs estimates are used in CPM which are normal time and normal cost,

Crash time and crash cost.

The path with longest duration of time,

starting from 1st event till last event withzero slack or float is known as critical path.

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Cont…… • CP is denoted by thick line or double arrow.

• There can be more than one critical path on anetwork.

• There can be sub-critical path with nextminimum float. Sub critical path become

critical path by crashing of activities.

• Crashing means reducing the duration of anactivities with more resources allocations.

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IMPORTANT CALCULATIONS IN NETWORK:

• Event Time: Event time is a point of time when an activity starts or ends. There aretwo types Event Times:

Latest Expected Event Time(TL)

Earliest Expected Event Time(TE)

•

Slack: It is also known as float. It showsthe free time associated with an event.

Slack of an Event=TL-TE

C l l h C i i l P h

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Calculate the Critical PathEvents Activities Duration

1-2 A 102-3 E 5

2-5 B 9

3-4 F 17

4-7 G 8

5-6 C 3

6-7 D 15

7-8 H 7

4-5 Dummy 0

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Difference between PERT and CPMPERT

Activity is shown by anarrow and Event is shown by node.

Multiple time estimates

are used.It is used for non routine jobs.

Cost is assigned to every

activity.PERT is suitable for new projects.

Pert is probabilistic.

CPM

Activity and event bothare shown by node.

Single known time is

used.It is used for routine andrepetitive jobs.

Cost is assumed to have

been related with time only.CPM is used for projecthaving past information.

CPM is deterministic.

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Time Estimates in PERTPERT uses three time estimates for a single

activity. These are:• Most optimistic time: it is least possible

time taken by an activity if everything goes

perfect in project work. (To)• Most pessimistic time: it is the maximum

possible time taken by an activity

considering the worst possibility. (T p)• Most likely time: it is the best estimate of

what would normally occur. (Tm)

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Expected project completion time/ Expectedduration of activities is calculated by

following formula:

Te= To+Tp+4Tm

6

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Activity times calculations and floats

• Earliest start times (Est)

• Earliest finish times (Eft)

• Latest start times (Lst)

• Latest finish times (Lft)

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Floats and their calculations

Total floats: It is the time by which thefinishing time of an activity can be delayed without affecting the total project.

TF= Est-Lst or Eft-Lft

.

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Free Floats: It is the time by which the anactivity can be delayed without affectingthe times of succeeding the next activities

FF=Est of the succeeding activity-Eft of the activity for which we calculating the

Free float.

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Crashing

Two concepts are associated with all typesof project. These are time and cost.

Suppose we want to complete the project before desired dates it will increase thecost.

What is Crashing:……………….

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Normal time: it is the time taken by project on an activities under normal

circumstances. Cost associated with it is asminimum cost.

Crash time: it is the minimum time taken

by project on an activities. Cost associated with it is as maximum cost.

Crash Cost: Cost associated with an

activities at crash time.Normal Time: Cost associated with anactivities at normal time

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Cost slope: it is known as crashing cost perunit of time

Cost slope= (Crash cost-Normal cost)

(Normal time- Crash time)

Critically activities to be crashed first chosen with its help

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Resources Allocation

Availability of resources e.g. manpower,machines etc. Limited with the projects.There are two methods of allocation of

resources:• Level of resources, with an assumption of

unlimited resources

• With limited resources, try to reduce theproject completion time.

S i l P fit bilit A l i

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Social Profitability Analysis

(Economic Analysis)Economic cost and benefit of project

Impact of project on distribution of income in society

Impact of project on the level of savingsand investment in the society

Contribution towards self-sufficiency,employment and social order

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