CAPITAL

BUDGETING
 PROJECT
APPRAISAL
TECHNIQUES
 RATIONALE BEHIND
CAPITAL EXPENDITURE
Benefits expected over a longer period.
Far reaching effects on the success or failure
Assets once acquired can not be disposed off except at a
substantial loss.
If capital assets are purchased on long term credit basis, a
continuing liability is incurred over a longer period.
If earnings are not increased commensurate with the
purchase of the additional capital assets, the ability of the
enterprise to discharge its financial obligations may be
affected adversely.
 RATIONALE BEHIND
CAPITAL EXPENDITURE
Expansion of capital facilities by means of the issue
of shares may dilute holding in the company and if
not carefully planned and controlled, it can result in
the loss of control by the management.
It influences long-term prospects and future earning
capacity of the firm.
In this context the forecasting and budgeting of
capital expenditure becomes a vital part of policy
making and management function.
 CONCEPT OF CAPITAL
BUDGETING
Long term planning of expenditure whose returns stretch
themselves over a future period
A process of deciding whether or not to commit resources to
a project, whose benefits would be spread over several
time periods.
It considers proposed capital outlay and its financing.
The exercise involved in capital budgeting is to co-relate the
benefits to costs in some reasonable manner which would
be consistent with the profit maximising objectives of the
business.
 CONCEPT OF CAPITAL
BUDGETING
It is a managerial decision, since it involves more extended
estimation and prediction of things to come requiring high
order of intellectual ability.
The economic justification for a capital expenditure
programme requires a long term estimates of profits, which
in turn involves projection of sales and cost of operation
over a period of years
It includes searching for new and more profitable
investment proposals, investigation, engineering and
marketing considerations to predict the consequences of
accepting the investment and making economic analysis to
determine the profit potential of each investment proposal.
A Screening process.
 ASPECTS OF CAPITAL
BUDGETING
It ranks various proposals by measuring their
profitability ( before considering cost of capital ) in
descending order.

The company has to decide minimum desired rate of

return or cut-off rate ( average cost of capital + return
for risk ) to decide about the acceptance or rejection.

Volume of investment to be made.

 TYPE OF INVESTMENT
PROPOSALS
Cost reduction proposals
– by replacement of machinery and equipment
– plant re-arrangement programmes
– mechanisation of process
– Provision of facilities to manufacture
components currently purchased

Income maintaining proposals

– Replacement of worn out equipment
 TYPE OF INVESTMENT
PROPOSALS
Income Increasing proposals
– Additions and extensions to plant and machinery for having
additional volume of existing production
– Installation of new plant and machinery for taking up a new
product or product lines
Research and Development proposal
Summary of Proposals
– Replacement proposal
– Expansion proposal
– New product Line or Diversification proposal
– Strategic Investment proposal
– Contractual Investment proposal
SELECTION OF PROJECTS
Emphasize the importance on 3 aspects
– Estimating the amount of investment
– Timing estimates
– Estimating the income from the project

One of the most vital aspects of the capital budgeting process is

the accuracy of these three major estimates involved. In fact
these aspects receive less attention in the evaluation tests.
 FACTORS AFFECTING
CAPITAL INVESTMENT
DECISIONS
1. Amount of investment

2. Operating cash inflows

3. Choice of horizons
 1. AMOUNT OF
INVESTMENTS
Covers amount of funds committed to project -
– Cost of purchase of land, building, plant etc.
– Increase in level of working capital
– Salvages value from old assets (in case of replacement) or
write off of assets not fully depreciated.
– Cost of installation and other incidental costs
– Opportunity cost of using existing resources
– Tax impact on sale of old assets
– Residue / Terminal / Salvage value of capital expenditure
– Realisable value of working capital at the end of economic life
– Deferred Investment
– Capital subsidy
2. OPERATING CASH FLOWS
– Cash Receipts
– Cash Disbursements
– Timing of cash receipts and disbursements
– Range of estimates - highest and lowest
estimates considering the uncertainties
– After tax and without tax proceeds
– Absolute and relative cash Flows
 3. CHOICE OF HORIZONS
Selection of the time period is important for the decision
makers for evaluating benefits and costs. The most
practical way of resolving the horizon problems is to let
the discount rate take care of it. In fact, many companies
impose a shorter limit of benefits and costs, considered
for many type of projects.
Life of the project may be divided into -
– Physical life
– Economical life
The relevant period in Investment Analysis is economic
life as investment are made for the economic benefits.
 METHODS OF RANKING
There are several techniques for evaluation and ranking of
the capital investment proposals. In case of all these
methods the main emphasis is the return which will be
derived on the capital investment in the project.
Fundamental Principles :
– “BIGGER THE BETTER PRINCIPLE”, which means that, other
things being equal, bigger benefits are preferable to small ones.
– “BIRD IN HAND PRINCIPLE”, which means that other things
being equal, early benefits are preferable to latter benefits.
– Mean has to be found for considering both of them in a single
yardstick.
 1. PAYBACK PERIOD
Payback period refers to the period in which the project will
generate the necessary cash to recoup the initial
investment
Initial Investment
Payback Period = ————————————
Annual Cash inflows
Annual cash inflows = Estimated cash inflows resulting
from the proposed investment ( i.e. net income on account
of investment before depreciation but after taxation )
In case of uneven cash inflows , by calculating cumulative
cash in Flows, the pay-back period can be calculated.
 PAYBACK PERIOD
Accept or reject criterion :
– A project whose actual pay-back period is more than what has
been predetermined by the management will be straight way
rejected. The fixation of maximum acceptable pay-back period is
generally done by taking into account the reciprocal of the cost of
capital ( i.e. maximum acceptable pay-back period = 100 divided
by desired rate of return )
– The payback period can also be used in case of mutually
exclusive projects. The projects are then arranged in ascending
order according to the length of their pay back periods.
 2. ACCOUNTING OR
AVERAGE RATE OF
RETURN ( ARR )
According to this method, the capital investment proposals
are judged on the basis of their relative profitability. For
this purpose, capital employed and expected income are
determined according to commonly accepted accounting
principles and practices over the entire economic life of
the project and then the average yield is calculated. Such
a rate is termed as Accounting rate of return. It may be
calculated, according to either of the following formula –
Average annual net earnings
i. x 100
Original Investment

