Module-3

-------------------------------------------------UNIT 1 INVESTMENT DECISIONS

---------------------------------------------------------------------------

Objectives

To identify long term investment decisions

To study the significance of Capital Budgeting

To torch on capital budgeting process

Unit outline
3.1.1 Introduction
Classification of investment decisions
Long-term investment decision or capital budgeting and
Short-term decision or Working capital decision.
Expenses comes under capital investment
3.1.2

Meaning of Capital Budgeting

3.1.3 Importance of Capital Budgeting

3.1.4 Capital Budgeting Process

-------------------------------------------------3.1.1 INTRODUCTION
--------------------------------------------------------------------------The investment decision is the most important of the firm's three
major decisions when it comes to the value creation. Investment decision
relates to the determination of total amount of assets to be held in the firm,
the composition of these assets like the amount of fixed assets, current
assets and the extent of business risk involved by the investors.
The investment decisions can be classified in to two groups: (1) Longterm investment decision or capital budgeting and (2) Short-term decision or
Working capital decision.
In this module the long-term investment decision or capital budgeting is
discussed in detail. The capital budgeting decisions, require comparison of
cost against benefits over a long period. The investment made in capital
assets cannot be recovered in the short run. Such assets will generate
returns ranging from 2 to 20 years or more. Such investment decision
involve a careful consideration of various factors like profitability, safety,
liquidity and solvency etc. a business organisation has to face quite often the
problem of capital investment decisions. Capital investment refers to the
investment in projects whose results would generate revenue or earnings
from alter a year and it will continue for several numbers of years. The
following are the expenses which comes under capital investment are:
a) Replacements of old technology with new technology
ii) Expansion of production activity
iii) Diversification of products due to competition and for growth
iv) Research and Development expenditure
v) Miscellaneous expensed for installation of equipment, pollution control
equipment etc.

-------------------------------------------------3.1.2

MEANING OF CAPITAL BUDGETING

--------------------------------------------------------------------------Capital budgeting is the process of making investment decisions in

capital expenditures. A capital expenditure refers to an expenditure whose
benefits are expected be received over period of time exceeding one year.
Charles T. Horngreen has defined capital budgeting as, "Capital
budgeting is long term planning for making and financing proposed capital
outlays".
Richard and Greenlaw have referred to capital budgeting as "acquiring
inputs with long-run return".
Lynch

defines

it

as

"Capital

budgeting

consists

in

planning

development of available capital for the purpose of maximising the long term
profitability of the concern."

-------------------------------------------------3.1.3

IMPORTANCE OF CAPITAL BUDGETING

--------------------------------------------------------------------------A capital budgeting or investment decision involves huge capital on

capital assets of the concern. Any wrong decision in capital budgeting will
cost the organisation through its capital loss and also revenue loss of the
company. Hence this decision is so critical and important, the finance
manager should take special care in making these decisions. They are
a) It involves heavy funds. Capital budgeting decisions, generally,
involve large investment of limited funds. These funds are to be

invested properly. Hence it is important to plan and control these

funds.
b) These funds will have long term implications. Since the funds
are limited and also involves huge investments for long term or
permanent basis. Hence it involves more risks, it should be
properly managed.
c) Irreversible decisions. Once the investment is made on capital
assets, it is not possible to reverse the decisions without incurring
heavy losses.
d) Long term impact on profitability. Capital budgeting decisions
will have a long-term and significant effect on the profitability of a
concern. An unwise decision may prove disastrous and greater loss
to the organisation.
e) Difficulties of Investment decisions. The capital budgeting
decisions require an assessment of future events which are
uncertain, hence it is very difficult to estimate the probable events
it is very difficult to asses the probable costs, benefits accurately in
this dynamic environment.
f) It is national important. The investment decision taken by the
individual concern is of national importance because it generates
employment, economic activities and economic growth.

