FINANCE FUNCTION:

There are four functions of finance:

1. Fund Requirement Decision:

In this function first of all we will decide that

how much fund is required for starting an organization?
e.g. If suppose ABC wanted to start an organization ABC Co. Ltd. with Rs.
5,00,000

Birr

ABC Birr 5, 00,000

2. Fund Procurement Decision (Financing decision):

Now after deciding the amount of fund required for an organization,

the second question arises is the resources from which one can procure the fund?

To know the types of resources we should know first of all

The types of capital.

There are four resources under the types of capital from which one can procure
the fund.

(CAPITAL) i.e. EQUITY

INTERNAL EQUITY EXTERNAL EQUITY

(EQUITY SHARE CAPITAL, (DEBENTURE CAPITAL,
PREFERENCE SHARE CAPITAL LONG TERM BANK LOAN)

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 In this way we know about the resources from which one may start the
organization. These resources are Equity Share Capital, Preference Share Capital,
Debenture Capital, and Long Term Bank Loan.

Now the next question arises is

To know the proportion of the fund from each resources.
the answer for this question is that
the Debt Equity Ratio of an organization. The Ideal Debt Equity Ratio of an
organization is 0.67 (i.e. 2/3rd. fund should be procured from external equities and
1/3rd. from internal equities).

Thereafter, the next question arises is

Where to invest these funds?

i.e. the third finance function (Investment Decision)

3. Investment Decision:
First of all we should select the most preferable organization out of so many
alternatives in which we want to invest our fund.
Suppose, we want to invest Rs. 5, 00,000 in an organization which we want to start.
We have also selected few alternatives organization say A, B, C, D etc.
Now the question arises is, that
after all which alternative is the most preferable one?

The answer to this question is the highest return at the shortest period of time.
i.e. to understand the Capital Investment Appraisal Method
Now to know the highest return at the shortest period of time we have to check
few aspects about the organization:
1. amount of investment and
2. the annual return

Now suppose, the project cost of the organization which we want to start is
Birr 5, 000,000.

(A) (If the annual return from the project is uniform all the year)
Project A B C D
Project Cost Annual Return Annual Return Annual Return Annual Return

Birr Birr Birr Birr Birr

5, 00,000 1, 00,000 1, 50,000 2, 00,000 2, 50,000
1, 00,000 1, 50,000 2, 00,000 2, 50,000
1, 00,000 1, 50,000 2, 00,000 2, 50,000
1, 00,000 1, 50,000 2, 00,000 2, 50,000
1, 00,000 1, 50,000 2, 00,000 2, 50,000
Page 2 of 31
 Here in this example, the annual return is uniform hence we may calculate the
period required to recover the original investment at the shortest period of time
(i.e. we may call it as Pay Back Period Method the first method in Capital
Investment Appraisal Method). We may compute the Pay Back Period as the
relationship between Original Investment and Annual Return.

Pay Back Period Method= Original Investment / Annual Return

Project A B C D
Pay Back Period 5,00,000 5,00,000 5,00,000 5,00,000
1, 00,000 1, 50,000 2, 00,000 2, 50,000

Pay Back Period 5 years 3.33 years 2.5 years 2 years

By analyzing the pay back period method we come in conclusion that the most
preferable organization is the Project D because if we invest Rs. 5, 00,000 in
Project D we will get back our original investment at the shortest period of time
i.e. in 2 years only.

(B) (If the annual return from the project is not uniform all the year)
Project A B C D
Project Annual Cum. Annual Cum. Annual Cum. Annual Cum.
Cost Return Amt. Return Amt. Return Amt. Return Amt.
Birr Birr Birr Birr Birr Birr Birr Birr Birr
5, 00,000 1,00, 000 1, 00,000 1,50,000 1, 50,000 1,80,000 1, 80,000 2,40,000 2, 40,000
1,20,000 2,20,000 1,70,000 3,20,000 1,90,000 3,70,000 2,60,000 5,00,000
1,40,000 3,60,000 1,80,000 5,00,000 2,60,000 2,65,000
1,40,000 5,00,000 1,50,000 2,00,000 2,75,000
1, 80,000 1, 50,000 2, 00,000 2, 90,000

Pay Back Period 4 years 3 years 2.5 years 2 years

By analyzing the pay back period method (when the annual return is not uniform in
all the years) we come in conclusion that the most preferable organization again is
the Project D because if we invest Rs. 5,00,000 in Project D we will get back our
original investment at the shortest period of time i.e. in 2 years only.

Hence, the decision to invest our fund in the most preferable project is the Project D.

4. Now, the last function in finance is the Dividend Decision:

In this function we have to decide that how much proportion out of the profit [i.e.
Net Profit after Interest, Tax and Dividend (EBITD or PBITD) after the
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 calculation of Earning per Share i.e. EPS] we distribute to the equity shareholder
of the organization.

CAPITAL BUDGETING

The process of making investment decision

in
Capital Expenditure
is called

Capital Budgeting

Capital Expenditure
is an expenditure

for acquiring or improving the fixed assets

the benefits of which are expected to be received over a number of years in future.

Capital Expenditure
involves

Non-flexible long term commitment of funds.

Capital Budgeting
is also known as

long term investment decisions.

Charles T. Horngreen has defined Capital Budgeting as

“a long term planning for making and financing proposed capital outlays”.

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 Capital budgeting decisions are among the most crucial and critical business
decisions. Special care should be taken in making these decisions on account of the
following reasons.
1. Heavy investment: All capital expenditure projects involve heavy
investment of funds. These funds are raised by the firm from various
external and internal sources. Hence, it is important for a firm to plan its
capital expenditure.
2. Permanent Commitment of Funds: The funds involved in capital
expenditures are not only large but more or less permanently blocked
also. Therefore, these are long term investment decisions. The longer the
time, the greater the risk involved. Hence, careful planning is essential.
3. Long term effect on profitability: Capital budgeting decisions have a
long term and significant effect on the profitability of the concern. If
properly planned they can increase not only the size, scale and volume of
sales of the concern but its growth potential also.
4. Irreversible in nature: In most cases, capital budgeting decisions are
irreversible. Once the decision for acquiring a permanent asset is taken,
it is very difficult to reverse that decision. This is because it is difficult to
dispose of these assets without incurring heavy losses.

Methods of evaluating capital expenditure proposals

There are a number of methods in use for evaluating capital investment

proposals. Different firms may use different methods for evaluating the project
proposals. While evaluating, two basic principles are kept in view namely, the bigger
benefits are always preferable to small ones and that early benefits are always better
than the deferred ones. While evaluating, the following three methods are usually
followed.