Annual average net earnings

ii. x 100
Average Investment
 ACCOUNTING OR
AVERAGE RATE OF
RETURN ( ARR )
The term “ Average annual net earnings” is the average of
the earnings (after depreciation and tax) over the whole of
the economic life. One may calculate " Average annual
net earnings " before tax. Such rate is known as pre - tax
accounting rate of return.
The amount of “ Average Investment” is
calculated as follows -

L
Original Investment - Scrap Value O
M P+ Additional Net Working Capital + Scrap Value
N 2 Q
 ACCOUNTING OR
AVERAGE RATE OF
RETURN ( ARR )
Accept / Reject Criterion -
Any project expected to give a return below minimum
desired rate of return will be straight way rejected. In
case of several project, where a choice has to be made,
the different projects may be ranked in the descending
order on the basis of their rate of return.
 3. DISCOUNTED CASH
FLOWS (DCF) METHOD
An investment is essential outlay of funds in anticipation
of future returns, the presence of time as a factor in
investment is fundamental rather than incidental to the
purpose of evaluation of investments. Time is always
crucial for the investor, so that a sum received today is
worth more than the same sum to be received
tomorrow. Thus in evaluating investment projects, it is
important to consider the timings of return on
investments.
 DCF METHOD
Assumptions of Discounting Table :
1. Opportunity for investment is available at any time for any
amount.
2. Interest will accrue at the same rate.
3. Interest will be received at the end of the year.
4. Interest will be reinvested at the same opportunity rate
5. Price level remains the same

DCF methods for evaluating capital expenditure

proposals are of two types -
i. Net Present Value Method ( NPV )
ii. Internal Rate of Return Method ( IRR )
 DCF METHOD - NPV
A. Net Present Value Method :
The net present value is the difference between present
value of benefits and present value of costs. If the net
present value is positive the conclusion is favourable to the
decision to go ahead with the project but if it is negative,
the project is rejected. The analyst who uses this method
feels that it gives desired indication with the least
confusion.
Accept/Reject Criterion :
Where NPV > Zero accept the proposal
NPV = Zero accept the proposal
NPV < Zero reject the proposal
NPV = Net Present Value
 DCF METHOD – Profitability
Index
B. Profitability Index / Desirability Factor :
If the present value method is used, the present value of
the earnings of one project can not be compared directly
with the present value of earnings of another, unless the
investments are of the same size. In order to compare
proposals of different size, the Flows to investment must
be related. This is done by dividing the present value of
earnings by the amount of investment, to give a ratio i.e.
called the profitability index / ratio or desirability factor.
Discounted Cash inflow
Pr ofitablity Index =
Discounted Cash outflow
OR
Discounted Cash inflow
Profitability Ratio = x 100
Discounted Cash outflow
DCF METHOD – Profitability
Index
Higher the index number, the better the project.
This is called benefit cost ratio.
Accept / Reject Criterion -
Where PI > 1 accept the proposal
PI = 1 accept the proposal
PI < 1 reject the proposal
PI = Profitability Index
 DCF METHOD - IRR
C. INTERNAL RATE OF RETURN ( IRR ) :
In the net present value method, the required earnings
rate is selected in advance. There is an alternative
method which finds the earnings rate at which the
present value of the earnings equals the amount of the
investment. This rate is called the time - adjusted rate
of return, DCF rate of return, internal rate of return,
yield rate, marginal efficiency of capital etc. IRR is the
rate which brings the sum of the future cash Flows to
the same level as the original investment. Thus IRR is
the rate of return at which the sum of discounted cash
inflows equals the sum of discounted cash outflows.
 DCF METHOD - IRR
Accept / Reject Criterion :
Where
IRR > Cut -off -rate accept the proposal
IRR = Cut -off- rate accept the proposal
IRR < Cut -off -rate reject the proposal

