HITESH VERMA

50614901717
BBA(G) SEC(B) SHIFT (1)
PROJECT MANAGEMNET
ASSIGNMENT

Q. What techniques are used in for risk and uncertainty analysis of

any project? Explain them briefly with suitable examples?
Q.2 Define Social Cost Benefit Analysis (SCBA)? Explain the UNIDO
Approach and LM approach of SCBA?
Q.3 Define Capital Budgeting? Explain the various discounting and
non-discounting techniques of capital budgeting?

ANSWER
Ans.1 The following points highlight the four popular techniques for
measuring risk and uncertainty in different projects. The techniques
are: 1. Risk Adjusted Discount Rate Method 2. The Certainty
Equivalent Method 3. Sensitivity Analysis 4. Probability Method.
Technique # 1. Risk Adjusted Discount Rate Method:
This method calls for adjusting the discount rate to reflect the degree
of the risk and uncertainty of the project. The risk adjusted discount
rate is based on the assumption that investors expect a higher rate of
return on risky projects as compared to less risky projects. The rate
requires determination of:
(i) Risk free rate -Risk-free rate is the rate at which the future cash
inflows should be discounted. It is the borrowing rate of the investor.
(ii) Risk premium rate -Risk premium rate is the extra return
expected by the investor over the normal rate. The adjusted discount
rate is a composite discount rate. It takes into account both time and
risk factors. In this technique, the discount rate is raised by adding a
risk margin in it while calculating the NPV of a project. For example, if
the rate of discount is 10% for the project, it may be raised to 11% by
adding 1% to take account of risks and uncertainties. The increased
discount rate will reduce the discount factor, thereby lowering the
NPV. Thus the project would be judged as undesirable. This method
is used for ranking of risky projects. But the problem with this
method is that there is no ‘specified margin’ which should be added
to the free risk rate.
Technique # 2. Hillier Model
According to this method, the estimated cash flows are reduced to a
conservative level by applying a correction factor termed as certainty
equivalent coefficient. The correction factor is the ratio of riskless
cash flow to risky cash flow.
The certainty equivalent coefficient which reflects the management’s
attitude towards risk is :
Certainty Equivalent Coefficient = Riskless Cash Flow/Risky Cash
Flow. If a project is expected to generate a cash of Rs. 40,000, the
project is risky. But the management feels that it will get at least a
cash flow of Rs. 24,000. It means that the certainty equivalent
coefficient is 0.6.
Under the certainty equivalent method, the net present value is
calculated as:
Where αt = Certainty Equivalent Coefficient
At = Expected Cash Flow for year t
I = Initial outlay on the project
i = Discount rate

Technique # 3. Sensitivity Analysis:

The future is not certain and involves uncertainties and risks. The
cost and benefits projected over the lifetime of the project may turn
out to be different. This deviation has an important bearing on the
selection of a project.
If the project can stand the test of changes in the future, affecting
costs and benefits, the project will be selected. The technique to find
out this strength of the project is covered under the sensitivity
analysis of the project. This analysis tries to avoid overestimation or
underestimation of the costs and benefits of the project.
In sensitive analysis, a range of possible values of uncertain costs and
benefits are given to find out whether the projects desirability is
sensitive to these different values. In this analysis, we try to find out
the critical elements which have a vital bearing on the costs or
benefits of the project.
In investment decision, one has to consider as many elements of
uncertainty as possible on costs or benefits side and then arrive at
critical elements which affect the expected costs or benefits of the
project. How many variables should be tested to carry out the
sensitivity analysis in order to find out its impact on costs or benefits
of the projects. It is a matter of judgement. In sensitivity analysis, one
has to consider the changes in the various factors correlated with
changes in the other. In order to arrive at the degree of uncertainty,
the decision maker has to make alternative calculation of costs or
benefits of the project.
When there are several uncertain outcomes, three cost-benefit
calculations are made in this analysis:
(i) The most pessimistic where all the worst possible outcomes are
estimated.
(ii) The most likely where all the middle of the range outcomes are
estimated.
(iii) The most optimistic where all the best possible outcomes are
estimated.
It explains how sensitive the cash flows are under these three
different situations. If the difference is larger between the optimistic
and pessimistic cash flows, the riskier is the project. The most likely
outcome can give a good guide to how ‘borderline’ is the project.
Technique # 4. Probability Method:
Another method for dealing with risks and uncertainties is to
estimate the probable value for a result. Here one has to see a range
of possible cash flows from the most optimistic to the most
pessimistic for each pertinent year. Probability means the likelihood
of happening of an event. It is the proportion of times an event
occurs i.e. its frequency. It is the ratio of favorable number of events
to the total number of events.
In a particular situation, if all possible outcomes of an event are listed
and the probability of occurrence is assigned to each outcome, it is
called a probability distribution. For any probability distribution there
is an expected value. The expected value is the weighted average of
the values associated with the various outcomes, using the
probabilities of outcome as weights.
If NPV1 NPV2 and NPV3 are three possible estimates of the net
present value of a project under uncertainty, and’ the probability of
each outcome of NPV is P1 P2 and P3 then the expected net present
value is:

Ev (NPV) = P1 (NPV1) + P2 (NPV2) + P3 (NPV3).

This method is conceptually sound. But it lacks objectivity as it is not
possible to find out the probabilities of different outcomes.
Technique # 5. Decision tree analysis
It is a powerful decision-making tool which initiates a structured
nonparametric approach for problem-solving. It facilitates the
evaluation and comparison of the various options and their results,
as shown in a decision tree. It helps to choose the most competitive
alternative. It is a widely used technique for taking crucial decisions
like project selection, cost management, operations management,
production method, and to deal with various other strategic issues in
an organization.
Following steps simplify the interpretation process of a decision tree:
-The first step is understanding and specifying the problem area for
which decision making is required.
-The second step is interpreting and chalking out all possible
solutions to the particular issue as well as their consequences.
-The third step is presenting the variables on a decision tree along
with its respective probability values.
-The fourth step is finding out the outcomes of all the variables and
specifying it in the decision tree.
-The last step is highly crucial and backs the overall analysis of this
process. It involves calculating the EMV values for all the chance
nodes or options, to figure out the solution which provides the
highest expected value.
Decision Tree Analysis Example To enlighten upon the decision tree
analysis, let us illustrate a business situation.
ABC Ltd. is a company manufacturing skincare product. It was found
that the business is at the maturity stage, demanding some change.
After rigorous research, management came up with the following
decision tree:
In the above decision tree, we can easily make out that the company
can expand its existing unit or innovate a new product, i.e., shower
gel or make no changes.