1. Pay Back Period Method

2. Accounting Rate of Return Method
3. Discounted Cash Flow Method:
(a) Net Present Value Method
(b) Excess Present Value Index Method
(c) Internal Rate of Return Method

1. Pay Back Period Method:

First of all we should select the most preferable organization out of so many
alternatives in which we want to invest our fund.
Suppose, we want to invest Rs. 5, 00,000 in an organization which we want to start.
We have also selected few alternatives organization say A, B, C, D etc.
Now the question arises is, that
After all which alternative is the most preferable one?
Page 5 of 31
 The answer to this question is the highest return at the shortest period of time.
i.e. to understand the Pay Back Period Method the first appraisal method in
Capital Investment Appraisal Method
Now to know the highest return at the shortest period of time we have to check
few aspects about the organization:
3. amount of investment and
4. the annual return
Now suppose, the project cost of the organization which we want to start is
Rs. 5,00,000.
(A) (If the annual return from the project is uniform all the year)
Project A B C D
Project Cost Annual Return Annual Return Annual Return Annual Return

Birr Birr Birr Birr Birr

5, 00,000 1,00,000 1,50,000 2,00,000 2,50,000
1,00,000 1,50,000 2,00,000 2,50,000
1,00,000 1,50,000 2,00,000 2,50,000
1,00,000 1,50,000 2,00,000 2,50,000
1,00,000 1,50,000 2,00,000 2,50,000
Here in this example, the annual return is uniform hence we may calculate the
period required to recover the original investment at the shortest period of time
(i.e. we may call it as Pay Back Period Method the first method in Capital
Investment Appraisal Method). We may compute the Pay Back Period as the
relationship between Original Investment and Annual Return.
Pay Back Period Method= Original Investment / Annual Return

Project A B C D
Pay Back Period 5,00,000 5,00,000 5,00,000 5,00,000
1,00,000 1,50,000 2,00,000 2,50,000
Pay Back Period 5 years 3.33 years 2.5 years 2 years

By analyzing the pay back period method we come in conclusion that the most
preferable organization is the Project D because if we invest Rs. 5,00,000 in
Project D we will get back our original investment at the shortest period of time
i.e. in 2 years only.

(B) (If the annual return from the project is not uniform all the year)
Project A B C D
Project Annual Cum. Annual Cum. Annual Cum. Annual Cum.
Cost Return Amt. Return Amt. Return Amt. Return Amt.
Birr Birr Birr Birr Birr Birr Birr Birr Birr
5, 00,000 1,00,000 1,00,000 1,50,000 1,50,000 1,80,000 1,80,000 2,40,000 2,40,000
1,20,000 2,20,000 1,70,000 3,20,000 1,90,000 3,70,000 2,60,000 5,00,000
1,40,000 3,60,000 1,80,000 5,00,000 2,60,000 2,65,000
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 1,40,000 5,00,000 1,50,000 2,00,000 2,75,000
1,80,000 1,50,000 2,00,000 2,90,000

Pay Back Period 4 years 3 years 2.5 years 2 years

By analyzing the pay back period method (when the annual return is not uniform in
all the years) we come in conclusion that the most preferable organization again is
the Project D because if we invest Rs. 5,00,000 in Project D we will get back our
original investment at the shortest period of time i.e. in 2 years only.

Hence, the decision to invest our fund in the most preferable project is the Project D.
Demerit:

(a) We ignore accounting profit and time value of money.

2. Accounting Rate of Return:

It is known as accounting rate of return method because it takes into account, the
accounting concept of profit (i.e. profit after depreciation and tax) and not the
cash inflows. The project which yields the highest rate of return is selected.
In this method
We consider the accounting profit but
We ignore the time value of money.
Higher the rates of return better the project for approval.
Mathematically we calculate the Accounting Rate of Return as follows:

Annual Return____ X 100

Accounting Rate of Return = Original Investment

Average Annual Return_ X 100

Accounting Rate of Return (Average) = Average Investment

The term average annual return or profit refers to average profit after
depreciation and tax over the life of the project.
The average investment can be calculated by any of the following methods.

 Original Investment or
2
 Original investment – Scrap Value
2

Merits:
The following are the merit so of accounting rate of return method:
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  It is simple to understand and easy to calculate.
 This method gives due weighted to the profitability of the project.
 It takes into accounts the total earnings from the project during its life time.
 Rate of return may be readily calculated with the help of accounting data.
Demerits:
This method suffers from the following weaknesses:
 It uses the accounting profits and not the cash inflows in appraising the
project.
 It ignores the time value of money. Profits earned in different periods are
valued equally.
 It considers only the rate of return and not the life of the project.
 It ignores the fact that profits can be reinvested.
 This method does not determine the fair rate of return on investment.
 There are different methods for calculating the Accounting Rate of Return
due to many concepts of investments as well as profit. Each method gives
different results. This reduces the reliability of the method. s

(a) (If the annual return from the project is uniform all the year)

Project A B C D
Project Cost Annual Return Annual Return Annual Return Annual Return

Birr Birr Birr Birr Birr

5, 00,000 1,00,000 1,50,000 2,00,000 2,50,000
1,00,000 1,50,000 2,00,000 2,50,000
1,00,000 1,50,000 2,00,000 2,50,000
1,00,000 1,50,000 2,00,000 2,50,000
1,00,000 1,50,000 2,00,000 2,50,000

Here in this example, the annual return is uniform hence we may calculate the
A.R.R (i.e. we may call it as Accounting Rate of Return Method the second
method in Capital Investment Appraisal Method). We may compute the
Accounting Rate of Return (ARR) as the relationship between Annual Return and
Original Investment.
Annual Return____ X 100
Accounting Rate of Return (ARR) = Original Investment Project

A B C D
A.R.R = 1,00,000X100 1,50,000X100 2,00,000X100 2,50,000X100
5,00,000 5,00,000 5,00,000 5,00,000
A.R.R = 20% 30% 40% 50%

Page 8 of 31
 From the above calculation we can say that the A.R.R of Project D is the highest
i.e. 50%. Hence, Project is the best for the investment out of the alternative A, B,
C, and D.

(B) (If the annual return from the project is not uniform all the year)

Project A B C D
Project Annual Cum. Annual Cum. Annual Cum. Annual Cum.
Cost Return Amt. Return Amt. Return Amt. Return Amt.
Birr Birr Birr Birr Birr Birr Birr Birr Birr
5, 00,000 1,00,000 1,00,000 1,50,000 1,50,000 1,80,000 1,80,000 2,40,000 2,40,000
1,20,000 2,20,000 1,70,000 3,20,000 1,90,000 3,70,000 2,60,000 5,00,000
1,40,000 3,60,000 1,80,000 5,00,000 2,60,000 6,30,000 2,65,000 7,65,000
1,40,000 5,00,000 1,50,000 6,50,000 2,00,000 8,20,000 2,75,000 10,40,000
1,80,000 6,80,000 1,50,000 8,00,000 2,00,000 10,20,000 2,90,000 13,30,000
5 5 5 5
Average Rate = 1,36,000 1,60,000 2,04,000 2,66,000
Of Return
Average Return____ X 100
Average Rate of Return (ARR) = Original Investment Project
A B C D
A.R.R = 1,36,000X100 1,60,000X100 2,04,000X100
2,66,000X100
5,00,000 5,00,000 5,00,000 5,00,000
A.R.R = 27.2% 32% 40.8% 53.2%

From the above calculation we can say that the A.R.R of Project D is the highest
i.e. 53.2%. Hence, Project is the best for the investment out of the alternative A, B,
C, and D.

3. Discounted Cash Flow Method:

We know the value of rupee today is more valuable than value of rupee of
tomorrow. So, it is needed to consider the time value of money.
In this method the rate (i.e. the cost of capital) is known. At this rate we should see
the present value of rupee one (i.e. Re.1).

