CAPITAL BUDGETING

TECHNIQUES
UNIT 3
CONCEPT
Capital budgeting is the process of evaluating
and selecting long-term investments that are
consistent with the firms goal of maximizing
owner wealth.
STEPS INVOLVED IN CAPITAL
BUDGETING:
1. Estimation of costs and benefits of proposal
2. Estimation of required rate of return
3. Evaluation of different proposals in order to
select one
IMPORTANCE OF CAPITAL
BUDGETING
Develop and formulate long-term strategic goals the ability to set
long-term goals is essential to the growth and prosperity of any business.
The ability to appraise/value investment projects via capital budgeting
creates a framework for businesses to plan out future long-term direction.
Seek out new investment projects knowing how to evaluate investment
projects gives a business the model to seek and evaluate new projects, an
important function for all businesses as they seek to compete and profit in
their industry.
Estimate and forecast future cash flows future cash flows are what
create value for businesses overtime. Capital budgeting enables executives
to take a potential project and estimate its future cash flows, which then
helps determine if such a project should be accepted.
Facilitate the transfer of information from the time that a project
starts off as an idea to the time it is accepted or rejected, numerous
decisions have to be made at various levels of authority. The capital
budgeting process facilitates the transfer of information to the appropriate
decision makers within a company.
Monitoring and Control of Expenditures by definition a budget
carefully identifies the necessary expenditures and R&D required for an
investment project. Since a good project can turn bad if expenditures aren't
carefully controlled or monitored,
Creation of Decision when a capital budgeting process is in place, a
TRADITIONAL TECHNIQUES OF
CAPITAL BUDGETING

1. Payback period
2. Accounting rate of return
PAYBACK PERIOD
Payback period: amount of time required
for a firm to recover its initial investment
in a project, as calculated from cash
inflows.
Decision criteria:
The length of the maximum acceptable payback
period is determined by management.
If the payback period is less than the maximum
acceptable payback period, accept the project.
If the payback period is greater than the maximum
acceptable payback period, reject the project.
Figure 10.1 Bennett
Companys Projects A and B

10-6
Payback Period
(calculation)
We can calculate the payback period for Bennett Companys
projects A and B using the data in Table 10.1.
For project A, (When annual cash flows are equal)
The payback period is 3 years
initial investment annual cash inflow
$42,000/ $14,000 = 3
For project B, (When annual cash flows are not equal)
In year 1, the firm will recover $28,000 of its $45,000 initial investment.
By the end of year 2, $40,000 ($28,000 from year 1 + $12,000 from year
2) will have been recovered.
At the end of year 3, $50,000 will have been recovered.
Only 50% of the year-3 cash inflow of $10,000 is needed to complete
the payback of the initial $45,000.
The payback period for project B is therefore 2.5 years (2 years +
50% of year 3).

10-7
Advantages of Payback
Method
Easy method to compute.
Indicates liquidity. A firm which
faces liquidity problem should
use this method.
It also deals with risk. Project
with shorter payback period will
be less risky.
Disadvantages of Payback
period
It ignores cash inflows which the firm
earns after recovering the initial outlay.
It ignores timing of occurrence of cash
flows.
It ignores salvage value and the total
economic life of the investment.
It is more a method of liquidity than
profitability.
It is mostly beneficial for projects which
involves large investment outlay at the
start.
Accounting Rate of Return
Accounting rate of return (also
known as simple rate of return) is
the ratio of estimated accounting
profit of a project to the average
investment made in the project.
Formula
Accounting Rate of Return is calculated
using the following formula:

Average Accounting Profit X

100

Average Investment
Decision criteria:
Accept the project if its ARR is equal to or
greater than required accounting rate of return.
Calculation
1. Initial outlay as average
investment
Initial investment = 10,00,000
Annual profit = 1,50,000
ARR = 15%
Example
Compare the following two mutually exclusive projects
on the basis of ARR. Cash flows and salvage values are
in thousands of dollars. Use the
straight line depreciation method.
Project A:
Year 0 1 2 3
Cash Outflow -220
Cash Inflow 91 130 105
Salvage Value 10
Project B:
Year 0 1 2 3
Cash Outflow -198
Cash Inflow 87 110 84
Salvage Value 18
 Answer
Project A:
Step 1: Annual Depreciation = ( 220 10 ) / 3=70
Step 2: Year 1 2 3
Cash Inflow 91 130 105
Salvage Value 10
Depreciation* -70 -70 -70
Accounting Income 21 60 45
Step 3: Average Accounting Income = ( 21 + 60 + 45 ) / 3=42
Step 4: Accounting Rate of Return = 42 / 220 = 19.1%
Project B:
Step 1: Annual Depreciation = ( 198 18 ) / 3 = 60
Step 2: Year 1 2 3
Cash Inflow 87 110 84
Salvage Value 18
Depreciation* -60 -60 -60
Accounting Income 27 50 42
Step 3: Average Accounting Income = ( 27 + 50 + 42 ) / 3 = 39.666
Step 4: Accounting Rate of Return =39.666 / 198 20.0%
Since the ARR of the project B is higher, it is more favorable than the
Advantages & Disadvantages of
ARR
Advantages
Likepayback period, this method of investment appraisal is easy
to calculate.
It recognizes the profitability factor of investment.
Disadvantages
It ignorestime value of money. Suppose, if we use ARR to
compare two projects having equal initial investments. The
project which has higher annual income in the latter years of its
useful life may rank higher than the one having higher annual
income in the beginning years, even if the present value of the
income generated by the latter project is higher.
It can be calculated in different ways. Thus there is problem of
consistency.
It uses accounting income rather than cash flow information.
Thus it is not suitable for projects which having high
maintenance costs because their viability also depends upon
timely cash inflows.
Discounted cash flow
techniques
Discounted payback period
Net present value (NPV)
Profitability index
Internal rate of return (IRR)
Discounted payback
period
Discounted payback period is the
amount of time to cover the cost, by
adding positive discounted cash flow
coming from the profits of the
project.
Compared to payback period, the
discounted payback period takes the time
value of money into consideration. It is the
amount of time that it takes to cover the
cost of a project, by adding positive
discounted cash flow coming from the
profits of the project.
10-17
EXAMPLE
Year 0: -2000, year 1: 1000, year
2: 1000, year 3: 2000.
Assume the discount rate is 10%,

10-18
EXAMPLE (cont.)
we would apply the following formula to each cash
flow. Discounted Cash Flow at 10%: Year 0: -2000,
year 1: 909, year 2: 827, year 3: 1503.
The next step is to compute the cumulative
discounted cash flow, by summing the discounted
cash flow for each year. Accumulated discounted cash
flows: Year 0: -2000, year 1: -1091, year 2: -264, year
3: 1239.
We see that between years 2 and 3 we will recover
our initial investment. To calculate specifically when
we could see how long it took to recover the 264
remaining by end of year 2 as followed: 264/1503 =
0.1756 years. Thus, it will take a total of 2.1756 years
to recover the initial investment.

10-19
Disadvantages of discounted
payback
The time value of money is not considered when you
calculate payback period. In other words, no matter in
which year you receive a cash flow, it is given the same
weight as the first year. This flaw overstates the time to
recover theinitial investment.
The lack of consideration ofcash flowsbeyond the payback
period. If thecapital projectlasts longer than the payback
period, then any cash flows the project generates after the
initial investment is recovered are not considered at all in
the payback period calculation.
Calculating the discounted payback period does not really
give the financial manager orbusiness ownerthe
information needed to make the best investment decision.
In addition to the first two flaws, the business owner also
has toguess at the interest rate orcost of capital.
Consequently,it is not the best method to use when
choosing aninvestment project. That said, this third flaw of
the discounted payback period can be dismissed if the
weighted average cost of capitalis used as the rate at
Advantages of discounted
payback
Takes into account the time value
of money.
Easy method to compute.
Indicates liquidity. A firm which
faces liquidity problem should
use this method.
It also deals with risk. Project
with shorter payback period will
be less risky.
Net Present Value (NPV)
Net present value (NPV) is a sophisticated capital
budgeting technique; found by subtracting a projects initial
investment from the present value of its cash inflows
discounted at a rate equal to the firms cost of capital.
NPV = Present value of cash inflows Initial investment
NPV
Decision criteria:
If the NPV is greater than $0, accept the project.
If the NPV is less than $0, reject the project.

