Risk And Return Analysis, Capital Budgeting Analysis

Risk and Return Analysis

An investor undertakes risk in order to get returns from an investment. The return is the form of dividends from the stock and also the stock price appreciation. Risk is the variation in the price of the stock over a period of time. Higher the risk, higher is the return of the stock. An investor normally undertakes the risk return analysis of the stock before investing in a stock in order to know if the returns are higher than the risk. The analysis is done with respect to the market. if a stock has returns higher and risk lower than the market, it is advisable to invest in the stock. In the report, we have undertaken the risk analysis of APA Group Stapled for a period of five years.

Capital budgeting is a process of determining whether the long term investment undertaken by the company is feasible or not in terms of its profitability. There are various techniques which are used to arrive at such decisions. NPV and IRR are the two most effective and popular methods. A capital budgeting analysis has been carried out for ABC Ltd. which plans to set up a new expansion plant. The decision has been given on the basis of NPV, sensitivity analysis and scenario analysis.

Risk and Return Analysis

1) The daily returns, monthly returns and the yearly returns of APA Group Stapled from the period 1-1-2012 to 31-12-2016 are given in the annexure.

2) The yearly standard deviation for the daily returns of 5 years for the company is presented below:

Year	Yearly standard deviation
2012	0.0135
2013	0.2424
2014	0.6100
2015	0.0161
2016	0.0123

(Finance. yahoo, 2017)

From the yearly standard deviation, the total risk can be calculated using the formula:

Total Risk = average of standard deviation of yearly standard deviation

= 17.89%

3) The systematic risk using the daily returns of the stock and the market has been calculated in excel using the excel function:

Beta = Covariance (Stock daily returns, market daily returns)  / variance of market returns

          = 0.7   

The calculations are included in the annexure attached (Finance. Yahoo, 2017)

4) The unsystematic risk or the firm specific risk is the same as total risk calculated above. It is the standard deviation of the daily returns of the stock.

Unsystematic risk = 58.25%

While selecting a stock for investment, the investor should look at the beta of the company. Beta is the volatility of the stock in comparison to the market. It is the change in the stocks returns as a result of a change in the market return. A beta of 1 means the change in stock return is equal to the change in market return. A beta of more than 1 means the increase in return stock return is higher than the increase in market return and a beta of less than 1 means increase in stock return is lower than the market return. If an investor has invested in a stock with beta more than 1, it is assumed to be a risky stock and if the investor is not getting the required return than he should sell it off.

Capital Budgeting Analysis

Here the APA Group Stapled stock has a beta of 0.7 which is less than 1. This means the stock is more or less stable as compared to the market. If there is an increase in market returns by 10%, the return of the company’s stock will increase by only 7%. Whereas if there is a fall in the market return by 10%, the returns from the company’s stock will fall only by 7%, thus minimizing risk. So it can be considered to be a safe stock with low market volatility. Though the increase in stock return would be less than thr market return but when the market return will decrease, the stocks return will decrease by a lower margin, thus making it less risky. Such stocks are suitable to risk averse investor who is interested in undertaking lower risk and can settle for lower returns as well. Also such investors are interested in regular returns in the form of dividends.  Moreover, for selecting a stock an investor also sees if the stock is overpriced or underpriced.

An investor will not invest all the money in this stock because the returns would be low for this stock as compared to the market. Hence in order to increase his overall returns, an investor would invest in a more risky stock which would be a growth stock. A risky stock will have a beta of more than 1 and will give higher market returns when the market is rising. And in times of falling market returns, the stocks of APA group will help balance the fall in returns as the returns will not fall as much as the market and thus a balance would be maintained. Therefore, in order to minimize risks and maximize returns, one should have a diversified portfolio of stocks where all types of stocks like with beta less than 1 and more than 1 are present. Also other than stocks, investments can be made in bonds (Damodaran, NA)

Capital Budgeting Analysis

The capital budgeting analysis of the new expansion plant by ABC Ltd. is discussed below:

1) Initial Investment outlay

Building	$24,000
Equipment	$16,000
Working capital	$12,000
Initial investment	$52,000

Operating Cash Flows for the projects life

Year	1	2	3	4
Sales	$80,000	$80,000	$80,000	$80,000
Variable manufacturing costs	$48,000	$48,000	$48,000	$48,000
Fixed overhead costs	$10,000	$10,000	$10,000	$10,000
Depreciation on building	$600	$600	$600	$600
Depreciation on equipment	$3,200	$3,200	$3,200	$3,200
Total operating income	$18,200	$18,200	$18,200	$18,200
Tax @40%	$7,280	$7,280	$7,280	$7,280
After tax income	$10,920	$10,920	$10,920	$10,920
Operating cash flows	$14,720	$14,720	$14,720	$14,720

Terminal Cash flows

Terminal cash flows would comprise of after tax salvage value of building and equipment and the return of working capital.