-------------------------------------------------3.1.4

CAPITAL BUDGETING PROCESS

---------------------------------------------------------------------------

Capital budgeting involves complex process because it involves

investment of current funds for achieving benefit in future and the future is
always uncertain. However, the following procedure may be adopted in the
process of capital budgeting:

1)

Identification of Investment proposal. It is first and important stage in

the capital budgeting process. The proposal or the idea bout potential
investment opportunities may originate from top management or may
come from the any part of organisation structure. The ideas are
analysed by the departmental head in the light of the corporate
objectives and strategies.

2)

Screening the proposals. Each proposal received by the department is

screened from various angles to see whether it is technically feasible,
amount of expenditure involved, returns generated, risks involved
etc.,

3)

Evaluation of various proposals . the next stage is to evaluate the

various proposals received from the departments by using capital
budgeting techniques.

4)

Fixing priorities. After evaluating various proposals, the unprofitable

or uneconomical proposals are rejected. Out of selected proposals

once again are listed on the basis of priorities after considering

urgency, risk and profitability of the proposal.

5)

Final approval and preparation of capital expenditure budget.

For the

approved proposal in the meeting the capital expenditure budget is

prepared. This budget lays down the amount of estimated expenditure
to be incurred on fixed assets during the budget period.

6)

Implementing proposal. While implementing the project or proposal, it

is better to assign responsibilities for completing the project within the
given time frame and cost limit so as to avoid unnecessary delays and
cost over runs. Network techniques used in the project management
such as PERT and CPM can also be applied to control and monitor the
implementation of the projects.

7)

Performance review. The last stage in the process of capital budgeting

is the evaluation of the performance of the project. The evaluation is
made through post completion audit by way of comparison of actual
expenditure on the project with the budgeted one. Any unfavourable
variances, if any should be looked into and the causes of the same be
identified so that corrective action may be taken in future.

-------------------------------------------------UNIT 2

METHODS OR TECHNIQUES OF CAPITAL BUDGETING

---------------------------------------------------------------------------

Objective

To understand the various techniques of Capital Budgeting

Unit outline
3.2.1 Technique that recognize Payback of Capital Employed:
Payback Period Method.
3.2.2 Techniques that use Accounting Profit for Project
evaluation:
a. Accounting Rate of Return method.
b. Earning Per Share.
3.2.3 Techniques that recognize Time Value of Money:
a. Net Present Value Method.
b. Internal Rate of Return Method.
c. Net Terminal Value Method.
d. Profitability Index Method.
e. Discounted Payback Period Method.

-------------------------------------------------UNIT 2

METHODS OR TECHNIQUES OF CAPITAL BUDGETING

---------------------------------------------------------------------------

Methods or techniques of capital budgeting or Investment Appraisal

Techniques
The techniques available for appraisal of investment proposal are classified
three heads:
I.

Technique that recognize Payback of Capital Employed:

Payback Period Method.

II.

Techniques that use Accounting Profit for Project evaluation:

c. Accounting Rate of Return method.
d. Earning Per Share.

III. Techniques that recognize Time Value of Money:

f. Net Present Value Method.
g. Internal Rate of Return Method.
h. Net Terminal Value Method.
i. Profitability Index Method.
j. Discounted Payback Period Method.

------------------------------------------------------------------------------3.2.1 Technique that recognize Payback of Capital Employed

---------------------------------------------------------------------------

Payback Period Method.