If the NPV is greater than $0, the firm will earn a

return greater than its cost of capital. Such action
should increase the market value of the firm, and
therefore the wealth of its owners by an amount
equal to the NPV.
Calculation of NPVs for Bennett Companys
Capital Expenditure Alternatives

10-24
 Calculation

10-25
Advantages of NPV
1. NPVgives important to the time value of
money.

2.In thecalculationofNPV, both aftercash

flowand beforecash flowover the life span
of the project are considered.

3. Profitability and risk of the projects are

givenhigh priority.

4.NPVhelps in maximizing thefirm'svalue.

Disadvantages of NPV
1.NPVis difficult to use.

2.NPVcan not give accurate decision if

the amount ofinvestmentof mutually
exclusive projects are not equal.

3. It is difficult to calculate the appropriate

discount rate.

4.NPVmay not give correct decision when

the projects are of unequal life.
Internal Rate of Return
(IRR)
The Internal Rate of Return (IRR) is a sophisticated
capital budgeting technique; the discount rate that equates
the NPV of an investment opportunity with $0 (because the
present value of cash inflows equals the initial investment);
it is the rate of return that the firm will earn if it invests in
the project and receives the given cash inflows.

10-28
 Steps in calculation of IRR
Find the rate at which NPV is greater than 0.
This will be the lower rate (iL). And this NPV
will be npvL
Find the rate at which NPV is less than 0. This
will be the upper rate iU. And this NPV will be
npvU
We need to find the rate at which NPV = 0 by
using process of linear interpolation where,
IRR = iL + [(iU-iL)(npvL)] / [npvL-npvU]

10-29
Internal Rate of Return
(IRR)
Decision criteria:
If the IRR is greater than the cost of capital, accept
the project.
If the IRR is less than the cost of capital, reject the
project.

These criteria guarantee that the firm will earn at

least its required return. Such an outcome should
increase the market value of the firm and,
therefore, the wealth of its owners.

10-30
Here is an example say we were
investing $100,000 and
expecting four cash inflows at the
end of each of the next four years
in amount of $30,000 each

10-31
 Net Cash Flows
CF0 = -100000
CF1 = 30000
CF2 = 30000
CF3 = 30000
CF4 = 30000
Discounted Net Cash Flows at 5%
DCF1 = 30000/(1+5%)1 = 30000/1.05 = 28571.43
DCF2 = 30000/(1+5%)2 = 30000/1.1025 = 27210.88
DCF3 = 30000/(1+5%)3 = 30000/1.15763 = 25915.13
DCF4 = 30000/(1+5%)4 = 30000/1.21551 = 24681.07
NPV Calculation at 5%
NPV = 28571.43 + 27210.88 + 25915.13 + 24681.07 -100000

NPV = 106378.51 -100000

NPV at 5% = 6378.51

10-32
 Discounted Net Cash Flows at 10%
DCF1 = 30000/(1+10%)1 = 30000/1.1 = 27272.73
DCF2 = 30000/(1+10%)2 = 30000/1.21 = 24793.39
DCF3 = 30000/(1+10%)3 = 30000/1.331 = 22539.44
DCF4 = 30000/(1+10%)4 = 30000/1.4641 = 20490.4
NPV Calculation at 10%
NPV = 27272.73 + 24793.39 + 22539.44 + 20490.4
-100000
NPV = 95095.96 -100000
NPV at 10% = -4904.04

10-33
 IRR with Linear Interpolation
iL = 5%
iU = 10%
npvL = 6378.51
npvU = -4904.04
irr = iL + [(iU-iL)(npvL)] / [npvL-npvU]
irr = 0.05 + [(0.1-0.05)(6378.51)] / [6378.51--
4904.04]
irr = 0.05 + [(0.05)(6378.51)] / [11282.55]
irr = 0.05 + 318.9255 / 11282.55
irr = 0.05 + 0.0283
irr = 0.0783
irr = 7.83%

10-34
Advantages of IRR
1) This technique gives equal importance to all thecash
flows. We just need to identify the point at which the
present value of cash inflow is equal to present value of
cash outflow.

