UNIT-I 1. Define project: Gillinger defines project as the whole complex of activities involved in using resources to gain benefits.

2. What are the classifications of projects? -Quantifiable and Non-Quantifiable Projects -Sectoral Projects -Techno-Economic Projects 3. Difference between project management and project investment management? a) Project investment management is about investment and financing analysis of project, whereas, project management is wholesome process which involves identification project, finding out feasibility and execution of project. B )In the feasibility analysis itself there are several feasibility studies are involved. Project management requires all kinds feasibility analysis such as market feasibility, technical feasibility, financial feasibility and operational feasibility. The project investment management requires only the financial feasibility. c) Project management requires technical, marketing and financial skill, whereas project investment management requires only financial knowledge. 4. Explain the importance of capital budgeting. a.Huge amount of investment: Capital expenditure decisions can commit the firm for huge investment over a period of time. A wrong decision can result in heavy loss. b. Permanent and Irreversible Commitment of funds: Capital expenditure decisions result in commitment of funds on long term basis. Once a project is taken up and investment is made, it is not usually possible to reverse the decision. The reversal will be at the cost of heavy loss. c. Long-term impact on profitability: The Capital expenditure decisions will shape the future revenue streams and the profitability of operations. d.Growth and Expansion: Business firms grow, expand, diversity and acquire stature in the industry through their capital budgeting activities. The success of mobilization and deployment of funds determines the future of a firm. e. Cost over runs: If not meticulously implemented, delay in completion of projects will automatically result in excess costs and heavy losses. f.Alternatives: Limited funds at the disposal of a firm have to be deployed in the most profitable of the alternative projects. The elimination process is a difficult one. g.Multiplicity of variables: Large number of factors affect the decisions on capital

expenditure. The make the capital expenditure decisions the most difficult to make. h.Top Management Activity: The metamorphic impact of capital expenditure decisions automatically thrusts them on the top management. Only senior managerial personnel can take these decisions and bear responsibility for them. 5. Explain the types of project. Quantifiable and Non-Quantifiable Projects Projects for which a plausible quantitative assessment of benefits can be made are called quantifiable projects/ projects concerned with industrial development, power generation, and mineral development fall in this category. On the contrary, non- quantifiable projects are those in which a plausible quantitative assessment cannot be made. Projects involving health education and defence are the examples of non-quantifiable projects. Sectoral Projects According to this classification, a project may fall in any one of the following sectors: (i)Agriculture and Allied Sector (ii) Irrigation and Power Sector iii) Industry and Mining Sector (iv) Transport and Communication Sector (v) Social Services Sector (vi) Miscellaneous Sector The project classification based on economic sectors is found useful in resource allocation more especially at macro levels. Techno-Economic Projects Projects classification based on techno-economic characteristics fall in this category. This type of classification includes factors in intensity oriented classification, causation oriented classification and magnitude-oriented classification. These are discussed as follows: a. Factor Intensity-Oriented Classification: Based on factor intensity classification, projects may be classified as capital intensive or labour intensive. If large investment is made in plant and machinery, the projects will be termed as capital intensive. On the contrary, projects involving large number of human resources will be termed as labour intensive. b. Causation-Oriented Classification: Where causation is used as a basis of classification, projects may be classified as demand based or raw

