Capital Budgeting-Il 311

Table 12-6 Sensitivity analysis:'Sensor Corponation each scenario, and finally, compute the NPV under each scenario.
(Ffuures h Rs) The expected value of the NPV is the measure of the potential
ofthe project, The risk ofthe project cari be assessedthrough
its standard deviation or the coefficient of variation @xpected
NPV / Stadard deviation).
As an example, consider five different sceirarios for Sensor
Cornor:afion denoferl ss excellF-arf onrvl notm-al hcd qnd wonf
htal htrcfittent(Rs) 8,0m 8,ffi 8,0m 8,0m 8,000
Under each of the five scenarios with changes in the four
UbdteEql€d variables ofdemand, selling price, variable cost and overheads
'' (Ycra) 10 10 10 10 10
from the.projections made earlier in the firs(column of Table
DbcotrilRab 15)o/o 1\Yo 16.5% 15o/o 1,SYo
l2-7 are presented below:
Opsrding tad
';'flG.) 3,000 3,000 3,000 3,000 ' 3,000 - 'Table12-7 Scenario descripti0n: Sensor Corporation
8dft0 Pdoo (Rs) 3.20 3.20 3.20 3.20 3.20

Revenue 9,UUU Y,0W 9,buu Y,UUU v,buu '

Variable Cost 5,400 5,400 5,400 5,940 5,400 Demand Level (Nos.) +10o/o +5o/o 3,000 -SYo -10o/o '

Contibution 4,200 4,200 4,2N 3,660 4,200 Selling Price (Rs/unit) + 5o/o Sarne 3n -5Yo =10o/o
Exed Costs . 1,200 1,200 1,m0 .1;200 1,32tr Variable Cost (Rs) +10o/o Sanp 5,400 Sarne +10o/o'
Depreciation 1,200 1,320 1,200 1,200 1,200 Overtreads + 5o/o -5o/o 1Zffi +10o/o +20o/o
PBIT . 1,800 1,800 ,,ry 't,680
lnterest ',uI Under each scenario, the NPVa is calculated in faUte fj-S.
PBT 1,8m 1,680 1,800 1,260 1,680 With the estimated probabilities to each scenario the expected
-7n
Tax 720 672 504 672 NPV of the project is Rs 1,978 as against NPV of Rs 3,443 rnder
'
PAT" 1,080 1,008 1,080 756 1,008 'normal' scenario. Due to the interplay and compounding of
Gash Flow from variables the effects onNPV become skewed and the risk cannot
.l,956
' op6ations 2,280 2,329 2,280 2,208 be measured from the change in NPV per unit'of change in the
ilet Prceenl Value 3,143 2,EU 2,818 1,817 3,081 independent variable, as was measured under sensitivity
Sensltlvity analysis.
urlarEE ur Nrv ru
1% drange in he 1 Table l2-8 ,scenario analysis: Sensor Corporation

vadaHe (s6) (63) (163) (36) I (Figures in Rs unless gecflieo)

% change in NPV lrfiial lnvestnent 8,0m 8,000 8,0m 8,000 8,m0

br-1% change in Life of he goject (Years) 10 10 10 10 10
15Io ' 1596
tp vadable -1.620/o -1.82% 4.720/o -1.050/o
Disccxint Rate 15olo 15o/o, 15o/o

SCENARIO Excelleil Good Norma 'Bad Worst

SCENARIO ANALYSIS Operating Level (Nos,) 3,3m 3,150 .3,m0 2,850 27fi
Selling Price 3.36 3.m 320 3.04 2.88
While sensitivity analysis.is the most widely used tool of Revenue 11,088 9,450 9,6m 8,664 7,n6
assessing the risk of the project, the minagers are often Variable Cost 5,940 5,4m 5,4m 5,400 5,940
interested in knowing how the project Coffiihnbn 5,148 4,050 4,2@ 3& 1,836
would behave if several variables change Fixed Costs 1260 1,140 1N 1,320 1,m
at the same time. The scenario analysis Oepre*ttion 1200' 1N 1N 12fi 1N
is a tool that overcomes the limitation of PBIT .2,689 1,710 1,800 744 (804)

