INVESTMENT DECISION - CAPITAL

BUDGETING

Nature of Investment Decisions

The allocation of funds of a concern mainly

depends on its investment decision. It is the
choice of assets such as short-term or current
assets and long-term or fixed assets where funds
will be invested. The investment decision relating
to the long-term or fixed assets is know as capital
budgeting or capital expenditure decisions or long
term investment decision.
A capital budgeting decision may be defined as
the firm's decision to invest its current funds more
efficiently in the long-term assets in anticipating or
an expected flow of benefits over a series of
years. The firm's investment decisions would
generally include expansion, acquisition,
modernization and replacement of the long-term
assets.
Investment in long-term assets invariably requires
large funds to be tied up in the current assets
such as inventories and receivable. As such,
investment in fixed and current assets is one
single activity.
Is a sale of a division or business
(divestment) is also an investment decision
?
In finance and economics. divestment or divestiture is
the reduction of some kind of assets for either financial or
ethical objectives. A divestment is the opposite of an
investment.
Often the term is used as a means to grow financially in
which a company sells off a business unit in order to
focus their resources on a market it judges to be more
profitable, or promising. Sometimes, such an action can
be a spin-off ; A company can divest assets to wholly
owned subsidiaries.
The largest, and likely most-famous, corporate divestiture
in history was the 1984 US Department of Justice-
mandated break-up off the Bell System into AT&T and
the seven Baby Bells
A spin-off is a new organisation or entity formed by a
split from a larger one.

 Yes, sale of a division or business

(divestment) is also as an investment decision.
Decisions like the change in the methods of sales
distribution or an advertisement campaign or a
research and development programme have
long-term implications for the firm's
 expenditure and benefits, and therefore, they
should also be evaluated as investment
decisions.

Types of Investment Decisions

Normally, the following types of capital
expenditures are incurred in a large business
concern :

 Expansion and Diversification(spreading

investments) : When a company add capacity
to its existing product lines to expand existing
operations (Production) is termed as related
diversification. When a firm expand its
activities in a new business, expansion of a
new business requires investment in new
product and a new kind of production activity
within the firm is termed as unrelated
diversification. Sometimes a company
acquires existing firms to expand its business.
In either case, the firm makes investment in
the expectation of additional revenue.
Investments in existing or new product may
also be called a revenue-expansion
investments.
 Replacement and Modernisation : The main
objective of modernisation and replacement is
to improve operating efficiency and reduce
costs. Cost savings will reflects in the
increased profits, but the firm's revenue may
remain unchanged. Assets become outdated
and obsolete with technological changes. The
firm must decide to replace those assets with
new assets that operate more economically.
Replacement decision help to introduce more
efficient and economical assets and therefore,
are also called cost-reduction investments.

 Mutually Exclusive Investments : Mutually

Exclusive Investment serve the same purpose
and compete with each other. If one
investment is undertaking, others will have to
be excluded.

 Independent Investments : Independent

investments serve different purposes and do
not compete with each other. Investment in
machinery, automobiles, buildings and so on
are the examples of the independent
investment decisions. Acceptance of each of
these projects is done on its own merit without
depending on other projects.
  Contingent Investments : Contingent
investments are dependent projects; the
choice of one investment necessitates
undertaking one or more other investments.
e.g., if a company decides to build a factory in
a remote, backward area, it may have to
invest in houses, hospitals, schools etc, for
employees to attract the work force. Thus
building of factory also require investment in
facilities for employees. The total expenditure
will be treated as one single investment.

Meaning of Capital Budgeting

Capital Budgeting is the most important and

complicated problem of managerial decisions. It is
concerned with designing and carrying out through a
systematic investment programme. It involves the
planning of such expenditures which provide yields
over a number years. Under Capital Budgeting ,
proposed capital expenditure and their financing are
considered and projects assuring the most profitable
use of given resources are undertaken.

"Capital Budgeting is long-term planning for

making and financing proposed capital outlays."
- Charles T. Horngren.
"Capital Budgeting consists in planning for
development of available capital for the purpose
of maximising the long-term profitability (return
on investment) of the firm."
- R.M Lynch.

Feature of Capital Budgeting Decisions

 It involves exchange of current funds for future

benefits.
 Funds are invested in long-term activities.
 The benefits will occur to the firm over a series
of periods.
 They have the effect of increasing the
capacity, efficiency, span of life regarding
future benefits.

Significance of Capital Decisions

 Growth : Influence the firm's growth in the

long run.

 More Risky : If the adoption of an investment,

increases average gain but causes frequent
fluctuations in its earning , the firm will
become more risky.
 Irreversible : Most investment decisions are
irreversible since it is very difficult to find out a
market for such capital items once they have
been used.