material based projects. The very existence of demand for certain goods or services makes the project demand-based and the availability of certain raw materials, skills or other inputs makes the project raw material-based. c. Magnitude-Oriented Classification: In case of magnitude-oriented classification, based on the size of investment involved in the projects, the projects are classified into large scale, medium-scale or small-scale projects. Project classification based on techno-economic characteristics is found useful in facilitating the process of feasibility appraisal of the project 6. Discuss the essentials of profitable project management. a) Define scope, deadlines and goals The firm should clearly define each project before bringing in the full team. If the firm is unsure of the objectives, scope and deadlines, the effort will begin in confusion. Responsibilities and even resources can be worked out at the first meeting, but not without a firm grasp of what is to be achieved, when and for how much. The internal kickoff meeting is an opportunity to energize and unite the team to work for a successful project outcome. It serves notice to all team members that the project has begun. Have an agenda that includes a clear exchange between sales and the project team. Communicate the project requirements. Ensure everyone understands the work to be done and their part in the effort. Nodding heads do not mean message received! Ask each member to state their responsibilities in their own words before adjourning. No one should be guessing at what the client and management want! b)Communicate, Communicate and Collaborate Lack of communication derails even the most brilliant teams and shining projects. Ensuring key messages are received and understood as a matter of routine is the single most important factor in a projects success. There cannot be enough communication among team members and with the client. The management must talk, chat, discuss and exchange ideas. Communication should not just float off into space or rely on individual recollection. Every organization can benefit from a tool that enables to capture all material information. E-mail is unreliable, particularly when unacknowledged or lost in the spam. Investigate a projects library and collaboration system. A systematic approach to communication can be a boost to individuals or groups reluctant to interact, like engineers and software programmers. An automated, accessible and mandated communication and collaboration tool can be a wise investment! c) Meet deadlines even if the firm must reduce scope Time is becoming the new corporate metric, says management consultant Peter Drucker. In an ideal world, the firm would completely finish every project on time.When forced to choose, the best bet is usually to get something demons ratably done by deadline. Today, time is as important as cost and quality. Time to market is critical. Time to respond to a client request is critical. Time to incorporate change is critical. And time to install a finished system is critical.

In addition, work expands to fill the time available for completion. When under a tight schedule, which the firm should be, keep in mind that clients remember meeting schedule commitment, not reduced scope. Communication matters here too. Involve the entire team in establishing andmaintaining schedules. Keep your milestones to ones that matter. It is better to have a few the firm meet than many milestones it doesnt! d) Run every project the same way When it comes to projects, consistency is quality. It builds efficiencies, reduces costs and improves quality. Consistency is the most cost-effective, least capital-intensive route to profitability. The firm should have a common methodology to follow for everyproject, regardless of the project content. Invest in technology that supports standards and methodology, as this will reduce ongoing costs. With or without a project application system, the project methodology should include: a) A known location for communication, updates, documents and changes. b) An acknowledgment system for important communications like change orders. e) Chose proven projects technology, deploy it properly Technology for projects management and collaboration should be field-proven. This sounds obvious. Teams with few projects of experience often overemphasize technology. Seeing some application as a primary driver of their solution, they lose focus of the primary purpose of the technology: improving project delivery and completion. Selecting projects management tools by technological parameters instead of functionality is a mistake. Remember that advanced features are seldom used. The firm wants stable technology that improves, not hinders, its work.The firm needs sufficient training and implementation services at start-up. Typically the biggest investment in application deployment is staff time. Good installation and proper training accelerate the learning curve. f)Monitor real-time costs Many project managers are flying blind on project costs. Perhaps they dont see it as part of the job. Perhaps the accounting system doesnt produce reports until month- or project-end when it is too late to make adjustments. Perhaps they have a latent desire to change careers! The firm should put in place a project management system that lets to see individual project costs at any time. Move cost-tracking responsibility into project team rather than leaving it up to accounting. This is easily done with the right system and speeds upoverall project execution. Let all project members see and understand project costs to help the firm work within budget. A system that allows the firm and the team to track project costs in real-time keeps more projects on track. 7. What are the factors influencing capital expenditure decisions? (1) Availability of funds: This is the crucial factor affecting all capital expenditure decisions. However attractive some projects may be, they cannot be taken up if they are too big for a firm to mobilize the needed funds. (2) Future Earnings: Every project has to result in cash inflows in future. The

