Unit -3

Technical, Economic, Financial, Legal and Social Appraisal of the industrial projects, Problems arising due to rate of discount, wagerates, treatment of taxes, social cost benefits, treatment of risk and uncertainty, sensitivity analysis and probability approach single as well as multiple projects

Project Appraisal
Project appraisal is the process of detailed examination of several aspects of a Given project before its recommendation. Various aspects of project appraisal are as mentioned below:1. Technical appraisal: Selection of process / technology Scale of operation Technical know how Collaboration agreement Product mix Selection and procurement of plant and machinery Plant lay out Location of a project Project scheduling and implementation

Project Appraisal
Collaboration agreements:- If the project promoters have entered into agreement with foreign collaborators, the term and conditions of the agreement may be studied appropriately. Following points deserve special consideration:1. The competence and reputation of the collaborators need to be ascertained through possible sources. 2. The technology proposed to be imported should suit to local conditions. 3. It should have necessary approval of the government of India. 4. There should not be any restrictive clause regarding import of machinery /equipment. There should not be any clause for the payment of any kind of commission. There should not be any restriction on import of goods/services. Promoters should be free for targeting any market. 5. It is better to have buy back agreement with the technical collaborator, this to ensure that the collaborator will be serious about the transfer of correct know how and would ensure quality of the output. 6. And few other points.

Project Appraisal
Project scheduling:- scheduling is nothing but the arrangement of activities of the project in the order of time in which they are to be performed. The schedule which broadly indicates the logical sequence of events would be as mentioned:1. Land acquisition 2. Site development 3. Preparing building plans, estimates, designs, getting necessary approvals and entrusting the construction works to the contractors. 4. Construction of building, machinery foundation and other related civil works and completion of the same. 5. Placing order for machinery. 6. Receipt of machinery at site. 7. Erection of machinery. 8. Commissioning of plant and taking trial runs. 9. Commencement of regular commercial production.

Factors in Facility Location Planning

Availability of power supply

Good transportation facilities

Basic amenities

Close Proximity to the raw material

Government policies

Close Proximity to Markets

Facility Location Planning

Environment and community

Residential complexes, schools, hospitals, clubs, etc.

Proximity to subcontractors

Availability of cheap & skillful labor

Easy availability of cheap land Less construction costs

Factors of location
Primary factors 1. Availability of raw materials 2. Nearness of market for the finished product 3. Availability of fuel and power 4. Transport facilities 5. Availability of labor 6. Availability of water (for paper & chemical inds) and other resources required
Secondary factors 1. Soil and climate 2. Industrial atmosphere 3. Financial and other aids 4. Availability of facilities like housing, schools, hospitals and recreation clubs 5. Momentum of an early start 6. Special advantage of the place(subsidies, tax holidays) 7. Personal factors. 8. Historical factors 9. Political stability

Rural Vs urban locations

Selecting the site in an urban location Advantages:1. Good transport facilities for the company and its employees 2. Good market for products manufactured 3. Availability of a good mix of labor(skilled/semi skilled/trained/experienced) 4. Power is easily available, service of trained professionals 5. Good medical facilities, availability of readily built building for rent 6. Availability of Maintenance and other facilities Disadvantages:1. Cost of land, construction cost, and Local taxes, these are normally very high 2. Expansion in the same area may be a problem, due to many constrains 3. labor cost is very high and labor union problem may exist, which may strain employee employer relationships

Rural Vs urban locations

Selecting a site in Rural/sub-urban area Advantages 1. Availability of land at a reasonable price, making even future expansion easy 2. Reasonable unskilled labor is available and labor union has minimum or no influence 3. Municipal/other regulation & taxes are very reasonable (seldom burdensome) 4. Government will give subsidies, incentives and tax holidays Disadvantages:1. Transport facilities may not be as good as in the urban areas 2. Difficult to find skilled labors and managers, as well as ancillary services 3. Availability of continuous power, good hospitals, good schools, financial institutions and banks might be a problem

