Calculation Of Risk And Return, Capital Budgeting And Sensitivity Analysis

Monthly return of OEL

In this question, Origin Energy Limited Company (OEL) is selected for the investment purpose. OEL is traded on an Australia Stock Exchange (AX).

OEL’s historical daily data of last 5 years that is April, 01 2012 to March, 31 2017 was taken from https://au.finance.yahoo.com/.

Now, detailed analysis of return and risk of OEL and market (AX) is calculated below:

Calculation of Daily return, monthly return and yearly return of OEL and market (ASX) from April, 01 2012 to March, 31 2017 (Source: https://au.finance.yahoo.com/, 2017).

Refer MS-Excel sheet for the daily returns of OEL and market from April, 01 2012 to March, 31 2017.
Monthly Returns of OEL and market from April,01 2012 to March, 31 2017 is below:

Months/Years Save Time On Research and Writing Hire a Pro to Write You a 100% Plagiarism-Free Paper. Get My Paper	2012-2013	2013-2014	2014-2015	2015-2016	2016-2017
April	0.35%	-7.29%	4.23%	12.20%	9.01%
May	-2.70%	9.11%	1.36%	4.74%	4.76%
June	-5.27%	-6.74%	-3.00%	-9.99%	1.71 %
July	-2.94%	-4.73%	-1.94%	-5.07%	-4.11%
August	4.53%	12.78%	10.11%	-26.15%	-3.95%
September	-4.87%	6.45%	-3.53%	-28.85%	3.92%
October	0.39%	3.90%	-4.62%	4.65%	-0.96%
November	-2.97%	-4.59%	-14.75%	2.76%	10.93%
December	5.76%	1.03%	-4.28%	-16.60%	11.01%
January	8.10%	-0.50%	-8.47%	-11.55%	7.49%
February	0.66%	5.37%	16.30%	11.78%	-7.48%
March	8.87%	-0.95%	-7.43%	14.76%	7.49%

(Source: https://au.finance.yahoo.com/, 2017).

Monthly return of Market (AX)

Months/Years	2012-2013	2013-2014	2014-2015	2015-2016	2016-2017
April	1.57%	4.50%	1.77%	-1.67%	3.35%
May	-7.43%	-5.18%	0.09%	-0.14%	2.44%
June	0.54%	-2.43%	-1.74%	-5.55%	-2.60%
July	4.25%	5.17%	4.33%	4.43%	6.14%
August	1.13%	1.69%	-0.09%	-8.79%	-2.32%
September	1.66%	1.66%	-6.05%	-3.33%	0.12%
October	2.95%	3.92%	4.39%	4.34%	-2.16%
November	-0.19%	-1.93%	-3.90%	-1.28%	2.40%
December	3.14%	0.66%	1.95%	2.60%	4.10%
January	4.85%	-3.03%	3.29%	-5.52%	-0.75%
February	4.59%	4.10%	5.98%	-2.32%	1.63%
March	-2.65%	-0.14%	-0.56%	4.14%	2.69%

(Source: https://au.finance.yahoo.com/, 2017).

Yearly Returns of OEL and market from April,01 2012 to March, 31 2017 is below:

Years

Yearly return of OEL

Yearly return of Market index

2012-2013

2013-2014

2014-2015

2015-2016

2016-2017

9.920303%

13.833651%

-16.026374%

-47.322779%

39.815152%

14.403861%

9.009812%

9.468034%

-13.106596%

15.053574%

Below is the calculation of yearly Total Risk (σ) of OEL and market index (AX):

Years

σ of OEL

σ of Market index

Below is the calculation of yearly Systematic Risk of OEL:

Years

Systematic Risk of OEL

2012-2013

2013-2014

2014-2015

2015-2016

2016-2017

0.000079%

0.000000%

0.000001%

0.000220%

0.000257%

Below is the calculation of yearly Un-Systematic Risk of OEL:

Years

Un-Systematic Risk of OEL

Before answering OEL is good or not for investment decisions, following terms required to be understood:

As everyone knows that both risk and return is the characteristics of the investment.

Return:Returns of the company form the basis for the investment decisions to the investor. If the returns are highly fluctuating, then it is called as high risk investments. Thus, considering the returns of the OEL for 2015-2016 and 2016-2017, shows drastically growth from -47.32% to 39.81%. Hence, on the basis of returns this is considered as good investments (Banz, 1981).
Risk (σ):Risk is correlated with the returns of the company. It is calculated to find out the deviations in the returns which are the best measure of analysing risks. It is a sum of Systematic risk and Unsystematic risk (Kaplan and Garrick, 1981).
Systematic Risks: It is based on external factors and this risk is not controlled by the company because it is related with the market. Investor needs to consider this risk for its investment decisions.