the sensitivity analysis as the variables lnterest

are stongly correlated with each other, PBT 2,688 1,710 1,800 * (804)

i.e., a change in one is often linked with Tax @ 40o/o 1,075 684 7n m tw)
the change in another variable, it is PAT 1,613 1,U26 1,080 446 (482)
Gash Flow from
to analyse the impact of
necessary
changes in several parameters, @rations 1813 2,26 zm 1,646 718
Present Value of
simultaneously..For example, if the market.
,is good the firrn may be able to charge higher price and yet sell
Cash in flows / 14.117 11.172 't1.443 I 263 3 60{
Net Present Vafue 6,117 3.1n 3.443 263 td399)
more quantity. On the oontrary, if the product has a bad price in Probabili$ (%) 15% zWe . 3{l|lo 2V/o 15f:/o
the market then its quantity sold would be lower than expected.
Tho,rgh in the projections of cash flows, the price and quaotity Expected NPV t,97E
ulanoarc uevEuon oT Nrv 'lru,,
sold inay form two independent assurnptions but they may be
Coeficientof Variation 031
closely related in reality so as to overly underestimate or
overestimate the cash flows. aWhat applies to sensitivity analysis also applies to
scenario analysis.
- DuG b s stroqg oonelation smong tre vrriables determining
lh! cash flows, managerg mrut first visualize a broad scenario
We may exarnine the change in IRR v/ith each scenario as measure of
risk but we continue with NPV due to its established superiority over
x'ith ib likelihoo4 666 resign a valuc to all thc variables under IRR as method of evaluation of capital budgeting proposals.

L-_
312 Financial Management

To have a more clear view of rislq lve may compute the SIMULATION ANALYSIS
expectedNPVs by assiping probabilities to different scenarios.
The expected NPV, given by Equation l2-3, of Sensor Known as tle Monte Carlo simulation, this technique tries 3g

Corporation is: overcome the objectionwith scenario analysis. The Monte Carlo
simulation is inathernatically complex and can't be considered
ExpectedNPV : Lo,x NPY (123) as a zuitable tgchnique if computers-are not available. Monte
I Carlo simulation slmthesizes a sufficiently large number of
= (0.15 x6,117)+ (0.20x'3,172) combinations of varieibles of a project with respective MVs,
+ (0.30 x 3,43) + (0.20 x 263) with a large number of possible NPVs becoming statistically
-(0.15 x4,39) more reliable to assess expected value and risklof the project.
)" = Rs 1,978 Monte Carlo simulation is done with following steps:
For measr.uement of aggr:egate risk in the project \ile rnay 1. Identiff the exogenous variables that determine'the cash
gompute the variance or standard deviation or coefficient of flows of the project and its NPV. We also need to deten-trine
variation. These are computed below using Equation 124: how each variable is related to NPV. These variables are
normally demand, selling price, variable cost, etc. of the
Variance :2p, x(&-
5
X)2 (124\ project and are beyond the contol of the management.
I 2 $pecify the probability distribution for each of the
whereX,:NPV of the scenario i, -F =ExpectedNPV, exogenous variable.
p, = Probability of scenario i 3. Allocate the random munbers to all the possible values of
Ther"fo.e, the variance ofsggsor corporation is: each variable.
: 0.15 x (6,1 I 7 - LnSf + 020 x Q,172 - 1,978f 4. Pick random numbers for each variable, and for
corresponding values compute the NPV of the project. This
. +0.30 xQA43 - 1,978f + 0.20xQ63 -l,g78f is iteration l.
+ 0.15 x (4,399 -1,978f .

