CA Inter FM-ECO CA Mayank Kothari

Chapter 8
Risk Analysis in Capital Budgeting

Q1. What are the different techniques of risk analysis in capital budgeting?
Answer:
The different techniques of risk analysis in capital budgeting has been mentioned
below:

Techniques of Risk Anaysis in Capital Budgeting

Statistical Techniques Conventional

Other Techniques
1. Probability Techniques
1. Sensitivity-Analysis
2. Variance of 1. Risk-adjusted
2. Scenario Analysis
standard deviation discount rate
3. SImulation
3. Coefficient of 2. Certainty
4. Decision tree
variation equivalents

Q2. What are the different types of decision making that we can take
considering the fact that investment projects are exposed to various
degrees of risk?
Answer:
Considering the fact that investment projects are exposed to various degrees of
risk, there can be three types of decision making, as mentioned below:
1. Decision making under certainty : When cash flows are certain
2. Decision making involving risk: When cash flows involve risk and
probability can be assigned.
3. Decision making under uncertainty: When the cash flows are uncertain
and probability cannot be assigned.
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Q3. Briefly explain the terms “Risk” and “Uncertainty”. Also comment on their
relationship. Can they be used interchangeably?
Answer:
The terms “Risk” and “Uncertainty” has been explained as below:
 Risk is the variability in terms of actual returns comparing with the
estimated returns.
 Most common techniques of risk measurement are Standard Deviation
and Coefficient of variations.
 There is a very thin difference between risk and uncertainty.
 In case of risk, probability distribution of cash flow is known.
 However, when no information is known to formulate probability
distribution of cash flows, the situation is referred as uncertainty.
 However these two terms are often used interchangeably.

Q4. Mention and briefly explain the different sources of risk.

Answer:
Risk can arise from different sources, depending on the type of investment, the
circumstances and the industry in which the organization is operating.
Some of the sources of risk are as follows:
1. Project-specific risk:
 These risks are related to a particular project and they affect the
project’s cash flows; it includes completion of the project in
scheduled time, error of estimation in resources and allocation,
estimation of cash flows etc.
 For example, a nuclear power project of a power generation
company has different risks than hydel projects.
2. Company specific risk:
 Risk which arise due to company specific factors like downgrading
of credit rating, changes in key managerial persons, cases for
violation of Intellectual Property Rights (IPR) and other laws and
regulations, dispute with workers etc.
 All these factors affect the cash flows of an entity and access to
funds for capital investments.
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 For example, two banks have different exposure to default risk.

3. Industry-specific risk:
 These are the risks which affects the whole industry in which the
company operates.
 The risks include regulatory restrictions on industry, changes in
technologies etc.
 For example, regulatory restriction imposed on leather and
breweries industries.
4. Market risk:
 The risk which arise due to market related conditions like entry of
substitute, changes in demand conditions, availability and access to
resources etc.
 For example, a thermal power project gets affected if the coal
mines are unable to supply coal requirements of a thermal power
company etc.
5. Competition risk:
 These are risks related with competition in the market in which a
company operates.
 These risks are risk of entry of rival, product dynamism and change
in taste and preference of consumers etc.
6. Risk due to Economic conditions:
 These are the risks which are related with macro-economic
conditions like changes in monetary policies by central banks,
changes in fiscal policies like introduction of new taxes and cess,
inflation, changes in GDP, changes in savings and net disposable
income etc.
7. International risk:
 These are risk which is related with conditions which are caused by
global economic conditions like restriction on free trade,
restrictions on market access, recessions, bilateral agreements,
political and geographical conditions etc.
 For example, restriction on outsourcing of jobs to overseas
markets.

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Q5. What are the reasons for considering risk in capital budgeting
decisions? Answer:
The reasons for considering risk in capital budgeting decisions are mentioned as
below:
1. There is an opportunity cost involved while investing in a project for the
level of risk. Adjustment of risk is necessary to help make the decision as
to whether the returns out of the project are proportionate with the
risks borne and whether it is worth investing in the project over the
other investment options available.
2. Risk adjustment is required to know the real value of the Cash Inflows.

