CHAPTER 1

OVER VIEW
 OUTLINE

• Capital investments: Importance and difficulties

• Types of capital investments
• Phases of capital budgeting
• Levels of decision making
• Facets of project analysis
• Feasibility study: A schematic diagram
• Key issues in major investment decisions
• Objectives of capital budgeting
• Common weaknesses in capital budgeting
 Capital Investments : Importance and Difficulties

Importance
• Long – term effects
• Irreversibility
• Substantial outlays
Difficulties
• Measurement problems
• Uncertainty
• Temporal spread
 Types of Investments

• Mandatory Investments
• Replacement investments
• Expansion investments
• Diversification investments
• R & D investments
• Miscellaneous investments
Capital Budgeting Process

Planning

Analysis

Selection

Financing

Implementation

Review
 Levels of Decision Making

Operating Administrative Strategic

decisions decisions decisions

◼ Where is the decision taken Lower level Middle level Top level
management management management

◼ How structured is the decision Routine Semi-structured Unstructured

◼ What is the level of resource Minor resource Moderate Major

commitment commitment resource resource
commitment commitment

◼ What is the time horizon Short-term Medium-term Long-term

 Key Issues in Project Analysis

Potential Market
Market Analysis
Market Share
Technical Viability
Technical Analysis
Sensible Choices
Risk
Financial Analysis
Return
Benefits and Costs in Shadow
Economic Analysis Prices
Other Impacts
Environmental Damage
Ecological Analysis
Restoration Measures
 Feasibility Study : A Schematic Diagram
P Generation of Ideas
r
e
l
Initial Screening
i
m
i
Is the Idea Prima Facie Promising
n Yes No
a
r Plan Feasibility Analysis
y Terminate

W
Conduct Market Analysis Conduct Technical Analysis
o
r
k
Conduct Financial Analysis
E
A
v
n
a Conduct Economic and Ecological Analysis
a
l
l
u
y Is the Project Worthwhile ?
a
s
t Yes No
i
i
s
o Prepare Funding Proposal Terminate
n
 Key Issues in Major Investment Decisions

• Investment story
• Risks
• DCF Value
• Financing
• Impact on Short-term EPS
• Options
 Objective of Capital Budgeting

Finance theory rests on the premise that managers should manage

their firm’s resources with the objective of enhancing the firm’s
market value. This goal has been eloquently defended by
distinguished finance scholars, economists, and practitioners. Wit
the following :

“ The quest for value drives scarce resources to their

most productive uses and their most efficient users. The
more effectively resources are deployed, the more robust
will be the economic growth and the rate of
improvement in our standard of living.”
 Basic Considerations : Risk and Return

Investment
Return
decisions

Market value
of the firm

Financing
Risk
decisions
 Common Weaknesses in Capital Budgeting
• Poor alignment between strategy and capital budgeting
• Deficiencies in analytical techniques
• Poor identification of base case
• Inadequate treatment of risk
• Improper evaluation of options
• Lack of uniformity in assumptions
• Neglect of side effects
• No linkage between compensation and financial measures
• Reverse financial engineering
• Weak integration between capital budgeting and expense budgeting
• Inadequate post - audits
 SUMMING UP
◼ Essentially a capital project represents a scheme for investing resources that
can be analysed and appraised reasonably independently.
◼ The basic characteristic of a capital project is that it typically involves a
current outlay (or current and future outlays) of funds in the expectation of a
stream of benefits extending far into the future.

◼ Capital expenditure decisions often represent the most important decisions

taken by a firm. Their importance stems from three inter-related reasons:
long-term effects, irreversibility, and substantial outlays.

◼ While capital expenditure decisions are extremely important, they pose

difficulties which stem from three principal sources: measurement problems,
uncertainty, and temporal spread.

◼ Capital budgeting is a complex process which may be divided into six broad
phases: planning, analysis, selection, financing, implementation and review.
◼ One can look at capital budgeting decisions at three levels: operating,
administrative, and strategic.

◼ The important facets of project analysis are: market analysis, technical

analysis, financial analysis, economic analysis, and ecological analysis.

◼ Financial theory, in general, rests on the premise that the goal of financial
management should be to maximise the present wealth of the firm’s equity
shareholders. Business firms may pursue other goals. When these other goals
conflict with the goal of maximising the wealth of equity shareholders, the
trade-off has to be understood.