It is calculated by using stock returns and the market index returns. In this case, considering the past trends of OEL, it is seen that Systematic risk showing the slightly upward trend which indicates that OEL is a good for the investment (Klemkosky and Martin, 1975 ; Lakonishok, and Shapiro,1986).

Un-Systematic Risks: It is based on internal company’s factor and which company has a control over this risk. This risk can be eliminated but it is not important for the investor to consider this risk for investment decisions (Tang and Shum, 2003).

Therefore, on the basis of above understanding it can be said that OEL is a good for the investment.

Criteria: Return of 2016-2017, showing a positive return as compared to 2015-2016 which was negative and also it is observed that systematic risk of 2016-2017 is slightly showing upward trend from 2015-2016. On the basis of these two criteria, an investor should select this stock for investment.

No, investor should not invest all of his money into this stock; instead he should invest in diversified securities so that its return and risk is minimum.

Cost of the building = AUD 24,000
Life of the building = 40 years
Cost of the equipment (incl. installation costs) = AUD 16,000
Life of the equipment = 5 years
Investment in net working capital = AUD 12,000
Project’s Life = 4 years
Annual Sale = AUD 80,000
Variable manufacturing cost is 60% of total sales = 60% of AUD 80,000 = AUD 48,000
Fixed overhead cost (excl. depreciation) = AUD 10,000
Taxation rate = 40%
Depreciation is calculated with Straight line method
Cost of capital (discount rate) = 12%
Building Equipment
- Market Value AUD 15,000 AUD 4,000
- Book Value AUD 21,600 AUD 3,200

a	Initial Investment outlay:
	Particulars	Amount in AUD
	Cost of the building	24,000
	Cost of the Equipment	16,000
	Net Working Capital	12,000
	Initial Investment outlay	52,000
b	Operating cash flows of four years:
	Particulars	Amount in AUD
	Sales	80,000
	Less: Variable Costs	48,000
	Contribution	32,000
	Less: Fixed Costs excluding depreciation	10,000
	Less: Depreciation (W.N.i.)	3800
	Profit before tax (PBT)	18,200
	Less: Tax @ 40%	7280
	Profit after tax (PAT)	10,920
	Add: Depreciation	3800
	Cash flow after tax (CFAT)	14,720
	PVF (12%, 4) (W.N. ii.)	3.037
	Present value of Cash Inflows	44710
c	Terminal Inflows at the end of 4th year:
	Particulars	Amount in AUD
	Net working Capital	12,000
	PVF of 12% of 4th year	0.636
	PV of terminal cash inflows	7626
	Working Notes:
	Calculation of total Depreciation:
	Depreciation of Building and Equipment:
	Depreciation = (Cost – Scrap Value)/ No. of years
	Particulars	Building
	(Amount in AUD)
	Cost	24,000
	Scrap Value	0
	No. of years	40
	Depreciation	600
	Calculation of Present value factor of 12% of 4 years:
	Year	PVF @ 12%
	1	0.893
	2	0.797
	3	0.712
	4	0.636
	Total	3.037

NPV:

Calculation of NPV:
Particulars	Amount in AUD
PV of Cash Inflows	44710
Add: PV of Terminal cash inflows	7626
Total PV of cash inflows	52336
Less: Initial investment outlay	52,000
NPV	336

Since NPV is positive, ABC Ltd. should accept the project of new expansion plant.

3.Sensitivity Analysis: It is used for the measurement of the risk. This is calculated by changing one variable at one time and keeping all the other variables constant (Saltelli, Chan and Scott, 2000).

In this question, sensitivity analysis is measured using 10% level of change in both ways with respect to sales, variable cost and cost of capital.

Sensitivity analysis of sales:

Let us assume Sales be increased by 10% i.e. AUD 80,000 + 10% = AUD 88,000.