Location analysis
Cost analysis (comparative cost analysis):- In this method all the costs involved in establishing and operating the plant are listed and total cost is calculated. Based on the total cost the location decisions are being made.
Factors (Cost of) Land Building Water Power Labor Freight (In coming + out going) Fuel Raw mat & other supplies Taxes Total cost Community facilities, community attitude Housing facilities Cost of living Community size Location 1 (cost in Rs.) 100000 1200000 5000 15000 140000 280000 40000 140000 4000 1924000 Good, all right Very good High Small Location 2 (cost in Rs.) 90000 1300000 6000 17000 120000 260000 35000 130000 2000 1960000 Excellent, Encouraging Good Normal Medium

Considering cost alone location 1 is better, but considering cost plus facilities, location 2 can be recommended

ROR (Rate of return analysis)

This analysis is based on the rate of return on the total investment. In this Analysis location decision is made based on higher rate of return from the Various Alternatives From the following data, select the most advantageous location for setting up a plant to manufacture electric and electronic products.
Particulars Tot initial investment Tot expected sales for the period Distribution expenses Raw material expense Power & water supply expenses Wages & salaries Other expenses Community attitudes Employee housing facility Site X 200000 250000 40000 70000 40000 20000 25000 Indifferent Poor Site Y 200000 300000 40000 80000 30000 25000 40000 Wants business Excellent Site Z 200000 250000 75000 90000 20000 20000 30000 Indifferent good

Locational Break-Even Analysis Example

Three locations: Fixed Variable City Cost Cost Akron $30,000 $75 Bowling Green $60,000 $45 Chicago $110,000 $25 Selling price = $120 Expected volume = 2,000 units Total Cost $180,000 $150,000 $160,000

Total Cost = Fixed Cost + Variable Cost x Volume

Facility Capacity & Layout Planning

The efficiency of production depends on how well the various machines; production facilities and employees amenities are located in a plant. Only the properly laid out plant can ensure the smooth and rapid movement of material, from the raw material stage to the end product stage. Plant layout encompasses new layout as well as improvement in the existing layout. It may be defined as a technique of locating machines, processes and plant services within the factory so as to achieve the right quantity and quality of output at the lowest possible cost of manufacturing. It involves a judicious arrangement of production facilities so that workflow is direct.

The lay out should be such that future expansion can be done without much alteration. It should facilitate effective supervision of work. It should ensure smooth flow of men and materials during the process. Lay-out should create a favorable environment for the process and the workers ensuring maximum efficiency, health, safety and hence maximum profitability.

Types of Layouts

Product Layout Process Layout Fixed-Position Layout Combined Layout

Project Appraisal
2. Commercial appraisal:Commercial appraisal of the project is done studying the commercial successfulness of the product/service offered by the project from the following angles:1. Demand for the product 2. Supply position for the product 3. Distribution channel 4. Pricing of the product 5. Government policies

Project Appraisal
Demand forecasting techniques:- Broadly speaking there are two approaches to business forecasting. One approach is to obtain information about the intentions of consumers through collecting views and opinions of experts in the field or by conducting interviews with the consumers. This approach is called survey method . The other approach is to use historical data i.e extrapolating the statistical data. This approach is called statistical approach. While survey method is suitable for short term planning, the statistical approach is suitable for long term forecasting. Estimating future demand for the existing products can be done by either of the methods but demand forecasting for the new products can only be done by survey methods, since historical data is not available in this case for extrapolation.

Project Appraisal
Survey methods:Jury of experts opinion method:- In this method, experts in the particular field are requested to give their view on the likely demand for the product in future. Delphi Technique:This is a group decision by experts in which the individual experts act separately. Their views are pooled together and an attempt is made to arrive at consensus. Consumers survey method:- this is the most direct method. Sales forecast = tot population size/sample size X no. of respondents who said yes X % of
those who said yes who will actually purchase X ave. qty. that will be purchased by a buyer

Project Appraisal
Statistical methods:1. Trend analysis 2. Regression techniques Trend analysis:- following are some of the methods used in trend analysis to estimate the future demand based on historical data. The process of extending the past trend to the future is called extrapolation. 1. Curve fitting 2. Moving average method 3. Weighted moving average method 4. Exponential smoothing method The basic assumption of trend analysis is that in future all the factors that were responsible for the past movements will be present and will exert influence in the same way as they had been in the past. The relationship is often expressed in the form of a mathematical formula or model.