After tax salvage value (building)

Cost of building	$24,000
Useful life	40 years
Depreciation	$600
Book value end of 4 years	$21,600
Market value	$15,000
loss on sale	$6,600
Tax gain on sale	$2,640
After tax salvage value	$17,640

After tax salvage value (Equipment)

Cost of Equipment	16000
Useful life	5 years
Depreciation	$3,200
Book value end of 4 years	$3,200
Market value	$4,000
Gain on sale	$800
Tax gain on sale	$320
After tax salvage value	$3,680

Terminal value

Return of working capital	$12,000
After tax salvage value (building)	$17,640
After tax salvage value (equipment)	$3,680
Terminal value	$33,320

2) NPV of the project

Year	0	1	2	3	4
Sales		$80,000	$80,000	$80,000	$80,000
Variable manufacturing costs		$48,000	$48,000	$48,000	$48,000
Fixed overhead costs		$10,000	$10,000	$10,000	$10,000
Depreciation on building		$600	$600	$600	$600
Depreciation on equipment		$3,200	$3,200	$3,200	$3,200
Total operating income		$18,200	$18,200	$18,200	$18,200
Tax @40%		$7,280	$7,280	$7,280	$7,280
After tax income		$10,920	$10,920	$10,920	$10,920
Operating cash flows		$14,720	$14,720	$14,720	$14,720
Terminal value					$33,320
Initial investment	-$52,000
Net Cash flows	-$52,000	$14,720	$14,720	$14,720	$48,040
Discount [email protected]%	$1	$0.893	$0.797	$0.712	$0.636
Present value of cash flows	-$52,000	$13,143	$11,735	$10,477	$30,530

NPV = $13885.2

NPV is the most preferred capital budgeting technique and projects acceptability depends mostly on NPV. Other techniques in capital budgeting include IRR, payback period and ARR. Other techniques also are helpful in deciding the acceptability of the project depending on the nature of the project.

Yes, the project should be accepted as the NPV is positive. Under capital budgeting, if the NPV of a project is positive it means the cash inflows are more than the cash outflows and there is profit from the project, hence it is recommended to accept the project.

3) A sensitivity analysis was performed by using different levels of change of the three key inputs, sales, variable costs and cost of capital. Both increase and decrease in the above inputs was taken into consideration individually and the impact of the same was seen on NPV. The table below represents the change in the NPV values with a change in the above inputs:

	2%	5%	10%
Original NPV
Increase in sales	$15,052	$16801.10	$19716.95
% Change in NPV	8.4%	21.0%	42.0%
Decrease in sales	$12718.90	$10969.389	$8053.5340
% Change in NPV	-8.4%	-21.0%	-42.0%
Increase in variable costs	$12135.73	$9511.46	$5137.67
% Change in NPV	-12.6%	-31.5%	-63.0%
Decrease in variable costs	$15634.75	$18259.027	$22632.81
% Change in NPV	12.6%	31.5%	63.0%
Increase in cost of capital	$10617.95	$6161.63	$-252.99
% Change in NPV	-23.5%	-55.6%	-101.8%
Decrease in cost of capital	$17418.42	$23279.41	$34832.29
% Change in NPV	25.4%	67.7%	150.9%

From the above table, we see that NPV is most sensitive to the cost of capital, followed by variable costs and lastly sales. Even by a 2% increase in cost of capital, the NPV becomes negative and the project becomes unacceptable. With a decrease in cost of capital by 10%, the NPV increases by 151%. So we can say NPV is highly sensitive to the cost of capital. If the assumption of cost of capital goes wrong, the whole project may go in for a toss. Hence the company should focus on determining the most accurate cost of capital if the project is to be successful.

4) Cost of the capital is the most sensitive factor.

5) Scenario Analysis

For the scenario analysis, the best case has been taken as increase in sales by 10%, decrease in variable costs by 10% and decrease in cost of capital by 10% and vice versa for the worst case. The results are presented below:

	Total Sales	Variables Costs	Cost of capital	NPV
Normal case	320000	60%	12%	$13,885.2
Best case	352000	54%	2%	$54,206
Worst case	288000	66%	22%	-$11,504

We see that the worst case proves the project unacceptable.

Conclusion

On the basis of the risk and return analysis of APA Group Stapled, it is advisable for an investor to invest in the company as the company has risk lower than the market and the average returns are higher than the market. It is a good investment for a risk averse investor. But it is advisable that the investor should also look at other stocks which are growth stocks in order to diversify his portfolio. The stock of APA Group Stapled are low risk stocks as the beta is less than 1, hence it is advisable that the investor should also invest in stocks with higher beta in order to maximize his returns.

The NPV analysis makes the project acceptable as the NPV is positive. This means the inflows are more than the project outflows. Moreover the sensitivity and scenario analysis also give positive results to a far extent and only make the project unacceptable when the cost of capital increases by 10% as cost of capital is the most sensitive to the project.

Reference

Finance. Yahoo, (2017), APA Group (APA.AX), accessed online on 29^th March, 2017, available at https://nz.finance.yahoo.com/quote/APA.AX/history?ltr=1

Finance. Yahoo, (2017), S&P/ASX 200 (^ AXJO), accessed online on 29^th March, 2017, available at https://in.finance.yahoo.com/quote/%5EAXJO?ltr=1

Damodaran, A., (NA), Estimating Risk Parameters, Stern School of Business, New York.