2 risk and uncertainity in capital budgeting

8/3/2019 2 Risk and Uncertainity in Capital Budgeting

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Capital Budgeting


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Capital Budgeting Decisions

Capital investment refers to the investment in projectswhose results would be available only after a year. Theinvestments would be heavy and the return will beavailable only after some time.

Cases of capital budgeting decisions Replacements

Expansion

Diversification

R & D Miscellaneous (Pollution control as per legal requirements)


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Concept of Capital Budgeting

Capital Budgeting refers to long-term planningfor proposed capital outlays and their financing.

It includes both raising of long-term funds aswell as their utilisation.

It is the decision making process by which thefirms evaluate the purchase of major fixed assets

It refers to the firms formal process for the

acquisition and investment of capital


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Capital Expenditure Budget

It is a functional budget It provides guidance as to the amount of capital

that may be required for procurement of capital

assets during the period

The budget is prepared after taking into

consideration the available production

capacities, probable reallocation of existing

resources and possible improvements in the

production techniques


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Need & Importance of Capital Budgeting

Large investments Long term commitment of funds

Irreversible nature

Long term effect on profitability Difficulties of investment decision

National importance


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Capital Budgeting Process

Capital

Budgetin

g Process

1. Identification

of Investment

Proposal

2. Screen

Proposals

3. Evaluate

Proposals

4. Fix

Priorities

5. Final

approval

6.

Implementthe Proposal

7. Review

the

performance


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Kinds of Capital Budgeting Decisions

Basic categories Those which increase revenue

Those which reduce cost

Other Categories Accept/Reject decisions

Mutually exclusive project decisions

Capital rationing decisions


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Methods/Evaluation of Investment Proposals

Traditional methods Pay-Back Period/ Pay Out/ Pay Off Method

Improved Pay-Back Period Method

Post-pay Back Profitability method

Pay back Reciprocal method Post-pay Back Period method

Discounted Pay-Back Method

Rate of Return/Accounting Method

Average rate of Return Method

Return per unit of investment method

Return on average investment method

Average return on average investment method


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Methods/Evaluation of Investment Proposals

Time-Adjusted/ Discounted Methods

Net Present Value Method- NPV

Internal Rate of Return Method- IRR Profitability Index Method-PI


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RISK MANAGEMENT FUNCTION

Risk management

involves identifying a

firms risk exposures

and using insurance

products or selfinsurance to manage

those exposures.


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RISK AND UNCERTAINTY IN CAPITAL BUDGETING


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1. Risk Adjusted Discount Rate/ Method ofvarying discount rate- RAD

2. Certainty equivalent method-CE

3. Sensitivity technique

4. Probability Distribution technique-PD5. Standard deviation method-SD

6. Co efficient of variation method-COV/CV

7. Decision tree analysis

8. Simulation Analysis

RISK AND UNCERTAINTY IN CAPITAL BUDGETING


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RAD is the simplest method of accounting for risk

in capital budgeting The cut-off rate or the discount factor will be

increased by a certain percentage on account of risk

The highly risky projects which have grater

variability in expected returns will be discounted at a

higher rate when compared to the projects which are less

risky and are expected to have lesser variability in

returns

The drawback of this method is that it is not

possible to determine the risk premium rateappropriately

Another drawback is that it is the future cash flow

which is uncertain and requires adjustment and not the

discount rate

Risk Adjusted Discount Rate/Method of Varying Discount Rate


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CE is another simple method

This method aims to reduce expected cash flows bycertain amounts

It can be employed by multiplying the expected cash

flows by certainty equivalent co-efficient as to convert the

uncertain cash flows to certain cash flows

Certainty Equivalent Method-CE


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Sensitivity Technique is applied where cash inflows

are very sensitive under different circumstances In such cases, 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 net present values under these three different

situations

If the NPVs under the three situations differ widelyit implies that there is a great risk in the project and the

investors decision to accept or reject a project will

depend upon his risk bearing abilities

Sensitivity Technique


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A probability is the 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 The monetary values of the inflows may further be

discounted to find the present values

The project that gives higher net present value may

be accepted

Probability Distribution Technique


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If two projects have the same cost and their net

present values are also the same, standard deviation ofthe expected cash inflows of the two projects may be

calculated to judge the comparative risk of the projects

The project having a higher standard deviation is

said to be more risky as compared to the other

Standard Deviation Method


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Coefficient of variation is a relative measure of

dispersion. If the projects have the same cost butdifferent NPVs, relative measure i.e., Coefficient of

variation should be computed to judge the relative

position of risk involved. It can be calculated as

Coefficient of variation= (Standard Deviation/Mean)*100

Coefficient of Variation Method


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In modern business there are complex investment

decisions which involve a sequence of decisions overtime Such subsequential decisions can be handled by

plotting decision trees

A decision tree is a graphic representation of the

relationship between a present decision and futureevents, future decisions and their consequences

The sequence of events is mapped out over time in a

format resembling branches of tree and hence the

analysis is known as decision tree analysis

Decision Tree Analysis


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Identification of the problem

Finding out the alternatives Exhibiting the decision tree indicating the decision

points, chance events and other relevant data

Specification of probabilities and monetary values

for cash inflows Analysis of the alternative

Steps in Decision Tree Analysis


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Simulation analysis is a technique to analyse risk in

capital budgeting decisions It is unique in the sense that it allows all the

variables to vary at the same time

It also finds out the impact of NPV

Random numbers are used for simulation

Simulation Analysis


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1. Model the project. The model of the project shows

how the NPV is related to the parameters and theexogenous variables.

(Parameters are input variables specified by the decision

maker and held constant over all simulation runs.

Exogenous variables are input variables which are

stochastic in nature and outside the control of the

decision maker)

2. Specify the values of parameters and the probability

distributions of the exogenous variables

3. Select a value, at random, from the probabilitydistributions of each of the exogenous variables

4. Determine the net present value corresponding to the

randomly generated values of exogenous variables and

pre-specified parameter values

Procedure for Simulation Analysis


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5. Repeat steps (3) & (4) a number of times to get a large

number of simulated NPVs6. Plot the frequency distribution of the NPVS

(Problem Financial Management Prasanna Chandra

Pg.No 340)

Procedure for Simulation Analysis-contd

2 risk and uncertainity in capital budgeting

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