Project Appraisal (Trend Analysis)

Curve fitting:- Suppose there are two variables X and Y that are related to each other. For example, the consumption level (Y) of a particular good might increase with the increase of time (X). For instance, the consumption of a particular good in the year 1985 was 2.0 tones, in the year 1986 2.4 tones, in the year 1987 3.3 tones, in the year 1988 - 4.7 tones in the year 1989 5.9 tones and in the year 1990 7.1 tones. So here we can find a trend and there is a relationship between time (X) and the consumption level (Y). If we are in year 1991 and there are indications that the trend will continue for another 10 years, we can arrive at the demand pattern for the next ten years, by fitting a curve with the available data. Fitting a curve using the available data can be done with minimum error, using the principle of least squares. The principle of least squares fits a straight line in such a way that the error of estimation is minimum.

Project Appraisal
7 B

X
5 4 2 1 Y2 Y3

Fitment error at point 1 = (Y1 Y1) Fitment error at point 2 = (Y2 Y2) Fitment error at point 3 = (Y3 Y3) etc

Y2 Y1 Y1

Y3

X1
X2 X3

Project Appraisal
The best fitting line will be one for which the absolute value of fitment error is minimum. Hence our aim is to find a line that passes closest to the all points. Since some of the points are above the line and others are below the line, so the difference between the line and points above the line would be +ve and the difference between the line and the points below the line would be ve. Thus, the differences would cancel out one another and hence the total sum of differences as a measure of best fit would be incorrect. So we take square of the differences to solve this problem. Sice we are looking for a line that is closest to all the points, for such a line, sum of squares of differences would be minimum. Hence this method of arriving at the line of best fit, is called the method of least squares. If Y = a + bX is the relation for the best fitting line, using the principles of least squares, the value of the parameters a and b can be calculated, using the equations:y = n . a + b . x and x y = a . x + b . x^2

Project Appraisal
Fit a straight line trend to the following data, using the method of least squares. From the straight line trend, estimate the demand in the year 1995.
Year (X) Demand for household water heaters (Y) (numbers in 1000s) 1979 600 1980 825 1981 970 1982 1210 1983 1440 1984 1790 1985 2070

Project Appraisal
Year (X) 1979 Demand (Y) 600 X -- 3 X^2 9 XY --1800

1980 1981
1982 1983 1984 1985

825 970
1210 1440 1790 2070 = 8905

--2 --1
0 1 2 3 =0

4 1
0 1 4 9 = 28

--1650 --970
0 1440 3580 6210 = 6810

Here no. of observations = 7, so n = 7 Now we will use two equations to find values for a and b and we will calculate demand for the year 1995

Value of a = 1272.14 Value of b = 243.21 Y = 1272.14 + 243.21 X, substitute X = (x-1982) and you will get demand in 1995 = 4433070 units

Project Appraisal
Moving average method:- According to moving average method of forecasting, the forecast for the next year is arrived at by taking the average of the actual data for a few immediately preceding years. If the data of preceding three years are considered for arriving at the forecast for the fourth year, it is called a three year moving average. For example,
Actual sales year 1994 1995 1996 1997 2219 2302 2007 (2219+2302+2007) / 3 = 2176 sales Forecast

Determining the period of moving average is an important factor in calculating the trend values in the moving average method. This method is used when past data do not exhibit a steady increase or decrease in trend over time, but show fluctuations.

Project Appraisal
Weighted moving average method:- in the moving average method of forecasting , only the simple average of a few previous years data are taken as the forecast for the next year. It is likely that the more recent data might give a better indication of the trend than a past data. If this is so, in the calculation of moving average, weight of moving average will vary according to their period, the more recent data will get more weight and vice versa.
Actual sales year 1987 1988 1989 1990 1991 1992 1993 sales 2999 1999 2182 2219 2302 2007 0.6 0.7 0.8 0.9 (0.6X2182 + 0.7X2219 + 0.8X2302 + 0.9X2007) / 4 = 1627.6 weight Forecast

Project Appraisal (Exponential Smoothing)

Exponential smoothing method:- The specialty of exponential smoothing method is that forecasts are modified in the light of observed errors. This method takes into account the decreasing influence of the past time periods as we move further into the past data. This decreasing trend as we move down into the past time period is found to be exponentially distributed and hence this method is designated as exponential smoothing method.