:25,81,45 5. Perform sufficiently large iterations by repeating steps I to

And, the standard deviation : J258144i : 16O7
For finding the relative risk of the project coefficient
variation may be used. As an absolute measiure of rislq variance
or standard deviations are adequate measures. When the projects
bave differ€,nt sizes, differ,ent orpectedNPV anddiffere,nt stadard
deviations they need to be compared for relative risk. The
coefficient of variation provides h partial answer to this problern.
The coefficient of variation for Se,nsor C;orporation is b.St stating
the change in expected NPV p€r unit change in rish is computed
belowusingEquationl2-5:
.-t-.--*-.*....+-
4 and get all the NPVs.
6 Find the mean and standard deviation of the NPVs to make
of assessment of risk of the project.
For Sensor Corporation, we consider ttree variables of
d€m8o4 selling pnoe, and variable cost. For conveiieoce and
illtrstatim purpooe, we hsve assumed a disccte distribution
for all fuee variables. In ac0ral practice, infinitc values of demm4
price, and variable cost sle possible. Depending upon the
probability of occurrence, we assig!
random numbers to each value. Ttris is
done in Table l2-9. Allocation of a range
of rmdom numbers to tbc difrerrm values
is proportional to the gobobility.

Tilq,Kp
t,($* ,1 Now, we pick a eet of random numbat,
one for each variable and frnd the

The major
i#Did:s'i
liiitation of souari/anatygis'is its inat'ility to
(rasr
cor€sponding values of the variables.
For ttese values basod on the random
consider sufficiently large number of sce,narios to reasonably numbers picked we compute the MV.
assess tue expected value of NPV and its variability.

Table l2-9 Simulation: Sensor Corponation

 Capital Budgeting-Il 313

i
Table 12-10 illustates the rairdom numbers picked that determine The.simulation of NPVs and the measurement of expected
:+ the values of the variables for the iteration of NPV calculation. values and the risks are closest to realJife.situations as it
For example, as the first draw of num.bgr, we get 18, 81, and62, recognizes the existence of infinite numerous values and
respectively for the dem-and level, selling price, ant variable combinations, of variables. Besides the statistical accuracy, the
cos! respectively. These r-andom numbers correspond to the basic diffeience in simulation and scenario analysis is in its
d€mand level of 2,700, selling price of Rs 3.15, and variable cost
of Rs 1.80. For these independent variables, we compute the
cash flows and NPV of the project.

Table 12-10 Simulation: Sensor Corporation trot

frcr-it tioHiro itiuity ima=6arf
analysis are beSt overcome in simulation. "iR;.iS
4pHowever, simulation has its own shtirtcomings. Ttie daia
requirettr-eiil*"if hfge
D6mud LtY6a
distributions-of ttc+iria*rrcmfiffiaimsdt io ascatad"
(Nos.)
Further; each'v-dii'alile is treatE6 ds independent of?thCrs;
SdhgPtlco whereas,.in reality'they are intenelatbd. AIib, the Valite dfei;En-
(Rst'n$ a single variabl,ais.dependenl upon its own values in the past.
VflttleCod For example, if the selling price is increased from Rs.3.00 to
@tff Rs 3.15, there is no possibility of it becoming Rs 5 in the next
p€riod" Such a situation is ignorcd by simulation since wery
For the ,three iterations as given in Table 12-10, the it€ration is independent of the previous one. Simulation hopes
computations of NPV are done in Table l2-l l. Depending upon to remove such deficie,nry by increasing the number of iterations,
the accuracy of results desired we determine the number of which adds to the cost and time. kstly, simulation may measur€
iterations to be performed- The larger the iteration, the closer the risk but it does not convey the desirability of acceptance or
would it be to reality. rejection of the p,rojert and for which we need to adopt some
other method, unless we decide to use the expected NPV of the
Table l2-11 Simulation: Sensor drporation simulatisn as decision making tool.