Ans 2. The foremost aim of all the individual firm or a company is to

earn maximum possible return from the investment on their project.
In this aspect project promoters are interested in wealth
maximization. Hence the project promoters tend to evaluate only the
commercial profitability of a project. There are some projects that
may not offer attractive returns as for as commercial profitability is
concerned but still such projects are undertaken since they have
social implications. Such projects are public projects like road,
railway, bridge and other transport projects, irrigation projects,
power projects etc. for which socio-economic considerations play a
significant part rather than mere commercial profitability. Such
projects are analyzed for their net socio-economic benefits and the
profitability analysis which is nothing but the socio-economic cost
benefit analysis done at the national level. All the projects impose
certain costs to the nation and produces certain benefits to the
nation. The cost may be of two types i.e. direct cost and indirect cost.
In this respect the benefit derived from any project will also be of
two types i.e. direct benefits and indirect benefits.
The social cost benefit analysis is a tool for evaluating the value of
money, particularly of public investments in many economies. It aids
in decision making with respect to the various aspects of a project
and the design programs of closely interrelated project. Social cost
benefit analysis has become important among economists and
consultants in recent years.
Features of Social Cost Benefit Analysis
-Assessing the desirability of projects in the public as opposed to the
private sector
-Identification of costs and benefits
-Measurement of costs and benefits
-The effect of (risk and uncertainty) time in investment appraisal
-Presentation of results – the investment criterion.
-Stages of Social Cost Benefit Analysis of a Project
-Determine the financial profitability of the project based on the
market prices.
-Using shadow prices for the resources to arrive at the net benefit of
the project at economic process.
-Adjustment of the net benefit for the projects impact on savings and
investment.
-Adjustment of the net benefit for the projects impact on income
distribution.
-Adjustment of the net benefit for the goods produced whose social
values differ from their economic values.
Limitations of Social Cost Benefit Analysis
Social cost benefit analysis suffers from the following limitations.
-The problems of qualification and measurement of social costs and
benefits are formidable. This is because many of these costs and
benefits are intangible and their evaluation in terms of money is
bound to be subjective.
-Evaluation of social costs and benefits has been completed for one
project, it may be difficult to judge whether any other project would
yield better results from the social point of view.
-The nature of inputs and outputs of projects involving very large
investment and their impact on the ecology and people of the
particular region and the country as a whole are bound to be
differing from case to case.
UNIDO's approach
UNIDO’S approach: overcoming the challenges CSR poses on SMEs
Governments have not yet reached consensus on common
approaches to CSR, which has meant that the “rules” are being set
de facto by the companies embracing it, and these are mostly large
Transnational Companies (TNCs). As a result, SMEs, especially those
in developing countries and countries in transition, find themselves
confronted with approaches to CSR that are often very incompatible
to their economic and social contexts. Yet, they cannot afford to
ignore CSR, since the very same TNCs that are pushing the CSR
agenda hardest are also their clients. This situation attracted the
attention of UNIDO, which for many years has been at the forefront
of supporting the development of small and medium enterprises in
developing countries and economies in transition. Recognizing the
need of meeting the specific requirements of SMEs with regard to
CSR, UNIDO became the fifth core UN agency in the Global Compact
in 2003. It was primarily within this context that UNIDO has
formulated its approach for the promotion of CSR as a means
towards increased productivity and competitiveness of developing
economies. UNIDO further has a leading role within the UN system in
terms of supporting environmentally and socially responsible
entrepreneurship through its training capacities and support tools
for enterprises and through the UNIDO/UNEP network of
National Cleaner Production Centers (NCPCs).
In its CSR Projects, UNIDO usually targets one or more of the
following levels:
*Micro-level: Assistance on the micro-level involves direct support to
a group of companies belonging to the same sector, region, cluster,
supply chain, etc. Due to limited outreach and up-scaling effects, this
level is targeted only on a pilot basis for demonstration and CSR case
building purposes.
*Meso-level: Support on this level focuses on business support and
