FIN 314: BUSINESS FINANCE I

CAPITAL BUDGETING UNDER UNCERTAINTY

LECTURER: Prof. R. A. Olowe

 COURSE RESOURCES
• The lecture is based on the recommended text for the course
Main reading:

• Olowe, R. A. (2017). Financial Management: Concepts, Financial System and Business Finance. 4th
edition. Lagos: Brierly Jones (ORA) – Chapter 14
• Brealey, A. R., and Myers, S. C. Principles of Corporate Finance.10th Edition (or earlier). (BM)
• Owualah, S. I. (2000). Principles of Financial management, Ikeja: G-Mag Investments Ltd. (OSI)
• Ross S., Westerfield, R. And Jaffe, J. (2012). Corporate Finance. Tenth Edition. IRWIN-McGraw-Hill.
• Ezike, J. E. (2012). Essentials of Corporate Financial Management, Lagos: Jaylycent
Communications (EJE)
• Shiro, A. A. (2004). Problems and Solutions in Financial Management. (SAA)
 CONTENT
• Nature of Risk and Uncertainty
• Business Vs Financial Risk
• Methods Of Treating Risk Or Uncertainty In Capital Budgeting
• Summary
• Review Quiz
 Nature of Risk and Uncertainty
(ORA – Chap. 14)
• Risk - variability that is likely to be associated with future returns from
a project. Risk and uncertainty are often used interchangeably.
• Risk - the future outcome is unknown, but the likelihood of various
possible future outcomes may be assessed based on a knowledge of
past or existing events so that probability estimates are available..
• Uncertainty - the future outcome cannot be predicted with any
degree of confidence from a knowledge of past or existing events, so
that no probability estimates are available.
• Risk arises in capital investment analysis because possible future
events cannot be anticipated with certainty and, thus, cash flow
sequence cannot be correctly forecasted.
 Business Vs Financial Risk
(ORA – Chap. 14)
• Financial risk - risk arising as a result of introduction of debt finance

• Business risk – risk associated with potential variability of earnings

caused by the nature and type of business operations.
 Methods Of Treating Risk Or Uncertainty In Capital
Budgeting (ORA – Chap. 14)
Non probability-based Approach
Probability-based Approach
 Non probability-based Approach
(ORA – Chap. 14)
• Payback period.
• Risk adjusted discount rate approach.
• Certainty equivalent cash flow approach.
• Sensitivity analysis.
 Payback period
(ORA – Chap. 10 &14)
• The payback period can be used to reduce the risk on a capital project
by applying a payback time limit, which is setting maximum payback
period for a project before it can be accepted.

• Example
• See worked Example 14.1 in ORA (Chap. 14)
 Risk adjusted discount rate approach.
(ORA – Chap. 14)
• This method allows for risk by building in risk premium to the
discount rate used in evaluating capital investment projects.
• NPV with this approach is given as:
N
At
• NPV = 
t  0 (1  k A )

• where KA is the risk-adjusted discount rate

• KA = Rf + P.
where Rf = risk-free rate.
P = risk premium.
 Risk adjusted discount rate approach Contd.
ORA – Chap. 14
• Example
• See worked Example 14.2 in ORA (Chap. 14)
 Certainty equivalent cash flow approach
(ORA – Chap. 14)
• This method allows for risk by adjusting the future (forecast) cash flows in a
capital investment project to the best estimate or certainty-equivalent by a
risk-adjustment factor or certainty-equivalent coefficient.
• NPV with this approach is given as:
N
t At
• NPV =   A0
t 1 (1  R f )
t

• where αt = certainty-equivalent coefficient at a time.

• At = forecast cash flow at time t.
• Rf = risk-free rate.
 Certainty equivalent cash flow approach
(ORA – Chap. 14)
• The value of α varies between 0 and 1 and it depends on the risk of
the project.

• Example
• See worked Example 14.3 in ORA (Chap. 14)
 Sensitivity analysis
(ORA – Chap. 14)
• This method allows for risk by varying the values of the key factors.

How to Apply Sensitivity Analysis in Project Appraisal

• There are two methods
• (1) Varying the expected cash flows of a project to measure what would happen if the project were to
work out somewhat worse than expected. For instance, the NPV or IRR of the project can be recalculated if:
• the initial cost of the project was, say 10% higher than expected; operating costs were, say 8% higher, or
revenue were, say 12% lower than estimated.
• (2) Break even Method
.
 Sensitivity analysis
(ORA – Chap. 14)
• Example
• See worked Example 14.5 and 14.6 in ORA (Chap. 14)
 PROBABILITY-BASED METHOD OF ASSESSING RISK
(ORA – Chap. 14)
• Based on past experience and analysis of events affecting
each cash flow estimate in a capital investment project, a
decision maker might be able to assess the likelihood of
each estimate occurring, i.e., he can assign probabilities.
• Once probabilities have been assigned to future cash flows,
risk can be assessed by calculating the expected value (EV)
and standard deviation (STD).
 PROBABILITY-BASED METHOD OF ASSESSING RISK
(ORA – Chap. 14)
• Expected Value of Cashflow (EV) is given as:
N
• EV = A t   A jt Pjt
j1

• where Āt = expected cash flow or value in period t.

• Ajt = the cash flow or value for a jth event in period t.
• Pjt = the probability of the cash flow for the jth event in period t.
 PROBABILITY-BASED METHOD OF ASSESSING RISK
(ORA – Chap. 14)
• Standard Deviation of Cash flows
•
N
• σt =  jt t Pjt
(A
t 1
 A ) 2

• where σt = standard deviation of net cashflows.

• Ajt = possible net cash flows in period t.
• Āt = expected value of net cash flow in period t.
• Pjt = the probability associated with each cash flow.
 PROBABILITY-BASED METHOD OF ASSESSING RISK
(ORA – Chap. 14)
• Example
• See worked Example 14.7 and 14.8 in ORA (Chap. 14)
 Coefficient of Variation

• This is a relative measure of risk and is measured as:

• Coefficient of Variation = STD

EV

• Example

• See worked Example 14.9 in ORA (Chap. 14)

 PROBABILITY DISTRIBUTION:
• Projects whose cash flows over time can be explained by a probability
distribution need to make an assumption concerning the dependence
and independence of cash flows over time for a proper analysis of the
risk of the project.
• Dependence of Cashflows - causative relationship between cash flows
from period to period.

• Independence of Cashflows – No causative relationship between cash

flows from period to period.
• Focus – Independence of Cashflow
 Independence of Cashflows

N
At
• Expected NPV of the project = 
t 0 (1  R ) t
f

• The standard deviation of the probability distribution of net present

value is given by:
• STD =
N
 2


t 1 (1 
t

R ) t
f
 Independence of Cashflows
(ORA – Chapter 14)
• Where Āt is the expected value of cash flow in period t.
• Rf is the risk-free rate.
• σt2 = Variance of net cash flows in period t.
N

• σt =  jt t Pjt
(A 
t 1
A ) 2

• σt is the standard deviation of net cash flow for period t.

• Ajt is possible net cash flows in period t.
• Āt is the expected value of net cash flow in period t.
• Pjt is the probability associated with each cash flow.
 Independence of Cashflows Contd.
• Example
• See worked Example 14.10 in ORA (Chap. 14)
 SUMMARY
• Risk can be assessed by using the risk-adjusted discount rate method,
certainty-equivalent method, payback period, sensitivity analysis and
probabilities-based method.
• All the methods have their strengths and weaknesses.
 Review Question
• Try to Solve

• Illustrative Problem 4 in ORA Chapter 14