extent of the revenues anticipated is the most significant factor which affects the choice of a project. (3) Legal compulsions: When statutory compulsion arises, cost and profit considerations have to be secondary. For example, waste disposal plants have to be installed to satisfy environmental laws in most of the countries in the world, particularly in industries like leather and chemicals. (4) Degree of uncertainty or risk: The level of risk involved in a project is vital for deciding its desirability. (5) Urgency: Projects which are to be immediately taken up for a firms survival have to be treated differently from optional projects. (6) Research and Development projects: Projects, which may result in invention of new products or methods, etc., are a sort of investment with hope. They may prove successful or not. But R & D is a must in most of the industries, particularly in technology based industries. (7) Obsolescence: If obsolete machinery and plant exist in a firm, their replacement becomes a compulsion. (8) Competitors Activities: When competitors perform certain activities, they may compel a firm to undertake similar activities to withstand competition. (9) Intangible Factors : Firms prestige, workers safety, social welfare, etc., influence capital expenditure which may be deemed as emotional factors. 8. Explain the methods of evaluation of investment proposals. Traditional Methods These methods generally ignore Time Value of money and treat incomes estimated for different future periods alike. These methods have been traditionally used in business units. Pay-Back Period Method Pay-back period is also called pay-out period or pay-off-period. Pay-back period is the time span in which a project pays for itself through surplus cash flows. It is the period within which investment in fixed assets or projects can be recovered. It is the time required for the Savings in costs or net cash inflows from a project to equal the investment made therein. Thus, pay-back period is the period of time for the cost of a project to be recovered from the additional earnings of the project itself. Pay - back period = Initial Cost of asset/Initial Investment in project Note : Annual cash inflow is the net income from the asset or project after tax, but before depreciation. Investment decisions, based on pay-back period 1. Ranking of Projects: Pay-back period can be used as the criterion to rank different investment proposals, those with lower pay-back period being ranked higher and vice versa. This method is very useful in case of Mutually exclusive projects, Ranking can help in choosing projects in situations of limited funds being available. 2. When pay-back period of two or more projects is equal, the project with higher initial cash inflows is preferred over the projects with lower initial cash inflows. Advantages: (1) It is simple to understand and easy to calculate.

(2) Inherently, the method provides for uncertainty. Dealing with risk is a Built-in feature of this method. Its focus on recovery of investment takes care of uncertainty and risk to a great extent. (3) Loss through obsolescence is minimized because short-term projects are preferred through lower pay-back criterion. (4) Profit is recognised only after the pay-back period. So, it acts as a guideline for dividend policy in the case of new firms. (5) The importance given to liquidity through the emphasis on early returns from projects will enable a firm to manage with lower funds. Disadvantages (1) It ignores post-pay-back period returns. Thus many highly profitable projects may be ignored. (2) It is not concerned with the length of a projects lifetime. Particularly after payback period. All projects which have longer gestation periods but very long periods of profitable operation are ignored by this method. (3) It completely ignores Time value of money. It treats the cash inflows in the first year and the last year alike. Thus, the interest aspect and the risk aspect which make cash inflows in the distant future less desirable than the immediate cash inflows are not recognised in this method. (4) It does not make use of cost of capital which is highly relevant for investment analysis in the sense it represents the cost of funds to be invested. (5) Standard pay back period or Norm for pay back is difficult to determine because it is a subjective decision. (6) The method treats each project in isolation where as in practice investment in different assets is interrelated. (7) Pay-back period method does not measure profitability of projects at all because it is concerned with a short period of a projects life time. ACCOUNTING RATE OF RETURN This method takes into account the total earnings expected from an investment proposal over its full life time. The method is called Accounting rate of return method because it uses the accounting concept of profit i.e., income after depreciation and tax as the criterion for calculation of return. A.R.R = Annual average net earnings/ Original investment Scrap Value Advantages of Accounting Rate of Return method (1) When the method of calculating is decided, it is easy to understand and operate. (2) This method uses the entire earnings of an investment proposal, unlike the payback period method. (3) It gives a clear picture of the profitability of a project. (4) As the basis for the method is accounting concept of profit, it can be readily calculated from the data available in the firms accounting records. (5) This method is based on Net earnings i.e. earnings after depreciation and tax, unlike other methods. It provides a more comprehensive comparative assessment of projects. Disadvantages