Q6. Briefly explain the term “probability” and “Expected Net Cash Flows” and
“Expected Net present value”.
Answer:
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.
Expected Net Cash Flows:
 Expected Cash flows are calculated as the sum of the likely Cash flows of
the Project multiplied by the probability of cash flows. Expected Cash
flows are calculated as below:
 It is given by:
n

E (R)/ENCF = ∑ Ri × Pi
i=1
Where,
E(R)/ENCF = Expected Cash Flows
Pi= Probability of Cash flows
Ri = Cash Flows
Expected Net Present Value:
 Expected net present value = Sum of present values of expected net
cash flows

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 It is given by,
n
ENCF
ENPV = ∑
(1 + k)t
t=1
 Where,
ENPV = Expected net present value,
ENCF = Expected net cash flows (including both inflows and outflows)
t = Period
k = Discount Rate

Q7. How will you classify Expected Net Present

Value? Answer:
Expected Net Present Value can be classified into
following:
a. Expected Net Present Value – Single Period
b. Expected Net Present Value – Multiple Period

Q8. Briefly explain the meaning of the term “Variance”.

Answer:
 Variance is a measurement of the degree of dispersion between
numbers in a data set from its average.
 In simple words, variance is the measurement of difference between the
average of the data set from every number of the data set.
 Variance is calculated as below :
n

σ2 = ∑(NCF j − ENCF)2 Pj
j=1
Where,
σ2= Variance in net cash flow
P = Probability
ENCF = Expected Net Cash
Flow
 Thus, variance helps an organization to understand the level of risk it
might face on investing in a project.

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Q9. Different values of variance have different meanings. Explain those

meanings.
Answer:
 A variance value of zero would indicate that the cash flows that would
be generated over the life of the project would be same.
 This might happen in a case where the company has entered into a
contract of providing services in return of a specific sum.
 A large variance indicates that there will be a large variability between
the cash flows of the different years.
 This can happen in a case where the project being undertaken is very
innovative and would require a certain time frame to market the
product and enable to develop a customer base and generate revenues.
 A small variance would indicate that the cash flows would be somewhat
stable throughout the life of the project.
 This is possible in case of products which already have an established
market.

Q10. Briefly explain the concept of standard deviation.

Answer:
 Standard Deviation is a degree of variation of individual items of a set of
data from its average.
 For Capital Budgeting decisions, Standard Deviation is used to calculate
the risk associated with the estimated cash flows from the project.
 Mathematically, the square root of variance is called Standard Deviation.

Q11. Briefly explain the concept of coefficient of variation.

Answer:
 The standard deviation helps in calculating the risk associated with the
estimated cash inflows from an Investment.
 However in Capital Budgeting decisions, the management in several
times is faced with choosing between many investments avenues.

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 Under such situations, it becomes difficult for the management to

compare the risk associated with different projects using Standard
Deviation as each project has different estimated cash flow values.
 In such cases, the Coefficient of Variation becomes useful.
 The Coefficient of Variation calculates the risk borne for every percent of
expected return.
 It is calculated as:
Standard Deviation
Co − efficient of variation =
Expected Return or Expected Cash Flow
 When a selection has to be made between two projects, the
management would select a project which has a lower Coefficient of
Variation.

Q12. Briefly explain the concept of “risk-adjusted discount rate” as a

conventional technique of risk analysis in capital budgeting.
Answer:
 The use of risk adjusted discount rate is based on the concept that
investors demands higher returns from the risky projects.
 The required rate of return on any investment should include
compensation for delaying consumption equal to risk free rate of
return, plus compensation for any kind of risk taken on.
 In case, the risk associated with any investment project is higher than
risk involved in a similar kind of project, discount rate is adjusted
upward in order to compensate this additional risk borne.