◼ The common weaknesses found in capital budgeting systems in practice are:

poor alignment between strategy and capital budgeting; deficiencies in
analytical techniques; no linkage between compensation and financial
measures; reverse financial engineering; weak integration between capital
budgeting and expense budgeting; inadequate post-audits.
 CHAPTER 3
GENERATION AND SCREENING OF
PROJECT IDEAS
 OUTLINE
• Generation of ideas
• Monitoring the environment
• Corporate appraisal
• Profit potential of industries : Porter model
• Scouting for project ideas
• Preliminary screening
• Project rating index
• Sources of positive net present value
• On being an entrepreneur
 Generation of Ideas

To stimulate the flow of ideas, the following are helpful

• SWOT analysis
• Clear articulation of objectives
• Fostering a conducive environment
Business Environment

Competitor
 Corporate Appraisal

• Marketing and distribution

• Production and operations
• Research and development
• Corporate resources and personnel
• Finance and accounting
 Tools for Identifying Investment Opportunities

There are several tools or frameworks that are helpful in identifying

promising investment opportunities. The more popular ones are:

• Porter model
• Life cycle approach
• Experience Curve
 Porter Model
According to Michael Porter the profit potential of an industry depends
on the combined strength of the five basic competitive forces as shown
below
Forces Driving Industry Competition
Potential
Entrants

Threat of New
Entrants
Bargaining
Power of Bargaining
THE INDUSTRY
Suppliers Power of Buyers
Suppliers Rivalry Among Buyers
Existing Firms

Threat of
Substitute
Products

Substitutes
 Life Cycle Approach
Many industrial economists believe that most products evolve through a
life cycle that has four stages:

• Pioneering stage
• Rapid growth stage
• Maturity and stabilisation stage
• Decline stage

Investment in the pioneering stage, per se, may have a low return and
negative NPV. However, it may create options for participating in
growth.
Most products evolve through a life cycle. The broad stages and
the investment returns in these stages are as follows:

Stage Investment Return

◼ Pioneering ◼ May have negative NPV
but may create options
for participating in
growth stage
◼ Rapid growth ◼ Positive NPV
◼ Maturity ◼ NPV – neutral
◼ Decline ◼ Negative
 Experience Curve
• The experience curve shows how the cost per unit behaves with respect to
the accumulated volume of production

100

80

60

40
10 20 40 80
Accumulated volume of production

• The key factors that contribute to decline in unit cost with respect to the
accumulated volume of production are learning effects, technological
improvements, and economies of scale
 Scouting for Project Ideas
• Analyse the performance of existing industries
• Examine the inputs and outputs of various industries
• Review imports and exports
• Study plan outlays and governmental guidelines
• Look at the suggestions of financial institutions and development agencies
• Investigate into local materials and resources
• Analyse economic and social trends
• Study new technological developments
• Draw clues from consumption abroad
• Explore the possibility of reviving sick units
• Identify unfulfilled psychological needs
• Attend trade fairs
• Stimulate creativity for generating new product ideas
• Hope the chance factor will favour you
 Preliminary Screening

Compatibility with the promoter

Consistency with governmental priorities
Availability of inputs
Adequacy of market
Reasonableness of cost
Acceptability of risk level
 Project Rating Index
The steps involved in determining the project rating index are
as follows:
• Identify factors relevant for project rating
• Assign weights to these factors ( the weights are supposed to
reflect their relative importance)
• Rate the project proposal on various factors, using a suitable
rating scale (Typically a 5-point scale or a 7-point scale is used
for this purpose.)
• For each factor, multiply the factor rating with the factor weight to
get the factor score
• Add all the factor scores to get the overall project rating index
 Construction of a Rating Index

Factor Factor Rating Factor

Weight Score
VG G A P VP
5 4 3 2 1

Input availability 0.25 ✓ 0.75

Technical know-how 0.10 ✓ 0.40
Reasonableness of cost 0.05 ✓ 0.20
Adequacy of market 0.15 ✓ 0.75
Complementary relationship
with other products 0.05 ✓ 0.20
Stability 0.10 ✓ 0.40
Dependence on firm’s
strength 0.20 ✓ 1.00
Consistency with
governmental priorities 0.10 ✓ 0.30

Rating Index 4.00

 Sources of Positive NPV

It appears that there are six main entry barriers that result in
positive NPV projects. They are as follows:

• Economies of scale

• Product differentiation

• Cost advantage

• Marketing reach

• Technological edge

• Government policy
 The Questions Every Entrepreneur Must Answer
According to Amar Bhide the following are the question that every
entrepreneur must answer:
Are my goals well defined?
• Personal aspirations
• Business sustainability and size
• Tolerance for risk
Do I have the right strategy?
• Clear definition
• Profitability and potential for growth
• Durability
• Rate of growth
Can I executive the strategy
• Resources
• Organisational infrastructure
• The founder’s role
 Qualities and Traits of a Successful Entrepreneur

It appears that a successful entrepreneur has the following qualities and

traits :
Willingness to make sacrifice
Leadership
Decisiveness
Confidence in the project
Marketing orientation
Strong ego
Open-mindedness
 On Entrepreneurship

An internationally acknowledged authority on development

economics, Nobel Laureate Sir Arthur Lewis commented as
follows on the role of entrepreneurship.

“ I have devoted a lifetime to the study of developing economies. I

have examined strategies of development, the role of foreign trade, of
savings and investment, the most helpful role of government, and a
myriad of other factors. I am now convinced that nothing matters
more than the work ethic and entrepreneurial spirit of the
population.”
 SUMMARY
◼ Identification of promising investment opportunities requires imagination, sensitivity
to environmental changes, and a realistic assessment of what the firm can do.

◼ To stimulate the flow of investment ideas, the following are helpful: (i) SWOT
analysis, (ii) clear articulation of objectives, and (iii) conducive climate.
◼ The business environment which needs to be monitored regularly to identify
investment opportunities, may be divided into six broad sectors: economic sector,
government sector, technological sector, socio-demographic sector, competition
sector, and supplier sector.

◼ A realistic appraisal of corporate strengths and weaknesses is essential for

identifying investment opportunities which can be profitably exploited. The broad
areas of corporate appraisal are: market and distribution, production and operations,
research and development, corporate resources and personnel, and finance and
accounting.

◼ According to Michael Porter the profit potential of an industry depends on the

combined strength of the following five basic competitive forces (i) threat of new
entrants, (ii) rivalry among existing firms, (iii) pressure from substitute products, (iv)
bargaining power of buyers, and (v) bargaining power of sellers. Good project ideas
– the key to success are elusive. So a wide variety of sources should be tapped to
identify them.
◼ It is possible to develop a long list of project ideas. For the preliminary screening of
these ideas, the following aspects may be looked into: compatibility with the
promoter, consistency with governmental priorities availability of inputs, adequacy
of market, reasonableness of cost, and acceptability of risk level. When a firm
evaluates a large number of project ideas regularly, it may be helpful to streamline
the process of preliminary screening by employing a project rating index.
◼ It appears that there are six main entry barriers which result in positive NPV
projects: economies of scale, product differentiation, cost advantage, marketing
reach, technological edge, and government policy.
◼ Every entrepreneur must answer the following questions: Are my goals well
defined? Do I have the right strategy? Can I execute the strategy?

◼ It appears that a successful entrepreneur has the following qualities and traits:
willingness to make sacrifices, leadership, decisiveness, confidence in the project,
marketing orientation, and a strong ago.
 Indian Infrastructure
&
Project Identification, Feasibility
and Appraisal
Indian Infrastructure
Index Component Value Score Rank out of Best
141 Perfor
mer

