You are on page 1of 19

UNIT II INVESTMENT DECISIONS INTRODUCTION Capital budgeting is budgeting for capital projects.

The exercise involves ascertaining and estimating cash inflows and outflows, matching the cash inflows with outflows appropriately and evaluation of the desirability of the project, under consideration. CAPITAL PROJECTS Businesses investments in capital projects are of different nature. These capital projects involve investment in physical assets, as opposed to financial assets like shares, bonds or funds. Capital projects necessarily involve processing, manufacturing or service works. These require investments with a longer time hori on. The initial investment is heavy in fixed assets and investment in permanent working capital is also heavy. The benefits from the projects last for few to many years. Capital projects may be new ones, expansion of existing ones, diversification of existing ones, renovation or rehabilitation of projects, !"# activities, or captive service projects. $n enterprise may put up a new subsidiary, increase stake in existing subsidiary or acquire a running firm. $ll these are considered as capital projects. Capital projects involve huge outlay and it will last for years. %ence, these are riskier than investments in financial assets. Capital projects have technological dimensions and environmental dimensions. &o, careful analysis is needed. #ecisions once taken cannot be easily reversed in respect of capital projects and therefore thorough evaluation of costs and benefits is needed.

SIGNIFICANCE OF CAPITAL BUDGETING 'very business has to commit funds in fixed assets and permanent working capital. The type of fixed assets that a firm owns influences i( the pattern of its cost )i.e. high or low fixed cost per unit given a certain volume of production(, ii( the minimum price the firm has to charge per unit of production iii( the break*even position of the company, iv( the operating leverage of the business and so on. These are all very vital issues shaping the profitability and risk complexion of the business. Capital budgeting is significant because it deals with the right kind of evaluation of projects. $ project must be scientifically evaluated, so that no undue favor or dis*favor is shown. $ good project must not be rejected and a bad project must not be selected. Capital investment proposals involve i( longer gestation period, ii(. huge capital outlay, iii( technological considerations needing technological forecasting, iv( environmental issues too, which require the extension of the scope of evaluation to go beyond economic costs and benefits, v( irreversible decision once committed, vi( considerable peep into the future which is normally very difficult, vii( measuring of and dealing with project risks which is a daunting task in deed and so on. $ll these make capital budgeting a significant task. Capital budgeting involves capital rationing. That is, the available funds must be allocated to competing project in the order of project potentials. +sually, the indivisibility of project poses the problem of capital rationing because required funds and available funds may not be the same. $ slightly high return projects involving higher outlay may have to be skipped to choose one with slightly lower return but requiring less outlay. This type of trade*off has to be skillfully made. The building blocks of capital budgeting exercise are mostly estimates of price and variable cost per unit output, quantity of output that can be sold, the tax rate, the cost of

capital, the useful life of the project, etc. over a period of years. $ clear system of forecasting is also needed. ,hat should be the discount rate- &hould it be the pre*tax overall cost of capital- .r the post*tax overall cost of capital- The choice is very crucial in making capital budgeting exercises a significant one. /inally, which is the appropriate method of evaluation of projects. There are over a do en or more methods. The choice of method is important. $nd different methods might rank projects differently leading to a complex picture of project desirability ranks. $ clear thinking is needed so that confusion is not descending on the choice of projects. Appraisal of Capital Proje ts $ppraisal means examination and evaluation. Capital projects need to be thoroughly appraised as to costs and benefits. The costs of capital projects include the initial investment at the inception of the project. 0nitial investment made in land, building, machinery, plant, equipment, furniture,fixtures, etc. generally, gives the installed capacity. 0nvestment in these fixed assets is one time. /urther, a one*time investment in working capital is needed in the beginning, which is fully salvaged at the end of the life of the project. $gainst this committed returns in the form of net cash earnings are expected. These are computed as follows. 1et 234 stand for price per unit, 254 for variable cost per unit, 264 for quantity produced and sold, 2/4 stand for total fixed expenses exclusive of depreciation, 274 stand for depreciation on fixed assets, 204 for interest on borrowed capital id 2T4 for tax rate(. Then, cash earnings 8 9)3*5( 6*/*#*0:);*T(<#