 Huge Funding : Investment decisions

generally involve large amount of funds, which
make it imperative for the firm to plan its
investment programme very carefully and
make an advance arrangement for procurring
finances internally or externally.

 Effect on other projects : Whenever long-

term asset investment is a part of the
expansion programme, its cashflow effects the
projects under consideration, if it is not
economically independent.

 Difficult Decision : Capital budgeting

decision is very difficult as its decision
involves future years cash inflows and
uncertainty of future and more risk.
 Capital Budgeting Process

Project Project Project Project

Generation Evaluation Selection Execution

Project Generation : Investment proposals of

various types may originate at different levels
within a firm, such as.
 Proposals to add new product to the product
line.
 Proposals to expand capacity in existing
product lines.
 Proposals to reduce the costs of the output.

Project Evaluation : Project evaluation involves

two steps:
 Estimation of benefits and costs. The benefits
and costs must be measures in terms of cash
flows.
 Selection of an appropriate criterion to judge
the desirability of the project.

Project Selection : The step is related to the

screening and selecting the projects. Though the
final approval of the projects may be given by the
top management, projects under consideration
may be screened at various levels of
management.

Project Execution : The funds are appropriated

for capital expenditure after the final selection of
investment proposals .The formal planning for the
appropriation of funds is called the capital budget.
The project execution committee or the
management must ensure that the funds are
spent in accordance with appropriations made on
the capital budget.

According to financial managers, the Capital

Budgeting Process is classified as under :

 Planning/idea Generation: The search for

promising project ideas is the first step in
capital budgeting process. Identifying a new
worthwhile project is a complex problem. It
involves a careful study from many different
angles. Idea can be generated from the
sources like, performance analysis of existing
industries, examination of input and output of
various industries, review of import and export
data, study plans outlays and government
guidelines, study of new technological
developments, draw clues form the
 consumption abroad, attending trade fairs and
etc.

 Evaluation/Analysis : when the project

proposal suggests that the project is prima
facie worthwhile, then it is required to go for
evaluation/analysis. Marketing, technical,
financial, economic and ecological may be the
aspects of analysis.

 Selection : Selection or rejection follows the

analysis phase. If the project is worthwhile,
after using a wide range of evaluation
technique then we accept the proposal.

 Financing : After the selection of the project,

the next step is financing. Generally the
amount required is known after the selection
of the project. There are two broad sources
available such as equity ( shareholder’s funds-
paid up share capital, Share premium and
retatined earnings) and debt (long funds- term
loans, debentures and working capital
advances). While deciding the capital
structure we have to examine the factors like
Risk, Income, control and Tax benefits.
  Execution/Implementation : Planning of
paper work and implementation is physically
different in implementing the selected project.
Implementation of an industrial project
involves the stages, project and engineering,
design, negotiations and contracting,
construction, training a plant commissioning

 Review : Once the project is converted from

paper work to concrete work, then, there is
need to review the project. Performance
review should be done periodically, under this
performance review, actual performance is
compared with the predetermined or projected
performance.

Capital Budgeting Appraisal

Methods

It is very necessary that the method adopted for

appraisal of capital investment proposal should be
a sound one. Any appraisal method should
provide for the following.
 A basis of distinguishing between acceptance
and non- acceptable projects.
 Ranking of Project in order of their desirability.
  Choosing among several alternatives.
 Recognising the fact, that bigger benefits are
preferable to smaller ones and early benefits
are preferable to later ones.

Techniques Of Project Evaluation

Project Evaluation
Techniques

Traditional / Non- Modern/ Discounted

discounted cash Cash Flow
flow

Pay Back Accounting NPV IRR PI

Period Role of Return Method Method

Investment Evaluation Criteria

(I) Traditional Techniques or Non-

Discounted Cash Flow Techniques :

The traditional techniques are further subdivided

into two, such as (a) Pay Back period, and (b)
 Accounting Rate of Return or Average Rate of
Return (ARR)

(A) Pay Back Period : The payback (PB) is one

of the most popular and widely recognized
traditional methods of evaluating proposals.
Payback is the number of years required to
recover the original cash outlay invested in a
project. If the project generates constant annual
cash inflows, the payback period can be
computed by dividing cash outlay by the annual
cash inflow. That is:

Pay Back Period (PBP) = Original Investment /

Constant Annual Cash Flows After Taxes.

Illustration : Project requires an outlay of

Rs.90,000 and yields annual cash inflow of
Rs.15,000 for 8 years. What is the payback
period of the project ?

Solution : Pay Back Period (PBP) = Original

Investment / Constant Annual Cash Flows After
Taxes.
= 90,000/15,000
 = 6 years

Unequal Cash flows : In case of unequal cash

inflows , the payback can be found out by adding
up the cash inflows until the total is equal to the
initial outlays.