Source: Global Competitiveness Index 4.0 2019 edition

Indian Infrastructure

Source: Global Competitiveness Index 4.0 2019 edition

Introduction to Infrastructure
• Global Competitiveness Index (GCI) tracks the
performance of close to 141 countries on 12 pillars of
competitiveness. It assesses the factors and institutions
identified by empirical and theoretical research as
determining improvements in productivity, which in
turn is the main determinant of long-term growth and
an essential factor in economic growth and prosperity.
• The Global Competitiveness Report hence seeks to help
decision makers understand the complex and
multifaceted nature of the development challenge;
Dr. C. Rangarajan Commission’s Notion of
Infrastructure (2001)
Six characteristics of infrastructure sectors:
(a) Natural monopoly
(b) High-sunk costs
(c) Non-tradability of output
(d) Non-rivalness (up to congestion limits) in
consumption
(e) Possibility of price exclusion, and
(f) Bestowing externalities on society
Dr. Rakesh Mohan Committee Report (1996)
and the Central Statistical Organisation (CSO)
“The India Infrastructure Report” included
Electricity, gas, water supply, telecom, roads,
industrial parks, railways, ports, airports, urban
infrastructure, and storage as infrastructure. Except
industrial parks and urban infrastructure, all these
sub-sectors are treated by CSO also as infrastructure.
Reserve Bank of India (RBI) circular on
Definition of Infrastructure:
As per the RBI, a credit facility is treated as “infrastructure lending” to a borrower
company which is engaged in developing, operating and maintaining, or
developing, operating and maintaining any infrastructure facility that is a project in
any of the following sectors, or any infrastructure facility of a similar nature:
a road, including toll road, a bridge or a rail system; a integrated highway project,
port, airport, inland waterway or inland port;
water supply project, irrigation project, water treatment system, sanitation and
sewerage system or solid waste management system;
telecommunication services, industrial park or special economic zone;
generation or generation and distribution of power; transmission or distribution
system of power,
construction relating to projects involving agro-processing and supply of inputs ,
preservation and storage to agriculture;
construction of educational institutions and hospitals;
any other infrastructure facility of similar nature
PPP
A PPP refers to a long-term contractual arrangement between
public (national, state, provincial, or local) and private entities
through which the skills, assets, and/or financial resources of
each of the public and private sectors are allocated in a
complementary manner—thereby sharing the risks and rewards,
to seek to provide optimal service delivery and good value to
citizens.
PPPs may be characterized by the following four elements:
Duration: Contracts between public and private sector partners
are usually medium- to long-term, often covering the lifetime of
the asset being produced under the PPP contract.
PPP
Financing, responsibilities, and ownership: Asset financing by the
public and/or private sector is often complex and can involve
revenues obtained from the operation of the asset over a
designated period. Responsibility for constructing, operating, and
maintaining the asset can often be included in the responsibilities
of the private partner. Ownership of the asset varies by PPP
arrangement. In some cases, the private sector operator owns the
asset and transfers ownership to the public sector partner after a
designated period. In other cases, ownership is shared or may be
retained by the public sector partner over the life of the asset.
PPP
Performance-based returns: PPPs develop assets or projects for the
purpose of delivering ongoing services to the public, rather than
the asset being the deliverable of the contract, with payment being
contingent on the operator of the asset meeting performance
standards. The public sector partner is usually responsible for
monitoring performance over the life of the contract.

Output and quality specification: The private sector partner

participates in stages of the project defined by the public sector
partner (e.g., design, construction, operation, maintenance, and
financing). The public sector partner defines the outcomes to be
achieved in terms of public interest, quality of services provided,
and pricing policy.
 Public and Private Provision of Infrastructure

* Also known as Design-Construct-Manage-Finance (DCMF) or Design-Build-Finance-Maintain

(DBFM)
** Also known as Build-Transfer-Lease (BTL), Build-Lease-Operate-Transfer (BLOT) or Build-
Lease-Transfer (BLT)
*** Also known as Build-Own-Operate-Transfer (BOOT)
 Project finance for a power-purchase agreement

Source: Yescombe and Farquharson (2018), “public-private partnerships for infrastructure”

Project finance for a toll-road concession

Source: Yescombe and Farquharson (2018), “public-private partnershipsfor infrastructure”

Project finance for a PPP school project

Source: Yescombe and Farquharson (2018), “public-private partnerships for infrastructure”

Value for Money
Year Wise Summary: Projects recommended by the Public Private
Partnership Appraisal Committee (PPPAC)
S.No. Financial Year Number of Projects Total Project Cost (In Rs. Crore)
Approved

1 2019-2020 3 3718
2 2018-2019 8 9730.38
3 2017-2018 4 7851.78
4 2016-2017 9 12401.28
5 2015-2016 17 28674.1
6 2014-2015 18 29070.77
7 2013-2014 25 55326.29
8 2012-2013 25 25641.53
9 2011-2012 52 53248.6
10 2010-2011 33 26010.24
11 2009-2010 53 57854.97
12 2008-2009 48 53381.78
13 2007-2008 13 11227.46
14 2006-2007 15 6533.54
Total 323 380670.72
Source: https://www.pppinindia.gov.in
Sector Wise Summary: Projects recommended by the
PPPAC

Number of Projects Total Project Cost (In Rs.