These cash earnings have to be estimated throughout the economic life of the investment. That is, all the variables in the equation have to be forecasted well over a period of years. =ow, that we have the benefits from the investment estimated, the same may be compared with costs of the capital project and 2netted4 to find out whether costs exceed benefits or benefits exceed costs. This process of estimation of costs and benefits and comparison of the same is called appraisal. 3ayback period, accounting rate of return, net present value, rate of return, decision tree technique, sensitivity analysis, simulation and capital asset pricing model )C$3>( are certain methods of appraisal. Met!o"s #se" for Proje ts Appraisal A$ Pa%&a ' Perio" (PBP) Met!o" 3ay back period refers to the number of years one has to wait to setback the capital invested in fixed assets in the beginning. /or this, we have to get cash flow from business. ,e have invested !s. ?7,77,777 at time ero. $fter one year, a sum of !s.;@, ;7,777 is returned. By next year, a sum of !s. ;A,B7,777 is returned. But we have to get back only !s. C,A7,777 )i.e., ?7,77,777 * ;@,;7,777(. &o, in the second year we have to wait only for part of the year to get back !s. C,A7,777. The part of the year 8 C.A7,777D ;A,B7,777 8 7.E7 that is, pay back period is ;.E7 years or ; year, E months and ;A days. 0n general payback period is given by 2n4 in the equation

,here 2t4 ; to n, 0 8 initial investment, C/ 8 cash flow at time 2t4 and t 8 time measured in years.

=ormally, businesses are want projects that have lower pay back period, because the invested money is got back very soon. $s future is risky, the earlier one gets back the money invested, the better for the business. &ome businesses fix a maximum limit on pay back period. This is the cut*off pay back period, serving as the decision criterion. $ccordingly, a pay back period ceiling of E years means, only projects with payback period equal to or less than E years will be accepted and others will be rejected. Merits of pa%&a ' perio" ;. 0t is cash flow based which is a definite concept ?. 1iquidity aspect is taken care of well E. !isky projects are avoided by going for low gestation period projects @. 0t is simple and common sense oriented De*erits of pa%&a ' perio" ;. Time value of money is not considered as earnings of all years are simply added together ?. 'xplicit consideration for risk is not involved E. 3ost*payback period profitability is ignored totally. B$ A o#+ti+, Rate of Ret#r+ (ARR) Met!o"

%ere, the accounting rate of return )$!!( on an investment is calculated. 0t is also called as the average rate of return. To compute $!!, average annual profit is calculated. Merits of ARR ;. 0t is simple and common sense oriented. ?. 3rofits of all years are taken into account. De*erits of ARR i. Time value of money is not considered.

ii. iii.

!isk involved in the project is not considered. $nnual average profits might be the same for different projects but accrual of profits might differ having significant implications on risk and liquidity.

iv.

The $!! has several variants and it lacks uniformity.

$ minimum $!! is fixed as the benchmark rate or cut*off rate. The estimated $!! for an investment must be equal to or more than this benchmark or cut*off rate so that the investment or project is chosen. C$ Net Prese+t Val#e (NPV) Met!o" =et present value is computed given the original investment, annual cash flows )3$T < #epreciation( and required rate of return which is equal to cost of capital. 0f the =35 8 74 or greater than ero, the project can be taken. 0ncase, there are several mutually exclusive projects with =35 F7, we will select the one with highest =35. 0n the case of mutually inclusive projects you first take up the one with the highest =35 and next the project with next highest =35, and so on as long as your funds for investment lasts. The factor GkG need not be same for all projects. 0t can be high for projects whose cash flows suffer greater fluctuations due to risk, and lower for projects with lower fluctuations risk. D$ I+ter+al Rate of Ret#r+ (IRR) Met!o" 0nternal !ate of !eturn )0!!( is the value of 2kG in the equation, 0 < H C/ D )l<k( t 8 7. 0n other words, 0!! is that value of GkG for which aggregated discounted value of cash flows from the project is equal to original investment in the project. ,hen manually computed, GkG i.e., 0!! is got through trial and error. &uppose for a particular value of 0 <' C/; 0 )l<k( t F7, we have to use a higher 2k4 in our trial and if the value is I7, a lower 2k4 has to employed next time. Then, you can interpolate k. The value of 2k4 thus got is the 0!!.