 It is given by,
n
NCFt
NPV = ∑ −
t=0
(1 + k) t
I
Where,
NCFt = Net Cash Flow
K = Risk adjusted discount rate
I = Initial Investment
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Q13. What are the different concepts of “risk-adjusted discount rate”.Briefly

explain such components.
Answer:
 A risk adjusted discount rate is a sum of risk free rate and risk
premium.
 The Risk Premium depends on the perception of risk by the investor of
a particular investment and risk aversion of the Investor.
So, Risks adjusted discount rate = Risk free rate+ Risk premium
 Risk Free Rate:
It is the rate of return on Investments that bear no risk. For e.g.,
Government securities yield a return of 6 % and bear no risk. In such
case, 6 % is the risk-free rate.
 Risk Premium:
It is the rate of return over and above the risk-free rate, expected by
the Investors as a reward for bearing extra risk. For high risk project,
the risk premium will be high and for low risk projects, the risk
premium would be lower.
Q14. Briefly explain the advantages and limitations of “risk-adjusted discount
rate” as a conventional technique of risk analysis in capital budgeting.
Answer:
Advantages of Risk-adjusted discount rate:
1. It is easy to understand.
2.It incorporates risk premium in the discounting factor.
Limitations of Risk-adjusted discount rate:
3. Difficulty in finding risk premium and risk-adjusted
discount rate.
4. Assumption that investors are risk averse is always not
true.

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Q15. Briefly explain the concept of “Certainty Equivalent (CE)” as a

conventional technique of risk analysis in capital budgeting.
Answer:
 The definition of “Certainty Equivalent (CE)” as per CIMA terminology
can be stated as below:
“An approach to dealing with risk in a capital budgeting context.”
 It involves expressing risky future cash flows in terms of the certain
cash flow which would be considered, by the decision maker, as their
equivalent.
 Thus, in this approach a set of risk less cash flow is generated in place
of the original cash flows.
 As a result of this, the decision maker would be indifferent between
the risky amount and the (lower) riskless amount, considering it to be
equivalent.”
 The certainty equivalent is a guaranteed return that the management
would accept rather than accepting a higher but uncertain return.
 This approach allows the decision maker to incorporate his or her
utility function into the analysis.

Q16. Mention briefly the steps involved in “Certainty Equivalent (CE)”.

Answer:
Step 1:
 Remove risk by substituting equivalent certain cash flows from risky
cash flows. This can be done by multiplying each risky cash flow by
the appropriate αt value (CE coefficient)
 For example,
 Suppose on tossing out a coin, if it comes head you will get `
10,000 and if it comes out to be tail, you will win nothing.
 Thus, you have 50% chances of winning and expected value is `
5,000.

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 In such case if you are indifferent at receiving ` 3,000 for a

certain amount and not playing then ` 3,000 will be certainty
equivalent and 0.3 (i.e. 3,000/10,000) will be certainty
equivalent coefficient.
Step 2:
 Discounted value of cash flow is obtained by applying risk less rate of
interest.
 Since you have already accounted for risk in the numerator using CE
coefficient, using the cost of capital to discount cash flows will
tantamount to double counting of risk.
Step 3:
 After that normal capital budgeting method is applied except in case
of IRR method, where IRR is compared with risk free rate of interest
rather than the firm’s required rate of return.
 Certainty Equivalent Coefficients transform expected values of
uncertain flows into their Certainty Equivalents.
 It is important to note that the value of Certainty Equivalent
Coefficient lies between 0 & 1. Certainty Equivalent Coefficient 1
indicates that the cash flow is certain or management is risk neutral.
 In industrial situation, cash flows are generally uncertain and
managements are usually risk averse.
 Under this method
n α NCF
NPV = ∑ (1t + kt −
f)
tI
t=0
Where,
NCFt = the forecasts of net cash flow without risk-adjustment
αt = the risk-adjustment factor or the certainty
equivalent coefficient
Kf = risk-free rate assumed to be constant for all periods

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Q17. Mention the advantages and disadvantages of Certainty Equivalent