2) It is a good method of capital budgeting. The IRR

method is considered more popular and straightforward
than the NPV approach.

3) IRR can be used to rank different prospective projects

and the project with the highest IRR would be considered
the best.

4) This method considers the time value of money and is

therefore more realistic.
Disadvantages of IRR
1) This technique can be difficult to
understand.

2) IRR does not take into account of thecost of

capital, thus it should not be used to compare
projects of different duration.

3) The IRR could be difficult to find if we want

to calculate it by using trial and improvement.

4) It fails to recognize the varying size of

different investment project.
 Profitability Index

For a project that has an initial cash outflow

followed by cash inflows, the profitability index
(PI) is simply equal to the present value of cash
inflows divided by the initial cash outflow:

When companies evaluate investment opportunities

using the PI, the decision rule they follow is to
invest in the project when the index is greater than
1.0.
10-37
 Calculation

10-38
Profitability Index (cont.)
We can refer back to Figure 10.2,
which shows the present value of
cash inflows for projects A and B, to
calculate the PI for each of Bennetts
investment options:
PIA = $53,071 $42,000 = 1.26
PIB = $55,924 $45,000 = 1.24
10-39
 Capital Rationing
Capital Rationing occurs when a
constraint (or budget ceiling) is
placed on the total size of capital
expenditures during a particular
period.
Example: Julie Miller must determine
what investment opportunities to
undertake for Basket Wonders (BW). She
is limited to a maximum expenditure of
$32,500 only for this capital budgeting
period.
 Available Projects for
BW
Project Outflow IRR NPV
PI
A $ 500 18% $ 50
1.10 B 5,000 25 6,500 2.30 C
5,000 37 5,500 2.10 D 7,500
20 5,000 1.67 E 12,500 26
500 1.04 F 15,000 28 21,000
2.40 G 17,500 19 7,500 1.43 H
25,000 15 6,000 1.24
 Choosing by IRRs for
BW
Project Outflow IRR NPV
PI
C $ 5,000 37% $ 5,500
2.10 F 15,000 28 21,000
2.40 E 12,500 26 500 1.04 B
5,000 25 6,500 2.30
Projects C, F, and E have the
three largest IRRs.
The resulting increase in shareholder
wealth is $27,000 with a $32,500 outlay.
 Choosing by NPVs for
BW
Project ICO IRR NPV
PI
F $15,000 28% $21,000
2.40 G 17,500 19 7,500 1.43 B
5,000 25 6,500 2.30
Projects F and G have the two
largest NPVs.
The resulting increase in shareholder
wealth is $28,500 with a $32,500 outlay.
 Choosing by PIs for BW
Project ICO IRR NPV PI
F $15,000 28% $21,000 2.40 B
5,000 25 6,500 2.30 C 5,000
37 5,500 2.10 D 7,500
20 5,000 1.67 G 17,500 19
7,500 1.43
Projects F, B, C, and D have the four largest
PIs.
The resulting increase in shareholder wealth is
$38,000 with a $32,500 outlay.
 Summary of
Comparison
Method Projects Accepted Value
Added
PI F, B, C, and D $38,000
NPV F and G $28,500
IRR C, F, and E $27,000
PI generates the greatest increase in
shareholder wealth when a limited capital
budget exists for a single period.
Advantages of Capital
Rationing
Capital rationing introduces a sense of strict budgeting of
corporate resources of a company.
Capital rationing prevents wastage of resources by not
investing in each and every new project available for
investment.
Capital rationing ensures that less number of projects are
selected by imposing capital restrictions. This helps in
keeping the number of active projects to a minimum and
thus manage them well.
Through capital rationing, companies invest only in projects
where the expected return is high, thus eliminating projects
with lower returns on capital.
As the company is not investing in every project, the
finances are not over-extended. This helps in having
adequate finances for tough times and ensures more
stability and increase in the stock price of the company.
Disadvantages of Capital
Rationing
Allthe projects that add to companys value and
increase shareholders wealth should be invested in.
However, by following capital rationing and investing in
only certain projects, this wont happen.
Capital rationing does not allow for maximizing value
creation as all profitable projects are not accepted and
thus, the NPV is not maximized.
Capital rationing may lead to the selection of small
projects rather than larger scale investments.
Capital rationing does not add intermediate cash flows
from a project while evaluating the projects. It bases its
decision only the final returns from the project.
Intermediate cash flows should be considered in keeping
the time value of money in mind.
Concept of Risk
Risk may be defined as the variation
of actual cash flows from the
expected cash flows.
The term risk in capital budgeting
decisions may be defined as the
variability that is likely to occur in
future between the estimated and
the actual returns. Risk exists on
account of the inability of the firm to
make perfect forecasts of cash flows.
TYPES OF RISK
General factors
Industry factors
Company factors
Incorporating the Risk
Factor
It is important to incorporate the
risk factor because an investor
should get return commensurate
with his risk profile.
If risk-free rate is used in every
case then, even risky projects
might be selected when they
should actually be rejected.
General Techniques
1. Risk Adjusted Discount Rate
2. Certainty Equivalent Coefficient
 Risk Adjusted Discount
Rate
The basis of this approach is that there should be adequate
reward in the form of return to firms which decide to execute
risky business projects. Man by nature is risk-averse and tries
to avoid risk. To motivate firms to take up risky projects
returns expected from the project shall have to be adequate,
keeping in view the expectations of the investors.
Therefore risk premium need to be incorporated in discount
rate in the evaluation of risky project proposals.
Therefore the discount rate for appraisal of projects has two
components - Risk-free rate & Risk premium
Risk Adjusted Discount rate = Risk free rate + Risk premium
Risk free rate is computed based on the return on
government securities.
Risk premium is the additional return that investors require
as compensation for assuming the additional risk associated
with the project to be taken up for execution.
The more uncertain the returns of the project the higher the
risk. Higher the risk greater the premium. Therefore, risk
Example
An investment will have an initial outlay of Rs
100,000. It is expected to generate cash inflows
as under:
Year Cash in flows
1 40,000
2 50,000
3 15,000
4 30,000
Risk free rate of interest is 10%. Risk premium is
10%.
(a) compute the NPV using risk free rate
(b) Compute NPV using risk adjusted discount rate
Answer (a)
YEAR CASH PV FACTOR PV of CASH
INFLOWS @ 10% FLOWS
1 40000 0.909 36360
2 50000 0.826 41300
3 15000 0.751 11265
4 30000 0.683 20490