De isio+ Tree Approa ! #ecision tree approach is a versatile tool used for decision*making under conditions of risk. The features of this approach areJ );( it takes into account the results of all expected outcomes, )ii( it is suitable where decisions are to be made in sequential parts * that is, if this has happened already, what will happen next and what decision has to follow, )iii( every possible outcome is weighed using joint probability model and expected outcome worked out, )iv( a tree*form pictorial presentation of all possible outcomes is presented here and hence, the term decision*tree is used. $n example, will make understanding easier. $n entrepreneur is interested in a project, say introduction of a fashion product for which a ? year market span is foreseen, after which the product turns fade and that within the two years all money invested must be realised back in full. The project costs !s. @,77,777 at the time of inception. #uring the ;st year, three possible market outcomes are foreseen. 1ow penetration, moderate penetration and high penetration are the three outcomes, whose probability values, respectively, are 7.E, )i.e., E7K chance(, 7.@ and 7E and the cash flows after tax under the three possible outcomes are respectively estimated to be !s. ;,L7,777, !s. ?,?7,777 and !s. E,77,777. The level of penetration during the ?nd year is influenced by the level of penetration in the first year. The probability values of different penetration levels in the ?nd year, given the level of penetration in the ;st year and respective cash flows are estimated as followsJ

0f low penetration resulted in ;st year, low penetration in ?nd year with probability of 7.? and cash flow of !s.M7, 777, moderate penetration in ? year with probability of 7.L and cash flow of !s.?, 77,777 and high penetration in ?G year with probability of 7.? and cash flow of !s.E, 77,777 are possible. &imilarly, you can follow for other cases. Combining ;st and ?nd year penetration levels together, A outcomes are possible. These areJ

$t this stage, we may go for present value evaluation of these sets of outcomes. $nd this is done below. /or this, we require a discounting rate. 1et us take a ;7K discount rate. Then the present value of !s.; receivable at ;st year end is !s.7.A7A )i.e. ;D;.;( and at ?nd ; year end it !s.7.M?L )i.e., ;D;.; ?(. =ow, the present values of the A

cash flow streams can be worked out. These values, the =35 relevant to each stream )i.e., the aggregate of the present value of the two cash flows of each stream minus investment of !s.@,77,777(, joint probability )i.e., product of probabilities of the two cash flows of each stream( and expected value of =35 )i.e., joint probability times =35 of each stream( are given below in table B.

The expected =35 of the project is negative at !s.;??LA, if low penetration prevailed both in the ;st and ?nd years and this has a probability of L out of ;77 or .7L. The expected =35 is negative at !s.;L7MC, if low penetration in ;st year and moderate penetration in ?nd year have prevailed and the probability of this happening is ;MK. .utcome M shows that =35 of !s.@M, B@@ with probability of ?@K is possible when high penetration in ;st year and moderate penetration in the ?nd year result. The expected =35 of the project is the aggregate of the expected =35 of the different streams 8 !s.@BEAC. &ince, it is positive, the project may be taken up.

Capital Asset Pri i+, Mo"el (CAPM) Capital $sset 3ricing >odel )C$3>( is one of the premier methods of evaluation of capital investment proposals. C$3> gives a mechanism by which the required rate of return for a diversified portfolio of projects can be calculated given the risk. $ccording to C$3>, the required rate of return comprises of two partsJ first, a risk*free rate of return and second a risk premium for the amount of systematic risk of the portfolio. The formula isJ !equired rate of return 8 !f < )!m *!f( Bi, where !;* risk free rate of return !m* return on market portfolio Bi* Beta or risk coefficient of the evaluated portfolio given market portfolio beta 8 ; C$3>, therefore, gives a risk*return relationship for the portfolio of various projects. CAM te !+i-#e for e.al#ati+, apital proje ts ,e have to calculate the required rate of return for the capital project given its beta coefficient, risk free return and market return. Then, get the estimated return for the project. 0f the estimated return for the project is greater than or equal to the required rate of return, accept the project. .therwise, reject the project. The risk*free return is the rate of return obtainable on risk free investments, like investment in any government securities. Si*#latio+ A+al%sis ,hen uncertainty haunts the estimation of variables in a capital budgeting exercise, simulation technique may be used with respect to a few of the variables, taking the other variables at their best estimates. 3, 5, /, 6, T, N, 0, # and = are the important variables. )3 *3rice per unit of output, 5 *. 5ariable cost per unit of output, / * /ixed cost of operation, 6 * 6uantity of output, T *

Tax rate, N * #iscount rate or cost of capital, 0 * .riginal investment, # * $nnual depreciation and = * =umber of years of the project4s life(. &uppose, in a project, 3, 5, /, 6, = and 0 arc fairly predictable but k and 2T4 are playing truant. 0n such cases, the N and T will be dealt through simulation while others are take at given values. &uppose, that 3 8 !s.E77Dunit, 5 8 !s. ;C7Dunit, / 8 lC,77,777Dp.a,

