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Capital Budgeting-Final

The document discusses capital budgeting, a process for evaluating long-term investments based on cash flows rather than profits. It covers various methods for incorporating risk, such as probability, standard deviation, sensitivity analysis, and decision trees, to aid in investment decision-making. Additionally, it highlights the importance of understanding uncertainty and the statistical techniques used to assess the viability of investment proposals.

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Ruhaan Narang
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11 views32 pages

Capital Budgeting-Final

The document discusses capital budgeting, a process for evaluating long-term investments based on cash flows rather than profits. It covers various methods for incorporating risk, such as probability, standard deviation, sensitivity analysis, and decision trees, to aid in investment decision-making. Additionally, it highlights the importance of understanding uncertainty and the statistical techniques used to assess the viability of investment proposals.

Uploaded by

Ruhaan Narang
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Capital Budgeting

Prof. Bagesree Behani


Topics to be covered
➢Concept & Meaning ➢Standard Deviation (SD)

➢Dealing with risk ➢Sensitivity analysis

➢Probability ➢Decision tree

➢Expected Net present ➢Certainty equivalent


Value (ENPV) method
Capital budgeting is a process that helps
companies decide whether to invest in long-
term assets, like new equipment, plants,
software upgrades, expand business in
another geographic area or replace a delivery
truck.

Capital budgeting focuses on cash flows,


rather than profits.
It helps companies determine if an investment
is worth pursuing and how to allocate their
capital resources.
Capital budgeting investments can be funded
through debt capital, equity capital, or
retained earnings.
Dealing with Risk in Investment Decisions
In the previous level, we assumed that the investment proposals do not involve any risk
& cashflows of the project are known with certainty. However, this assumption is not
correct in practice.

Investment projects are exposed to various degrees of risk. There can be three types of
decision making:

(i) Decision making under certainty : When cash flows are certain.

(ii) Decision making involving risk : When cash flows involves risk & probability can
be assigned

(iii)Decision making under uncertainty: When the cash flows are uncertain and
probability cannot be assigned.
Capital Budgeting (CB) Facts:
1) CB decisions are based on estimates of
future cash flows

2) Future CF are uncertain

3) Future CFs are uncertain, therefore risk


arising b’coz of uncertainty are completely
unavoidable

4) How to cope with risk/uncertainty


involved
Methods of incorporating risk in Capital Budgeting
Statistical Techniques----- Probability
Probability is a measure about the chances that an event will occur. When
an event is certain to occur, probability will be 1 and when there is no
chance of happening an event, probability will be 0.

Assumptions Cash Flows (INR) Probability


Best Guess 3,00,000 0.3
High Guess 2,00,000 0.6
Low Guess 1,20,000 0.1

In the above example chances that cash flow will be INR 3,00,000, INR
2,00,000 and INR 1,00,000 are 30%, 60% and 10% respectively.
Capital Budgeting

Prof. Bagesree Behani


Probability problem (1):
ABC & co. is evaluating a proposal having initial outlay of INR 1,40,000 and
economic life of 2 years. The cash inflow and the respective probabilities have
been found to be as follow:
Year 1 Year 2
Cash Flows (INR) Probability Cash Flows (INR) Probability
1,00,000 0.3 1,40,000 0.5
80,000 0.5 70,000 0.3
10,000 0.2 60,000 0.2

Evaluate the proposal on the basis of expected NPV, given that the firm has
required rate of 10%.
ENPV problem (2):
The following information is available regarding the expected cash flows
generated & their probability for Company X.
What is the expected return on the project ? Assuming 10% as discount rate, &
10,000 as initial outlay find out the PV of the expected monetary returns:

Year 1 Year 2 Year 3

CF Probability CF Probability CF Probability

3000 0.25 3000 0.50 3000 0.25

6000 0.50 6000 0.25 6000 0.25

8000 0.25 8000 0.25 8000 0.50


Standard Deviation (SD)
Standard deviation (SD) is a degree of variation of individual items of
a set of data from its average. The square root of variance is SD.
For Capital Budgeting decision, SD is used to calculate the risk
associated with the estimated cash flows from the project.
Variance is the measurement of difference between the avg. of the
data set from every number of the data set.
σ=

Standard deviation (σ)


Importance of Variance & SD in Capital budgeting
Importance of Variance & SD in Capital budgeting
• SD & Variance is the deviation from the mean.

• SD is calculated as square root of variance, hence variance is prerequisite


for calculation of SD.