Under this method we have to go through various methods which are as follows:

(a) Net Present Value Method

(b) Excess Present Value Method and
(c) Internal Rate of Return Method

(a) Net Present Value Method

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 Under this method present value of cash inflows is calculated at the required
rate of return and compared with the original investment. If the present value
is higher than the original investment, the project can be selected, other
rejected.
In this method first of all we should following aspects of the organization:
 First of all we should know the various resources from which we procure the
capital for starting the project.
 Secondly, we also know the cost at which we procure that capital.
 Thereafter, we need to know the annual return the project earns after n
years of time.
 At last we calculate the present value of rupee one year after year by
multiplying the present value factor with the amount of annual return which
the organization earn year after year.
 Last but not least, we calculate the Net Present Value (NPV) by deducting
the original investment (i.e. the total present value of cash outflow) from the
total of the addition of the present value of rupee year after year.
 After comparing the Net Present Value of various project alternatives the
higher the Net Present Value the best suitable project for consideration.
Project A B C D
Project Yr. Annual PV Amt. Annual PV Amt. Annual
PV Amt. Annual PV Amt.
Cost Return Factor Return Factor Return Factor
Return Factor
Birr Birr Birr Birr Birr Birr Birr
Birr
5, 00,000 1 1,00,000 0.909 90,900 1,50,000 0.909 1,36,350 1,80,000
0.909 1,63,620 2,40,000 0.909 2,18,160
2 1,20,000 0.826 99,120 1,70,000 0.826 1,40,420 3,70,000
0.826 3,05,620 2,60,000 0.826 2,14,760
3 1,40,000 0.751 1,05,140 1,80,000 0.751 1,35,180 6,30,000
0.751 4,73,130 2,65,000 0.751 1,99,015
4 1,40,000 0.683 95,620 1,50,000 0.683 1,02,450 8,20,000 0.683
5,60,060 2,75,000 0.683 1,87,825
5 1,80,000 0.6211,11,780 1,50,000 0.621 93,150 10,20,000
0.621 6,33,420 2,90,000 0.621 1,80,090
TOTAL PRESENT VALUE 5,02,560 6,07,550
21,35,850 9,99,850
OF CASH OUTFLOW
Less - Original Investment 5, 00, 000 5, 00,000 5, 00,000
5, 00,000
(Total present value of cash inflow)
NET PRESENT VALUE 2,560 1,07,550
16,35,850 4,99,850

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From the above calculation we come in conclusion that the Net Present Value of the
Project D is the highest i.e. Rs.4, 99,850. Hence, the most preferable project is Project
D.

4. Internal Rate of Return Method

Internal rate of return is a percentage discount rate used in capital investment
appraisals which brings the cost of a project and its future inflows into equality. It
is the rate of return which equates the present value of anticipated net cash flows
with the initial cash outlay. The IRR is also defined as the rate at which the net
present value is zero. The rate for computing IRR depends as bank lending rate or
opportunity cost of funds to invest which is often called as personal discounting
rate or accounting rate. The test of profitability of a project is the relationship
between the internal rate of return (%) of the project and the minimum
acceptable rate of return (%).
Internal rate of return is the rate of return at which the total present value of
future cash inflows is equal to total present value of cash outflow i.e. the original
investment. This method is used when the cost of investment and cash inflows are
known but the rate of return is not known. The rate of return is generally found
by trial and error method.

Merits of Discounted cash Flows Method:

 This method considers the entire economic life of the project.

 It gives due weighted to the time factor.
 This approach by recognizing time factor makes sufficient provision for
uncertainty and risk.
 It is the best method where cash inflows are uneven.
Demerits:
 It involves a great deal of calculations. Hence it is difficult and
complicated.
 It is very difficult to forecast the economic life of any investment exactly.
 The selection of an appropriate rate of interest is also difficult.
 It does not correspond to accounting concepts for recording costs and
revenues.
5. Excess Present Value Index:
One of the major disadvantages of the present value method is that it is not easy to
rank projects on the basis of net present value when the costs of the projects is differ.
To compare each project the present value index is prepared. It can be calculated
with the help of the following formula.

Total Present Value of Cash Inflows

Excess Present Value Index =----------------------------------------------- X 100
Total Present Value of Cash Outflows
Higher the profitability index, the more desirable the investment.
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Conflicting Rankings between the NPV and IRR Methods and Capital Rationing

1. Conflicting rankings between the NPV and IRR methods

For independent projects: both the NPV and IRR methods will produce the same
accept/reject indication.
Rules:
- Accept projects having NPV>0 (of course, IRR> the hurdle rate).
- Reject projects having NPV<0 (of course, IRR< the hurdle rate).
- For mutually exclusive projects: in ranking, a conflict occasionally arises.
Ex: one project may have a higher NPV than another project, but a lower IRR.

The differences in the projects´ cash flow timing and the size of cash flows have a
considerable effect on the NPV and IRR.
Rule decision: project having a higher NPV should be chosen instead of a higher
IRR. Here are reasons:
 NPV method makes maximizing the firm value.
 NPV method assumes that a project’s cash flows can be reinvested at the cost
of capital.
Whereas, IRR method’s assumption on cash flows reinvestment is the IRR.
2. Modified internal rate of return (MIRR) method
Limits on IRR: assume that the cash flows from each project are reinvested at the
project’s own IRR.
MIRR method assumes that cash flows from all projects are reinvested at the cost of
capital instead of IRR. Calculations.

3. Capital rationing
Setting limits on capital budgeting projects is known as capital rationing.
Capital rationing seeks the combination of projects that maximizes the value of
the firm within the capital budget limit.
Reasons that cause capital budget limit:

RISK ANALYSIS IN CAPITAL BUDGETING

It is impossible to predict the outcome of some decisions with complete certainty