The IRR is calculated under two situations -

1. When cash Flows are uniform
2. When cash Flows are not uniform
 DCF METHOD - IRR
1. When cash Flows are uniform :
In the case of those projects which generate uniform
cash inflows, the IRR can be calculated by locating the
factor in Annuity Table II.
Steps for Calculation of IRR :
a. Divide the Investment by the annual cash in Flows. The result
is called the ‘Factor’ or ‘Payback’
b. Go across the row of the year (equivalent to the life of the
project) of Table II and Check up the closest figure to the factor
( as determined in step (a) above ) and ascertain the rate.
 DCF METHOD _ IRR
c.If IRR is greater or equal to minimum desired
rate of return accept the project. If IRR is
less than minimum desired rate of return reject
the project.

Note : Alternatively IRR may be calculated

as per method prescribed for "uneven cash
Flows“.
 DCF METHOD - IRR
2.If Cash Flows are not the same each year :
The IRR can be found out by trial calculations. The cash
Flows of project for each year and its residue value are
listed and various discount rates are applied to these
amounts until the closest rate is found that makes their
total present value equal to the amount of investment. The
indication for discounting at higher or lower rate can be
considered on the following basis-
V>C = Higher the rate of discounting
V<C = Lesser the rate of discounting
V = Discounted Cash Inflows
C = Cost of the investment
 DCF METHOD - IRR
With the discounting rates ( where there is positive
NPV i.e. Start rate and Negative NPV i.e. end
rate ), IRR is obtained
L by interpolation as under
Surplus O -
M xDifference in start and end rate P
= Start Rate + M M
Surplus  Deficit P
P
N Q
or
L
M Deficit O
x Difference in start and end rateP
= End Rate - M NSurplus  Deficit P
Q
Surplus = Surplus at Start Rate
Deficit = Deficit at End Rate
Under this method it is presumed that cash inflows
can be reinvested at internal rate of return.
 RISK AND UNCERTAINITY
Evaluation of capital expenditure proposal involves
projects of the future. Future is always uncertain.
Nobody can say with certainty about the quantum and
frequency of the future cash Flows.
There are too many unknown and uncertain factors
which influence cash Flows and therefore, it is
important to recognise that each cash inflows or
outflows is only a probable figure.
It is necessary to consider risk and uncertainty while
carrying out the capital budgeting exercise. Risk and
return have a direct relationship.
Higher the return from the project, higher would be the
risk normally and vice versa. It is, therefore, necessary
that the capital budgeting exercise should attempt to
optimise both, the return and risk factors.
RISK AND
RETURN
ANALYSIS
 INTRODUCTION
Risk and Return are closely related.
Project with potentiality of high profit may also increase
perceived risk of the firm.
The trade off between risk and return will have bearing on
investors perception before and after accepting a specific
proposal.
If a proposal makes a firm more risky the investors will also
expect higher return.
It is necessary to incorporate risk analysis in the analysis of
Capital Budgeting.
DIAGRAM OF RISK
AND RETURN
High Risk – Higher Expected
Return

Positive Relationship
Risk Return

Low Risk – Lower Expected

Return

 Higher Risk has potentiality of Higher Returns, which will in

turn will maximise the Wealth of the shareholders.
 Look towards risk as an opportunity.
 DESCRIPTION OF RISK
What is Risk?
– The estimation of future returns is done on the basis of
various assumptions such as sales volume, sales
price, cost, competition etc.
– Each of the factor in turn, depends on other variables
like state of economy, rate of inflation and so on.
– The actual return will vary from the estimates.This is
technically referred as risk.
 DESCRIPTION OF RISK

Risk with reference to Capital Budgeting:

“The variability in the actual returns from a

project over its working life, in relation to
estimated return as forecasted at the time
of initial Capital Budgeting decision”.
 DESCRIPTION OF RISK
Decision situations :
Can be broken up into 3 parts.
1.Risk

2.Uncertainty

3.Certainty

The Risk situation is one in which probability of

occurrence of a particular events are known.
 DESCRIPTION OF RISK
The Uncertainty situation is one in which probability
of occurrence of a particular events are less known
with greater variability as compared to risk.

The Certainty situation is one in which probability of

occurrence of a particular events are known with
greater degree of accuracy as compared to risk
and uncertainty.
 DESCRIPTION OF RISK
Risk and Uncertainty:
“Risk refers to set of unique outcomes for
given event which can be assigned
probabilities, while uncertainty refers to
outcomes of a given event which are too
unsure to be assigned probabilities.”
RISK AND RETURN SUMMARY
FOR ACCEPTABILITY OF A
PROJECT.
Situation Risk Return Acceptability
I High High Not Recommended
II Low Low Not Recommended
III High Low Never acceptable
IV Low High Recommended
 MEASUREMENT OF RISK

Risk with reference to Capital Budgeting, results

from Variation between Estimated and Actual

Returns.