S.No. Sector Approved Crore)
1 Airports 10 9017
2 Housing 9 7633.55
3 Ports 37 51911.3
4 Railways 1 8500
5 Roads 257 302388
6 Sports 5 0
7 Tourism 4 1220.87
Total 323 380670.72

Source: https://www.pppinindia.gov.in
Authority Wise Summary: Projects recommended by the PPPAC

S.No. State Number of Projects Total Project Cost

Approved (In Rs. Crore)

1 Airports Authority of India 6 9017

2 Department of Economic Affairs (Currency 1 148.87
and Coinage Division)
3 Ministry of Civil Aviation 4 0
4 Ministry of Home Affairs 8 7299.17
5 Ministry of Horme Affairs 3 1072
6 Ministry of Railways 1 8500
7 Ministry of Road Transport and Highways 257 302388

8 Ministry of Shipping 38 52245.68

9 Ministry of Youth Affairs and Sports 5 0
(MoYA&S)
Total 323 380670.72

Source: https://www.pppinindia.gov.in
 State Wise Summary: Projects recommended by the PPPAC

State Number of Projects Approved Total Project Cost (In Rs. Crore)

Andaman and Nicobar Islands 2 770

Andhra Pradesh 22 21220.48
Assam 5 4078.53
Bihar 13 12262.44
Chhattisgarh 4 3466.07
Delhi 8 9492.58
Goa 5 4936.3
Gujarat 16 21692.01
Haryana 12 16046.2
Himachal Pradesh 5 6419.73
Jammu & Kashmir 8 20927.55
Jharkhand 3 3777.43
Karnataka 23 20501.62
Kerala 12 10869.44
Lakshadweep 1 302
Madhya Pradesh 20 20758.9
Maharashtra 29 51176.94
Meghalaya 1 536
Multiple State 14 27955.76
Odisha 21 25436.82
Punjab 12 10981.37
Rajasthan 21 18839.77
Tamil Nadu 26 21879.95
Uttar Pradesh 25 31248.81
Uttrakhand 2 1021.61
West Bengal 13 14072.41
Total 323 380670.72
 Feasibility Study : A Schematic Diagram
P Generation of Ideas
r
e
l
Initial Screening
i
m
i
Is the Idea Prima Facie Promising
n Yes No
a
r Plan Feasibility Analysis
y Terminate

W
Conduct Market Analysis Conduct Technical Analysis
o
r
k
Conduct Financial Analysis
E
A
v
n
a Conduct Economic and Ecological Analysis
a
l
l
u
y Is the Project Worthwhile ?
a
s
t Yes No
i
i
s
o Prepare Funding Proposal Terminate
n
Key Issues in Project Analysis
Potential Market
Market Analysis
Market Share
Technical Viability
Technical Analysis
Sensible Choices
Risk
Financial Analysis
Return
Benefits and Costs in Shadow
Economic Analysis Prices
Other Impacts
Environmental Damage
Ecological Analysis
Restoration Measures
 Sources of Positive NPV
It appears that there are six main entry barriers that result in
positive NPV projects. They are as follows:

Economies of scale

Product differentiation

Cost advantage

Marketing reach

Technological edge

Government policy
Annuity
Future Values of Annuity Present Value of Annuity
Capital Budgeting
Capital budgeting is the process that companies use for
decision making on capital projects (projects with a life of
a year or more).

Capital budgeting is primarily concerned with sizable

investments in long-term assets. These asset may be
tangible (property, plant or equipment) or intangible ones
(technology, patents, or trademarks).

Investments in processes such as advertisement campaign,

sales distribution, and research & development may be
considered in the investment in intangibles.
Investment Decisions
Main features:
The expenditure and benefits both should be
measured in cash.
The exchange of current funds for future benefits.
The funds are invested in long-term assets.
The future benefits will occur to the firm over a
series of years.