• Both concepts are an absolute measure of volatility in estimated CFs

• An investment proposal in which expected flows are close to the


estimated net cash flow are seen as less risky and has the potential to
make profit. i.e if 2 projects have the same expected value (mean), the one
with higher sigma will have higher uncertainty or risk
SD & Variance Problem (1):
Calculate variance & SD of Project A & Project B on the basis of following
information:
SD problem (2):
X & Y are two mutually exclusive projects. Basis SD of projects X&Y ,
select the project with lower risk :

Project X Project Y

CF Probability CF Probability

5636 0.25 -40000 0.25

20848 0.50 20848 0.50

36060 0.25 81696 0.25


Certainty Equivalent Approach (CEA):
Certainty Equivalent Approach (CEA):
Steps involved in CEA:
❖ Find Comparable Riskless Flow
❖ Present value calculations using risk free return
❖ Accept- Reject rule
CEA Problem (1):
CEA Problem (2):
A company employs certainty equivalent approach in the evaluation of risky
investments. Refer to the following information:
Expected CFAT Certainty Equivalent
Year (INR in thousand) Quotient
0 -200 1
1 160 0.8
2 140 0.7
3 130 0.6
4 120 0.4
5 80 0.3
The firm's cost of equity capital is 18%,cost of debt is 9% & riskless rate of intt on
Govt securities is 6%. Should the project be accepted ?
Sensitivity analysis is a modelling technique which is used in
Capital Budgeting decisions, to study the impact of changes in
the variables on the outcome of the project.

In sensitivity analysis, the project outcome is studied after


taking into account change in only one variable.

It provides information as to how sensitive the estimated


project parameters, namely, the expected cash flow, the
discount rate and the project life are to estimation errors. The
analysis on these lines is important as the future is always
uncertain and there will always be estimation errors.
Sensitivity analysis takes care of estimation errors by using a
number of possible outcomes in evaluating a project.
Steps involved in Sensitivity Analysis :

Sensitivity analysis is a way of finding impact on the project’s NPV(or IRR)


for a given change in one variable.

Net present value (NPV) is the difference between the present value of
cash inflows and the present value of cash outflows over a period of time.

Internal rate of return (IRR) is a calculation used to estimate the


profitability of potential investments.
Sensitivity Analysis Problem (1):
Sensitivity Analysis problem (2):
The following information applies to a new project:

Initial Investment – INR 1,25,000


Selling Price per unit--- INR 100
Variable cost per unit--- INR 30
Fixed Cost for the period--- INR 1,00,000
Sales Volume--- 2000 units
Life --- 5 years
Discount Rate--- 10%
Annuity factor for 10 % for 5 years is 3.791

Required project’s NPV and show how sensitive the results are to various
input factors.
Decision Tree Analysis
Decision Tree (DT) is a graphic display of the relationship between a
present decision and future events, future decisions, and their
consequences.
Practically, investment decisions may have implications for future
decisions and events. Such situation can be handled by taking a sequence
of decisions over a period. The technique to handle this type of sequential
decisions is done through “Decision Tree” technique. Approach is
especially useful when decisions at one point affect decisions at some later
date.
Assumptions:
1) The Manager has control or power to determine what happens next.
This is known as “Decision”, as he can do what he desires to do.
2) The finance manager has no control on what happens next. This is
known as “Event”.
Steps involvement in Decision Tree analysis:

✓Define Investment

✓Identification of Decision Alternatives

✓Drawing a Decision Tree

✓Evaluating the Alternatives


Decision Tree Problem (1):
Decision Tree Problem (2):
A firm has an investment proposal, requiring an outlay of INR
2,00,000 at present (t=0). The investment proposal is expected to
have 2 year’s economic life with no salvage value. In year 1, there
is 0.3 probability that CFAT will be INR 80,000; a 0.4 probability
that CFAT will be INR 1,10,000 and a 0.3 probability that CFAT
will be INR 1,50,000.
In year 2, the CFAT possibilities depend on the CFAT that occurs
in year 1 i.e the, the CFAT for the year 2 are conditional on CFAT
for the year 1. Accordingly, the probabilities assigned with the
CFAT for the year 2 are conditional probabilities. The estimated
conditional CFAT and their associated conditional probabilities
are as follow: P.T.O
Decision Tree Problem :
Details as follows:
IF CFAT1= INR 80,000 IF CFAT1= INR 1,10,000 IF CFAT1= INR 1,50,000

CFAT 2 Probability CFAT 2 Probability CFAT 2 Probability

40,000 0.2 1.30,000 0.3 1,60,000 0.1

1,00,000 0.6 1,50,000 0.4 2,00,000 0.8

1,50,000 0.2 1,60,000 0.3 2,40,000 0.1

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