The term payback refers to the period in which the project will
generate the necessary cash to recover the initial investment. For example,
if a project requires Rs. 30,000 as initial investment and it will generate an
annual cash inflow of Rs. 6,000 for ten years, the pay back period will be 5
years, it is calculated as follows:
Initial Investment
Pay back period = ------------------Annual Cash Inflow
=

Rs 30,000
-----------Rs 6,000

Cash inflow is calculated by taking into profits from the project before
depreciation and after Tax.When the cash inflow is uneven then the payback
period is calculated bu cumulative cash inflows and by interpolation, the
exact payback period can be calculated. For example, if the project requires
an initial investment of Rs. 40,000 and the annual cash inflows for 5 years
are Rs. 12,000, Rs, 10,000, Rs. 14,000, Rs. 11,000 and Rs. 9,000
respectively, the pay back period will be calculated as follows:
Year

Cash inflows

Cumulative cash inflows

(in Rs)
12,000

(in Rs)
12,000

10,000

22,000

14,000

36,000

11,000

47,000

9,000

56,000

From the above table we are clear that in 3 years Rs. 36,000 has been
recovered. Rs. 4,000 is left out of initial investment. In the fourth year the
cash inflow is Rs. 11,000. It means the pay back period is between three to
four years calculated as follows.
Amount to be recovered
Pay back period = 3 years + ------------------------------------Amount available in the next year.
= 3 + 4,000/ 11,000
= 3.33 years.
Advantages of Pay back period
a. The main advantage of this method is that it is simple to
understand and easy to calculate.
b. In this method, as a project with a shorter pay back period is
preferred to the one having a longer pay back period. Hence the
project of loss from quick obsolescence can be overcome from this
method.
c. This method gives an indication to the prospective investors
specifying when their funds are likely to be repaid.
d. This method is suitable when the future is very uncertain.
Disadvantages
a. This method does not take into account the cash inflows earned
after the pay back period and the true profitability of the projects
cannot be correctly assessed.
b. This method ignores the time value of money and does not
consider the magnitude and timing of cash in flows.

c. It does not take into consideration the cost of capital which is a

very important factor in making sound investment decisions.
d. It treats each asset individually in isolation with other assets which
is not feasible in real practice.
e. This method does not consider the salvage value of an investment.
--------------------------------------------------------------------------3.2.2 Techniques that use Accounting Profit for Project evaluation
-------------------------------------------------------------------------Accounting Rate of Return Method
It is also known as return on investment or return on capital employed. This
method applied the normal accounting technique to measure the increase in
profit expected to result from an investment by expressing the net
accounting profit arising form the investment as a percentage of the capital
investment. That is:

ARR =

Average annual profit after tax

----------------------------------- X 100
Average or Initial Investment

Initial investment + Salvage value

Average investment = ----------------------------------------2
Under this method the project which gives highest rate of return will be
selected.
Merits
1. It is easy to calculate because it makes use of readily available
accounting information.

2. It is concerned with profits available for shareholders rather than cash

flows.
3. This method takes into consideration all the years profit throughout its
life.
4. Quick decision of capital investment proposals is possible.
5. If high profits are required, this is certainly a way of achieving them.
Demerits
1. It does not take into account the time value of money.
2. It uses the straight line method of depreciation. Once this method is
changed the method will not be easy to use.
3. It is biased against short-term projects in the same way that payback is
biased against longer-term ones.
4. There are different methods for calculating the accounting rate of return
due to diverse concepts of investments as well as earnings. Each method
gives different results. This reduces the reliability of the method.
------------------------------------------------------------------------------3.2.3 Techniques that recognize Time Value of Money
-------------------------------------------------------------------------Net present Value Method
This is generally considered to be the best method for evaluating the
capital investment proposals. In this method first cash inflows and cash
outflows associated with each project are worked out. The present value of
these cash inflows and outflows are then calculated at the rate of return
acceptable to the management. This rate of return is considered as the cutoff rate and is generally determined on the basis of cost of capital adjusted
risk element in the project. The Net Present Value (NPV) is the difference
between the total present value of future cash inflows and the total present
value of future cash outflows.