(1) Like pay-back period method, this method also ignores the time value of money and treats all incomes received, whether in the first year or last year, alike. (2) Reliability of A.R.R. method is affected due to the various concepts of investment. Different rates can be obtained, using different interpretations of the meaning of investment. (3) By considering profit as the criterion, cash flow aspect of projects is not properly assessed. (4) It is not useful to assess projects where investment is made in two or more installments, at different times. Net Present Value (NPV) Method Net present value method is one of the discounted cash flow methods of capital budgeting. It recognizes the time value of money and that cash flows arising at different periods of time differ in value and are not comparable unless their equivalent present values are found. The net present value of all inflows and outflows of cash occurring during the entire life of a project is determined by discounting these flows by the firms cost of capital or some other pre-determined rate. NPV = P.V. of cash inflows P.V. of cash out flows. Accept or Reject Criterion: N.P.V. is a clear cut accept/Reject criterion. If the N.P.V. is positive, project is acceptable. If N.P.V. is negative, project should be rejected. Merits of N.P.V. Method (1) It recognizes the time value of money and thus better than the traditional methods. (2) It considers the earnings over the entire life of the project which makes a true assessment of profitability of a project possible. (3) It tries to maximize the profits by favouring more profitable projects. Demerits (1) Compared to traditional methods it is complicated to understand and operate. (2) Comparison of projects with unequal life times may be misleading because the amount of N.P.V. alone is considered in this methods without any weightage for the time span. (3) Comparing different projects with different amounts of investments becomes difficult in this method. Profitability Index (P.I.) (or) Excess Present value Index Method: The profitability index is also called Benefits cost Ratio Though this is treated as a separate method due to the importance of results obtained by its usages, it is only a refinement of the N.P.V. method. It shows the relationship between P.V. of cash inflows and P.V. of cash outflows. Formula: Profitability Index (P.I.) = Present value of future cash outflows Present value of future cash inflows (or) Benefit cost ratio (B/C) Accept or reject criterion: If the P.I. or B/C is more than 1 project is acceptable. Projects with P.I. of less than

1 are to be rejected out right. Accept when P.I. > 1 Reject when P.I < 1 Merits and Demerits P.I. Method possesses all the merits and demerits of N.P.V. method because P.I. is a refinement of N.P.V. method. However it is more useful in ranking two or more projects. Thus, P.I. is more suitable for comparative assessment of projects whereas N.P.V. is appropriate to decide about a particular project. Internal Rate of Return (IRR) Method Internal rate of return is that rate of return at which the present values of cash inflows and cash outflows are equal. Thus, at I.R.R. the total of discounted cash inflows equals the total of discounted cash out flows. I.R.R. discounts the total cash flows to the level of zero. Accept or Reject criterion under I.R.R. Method I.R.R. is the return that can be expected from the project which is under consideration. The project is acceptable if cut-off rate or cost of capital is less than the I.R.R. and vice versa. Accept when IRR > Cut-off rate Reject when IRR < Cut-off rate Merits of I.R.R. Method 1. Like all the other D.C.F. based methods, I.R.R. also takes into account the time value of money and can be applied where the cash inflows are even or unequal. 2. It also considers the profitability of a project over its entire economic life and thus the true profitability of a project can be assessed. 3. Cost of capital or pre-determined cut-off rate is not a pre-requisite for applying I.R.R. method. Hence it is better than the N.P.V. and P.I. methods in all those situations where determining cost of capital is difficult. 4. I.R.R. provides for ranking of various proposals because it is a percentage return. 5. It provides for maximizing profitability. Demerits 1. It is complicated method and may lead to cumbersome calculations. 2. The underlying assumption of I.R.R. that the earnings are reinvested at I.R.R. for the remaining life of the project is not a justifiable assumption. From this point of view, N.P.V. and P.I. which assume reinvestment at cost of capital rate are better. 3. The results obtained through NPV or PI methods may differ from that obtained through I.R.R. depending on the size, life and timings of the cash flows. Comparison of I.R.R. with N.P.V. and P.I. Methods Differences 1. Cost of capital or cut-off rate is determined in advance in NPV and PI. In I.R.R., the discounting rate is the unknown factor. 2. NPV and PI strive to ascertain the amount which can be invested in a project which can earn the required rate of return. I.R.R. ascertains the maximum interest that can be paid out of returns from the project.