6 8 ?.,777Dp.a, = 8 E years and 0 8 !s.;M,77,777. Then rural profit before tax 8 9)3*5( 6: * / * # 8 9)E77*0 C7(O?7777; * ;C,77.777 * 777 8 !s. A,77,777Dp.a. The profit after tax and hence cash flow cannot be computed as tax rate, T is not predictable. /urther, as 2k4 is also redictable, present value cannot be computed as well. &o, we use simulation here. &imulation process gives a probability distribution to each of the truant playing variables. 1et the probability distribution for 2T4 and 2N4 be as followsJ

=ext, we construct cumulative probability and assign number ranges, separately for T and N. Two digit random n ranges are used. ,e start with 77 and end with AA, thus using ;77 numbers. /or the different values of the variable in question, as many random numbers as are equal to the probability values of respective values are used. Thus, for variable T, ?7K of random numbers aggregated for its first E7K and C7K of random number for its next value ECK and @7K.

/or the first value of the unpredictable variable, we assign random numbers 77 to ;A. /or the second value we assign random numbers ?7PLA and for the third value random numbers B7 * AA are assigned. &imilarly, for the variable 2N4 also random numbers are assigned as given in table L. &imulation process now involves reading from random number table, random number pairs )one for 2T4 and another for 2N4(. The values of 2T4 and 2N4 corresponding to the random numbers read are taken from the above table. &uppose the random numbers read areJ @M and M7. Then 2T4 is ECK and the random number @M falls in the random number range ?7*LA corresponding to ECK and 2N4 is ;?K as the random number M7 fails in the random number range M7*AA corresponding to ;?K. =ow taking the T 8 ECK and N 8 ;?K. the =35 of the project can be worked out. ,e know that the project gives a 3$T of !s.A,77,777 pDa for E years. &o, the 3$T 8 A,77,777 Q Tax R ECK 8 !s.A,77,777 * E,;C,777 !s.C,MC,777 pa. To this, we have to add depreciation of !s.L,77,777 )i.e. !s.;M,77,777 D E years( to get the cash flow. &o, the cash flow8 C,MC,777 < L,77,7778 !s. ;;,MC,777 p.a.

8 );;,MC,777 D;.;? < ;;,MC,777D;.;?? < ;;,MC,777 D ;, ;?E( *;M,77,777 8 ;;,MC,777 9;D;.;? < ;D;.;?? < ;D;.;?: * ;M,77,777

8 ;l, MC,777 x ?.@7;M * ;M,77,777 8 ?M,CL,BAM * ;M,77,777 8 !s. ;7,CL,BAM ,e have just taken one pair of random numbers from the table and calculated the =35 as !s.l7, CL,BAM. This process must be repeated at least ?7 times, reading ?7 pairs of random numbers and getting the =35 for values of T and N corresponding to each pair of random numbers read. &uppose the next pair of random numbers are ?M and @AJ Corresponding 2T4 8 ECK and 2N4 8 ;;K. Then the 3$T 8 3BT * T 8 !s.A, 77,777 Q !s.E, ;C,777 8!s. C,MC,777. The cash flow 8 !s C,MC,777 < !s.L, 77,777 8 !s. ;;,MC,777.

8)!s.;;, MC,777D;.;;<!s.;;, MC,777D;.;; ?<!s.;;, MC,777D;.;;E(* !s.;M, 77,777 8 )!s.;7, LB,CAM <!s. A,L ;,BBE <!s. M,LL,@L?( Q!s. ;M,77,777 8 !s.?M, AC,M7E Q!s. ;M,77,777 8 !s.;7, AC,M7E &imilarly, the =35 for other simulations can be obtained. =35s may be averaged if the same is positive. Se+siti.it% A+al%sis &ensitivity analysis attempts to study the level of sensitivity of the project say the =35, for changes in a key influencing factor, keeping the influence of all other influencing factors at constant level. &ensitivity analysis presumes uncertainty of the values of all or some of the influencing factors. /or such factors, the range of their values and most likely values are given. .ther factors are taken at constant values. ,e know, that =35 of a project is influenced by 3, 5, 6, /, ;, =, T and N. 1et /, ;, =, # and N be constant at !s.;C, 77,777, !s.;M, 77,777, E years, !s.L, 77,777 and ;CK