Method.
Answer:
Advantages of Certainty Equivalent Method:
1. The certainty equivalent method is simple and easy to understand and
apply.
2. It can easily be calculated for different risk levels applicable to different
cash flows. For example, if in a particular year, a higher risk is
associated with the Cash Flow, it can be easily adjusted and the NPV
can be recalculated accordingly.
Disadvantages of Certainty Equivalent Method:
3. There is no Statistical or Mathematical model available to estimate
certainty Equivalent. Risk being subjective, it varies on the perception
of the risk by the management because of bias and individual opinions
involved.
4. There is no objective or mathematical method to estimate certainty
equivalents. Certainty Equivalent is subjective and varies as per each
individual’s estimate.
5. Certainty equivalents are decided by the management based on their
perception of risk. However the risk perception of the shareholders
who are the money lenders for the project is ignored. Hence it is not
used often in corporate decision making.

Q18. Write a short note on:

“Risk-adjusted discount rate Vs. Certainty-Equivalent”
Answer:
 Certainty Equivalent Method is superior to Risk Adjusted Discount Rate
Method as it does not assume that risk increases with time at
constant rate.
 Each year’s Certainty Equivalent Coefficient is based on level of risk
impacting its cash flow.
 Despite its soundness, it is not preferable like Risk Adjusted Discount
Rate Method.
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 It is difficult to specify a series of Certainty Equivalent Coefficients but

simple to adjust discount rates.

Q19. Briefly explain the concept of “Sensitivity Analysis” as one of the

techniques of risk analysis in capital budgeting.
Answer:
 Definition of sensitivity analysis: As per CIMA terminology,
”A modeling and risk assessment procedure in which changes are
made to significant variables in order to determine the effect of
these
changes on the planned outcome. Particular attention is thereafter
paid to variables identifies as being of special significance”.
 Sensitivity analysis, in simple terms, is a modeling technique which is
used in Capital Budgeting decisions which is used to study the impact
of changes in the variables on the outcome of the project.
 In a Project, several variables like weighted average cost of capital,
consumer demand, price of the product, cost price per unit etc.
operate simultaneously.
 The changes in these variables impact the outcome of the project.
 However, it is very difficult to assess change in which variable impacts
the project outcome in a significant way.
 In Sensitivity Analysis, the project outcome is studied after taking into
change in only one variable.
Q20.  The more sensitive is the NPV, the more critical is that variable.
Answer:Mention the steps involved in Sensitivity Analysis.
The steps involved in conducting sensitivity analysis are explained as below:
1. Finding variables, which have an influence on the NPV (or IRR) of the
project
2. Establishing mathematical relationship between the variables.
3. Analysis the effect of the change in each of the variables on the NPV
(or IRR) of the project.

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Q21. Mention the advantages and disadvantages of Sensitivity

Analysis. Answer:
Advantages of Sensitivity Analysis:
1. Critical Issues:
This analysis identifies critical factors that impinge on a project’s
success or failure.
2. Simplicity:
This analysis is quite simple.
Disadvantages of Sensitivity Analysis:
3. Assumption of Independence:
This analysis assumes that all variables are independent i.e. they are
not related to each other, which is unlikely in real life.
2. Ignore probability:
This analysis does not look to the probability of changes in the
variables.
3. Not so reliable:
This analysis provides information on the basis of which decisions can
be made but does not point directly to the correct decision.

Q22. Briefly explain the concept of “Scenario Analysis” as one of the

techniques of risk analysis in capital budgeting.
Answer:
 Although sensitivity analysis is probably the most widely used risk
analysis technique, it does have limitations.
 Therefore, we need to extend sensitivity analysis to deal with the
probability distributions of the inputs.
 In addition, it would be useful to vary more than one variable at a time
so we could see the combined effects of changes in the variables.
 Scenario analysis provides answer to these situations of extensions.
 This analysis brings in the probabilities of changes in key variables and
also allows us to change more than one variable at a time.
 This analysis begins with base case or most likely set of values for the
input variables.
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 Then, go for worst case scenario (low unit sales, low sale price, high
variable cost and so on) and best case scenario.
 So, in a nutshell Scenario analysis examines the risk of investment, so
as to analyze the impact of alternative combinations of variables, on
the project’s NPV (or IRR).