because only one outcome can arise. However, there are many occasions when a
decision can lead to more than one possible outcome, such situation are beset with
uncertainty. The traditional definition of the difference between risk and uncertainty
has been that uncertainty cannot be quantified while risk can, in this sense, risk is
concerned with the use of quantification of the likelihood of future outcomes. The
word uncertainty to cover all future outcomes which cannot be predicted with
accuracy. People have different attitudes towards the future. Some welcome the
Page 12 of 31
opportunity to take risk and may be called risk takers or risk seekers. Others are risk
averse.
An organization’s performance is profoundly influenced by the elements contained
with in its environment. In turn the organization also has an impact on its
environment. There is a mutual dependence and the very survival of an organization
depends critically upon the willingness of its environment to sustain it. It is the role of
a management to predict events that are likely to occur within the environment in
order to that the enterprise may meet any challenges or take advantage of any new
opportunities.
Degree of Certainty:
The degree of certainty may be classified in to the following:
 Complete Certainty: All relevant information about the decision variables and
outcomes is known with certainty.
 Assumed Certainty: For all practical purposes the future is known exactly and
estimates become deterministic.
 Risk: When it is known exactly what will happen in future, but the variance
possibilities are neglected by their assumed probability of occurrence.
 Uncertainty: Where a variety of outcomes are possible but probabilities cannot
be assigned.
 Extreme Uncertainty: Where no information is available to assess the
likelihood of alternative outcomes.
In relation to decision-making order condition of risk and uncertainty the purpose of
expressing an opinion about the likelihood of an event occurring is to facilitate the
development of decision-making procedures that are consistent with the decision-
makers beliefs.
Uncertainty arises from a lack of previous experience and knowledge. In a new
venture, for example, it is possible for uncertainty to be attached to the following
factors:
 Date of completion
 Level of capital outlay required
 Level of selling prices
 Level of sales volume
 Level of revenue
 Level of operating costs and
 Taxation rules.
Inevitably decision making under condition of uncertainty is more complicated than
is the case under risk condition. In fact there is no single best criterion that should be
used in selecting a strategy of the various available techniques. Risk occurs where
future outcomes of current actions are unknown, but the probabilities of these future
outcomes can be reasonably estimated from knowledge of past and current events.
Risk is therefore normally measured by volatility of returns, because a certain
outcome has no variance and, hence, no volatility. Uncertainty, on the other hand,
occurs where the probabilities of future outcomes cannot be predicted from past or
current events, because no probability estimates are available.
Page 13 of 31
Business risk and Financial Risk:
The total risk of a company can be broken down into business risk and financial risk.
A company’s business risk is determined by how it invest its funds i.e., the type of
projects which it undertakes, while financial risk is determined by how it finances
these investments. A company’s competitive position, the industries in which it
operates, the company’s market share, the rate of growth of the market and the stage
of maturity all influence business risk. Financial risk, on the other hand, is primarily
influenced by the level of financial gearing interest cover, operating leverage and
cash flow adequacy.
Allowing for risk in Project Evaluation:
The easiest and most common method of allowing for risk is by adjusting the
discount rate applied to the future cash flows arising from the project. By this
method a premium can be added to the average required discount rate as a safety
margin to compensate for the enhanced risk of the project. This acknowledges that if
the same discount rate is applied to all proposed capital projects, no distinction would
be made between high and low risk projects.
However, another way of allowing for risk can be using the payback evaluation
technique in either its simple, crude form or preferably by calculating the discounted
payback for the projects. The company can set a maximum period for the project to
repay its original investment and this also reflects the risk profile of the project.
A further approach in allowing for risk in project evaluation is to carry out
sensitivity analysis in the project cash flows. Sensitivity analysis or ‘what ifs’ involve
evaluating the impact on the financial returns from the project if certain key
variables changed from those forecast in the base evaluation. The sensitivity of the
overall returns from the project to relatively small changes in one, or a few, key
variables helps managers to understand the risk profile of the project, if these
variables are also non-controllable, the level of risk may be unacceptably high and
the project is rejected.
Risk Analysis in the Project Selection:
The acceptability of the projects depends upon cash flows and risk. Cash flow is
operational cash receipts less operational cash expenditure and investment outlay.
Risk is a more difficult operational concept to grasp. Risk must be taken into account
when estimating the required rate of return on a project. Risk relates to the volatility
of the expected outcome, the dispersion or spread of likely returns around the
expected return. Investors do not like risk and the greater the riskiness of returns on
a project, the greater the return they will require. There is a trade-off between risk
and return which must be reflected in the discount rates applied to investment
opportunities.
2
7
5
Return 3
4
6 1
Page 14 of 31
 Risk
(Risk-return Relationship for Alternative Projects)

The above graph shows the risk-return relationship of seven projects. The best
available project is number 2, it is high return and low risk project, and presents the
most and desirable combination of these characteristics. The least desirable project is
number 1, which is a low return and high risk project. Investment number 3 will
always be preferred to investment number 4, because it has a higher return for the
same level of risk. The highest risk project is number 7, but it also has high
expectation return. Project 6 is a zero risk investment with a certain outcome. Such
an investment might be a shorter dated government security, where the exact interest
rate is known in advance.
If it is assumed that the line joining projects 6,3 and 7 represents the trade-off
between risk and return in the real world, these three projects can be examined
further, since these three projects are on the risk-return line, they have zero net
present values. Their expected returns are just enough to compensate for their
riskiness. Investors can be logical in their choice patterns and yet select either 6, or 3,
or 7. Equally, an investor could choose to invest any where along the risk-return line
6-3-7 by varying the proportions of his total portfolio. Modern capital markets are
very competitive and can therefore be considered to be efficient in the sense that the
prices of securities generally reflect all available information relating to those
securities, anticipated cash.
Sensitivity Analysis:
Sensitivity Analysis is the study of the key assumptions or calculations on which a
management decisions is based in order to predict alternative outcomes of that
decision if different assumptions are adopted. It is a ‘what if’ technique that measure
how the expected values in a decision model will be affected by changes in the date.
Sensitivity analysis is a modelling procedure used in forecasting whereby changes are
made in the estimates of the variables to establish whether any will critically affect
the outcome of the forecast. It is a study to determine the responsiveness of the
conclusions of an analysis to changes or errors in parameter values used in the
analysis, seeks to test the responsiveness of the outcome from decision models to
different input values and constraints as a basis for appraising the relative risk of
alternative courses of action. it is possible to use sensitivity analysis for helping to
determine the value of information in addition to its role in strategic decision making.
Sensitivity analysis seeks to determine the range of variations in the coefficient over
which the solution will remain optimal.
The variations can be classified under following five headings:
 Variations in the objective function coefficients
 Variations in the technical coefficients
 Variations in the constraint vector coefficients
 The addition or deletion of constraints
 The addition or deletion of variables.

Page 15 of 31
Methodology:
 List the key factors or parameters. For example, when estimating the likely
profitability of a project the factors may be market growth rate, market share,
selling price, and the costs of direct labour and direct material.
 Attach the most likely values of each of these parameters, and from these
predict the most likely level of profits.
 Calculate the effect of varying the values of all or a selected few of these
parameters. This may be done by working out what the impact be if all the
values varied equally by, say, 1,3 0r 5%. Different incidences of variation
between the values may be calculated if appropriate.
 List the outcomes of the alternative assumptions and make a subjective
assessment of their likelihood.
 Draw conclusions on any actions required which would make the achievement
of the better outcomes more likely.
Benefits:
Sensitivity analysis helps to prevent rash predictions about the outcome of plans by
ensuring that the assumptions on which the plans are based are examined and that
the effect of changes in these assumptions is gauged. This process may involve
challenging the original assumptions and could result in a rethink about the project.
Sensitivity analysis can indicate areas where improvements are likely to have the
greatest impact on results. In presenting a range of possible outcomes, sensitivity
analysis facilitates the development of alternative or contingency plans if the basic
assumptions have to be changed.
For example:
XYZ Ltd. has estimated the following sales and profits for a new product which it
may launch on to the market.
Sales (2000 Units) 4,000
Variable cost:
Material 2,000
Labour 1,000 3,000
Contribution 1,000
Less:
Incremental Fixed Costs 800
Profit 200
Analyze the sensitivity of the project.

(a) If incremental fixed costs are more than 25% above estimate, the project
would make a loss.
(b) If unit costs of materials are more than 10% above estimate, the project
would make a loss.
(c) Similarly, the project would be sensitive to an increase in unit labour costs
of more than Birr 200, which is 20% above estimate, or else to a drop in the
unit selling price of more than 5%.