3. The underlying assumption of the D.C.F. methods is that the cash inflows can be reinvested. However NPV and PI assume the reinvestment at cost of capital rate or the cut-off rate. I.R.R. assumes re-investment at the I.R.R. rate. 9. Describe the types of Disinvestment DIFFERENT AVENUES FOR DISINVESTMENT Sell Off: A sell off is the sale of an asset, factory, division, product line or subsidiary by one entity to another for a purchase consideration payable in cash or securities of the buyer. It is simply a reverse merger from the point of view of the divesting firm. The reasons for sell off could be that a product line or subsidiary may not fit in the core line of operations of the seller. During 1994-95, Glaxo Ltd. sold away its production facilities, brand value, research and development relating to baby food and glucose business to Heinz Ltd. The purchase consideration was received in cash, a major portion of which was distributed by Glaxo Ltd. as special dividend among its shareholders. Lakme Ltd. (a Tata group company) sold its entire production facilities to Lever Lakme Ltd. (a subsidiary of Hindustan Lever Ltd.) Spin Off: In case of spin off, a part of the business is separated and instituted as a separate firm. The existing shareholders of the firm get proportionate ownership (in terms of number of shares). So, there in no change in ownership and the shareholders directly own the spin-off part instead of owning through being the shareholders of the original firm. The management of the original firm gives up operating control of the separated business/ asset but the shareholders retain the same percentage ownership in both firms. In fact the original shareholders of the firm become the shareholder of two firms, i.e. the existing as well as that of the new firm. The reasons for spin off may be: i. The firm wants to give the separate identity to part / division. ii. To avoid the take over attempt on the whole firm. If a predator is looking to take over the control of the firm, the valuable division of the firm may be spun-off, so that it is assessed separately by the market. This may make the separated division un-attracted to the predator. iii. To separate out the regulated and unregulated lines of business. Carve Outs : It is a variant of spin off. In carve-out, the shares of the new company are not given to the existing shareholders, rather are sold for cash in the market by making a public offer. So, in carve out, the existing company, may sell either the majority stake or a minority stake, depending upon whether the existing management wants to continue to control or not the separated division. Buy Outs : It is also known as Management Buy Out (MBO) In this case, the management of the company buys a particular part of the business from the firm and then incorporate the business as a separate entity. In certain cases, the management may buy out the entire firm. In case, the existing management is short of funds to pay for buy-out, then it can arrange debt funds from investors, banks or financial institutions. In such cases, the buy- out is known as Leveraged Buy-Out (LBO). The LBO involves participation by third party (lenders) and the management no longer needs to deal with a diverse group of shareholders, but instead with the lender or lenders only. However, in LBO, there is a dramatic increase in the debt ratio. Still, the LBO may be acceptable because of tax

deductibility of interest payment on the debt. To sum up, mergers, acquisitions, demergers and divestments provide different means to streamline the operations of business firm. In merger, the activity base of the firm expands while in case of demergers, the base contracts. In both cases, however, proper evaluation of different factors, financial as well as others is required. There need not be haste in any such situation. 10. Explain the risk analysis in capital budgeting. CONVENTIONAL TECHNIQUES OF RISK ANALYSIS A number of techniques to handle risk are used by managers in practice . They range from simple rules of thumb to sophisticated statistical techniques. The following are the popular, non-conventional techniques of handling risk in capital budgeting: Payback Risk-adjusted discount rate Certainty equivalent These methods, as discussed below, are simple, familiar and partially defensible on theoretical grounds. However, they are based on highly simplified and at times, unrealistic assumptions. They fail to take account of the whole range of the effect of risky factors on the investment decision-making. 3.5.1 Payback Payback is one of the oldest and commonly used methods for explicitly recognising risk associated with an investment project. This method, as applied in practice, is more an attempt to allow for risk in capital budgeting decision rather than a method to measure profitability. Business firms using this method usually prefer short payback to longer ones, and often establish guidelines that a firm should accept investments with some maximum payback period, say three or five years. The merit of payback is its simplicity. Also, payback makes an allowance for risk by (i) focusing attention on the near term future and thereby emphasising the liquidity of the firm through recovery of capital, and (ii) by favouring short term projects over what may be riskier, longer term projects. It should be realised, however, that the payback period, as a method of risk analysis, is useful only in allowing for a special type of risk the risk that a project will go exactly as planned for a certain period and will then suddenly cease altogether and be worth nothing. It is essentially suited to the assessment of risks of time nature. Once a payback period has been calculated, the decision-maker would compare it with his own assessment of the projects likely, and if the latter exceeds the former, he would accept the project. This is a useful procedure, economic only if the forecasts of cash flows associated with the project are likely to be unimpaired for a certain period. The risk that a project will suddenly cease altogether after a certain period may arise due to reasons such as civil war in a country, closure of the business due to an indefinite strike by the workers, introduction of a new product by a competitor which captures the whole market and natural disasters such as flood or fire. Such risks undoubtedly exist but they, by no means, constitute a large proportion of the commonly encountered business risks. The usual risk in business is not that a project will go as forecast for a period and then collapse altogether; rather the normal business risk is that the forecasts of cash flows will go wrong due to lower sales,