The Net Present Value can be used as an 'accept or reject' criterion. In

case the NPV is positive the project should be accepted. If the NPV is
negative, the project should be rejected.
Merits
1. It recognises the time value of money and is suitable to be applied ina
situation with uniform or uneven cash inflows even at different periods of
time.
2. It takes into account the earnings over the entire life of the project and
the true profitability of the profit can be evaluated.
3. It takes into consideration the objective of maximum profitability.
Demerits
1. As compared to traditional method, the NPV method is more difficult to
understand and operate.
2. It is not easy to determine an appropriate discount rate.
3. The method is based on the presumption that cash inflow can be invested
at the discounting rate in the new projects. But this presumption does not
always hold good because it all depends upon the available investment
opportunities.
Internal Rate of Return (IRR)
Internal Rate of Return is that rate at which the sum of discounted
cash inflows equals the sum of discounted cash outflows. In other words, it
is the rate which discounts the cash flows to zero. It is also known as time
adjusted rate of return method or trial and error yield method.
Merits
It also takes into account the present value of money.
It considers the profitability of the project for its entire economic life and
hence enables evaluation of true profitability.

The determination of cost of capital is not a pre-requisite for the use of this
method and hence it is better than NPV method where the cost of capital
cannot be determined easily.
It provides for uniform ranking of various proposals due to the percentage
rate of return.
Demerits
1. It is difficult to understand and is the most difficult method of evaluation
of investment proposals.
2. This method is based upon the assumption that the earnings are
reinvested at the internal rate of return for the remaining life of the
project, which is not a justified assumption.
3. The results of NPV method and IRR method may differ when the projects
under evaluation differ in their size, life and timings of cash flows.
Discounted Pay back Period Method.
Under this method the draw back of time value of money not
considered in pay back period is considered. Hence this method is
improvement over the pay back period method. Under this method the
project which gives the greatest post pay-back period may be accepted.
Under this method the present values of all cash outflows and inflows are
computed at an appropriate discount rate. The time period at which the
cumulated present value of cash inflows equals th present value of cash
outflows is known as discounted pay back period.
Profitability Index Method or Benefit Cost Ratio
It is also a time-adjusted method of evaluating the investment proposals.
Profitability index also called as Benefit-Cost Ratio or Desirability factor is the

relationship between present value of cash inflows and present value of cash
outflows. Thus

Profitability Index =

Present value of cash inflows

------------------------Present value of cash outflows

The proposal is accepted if the profitability index is more than one and
is rejected in case the PI is less than one.

-------------------------------------------------UNIT 3

PROBLEMS ON CAPITAL BUDGETING

---------------------------------------------------------------------------

Objectives

To give practical exposure to the working of capital budgeting

To help in decision making process, in selecting a best method of capital

budgeting

To know the working knowledge of these methods

Unit outline
3.3.1 Problems on capital budgeting
Payback period
Accounting Rate of Return
Net Present Value
Internal Rate of Return

 Profitability index
-------------------------------------------------------------------------------

3.3.1 Problems on capital budgeting

-------------------------------------------------------------------------------

1. Calculate the cash inflow under pay back period with the following
information; Profit Before Tax and Before Depreciation (PBTBD) =50000,
Depreciation =10,000, Tax=35%
Solution:
PBTBD
Less Depreciation

50,000
10,000
_____
40,000
14,000
_____
26,000
10,000
_____
36,000
_____

PBTAD
Less: Tax 35%
PATAD
(+) Depreciation
PATBD

To calculate tax we have to first change depreciation.

2. Calculate the Pay Back Period (PBP) from the following:
Years

Inflows

500000

II

400000

III

300000

IV

100000

Initial Investment = Rs.10,00,000

Solution:
PBP = 2+1,00,000/3,00,000=2.33 years
3. Calculate PBP form the following; Initial investment 10, 00,000, life of the
project 4years, PBD and before Tax (PBTBD)
I

5,00,000

II

4,00,000

III

3,00,000

IV

1,00,000

Solution:
Calculation of Depreciation;
DEPN= Cost of asset + Installation charges-Scrap value/Life of Asset
=10,00,000/4=2,50,000
Rate of tax is assumed as 35%.
Given
Year PBTBD (-) Depn.