advisory institutions (public or private) that aim at expanding their
service portfolio and strengthening their institutional capacity. In this
context, UNIDO provides assistance to these intermediary
institutions to foster the uptake CSR concepts in their sphere of
influence.
*Macro-level: On the macro level, UNIDO involves in the field of CSR
related policy work with a view to support government institutions in
determining what public policies best support a country’s private
sector in its efforts to apply socially and environmentally responsible
business practices.
At the heart of UNIDO’s CSR programmer is the Responsible
Entrepreneurs Achievement Programmer (REAP), which supports
SMEs in implementing responsible business practices by building up
a worldwide network of trained and qualified UNIDO CSR
consultants.
LM Approach
Economic welfare is a subject in which rigor and refinement is
probably worse than useless. Rough theory, or good common sense,
is, in practice, what we require. It is satisfying, and impressive, that a
rigorous logical system, with some apparent reality, should have
been set up in the field of social sciences: but we must not let
ourselves be so impressed, that we forget that its reality is obviously
limited; and that the degree of such reality is a matter of judgement
and opinion. (Concluding sentences in I. M. D. Little, A Critique of
Welfare Economics, Oxford: Clarendon Press, 1950.) for the man of
education will seek exactness so far in each subject as the nature of
the thing admits ... (Aristotle, Nicomachean Ethics, 1094b). IT IS not
uncommon in the history of positive and normative economic
doctrine for a new law or a new rule to be announced which is
interesting and appears to reveal something important. Under the
impact of criticisms (including self-criticisms), the law or the rule is
qualified, refined, redefined and reformulated until it becomes a
tautology. The original, non-tautological proposition is now seen to
be false, though illuminating; the reformulated, redefined, qualified
proposition to be true, though tautological. Yet, the proposition and
others derived from it survive because they draw strength from
swinging in an indeterminate manner between falsehood and
tautology. In the area of positive economics, the assumption of profit
maximization, the equation of marginal revenue to marginal cost,
and the theories of the firm derived from these premises, may serve
as illustrations. In optimizing theory, the L-M (Little-Merles) method
of project appraisal in some respects resembles this procedure.
When it has 'body' and substance, when it is applicable and practical,
it is open to certain objections, most of them seen by the authors
themselves. When it is provisos, 'footnotes' and qualifications, it
tends to retreat into tautology. The paradigm, to which L-M
methods2 apply perfectly, is a project which has its impact on
international trade and local labour, but does not affect production
elsewhere in the economy. The impact of such a project may then be
assessed in terms of extra imports or reduced exports (for the direct
inputs of the project and extra consumption of those directly
employed) and additional exports or reduced imports (output)
caused directly and indirectly by the project. The position is
complicated by the introduction of non-tradable, but so long as
constant returns prevail, their cost may, by a process of iteration, be
translated into international prices. In such a case the application of
L-M methods requires prediction of shadow wage rates, the
Accounting Rate of Interest (ARI) and international prices. Infinite
elasticities are not necessary but ascertain ability is and anything less
than perfect elasticities destroys the neat distinction between
tradables and non-tradables since whether a good is traded or not
will not then be independent of production decisions, depending
only on transport costs, but will also depend on the quantities
concerned. There is room for disagreement about the values to be
attributed to the shadow wage rate (as, for example, in the
discussion below) and the ARI - but this is not disagreement about
the principles of the method but the judgements to be embodied in
that method. The free trade zones to be found in some countries,
like Taiwan, Mexico or the Irish Republic, most nearly resemble the
above paradigm. The claim made, in applying such methods more
widely, is that the paradigm also applies on a wide -possibly universal
- scale; i.e. that for traded goods (which are defined to include all
goods that 'would be traded' given 'optimal' trade policies) the
impact of a project is on trade and not on domestic activities; for
non-traded goods constant returns prevail and the impact may also
be ultimately split into the effect on labour and on international
trade. Those who feel that L-M methods do not contain the whole
answer to project selection and development do so because they
believe the paradigm does not universally (or even in most cases)
apply. The L-M methods may themselves be stretched to cover some
(possibly).