higher cost etc. Further, even as a method for allowing risks of time nature, it ignores the time value of cash flows. For example, two projects with, say a four-year payback period are at very different risks if in one case the capital is recovered evenly over the four years, while in the other it is recovered in the last year. Obviously, the second project is more risky. If both cease after three years, the first project would have recovered three-fourths of its capital, while all capital would be lost in the case of second project. Given the uncertainty element, it may well be that a four-year payback period, based on fairly certain estimates might be preferred to a three-year payback period, calculated with very uncertain estimates. Risk-Adjusted Discount Rate For a long time, economic theorists have assumed that, to allow for risk, the businessman required a premium over and above an alternative, which was risk-free. Accordingly, the more uncertain the returns in the future, the greater the risk and the greater the premium required. Based on this reasoning, it is proposed that the risk premium be incorporated into the capital budgeting analysis through the discount rate. That is, if the time preference for money is to be recognised by discounting estimated future cash flows, at some risk-free rate, to their present value, then, to allow for the riskiness, of those future cash flows a risk premium rate may be added to risk-free discount rate. Such a composite discount rate, called the risk-adjusted discount rate, will allow for both time preference and risk preference and will be a sum of the risk-free rate and the risk-premium rate reflecting the investors attitude towards risk. The risk-adjusted discount rate method can be formally expressed as follows: where k is a risk-adjusted rate. n NPV= NCFt/(1+K)t t=0 Risk-adjusted discount rate = Risk-free rate + Risk premium k=kf+kr (6) Under CAPM, the risk-premium is the difference between the market rate of return and the risk-free rate multiplied by the beta of the project. The risk-adjusted discount rate accounts for risk by varying the discount rate depending on the degree of risk of investment projects. A higher rate will be used for riskier projects and a lower rate for less risky projects. The net present value will decrease with increasing k, indicating that the riskier a project is perceived, the less likely it will be accepted. If the risk-free rate is assumed to be 10 per cent, some rate would be added to it, say 5 per cent, as compensation for the risk of the investment, and the composite 15 per cent rate would be used to discount the cash flows. The following are the advantages of risk-adjusted discount rate method: It is simple and can be easily understood. It has a great deal of intuitive appeal for risk-averse businessman. It incorporates an attitude (risk-aversion) towards uncertainty This approach, however, suffers from the following limitations: There is no easy way of deriving a risk-adjusted discount rate. As discussed earlier, CAPM provides for a basis of calculating the risk-adjusted discount rate. Its use has yet to pick up in practice. It does not make any risk adjustment in the numerator for the cash flows that are

forecast over the future years. It is based on the assumption that investors are risk-averse. Though it is generally true, there exists a category of risk seekers who do not demand premium for assuming risks; they are willing to pay a premium to take risks. Accordingly, the composite discount rate would be reduced, not increased, as the level of risk increases.