Pay Back Period (PBP) = Years before full

recovery + (unrecovered Amount of Investment/
Cash flows during the year).

Illustration : Project requires a cash outlay of

Rs.20,000, and yields annual cash inflow of
Rs.8,000; Rs.7,000; Rs. 4,000; and Rs.3,000
during the next 4 years. What is the payback
period of the project ?

Solution : When we add up the cash inflows, we

find that in the first three years Rs.19,000 of
the original outlays is recovered. In the fourth
year cash inflow generated is Rs.3,000 and only
Rs.1,000 of the original outlay remains to be
recovered. Assuming that the cash inflows
occurs evenly during the year, the time
required to recover Rs. 1,000 will be
(Rs. 1.000 x 12)/Rs.3,000 = 4 months. Thus the
pay back period is 3 years and 4 months.

Pay Back Period (PBP) = Years before full

recovery + (unrecovered Amount of Investment/
Cash flows during the year).
= 3years (1000/3000)
= 3.33 years.

Accept- Reject Rule

Acceptance or rejection of the project is based on
the comparison of calculated PBP with the
maximum or standard pay back period.

Accept : Cal PBP < Standard PBP

Reject : Cal PBP > Standard PBP
Considered : Cal PBP = Standard PBP

Advantages Pay Back Period

 It is very simple and easy to understand.
  Cost involvement in calculating pay back
period is very less as compared to other
methods.

Shortcomings of Pay Back Period Method

 It ignores cash flows after pay back period.
 It is not an appropriate method of measuring
the profitability of an investment, as it does not
consider all cash inflow yielded by the
investment.
 It does not take into consideration time value
of money.
 It is not consistent with the objective of
maximizing shareholder’s wealth. Share value
does not depend on pay back periods of
investment projects.

For calculating payback period we need cash

flow after tax (CFAT)
 Calculation of Cash flows After taxes (CFAT)

Particulars Rs.
Sales revenue xxx
Less : Variable Cost xxx
Contribution xxx
Less : Fixed Cost xxx
Earning before Depreciation and Taxes xxx
(EBDT)
Less : Depreciation xxx
Earning Before Taxes (EBT) xxx
Less : Taxes xxx
Earning After Tax (EAT) xxx
Add: Depreciation xxx
Cash Flows After Tax (CFAT) or xxx
Earning after Taxes but Before
Depreciation (EATBD)

Illustration : Hindustan Ltd. Is considering

the purchase of a raw machine for its
expansion programme. There are two possible
machine suitable for the purpose. Their details
are as under :

Machine
X Y
 (Rs.) (Rs.)
Capital Cost 6,00,000 6,00,000
Sales 10,00,000 8,00,000
Cost of Prod. : D. Material 80,000 1,00,000
D. Labour 1,00,000 60,000
Factory O.H. 1,20,000 1,00,000
Adm. Overheads 40,000 20,000
Selling & Dist. Exps. 20,000 20,000

The economic life of machine X is 5 years and that of Y is 4

years. The scrap value are Rs.60,000 and Rs.40,000
respectively. Sales are expected to be at the rate shown
each year during the machine. Tax to be paid is expected at
50% of the net earning each year. Show which machine
would be more profitable investments on the basis of pay-
back period.

Solution :
Calculation of Cash flows After taxes (CFAT)

Machine Machine
Particulars
(X) (y)
Sales revenue 10,00,000 8,00,000
Less : Variable & Fixed cost
Direct Material 80,000 1,00,000
Direct Labour 1,00,000 60,000
Factory O/H 1,20,000 1,00,000
Administrative O.H 40,000 20,000
Selling & Distribution Cost 20,000 20,000

Earning before Depreciation and Taxes (EBIT) 6,40,000 5,00,000

Less : Depreciation 1,08,000 1,40,000
Earning Before Taxes (EBT) 5,32,000 3,60,000
Less : Taxes 50 % 2,66,000 1,80,000
Earning After Tax (EAT) 2,66,000 1,80,000
Add: Depreciation 1,08,000 1,40,000
Cash Flows After Tax (CFAT) or 3,74,000 3,20,000
Earning after Taxes but Before Depreciation
(EATBD)

Pay Back Period = Initial Investment/Cash Inflow

Machine (X) PBP = 6,00,000/3,74,000 = 1.60Years

Machine (Y) PBP = 6,00,000/3,20,000= 1.87 Years

If we want the answer in months then multiply by 12

The Pay back period of Machine X is less, hence it is

more profitable.

(b) Accounting Rate of Return/ Average Rate

of Return (ARR) : This methods takes into
account the earnings expected from the
investment over their whole life. It is known as
accounting Rate of Return method or Return on
Investment (ROI) or the reason that under this
method, the accounting concept of profit (net
profit after tax and depreciation) is used rather
than cash inflows we can say that, under this
method we uses accounting information, as
revealed by financial statements, to measure the
profitability of an investment. It is measured in
terms of percentage-
ARR can be calculated in two ways.