PBTAD

(-) Tax 35%

PATAD

(+)Dep.

PATBD

500000 250000

250000

87500

162500

250000

412500

II

400000 250000

150000

52500

97500

250000

347500

III

300000 250000

50000

17000

32500

250000

282500

IV

100000

(150000)

250000

100000

250000 (150000)

PBP=2+2,40,000/2,82,500

(2,40,000=10,00,000-7,60,000)

= 2.85 Years
4. A Project involves the investment of Rs. 500000 which yields PADAT as
stated below:
Years

PATAD

25000

II

37500

III

62500

IV

65000

40000
At the end of 5 years the machinery in the project can be sold for

40,000. The cut-off rate is 8%. Suggest the management whether or not to
accept the proposal based on ARR.
Solution
Step I:

Average profit= Total cash inflows/life of project

=230000/5=46000

Step II;

ARR=AP/Initial Investment (I I)
=46000/(500000-40000) x 100=10%
Interpretation: It is advisable to accept the project since ARR is

above the cut-off rate.

Interpretation of NPV; If NPV is greater than or equal to zero then accept or
else rejects the project.
5. Calculate NPV and IRR of a project involving the initial cash outflow of
Rs.1,00,000 and generating annual cash inflow of Rs.35,000, Rs.40,000,

Rs.30,000, and Rs.50,000 for 4 years respectively. Assume discounting rate

of return at 15%.
Solution:
Calculation of NPV
Years

Cash inflows

Discount @15% [1/(1+r)n]

NPV values

35000

0.8696

30436

40000

0.7561

30244

30000

0.6575

19725

50000

0.5718

28590
________

Total Discount Cash inflows 1,08,995

Less; Initial Investment

1,00,000
______

Net NPV

8995

Interpretation: Since NPV is Greater than or equal to zero we accept the

project.
Calculation of IRR
Years Cash Inflows Discount @5% Discounted C.I

Discount @20% Discounted C.I.

35000

0.9524

33334

0.8333

29165.5

40000

0.9070

36280

0.6944

27776

30000

0.8638

25914

0.5787

17361

50000

0.8227

41135

0.4823

24115

________
Total DCI 136663
Less I.I
NPV
+ ve NPV

_____________
98418

100000

100000

________

_________

36663

(1582)

IRR= LRR+ ------------------------------ x difference in rates

(+ ve NPV) + (- ve NPV)
36,663
IRR= 5 + ------------------------------ x 15
(36,663) + (1,582)
= 19.38%
6. A Company has an investment opportunity costing Rs. 40,000 with the
following expected net cash flow (after tax before depreciation).
Years

Net Cash flow

Rs. 7,000

7,000

7,000

7,000

7,000

8,000

10,000

15,000

10,000

10

4,000

Using 10% as the cost of capital (rate of discount) determine the

following:
a) Pay back period.
b) Net present value at 10% discount factor.
c) Profitability Index at 10% discount factor.

d) Internal Rate of Return with the help of 10% discount factor and
15% discount factor.
Solution:
a) Pay back period = 5 + 5000/8000
= 5.625 years.
b) Net Present Value
Year
1
2
3
4
5
6
7
8
9
10

Cash Inflow
Rs.
7,000
7,000
7,000
7,000
7,000
8,000
10,000
15,000
10,000
4,000

Discount
10%
0.9091
0.8264
0.7513
0.6830
0.6209
0.5645
0.5132
0.4665
0.4241
0.3855

@ Discounted
inflow
6364
5785
5259
4781
4346
4516
5132
6998
4241
1542
---------48,963
(-) Initial Invt. 40,000
--------NPV
8,963

cash

c) Gross PI = Discounted cash inflow/Discounted Cash outflow

= 48,963/40,000 = 1.23
Net PI = Gross PI - 1
= 1.23 - 1 = 0.23
d) Internal Rate of Return
Year
1
2

Cash Inflow
Rs.
7,000
7,000

Discount
15%
0.8696
0.7561

@ Discounted
inflow
6087
5293

cash

3
4
5
6
7
8
9
10

7,000
7,000
7,000
8,000
10,000
15,000
10,000
4,000

0.6575
0.5718
0.4972
0.4323
0.3759
0.3269
0.2843
0.2472
Less
Invt.