lt@ Itlucfrrsrt(fu)
lfr of tte Fqipd (Yoart)
8,000
10
DECISION TREE ANALYSIS I
DeciSion tee analysis is a tool to arrive at sequential,decisions.
DbqrtRab 150h
Sequeritial decisions are those that involve a series-of decisions
IlattrrdLevel(Nor.) 27fi
SceEHb6 3.'t5

rcpresentation of a complex situation by it down into a

8,505 82fi 9,600
series of clouding
Vadable Cost 4,860 5,7m 5,440
the thought it is advisedto view period
Contitulin 3,645 2,550 4,160
' at a time and the impact The of decision tee
Fixed Cosb f2m 1N 1200
Oepoam 1N 1N 1200 afu not isolated
PBIT 1245 . 150 't,760
lntercst Decision tree name from the graphical
PBT 1245 1fl) 1,760 depiction of a problem risks associated with the
Iu @ 40% 498 m 7W situations by assigning the to each ofthe branches.
PAT 747 $ 1,056 Thrc decision tnee analysis the risk element associated
)") 1,94r rr90 zffi with the decisions and a c\rme event. For sxamFle, all
cash,flow projectiohs are on& various demand sce,narios.
toyearsIiy.f : t 1;,1/'lu1
Each of the demand
and assignedi
When sufficie,ntly large iteratio,ns ane performed we can get
at any point with
the distribution of the vatiables to check if the random numbers
selected in the iterations generate the probability distribution
may be as.Equation 12-6.
that matches the assumed distibltion For example, if 1,000 tr\
alue of thre CasA flows : IA xS Q2A
iterations are performed, the distibution of demand niust march l'.
whaf is reflected in columri two of Table l2-9. hee is cdnstnrcted wift{l) decidion points,
The mean and standard deviation of NPVs of the simulated the various coirrses of managerial actions\available
iterations will tnrly represent the worth and the risk of the project. point of time, and followed by (2) the chancd',events

lll "t x '?of ( tt t\*" ! 33 t ix')o

)o
'l'? + (( \'\
2 lft..r * \fP
?
Vi' 11v-f tr)-+ ,cr)vt -Lo *{t:V)1-
 tZ.2Z FinancialU:ryq"1!"rt

Decision-tree Approach
Tirc Decision-tree Approacl-r (DT) is anotl-rer uselul alternative for evahrating riskv inr-estmerrt
prc)-pc)srls. -fhe outstanding feature of this method is that it takes into account rhe. irnpact of ail
prob:rbilistic estilnates of potential outcomes. In other vu'orcls, every possible outcorne is *,eighed in
probahrlistic terms and then evaluated. The DT approach is especiaily useful for situatior-rs in which
dccisions :rt ()ne poinr of tirne also affcct the decisions of the firrn at sorne later
Decision tree
date. Another useful application of the DT approach is fbl projects w'hich require
is a pictonal
representation
decisions to be rnade in sequential parts.
in tree lbrm A decision tree rs a pictolial representafion in tree forn-r u,hich indicates the rnag-
rvhich indicate-q nitucle, probability and inter-rc-lationship of all possibler outcomes.lt'fhe format of
the magnitude, the erercise of the invcstment cJecision has an appearance c.,f a tree n'ith ltranches
probabilily and and, therefore. this method is referred to as the decision-tree method. A decision
irler-relationships tree shou.,s the sequential cash flrtw-s and the NPV of the proposed project under-
of all possible different circumstances. In Exarnple 12.9 we illustrate the application of this method
outcomes. to a particular investment decision problem.
Exanple 12.)
*suppose a Jir-m has an investrnent proposal, requiring an outlay of Rs 2,00,000 at present (r- 0). fhe investlnent
proposal r.s expected to have 2 years economic life with no saivage va1ue. In year 1, there is a 0.3 probability
(30 pel cent chance') that CFAT r.iil be Rs 80,000; a 0.4 probability (<O per cent charrce) that CFAT will be
Rs 1,10.000 ancl a 0.3 probabilitl (30 per cent chance) tl.rat Cll-AT wili be Rs 1,50,000. In year 2, the CFAT pos-
sitrilities depend on the CFAT that occurs in year 1. That is, the CFAT for the year 2 are conditional on CFAT'
fol the year 1. Accordingil,, the probabilities assigned with the CFAT of the year 2 are conditi<-rnai probabilities.
The estimated conditional CFAT ancl their associated conditional probabilities are as follows:
lf CFAT, = Rs 80,000 lfCFAT, = Rs 7,10,000 lf CFAT, = Rs 1.50,000
CFAT, Probability CFAT: Probabilitv CFAT', Probobilin
Rs 40,000 0.2 Rs 1,30,000 0.3 Rs 1,60,000 0.1
I,00,000 0.6 1,50,000 0.4 2,00,000 0.8
1,50,000 o.2 1,60,000 0.3 2,40,000 0.1