(i) Accounting Rate of Return (ARR) =

Average annual EAT or PAT/ Original
Investment (OI)

OI = Original investment + Additional NWC +

Installation Charges + Transportation Charge

(ii) Average Rate of Return = { Average

annual EAT / Average investment
(AI) } x 100
AI = [(original investment - scrap) / 2] +
Additional NWC + Scrap Value.

The version of the Accounting Rate of Return is

less consistent as earning are averaged but
investment is not.

Advantages of ARR Method

  The ARR method is simple to understand and
use. It does not involve complicated
computations.
 ARR can be readily calculated from the
accounting data. No adjustment are required
to arrive at cash flows of the project.
 It uses the entire earnings of a project in
calculating rate of return and not only the
earnings upto pay-back period and hence
gives a better view of profitability as compared
to pay-back period method.

Shortcomings of ARR Method

 This method also like pay-back period method

ignores the time value of money as the profits
 earned at different points of time are given
equal weight by averaging the profits.

 It uses accounting profits instead of actual

cash flows after taxes. Accounting profits are
based on arbitrary assumptions and choices
and also include non-cash items. It is
therefore, inappropriate to rely on this method.

 It does not differentiate between the size of

the investment required for each project.

 This method cannot be applied to a situation

where investment in a project is to be made in
parts.

Illustration : A Limited firm has under

consideration the following projects. Their
details are as follows:

Particulars Project X Project Y

 (Rs.) (Rs.)
Investment in Machinery 10,00,000 15,00,000
Working Capital 5,00,000 5,00,000
Life of Machinery (years) 4 6
Scrap value of Machinery (%) 10 10
Tax rate (%) 50 50
Income before depreciation and tax at the end
of
years 1 2 3 4 5 6
X (Rs.) 8,00,000 8,00,000 8,00,000 8,00,000
Y (Rs.) 15,00,000 9,00,000 15,00,000 8,00,000 6,00,000 3,00,000

You are required to calculate the average

rate or return and suggest which project is
to be preferred.

Solution :

Average Rate of Return = { Average annual

EAT / Average investment (AI) } x 100
Project X = (2,87,500 / 10,50,000) x 100
= 27.38 %

Project Y = (3,54,167 / 13,25,000) x 100

= 26.73 %

Working notes :
Calculation of Average Annual Income After
Depreciation and Taxes
Project X Project Y
Particulars (Rs.) (Rs.)
Average EBDT 8,00,000 9,33,333
Less: Depreciation 2,25,000 2,25,000
Average EBT 5,75,000 7,08,333
Less : Taxes @ 50 % 2,87,500 3,54,166
Average EAT 2,87,500 3,54,167

Calculation of Average Investment

AI = [(original investment - scrap) / 2] +

Additional NWC + Scrap Value.

Project X : (10,00,000-1,00,000)/2 + 5,00,000 + 1,00,000

= Rs. 10,50,000

Project Y : (15,00,000-1,50,000)/2 + 5,00,000 + 1,50,000

= Rs. 13,25,000

Calculation Depreciation
Project X : (10,00,000-1,00,000)/4 = Rs.2,25,000

Project Y : (15,00,000-1,50,000)/6 = Rs.2,25,000

Calculation EBIT
Project X : 32,00,000/4 = 8,00,000
Project y : 56,00,000/6 = 9,33,333

(II) Modern Techniques or Discounted

Cash Flow (DCF) Techniques :

Modern/discounted cash flow techniques take into

consideration almost all the deficiencies of the
traditional methods and consider all benefits and
cost occurring during the project’s entire life
period. This technique can be subdivided into
three method.
(a) Net Present Value (NPV), (b) Internal Rate of
Return (IRR) or trial and error and (c) Profitability
Index (PI) or Discounted Benefit Costs Ratio
(DBCR)

(A) Net Present Value Method : The net present

value (NPV) method is the Discounted Cash
Flow (DCF) technique which recognizes the
time value of money. It correctly postulates
that cash flows arising at different time
 periods differ in value and are comparable
only when their equivalents- present values-
are found out. It is the process of calculating
present value of cash inflows using cost of
capital as an appropriate rate of discount and
subtract present value of cash outflows form
the present value of cash inflows and find the
net present value, which may be positive or
negative. Positive net present value occurs
when the present value of cash inflow is
higher than the present value of cash outflows
and vice versa.

NPV = present value of cash inflows -

present value of cash outflows

Accept-Reject Rule

Acceptance or reject rule of the project is

decided on the NPV.