respectively 3, 5, 6 and T and let the uncertain variables. 1et their range of values and most likely values be as followsJ 3J !s.?77*!s.EC7S >ost 1ikely value is !s.E77 5 !s.;77*!s.?C7S >ost 1ikely value is !s.;C7 6J ;C777*??777S >ost 1ikely quantity is ?7,777 TJ E7K*@7KS >ost 1ikely rate is ECK &uppose, we want to study the sensitivity of =, with respect to 2T4. then other uncertain variables, namely, 5 and 6 will be assigned their most likely values. =eedless to say, the variables taking constant values will take their fixed values. The variable T4 will be taking different values within the range of its values for each such values of T. The =35 will be worked out and sensitivity of the =35 to that factor also be analysed. $ccordingly, for our purposeJ 0 8 !s. ;M,77,777, = 8 E years, # 8 !s.L, 77,777, / 8 !s.;C, 77,777, k 8 ;CK. 3, 5 and 6 at their most likely values are !s.E77, !s. ;C7 and ?7,777 units. 2T4 shall take different values within its rangeS say E7K, E?.CK, ECK, EB.CK and @7K. /or each of these C values of T, =35 will be worked out and sensitivity of =, be analysed. /irst let T be E7K. The annual cash flow isJ 8 9)3*5( 6 * / * #: )T*T( < # 8 9)!s.E77*!s.;C7( ?7777units*!s.;C, 77,777Q!s.L, 77,777:);*E7K( < !s.L, 77,777 8 9!s.E7, 77,777 Q!s. ?;,77,777: )7.B7( <!s. L,77,777 8 !s.A, 77,777)7.B7( <!s. L,77,777 8 !s. ;?,E7,777 pa =35 8 )!s.;?,E7,777 D ;.;C <!s.;?,E7,777D;.;C? <!s.;?,E7,777 D l.;CE( Q!s.;M,77,777 8 !s. ?M,7M,ELA *!s. ;M,77,7778 !s. ;7,7M,ELA 1et T be E?.CK. The annual cash flow isJ

8 9)3*5( 6 * / * #: )0*#( <# 8 9)!s.E77*!s.;C7( ?7777 units*!s. ;C,77,777 Q!s.L, 77,777: );*E?.CK( < !s.L, 77,777 8 9!s.E7, 77,777 *!s. ?;,77,777: )7.LBC( <!s. L,77,777 8 !s.A, 77,777)7.LBC( <!s. L,77,777 8 !s. ;?,7B,C77 p.a =35 8 )!s.;?,7B,C77D;.;C < !s.;?, 7B,C77D;.;C? < !s.;?,7B,C77D;.;CE( Q

!s.;M,77,777 8 !s.?B, CL,AA@ Q !s.;M,77,777 8 !s. A,CL,AA@ 1et T be ECK the annual cash flow isJ 8 9)3*5( 6 * / * #: )0*#( <# 8 9)E77*;C7( ?7777P ;C,77,777 P L,77,777: );*ECK( < L,77,777 8 9E7,77,777 P ?;,77,777: )7.LC( U L,77,777 8 A,77,777)7.LC( < L,77,777 8 !s. ;;,MC,777 p.a =35 8 )!s.;;, MC,777D;.;C<!s.;;, MC,777D;.;C?<!s.;;, MC,777D;.;C(* !s.;M, 77,777 8 !s. ?B,7C,L?? Q !s.;M, 77,777 8 !s. A,7C,L?? 1et T be EB.CK. The annual cash flow isJ 8 9)3*5( 6 * / * #: )0*#( <# 8 9)!s.E77*!s.;C7( ?7777 units*!s.;C, 77,777 Q!s. L,77,77: );* EB.CK( <!s. L,77,777 =35 8 )!s.l?, E7,77 < !s.;?, E7,777D;.;C? < !s.;?, E7,777Dl.lC(*!s.;M, 77,777 8 !s. ?M,7M,ELA Q!s. ;M,77,7778 !s. ;7,7M,ELA 1et T be E?K. The annual cash flow isJ 8 9)3*5( 6 * / * #: )0*#( <# 8 9)!s.E77*!s.;C7( ?7777 units*!s.;C, 77,777 Q!s.L,77,777: );* E?.CK( <!s. L,77,777