Ans.3 Capital budgeting is a company’s formal process used for

evaluating potential expenditures or investments that are significant
in amount. It involves the decision to invest the current funds for
addition, disposition, modification or replacement of fixed assets.
The large expenditures include the purchase of fixed assets like land
and building, new equipment’s, rebuilding or replacing existing
equipment’s, research and development, etc. The large amounts
spent for these types of projects are known as capital expenditures.
Capital Budgeting is a tool for maximizing a company’s future profits
since most companies are able to manage only a limited number of
large projects at any one time. Capital budgeting usually involves
calculation of each project’s future accounting profit by period, the
cash flow by period, the present value of cash flows after considering
time value of money, the number of years it takes for a project’s cash
flow to pay back the initial cash investment, an assessment of risk,
and various other factors. Capital is the total investment of the
company and budgeting is the art of building budgets.
FEATURES OF CAPITAL BUDGETING
1) It involves high risk
2) Large profits are estimated
3) Long time period between the initial investments and estimated
returns
CAPITAL BUDGETING PROCESS:
A) Project identification and generation:
The first step towards capital budgeting is to generate a proposal for
investments. There could be various reasons for taking up
investments in a business. It could be addition of a new product line
or expanding the existing one. It could be a proposal to either
increase the production or reduce the costs of outputs.
B) Project Screening and Evaluation:
This step mainly involves selecting all correct criteria to judge the
desirability of a proposal. This has to match the objective of the firm
to maximize its market value. The tool of time value of money comes
handy in this step.
Also the estimation of the benefits and the costs needs to be done.
The total cash inflow and outflow along with the uncertainties and
risks associated with the proposal has to be analyzed thoroughly and
appropriate provisioning has to be done for the same.
C) Project Selection:
There is no such defined method for the selection of a proposal for
investments as different businesses have different requirements.
That is why, the approval of an investment proposal is done based on
the selection criteria and screening process which is defined for
every firm keeping in mind the objectives of the investment being
undertaken. Once the proposal has been finalized, the different
alternatives for raising or acquiring funds have to be explored by the
finance team. This is called preparing the capital budget. The average
cost of funds has to be reduced. A detailed procedure for periodical
reports and tracking the project for the lifetime needs to be
streamlined in the initial phase itself. The final approvals are based
on profitability, Economic constituents, viability and market
conditions.
D) Implementation:
Money is spent and thus proposal is implemented. The different
responsibilities like implementing the proposals, completion of the
project within the requisite time period and reduction of cost are
allotted. The management then takes up the task of monitoring and
containing the implementation of the proposals.
E) Performance review:
The final stage of capital budgeting involves comparison of actual
results with the standard ones. The unfavorable results are identified
and removing the various difficulties of the projects helps for future
selection and execution of the proposals.
DISCOUNTING METHOD TECHNIQUES
Capital Budgeting Discounted Method # 1. Net Present Value
Method:
The net present value method is a modern method of evaluating
investment proposals. This method takes into consideration the time
value of money and attempts to calculate the return on investments
by introducing the factor of time element. It recognises the fact that
a rupee earned today is worth more than the same rupee earned
tomorrow. The net present values of all inflows and outflows of cash
occurring during the entire life of the project is determined
separately for each year by discounting these flows by the firm’s cost
of capital or a pre-determined rate.
Steps to Be Followed for Adopting Net Present Value Method The
following are necessary steps to be followed for adopting the net
present value method of evaluating investment proposals:
(i) First of all determine an appropriate rate of interest that should
be selected as the minimum required rate of return called ‘cut -off
rate or discount rate. The rate should be a minimum rate of return
below which the investor considers that it does not pay him to
invest. The discount rate should be either the actual rate of interest
in the market on long-term loans or it should reflect the opportunity
cost of capital of the investor.
(ii) Compute the present value of total investment outlay, i.e. cash
outflows at the determined discount rate. If the total investment is
to be made in the initial year, the present value shall be the same as
the cost of investment.
(iii) Compute the present values of total investment proceeds,/.e.,
cash inflows, (profit before depreciation and after tax) at the above
determined discount rate.
(iv) Calculate the net present value of each project by subtracting the
present value of cash inflows from the present value of cash outflows
for each project.
(v) If the net present value is positive or zero, i.e, when present value
of cash inflows either exceeds or is equal to the present values of
cash outflows, the proposal may be accepted. But in case the present
value of inflows is less than the present value of cash outflows, the
proposal should be rejected.
(vi) To select between mutually exclusive projects, projects should be
ranked in order of net present values, i.e. the first preference should
be given to the project having the maximum positive net present
value.
Capital Budgeting Discounted Method # 2. Internal Rate of Return
Method:
The internal rate of return method is also a modern technique of
capital budgeting that takes into account the time value of money. It
is also known as ‘time adjusted rate of return’ discounted cash flow’
‘discounted rate of return,’ ‘yield method,’ and ‘trial and error yield
method’. In the net present value method the net present value is
determined by discounting the future cash flows of a project at a
predetermined or specified rate called the cut-off rate. But under the
internal rate of return method, the cash flows of a project are
discounted at a suitable rate by hit and trial method, which equates
the net present value so calculated to the amount of the investment.
Under this method, since the discount rate is determined internally,
this method is called as the internal rate of return method. The
internal rate of return can be defined as that rate of discount at
which the present value of cash-inflows is equal to the present value
of cash outflows.