Accept : NPV > Zero

Reject: NPV < Zero

Consider : NPV = Zero

Advantages of ARR Method
 It recognizes the time value of money and is
suitable to be applied in a situation with
uniform cash outflows and uneven cash
inflows or cash flows at different periods of
time.
 It is particularly useful for the selection of
mutually exclusive projects.
 It takes into consideration the changing
discount rate.
 It is consistent with the objective of
maximization of shareholders wealth.
Shortcomings of Net Present Value Method

 As compared to the traditional methods, the

net present value method is more difficult to
understand and operate.
 It is not easy to determine an appropriate
discount rate.
 Calculation of required rate or discounting
factor or cost of capital is difficult, which
involves a lengthy and time consuming
process. At the same time calculation cost of
capital is based on different method.

Illustration : Project X costs Rs. 2,500 now

and is expected to generate year-end cash
inflows of Rs.900, Rs.800, Rs.700, Rs.600 and
Rs.500 in years through 5. The opportunity
cost of the capital may be assumed to be 10
percent.
Solution :
Formula of present value of uneven series

NVP = Present value of cash inflows - Present

value of cash outflows.
NPV = [{900/(1+0.10)}
+{800/(1+0.10)2}+{700/(1+0.10)3}+{600/(1+0.10)4}+
500/(1+0.10)5}] – Rs,2,500
= [Rs. 900 (PVIF1, 0.10) + Rs. 800 (PVIF2, 0.10) + Rs.
700 (PVIF3, 0.10) + Rs. 600 (PVIF4, 0.10) + Rs. 500
(PVIF5 0.10) ] – Rs.2,500
= [(Rs. 900 x 0.909) + (Rs. 800 x 0.826) + (Rs.
700 x 0.751) + (Rs. 00 x 0.683) + (Rs. 500 x
0.620) ] – Rs. 2,500
= Rs. 2,725- Rs.2,500 =+ Rs.225
Project X’s present value of cash inflows (Rs.
2,725) is greater than that of cash outflow
(Rs.2,500). Thus, it generates a positive net
present value (NPV = Rs.225). Project X adds
to the wealth of owners: therefore. It should
be accepted.

(B) Internal Rate Of Return (IRR) Method :

IRR is that rate at which the sum of Discounted

cash inflow (DCF) equals the sum of discounted
cash outflow. It is the rate at which the net
present value of the investment is zero. It is called
Internal Rate of Return because it depends
mainly on the outlay and proceeds associated
with the project and not on any rate determined
outside the investment. Internal rate of return may
be defined as that discounted factor at which the
present value of cash inflows equals to the
present value of cash outflow. In case of NPV
method, the discount rate is the required rate of
return and that is predetermined, usually by cost
of capital, which determines based on external
point of view, where as IRR is based on facts,
which is internal to the proposal

Computation of IRR is base on the cash flow after

taxes. Under this method evaluator selects any
discount rate to compute present value of cash
inflows. Generally the cost of capital is taken as
first trial. If we find that cash inflow is higher than
the present value of cash outflow then evaluator
has to try at higher rate and vice versa. This
process will be repeated till the present value of
cash inflows equals to the present value of cash
outflows. Generally, IRR may lie between two
discounting factors; in that case analyst has to
use interpolation formula for calculation of IRR.

IRR = A +{ (C - O)/(C - D) } x (B - A)

Where
A = Discounted factor of low trial
B = Discounted factor of high trial
C = Present value of cash inflow in low trial
D = Present value of cash inflow in high trial
O = Original or initial outlay

Illustration : A Project costs Rs.16,000 and is

expected to generate cash inflow of Rs.8,000,
Rs.7,000 and Rs.6,000 at the end of each year
for next 3 years. Find the IRR of a projcet.

Solution :
we know that IRR is the rate at which project
will have a zero NPV. As a first step, we try a
20% discount rate. The project's NPV at 20%
is.

- Rs.1,004 i.e., Total Amount of Present

Value of cash inflow is Rs.14,996

Now we have to try at a lower rate lets try

NPV at a discount rate of 16% it is
- Rs.57 i.e., Total Amount of Present Value
of cash inflow is Rs.15,943
The NPV is still less than the present value of
cash outflow, so we will try it at still lower
rate. Lets try NPV at a discount rate of 15 %
it is
Rs.200 i.e., Total Amount of Present Value
of cash inflow is Rs.16,200
it means that the discount rate will fall
somewhat in between 15% and 16%. Now we
will use interpolation formula.
IRR = A +{ (C - O)/(C - D) } x (B - A)

Where
A = 15%
B = 16%
C = Rs.16,200
D = Rs.15,943
O = Rs.16,000

IRR = 15% +{ (16,200 - 16,000)/(16,200 - 15943) } x

(16% - 15%)
= 15% + 0.80%
= 15.80%

(C) Profitability Index (PI) / Discounted Benefit

Cost Ratio (DBCR) Method :

This method is similar to NPV method. it is the

ratio of the present value of cash inflows, at the
required rate of return, to the initial cash outflow
of the investment proposal. PI method measures
the present value of future cash per rupee, where
as NPV is based on the difference between
present value of cash inflow and present value of
cash outflows.
PI is the ratio of present value of future cash
benefits at the required rate of return at the initial
cash outflow of the investment.