Total PV of 109415
cash inflows
PV of cash 100000
outflows
NPV 9415
Answer (b)
YEAR CASH PV FACTOR PV of CASH
INFLOWS @ 20% FLOWS
1 40000 0.833 33320
2 50000 0.694 34700
3 15000 0.579 8685
4 30000 0.482 14460

Total PV of 91165
cash inflows
PV of cash 100000
outflows
NPV (8835)
Implication
The project would be acceptable
when no allowance is made for risk.
But it will not be acceptable if risk
premium is added to the risk free
rate. It moves from positive NPV to
negative NPV.
If the firm were to use the internal
rate of return, then the project would
be accepted when IRR is greater than
the risk adjusted discount rate.
Advantages of RADR

1. It is simple and easy to

understand.
2. Risk premium takes care of the
risk element in future cash flows.
3. It satisfies the businessmen
who are risk averse.
Limitations of RADR
There are no objective bases of arriving at
the risk premium. In this process the
premium rates computed become arbitrary.
The assumption that investors are risk
averse may not be true in respect of
certain investors who are willing to take
risks. To such investors, as the level of risk
increases, the discount rate would be
reduced.
Cash flows are not adapted to incorporate
the risk adjustment for net cash inflows
Certainty Equivalent
Coefficient
Under this method the, expected future cash flows
are converted into cash flows with certainty. Here we
multiply uncertain future cash flows by the certainty
equivalent coefficient to convert uncertain cash flows
into certain cash flows. The certainty equivalent
coefficient is also known as the risk adjustment
factor.
Risk adjustment factor is normally denoted by t
(Alpha).
It is the ratio of certain net cash flow to risky net cash
flow= Certainty Equivalent = Certain
Cash flow
Risky Cash
flow
The discount factor to be used is the risk free rate of
interest. Certainty equivalent coefficient is between 0
Example
A project costs Rs 50,000. It is
expected to generate cash
inflows asCASH
YEAR
under: CE
INFLOWS
1 32000 0.9
2 27000 0.6
3 20000 0.5
4 10000 0.3