Q23. Write a short note on the following:

“Scenario Analysis vs. Sensitivity Analysis”
Answer:
 Sensitivity analysis and Scenario analysis both help to understand the
impact of the change in input variable on the outcome of the project.
 However, there are certain basic differences between the two.
 Sensitivity analysis calculates the impact of the change of a single input
variable on the outcome of the project viz., NPV or IRR.
 The sensitivity analysis thus enables to identify that single critical
variable that can impact the outcome in a huge way and the range of
outcomes of the project given the change in the input variable.
 Scenario analysis, on the other hand, is based on a scenario.
 The scenario may be recession or a boom wherein depending on the
scenario, all input variables change.
 Scenario Analysis calculates the outcome of the project considering
this scenario where the variables have changed simultaneously.
 Similarly, the outcome of the project would also be considered for the
normal and recessionary situation.
 The variability in the outcome under the three different scenarios
would help the management to assess the risk a project carries.
 Higher deviation in the outcome can be assessed as higher risk and
lower to medium deviation can be assessed accordingly.
 Scenario analysis is far more complex than sensitivity analysis because
in scenario analysis all inputs are changed simultaneously considering
the situation in hand while in sensitivity analysis only one input is
changed and others are kept constant.

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Q24. Briefly explain “Monte Carlo Simulation” as one of the techniques of risk
analysis in capital budgeting.
Answer:
 Monte Carlo simulation ties together sensitivities and probability
distributions.
 This analysis starts with carrying out a simulation exercise to model the
investment project.
 It involves identifying the key factors affecting the project and their
inter relationships.
 This analysis specifies a range for a probability distribution of potential
outcomes for each of model’s assumptions.
 Monte Carlo simulation is a computerized mathematical technique
that allows decision makers to calculate risk and uncertainty in
decision
making.
 Monte Carlo simulation generates a range of possible outcomes and
their probabilities associated with those outcomes.
 It also shows the probabilities of extreme possibilities like the
probability of best case and the worst case along with the probabilities
of a range of outcomes.
 The technique is widely used in fields as finance, project management,
Portfolio Management, Stock Return Analysis etc. Under Simulation
NPV can be calculated as NCFt
NPV = ∑ n −
t=0
(1 + k t ) t
I
Where,
𝐹=𝐶
𝑁
𝑡 Net Cash flow

𝐾𝑓 = Risk free rate

𝐼 = Initial Investment

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Q25. What are the different steps involved in Simulation Analysis.

Answer:
The following list down the different steps involved in Simulation
Analysis:
1. Identification of variables that influence cash inflows and
outflows.
2. Specify values of parameters and probability distributions
of variables.
3. Select a value at random from probability distribution of each of the
variables.
4. Determine NPV corresponding to the randomly generated value of
variables.
5. Repeat steps (3) & (4) a large number of times to get a large number of
simulated NPVs.
6. Plot probability distribution of NPVs.

Q26. What are the different applications of Simulation Analysis?

Answer:
The different applications of simulation analysis are mentioned as
below:
7. It is used in Project Finance to model the random Variables with which
uncertainty is associated viz., Cash flows, and variable expenses.
8. It is used for Options Pricing where the various factors like implied
volatility, price of the underlying asset are the random variables and
the different ranges of these individual random variables can be
calculated using Monte Carlo Simulation.
3. It is used for making a judgment of the return out of a Stock or a Stock
Portfolio. Thus it is of significant importance in Portfolio Management
and Retirement Planning.