PI = PV of cash inflows / Initial cash outlay

like IRR and NPV methods, profitability index is

conceptually sound method of appraising
investment projects. It provides ready
comparisons between investment proposals of
different magnitudes.

Accept-Reject Rule

Accept : PI >1
Reject : PI < 1
considered :PI = 1

Illustration : The initial cash outlays of a

project is Rs.1,00,000 and it generates cash
inflows of Rs.40,000, Rs.30,000, Rs.50,000,
and Rs.20,000. Assume a 10% rate of discount.
calculate profitability index.
Solution :

Calculation of Profitability Index

Years CFAT(Rs.) DF 10% Present Value (Rs.)
1 40,000 0.909 36,360
2 30,000 0.826 24,780
3 50,000 0.751 37,550
4 20,000 0.683 13,660
PV of Cash inflows 1,12,350

Profitability Index = PV of Cash inflows /

Initial investment = 1,12,350/1,00,000
= 1.12

Capital Rationing

The selection of only some of the profitable

investment proposals or projects and the rejection
of the other profitable investment proposals due
to limited available of funds or other
considerations, say, the desire of the
management to keep the growth of the firm within
limit, the preference of the management to safety
and control as compared to profit.

Steps Involved In Capital Rationing

(a) Ranking of the different investment

proposals: First, the different investment
proposals or capital projects available,
should be ranked on the basis of their
profitability (i.e. on the basis of their NPV or
IRR or Profitability Index) in the descending
order.
(b) Selection of some of the profitable
investment proposals: Then, on the basis
of their profitability in the descending order,
the selection of that combination of profitable
investment proposals, which would provide
the highest profitability, should be made
subject to the budget constraint for the
period.

Risk Analysis In Capital Budgeting

As risk is involved in every investment proposal,
in real situation, it is necessary to take into
account the risk factor, while taking the capital
budgeting decision.
Risk in an investment refers to the variability that
is likely to future between the estimated returns
and the actual returns from the proposal. The
greater is the variability between the two returns,
the more is the risk involved in the project and
vice versa.

Incorporation of the Risk in Investment Proposal :

As risk is involved in every capital budgeting

proposal, the management of a firm must take the
risk factor into account, while determining the
returns or cash inflows and the profitability of a
project for the purpose of capital budgeting.
There are two most popular Technique used for
incorporation of Risk Factor in Capital Budgeting
Decisions.

They are
(A) Ordinary techniques or general
techniques, such as (i) risk adjusted
discount rate and (ii) certainly equivalent
coefficient.
 (B) Quantitative techniques such as (i)
Sensitivity Analysis, (ii) Probability
Assignment, (iii) Standard Deviation, (iv)
Coefficient of Variance and (v) Decision
Tree.

(A) Ordinary or General Techniques

(i) Risk Adjusted Discounted Rate

Method.
Under the risk adjusted discount rate method, the
future cash flow from capital projects are
discounted at the risk adjusted discount rate and
decision regarding the selection of a project is
made on the basis of the net present value of the
project computed at the risk adjusted discount
rate.
The risk adjusted discount rate comprises two
rates, i.e.,
(i) risk-free, normal rate, usual discount rate
or unity rate that takes care of time
element and
(ii) risk premium rate, surplus rate or extra
rate that takes care of the risk factor. So,
the risk adjusted discount rate is the usual
or normal discount rate for the time factor
 plus the extra or additional discount rate
for the risk factor.

Risk premium rate is the extra or additional

discount rate at which the future cash flows of a
risky project are discounted. The risk-premium
rate or the extra discount rate for the risk factor
varies with the degree of risk involved in the
capital projects. So, for a less risky investment
proposal, the extra discount rate will be lower and
for a more risky investment proposal, the extra
discount rate for the risk factor will be more.

Illustration : From the following data, state

which project is preferable :
A (Rs.) B (Rs.)
Year 1 6,000 8,000
Year 2 5,000 6,000
Year 3 4,000 5,000
Initial cost of the 12,000 12,000
project
Riskless discount rate is 5%. Project A is less
risky as compared to project B and so, the
management considers risk premium rate at 5%
and 10% respectively as appropriate for
discounting the cash flows.