Risk-free
discount rate is 10%.
Compute NPV
 Answer
YEAR Uncer C Certai PV PV of
tain E n Facto Certai
Cash Cash r at n
Inflow Inflo 10% Cash
s ws Inflo
ws
1 32000 0. 28800 0.909 26179
9
2 27000 0. 16200 0.826 13381
6
3 20000 0. 10000 0.751 7510
Total PV of certain 5
cash 49119
inflows
4 10000 0. 3000 0.683 2049
Initial cash outlay 3 50000
NPV (881)
Answer (cont.)
The project has a negative NPV.
Therefore, it is rejected.
If IRR is used the rate of discount
at which NPV is equal to zero is
computed and then compared with
the minimum (required) risk free
rate. If IRR is greater than specified
minimum risk free rate, the project
is accepted, other wise rejected.
Evaluation
It recognizes risk. Recognition of risk by risk
adjustment factor facilitates the conversion of
risky cash flows into certain cash flows. But
there are chances of being inconsistent in the
procedure employed from one project to
another.
Because of high conservation in this process
only good projects are likely to be cleared when
this method is employed.
Certainty equivalent approach is considered to
be theoretically superior to the risk adjusted
discount rate.
Advantages of Certainty
Equivalent Coefficient
This method is simple.
It easily accommodates differential risk
among cash flows.
Disadvantages of Certainty
Equivalent Coefficient
No practical way of calculating CE. It
varies significantly for person to person
CE should reflect risk of shareholders
rather than management which it
doesnt.
Quantitative Techniques
1. Sensitivity analysis
2. Probability assignment
3. Standard deviation
4. Coefficient of Variation
5. Decision tree
Sensitivity analysis
Analyzing the change in the projects
NPV or IRR on account of a given
change in one of the variables is called
Sensitivity Analysis.
It is a technique that shows the change
in NPV given a change in one of the
variables that determine cash flows of a
project.
It measures the sensitivity of NPV of a
project in respect to a change in one of
the input variables of NPV.
Sensitivity analysis (cont.)
The reliability of the NPV depends on the reliability of
cash flows. If forecasts go wrong on account of
changes in assumed economic environments,
reliability of NPV & IRR is lost.
Therefore, forecasts are made under different
economic conditions - pessimistic, expected and
optimistic. NPV is arrived at for all the three situations.
Following steps are involved in Sensitivity analysis:
1. Identification of variables that influence the NPV &
IRR of the project.
2. Examining and defining the mathematical
relationship between the variables.
3. Analysis of the effect of the change in each of the
variables on the NPV of the project.
Example
Acompany has two mutually
exclusive projects under
consideration - project A &
project B. Each project requires
an initial cash outlay of Rs
3,00,000 and has an effective life
of 10 years. The companys cost
of capital is 12%.
Example (cont.)
What is the NPV of the project?
Which project should the
management consider?
Given PVIFA = 5.650
The following forecast of cash
flows are made by the
management.
CONDITION PROJECT A PROJECT B
CASH INFLOWS CASH INFLOWS
PESSIMISTIC 65000 25000
NORMAL 75000 75000
OPTIMISTIC 90000 100000
Answer
CONDITIO PROJECT- PVIFA @ PV OF NPV
N A 12% CASH
INFLOWS
Pessimistic 65000 5.650 3,67,250 67,250
Expected 75000 5.650 4,23,750 1,23,750
Optimistic 90000 5.650 5,08,500 2,08,500

