City University College Department of Accounting & Finance

City University College

Department of Accounting & Finance
Chapter 3 – Capital budgeting under risk

Methods of incorporating risk in capital budgeting

Expected cash flows and expected net present value
Under conditions of uncertainty, a separate probability distribution is used
to summarize the possible net investments or cash flows for each year. The
first step in evaluating the desirability of risky projects is to compute the
expected value of each probability distribution. This is obtained by
multiplying each possible cash value by its probability of occurrence and
adding the resulting product.

Where: is the possible cash value I for a given year

is probability of occurrence of fi
E is the expected value

Example: expected value of cash flows and probability distributions are as

follows:
Cash flow Probability
Year 1 2000 0.3
4000 0.4
6000 0.3
Year 2 1000 0.1
3000 0.5
7000 0.4
E1 = 0.3x2000+0.4x4000+0.3x6000=4000
E2 = 0.1x1000+0.5x3000+0.4x7000=4400

Expected Net present Value (ENPV)

The expected net present value of a capital budgeting alternatives, ENPV, is computed as
follows. Let k* represent the risk free rate of return, then:

∑ Et
(1+k)t
Example
Possible net investment Probability
(4000) 0.3
(5000) 0.4
(6000) 0.3

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Intermediate Finance Capital Budgeting under risk
City University College Department of Accounting & Finance

The bracket (negative) values indicate that a net investment is a cash

outflow. This probability distribution has an expected value of (5000)

Et
Year 0 (5000)
Year 1 4000
Year 2 4400

If the risk free rate of return is 8 percent, the NPV statistics for this project
are calculated as follows. The expected NPV is computed as follows:

ENPV = -5000 + 4000 + 4400

(1+.08)0 (1+.08)1 (1+.08)2

= 2,076

Sensitivity and Scenario analysis

Two approaches for dealing with project risk is to capture the variability of
cash inflows and NPV are Sensitivity and Scenario analyses.
Sensitivity analysis
Is a behavioral approach that uses a number of possible values for a
given variable, such as cash inflows, to assess its impact on the firm’s
return, measured by NPV. In capital budgeting, one of the most common
sensitivity approaches is to estimate the NPV associated with pessimistic,
most likely, and optimistic cash inflow estimates. By subtracting the
pessimistic outcome NPV from the optimistic outcome NPV, the range can
be computed.
Example:
Assume ABC company’s manager made pessimistic, most likely, and
optimistic estimates of the cash inflows for each project. The cash inflow
estimates and resulting NPV’s in each case are summarized as follows:
Sensitivity analysis of ABC’s Project X and Y.

Project
X Project Y
Br.
Initial investment 10,000 Br.10,000
Annual Cash inflows
Outcome
Pessimistic 1500 0
Most likely 2000 2000
Optimistic 2500 4000

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Intermediate Finance Capital Budgeting under risk
City University College Department of Accounting & Finance

Range 1000 4000

Net present Values
Outcome
Pessimistic 1409 -10,000
Most likely 5212 5212
Optimistic 9015 20424
Range 7606 30424

The values were calculated by using the corresponding annual cash

inflows. A 10% cost of capital and a 15 years life for the annual cash flows
were used. Comparing the ranges of cash inflows (br. 1000 for project X)
and 4000 for project Y) and more important the ranges of NPVs (br 7606
for project X and Br 30424 for project Y) makes it clear that project X is less
risky than project Y. Given that both projects have the same most likely
NPV of br 5212, the assumed risk averse decision maker will take project X
because it has less risk and no possibility of loss.
Scenario analysis, which is a behavioral approach similar to sensitivity
analysis but broader in scope is used to evaluate the impact of various
circumstances on the firm’s return. Rather than isolating the effect of a
change in a single variable, scenario analysis is used to evaluate the
impact on return of simultaneous change in a number of variables such as
cash inflows and the cost of capital resulting from differing assumptions
relative to economic and competitive conditions. For example, the firm
could evaluate the impact of both high inflation (scenario 1) no inflation
(scenario 2) on a projects NPV. Each scenario will affect the firm’s cash
inflows, cash outflows and cost of capital thereby resulting in different
levels of NPV. The decision maker can use these NPV estimates to roughly
assess the risk involved in respect the level of inflation.
Certainty Equivalent
One of the most direct and theoretically preferred approaches for risk
adjustment is the use of certainty equivalents which represents the
percent of estimated cash inflow that investors would be satisfied to
receive for certain rather than the cash inflows that are possible for each
year. The basic expression for NPV when certainty equivalents are used for
risk adjustment are as follows:

∑ (et)xCFt
(1+Rf)

Where: et is certainty equivalent factor in year (et is between 0 &1)

CFt is relevant cash inflow in year t
Rf is the risk free rate of return
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Intermediate Finance Capital Budgeting under risk
City University College Department of Accounting & Finance

The equation shows that the project is adjusted for risk by first converting
the expected cash inflows to certain amounts, (et X CFt) and discounting
the cash inflows at Rf.
Example ABC company wishes to consider risk in the analysis of two
projects A and B. the cost of capital is 10% when considering risk. The
project cash flows are as follows.
Year Project A Project B
Initial Br. 42,000 Br. 45,000
investment
Cash flows
1 14,000 28,000
2 14,000 12,000
3 14,000 10,000
4 14,000 10,000
5 14,000 10,000

By ignoring risk differences and using NPV at 10% cost of capital, project A
is preferred over project B since its NPV of br. 11,074 is greater than B’s NPV
of birr 10,914. Assume however, that on further analysis the firm found that
project A is actually more risky than project B, to consider the deferring
risks; the firm estimated the certainty equivalent factors for each project’s
cash inflows for each year. Certainty equivalent for project A and B are as
follows:
Year Project A Project B
1 0.90 1.00
2 0.90 0.90
3 0.80 0.90
4 0.70 0.80
5 0.60 0.70

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Intermediate Finance Capital Budgeting under risk
City University College Department of Accounting & Finance

Upon investigation, ABC’s management estimated the prevailing risk free

rate of return, Rf, to be 6 percent.

Required: calculate the NPV.

Project A
Year Cash Certainty equivalent Certainty Present value
flow factor cash inflows
1 14,000 0.90 12,600 X(1.06)-1= 11,882
2 14,000 0.90 12,600 X(1.06)-2= 11,214
3 14,000 0.80 11,200 X(1.06)-3= 9,408
4 14,000 0.70 9,800 X(1.06)-4= 7,762
5 14,000 0.60 8,400 X(1.06)-5= 6,275

Present value of cash inflows = 46,541

Less: initial investment = 42,000
NPV = 4,541
Project B
Year Cash Certainty equivalent Certainty Present value
flow factor cash inflows
1 28,000 1.00 28,000 X(1.06)-1= 26,404
2 12,000 0.90 10,800 X(1.06)-2= 9612
3 10,000 0.90 9,000 X(1.06)-3= 7560
4 10,000 0.80 8,000 X(1.06)-4= 6336
5 10,000 0.70 7,000 X(1.06)-5= 5229
Present value of cash inflows = 55141
Less: initial investment = 45,00
NPV = 10,141
Note that as a result of the risk adjustment, project B is now preferred. The
usefulness of the certainty equivalent approach for risk adjustment should
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Intermediate Finance Capital Budgeting under risk
City University College Department of Accounting & Finance

be quite clear, the only difficulty lies in the need to make subjective
estimates of the certainty equivalent factors.

Allowing for inflation

So far, the effect of inflation has not been considered on the appraisal of
capital investment proposals. Inflation is particularly important in
developing countries as the rate of inflation tends to be rather high. As
inflation rate increases, so will the minimum return required by an investor.
For example, one might be happy with a return of 10% with zero inflation,
but if inflation was 20%, one would expect a much greater return.
Example
Keymer Farm is considering investing in a project with the following cash
flows:
ACTUAL CASH FLOWS
TIME $
0 (100,000)
1 90,000
2 80,000
3 70,000
Keymer Farm requires a minimum return of 40% under the present
conditions. Inflation is currently running at 30% a year and this is expected
to continue indefinitely. Should Keymer Farm go ahead with the project?

Let us take a look at Keymer Farm’s required rate of return. If it invest

$10,000 for one year on 1 January, then on 31 December it would required
a minimum return of $4,000. With the initial investment of $10,000, the total
value of the investment by 31 December must increase to $14,000. During
the year, the purchasing value of the dollar would fall due to inflation. We

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Intermediate Finance Capital Budgeting under risk
City University College Department of Accounting & Finance

can restate the amount received on 31 December in terms of the

purchasing power of the dollar at 1 January as follows:

Amount received on 31 December in terms of the value of the dollar at 1

January:
= $14,000
(1.30)1
= $10,769
In terms of the value of the dollar at 1 January, Keymer Fram would make
a profit of $769 which represents a rate of return of 7.69% in “today’s
money” terms. This is knows as the real rate of return. The required rate of
40% is a money rate of return (sometimes known as a nominal rate of
return). The money rate measures the return in terms of the dollar, which is
falling in value. The real rate measures the return in constant price level
terms.
The two rates of return and the inflation rate are linked by the equation:
(1+ money rate)= (1 + real rate)x (1 + inflation rate)
Where all the rates are expressed as proportions.
In the example,
(1+0.40)= (1+0.0769)x (1+0.3)
= 1.40
So, which rate is used in discounting? As a rule of thumb:
a) If the cash flows are expressed in terms of actual dollars that will be
received or paid in the future, the money rate for discounting
should be used.
b) If the cash flows are expressed in terms of the value of the dollar at
time 0 (i.e. in constant price level terms), the real reate of
discounting should be used.

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Intermediate Finance Capital Budgeting under risk
City University College Department of Accounting & Finance

In Keymer Farm’s case, the cash flows are expressed in terms of the actual
dollars that will be received or paid at the relevant dates. Therefore, we
should discount them using the money rate of return.
TIME CASH FLOW DISOCUNT FACTOR PV
$ 40% $
0 (150,000) 1.000 (100,000)
1 90,000 0.714 64,260
2 80,000 0.510 40,800
3 70,000 0.364 25,480
30,540

The project has a positive net present value of $30,540, so Keymer Farm
should go ahead with the project. The future cash flows can be re-
expressed in terms of the value of the dollar at time 0 as follows, given
inflation at 30% a year.

TIME ACTUAL CAHS FLOW CASH FLOW AT TIME 0 PRICE LEVEL

$ $
0 (100,000) (100,000)
1 90,000 90,000 x 1 = 69,231
(1.30)1
2 80,000 80,000 x 1 = 47,337
(1.30)1

3 70,000 70,000 x 1 = 31,862

(1.30)1

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Intermediate Finance Capital Budgeting under risk
City University College Department of Accounting & Finance

The case flows expressed in terms of the value of the dollar at time 0 can
now be discounted using the real value of 7.69%.

TIME CAHS FLOW DISCOUNT FACTOR PV

$ 7.69% $
0 (100,000) 1.000 (100,000)
1 69,231 1 64,246
(1.0769)1
2 47,337 1 40,804
(1.0769)2
3 31,862 1 25,490
(1.0769)3
30,540

The NPV is the same as before

Expectations of inflation and the effects of inflation
When a manager evaluates a project, or when a shareholder evaluates
his/her investments, he/she can only guess what the rate of inflation will
be. These guesses will probably be wrong, at least to some extent, as it is
extremely difficult to forecast the rate of inflation accurately. The only way
in which uncertainty about inflation can be allowed for in project
evaluation is by risk and uncertainty analysis.

Inflation may be general, that is, affecting prices of all kids, or specific to
particular prices. Generalized inflation has the following effects.
a) Inflation will mean higher costs and higher selling prices. It is difficult
to predict the effect of higher selling prices on demand. A
company that raises its prices by 30%, because the general rate of
inflation is 30%, might suffer a serious fall in demand.
b) Inflation, as it affects financing needs, is also going to affect
gearing, and so the cost of capital.

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Intermediate Finance Capital Budgeting under risk
City University College Department of Accounting & Finance

c) Since fixed assets and stocks will increase in money value, the same
quantities of assets must be financed by increasing amounts of
capital. If the future rate of inflation can be predicted with some
degree of accuracy, management can work out how much extra
finance the company will need and take steps to obtain it, e.g. by
increasing retention of earnings, or borrowing.
However, if the future rate of inflation cannot be predicted with a certain
amount of accuracy, then management should estimate what it will be
and make plans to obtain the extra finance accordingly. Provisions should
also be made to have access to contingency fund’s should the rate of
inflation exceed expectations, e.g a higher bank overdraft facility might
be arranged should the need arise.
Many different proposals have been made for accounting for inflation.
Two systems known as “Current purchasing power” (CPP) and “Current
cost accounting” (CCA) have been suggested.
CPP is a system of accounting which makes adjustments to income and
capital values to allow for the general rate of price inflation.
CCA is a system which takes account of specific price inflation 9i.e.
changes in the prices of specific assets or groups of assets), but not of
general price inflation. It involves adjusting accounts to reflect the current
values of assets owned and used.
At present, there is very little measure of agreement as to the best
approach to the problem of “accounting for inflation’. Both these
approaches are still being debated by the accountancy bodies

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