Page 16 of 31
(d) The margin of safety, given a break-even point of 1,600 units, is 400/2,000 =
20%.
Management would then be able to judge more clearly whether the product is likely
to be profitable. The items to which profitability is most sensitive in this example are
the selling price (5%) and material costs (10%). Sensitivity analysis can help to
concentrate management attention on the most important forecasts.

Hi Tech Instruments Ltd. has projected cash flows of its diversification project as
follows:
(Birr)
Immediate outlay 27,000
Inflows: Year 1 -----
2 5,000
3 22,000
4 14,000
5 14,000
==================================
The variables used in the projected cash inflow of diversification project are as
follows:
Year Sales/Production Prod. S. P
Qty. in Units Cost /Units
/Units
--------------------------------------------------------------
2 10,000 1.50 2.00
3 40,000 1.45 2.00
4 28,000 1.40 1.90
5 28,000 1.40 1.90

Make Sensitivity Analysis based on the above variables.

Sensitivity analysis of the diversification project can be done with the following
assumptions and its impact on project cash flows.
(a) Sales /Production quantity being reduced by 10%
(b) Production cost per unit being increases by 10%
(c) Sales Price per unit being reduced by 10%
(d) With the above assumption the cash flow will stand as follows:
Year Assumption (a) Assumption (b) Assumption (c)
0 27.00 27.00 27.00
1 ---- ----- -----
2 4.50 3.50 3.00
3 19.80 16.20 14.00
4 12.60 10.08 8.68
5 12.60 10.08 8.68
Alternatively, the change in cash flow may be considered as follows:
Year Assumption (a) Assumption (b) Assumption (c)
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 2 -0.50 -1.50 -2.00
3 -2.20 -5.80 -8.00
4 -1.40 -3.92 -5.32
5 -1.40 -3.92 -5.32
From the above sensitivity analysis we can observe that the change due to sales price
have a greater effect on cash flow than the other two variable factors and this
requires careful consideration.
SIMULATION:
The dictionary meaning of Simulation is “to assume the mere appearance of
without the reality”. Thus the appearance is true but not real, which implies that
simulation is imitation of reality. Simulation is the representation of a system by a
model which will reach to change in a similar way to that which is simulated. This
evolves a decision maker to predict the outcome of particular decision through testing
it via the model. Normally simulation techniques are used to solve problems involving
uncertainty. There are several techniques of simulation that are in use. However,
‘Monte-Carlo’ method is very popular as it is very simple and easy to use. The
techniques uses random numbers and is used to solve problems which involves
conditions of uncertainty.
In simulation, a computer would normally be used to build and run the model. This
is particularly important in this area, since meaningful information can be extracted
from the simulation only after a number of runs with different random numbers. If
we are interested in the steady state of the model, the simulation must be allowed to
proceed for a long period of simulated time so that average volumes of the relevant
statistics may be calculated. If the period is too short, the initial start up fluctuations
can affect the mean values.
Some problems are too complex to solve with pure mathematics, or they involve
random elements or risk situations that defy a practical mathematical solution. In
such situations, analysts sometimes construct a model of real world problem and use
a trail and error approach to arrive at reasonable solutions to the problem. For using
simulation one should go through the following steps:
 Define the problem precisely
 Introduce the variables associated with the problems.
 Construct a numerical model.
 Set up possible courses of action for testing.
 Run the experiment.
 Consider the results and the possibilities to modify or change data inputs, and
decide what course of action to take.
Steps for Monte-Carlo Simulation –
There are11 steps in a Monte-Carlo simulation. Each of these steps is as follows:
(1) The performance measure must be specified. The performance measure may
be, for example, Dollar profits, Dollar Costs, or machine-hour utilization.
(2) The problem under investigation must be expressed mathematically. The
mathematical description of the problem must include all important variables
and their interactions. The variables in the mathematical model will be either
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 deterministic or random. A deterministic variable can take on only one value;
random variable can take on more than one value.
(3) For those variables that are random variables, a probability distribution for
each must be specified.
(4) For each variable whose probability distribution must be specified, the
probability distribution must be converted into a cumulative probability
distribution.
(5) For each random variable, representative numbers must be assigned to each
possible outcome specified by the probability distribution. The number must be
assigned on the basis of the cumulative probability distribution.
(6) A random number must be obtained for each random variable.
(7) For each random number, the corresponding value of the random variable
must be determined.
(8) The corresponding value of each random variable found in the previous step
must be used to determine the value of the performance measured developed in
step 2.
(9) Step 6 to 8 must be repeated many times, say 100 to 1,000 times. The repetition
of steps 6 to 8 is known as trial.
(10) On the basis of the value for the performance measure fore each trial, a
probability distribution and cumulative probability distribution must be
constructed.
(11) The cumulative probability distribution constructed in step 10 must be
analyzed.
Practical Application:
Simulation modelling is extremely useful in production scheduling, manpower
planning decisions, parking problems, inventory problems, investment analysis,
queuing problems, maintenance problems, testing a series of marketing problems,
location of factories for cost reduction etc. the following illustrations will highlight the
importance of simulation models in decision-making under uncertainty.
Advantages and Disadvantages:
Advantages:
 Simulation can be used to investigate the behaviour of problems which are too
complex to be modeled mathematically.
 The technique can also be used when the variables in the problem e;g., arrival
time, service time do not follow the standard distributions required for the
mathematical models, i.e., Poisson distribution, Normal exponential Distribution.
 The basic principles of simulation technique are fairly simple and it is, therefore,
more attractive to people who are not expert in Quantitative techniques.
 Simulation does not interfere with the real world system but only with table model
and, therefore, it results in saving of cost.
 It is micro analysis of big and complicated system by breaking into each sub-
system and studying the interface of the various sub-systems and studying the
interface of the various systems.