.folution
Tlre estinrated values have been portrayed in Fig. I2.4.
It nray be notecl that the DT tigure covers a1l the dimensions of the problem: (i) the timing of
the CFAT, (ii) the possible CFAT outcomes in each year (including the conditional nature of the
CFAf' outcolnes in year 2), and the probabilities associated with these outcomes. The DT show,s 9
distinct possibilities, the project could assume if accepted. For example, one possibility is that the
CFAT for the year one may amount to Rs 80,000 and for the year 2 Rs 40,000. A close perusal of
Pig. 12.4 would also indicate that this is the worst event that could happen. Assuming a 8 per cent
risk free,/discount rate for the project, the NPV would be negative. Liken,ise. the best outcome that
couid occtrr rs CFATr: Rs 1,50,000 and CFATr: Rs 2,40,000. The NPV would be the highest among
all the 9 possible combinations. Figure 12.4 shows the NPV at 8 per cent discount rate of each of
tire estimated CFATs.
The expectecl NPV dpv I of the project is given by the following mathematical formulation:

Npv=i r,*nr, (r2.g)

 ,Analysis of Risk and Uncertainty 12.23

Path Eryected NPV Joint Expected NPV

oent at 8o/o Et€ of Probability NPV (x) Pj
f all Time: 0 Year I Year 2 discount (Pl"
din
hich
later -' ---: Rs 40,000 1 Rs (- 91,640) 0.06 Rs (- 5,498.4)
4.6 z
pke
1,00,000 2 (4o,22o) 0.18 (-7,239.6)

nzg- 1,so,000_ 3 . 0.06

(-2.630) (-157.8)
rt of
ches 1,30,000 4 't3,270 0.12 1,592.4
lslon
nder 1,50,000 5 30,410 0.16 4,865.6
*rod
1,60,000. 6 38,980 0.12 4,677.6
0.1
1,60,000 ' 7 76,020 o.O3 2,280.6
rr'tl n f

i.rlir)
2,00,000 8 1,10,300 0.24 26,472.0
rll Lrr
L)r ):- 2,40,000. I 1,44,580 0.03 4,337.4
:.F.\T
Irlres.
1.00 31,329.8
' PV factors for years I and 2 at 80/o discount rate as per Table A-3 arc 0.926 and 0.857 respectively. Mul-
tiply CFATrby 0.926 and CFAT2by 0.857; summing up, we get total PVfor individual possible Cr14f;
a substracting Rs. 2,00,000 (CO), we get the IWIZ
ttry " Product of probabilities of CFAT for years I ar,d 2.