CONDITIO PROJECT- PVIFA @ PV OF NPV

N B 12% CASH
INFLOWS
Pessimistic 25000 5.650 1,41,250 (1,58,750)
Expected 75000 5.650 4,23,750 1,23,750
Optimistic 100000 5.650 5,65,500 2,65,000
Decision
1. Under pessimistic conditions project A gives a
positive NPV of Rs 67,250 and Project B has a
negative NPV of Rs1,58,750. Project A is accepted.
2. Under expected conditions, both gave some positive
NPV of Rs 1,23,000. Any one of two may be accepted.
3. Under optimistic conditions Project B has a higher
NPV of Rs 2,65,000 compared to that of As NPV of Rs
2,08,500.
4. Difference between optimistic and pessimistic NPV
for Project A is Rs 1,41,250 and for Project B the
difference is Rs 4,23,750.
5. Project B is risky compared to Project A because the
NPV range is of large differences.
Probability Distribution
Approach

When we incorporate the chances of

occurrences of various economic
environments computed NPV becomes
more reliable. The chances of occurrences
are expressed in the form of probability.
Probability is the likelihood of occurrence
of a particular economic environment.
After assigning probabilities to future
cash flows, expected net present value is
computed.
 illustration
A company has identified a
project with an initial cash outlay
of Rs 50,000. The following
distribution of cash flow is given
below for the life of the project of
3 years. Discount rate is 10%.

Cash Probabili Cash Probabili Cash Probabili

inflow YEAR-1
ty YEAR-2
inflow ty YEAR-3
inflow ty
15000 0.2 20000 0.3 25000 0.4
18000 0.1 15000 0.2 20000 0.3
35000 0.4 15000 0.2 20000 0.3
Solution
Year 1
= 15,000 x 0.2 + 18,000 x 0.1 + 35,000 x 0.4 +
32,000 x 0.300
=3,000 + 1,800 + 14,000 + 9,600 = 28,400
Year 2
=20,000 x 0.3 + 15,000 x 0.2 + 30,000 x 0.3 +
30,000 x 0.2
= 6,000 + 3,000 + 9,000 + 6,000 = 24,000
Year 3
=25,000 x 0.4 + 20,000 x 0.3 + 40,000 x 0.2 +
5,000 x 0.1
=10,000 + 6,000 + 8,000 + 4,500 = 28,500
TABULAR PRESENTATION
YEAR EXPECTED PV FACTOR PV OF
CASH @ 10% EXPECTED
INFLOWS CASH
INFLOWS
1 28400 0.909 25816
2 24000 0.826 19824
3 28500 0.751 21403
PV of 67043
expected cash
inflows
PV of initial 50000
cash outlay
Expected NPV 17043
Variance

A study of dispersion of cash flows of

projects will help the management in
assessing the risk associated with the
investment proposal.
Dispersion is computed by variance
or standard deviation. Variance
measures the deviation of each
possible cash flow from the expected.
Square root of variance is standard
deviation.
Example
Following details are available in
respect of a project which
requires an initial cost of Rs
5,00,000.
Example(cont.)
YEAR Economic Cash flows Probability
condition
1 High growth 2,00,000 0.3
Average 1,50,000 0.6
growth
No growth 40,000 0.1
2 High growth 3,00,000 0.3
Average 2,00,000 0.5
growth
No growth 5,00,000 0.2
Solution
YEAR-1
Economic Cash inflow Probability Expected
Condition value of
Cash inflow
High growth 200000 0.3 60000
Average 150000 0.6 90000
growth
No growth 40000 0.1 4000
Expected 154000
Value
YEAR-2
Economic Cash inflow Probability Expected
Condition value of
Cash inflow
High growth 300000 0.3 90000
Average 200000 0.5 100000
Solution(cont.)
Expected NPV =
1,54,000 + 2,00,000
1.10 (1.10)^2
= 1,40,000 + 1, 65, 289 5,00,000
= (1,94,711) => negative NPV
Solution(cont.)
Standard Deviation for year-1
Cash inflow Expected (C-E)^2 (C-E)^2 X
(C) value (E) Prob.
2,00,000 1,54,000 (46,000)^2 (46,000)^2 x
0.3 =
634800000
1,50,000 1,54,000 (-4,000)^2 (4,000)^2 x
0.6
= 9600 000
40,000 1,54,000 (-1,14,000)^2 (1,14,000)^2
x 0.1
= 12996 00
Standard deviation of Cash flows for I000
year =
44091 Total 1944 000 000
Solution(cont.)
Standard Deviation for year-2
Cash inflow Expected (C-E)^2 (C-E)^2 X
(C) value (E) Prob.
3,00,000 2,00,000 (1,00,000)^2 (1,00,000)^2
x 0.3
= 3000 000
000
2,00,000 2,00,000 (0)^2 (0)^2 x 0.5 =
0
50,000 2,00,000 (-1,50,000)^2 (1,50,000)^2
x 0.2
= 45 00 000
000
Total 7500 00 0000
Standard 8660
Deviation of
Solution(cont.)
Standard Deviation of NPV
44091 + 8660
1.10 (1.10)^2
= 40083 + 7157
= 47240
Coefficient of variation