Ex: Investment in Delhi Airport by GMR

Infrastructure
Investment Decisions Significance
Growth in long run

Risk affects overall risk of the firm

Funding needs deployment of large amount of funds

Irreversibility mostly irreversible or even if

reversible at substantial losses

Complexity needs fair assessment of future events

Example: Reliance Industries launch of R-JIO
Investment Evaluation Criteria
Three steps are involved in the evaluation of an
investment:
i. Estimation of cash flows

ii. Estimation of the required rate of return (the

opportunity cost of capital)

iii. Application of a decision rule for making the

choice
Investment Decision Rule
a. It should maximise the shareholders’ wealth.
b. It should consider all cash flows to determine the true
profitability of the project.
c. It should provide for an objective and unambiguous
way of separating good projects from bad projects.
d. It should help ranking of projects according to their
true profitability.
e. It should recognise the fact that bigger cash flows are
preferable to smaller ones and early cash flows are
preferable to later ones.
f. It should help to choose among mutually exclusive
projects that project which maximises the
shareholders’ wealth.
Evaluation Criteria
Non-discounted Cash Flow Criteria
Payback Period (PB)
Discounted payback period (DPB)
Accounting Rate of Return (ARR)
Discounted Cash Flow (DCF) Criteria
Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index (PI)
Payback Period
Payback Period Example
Year 0 1 2 3 4

Cash flow -15000 +5000 +5000 5000 5000

Cumulative cash -15000 -10000 -5000 0 5000

flows

Year 0 1 2 3 4

Cash flow -15000 +6000 +7000 8000 9000

Cumulative cash -15000 -9000 -2000 6000 15000

flows
Acceptance Rule
a. The project would be accepted if its payback
period is less than the maximum or standard
payback period set by management.

b. As a ranking method, it gives highest ranking

to the project, which has the shortest payback
period and lowest ranking to the project with
highest payback period.
Advantages of Payback Period
a. Simplicity: very simple in calculation and application without
numerous hidden assumptions and concepts.

b. Cost effective: very low cost in terms of analysis, time and uses of
sophisticated computers.

c. Risk shield: it favours project which generates substantial cash inflows

in earlier years but discriminates against the projects with substantial cash
inflows in later phases but not in earlier phases. If risk tends to increase
with futurity, then it provides some rough idea about riskiness of project.

d. Liquidity: project with a shorter payback period tends to be more liquid

than a project with longer payback period.
Limitations of Payback Period
Time value of money not considered.

Cash flows after payback period is not taken into account.

Thus, not true measure of profitability.

Cash flow patterns particularly timings and magnitude are not

taken in to account.

Administrative difficulties in setting up maximum acceptable

payback period.
Discounted Payback Period
It overcomes the one of the major shortcomings of
payback period by considering time value of money of
the cash flows.

The discounted payback period is the number of periods

taken in recovering the investment outlay on the present
value basis.

The discounted payback period still fails to consider the

cash flows occurring after the payback period.
 Discounted Payback Period Example

Year 0 1 2 3 4
Cash flow -15000 +5000 +5000 5000 5000
Cumulative cash flows -15000 -10000 -5000 0 5000

PBP 3 Years
Present Value @12% -15000 4464.28 3985.96 3558.90 3177.59
p.a
Cumulative -15000 -10535.72 -6549.76 -2990.86 186.73
Discounted Cash
Flows

DPBP 3 Years 11 Months 14 Days

Accounting Rate of Return (ARR)
ARR Example
A project will cost Rs 40,000. Its stream of earnings before
depreciation, interest and taxes (EBDIT) during first year
through five years is expected to be Rs 10,000, Rs 12,000, Rs
14,000, Rs 16,000 and Rs 20,000. Assume a 50 per cent tax
rate and depreciation on straight-line basis.
Accounting Rate of Return = 3200 * 100 /
20000 = 16%
 Example
Year 1 Year 2 Year 3 Year 4 Year 5 Average
EBDIT 10000 12000 14000 16000 20000 14400
Depreciation 8000 8000 8000 8000 8000 8000
EBIT 2000 4000 6000 8000 12000 6400
Taxes 1000 2000 3000 4000 6000 3200
Earnings before interest
and after taxes 1000 2000 3000 4000 6000 3200
Book value of investment
Beginning 40000 32000 24000 16000 8000
Ending 32000 24000 16000 8000 0
Average 36000 28000 20000 12000 4000 20000
Net Present Value (NPV)
Future cash flows of the project needs to be forecasted based
on realistic assumptions.

Appropriate discount rate based on opportunity cost of capital

should be identified to discount the forecasted cash flows.

Present value of cash flows should be estimated using the

opportunity cost of capital as the discount rate.

Net present value should be computed by subtracting present

value of cash outflows from present value of cash inflows.

The project with positive NPV (NPV > 0) only to be accepted.