Greater the variability between the two more risky

the project.
 MEASUREMENT OF RISK
Example:
Project NPV(Rs.) Probability
X 320 1.0
Y 400 0.8
0 0.2
 Both the projects have equal expected NPV i.e. Rs.320.
However the risk profile of project Y is greater than project X ,
Hence Project Y is risky.
 Project X with lesser risk is expected to have same returns as of
Project Y, hence Project X is the better choice.
 1. HILLER’S MODEL – Risk
Evaluation
Hiller argues that uncertainty or risk associated with a capital
expenditure proposal is shown by Standard Deviation of expected cash
flows.

Situation Standard Appraisal of

Deviation Risk
I Low Lesser risk
II High Higher risk
HOW DOES HILLER’S MODEL
WORKS?
Working out Standard Deviation of the Various ranges

of Cash flows will help in the process of taking

cognizance of uncertainty involved with future projects.

Hiller takes into account the mean of present value of

the cash flows and the Standard deviation of such

cash flows, which may be determined as follows.

 STANDARD DEVIATION
Standard deviation is a measure that indicates the degree
of uncertainty (or dispersion) of cash flows and is one
precise measure of risk.
Standard deviation is Square root of the Mean of the
Squared deviation.
Deviation is the difference between the Value of Outcome
and the expected mean of value of all outcomes.
Further to calculate the value of standard deviation weights
are provided to each deviation by its probability of
occurrence.
 EXAMPLE OF STANDARD
DEVIATION
Project X Project Y
PV of PV of
Expected Deviation Expected Deviation
Cash from Deviation Cash from Deviation
Year flows Mean Square 2 flows Mean Square 2
1 1,000 (500) 250,000 1,000 (500) 250,000
2 1,200 (300) 90,000 1,100 (400) 160,000
3 1,400 (100) 10,000 1,250 (250) 62,500
4 1,600 100 10,000 1,450 (50) 2,500
5 1,800 300 90,000 1,900 400 160,000
6 2,000 500 250,000 2,300 800 640,000
Total 9,000 0 700,000 9,000 - 1,275,000
Mean 1,500 - 116,667 1,500 - 212,500
Standard Deviation 342 461
Return for both project is the same. Project Y is having higher Standard
Deviation (Higher risk).Thus Project Y is more risky than Project X.
Hence Project X is a better Choice.
 EXAMPLE OF STANDARD
DEVIATION WITH DIFFERENT
MEANS
If the sizes of the projects outlay differ, Standard
deviation will be misleading therefore decision maker
should make use of the Coefficient of variation to judge
the riskiness of the project.

Co-efficient of Variation (v)

Standard Deviation
=
Mean of Expected Cash Flows
 2. DECISION MAKING WITH
THE HELP OF CO-EFFICIENT
OF VARIATION
Situation Co-efficient of Appraisal of
Variation Risk
I Low Lesser risk
II High Higher risk

Co-efficient of Variation is better measure than

Standard deviation because it adjusts the
size(Quantum) of cash flows.
 EXAMPLE
Project X Project Y
PV of PV of
Expected Deviation Expected Deviation
Cash from Deviation Cash from Deviation
Year flows Mean Square flows Mean Square
1 1,000 (417) 173,611 1,100 (475) 225,625
2 1,200 (217) 46,944 1,350 (225) 50,625
3 1,300 (117) 13,611 1,500 (75) 5,625
4 1,550 133 17,778 1,650 75 5,625
5 1,650 233 54,444 1,850 275 75,625
6 1,800 383 146,944 2,000 425 180,625
Total 8,500 - 453,333 9,450 - 543,750
Mean 1,417 - 75,556 1,575 - 90,625
Standard Deviation 275 301
Co-Efficient of Variation 0.1940 0.1911
Expected Cash flows from both projects being different. Project Y is
recommended on the basis of lesser Co-efficient of variation.
 3. Sensitivity Analysis
A Precise Measure of
Evaluating
Sensitivity analysis Riskas to how the
provides information
sensitive estimate project parameters make variations in
sensitive estimate project parameters make variations in
project output results.
Sensitivity analysis takes care of estimation errors by
finding out possible outcomes in evaluating the a project.
Sensitivity analysis provides decision maker insight into
variability of the outcomes.
Sensitivity analysis provides different cash flow estimates
under three assumptions.
1. the worst (Most pessimistic)
2. the expected (Most likely)
3. the best (Most optimistic)
 SENSITIVITY PARAMETERS