FIGURE 12.4 Decision Tree

where Pr: The probability of the jth path occurring which is equal to the joint probability along
the path;
IWY: NPV of the 7th path occurring.
ig of In our example, the joint probabiliry, P, for the worst path is 0.06 (0.3 X 0.2) and for the best
f the path is 0.03 (0.3 X 0.1). The sum of all these joint probabilities must be equal to 1. The last column
ss 9 shows the expected NPV (NPy), which is obtained by summing up the product of NPV of 7th path
r rhe and the coresponding probabiliry of 7th path (E!j x NPQ. The sum of these weighted NPVs is
,:il of positive and, therefore, the project should be accepted.
aent This approach has the advantage of exhibiting a bird's eye view of all the possibilities asso-
: rhat ciated with the proposed project. It also makes the management aware well in advance of the
nong adverse possibilities (when the NPV is negative). The conditional nature of CFAT associated with
:ir of the project is clearly shown. The primary limitation of the method is that the decision tree format
may itself become very unwieldy, complex and difficult to understand and construct if the nurnber
n: of years of the expected life of the project and the number of possible outcomes for each year
are large. For instance, if we have a 3 year proiect, there will be 27 paths and, 60,000 paths if the
t2.g) project life is 10 years, assuming only 3 possible outcomes.
 r: 1 _!!,u l:!"1 Y Illg9!:4

sectox II rusr AND REAL oprotNs

Real options A: discussed eadier, a capital budgeting plojecr is accepted if it promises positive
I N?V
are.opportunrtres, and is relected in case the N?v is negative. This traditional capital budgeting
procedure has yielded good clecisions for a considerable period. A more rr,i,"gi!
^, l" f:o-:11 :: I
t"::-*j1t,^T."::tjl approach for recognising realoptions in investment projects has emerged in recenr
conditions and
I u|r.-..,2
influence the I
,;;;;#; I I, may be recalled that the traditional capital budgeting rheory, b). and large, is
p.oi..i, I silent about actions that can be taken after the project has been accepted and placed
in operation which might cause cash flows to change.l3 However, this may not hold
true in practice. Managers can (and often do) make changes that affect future cash flows and,/or the
life of the project. The traditional DCF methods often ignores these options and the future manage-
rial flexibiliry that accompanies them. The flexibility relares to changes in the old decisions when
conditions change.l4 Professional managers can most often respond to changing market conditions
and the actions of competitors. Opportunities to respond tc., changing circumstances and as a resrrlt
influence the outcc.rme of a proiect are called managerial strategic options.l5 They are more
popularly known as real options as they are associated with real assets.
Real options have value. There may be a negative NPV of a project but it may have the potential
to provide the opportunity to make follow-on investments that could be extremely profitable. In
operational feffns, a prgect having negative NPV may turn out eventr-rally worth accepting, keeping
in mind the option such as those a project creates in terms of opponuniries ro expand in furure.
The real options have value and enhance the worth of an investment project. The i'alue of an in-
vestment prol'ect would be the sum of the NPV of the project (determined in the usual way) and
the value of the option(s). Symbolically, its vaiue is given by Equation 12.1C
Project w-orth = [NPV (rraditional) + Oprion value] GZ.]D)
The option value will depend on the number of options available; the greater is the number of
options, the greater is the option value and the greater is the project's worth.

Types of Option

There are four major rypes of options: (1) Growth option (2) Abandonment option (3) Timing
option and (4) Flexibiliry opdon.
Growth option I Grcuth Option lt is an option to expand production/markets if the sales demand
is an ontion I for a product \il'erc' to exceed expectations (i.e.. the project tums out to be highly
successful)' Such an option has the potentiai to develop follow-on proiects. If an
investrnent proier-t under consitleration has the potentials to open new doors, if suc-
":#ill?l cessful. then recognition of cash flows frorn such opportunities should be included to
sales exceed I
expectation. ! iudge the q'orth of an investment proiect, at its iriitiation stage itself. Clearly, growth
()ppofiunities embedded in a capital budgeting proiect (not reckoned in the traditional
Abandonment capital budgeting procedure) often contribute rn €nFa-neing the project,s Npv.16
option
is an option to Abandonment Option This is an option to abandon/terminate,/shut-down an invest-
abandorvshut- ment proiect prior to its expected economic useful life. Such an embedded option
down/terrninate a enables the management to minimise a firm's losses, if the project turns out to be
project prior to its badlunsuccessful. In othcr words. the profects having abandonment value, in many
expected useful cases, can lower the project's risk by limiting downside losses and enhancing its
life.

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