Solution :
First Step : Calculation of Risk-Adjusted Discount
Rate.
For Project A

Riskless discount rate 5%

Add Risk-Premium rate 5%
Risk adjusted discount rate 10%

For Project B

Riskless discount rate 5%

Add Risk-Premium rate 10%
Risk adjusted discount rate 15%

First Step : Calculation of Discount cash inflows

(i.e., present value and net present value of the
projects) :

Years Project A Project B

Discounted Cash Discounted Cash
inflows at 10% inflows at 15%
Rs. Rs.
1 (6,000 x .909) 5,454 (8,000 x .876) 7,008
2 (5,000 x .826) 4,130 (6,000 x .756) 4,536
3 (4,000 x .751) 3,004 (5,000 x .658) 3,250
Total 12,588 14,794
Less: Intial outlay 12,000 12,000
Net Present value 588 2,794

Comment : The net present value of Project B is higher than

that of Project A. So, Project B is preferable.

(ii) Certainty Equivalent Coefficient

Method.
Under this method, adjustment against risk is
made in the estimates of future cash inflows of a
risky capital project by a adjusting (i.e., reducing)
to a conservative level the estimated cash flows
of a capital investment proposal by applying a
correction factor termed as certainty equivalent
coefficient.
The certainty equivalent coefficient is the ratio of
riskless cash flow to risky cashflow. Riskless cash
flow means the cash flow which the management
expects, when there is no risk in investment
proposal. Risky cash flow means the cash flow
which the management expects when there is risk
in investment proposal.

certainty equivalent coefficient =

Riskless cash flow/ Risky cash flow

Illustration : Two mutually exclusive investment
proposals, X and Y are under consideration
before the management of a company. The initial
outlay of each project is Rs. 30,000. Both the
projects are estimated to have a useful economic
life-span of 5 years.
The estimates of cash inflow and their certainty
equivalent coefficient are as follows:
Years Project X Project Y
Est. Cash Flow Certainly Est. Cash Flow Certainly
Rs. Equi.Coeffiecint Rs. Equi.Coeffiecint

1 25,000 .7 30,000 .6
2 30,000 .5 35,000 .5
3 20,000 .4 25,000 .4
4 15,000 .3 12,000 .2
5 10,000 .2 10,000 .1

The cost of capital for the company is 15%

Compare the net present value of the two projects and
suggest which project should be accepted by the
management.

Solution :

First Step- Computation of the net present value

of the projects :

Project X
 Risk Adjusted
Est.Cash PVF @ Present Value
Years CEC Cash Flows
Flow (Rs.) 15% (Rs.)
(Rs.)
(25,000 x .7) (17,500 x .870)
1 25,000 0.7 = 17,500
0.870 = 15,225
(30,000 x .5) (15,000 x .756)
2 30,000 0.5 = 15,000
0.756 = 11,340
(20,000 x .4) (8,000 x .658)
3 20,000 0.4 = 8,000
0.658 = 5,264
(15,000 x .3) (4,500 x .572)
4 15,000 0.3 = 4,500
0.572 = 2,574
(10,000 x .2) (2,000 x .497)
5 10,000 0.2 = 2,000
0.497 = 994
Gross Present Value 35,397
Less : Initial Capital outlay 30,000
Net Present Value 5,397
Project Y

Net Present Value 7,340

Decision-making : Here, both the projects have

positive net present value. So, both projects are
acceptable

However, the net present value of Project Y is

more than that of project X. That means, Project
Y is preferable.

(B) Quantitative Techniques

 (i) Sensitivity Analysis.
While making capital investment decision, if we
consider only one figure of estimated cash
inflows, there are chances of estimation errors
creeping into the capital investment decision. So
to avoid this, the sensitivity analysis has been
introduced.

Under the sensitivity analysis, usually,

estimation of the cash inflows of a project is
made under three assumptions or situation.

(i) Pessimistic
(ii) Most likely and
(iii) Optimistic

Outcomes associated with the projects. After

estimating the cash inflows and determining the
net present value of the project under the three
different situations, conclusion is drawn about the
riskness of the projects. The larger is the
difference between the pessimistic and optimistic
cash inflows and the resultant net present value,
the more is the risk of the project and vice versa.

(ii) Probability Assignment Method.

Sensitivity analysis method suffers from a
limitation. It, no doubt, provides cash inflow
estimated under three different assumption or
situations, i.e., pessimistic, most likely and
optimistic. But is does not indicate the chances of
occurrence of each of these three estimates.
Under Probability Assignment Method we assign
approximate probabilities to these three cash
inflow estimates. The cash inflows as adjusted by
probability will give a more precise estimates of
the likely cash inflows as compared to the cash
inflows which are not adjusted by probabilities.

Illustration:
A company has two capital investment proposals,
A and B under consideration both the projects
require investment of Rs.6,000.