Capital Budgeting Discounted Method # 3. Profitability Index

Method:
It is also a time -adjusted method of evaluating the investment
proposals. Profitability index also called as Benefit-Cost Ratio (B/C) or
‘Desirability factor’ is the relationship between present value of cash
inflows and the present value of cash outflows.
The net profitability index can also be found as Profitability Index
(gross)minus one. The proposal is accepted if the profitability index is
more than one and is rejected in case the profitability index is less
than one. The various projects are ranked under this method in order
of their profitability index, in such a manner that one with higher
profitability index is ranked higher than the other with lower
profitability index.
Capital Budgeting Discounted Method # 4. Terminal Value Method:
The terminal value method is an improvement over the net present
value method of making capital investment decisions. Under this
method, it is assumed that each of the future cash flows is
immediately reinvested in another project at a certain (hurdle) rate
of return until the termination of the project. In other words, the net
cash flows and outlays are compounded forward rather than
discounting them backward as followed in net present value (NPV)
method. In case of a single project, the project is accepted if the
present value of the total of the compounded reinvested cash
inflows is greater than the present value of the outlays, otherwise it
is rejected. In case of mutually exclusive projects, the project with
higher present value of the total of the compounded cash flows is
accepted. The terminal value method can be further extended to
calculate the Terminal Rate of Return (also called Modified Internal
Rate of Return) to overcome the shortcomings of the internal rate of
return (IRR) method. The terminal rate of return is the compound
rate of return, that, when applied to the initial outlay, accumulates
to the terminal value. This method is presently being used in
advanced countries like U.S.A.
Non-Discounted Cash Flow Criteria:
These are also known as traditional techniques:
(a) Pay Back Period (PBP):The pay back period (PBP) is the traditional
method of capital budgeting. It is the simplest and perhaps, the most
widely used quantitative method for appraising capital expenditure
decision. It is the number of years required to recover the original
cash outlay invested in a project. Methods to compute PBP:
There are two methods of calculating the PBP.
(a) The first method can be applied when the CFAT is uniform. In
such a situation the initial cost of the investment is divided by
the constant annual cash flow: For example, if an investment
of Rs. 100000 in a machine is expected to generate cash inflow
of Rs. 20,000 p.a. for 10 years. Its PBP will be calculated using
following formula
(b) The second method is used when a project’s CFAT are not
equal. In such a situation PBP is calculated by the process of
cumulating CFAT till the time when cumulative cash flow
becomes equal to the original investment outlays.

Decision Rule:
The PBP can be used as a decision criterion to select investment
proposal. If the PBP is less than the maximum acceptable payback
period, accept the project. If the PBP is greater than the maximum
acceptable payback period, reject the project. This technique can be
used to compare actual pay back with a standard pay back set
up by the management in terms of the maximum period during
which the initial investment must be recovered. The standard PBP is
determined by management subjectively on the basis of a number of
factors such as the type of project, the perceived risk of the project
etc. PBP can be even used for ranking mutually exclusive projects.
The projects may be ranked according to the length of PBP and the
project with the shortest PBP will be selected.
Merits:
1. It is simple both in concept and application and easy to calculate.
2. It is a cost-effective method which does not require much of the
time of finance executives as well as the use of computers.
3. It is a method for dealing with risk. It favours projects which
generates substantial cash inflows in earlier years and discriminates
against projects which brings substantial inflows in later years. Thus
PBP method is useful in weeding out risky projects.
4. This is a method of liquidity. It emphasizes selecting a project with
the early recovery of the investment.