8 9!s.E7, 77,777 Q!s.?;, 77,777: )7.LBC( < !s.L, 77,777 8 A,77,777)7.LBC( < L,77,777 8 !s. ;?,7B,C77 p.a =35 8 )!s.;?, 7B,C77D;.;C<!s.;?, 7B,C77D;.;?<!s. ;?,7B,C77D;.;C( * !s.;M, 77,777 8 !s.?B, CL,AA@ Q !s.;M, 77,777 8 !s. A,CL,AA@VVV. 1et T be ECK the annual cash flow isJ 8 9)3*5(6 * / * #: )0*#( <# 8 9)E77*;C7( ?7777P ;C,77,777 P L,77,777: );*ECK( < L,77,777 8 9E7,77,777 P ?;,77,777: )7.LC( U L,77,777 8 A,77,777)7.LC( < L,77,777 8 !s. ;;,MC,777 p.a =35 8 );;,MC,777D;.;C < ;;,MC,777D;.;C? < ;;,MC,777D;.;C(P ;M,77,777 8 ?B,7C,L?? * ;M,77,777 8 !s. A,7C,L?? 1et T be EB.CK. The annual cash flow isJ 8 9)3*5(6 * / * #: )0*#( <# 8 9)E77*;C7( ?7777 P ;C,77,777 P L,77,.744: );*EB.CK( < L,77,777 8 9E7,77,777P?;,77,777: )7.L?C( < L,77,777 8 !s. ;;,L?,C77 p.a =35 8 );;,L?,C77D;.;C < ;;,L?,C77D;.;C? < ; ;,L?,C77D;.;CE(P ;M,77,777 8 ?L,C@,?@A * ;M,77,777 8 !s. M,C@,?@A 8 9E7,77,777 * ?;,77,777: )7.L7( < L,77,777 8 A,77,777 )7.L7( < L,77,777 8 !s. ;;,@7,777 p.a =35 8 )!s.;;, @7,777D;.;C<!s;;, @7,777D;.;C?<!s.;;,@7,777Dl.;CE(*;M,77,777 8 !s.?L, 7?,MBL Q !s.;M,77,777 8 !s. M,7?,MBL

Wou might have noted that as T rises, npv falls. !ate of change in =35 for a given change in T. ,hen T rises to E?.CK )i.e. )7.E?C( from E7K )i.e. 7.E( =35 falls to !s.A,CL,AA@ from !s.;7,7M,ELA. !ate of change 8

,hen T rises to ECK )i.e. )7.EC( from E?.CK )i.e. 7.E?C( =35 falls to !s.A, 7C,L?? from !s.A, CL,AA@.

!ate of change 8

,hen T rises to EB.CK from ECK =35 falls to !s.M,C@,?@A from !s. A,7C,L??

!ate of change 8

,hen T rises to @7K from EB.CK =35 falls to !s.E,7?,M;L falls to !s. M,7?,M;L from !s. M,C@,?@A

!ate of change 8

The rate of >0 in =T45 is rising with the rise in tax rate. %ence, =35 is highly negatively sensitive with tax rate. ,e can study the sensitivity of =35 to 2T4 in the form of a graph, taking =35 on the W axis and 2T4 on the X*axis also. ,e can do the sensitivity analysis of =35 with respect to another uncertain variable, say 23,4 keeping 5, 6 and T at their most likely values, other variables at their fixed values and changing the value of 3 within its given range of values. &imilarly, we can do the sensitivity analysis of =35 with respect to 5, keeping 3. 6 and T at their most likely values, other variables at their fixed values and changing the value of 5 within its given range of values. &o, also we can replicate the sensitivity with respect to 264. =ow, of the @ uncertain variables, namely, 3, 5, 6 and T, with respect to which variable the =35 is most sensitive, can be seen. Nnowledge of the same will help in monitoring the project with respect to those variables very ably. %ence, the utility of sensitivity analysis. Ris' Ret#r+ A+al%sis for M#lti Proje ts ,hen multiple projects are considered together, what is the overall risk of all projects put together- 0s it the aggregate average of standard deviation of =35 of all projects=o, it is not. Then what- =ow another variable has to be brought in to the scene. That is the correlation coefficient between =35s of pairs of projects. ,hen two projects are considered together, the variation in the combined =35 is influenced by the extent of correlation between =35s of the projects in question. $ high correlation results in high risk and vice versa. &o, the risk of all projects put together in the form of combined standard deviation is given by the formulaJ

,here,

sp 8 combined portfolio standard deviation 3ij 8 correlation between =35s of pairs of projects )i and j( si, sj 8 standard deviation of iin and jth projects, i.e., any pair of projects taken at a time. /a.e %o# #+"erstoo"0 ;. bring out the meaning and significance of capital projects. ?. Calculate payback period, $!!, =35 )at k8;7K( and given 0!!.