The forecast for the next time period is given by the following relationship. F(t+1) = . At +(1 ) . Ft, Where, F(t+1) = forecast for the time period (t+1) = smoothing factor (which lies between 0 and 1, including 0 and 1) At = Actual value for the time period t Ft = forecast for the time period t

Project Appraisal (Exponential Smoothing)

If the initial forecast is 320 units, find out and compare the forecast for = 0.5 by exponential smoothing method. The following series of information is given. Sl.no. Forecasted units in numbers 1 350 2 360 3 310 4 370 5 300 6 320 7 390 8 310 9 400

Solution
Old forecast = F1 = 320 units Actual observation = D1 = 350 units for = 0.5, F0 = F1 + (D1 F1) = 320 + 0.5(350 320) = 320 + 15 = 335.

Project Appraisal (Exponential Smoothing)

Observation D1 350 360 310 370 300 320 390 310 400 Forecast 320 335 347.5 328.75 349.375 324.6875 322.34375 356.171875 Error (D1-F1) 30 25 -37.5 41.25 -49.375 -4.6875 67.65625 -46.171875 Error 15 12.5 -18.75 20.625 -24.6875 -2.34375 33.828125 -23.085938 New forecast in units 335 347.5 328.75 349.375 324.6875 322.34375 356.171875 333.0859375

333.0859375 66.9140625

33.4570313 366.5429688

Project Appraisal (Regression Technique)

A regression model is an equation relating a dependent variable to many independent variables. For example, anticipated sales(dependent variable) may be expressed as a function of independent variables like disposable income, of consumers, price relative to the price of competitive products, level of advertising etc., and the relationship can be expressed as:Y = a1 + (b1 . X1) + (b2 . X2) +.. (Bn . Xn) Where Y represents sales and a1, b1, b2, bn are constants And X1, X2,.. Xn are independent, variables, which affect dependent variable Y. With the time series data collected, a relationship is established as above. After establishing the relationship, values for independent factors for the future period are estimated. Substituting these values in the relationship, estimate for the future years can be made. When the number of independent variables are more, multiple regression analysis can be undertaken with the help of computers.

Project Appraisal
3. Economic Appraisal:- It measures the effect of the project on the whole economy. Developing and under developed countries face scarcity of capital, foreign exchange and many other resources. Government in such countries wants to make sure that scarce resources are being used in the possible best manner in the overall interest of the economy. So, among the project Alternatives, policy makers make a choice based on the economic return.

4. Financial appraisal:- Financial appraisal of project consists of two major areas. 1. arriving at the cost of the project and 2. arriving at the appropriate means of financing the project. By means of financing we mean the combination of debt and equity. The proper debt equity combination depends upon the revenue earning capacity of the project. We have already discussed about these two points in the earlier unit. For details please refer to slides of unit 2.

Project Appraisal
5. Management appraisal:- Management is the most important factor that Can either make a project a success or a failure. A good project at the hands of poor management may fail while a not so-good project at the hands of an effective management may succeed. Hence banks and financial institutions, that lend money for financing projects lay more emphasis on the management appraisal.
6. Legal and Social appraisal:- Till now, we examined the financial yields from the projects. While financial yields of a project are very important for an industrial project, there are other legal and socio-economic considerations such as projects conformity with the rules and regulation of the concerned economy or projects overall impact on the economic and social health of a country, its impact on forex reserve of a country, development of backward areas, defense requirement, self reliance etc. these factors may carry more weight with certain projects. While legal considerations are important for all projects, social profitability analysis is most used for evaluating public sector projects where the principal objective may not be to maximize financial yields from the capital investments.

Project Appraisal
It may be relevant for certain Private projects also, since the fund providing institutions would like to see that the national interests / considerations are taken care of in the private investment proposals. Besides, implementation of the project may result in self sufficiency in certain crucial areas. These benefits may be more important to the society than mere financial returns.