Operating cash flows of four years:
Particulars	Amount in AUD
Sales	88,000
Less: Variable Costs	52,800
Contribution	35,200
Less: Fixed Costs excluding depreciation	10,000
Less: Depreciation (W.N. i.)	3800
Profit before tax (PBT)	21,400
Less: Tax @ 40%	8560
Profit after tax (PAT)	12,840
Add: Depreciation	3800
Cash flow after tax (CFAT)	16,640
PVF (12%, 4) (W.N. ii.)	3.037
Present value of Cash Inflows	50541
Terminal Inflows at the end of 4th year:
Particulars	Amount in AUD
Net working Capital	12,000
PVF of 12% of 4th year	0.636
PV of terminal cash inflows	7626
Calculation of NPV:
Particulars	Amount in AUD
PV of Cash Inflows	50541
Add: PV of Terminal cash inflows	7626
Total PV of cash inflows	58168
Less: Initial investment outlay	52,000
NPV	6,168
Thus, NPV is increased by (%) =	1736%

Let us assume Sales be decreased by 10% i.e. AUD 80,000 – 10% = AUD 72,000.

Operating cash flows of four years:
Particulars	Amount in AUD
Sales	72,000
Less: Variable Costs	43,200
Contribution	28,800
Less: Fixed Costs excluding depreciation	10,000
Less: Depreciation (W.N.i.)	3800
Profit before tax (PBT)	15,000
Less: Tax @ 40%	6000
Profit after tax (PAT)	9,000
Add: Depreciation	3800
Cash flow after tax (CFAT)	12,800
PVF (12%, 4) (W.N.ii.)	3.037
Present value of Cash Inflows	38878
Terminal Inflows at the end of 4th year:
Particulars	Amount in AUD
Net working Capital	12,000
PVF of 12% of 4th year	0.636
PV of terminal cash inflows	7626
Calculation of NPV:
Particulars	Amount in AUD
PV of Cash Inflows	38878
Add: PV of Terminal cash inflows	7626
Total PV of cash inflows	46504
Less: Initial investment outlay	52,000
NPV	-5,496
Thus, NPV is decreased by (%) =	1736%

Sensitivity analysis of Variable costs:

Let us assume variable costs be increased by 10% i.e. AUD 48,000 + 10% = AUD 52,800.

Operating cash flows of four years:
Particulars	Amount in AUD
Sales	80,000
Less: Variable Costs	52,800
Contribution	27,200
Less: Fixed Costs excluding depreciation	10,000
Less: Depreciation (W.N.i.)	3800
Profit before tax (PBT)	13,400
Less: Tax @ 40%	5360
Profit after tax (PAT)	8,040
Add: Depreciation	3800
Cash flow after tax (CFAT)	11,840
PVF (12%, 4) (W.N.ii.)	3.037
Present value of Cash Inflows	35962
Terminal Inflows at the end of 4th year:
Particulars	Amount in AUD
Net working Capital	12,000
PVF of 12% of 4th year	0.636
PV of terminal cash inflows	7626
Calculation of NPV:
Particulars	Amount in AUD
PV of Cash Inflows	35962
Add: PV of Terminal cash inflows	7626
Total PV of cash inflows	43588
Less: Initial investment outlay	52,000
NPV	-8,412
Thus, NPV is decreased by (%) =	2603%

Let us assume variable costs be decreased by 10% i.e. AUD 48,000 – 10% = AUD 43,200.

Now the revised NPV is calculated as follows:

Operating cash flows of four years:
Particulars	Amount in AUD
Sales	80,000
Less: Variable Costs	43,200
Contribution	36,800
Less: Fixed Costs excluding depreciation	10,000
Less: Depreciation (W.N.i.)	3800
Profit before tax (PBT)	23,000
Less: Tax @ 40%	9200
Profit after tax (PAT)	13,800
Add: Depreciation	3800
Cash flow after tax (CFAT)	17,600
PVF (12%, 4) (W.N.ii.)	3.037
Present value of Cash Inflows	53457
Terminal Inflows at the end of 4th year:
Particulars	Amount in AUD
Net working Capital	12,000
PVF of 12% of 4th year	0.636
PV of terminal cash inflows	7626
Calculation of NPV:
Particulars	Amount in AUD
PV of Cash Inflows	53457
Add: PV of Terminal cash inflows	7626
Total PV of cash inflows	61084
Less: Initial investment outlay	52,000
NPV	9,084
Thus, NPV is increased by (%) =	2603%

Sensitivity analysis of Cost of capital:

Let us assume cost of capital be increased by 10% i.e. 12% + 10% = 13.2%

Operating cash flows of four years:
Particulars	Amount in AUD
Sales	80,000
Less: Variable Costs	48,000
Contribution	32,000
Less: Fixed Costs excluding depreciation	10,000
Less: Depreciation (W.N.i.)	3800
Profit before tax (PBT)	18,200
Less: Tax @ 40%	7280
Profit after tax (PAT)	10,920
Add: Depreciation	3800
Cash flow after tax (CFAT)	14,720
PVF (13.2%, 4) (W.N.iii.)	2.962
Present value of Cash Inflows	43603
Terminal Inflows at the end of 4th year:
Particulars	Amount in AUD
Net working Capital	12,000
PVF of 13.2% of 4th year	0.609
PV of terminal cash inflows	7308
Calculation of NPV:
Particulars	Amount in AUD
PV of Cash Inflows	43603
Add: PV of Terminal cash inflows	7308
Total PV of cash inflows	50911
Less: Initial investment outlay	52,000
NPV	-1,089
Thus, NPV is decreased by (%) =	424%

Let us assume cost of capital be decreased by 10% i.e. 12% – 10% = 10.8%

Now the revised NPV is calculated as follows:

Operating cash flows of four years:
Particulars	Amount in AUD
Sales	80,000
Less: Variable Costs	48,000
Contribution	32,000
Less: Fixed Costs excluding depreciation	10,000
Less: Depreciation (W.N.i.)	3800
Profit before tax (PBT)	18,200
Less: Tax @ 40%	7280
Profit after tax (PAT)	10,920
Add: Depreciation	3800
Cash flow after tax (CFAT)	14,720
PVF (10.8%, 4) (W.N.iv.)	3.116
Present value of Cash Inflows	45864
Terminal Inflows at the end of 4th year:
Particulars	Amount in AUD
Net working Capital	12,000
PVF of 10.8% of 4th year	0.664
PV of terminal cash inflows	7962
Calculation of NPV:
Particulars	Amount in AUD
PV of Cash Inflows	45864
Add: PV of Terminal cash inflows	7962
Total PV of cash inflows	53826
Less: Initial investment outlay	52,000
NPV	1,826

Thus, NPV is increased by (%) =	443%

Calculation of Present value factor of 13.2% of 4 years:

Year	PVF @ 13.2%
1	0.883
2	0.780
3	0.689
4	0.609
Total	2.962

Calculation of Present value factor of 10.8% of 4 years:

Year	PVF @ 10.8%
1	0.903
2	0.815
3	0.735
4	0.664
Total	3.116

Scenario Analysis: It is the extension of the sensitivity analysis because it considers changing of 2 variables at one time so that combined effect is obtained. It moves from Best case to the worst case of the outcome (The Economic times, 2017). It has 4 components:

In 1^stcomponent, factor is determined which ranges from market to competitor’s response.
2^ndcomponent determines number of outcomes for each factor which can be best, average and worst.
3^rdcomponent focuses on critical factors for each outcome.
Last in 4^thcomponent, probabilities are assigned to each factor.

References

Banz, R.W.,1981, The relationship between return and market value of the common stocks, Journal of financial economics, Vol.9, no.1, pp.3-18.

Kaplan, S. and Garrick, B.J., 1981, On the quantitative definition of risk, Risk analysis. Vol.1, no.1, pp. 11-27.

Klemkosky, R.C. and Martin, J.D.,1975, The adjustment of beta forecasts, the journal of finance, vol.30, no.4, pp.1123-1128.

Lakonishok, J. and Shapiro, A.C., 1986, Systematic risk, total risk and size as determinants of stock market returns, Journal of banking & finance, vol.10, no.1, pp,105-132.

Origin Energy Limited (ORG. AX), 2017, Historical Data, viewed on 3 April 2017, from <https://au.finance.yahoo.com/quote/ORG.AX/history?period1=1333218600&period2=1490898600&interval=1d&filter=history&frequency=1d>.

S&P/ASX 200(^AXJO), 2017, Historical Data, viewed on 3 April 2017, from <https://au.finance.yahoo.com/quote/%5EAXJO/history?period1=1333218600&period2=1490898600&interval=1d&filter=history&frequency=1d>.

Saltelli, A., Chan, K. and Scott, E.M., 2000, Sensitivity analysis, New York: Wiley.

Shapiro, A.C., 2005, Capital budgeting and investment analysis,Prentice hall.

Tang, G.Y. and Shum, W.C., 2003, The relationships between unsystematic risk, skewness and stock returns during up and down markets, international business review, vol.12, no.5, pp. 523-541.

The Economic times, 2017, definition of ‘scenario analysis’.

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