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Q27. Mention the advantages and limitation of Simulation

Analysis? Answer:
Monte Carlo simulation has the following advantages for analysis of results
where uncertainty is associated:
1. Monte Carlo simulation provides useful inputs for Sensitivity Analysis
by helping to understand variability in which inputs affects the
outcome to the biggest extent.
2. Using Monte Carlo simulation, a judgment can be made as to the
range in which the input lies under a particular scenario. Thus using
the
results of Monte Carlo Simulation, different scenarios can be studied.
3. The results produced by Monte Carlo Simulation also show the
associated probability of the results occurring. Thus it simplifies the
decision making process of the management.
4. In a complex decision making environment, different variables are
inter- dependent on each other and that impacts the end result out of
a project. Monte Carlo simulation helps to understand the
interdependency between input variables. Understanding this inter
dependability, enables to reduce the complexity of decision.
The limitations of simulation analysis are mentioned as below:
5. Difficult to model the project and specify probability distribution of
various variables.
6. Simulation provides only rough approximation
of probability distribution of NPV.
7. Simulation model is complex and can be constructed by management
expert and not by the decision maker.
4. Determine NPV in simulation run, risk free discount rate is used which
may not give correct picture.

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Q28. Write a short note on decision tree analysis.

Answer:
 Practically investment decisions may have implications for future or
further investment decisions, and may also impact future decision and
events.
 Such situation can be handled by taking a sequence of decisions over a
period of time.
 The technique to handle this type of sequential decisions is done
through “Decision Tree” technique.
 A Decision tree is a graphical representation of relationship between
future decisions and their consequences.
 The sequence of events is shown in a format resembling branches of
tree, each branch representing a single possible
decision, its
alternatives and the probable result in terms of NPV, ROI etc.
 The alternative with the highest amount of expected monetary value is
selected.

Q29. Mention the different assumptions used in decision tree analysis.

Answer:
The decision tree analysis approach assumes that there are only two types of
situation that a finance manager has to face :
1. The first situation is where 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 second situation is where finance manager has no control over
what happens next. This is known as “Event”. Since the outcome of the
events is not known, a probability distribution needs to be assigned to
the various outcomes or consequences.
3. When a finance manager faced with a decision situation, he is
assumed to act rationally. For example, in a commercial business, he
will choose the most profitable course of action and in non-profit
organization; the lowest cost may be rational choice.

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Q30. What are the different steps involved in decision tree

analysis? Answer:
The steps involved in decision tree analysis are mentioned as below:
Step 1: Define Investment:
 Decision three analyses can be applied to a variety of business
decision-making scenarios.
 Normally it includes following types of decisions.
 Whether or not to launch a new product, if so, whether this
launch should be local, national, or international.
 Whether extra production requirement should be met by
extending the factory or by out sourcing it to an external supplier.
 Whether to dig for oil or not if so, up to what height and
continue to dig even after finding no oil up to a certain depth.
Step 2: Identification of Decision Alternatives:
 It is very essential to clearly identify decision alternatives.
 For example, if a company is planning to introduce a new product, it
may be local launch, national launch or international launch.
Step 3: Drawing a Decision Tree:
 After identifying decision alternatives, at the relevant data such as
the projected cash flows, probability distribution expected present
value etc. should be put in diagrammatic form called decision tree.
 While drawing a decision tree, it should be noted that NPVs etc.
should be placed on the branches of decision tree, coming out of the
decisions identified.
 While drawing a decision tree, it should be noted that:-
 The decision point (traditionally represented by square □), is the
option available for manager to take or not to take. This is known
as decision node.
 The event or chance or outcome (traditionally represented by
circle Ο) which are dependent on chance process, along with the
probabilities thereof, and monetary value associated with them.
This is known as chance node.

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This diagram is drawn from left to right.

Step 4: Evaluating the Alternatives:
 After drawing out the decision the next step is the evaluation of
alternatives.
 The various alternatives can be evaluated as follows:
i. This procedure is carried out from the last decision in the
sequence (extreme right) and goes on working back to the first
(left) for each of the possible decision.
ii. At each final stage decision point, select the alternative which
has the highest NPV and truncate the other alternatives. Each
decision point is assigned a value equal to the NPV of the
alternative selected at the decision point.
iii. Proceed backward in the same manner calculating the NPV at
chance or event or outcome points (Ο) selecting the decisions
alternative which has highest NPV at various decision points [□]
rejecting the inferior decision option, assigning NPV to the
decision point, till the first decision point is reached.