Problem arising due to:Rate of Discount:This will lead to inappropriate financial evaluations. Its adverse effect will be even more in long term project evaluations. This will lead to inappropriate calculations of various cash flows and so, may result into difficulty in successful completion of the projects.
Wage rate:Inappropriate cost of production, so lead to inappropriate profitability estimates Exchange rate:In case of imported capital/raw material /repayment of loan, inappropriate profitability estimates / company may face financial problems in serving its obligations

Treatment of Taxes

Year ------------------ Building at 10% on WDV (starting value: Rs. 11.82 Lakhs) Plant & Machinery, Electricals, Transport, & erection @ 25% on WDV (starting value Rs. 47.27 Lakhs) Miscellaneous asset at 10% on WDV (starting value: Rs. 1.18 Lakhs)

i 1.18
11.82 0.12

Ii 1.06
8.86 0.11

Iii 0.96
6.65 0.10

Iv 0.86
4.99 0.09

V 0.78
3.74 0.08

Vi 0.70
2.80 0.07

Vii 0.63
2.10 0.06

viii 0.57
1.58 0.06

Total

13.12

10.03

7.71

5.94

3.65

3.57

2.79

2.21

CALCULATION OF TAX
Profit before tax (after providing for depreciation as per companies act)

9.53

16.83

24.97

22.49

18.91

15.06

9.80

3.74

ADD depreciation as per Companies act

3.97
13.50

3.97
20.80

3.97
28.94

3.97
26.46

3.97
22.88

3.97
19.03

3.97
13.77

3.97
7.71

TOTAL
Less: Depreciation for tax purpose TAXABLE INCOME
Income tax @ 35% with a surcharge of 10% (net 38.50%)

13.12
0.38

10.03
10.77

7.71
21.23

5.94
20.52

3.65
19.23

3.57
15.46

2.79
10.98

2.21
5.50

0.15

4.15

8.17

7.90

7.40

5.95

4.23

2.12

(SCBA) Social Appraisal

According to Scidler and Ramanathan (1989), social accounting analyzes the social relevance and contribution of a firm from within and outside the business interest. A project can be financially viable but until and unless its socio-economic evaluation gives positive benefit or return, any project cannot be selected.. Social Cost Benefit Analysis (SCBA) is the process to describe and evaluate financially the social demerits and merits (Cost and Benefits) of proposed project, plan or venture with respect to a common monetary unit. Benefits can be real and nominal direct and indirect, visible and invisible. Economic analysis has been done from the point of view of the entire society or economy as a whole whereas the financial analysis is done from the firms or the industrys point of view.

Social cost benefits

Social cost benefits

Social cost benefits

UNIDO approaches
Famous economists S.Marglin, Amartya Sen and Partha Dasgupta prepared a manual based on UNIDOs (United Nations Industrial Development Organization (UNIDO)) experience in costbenefit analysis of projects. UNIDO method involves five stages: 1. Calculation of financial profitability measured at market prices to analyze the financial profitability of a project 2. Obtaining the net benefit of the project measured in terms of economic (efficiency) prices (using shadow prices for resources corrected market prices of various inputs and outputs, i.e calculating real prices/costs of inputs and outputs after considering subsidy and other factors) 3. Adjustment for the impact of the project on savings and investment required in the case of developing countries where there is shortage of capital as well as the required amount of savings and investment. It is important for project that generates benefits to groups who save very little out of additional income. 4. Adjustment for the impact of the project on income distribution Any project has to be analyzed whether it will make poor people poorer or rich people richer. 5. Adjustment for the impact of the project on merit goods and demerit goods If the project produces a good whose social and economic values are different, adjustment of this impact

Difference between LM & UNIDO

LM (Little-Mirrlees)Approach UNIDO Approach It measures cost and benefits or shadow It measures cost and benefits or shadow price in terms of international or border price in terms of domestic prices prices It measures cost and benefits in terms of It measures cost and benefits in terms of uncommitted social income consumption

It considers efficiency, redistribution at a time

savings

and It considers all in different stages

All India term lending financial institutions like ICICI, IFCI, and IDBI, apart from appraising the projects from financial point of view, give also consideration to social aspects. These institutions follow a partial L-M approach in the sense that some of the recommendations of L-M approach are followed and some are modified. International prices are used for the valuation of tradable inputs and outputs as recommended by L-M approach while for non tradable inputs and outputs, the valuation is done by using social conversion factors instead of by the methods suggested by the L-M approach.