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.
The coefficient of variation is a useful
measure of risk when we are comparing
the projects which nave 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
Coefficient of variation
Example
Like in the previous example,
CV for YEAR-1 will be
= 44091 = 0.28
154000
CV for YEAR-2 will be
= 8660 = 0.043
200000
Decision tree
approach
Many project decisions are complex investment
decisions. Such complex investment decisions
involve a sequence of decisions over time.
Decisions tree can handle the sequential decisions
of complex investment proposals. The decision of
taking up an investment project is broken into
different stages. At each stage the proposal is
examined to decide whether to go ahead or not.
The multi stages approach can be handled
effectively with the help of decision trees.
A decision tree presents graphically the relationship
between a present decision and future events,
future decisions and the consequences of such
decisions.
Example
R & D section of a company has developed
an electric moped. The firm is ready for pilot
production and test marketing. This will cost
Rs 20 million and take six months.
Management believes that there is a 70%
chance that the pilot production and test
marketing will be successful.
If successful, the company can build a plant
costing Rs 200 million. The plant will
generate annual cash in flow of Rs 50 million
for 20 years if the demand is high or an
annual cash inflow or 20 million if the
demand is low.
High demand has a probability of 0.6 and
Diagrammatic
Representation
I step: Computation of Expected
Monetary Value at point C2.
Cash inflow Probability Expected cash
inflows
50 0.6 30
20 0.4 8
Expected Monetary 38
Value (EMV)
Present Value of EMV = Expected value of cash inflow x PVIFA
(12%, 20 years)
=38 x 7.469
= Rs 283.82 million
Step 2: Computation of EMV at decision point

Decision taken Consequences The resulting

EMV at this level
D21 Invest Rs 200 283.82 200 83.82
million million
D22 Stop 0

Here the decision criterion is select

the EMV with the highest value.
Stage 3
Therefore EMV with Rs 83.82
million will be considered
therefore we select the decision
taken at D2
Stage 4:
Computation of EMV at the point C

Decision Consequence The resulting

taken s Em at this
level

D11 carry out Invest 58.67 20 = Rs

pilot 20 million 38.67 Million
production and
market test

D12 (do 0 0
nothing)
EMV at this 38.67
stage
Result
1. Carry out pilot production and
market test.
2. If the result of pilot production
and market test is successful, go
ahead with the investment
decision of Rs 200 million in
establishing a plant.
3. If the result of pilot production
and market test is future, stop.
Evaluation of Decision tree
approach (Advantages)
1. It portrays inter related, sequential and critical multi
dimensional elements of major project decisions.
2. Adequate attention is given to the critical aspects in an
investment decision which spread over a time sequence.
3. Complex projects involve huge out lay and hence risky.
There is the need to define and evaluate scientifically the
complex managerial problems arising out of the sequence
of interrelated decisions with consequential outcomes of
high risk. It is effectively answered by decision tree
approach.
4. Structuring a complex project decision with many
sequential investment decisions demands effective project
risk management. This is possible only with the help of an
analytical tool like decision tree approach.
5. Able to eliminate unprofitable outcomes and helps in
arriving at optimum decision stages in time sequence.
Disadvantages
The reliability of the information in the
decision tree depends on feeding the precise
internal and external information at the onset.
Even a small change in input data can at times,
cause large changes in the tree.
Decision trees are easy to use compared to other
decision-making models, but preparing decision
trees, especially large ones with many branches,
are complex and time-consuming affairs.
The complexity in creating large decision trees
mandates people involved in preparing decision
trees having advanced knowledge in quantitative
and statistical analysis.