SENSITIVITY ANALYSIS In the evaluation of an investment project, we work with the forecasts of cash flows. Forecasted cash flows depend on the expected revenue and costs. Further, expected revenue is a function of sales volume and unit selling price. Similarly, sales volume will depend on the market size and the firms market share. Costs include variable costs, which depend on sales volume and unit variable cost and fixed costs. The net present value or the internal rate of return of a project is determined by analysing the after-tax cash flows arrived at by combining forecasts of various variables. It is difficult to arrive at an accurate and unbiased forecast of each variable. We cant be certain about the outcome of any of these variables. The reliability of the NPV or IRR of the project will depend on the reliabilityof the forecasts of variables underlying the estimates of net cash flows. To determine the reliability of the projects NPV or IRR, we can work out how much difference it makes if any of these forecasts goes wrong. We can change each of the forecast, one at a time, to at least three values: pessimistic, expected, and optimistic. The NPV of the project is recalculated under these different assumptions. This method of recalculating NPV or IRR by changing each forecast is called sensitivity analysis. Sensitivity analysis is a way of analysing change in the projects NPV (or IRR) for a given change in one of the variables. It indicates how sensitive a projects NPV (or IRR) is to changes in particular variables. The more sensitive the NPV, the more critical is the variable. The following three steps are involved in the use of sensitivity analysis: Identification of all those variables, which have an influence on the projects NPV (or IRR). Definition of the underlying (mathematical) relationship between the variables. Analysis of the impact of the change in each of the variables on the projects NPV. The decision-maker, while performing sensitivity analysis, computes the projects NPV (or IRR) for each forecast under three assumptions: (a) pessimistic, (b) expected, and (c) optimistic. It allows him to ask what if questions. For example, what (is the NPV) if volume increase or decreases? What (is the NPV) if variable cost or fixed cost increases or decreases? What (is the NPV) if the selling price increases or decreases? What (is the NPV) if the project is delayed or outlay escalates or the projects life is more or less than anticipated? A whole range of questions can be answered with the help of sensitivity analysis. It examines the sensitivity of the variables underlying the computation of NPV or IRR, rather than attempting to quantify risk. It can be applied to any variable, which is an input for the after-tax cash flows. Pros and Cons of Sensitivity Analysis Sensitivity analysis has the following advantages

 It compels the decision maker to identify the variables, which affect the cash flow forecasts. This helps him in understanding the investment project in totality. It indicates the critical variables for which additional information may be obtained. The decision maker can consider actions, which may help in strengthening the weak spots in the project. It helps to expose inappropriate forecasts, and thus guides the decision-maker to concentrate on relevant variables. Let us emphasise that sensitivity analysis is not a panacea for a projects all uncertainties. It helps a decision-maker to understand the project better. It has the following limitations: It does not provide clear-cut results. The terms optimistic and pessimistic could mean different things to different persons in an organisation. Thus, the range of values suggested may be inconsistent. It fails to focus on the interrelationship between variables. For example, sale volume may be related to price and cost. A price cut may lead to high sales and low operating cost. SIMULATION ANALYSIS We have explained in the previous sections that sensitivity and scenario analyses are quite useful to understand the uncertainty of the investment projects. But both approaches suffer from certain weaknesses. As we have discussed, they do not consider the interactions between variables and also, they do not reflect on the probability of the change in variables. The Monte Carlo simulation or simply the simulation analysis considers the interactions among variables and probabilities of the change in variables.1 It does not give the projects NPV as a single number rather it computes the probability distribution of NPV. The simulation analysis is an extension of scenario analysis. In simulation analysis a computer generates a very large number of scenarios according to the probability distributions of the variables. The simulation analysis involves the following steps: First, you should identify variables that influence cash inflows and outflows. For example, when a firm introduces a new product in the market these variables are initial investment, market size, market growth, market share, price, variable costs, fixed costs, product life cycle, and terminal value. Second, specify the formulae that relate variables. For example, revenue depends on by sales volume and price; sales volume is given by market size, market share, and market growth. Similarly, operating expenses depend on production, sales and variable and fixed costs. Third, indicate the probability distribution for each variable. Some variables will have more uncertainty than others. For example, it is quite difficult to predict price or market growth with confidence. Fourth, develop a computer programme that randomly selects one value from the probability distribution of each variable and uses these values to calculate the projects NPV. The computer generates a large number of such scenarios, calculates NPVs and stores them. The stored values are printed as a probability distribution of the projects NPVs along with the expected NPV and its standard deviation. The risk-free rate should be used as the discount rate to compute the projects NPV. Since simulation is performed to account for the risk of the projects