Net Present Value Method
 Net Present Value Example
Year 0 1 2 3 4
Cash flow (Rs.) -15000 +5000 +5000 5000 5000
Present Value @12% p.a -15000 4464.28 3985.96 3558.90 3177.59
(Rs.)
Present Value of Cash -15000
Outflows (Rs.)

Present Value of Cash 15186.73

Inflows (Rs.)
Net Present Value (Rs.) 186.73
Limitations of Net Present Value
Involved cash flow estimation
Discount rate difficult to determine
Mutually exclusive projects
Ranking of projects
Internal Rate of Return
Advantages & Disadvantages
Advantages
Considers all cash flows of the projects
Time value of money considered.
True measure of profitability.
Generally consistent with wealth maximization concept.
Disadvantages
Non additivity
Cash flow forecasting a tedious job
Relatively complicated to calculate
Multiple rates in case of non-conventional projects.
 IRR Example
0 1 2 3 4
Cash flow (Rs.) -15000 +5000 +5000 5000 5000
Present Value @12% -15000 4464.28 3985.96 3558.90 3177.59
p.a (Rs.)

IRR 12.59%
Project Risk Analysis
Risk Analysis
Analysts uses 2 phase evaluation of capital investments:
a. NPV / IRR, Cost of Capital, and Cash Flows

b. Identification of underlying sources of the risk and

explores its consequences on the project viability.
Techniques for Risk Analysis
Techniques for Risk
Analysis

Analysis of Stand- Analysis of

Alone Risk Contextual Risk

Sensitivity Scenario Corporate Market Risk

Analysis Analysis Risk Analysis Analysis

Break-even Hillier
Analysis Model

Simulation Decision tree

Analysis Analysis
Analysis of Stand-Alone Risk
Sensitivity analysis
Scenario Analysis
Hillier Model
Decision Tree Analysis
Simulation Method
Sources of Risk
• Project - specific Risk
• Competitive Risk
• Industry specific risk
• Market Risk
• International Risk
Measures of Risk
• Risk refers to volatility / variability of expected outcome. It is
a complex and multi-faceted phenomenon. A variety of
measures have been used to capture different facets of risk.
The more important measures of Risk are:

Range
Standard Deviation
Coefficient of Variation
Semi – variance
Example
NPV Probability
200 0.30
600 030
900 0.20
1200 0.20
Example
Semi – Variance
Sensitivity Analysis
Sensitivity analysis calculates the effect on NPV of changes in
the one of the input variables. Usually there are several factors
which affect the NPV: unit selling price, unit variable cost, fixed
cost, sales volume, required rate of return.

Thus, Sensitivity analysis examines the impact of change in any

input variables on the NPV under three different scenarios:
expected, optimistic and pessimistic.

Also known as “What-If” Analysis.

Sensitivity Analysis
Expected: Most likely

Optimistic: higher revenue, higher sales volume, low cost

Pessimistic: Higher cost, lower sales volume, higher required rate of return

Based on the estimation, manager can know which factor affects

the maximum impact on NPV.
 Sensitivity Analysis
It shows degree of resistance under adverse changes in the input
factors
Refer to the example shown in the excel sheet

Table 1: Expected Cash Flow Forecast for ABC Power Plant Ltd.
(Rs. in crores)
Year 0 Year 1 - 10
Investments -20000
Sales 18000
Variable Costs (2/3 of sales) 12000
Fixed Cost 1000
Depreciation 2000
Pre-Tax Profit 3000
Taxes 1000
PAT 2000
Cash Flow from Operations 4000
Net Cash Flows -20000 4000
 Sensitivity Analysis
Table 2: Sensitivity of NPV to variations in the value of key variables
Range
Key inputs Pessimistic Expected Optimistic
Investments 24000 20000 18000
Sales 15000 18000 21000
Variable Costs (%age of sales) 70 66.66 65
Fixed Cost 1300 1000 800