Page 19 of 31
 Time will be saved in simulation e.g., the effects of ordering, advertising or other
policies over many months or years can be obtained by computer simulation in a
short time.
 Simulation allows us to study the interface effort of individual components or
variables in order to determine which are important.
Disadvantages:
 Simulation is not an optimizing technique. It is simply allows us to select the best
of the alternative systems examined.
 Reliable results are possible only if the simulation is continued for a long period.
 A computer is essential to cope with the amount of calculation in simulation
modelling.
 To develop a simulation model means consumption of voluminous data and it
may be very costly. Each simulation model is unique and its solution cannot be
applied to other problems however similar they may be.
 The simulation model does not produce answers by itself. Managers must
generate all of the conditions and constrains for solutions they want to examine.
 Simulation methods generally are not as efficient as the analytical methods.
For example:
ABC Ltd. is considering the purchase of an automatic pack machine to replace the 2
machines which are currently used to pack Product X. The new machine would result
in reduced labour costs because of the more automated nature of the process and in
addition, would permit production levels to be increased by creating greater capacity
at the packing stage with an anticipated rise in the demand for Product X, it has been
estimated that the new machine will lead to increase profits in each of the next 3
years. Due to uncertainty in demand, however, the annual cash flows (including
savings) resulting from purchase of the new machine cannot be fixed with certainty
and have, therefore, been estimated probabilistically as follows:
Annual Cash Flows (Birr in ‘000)
Year 1 Probability Year 2 Probability Year 3 Probability
10 0.3 10 0.1 10 0.3
15 0.4 20 0.2 20 0.5
20 0.3 30 0.4 30 0.2
40 0.3
Because of the overall uncertainty in the sales of product X, it has been decided that
only 3 tears cash flows will be considered in deciding whether to purchase the new
machine. After allowing for the scrap value of the existing machines, the net cost of
the new machine will be Birr 42,000. The effects of taxation should be ignored.
Required:
(a) Ignoring the time value of money, identify which combinations of annual
cash flows will lead to an overall negative net cash flow, and determine the total
probability of this occurring.
(b) On the basis of the average cost flow for each year, calculate the net present
value of the new machine given that the company’s cost of capital is 15%.
Relevant discount factors are as follows:
Page 20 of 31
 Year Discount factor
1 0.8696
2 0.7561
3 0.6575
(c) Analyze the risk inherent in this situation by simulating the net present
value calculation. You should use the random number given below in 5 sets
of cash flows. On the basis of your simulation results, what is the expected
net present value and what is the probability of the new machine yielding a
negative net present value?
Year Set 1 Set 2 Set 3 Set 4 Set 5
Year1 4 7 6 5 0
Year 2 2 4 8 0 1
Year 3 7 9 4 0 3

Solution:
(a) If the total cash flows in year 1, 2 and 3 is less than Birr 42,000, the net cash
flow will be negative. The combination of cash flow which total less than
Birr 42,000 are given below:
Cash flow (Birr’000)
Year 1 Year 2 Year 3 Total Probability
10 10 10 30
0.3X0.1X0.3=0.009
10 10 20 40 0.3X0.1X0.5=0.015
10 20 10 40 0.3x0.2x0.3= 0.018
15 10 10 35 0.4x0.1x0.3= 0.012
20 10 10 40 0.3x0.1x0.3= 0.009
TOTAL=0.063
The probability of a negative cash flow is 0.063
(b) Expected Cash Flow: (‘000)
Year 1 = EV = (10 X 0.3) + (15 x 0.4) + (20 x 0.03)= 15
Year 2 = EV = (10 X 0.1)+(20 x 0.2)+(30 x 0.04)+(40 X 0.3) = 29
Year 3 = EV = (10 X 0.3)+(20 X 0.5) + (30 X 0.2) = 19

Present Value of the Cash Flow =

= (15 X 0.8696)+(29 X 0.7561)+(19 X 0.6575)= 47.4634
The Net Present Value of the New Machine=
= Birr (47,463 -42,000) = Birr 5,463.

(c) Allocate Random Number ranges to the cash flows for each year.
Year Cash flow (‘000) Probability (‘000)
Year 1 10 0.3
15 0.4
20 0.3
Year 2 10 0.1
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 20 0.2
30 0.4
40 0.3
Year 3 10 0.3
20 0.5
30 0.2

We can now carryout the simulation.

No. Year 1 (‘000) Year 2 (‘000) Year 3 (‘000) Net PV
Random Cash DCF Random Cash DCF Random Cash DCF
1 4 15 13.044 2 20 15.122 7 20 13.150 - 0.684
2 7 20 17.392 4 30 22.683 9 30 19.725 17.800
3 6 15 13.044 8 40 30.244 4 20 13.150 14.438
4 5 15 13.044 0 10 7.561 0 10 6. 575 -14.820
5 0 10 8.696 1 20 15.122 3 20 13.150 - 5.032
Total -11.702
The average net present value of the cash flow = 11.702 /5 = Birr 2,340.40

Three out of five simulation produced negative NPV, therefore, we estimate the
probability of a negative NPV as 3/5 =0.6. Since the simulation is small, the estimates
are unlikely to be reliable.
(d) Optimistic –Pessimistic Estimates:
In decision-making the first step is usually to make a single ‘best estimate’ for each
item. One might then also make ‘optimistic’ and ‘pessimistic’ estimates for each
variable, though this does raise questions such as how to define ‘optimistic’ and
‘pessimistic’ and how to make use of these estimates. Another approach is to make
the ‘most likely’ estimate for each item in turn, to see how much difference it makes
to the overall result. Large changes to particular items will often not be important, so
we need to identify those critical variables where even a fairly small change can make
a large difference to the overall result.
The worst possible/ best possible outcomes can be evaluated from the pessimistic and
optimistic attitudes of the decision made. An optimistic decision maker considers the
most favourable outcome whereas a pessimistic decision maker is very conservative
in his approach. In making decision under uncertainty, the decision maker should
assess not only the most likely outcome from a decision but also the outcome that will
arise if the worst possible happens. This analysis will help in understanding the full
range of possible outcomes from a decision and will help the decision maker to take
right decision keeping in view the risk involved in the decision.
For example:
A manager is trying to decide which of three mutually exclusive projects to
undertake. Each of the projects could lead to varying net profits which are classified
as outcomes, I, II, III. The manager has constructed the following pay-off table or
matrix (a conditional profit table).
Project I II III
Page 22 of 31
A 50,000 65,000 80,000
B 70,000 60,000 75,000
C 90,000 80,000 55,000
Probability 0.2 0.6 0.2
Which project should be undertaken?
If the project with the highest EV of profit were chosen, this would be Project C

Outcome Probability Project A Project B project C

I 0.2 10,000 14,000 18,000
II 0.6 39,000 36,000 48,000
III 0.2 16,000 15,000 11,000
1.0 65,000 65,000 77,000
However, if the maximum criterion were applied, the assessment would be as follows:
Project Selected The worst outcome Profit (Birr)
That could happen
A I 50,000
B II 60,000
C III 55,000
By choosing B, we are ‘guaranteed’ a profit of at least Birr 60,000, which is more
than we would get from Project A or C if the worst outcome were to occur for them.
The decision would therefore be to choose Project B.
(e) Standard Deviation in measurement of Risk:
(i) Risk is measured by the possible variation of outcomes around the expected
value and the decision will be taken keeping in view the variation in the expected
value where two projects have the same expected value, the decision maker would
choose the project which has smaller variations in expected value. This can be clearly
understood with the example given below:

For example:
Which of the two following projects would be chosen by A (‘risk averse’ decision
maker)?
Project Estimated Net Probability
Cash Flow (Birr)
Project A 2,000 0.3
3,000 0.4
4,000 0.3
Project B 1,000 0.2
2,000 0.2
3,000 0.2
4,000 0.2
5,000 0.2
Sol:

Page 23 of 31
The projects have the same EV of net cash flow (Birr 3,000); therefore a risk averse
manager would choose the project with the smaller standard deviation of expected
profit.
(a) Project A:
Barr
Cash Flow Probability EV of cash Cash Flow p(x-x)2
(Birr) Flow (Birr) -EV of Cash flow
(X –X)
2,000 0.3 600 -1,000 3,00,000
3,000 0.4 1,200 Nil Nil
4,000 0.3 1,200 +1,000 3,00,000
EV= 3,000 Variance = 6,00,000
Standard Deviation = 6,00,000 = Birr 775.