No. Sensitive Project parameters

1 Project Cost
2 Project Life
3 Expected Cash Flow
Capacity Utilisation
Selling Price
Raw Material cost
Other Variable Cost
4 Project capacity
 Example
The capital investment outlay of a project consists
of Rs.100 lakhs for Plant and Machinery and
Rs.40 lakhs for Working Capital.
Other details are summarised below.
Sales (Lakh units p.a) for years 1-5 1
Selling price per unit 120
Variable cost per unit(Rs) 60
Fixed overheads (excluding Depreciation) Rs.lakhs 15
Rate of depreciation on plant and machinery (% on WDV) 25
Salvage value of plant and machinery Equal to WDV at the
end of year 5
Applicable tax rate 40
Time horizon (Years) 5
Post tax cut off rate % 12
Required –
1. Indicate the financial viability of project by calculating
NPV.
2. Determine the sensitivity of the projects NPV under
each of the following conditions.
a. Decrease in selling price by 10%
b. Increase in variable cost by 5%
c. Increase in variable cost by 10%
Calculation of NPV
Discounted
Cash flow cash flows
Year Ref. Rs.Lakhs D.F. @12% Rs. Lakhs
0 A -100.00 1.00 -100.00
B -40.00 1.00 -40.00
1 C 37.00 0.89 32.93
2 C 34.50 0.80 27.60
3 C 32.63 0.71 23.16
4 C 31.22 0.64 19.98
5 C 30.16 0.57 17.19
B 40.00 0.57 22.80
D 23.73 0.57 13.53
17.19

A=Capital cost
B=Working Capital
C= Opeartional cash inflow
D= Salvage Value
Depreciation on plant and Machinery
Depreciation
WDV @25%
Year Rs.Lakhs Rs.Lakhs
1 100.00 25.00
2 75.00 18.75
3 56.25 14.06
4 42.19 10.55
5 31.64 7.91
WDV 23.73
 Operational Cash inflow
Contribution Fixed
@Rs.60/unit overheads Operation
(For 1 lakh (excluding Depreciati al cash
units) Dep.) Rs. on PBT Tax inflow
Year Rs.Lakhs Lakhs Rs.Lakhs Rs. Lakhs Rs. Lakhs Rs.Lakhs
1 60 15 25.00 20.00 8.00 37.00
2 60 15 18.75 26.25 10.50 34.50
3 60 15 14.06 30.94 12.38 32.63
4 60 15 10.55 34.45 13.78 31.22
5 60 15 7.91 37.09 14.84 30.16
 Sensitivity Analysis
Revised
Sr. No. Change Calculation NPV Result
(1 X - 12) X
Decrease in selling (1-.40) X Negative
1 Price by 10 % 3.61 -8.80 NPV
(1 X -3) X Still
Increase in Variable (1-.40) X positive
2 cost by 5 % 3.61 10.70 NPV
(1 X- 6) X Still
Increase in Variable (1-.40) X positive
3 cost by 10 % 3.61 4.20 NPV
4. ASSIGNING PROBABILITY
Sensitivity Analysis provides more than one estimate
of future return of a project. It is therefore superior to
single figure forecast as it gives more precise ideas
regarding variability of the returns. But, it has a
limitation in that it does not disclose chances of these
occurrences of these variations.
Remedy is to provide more accurate forecast by
considering probability of occurrences.
ASSIGNING PROBABILITY
The Concept of probability is helpful as it indicates
the percentage chance of occurrence of each
possible cash flow.
The quantification of variability of returns involves two
steps.
1. Depending upon chance of occurrences of a particular
cash flow estimate, probabilities are assigned.
 Assignment of probabilities can be objective (large number of
observations under independent and identical situations and
past experience) and subjective (personal probability
assignment).
 ASSIGNING PROBABILITY
2. To estimate the expected return on the project the
returns are expressed in terms of expected monetary
values. The expected value of a project is a weighted
average return, where the weights are probabilities
assigned to the various expected cash flows.
 EXAMPLE
A new project Cost Rs.7,000 lakhs. The following information is
available regarding the cash flows generated, and their probability for
XYZ Ltd. What is expected return on the project? Assume 10% discount
rate and calculate present value of expected monetary values.

Year 1 Year 2 Year 3

Cash flows Cash flows Cash flows
Rs. Lakhs Probability Rs. Lakhs Probability Rs. Lakhs Probability
2000 0.20 2500 0.25 3000 0.40
2300 0.40 2800 0.50 3400 0.30
3200 0.40 3300 0.25 3800 0.30
Calculation of Expected Monetary Values and NPV
Expected Discountin
Monetary g Factor Discounted
Year Cash Flow Probability Values @ 10% Cash Flow
Rs. Rs. Rs.
0 -7000 1.00 -7000 1.00 -7000
1 2000 0.20 400
2300 0.40 920
3200 0.40 1280
Total 2600 0.91 2366
2 2500 0.25 625
2800 0.50 1400
3300 0.25 825
Total 2850 0.83 2366
3 3000 0.40 1200
3400 0.30 1020
3800 0.30 1140
Total 3360 0.75 2520
NPV 252
Conclusion: Project is recommended for adoption
PROBABILITY DISTRIBUTION
APPROACH
In earlier slides we have seen the concept of
probability for incorporating risk in evaluating capital
budgeting proposals.
The application of this theory in analysing risk
depends upon the behaviour of cash flows. From the
behavioural point of view cash flows are –
1. Independent cash flows
2. Dependent cash flows
PROBABILITY DISTRIBUTION
APPROACH
Independent cash flows signifies that
future cash flows are not affected by cash
flows of the preceding or following years.
Dependent cash flow depend upon the
cash flow of previous periods.
PROBABILITY DISTRIBUTION
APPROACH
By assigning probabilities to expected cash