Table 3: Sensitivity Analysis of NPV to variations in the value of key variables

Key inputs Pessimistic Expected Optimistic
Investments -645.74 2600.89 4224.21
Sales -1165.92 2600.89 6367.71
Variable Costs (%age of sales) 340.80 2600.89 3730.94
Fixed Cost 1470.85 2600.89 3354.26
 Scenarios Analysis
• More than one input variables are changed simultaneously to
examine their impact on the NPV under each scenario.
• Slightly more complicated & at least 3 scenario is considered
for the analysis.
Expected Scenario
Year
Particulars 0 1 - 10
Investment -20000
Sales 18000
Variable Costs (2/3 of sales) 12000
Fixed costs 1000
Depreciation 2000
PBT 3000
Tax@33.33% 1000
PAT 2000
Net cash flow 4000
Discount rate 12%
Project life 10 Years
Scenario Analysis: Pessimistic
Pessimistic
Year
Particulars 0 1
Investment -24000
Sales 15000
Variable Cost (70% of sales) 10500
Fixed costs 1300
Depreciation 2400
PBT 800
Tax@33.33% 266.66667
PAT 533.33333
Net cash flow 2933.3333
Required rate of return 12%
Project life 10 Years
NPV - 7,426.01
Scenario Analysis: Optimistic
Optimistic
Year
Particulars 0 1-10
Investment -18000
Sales 21000
Variable Cost (65% of sales) 13650
Fixed costs 800
Depreciation 1800
PBT 4750
Tax@33.33% 1583.33333
PAT 3166.66667
Net cash flow 4966.66667
Required rate of return 12%
Project life 10 Years
NPV 10,062.77
Scenario Analysis
Benefits over sensitivity analysis: As most of the times, input
variables move together. Thus assuming others constant, one
input variables may not define complete solidity of the
investment projects.

Expected: + 2600.89
Optimistic: + 10062.77
Pessimistic: -7426.01
Hillier Model
Hillier model states that the uncertainty or the risk associated
with any project investment proposal can be measured by the
standard deviation of the expected cash flows.
For more certain a project: deviation of the various cash flows
will be less from mean cash flows.
Thus, estimation of standard deviations of cash flows enables
the firm to determine the uncertainty of the project.
Hillier Model
Hillier Model: Uncorrelated Cash Flows
Hillier Model: Uncorrelated Cash Flows
Year 1 Year 2 Year 3
Net cash Net cash Probabilit Net cash
flows Probability flows y flows Probability
3000 0.3 2000 0.2 3000 0.3
5000 0.4 4000 0.6 5000 0.4
7000 0.3 6000 0.2 7000 0.3

Expected cash
flows 5000 4000 5000
NPV $2,475.06
2400000 2000000 2400000
2326.388
Hillier Model: Perfectly Correlated Cash Flows
Decision Tree Analysis
Decision tree analysis is a tool for analysing situations where
sequential decision making in face of risk is involved.

The key steps in decision tree analysis are:

Identifying the problem and alternatives
Delineating the decision tree
Specifying probabilities and monetary outcomes
Evaluating various decision alternatives
Decision Tree Analysis
The decision tree, exhibiting the anatomy of the decision
situation, shows :
The decision points (also called decision forks / D) and
the alternative options available for experimentation and
action at these decision points.
The chance points (also called chance forks / C) where
outcomes are dependent on a chance process and the
likely outcomes at these points.
The decision tree reflects in a diagrammatic form the nature
of the decision situation in terms of alternative courses of
action and chance outcomes which have been identified in the
first step of the analysis.
Decision Tree Analysis
Once the decision tree is delineated, the following data have to be
gathered :
Probabilities associated with each of the possible
outcomes at various chance forks, and
Monetary value of each combination of decision
alternative and chance outcome.
Decision Tree Analysis Example
The scientists at Spectrum have come up with an electric moped.
The firm is ready for pilot production and test marketing. This
will cost Rs.20 million and take six months. Management
believes that there is a 70 percent chance that the pilot production
and test marketing will be successful. In case of success,
Spectrum can build a plant costing Rs.150 million. The plant will
generate an annual cash inflow of Rs.30 million for 20 years if
the demand is high or an annual cash inflow of Rs.20 million if
the demand is moderate. High demand has a probability of 0.6;
Moderate demand has a probability of 0.4. what is the optimal
course of action using decision tree analysis? Assume 12%
discount rate.
Spectrum Case

C21 : High
demand Annual
cash flow
Probability 30 million
: 0.6
D21:Invest
c2
-Rs 150
million C22 : Moderate Annual
C11 : Success demand cash flow
D2 Probability
Probability 20 million
D11: Carry out pilot : 0.4
production and : 0.7 D22: Stop
market test
c1
-Rs 20
million
C12 : Failure D31: Stop
D1 D3
Probability : 0.3

D12:Do nothing