4603
4003
3480
3458
3759
4904
2843
989
-------39,418
Initial 40,000

(-)ve NPV

-------(-) 582

+ ve NPV
IRR= LRR+ ------------------------------ x difference in rates
(+ ve NPV) + (- ve NPV)
8,963
IRR= 10 + ------------------------------ x (15 - 10)
8,963 + 582
= 14.695 %
7. The L Company Ltd, is considering the purchase of a new machine. Two
alternative machines (A&B0 have been suggested each costing Rs. 4,00,000.
Earnings after taxation but before depreciation are expected to be as
follows:
Year
1

Machine A
40,000

Machine B
1,20,000

1,20,000

1,60,000

1,60,000

2,00,000

2,40,000

1,20,000

5
Total

1,60,000

80,000

7,20,000

6,80,000

The company has a target rate return on capital at the rate of 10%. On this
basis you are required:
1. Compare profitability of Machines and state which alternative you
consider financially preferable.
2. Compute Payback period for each project
3. Compute annual rate of return for each project.
Solution:
1. Net Present Value.
Year Machine
A
1
2
3
4
5

40,000
1,20,000
1,60,000
2,40,000
1,60,000

Discount

Discount

@10%

ed

0.9091
0.8264
0.7513
0.6830
0.6209

Machine B

cash

inflow
36,364
99,168
1,20,208
1,63,920
99,344
----------

Discounted
Cash inflow
(-) Initial Invt. 5,19,004
4,00,000
NPV
----------1,19,004

Discount
ed

1,20,000
1,60,000
2,00,000
1,20,000
80,000
Discounted
Cash inflow
(-) Initial Invt.

cash

inflow
1,09,092
1,32,224
1,50,260
81,960
49,672
-------------5,23,208
4,00,000
------------1,23,208

Interpretation: It is advisable to accept Machine B since NPV is more when

compared to Machine A.
2. Pay back period.
Machine A = 3 + 80,000/2,40,000 = 3.33 years

Machine B = 2 + 1,20,000/2,00,000 = 2.6 years

Interpretation: It is advisable to accept Machine B as per PBP.
3. ARR.
Calculation of Depreciation:
= Cost of asset + Installation charges-Scrap value/Life of Asset
= 4,00,000/5 = 80,000 p.a.
PATBD of

PATBD of

(-)

PATAD of

PATAD of

Machine A

Machine B

Depreciation

Machine A

Machine B

40,000

1,20,000

80,000

1,20,000

1,60,000

80,000

40,000

80,000

1,60,000

2,00,000

80,000

80,000

1,20,000

2,40,000

1,20,000

80,000

1,60,000

80,000

80,000

40,000

40,000

40,000

1,60,000
80,000

Average profit (A) = 3,20,000/5 = 64,000

ARR = 64,000/4,00,000 x 100 = 16%
Average profits (B) = 2,80,000/5 = 56,000
ARR = 56,000/4,00,000 x 100 = 14%
Interpretation: it is advisable to accept Machine A as per ARR
1. The expected cash flows of the project are as follows:
Years

Cash flows

- 1,00,000

20,000

30,000

40,000

50,000

60,000

The cost of capital is 12% calculate the following.

a) NPV
b) Benefit cost ratio (GPI)
c) PBP
d) IRR
e) Discounted PBP
Solution:
a) NPV
Year