flows, NPV is found out by applying appropriate

discount rate. This is estimate of return.

Risk is measured by finding out Standard

deviation of the project under consideration.

 EXAMPLE

A new project Cost Rs.7000 lakhs The following

information is available regarding the cash flows
generated, and their probability for XYZ Ltd. What is
expected return on the project? Assume 10% discount
rate and calculate present value of expected monetary
values.
Year 1 Year 2 Year 3
Cash flows Cash flows Cash flows
Rs. Lakhs Probability Rs. Lakhs Probability Rs. Lakhs Probability
2000 0.20 2500 0.25 3000 0.40
2300 0.40 2800 0.50 3400 0.30
3200 0.40 3300 0.25 3800 0.30
Calculation of Expected Monetary Values and NPV
Expected Discountin
Monetary g Factor Discounted
Year Cash Flow Probability Values @ 10% Cash Flow
Rs. Rs. Rs.
0 -7000 1.00 -7000 1.00 -7000
1 2000 0.20 400
2300 0.40 920
3200 0.40 1280
Total 2600 0.91 2366
2 2500 0.25 625
2800 0.50 1400
3300 0.25 825
Total 2850 0.83 2366
3 3000 0.40 1200
3400 0.30 1020
3800 0.30 1140
Total 3360 0.75 2520
NPV 252
 Standard Deviation
Deviation
2x Double
Probabilit Discountin Discount
Year Cash Flow Probability Expected Monetary
Deviation
Cash Flow 2
Deviation y g Factor ed Value
Rs. Rs. Rs.
1 2000 0.20 400.00 -600.00 360000 72000
2300 0.40 920.00 -300.00 90000 36000
3200 0.40 1280.00 600.00 360000 144000
Total 7500 1.00 2600.00 -300.00 810000 252000 0.82 206640
Mean 2500 2600.00
2 2500 0.25 625.00 -350.00 122500 30625
2800 0.50 1400.00 -50.00 2500 1250
3300 0.25 825.00 450.00 202500 50625
Total 8600 1.00 2850.00 50.00 327500 82500 0.68 56100
Mean 2867 2850.00
3 3000 0.40 1200.00 -360.00 129600 51840
3400 0.30 1020.00 40.00 1600 480
3800 0.30 1140.00 440.00 193600 58080
Total 10200 1.00 3360.00 120.00 324800 110400 0.56 61824
Mean 3400 3360.00
Total 324564
Standard Deviation of the project 570

By comparing the return and Risk with other similar project, a

project having minimum risk and maximum return is selected.
5. RISK ADJUSTED DISCOUNT
RATE (RAD) APPROACH
RAD approach is simplest and most widely used

method for incorporating risk into capital budgeting

decision .

Under this approach the amount of risk inherent in

a project is incorporated in discount rate employed

in the present value calculations.

 RAD APPROACH

Risk inherent Discount Rate to be Say

in a project applied
Very Risky Higher discount rate 25%
Risky High discount rate 20%
Safe Low discount rate 16%
 RAD APPROACH

The risk adjusted discount rate represents

different risk in different class of investment.

The use of single rate discount the different

risk of various projects would be logically
inconsistent with the firm’s goal of
shareholders wealth maximisation.
RAD APPROACH
 RAD APPROACH
Accept or Reject criteria:
– NPV Method :
NPV Positive – Acceptable
NPV Negative – Reject


– IRR method :
IRR Acceptable
IRR < Reject
 EXAMPLE
A textile company is considering two mutually exclusive
investment proposals. Their expected cash flow streams
(CFAT) are given as follows.
Year Proposal X Proposal Y
Rs. Thousand Rs. Thousand
0 -500 -700
1 145 100
2 145 110
3 145 130
4 145 150
5 145 160
6 145 150
7 120
8 120
9 110
10 100
The company employs the risk adjusted method of
evaluating risky projects and selects the appropriate
Project. Required rate of return are as follows.

Required rate
Project payback of return(%)
Less than 1 year 8
1 to 5 years 10
5 to 10 years 12
Over 10 years 15

Which proposal should be acceptable to the company?