(b) Project B:
Cash Flow Probability EV of cash Cash Flow p(x-x)2
(Birr) Flow (Birr) -EV of Cash flow
(X –X)
1,000 0.2 200 -2,000 8,00,000
2,000 0.2 400 -1,000 2,00,000
3,000 0.2 600 Nil Nil
4,000 0.2 800 +1,000 2,00,000
5,000 0.2 1,000 +2,000 8,00,000
EV= 3,000 Variance= 20,00,000
Standard Deviation = 20,00,000 = Birr 1,414
The risk averse manager would choose project A, which has smaller variations in
expected profit.

(ii) Coefficient of Variation:

In the previous example, Project A and B had the same EV of profit, but this
would be unusual in practice. Two projects may have similar EVs of profit, although
not exactly the same. In such circumstances, a useful measure of risk for project
comparison is the coefficient of variation, which is calculated as follows:
Standard Deviation
Coefficient of Variation=-------------------------- X 100
EV of Profit

A project with a higher coefficient of variation would be more risky than a project
with a lower coefficient of variation.
For example:
The manager of Ethiopian Plywood Co. Pvt. Ltd. is considering which of the two
mutually exclusive projects to select. Details of each project are as follows:
Project R Project K
Probability Profit (‘000) Probability Profit (‘000)
Page 24 of 31
0.3 150 0.2 (400)
0.3 200 0.6 300
0.4 250 0.1 400
0.1 800
Which project seems preferable R or K?

Sol:
On the basis of EVs alone, we find that that K is marginally preferable to R, by Birr
15,000.
Project R Project K
Probability Profit EV Probability Profit EV
0.3 150 45 0.2 (400) (80)
0.3 200 60 0.6 300 180
0.4 250 100 0.1 400 40
0.1 800 80
EV of Profit= 205 EV of Profit = 220
Project K, however is more risky, offering the prospect of a profit as high as Birr
8,00,000 but also the possibility of a loss of Birr 4,00,000. One measure of risk is the
standard deviation of the EV of profit.
(a) For Project R:
Probability (P) Profit (X) X – ā* P(X –X)2
0.3 150 -55 907.5
0.3 200 -5 7.5
0.4 250 45 810.0
Variance = 1,725.00
X(Bar)= Birr 205
Standard Deviation = 1,725 = 41.35 i.e., Birr 41,530
(b) For Project K:
Probability (P) Profit (X) X – ā* P(X –X)2
0.2 (400) -620 76,880
0.6 300 80 3,840
0.1 400 180 3,240
0.1 800 580 33,640
Variance = 1,17,600
X(Bar) = Birr 220
Standard Deviation = 1,17,600 = 342.93
i.e., Birr 342,930
Risk averse management might, therefore, prefer Project R because, although it has
a smaller EV of profit, the possible profit which may occur is subject to less variation
(or ‘dispersion’).
The much higher risk with Project K is directly comparable with the risk from
Project R if we calculate the coefficient of variation for each project i.e., the ratio of
the standard deviation of each project to its EV.

Page 25 of 31
 Project R Project K
Standard Deviation (a) 41,530 3,42,930
EV of Profit (b) 2,05,000 2,20,000
Coefficient of Variation (a/b) 0.20 1.56

(iii) Hiller’s Model for Risk Analysis:

In view of Hiller, uncertainty or risk associates with the capital investment decision is
determined by the variation (standard deviation) of the expected cash flows. There
will be lesser deviation in cash flows from the mean cash flow if the capital
investment and its cash flows are less vulnerable to risk and uncertainty. He further
argues that working out the standard deviation of the various levels of cash flow will
take into account the uncertainty factor of cash flows of a project. Based on his
theory he developed a model to evaluate the various alternative cash flows by taking
into the mean of present value of the cash flows and the standard deviation of such
cash flows.
(f) Value of information:
We can sometimes reduce the uncertainty involved in making a decision by collecting
more information. However, we will usually have to pay for this additional
information, the value of perfect information tells us the maximum amount it is
worth paying for it. If we know in advance, which one, of the outcomes will occur,
and then we choose the decision which will lead to the maximum pay-off. This does
not mean that we can control the choice of outcome.
The uncertainty about the future outcome form taking a decision can sometimes be
reduced by obtaining more information first about what is likely to happen.
Information can be obtained from various sources, such as the following:
 Market research survey
 Other surveys or questionnaires
 Conducting a pilot test
 Building a prototype model.
How reliable is the information likely to be for predicting what will happen in the
future with and so for helping managers to make better decisions? We can categorize
information into two groups.
(i) Value of Perfect Information:
Perfect information is the information about the future outcome of an event which
foretells the outcome with absolute certainty and is guaranteed to predict the future
with 100% accuracy. Perfect information, therefore, removes all doubts and
uncertainty from a decision, and it would enable managers to make decisions with
complete confidence that they have selected the most profitable course of action. We
can estimate a value of perfect information, based on Expected Values (EVs) as
follows:
 If we do not have perfect information and we must choose between two
or more decision options when the best option depends on what future
circumstances will turn out to be, we should select the decision option which
Page 26 of 31
 offers the highest EV of profit. This option will not be the best decision under
all circumstances. There will be some probability that the best option will not
be selected given the way actual events turn out in the future.
 With perfect information, the best decision option will always be selected.
Just what the profits from the decision will be must depend on the future
circumstances which are predicted by the information: nevertheless, the EV of
profit with perfect information should be higher than the EV of profit without
the information. The value of perfect information is the difference between
these two EVs.
(ii) Value of Imperfect Information:
There is one serious drawback of the technique we have just looked at.
Estimating the value of perfect information should help management to decide
whether obtaining information would be worth the cost of its collection, but in
practice information is rarely ever perfect. Market research findings or information
from pilot tests and so on are likely to be reasonably accurate, but they can still be
wrong: they provide imperfect information. It is possible, however, to arrive at an
assessment of how much it would be worth paying for such imperfect information,
given that we have a rough indication of how right or wrong it is likely to be. The
problem is related to posterior a probability which is in turn the subject of Bayes’s
theorem. We need not be concerned with the mathematical formulation of the theory
provided we understand its principles.
Information, whether perfect or imperfect, will cost money to obtain, and so if the
option exists for a decision maker to obtain the information or not, a further decision
that has to be made is: “would the information be worth the cost of obtaining it?”
For example:
The management of PWR Ltd. must choose whether to go ahead with either of two
mutually exclusive projects, A and B. The expected profits are as follows:
Particulars Profit if there Profit /Loss if there is
Strong Demand Weak Demand
Option A (Birr)4,000 (1,000)
Option B (Birr)1,500 500
Probability of Demand 0.3 0.7
(a) What would be the decision, based on expected values, if no information
about demand were available?
(b) What is the value of perfect information about demand?