cash flows, the discount rate should reflect only the time value of money. Simulation analysis is a very useful technique for risk analysis. Unfortunately, its practical use is limited because of a number of shortcomings. First, the model becomes quite complex to use because the variables are interrelated with each other, and each variable depends on its values in the previous periods as well. Identifying all possible relationships and estimating probability distribution is a- difficult task; its time consuming as well as expensive. Second, the model helps in generating a probability distribution of the projects NPVs. But it does not indicate whether or not the project should be accepted. Third, simulation analysis, like sensitivity or scenario analysis, considers the risk of any project in isolation of other projects. We know that if we consider the portfolio of projects, the unsystematic risk can be diversified. A risky project may have a negative correlation with the firms other projects, and therefore, accepting the project may reduce the overall risk of the firm. DECISION TREES FOR SEQUENTIAL INVESTMENT DECISIONS We have so far discussed simple accept-or-reject decisions, which view current investments in isolation of subsequent decisions. . But in practice, the present investment decisions may have implications for future investment decisions, and may affect future events and decisions. Such complex investment decisions involve a sequence of decisions over time. It is argued that since present choices modify future alternatives, industrial activity cannot be reduced to a single decision and must be viewed as a sequence of decisions extending from the present time into the future. If this notion of industrial activity as a sequence of decisions is accepted, we must view investment expenditures not as isolated period commitments, but as links in a chain of present and future commitments.2 An analytical technique to handle the sequential decisions is to employ decision trees.3 In this section, we shall illustrate the use of decision trees in analysing and evaluating the sequential investments. Steps in Decision Tree Approach A present decision depends upon future events, and the alternatives of a whole sequence of decisions in future are affected by the present decision as well as future events. Thus, the consequence of each decision is influenced by the outcome of a chance event. At the time of taking decisions, the outcome of the chance event is not known, but a probability distribution can be assigned to it. A decision tree is a graphic display of the relationship between a present decision and future events, future decisions and their consequences. The sequence of events is mapped out over time in a format similar to the branches of a tree. While constructing and using a decision tree, some important steps should be considered: Define investment The investment proposal should be defined. Marketing, production or any other department may sponsor the proposal. It may be either to enter a new market or to produce a new product. Identify decision alternatives The decision alternatives should be clearly identified. For example, if a company is thinking of building a plant to produce a new product, it may construct a large plant, a medium-sized plant, or a small plant initially- and expand it later on or construct no plant. Each alternative will have different consequences. Draw a decision tree The decision tree should be graphed indicating the decision points, chance events and other data. The relevant data such as the projected

cash flows, probability distributions, the expected present value etc., should be located on the decision tree branches. Analyse data -The results should be analysed and the best alternative should be selected. Usefulness of Decision Tree Approach The decision tree approach is extremely useful in handling the sequential investments. Working backwardsfrom future to presentwe are able to eliminate unprofitable branches and determine optimum decision at various decision points. The merits of the decision tree approach are: Clarity It clearly brings out the implicit assumptions and calculations for all to see, question and revise. Graphic visualisation it allows a decision maker to visualise assumptions and alternatives in graphic form, which is usually much easier to understand than the more abstract, analytical form what is meant by Coefficient of Variation? Coefficient of Variation: Relative Measure of Risk A relative measure of risk is the coefficient of variation. It is defined as the standard deviation of the probability distribution divided by its expected value: Expected value Coefficient of variation CV Standard deviation /expected value The coefficient of variation is a useful measure of risk when we are comparing the projects which have (i) same standard deviations but different expected values, or (ii) different standard deviations but same expected values, or (iii) different standard deviations and different expected values CERTAINTY EQUIVALENT FACTOR: It is yet another common procedure for dealing with risk in capital budgeting. It is to reduce the forecast of cash flow to some conservative level. In the common way the certainty equivalent factor may be expressed as : NPV= t NCFt (1 + kt )t The certainty equivalent coefficient t assume a value between 0 to 1 and varies inversely with risk. A lower t will be used if greater risk is perceived and a higher t will be used if lower risk is anticipated. The decision maker subjectively or objectively establishes the coefficients. These coefficient reflect the decision makers confidence in obtaining a particular cash flow in period t.