 6. CERTAINTY EQUIVALENT
APPROACH (CEA)
CEA is an alternative to the risk adjusted rate
method, which overcome the weaknesses of the
latter method. Under CEA approach the riskiness
of the project is taken into consideration by
adjusting the expected cash flows, while under
RAD approach the discount rate is adjusted.
 STEPS INVOLVED IN CEA
1. Modify the expected cash flows to adjust the risk. The risk adjustment
factor is expected in terms of Certainty Equivalent co-efficient.

Risk less cash flow

Co-efficient =
Risky Cash flow
The co-efficient is fractional number between 0 and 1. There is
inverse relationship between degree of risk and value of co-
efficient.
Degree of Risk Value of Co-efficient
High Risk Lower co-efficient
Lower Risk Higher co-efficient
 STEPS INVOLVED IN CEA
2. Calculate present values of cash flows
by applying Risk free discounting rate or
the rate which appropriately reflects the
time value of money.
 STEPS INVOLVED IN CEA
3. Accept or Reject criteria:
– NPV Method :
NPV Positive – Acceptable
NPV Negative – Reject

– IRR 
method :
IRR Acceptable
IRR < Reject
 EXAMPLE
A company employs certainty-equivalent of
risky investments. The capital budgeting
department of the company has developed the
following information regarding
Expected a new project:
Certainty-
Year CFAT equivalent
(Rs.Thousand)
0 -200 1.0
1 160 0.8
2 140 0.7
3 130 0.6
4 120 0.4
5 80 0.3

The firm,s cost of equity capital is Rs.18% , its cost of debt is 9%

and the riskless rate of interest in the market on the Government
securities is 6%. Should the project be accepted?
 7.DECISION TREE
APPROACH (DT)
DT is another useful alternative for evaluating risky
investment proposals.

The outstanding feature of this approach is that it

takes into account the impact of all probabilistic
estimates of potential outcomes.

The DT approach is especially useful for projects

require decisions in sequential parts.
DECISION TREE A PICTORIAL
PRESENTATION
A decision is a pictorial representation in tree form
which indicates probability and interrelationship of all
possible outcomes.

The format of the investment decisions has an

appearance of a tree with branches.

Decision tree shows the sequential cash flows and the

NPV of different projects under different circumstances.
 EXAMPLE 1
Investment proposal of X Ltd. requires an outlay of
Rs. 2,00,000 at present (t = 0). The investment
proposal is expected to have 2 years’ economic life
with no salvage value. In year 1, following are the
cash flows and probabilities.
Cash Flow Probability
80000 0.3
110000 0.4
150000 0.3
In year 2, the CFAT possibilities depend on the CFAT that
occurs in year 1. That is the CFAT for the year 2 are
conditional on CFAT for the year 1. Accordingly the
probabilities assigned with the CFAT of the year 2 are
conditional probabilities. The estimated conditional CFAT and
their associated conditional probabilities are as follows:

If CFAT1 = Rs. 80000 If CFAT2 = Rs. 110000 If CFAT3 = Rs. 150000

CFAT2 Probability CFAT2 Probability CFAT2 Probability
40000 0.2 130000 0.3 160000 0.1
100000 0.6 150000 0.4 200000 0.8
150000 0.2 160000 0.3 240000 0.1

Recommend whether project should be accepted or not using

decision tree approach. Assume Discount rate of 12%.
 DECISION TREE PRESENTATION

Year 1 Year 2 Path Expected NPV Expected

Time 0 Probabilities CFAT Probabilities CFAT @ 12% Joint Probability NPV
Rs. Rs. Rs. Rs.

0.2 40000 1 -96680* 0.06 -5800.8

0.3 80000 0.6 100000 2 -48860 0.18 -8794.8
0.2 150000 3 -9010 0.06 540.6

0.3 130000 4 1840 0.12 220.8

Cash Outlays 0.4 110000 0.4 150000 5 17780 0.16 2844.8
Rs. 200000 0.3 160000 6 25750 0.12 3090

0.1 160000 7 61470 0.03 1844.1

0.3 150000 0.8 200000 8 93350 0.24 22404
0.1 240000 9 125230 0.03 3756.9
1.00 19024

For NPV calculations, refer next slide

CALCULATION OF NPV FOR PATH 1

Discounting Discounted
Year Cash Flow Factor Cash Flow
0 -200000 1 -200000
1 80000 0.893 71440
2 40000 0.797 31880
NPV -96680

Similarly NPV may be calculated for other paths.

 SPREADSHEET PRESENTATION
Time 0 Year 1 Year 2 Path Expected NPV Joint Expected
CFAT Probabilities CFAT Probabilities @ 12% Probability NPV
Rs. Rs. Rs. Rs.
200000 80000 0.3 40000 0.2 1 -96680 0.06 -5800.8
200000 80000 0.3 100000 0.6 2 -48860 0.18 -8794.8
200000 80000 0.3 150000 0.2 3 -9010 0.06 -540.6
200000 110000 0.4 130000 0.3 4 1840 0.12 220.8
200000 110000 0.4 150000 0.4 5 17780 0.16 2844.8
200000 110000 0.4 160000 0.3 6 25750 0.12 3090
200000 150000 0.3 160000 0.1 7 61470 0.03 1844.1
200000 150000 0.3 200000 0.8 8 93350 0.24 22404
200000 150000 0.3 240000 0.1 9 125230 0.03 3756.9
1.00 19024.40

Since NPV is positive project is recommended for adoption.