Cash Inflow

1
2
3
4
5

20,000
30,000
40,000
50,000
60,000

Discount
@
12%
0.8929
0.7972
0.7118
0.6355
0.5674

factor Discounted
Cash inflow

Cash inflow
- Initial invt.
NPV

17,858
23,916
28,472
31,775
17,022
-----------1,19,043
1,00,000
-----------19,043

b) Benefit cost ration (GPI)

= Discounted Cash inflow / Discounted Cash outflow
= 1,19,043 / 1,00,000
= 1.19
c) Pay Back period
= 3 + 10,000 / 50,000
= 3.2 years
d) IRR
Year

Cash Inflow

20,000

Discount
@
20%
0.8333

factor Discounted
Cash inflow
16,666

2
3
4
5

30,000
40,000
50,000
60,000

0.6944
0.5787
0.4823
0.4019
Cash inflow
- Initial invt.
NPV

20,832
23,148
24,115
12,057
-----------96,818
1,00,000
------------ 3,182

+ ve NPV
IRR= LRR+ ------------------------------ x difference in rates
(+ ve NPV) + (- ve NPV)
19,043
IRR= 12 + ------------------------------ x (15 - 10)
19,043 + 3,182
= 18.85%
e) Discounted Pay Back period
= 3 + 29,754 / 31,775
= 3.9 years

-------------------------------------------------------------------------------

Unit 4

Risk and Uncertainty in Capital Budgeting

-------------------------------------------------------------------------------

Objectives
The objectives of this unit are:

To bring clarity in the concepts of Risk and Uncertainty

To study the methods of accounting the risk in capital budgeting

Unit outline
3.4.1 Risk and Uncertainty in Capital Budgeting
The following methods are suggested for accounting for risk in capital
budgeting.
(i)

(ii)

General Techniques:
(a)

Risk adjusted discount rate;

(b)

Certainty equivalent coefficient.

Quantitative Techniques:

(a)

Sensitivity analysis

(b)

Probability assignment

(c)

Standard deviation

(d)

Coefficient of variation

(e)

Decision tree analysis

-------------------------------------------------------------------------------

3.4.1

Risk and Uncertainty in Capital Budgeting

---------------------------------------------------------------------------All the techniques of capital budgeting require the estimation of future

cash inflows and cash outflows. The future cash flows are estimated, based
on the following factors:
(1)

Expected economic life of the project.

(2)

Salvage value of the asset at the end of its life.

(3)

Capacity of the project.

(4)

Selling price of the product.

(5)

Production cost

(6)

Depreciation and tax rate

(7)

Future demand for the product etc.,

But due to uncertainties about the future most of the above factors

cannot be exact. For example, the product becomes absolute, technology

becomes obsolescence, in these situations taking investment decisions
becomes difficult. But some allowances for the element of risk have to be
provided.
The following methods are suggested for accounting for risk in capital
budgeting.
(i) General Techniques:
(a)

Risk adjusted discount rate;

(b)

Certainty equivalent coefficient.

(ii) Quantitative Techniques:

(a)

Sensitivity analysis

(b)

Probability assignment

(c)Standard deviation

(d)

Coefficient of variation

(e)

Decision tree analysis

Risk adjusted discount rate

The risk adjusted discount rate is based on the presumption that
investors expect a higher rate of return on risky projects as compared to less
risky projects. The rate requires is determined by i) risk free rate and ii) risk
premium rate. Risk free rate is the rate at which the future cash inflows
should be discounted and there been no risk. Risk premium rate is the extra
return expected by the investor over the normal rate on account of the
project being risky. Therefore risk adjusted discount rate is a composite
discount rate that takes into account both the time and risk factors. A higher
discount rate will be used for more risky projects and lower rate for less
risky projects.
From the following data, state which project is better>
Year

Cash inflows
Project X

Project Y

-10,000

-10,000

5,000

6,000

4,000

6,000

2,000

4,000

Riskless discount rate is 5%. Project X is less risky as compared to

Project Y. the management considers risk premium rates at 5% and 10%
respectively appropriate for discounting the cash inflows.
Solution:
Project

Risk adjusted discount rate

5% + 5%

= 10%

5% + 10% = 15%

Year

Discounted Cash inflows

Project X

Project Y

-10,000

-10,000

4,545

5,218

3,320

4,536

1,502

2,630

--------- 633
---------

--------2,384
---------

NPV

Project Y is superior to Project X. since NPV is positive it may be accepted.