The following are the details of possible events, cash

inflows and probability assignments:

Project A Project B
Probable Cash Cash
Probability Probability
cash inflow inflow
Assign. Assign.
inflows Rs. Rs.
A 5,000 0.20 10,000 0.15
B 6,000 0.30 8,000 0.25
C 8,000 0.40 8,000 0.30
D 8,000 0.20 6,000 0.25
E 10,000 0.10 5,000 0.20
You are required to give your opinion regarding
the selection of the project.

Solution :

Project A
Probable Cash
Probability
cash inflow Expected Monetary Value
Assign.
inflows Rs.
A 5,000 0.20 5,000 x .20 = 1,000
B 6,000 0.30 6,000 x .30 = 1,800
C 8,000 0.40 8,000 x .40 = 3,200
D 8,000 0.20 8,000 x .20 = 1,600
E 10,000 0.10 10,000 x .10 = 1,000
Total Expected monetary
8,600
value

Project B

Total expected monetary value of Project B is

Rs.8,400

Hence value of project A is more than project B.

So, Project A is preferable.

(iii) Standard Deviation Approach.

Probability assignment approach is, no doubt, a
good technique of risk analysis in capital
budgeting. But it does not give precise results
about the extend of variability of cash inflows.
Keeping in view standard deviation method has
been introduced.

Standard deviation method is a statistical

technique of risk measurement . It is the square
root of the squared deviation calculated from the
mean. Standard deviation is used to compare the
variability of probable cash inflows of different
projects from their respective mean or expected
values.

Illustration :

A company has two projects A and B, under

consideration. Both the projects involve an equal
initial investment of Rs.6,000

Possible
Project A Project B
Events Cash inflow Probability Cash inflow Probability
Rs. Assign. Rs. Assign.
A 5,000 0.20 12,000 0.20
B 7,000 0.15 10,000 0.20
 C 9,000 0.30 9,000 0.40
D 9,000 0.20 8,000 0.15
E 10,000 0.10 6,000 0.10

Solution :

Computation of Standard deviation

Project A
Possi Cash Deviation from the Deviation Probability Product of
ble inflow A.mean Squared Assign. Standard
Event Rs. up deviation. &
Probability
A 5,000 8,000 - 5,000 = 3,000 90,00,000 0.20 90,00,000 x
0.20 =
18,00,000
B 7,000 8,000 - 7,000 = 1,000 10,00,000 0.15. 1,50,000
C 9,000 0.30 3,00,000
D 9,000 0.20 2,00,000
E 10,000 0.10 4,00,000
Total of Product of squared deviations and Probability 28,50,000
Standard Deviation = Square root of 28,50,000
= 1688.19

Project B

Total of Product of squared deviations and Probability =

30,50,000

Standard Deviation = Square root of 30,50,000

= 1,746.12
The standard deviation of project B is more than
that of project A. That means the variability of
cash flow is more in the case of project B than in
the case of project A. So, project B is more risky.

(iv) Coefficient of Variation Method.

Standard Deviation is an absolute measure. It

is not suitable for comparison, particularly
when investment proposals involve different
capital outlay or different monetary values of
probable cash inflows. In such a situation , a
relative measure of dispersion should be
employed for comparison. For comparison is
such cases, coefficient of variation approach
is the best measure.
Coefficient of variation is a relative measure of
dispersion. Coefficient of variation should be
computed to judge the relative position of risk
involved

Coefficient of variation = (Standard Deviation

x 100)/ Mean

If we consider the above Example, calculate the

coefficient of variation and suggest which
project is more risky.
The coefficient of deviation (i.e., Variation) of
the Project is:

Project A
Coefficient of variation = (Standard Deviation x
100)/ Mean
= 1688.19/8,000 = 0.21

Project B
Coefficient of variation = (Standard Deviation x
100)/ Mean
= 1746.42/9,000 = 0.19

The coefficient of deviation of Project A is more

than that of project B. That means, Project A is
more risky but in the case of standard deviation
B is more risky.

(v) Decision Tree Analysis.

Investment decisions are, generally, sequential

in nature. That is, They involve a sequence of
decisions over time. An investment decision
taken at one point of time results in a series of
decision alternatives at some other time in
future, depending upon the nature and extent of
outcome and events. As a result investment
decisions become complex.

The complex investment decisions can be

handled through the technique of decisions tree
analysis. The technique of decision tree
analysis can be employed effectively to analyse
and evaluate sequential investment decisions.

Step involved in the Decision Tree Process :

 Defining the investment opportunity or

proposal
 Finding out the alternatives
 Exhibiting the decision tree indication the
decision point, decision branches, chance
events and other data
 Specification of probability and cash flows
 Computation of expected monetary value
 Analysis of the alternatives.