What is risk
Risk is defined in Websters as a hazard; a peril; exposure to loss or injury. Thus, risk refers to the chance that some unfavourable event will occur. If you engage in sky diving, you are taking a chance with your life sky diving is risky. If you bet on the horses, you are risking your money. If you invest in speculative stocks, you are taking a risk in the hope of making an appreciable return. The most common risks associated with a project are:- Project completion risk, resource risk, price risk, technology risk, political risk, interest rate risk, exchange rate risk, An assets risk can be analysed in two ways: 1.On a stand-alone basis 2.On a portfolio basis
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Risk and uncertainty

If the probabilities of possible outcomes of a given problem are known, we can conclude that the problem contains risk; in other words the problem is risky. On the other hand, if the probabilities of possible outcomes of a given problem are not known, we can conclude that the problem has an element of uncertainty, i.e. the outcome cant be predicted.

We will discuss about various risks and specially project risk in details and we will also understand different techniques of risk analysis in the coming slides.

41

Risks encounters in Project Financing Deal

Types Of Risks Explaining the risk Project Risks Debtors Credit risk This threatens the operation of a specific project and thereby affects the repayment of the lenders loan. It is a risk that a particular debtor company will default on its loan for example, as a result of insolvency or other deterioration in its overall financial condition. When such debtor is a country, the risk of such default is referred as a sovereign credit risk Relates to technical, financial and other concerns that would face a project irrespective of its country location. Political or country risks relate to those risks presented by a particular country and its government. This generally of importance when foreign investors are involved in the project. These risks are outside the control of the participants a natural and unavoidable catastrophe that interrupts the expected 42 course of events.

Sovereign Credit Risk Commercial Risk Political Risk

Force majeure

Risk and uncertainty

Project risk:1. Project completion risk 2. Resource risk 3. Price risk 4. Technology risk 5. Political risk 6. Interest rate risk 7. Exchange rate risk Techniques of Risk analysis:1. Break even analysis 2. Sensitivity analysis 3. Decision tree analysis 4. Monte-carlo technique 5. Game theory

Break even analysis

Break even analysis:- costs of input and price of out is influenced by the market forces. The only thing that is under the control of project promoter is the level of output (i.e. Capacity utilization)hence it is very essential to know the level of operation level below which project will in cur losses. BEP refers to the level of operation at which the project will incur no profit and no loss. BEP(in terms of no. Of units) =_______Fixed cost_________________ (selling price/unit variable cost/unit)

Sensitivity Analysis
A technique of risk analysis which can be used to study the responsiveness of a criterion of merit like NPV or IRR to variations in underlying factors like selling price, quantity sold, etc. If a small change in one factor leads to a major change in the profitability of the proposed investment then the project is considered more sensitive to that factor. The sensitivity of a project can be studied as under:1. What happens to the NPV if the demand for the product drops down 2. What happens to the NPV if the economic life of the project reduces 3. What happens to the DSCR if the selling price of the project falls down etc. It provides the management the much needed information as to which are the critical factors that are prone to affect the profitability of the project.

Decision tree analysis

Its a graphical technique that can be used for analyzing the pros and cons of alternatives decisions and choosing the best possible course of action.

Success prob = 1

Gross Expected income: 4.0 L Cost : : 1.0 L E.M.V : :3.0 L

Chance point
Decision point
Success prob = .8

No investment
Gross Expected income: 8.0 L E.M.V : :6.4 L

Chance point
Success prob = .4

Gross Expected income: 12.0 L E.M.V : :4.8 L

46

Monte Carlo Simulation

Monte Carlo simulation furnishes the decision-maker with a range of possible outcomes and the probabilities they will occur for any choice of action.. It shows the extreme possibilitiesthe outcomes of going for broke and for the most conservative decisionalong with all possible consequences for middle-of-theroad decisions. The technique was first used by scientists working on the atom bomb; it was named for Monte Carlo, the Monaco resort town renowned for its casinos. Since its introduction in World War II, Monte Carlo simulation has been used to model a variety of physical and conceptual systems.

