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 RISK IN CAPITAL
BUDGETING AND TIME
VALUE OF MONEY
Presented By
N oman
A nil
F ahad
A dil
Investors Main Strategies
 Simple & Compound Interest

Simple Interest:
Interest continues to accrue over a period of time at a given rate.

SI = P(r)(n)

Compounding of interest:
compensation for the investor not actually receiving interest periodically.

A = P (1+ r)n
 Future & Present value

Future Value:
Value that money will acquire in future, if compounded at a given rate of return.

FV = PV (1+r)n

Present Value:
Value of money that is expected in future, today.

PV = FV/ (1+r)n
 What is Capital Budgeting?

Capital budgeting is used to determine the requirements of

the long-term investments of a company. Examples of
long-term investments are those required for replacement
of equipments and machinery.
Purpose…
Planning for Capital Assets
 Approaches

NPV:
If we consider a series of cash flows, and compute present values of all the
cash flows at a particular discounting rate, and then sum up the present
values, the result is called net present value.
NPV = CF0 – (CF1/(1+r)1 +CF2/(1+r)2+ .....+CFn/(1+r)n)

IRR:
The word internal or implicit is only to state that on the face of it, the rate was not explicit.

IRR is the rate where NPV = 0

NPV = 0 = CF0 – (CF1/(1+r)1 +CF2/(1+r)2+ .....+CFn/(1+r)n)
Or; CF0 = (CF1/(1+r)1 +CF2/(1+r)2+ .....+CFn/(1+r)n)
 Approaches

Profitability Index:
A ratio of whether and how much an investment will result in a profit. It is
calculated by taking the NPV of expected future cash flows from an
investment and dividing by the investment's original cost. A ratio above one
indicates that the investment will be profitable, while a ratio below one
means that it will not.
PI=PV of future cash flows/ Initial Investment

Payback Period:
The length of time it takes to recover the cost of an investment. It is
calculated as shown here:
PB= Cost of Project/ Annual Cash Inflows
 Relevant Risks in Capital Budgeting

 Stand-alone risk
 Corporate risk
 Market (or beta) risk
 Stand-Alone Risk

The project’s risk if it were the firm’s

only asset and there were no
shareholders.
Ignores both firm and shareholder
diversification.
Measured by the σ or CV of NPV, IRR,
or MIRR.
 Corporate Risk

Reflects the project’s effect on

corporate earnings stability.
Considers firm’s other assets
(diversification within firm).
Depends on:
project’s σ, and
its correlation with returns on
firm’s other assets.
Measured by the project’s corporate
beta.
 Market Risk

Reflects the project’s effect on a well-

diversified stock portfolio.
Takes account of stockholders’ other
assets.
Depends on project’s σ and correlation
with the stock market.
Measured by the project’s market beta.
Risk Analysis in Capital Budgeting

 Scenario Analysis
 Simulation Analysis
Decision Tree Analysis
 Scenario Analysis

 Examines several possible situations,

usually worst case, most likely case, and
best case.
 Provides a range of possible outcomes.
Examples

Scenario Probability NPV(000)

Worst 0.25 $ 15
Base 0.50 82
Best 0.25 148

E(NPV) = $ 82

σ(NPV) = 47

CV(NPV) = σ(NPV)/E(NPV) = 0.57

Since CV = 0.57 > 0.4, this project has high risk.

 Simulation Analysis

• A computerized version of scenario analysis which

uses continuous probability distributions.
• Computer selects values for each variable based
on given probability distributions.
Example

• NPV and IRR are calculated.

• Process is repeated many times (1,000 or more).
• End result: Probability distribution of NPV and IRR based on
sample of simulated values.
• Also gives σNPV, CVNPV, probability of NPV > 0.
NOMAN USMAN

ANIL SALEEM

FAhAD ALI

ADIL RAhMAN