Sensitivity analysis
Where cash inflows are very sensitive under different circumstances,
more than one forecast of the future cash inflows may be made. These
inflows may be regarded as 'Optimistic', 'Most Likely' and 'Pessimistic'.
Further cash inflows may be discounted to find out the NPV under these
three different situations. If the NPV under the three situations differ widely
it implies that there is a great risk in the project and the investor's decision
to accept or reject a project will depend upon his risk bearing abilities
Illustration
Mr. Tanu is considering tow mutually exclusive projects A and B. You
are required to advise him about the acceptability of the projects from the
following information.

Cost of the Investment

Forecast

Cash

Inflows

per annum for 5 years

Project A

Project B

Rs.
50,000

Rs.
50,000

Optimistic

35,000

40,000

Most Likely

25,000

20,000

Pessimistic

20,000

5,000

(The cut-off rate is 15%)

Solution
Computation of NPV of cash in flows at a Discount Rate of 15%
(Annuity of Re. 1 for 5 years)
Project A

Project B
Annual

Discou

Present

cash

nt

Value

inflow

factor

Optimistic

35,000

@ 15%
3.3522

1,17,327

Most Likely

25,000

3.3522

Pessimistic

20,000

3.3522

NPV

Annual

Discou

Present

NPV

cash

nt

Value

inflow

factor

67,327

40,000

@ 15%
3.3522

1,34,088

84,088

83,805

33,805

20,000

3.3522

67,044

17,044

67,044

17,044

5,000

3.3522

16,761

-33,239

The NPV calculated above indicate that Project B is more risky as compared
to Project A. at the same time during favorable conditions, it is more
profitable.
Probability Technique
A probability is a relative frequency with which an event may occur in
the future. When future estimates of cash inflows have different probabilities
the expected monetary values may be computed by multiplying cash inflow
with the probability assigned.
Illustration:
The ABC company Limited has given the following possible cash inflows fro
two of their projects X and Y out of which one they wish to undertake
together with their associated probabilities. Both the projects will require an
equal investment of Rs. 5,000.

You are required to give your considered opinion regarding the

selection of the project.
Possible

Cash inflows

Project X
Probability

Cash

Project Y
Probabilit
y
.10

event
A

4,000

.10

inflows
12,000

5,000

.20

10,000

.15

6,000

.40

8,000

.50

7,000

.20

6,000

.15

8,000

.10

4,000

.10

Solution:
Computation of Expected Monetary values for Project X and Project
Y
Cash

Project X
Probabilit Expecte Cash

inflows
4,000

y
.10

d value
Rs. 400

inflows
12,000

y
.10

d value
1,200

5,000

.20

1,000

10,000

.15

1,500

6,000

.40

2,400

8,000

.50

4,000

7,000

.20

1,400

6,000

.15

900

8,000

.10

800

4,000

.10

400

6000

Total

Total

Project Y
Probabilit Expecte

8,000

The expected monetary value of Project Y is higher than the expected

monetary value of Project X. Hence Project Y is preferable to project X.

Decision Tree Analysis

Decision tree anlysis is another technique which is helpful in tackling

risky capital investment proposals. Decision tree is a graphic display of
relationship between a present decision and possible future events, future
decisions and their consequences. The sequence of event is mapped out over
time in a format resembling branches of a tree. In other words, it is a
pictorial representation in tree form which indicates the magnitude,
probability and interrelationship of all possible outcomes.