47

Monte Carlo Simulation

It is observed that the demand for a product varies in a random fashion. The demand per day is observed o have the following probability:Demand/day: Probability 25 33 42 51 0.15 0.25 0.45 0.15 Cumulative Probability 0.15 0.40 0.85 1.00 Tag number 0-14 15-39 40-84 85-99

There will be 100 tag numbers representing a cumulative probability of 1 (0-99, both inclusive). After assigning tag numbers, the next step is to choose a set of 2 digits nos (random 2 digit numbers because the tag numbers are between 0 and 99). The number of random numbers to be chosen depends upon the accuracy required. More the Numbers more the accuracy. Lets choose say 30 numbers from the table.
48

Monte Carlo Simulation

Trial No. 1 2 Random No. 40 92 Simulated demand per day 42 51 Trial no 16 17 Random No. 99 17 Simulated demand per day

3
4 5 6 7 8 9 10 11 12 13 14 15

47
01 60 05 69 79 09 66 77 69 45 18 93

42

18
19 20 21 22 23 24 25 26 27 28 29 30

22
62 70 28 31 07 68 22 46 30 23 76 33

49

Game Theory
In real life situation, business firms compete with one another. Game theory deals with situations in which two intelligent opponents have conflicting interest. To achieve their goals two firms will form strategies. The strategy that one firm will depend upon the strategy formed by the other firm. The approach to such competitive problems was formed by Von Neuman, who named it game theory. Following are the properties of a competitive game:-

50

Simple Probability Analysis

This is one of the most effective and conceptually sound tools of appraising projects in a case of uncertainty.

51

Scenario Analysis

Managers are often interested in establishing the worst case and the best case scenario. That is, what NPV will result if all the assumptions made turn out to be too optimistic and too pessimistic.

52

Break Even Analysis

When we undertake a Sensitivity Analysis of a project, or when we look at alternative scenarios (as per scenario analysis) we are asking how serious it would be if sales and cost turns out to be worst than forecasted. Managers sometime rephrase the question and ask how bad sales may get before the project begins to loose money. This exercise is known as break even analysis.

53

Perfectly Correlated cash flows

If cash flows are perfectly correlated the behaviour of cash flows in all periods is alike. This means that if the actual cash flow in one year is Standard deviations to the left of its expected value, cash flows in other years will also be Standard deviations to the left of their respective expected values. Put in other words, cash flows of all years are linearly correlated to each other. The expected value and standard deviation of the net present value, when cash flows are perfectly correlated, are as follows:

(NPV)=

54

Simulation Analysis
The basic principle in Simulation is that since risk arises out of the events which cannot be fixed into a pattern, i.e. random events, a model can be developed in which all factors excepting the random factors are fixed, and the impact of the random factors on he output can be studied by generating the random events artificially. Using Simulation the manager or decision maker should: Define the problem Identify the fixed and variable factors Identify the various courses of action available to him Construct a mathematical model incorporating all the variables Decide on the best possible course of action

55

Decision Tree Analysis

56

A comparative analysis of each model

Name of the model Situation when it can be applicable Sensitivity Analysis Since the future is unknown, somebody wants to know what ill be the feasibility or viability of the project, when some variable like sales or investment deviates from its expected value. Scenario Analysis In previous model typically one variable is varied at a time. If variables are inter related i.e. there are more than one variable at a time then it will helpful to look at some plausible scenarios, each scenario depicts a combination of variables

Break even Analysis As a finance man he or she might be interested in knowing how much should be manufactured and sold at a minimum to ensure that the project does not loss money. To know the answer of this basic question one should undergone this particular model

57

A comparative analysis of each model

Name of the model Hiller Model Simulation Analysis Situation when it can be applicable When the expected NPV and the Standard Deviation of NPV may be obtained through analytical derivation then this model can be used. Sensitivity Analysis is useful but may not be adequate for decision making. If the decision maker would also like to know the likelihood of different sensitive occurrences, then simulation can provide the best possible answer. To analyse situations where sequential decision making in the face of risk is involved, decision tree analysis is a useful tool.

Decision Tree Analysis

Risk Adjusted Discount The risk adjusted discount rate is commonly employed in practice. Rate Method Firms use different discount rates for different types of investment projects. In that case a risk adjusted discount rate is the only solution. Certainty Method Equivalent When the risk free rate is applied for discounting purposes and the expected cash flow of the project are converted into their certainty equivalent, then it will be useful.

58