Sol:
(a) If there were no information to help with the decision, the project with the
higher EV of profit would be selected.
Probability Project A Project B
Profit EV Profit EV
0.3 4,000 1,200 1,500 450
0.7 (1,000) (700) 500 350
1.0 500 800
Page 27 of 31
Project B would be selected.
This is clearly the better option if demand turns out to be weak. However, if demands
were to turn out to be strong, Project A would be more profitable. There is a30%
chance that this could happen.
(b) Perfect information will indicate for certain whether demand will be weak or
strong. If demand is forecast ‘weak’ Project B would be selected. If demand is
forecast as ‘strong’, Project A would be selected, and perfect information
would improve the profit from Birr 1,500, which would have been earned by
selecting B, to birr 4,000.

Forecast Demand Probability Project Chosen Profit EV of profit

Weak 0.7 B 500 350
Strong 0.3 A 4,000 1,200
EV of Profit with perfect information = 1,550
The value of perfect information derives from 0.3 probability that if demand is going
to be strong, the information would reveal this fact, and the decision is changed from
‘choose B’ to ‘choose A’ thereby earning Birr 2,500 more profit.
The EV of the value of perfect information is therefore
0.3 X Birr 2,500 =Birr 750.
Another way of making this same calculation is as follows:
EV of profit without perfect information Birr 800
(i.e. choose B all the time)
EV of profit with perfect information Birr1,550
Value of perfect information Birr 750
Provided that the information does not cost more than Birr 750 to collect, it would be
worth having,

Ques:
ABC Ltd. must decide at what level to market a new product ‘X’ which can be sold
nationally, within a single sales region (where demand is likely to be relatively strong)
or within a single area. The decision is complicated by certainty about the general
strength of consumer demand for the product, and the following conditional profit
table has been constructed.
(Birr)
Particulars Weak Moderate Strong
Market Nationally (A) (4000) 2,000 10,000
On one Region (B) nil 3,500 4,000
In one area (c) 1,000 1,500 2,000
Probability 0.3 0.5 0.2
(a) What should the decision be, based on EVs of profit?
(b) What would be the value of perfect information about the state of demand?

Sol:

Page 28 of 31
(a) Without perfect information, the option with the highest EV profit will be
chosen.
Option EV of Profit (Birr)
A (4,000X0.3+2,000X0.5+10,000X0.2) = 1,800
B (NilX0.3+3,500X0.5+4,000X0.2) = 2,550
C (1,000X0.3 +1,500X0.5+2,000X0.2) = 1,450
Marketing regionally (Option B) has the highest EV of profit, and would be selected.
(b) However, if perfect information about the state of consumer demand were
available, Option A would be preferred if the forecast demand is strong and
Option C would be preferred if the forecast demand is weak.
Demand Probability Choice Profit EV of Profit
Weak 0.3 C 1,000 300
Moderate 0.5 B 3,500 1,750
Strong 0.2 A 10,000 2,000
EV of Profit with Perfect information 4,050
EV of Profit, selecting Option B 2,550
Value of perfect information 1,500
(c) SM Ltd. has three investment opportunities, each one yield different profits
depending on the state of the market. The Managing Director has estimated that
the probabilities of the three states occurring are as follows:
State Probability
I 0.5
II 0.2
III 0.3
The pay-off table showing the incremental profits with each profit is as follows:
Market state (‘000)
I II III
Project I 75 20 5
Project II 45 80 55
Project III 35 60 90
Required:
(a) Which project should be undertaken? Ignore risk and use the decision
rules that the project with the highest EV of profits should be taken.
(b) What would be the value of perfect information about the state of the
market? Would it be worth paying Birr 15,000 to obtain this information?
Sol:
(a) The EV of the profit for each Project:
Market State Probability Project A Project B Project C
Profit EV Profit EV Profit EV
I 0.5 75 37.5 45 22.5 35 17.5
II 0.2 20 4.0 80 16.0 60 12.0
III 0.3 5 1.5 55 16.5 90 27.5
EV of Profit 43.0 55.0 56.5

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Project C should be undertaken (ignoring risk) because it has the highest EV of
profits.
(b) With perfect information about the future state of the market, the company
would choose the most profitable project for the market state which the perfect
information predicts will occur.
(i) With State I is forecast, Project A would be chosen: value Birr 75,000.
(ii) With State II is forecast, Project B would be chosen: value Birr 80,000.
(iii) With State III is forecast, Project C would be chosen: value Birr 90,000.
The EV of profits, given perfect information, would be as follows:
Market State Choose Profit (000) Probability EV (Birr ‘000 )
I A 75 0.5 37.5
II B 80 0.2 16.0
III C 90 0.3 27.0
EV of Profits, with perfect information 80.5
Since the EV of profits without information is Birr 56,500 (choosing Project C) the
value of perfect information to the company is Birr (80,500 – 56,000) = Birr 24,000.
Since the cost of the information is Birr 15,000, it would be worthwhile to obtain it.
Non-Financial Factors:
In addition to the financial aspects of the capital investment decision there are also
many other areas which warrant attention such as:
(a) TECHNICAL:
 The need for technical superiority
 Flexibility and adaptability
 Ease of maintenance
 Operational considerations, e.g., need to restrain / recruit personnel.
 Servicing arrangements.
 Manuals provided for operating and servicing
 Peripherals necessary for efficient operation or addition at some future
date. It is not unheard of for an organization to purchase equipment and
find that they are unable to use it without first buying certain
peripherals.
 Capacity
(b) Imported Equipment:
Exchange rates may affect the position dramatically depending upon the
method of payment adapted. An important question which must be answered is
‘How good is the supplier’s servicing and availability of spares in the import
country?’ it may be first class in the supplier’s own country but very poor in
the import country. Other considerations under this heading involved the
following:
The additional administration necessary to deal with the additional
documentation and foreign exchange.
Delays caused in delivery of the equipment and spares by air and sea
transportation problems and political instability.
(c) Size and Weigh of equipment and spares:
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 Floors may need strengthening and walls may have to be knocked down and
rebuild to accommodate the equipment. This possibility will affect the cash
flows and should not be overlooked.
(d) Standardization of equipment:
The benefits of obtaining similar equipment from a tried and tested supplier
can have profound consequences upon the financial analysis. Saving should be
possible in the areas of operative training, ease of maintenance and inventory
of spares e.g., one component may fit several different machines.

(e) Look before you Buy:

It may well be with the time and expense to actually inspect the equipment in a
working environment. The opportunity to talk with operatives and personnel
involved with such equipment should certainly not be neglected.
(f) Human and Social factors:
Firms who ignore such factors as safety, noise, fumes etc. in today’s complex
and diverse business environment do so at their peril. The financial
consequences of ignoring them could be catastrophic.
(g) Organizational behaviour;
The effects of ‘people problems’ upon an organization cannot and should not
be underestimated. This area alone could jeopardize the success of the whole
venture for reasons such as:
 Resistance to change, e.g., introducing new technology.
 Empire building, e.g., where sub-unit goals conflict with the
organization’s own goals.
 Perceptions about what the management want.
 Organizational structure, e.g., certain personnel may be in control key
information junctions or have direct access to management.
 The board room balance of power, e.g., finance versus engineers.
There are of course, numerous other factors that need to be taken into account, e.g.,
special offers – two for the price of one; guarantees; and the possibility of
renegotiating the terms.
Thus, the so called non-financial factors may have a significant influence upon a
firm’s long term financial performance and cannot be ignored in the capital
investment decision-making process.

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