 EXAMPLE 2

A Company has the following estimates of the present

values of the future cash flows after taxes associated
with the investment proposal, concerned with expanding
the plant capacity. It intends to use a decision-tree
approach to get clear picture of the possible outcomes of
this investment. The plant expansion is expected to cost
Rs. 3,00,000. The respective PVs of future CFAT and
probabilities are as follows:
 PV of uture CFAT
With Without Probabaili
expansion expansion ties
Rs. Rs.
300000 200000 0.2
500000 200000 0.4
900000 350000 0.4

Advise the company regarding the financial feasibility of the

project.
 8. HERTZ’S MODEL
USE SIMULATION TECHNIQUE
Hertz has suggested that simulation technique which is
flexible tool of Operational Research may be used in Capital
Budgeting decisions.
He argues that planning problems of a firm are so complex
that they cannot be described by mathematical model.Even
while using mathematical model we make certain
assumptions because of which solution is not reliable for
practical purposes.
In most of the solutions due to uncertainties involved,
satisfactory mathematical model cannot be built.
 SUGGESTED MODEL FOR
INTRODUCTION OF A NEW
PRODUCT DEVELOPED BY HERTZ
Expected
Value (By
Variable using RN
Sr.No. Variable Expression Range theory)
From to
1 Market Size Lakh units 1 3.4 1.5
2 Selling Price Rs. 385 575 510
3 Market Growth Rate % 0 6 3
4 Market Share % 3 17 10
5 Investment Required Rs. Lakhs 350 500 475
6 Useful Life of Facilities Years 5 13 10
7 Residual Value Rs. Lakhs 35 50 45
8 Operating Cost Rs. Lakhs 370 545 450
9 Fixed Cost Rs. Lakhs 253 375 300
All the above factors do have bearing on NPV.
 DISCOUNTED CASH FLOW V
HERTZ’S MODEL
DCF Model Hertz Model
Mathematical Model Statistical Model
Commonly followed Operational Research
Technique Expert aided technique
DCF model would Hertz proposes that
merely consider distribution be described
expected value of each for each variable.
input variable.
Less flexible Highly flexible
HOW HERTZ MODEL WORKS?
Having derived Mean, Standard Deviation and Shape
(Graph) of Distribution of Each variables the simulation
experiment may be performed by considering different
levels of these factors.
e.g.
– In the first run High Operating Cost with low Market Share etc
may be used for computing NPV.
– In the next run it may be a moderate operating cost with a large
market size may be used for computing NPV.
HOW HERTZ MODEL WORKS?
– In the next run it may be a moderate operating cost with
a large market size may be used for computing NPV.
– Similarly it may be a moderate operating cost with a low
market size may be used for computing NPV.
– And so on ..... large number of runs (iterations) may be
made which would cover most of the probable situations
with SIMULATION TECHNIQUE.
 SIMULATION

It is statistical technique which applies to

predetermined probability distributions and

random numbers to estimate risky outcomes.

A simulation is akin to sensitivity analysis. The

technique is more comprehensive than Sensitivity

analysis.
 SIMULATION
Instead of showing the impact on the NPV for change in
one key variable (Say change in selling price, change in
variable cost) in Sensitivity analysis, Simulation enables
the distribution of probable values(NPV) for change in
all the key variables in one iteration/run only.
The technique provides more information and better
understanding about the risk associated with the
investment decision.
 SIMULATION

To be effective Simulation requires

sophisticated Computing package, as it
enables to try out large number of
outcomes with much ease.
 EXAMPLE
The production of certain commodity and the
corresponding probabilities are as follows.

Daily Production
(in Units) 10 11 12 13 14 15
Probability 0.3 0.24 0.16 0.15 0.08 0.07

Simulate the production on next 10 days and find out the

average daily production.
 SOLUTION
We decide the schedule of Random Numbers, where
the number of number of Random Numbers in
schedule is proportional to the probability.
Schedule of Random Numbers
Production Random
(in Units) Probability Numbers
10 0.30 00-29
11 0.24 30-53
12 0.16 54-69
13 0.15 70-84
14 0.08 85-92
15 0.07 93-99
 SOLUTION
We now consider any set of randomly selected 10
two digit numbers, to decide the daily production.
Random Daily
Day number production
1 12 10
2 27 10
3 0 10
4 87 14
5 52 11
6 11 10
7 73 13
8 27 10
9 46 11
10 79 13
Total Production 112
Average Daily
production 11.2