Q31. Mention the advantages and limitation of using decision tree analysis?
Answer:
The advantages of using decision tree analysis are mentioned as below:
1. The Decision nodes enable to set out the various options available thus
ensuring that no option is left out to be considered.
2. All the options available can are considered simultaneously thus
allowing comparison.
3. Risk is addressed in an objective manner by use of probabilities.
4. Decision Trees enable the evaluation of the options by considering the
Cash Outflows and the Cash Inflows. Thus it enables to evaluate the
different options on the basis of the Net benefit arising out of that
project.
5. Simple to understand and apply.

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The limitations of using decision tree analysis are mentioned as below:

1. Probabilities cannot be calculated objectively.
2. Decision Trees use only that data which can be quantified. It ignores
qualitative aspects of decisions.
3. Assignment of probabilities and expected values do not have any
relevant basis as it pertains to a future outcome which is uncertain.

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Practical Problems
1. FMCG Ltd. is evaluating to spend `4 lakhs on a project to manufacture and sell
a new product. The unit variable cost of the product is `6. It is expected that
the new product can be sold at `10 per unit. The annual fixed cost (only cash)
will be `20,000. The project will have a life of 6 years with a scrap value of
`20,000. The cost of capital of the company is 15%. The only uncertain factor is
the volume of sales. To start with the company expects to sell at least 40,000
units during the first year.
You are required to find out (ignoring tax):
a. Net Present Value of the project based on the sales expected during the
first year and on the assumption that it will continue at the same level
during the remaining years.
b. The minimum volume of sales required to justify the project.

2. Jumble Consultancy Group has determined relative utilities of cash flows of

two forthcoming projects of its client company as follows:
Cash -15000 -10000 -4000 0 15000 10000 5000 1000
flow in
Utilities -100 -60 -3 0 40 30 20 10
The distribution of cash flows of Project A and Project B are as follows
Project A
Cash flow(`) -15000 -10000 15000 10000 5000
Probability 0.10 0.20 0.40 0.20 0.10
Project B
Cash flow(`) -10000 -4000 15000 5000 10000
Probability 0.10 0.15 0.40 0.25 0.10
Which project should be selected and why?
[May 2011, 8 Marks]

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3. ABC Chemicals is evaluating two alternative systems for waste disposal, System
A and System B, which have lives of 6 years and 4 years respectively. The initial
investment outlay and annual operating costs for the two systems are expected
to be as follows:
System A System B
Initial Investment Outlay `5 million `4 million
Annual Operating Costs `1.5 million `1.6 million
Salvage value `1 million `0.5 million
If the hurdle rate is 15%, which system should ABC Chemicals choose?

4. A firm has an investment proposal requiring an outlay of `80,000. The

investment proposal is expected to have 2 years economic life with no salvage
value. The probabilities assigned to cash inflows after tax are as follows.

Year 1 Probability Year 2 Probability

50000 0.4 24000 0.2
32000 0.3
44000 0.5
60000 0.6 40000 0.4
50000 0.5
60000 0.1
The firm uses 10% discount rate for this type of investment.
Required:
a) Construct a decision tree for the proposed investment
project.
b) What net present value will the project yield if the worst outcome is
realized? What is the probability of occurrence of this NPV?
c) What will be the NPV in best outcome and the probability of occurrence of
that NPV?
d) Will the project be accepted?
e) Do the profitability index and the NPV criterion of evaluating investment
proposals lead to the same acceptance-rejection and ranking decisions? In
what situations will they give conflicting results?
------------------ [May 2004, 16 Marks] ----------------- [Nov 1999, 14 Marks] ------------

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 Risk Analysis in Capital Budgeting

5. A company is considering Projects X and Y with following information:

Project Expected NPV Standard Deviation
X `1,22,000 `90,000
Y `2,25,000 `1,20,000
a. Which project will you recommend based on the above data?
b. Explain whether your opinion will change, if you use coefficient of
variation as a measure of risk.
c. Which measure is more appropriate in this situation and why?
[May 2003, 3 Marks]

6. Gretel Limited is setting up a project for manufacture of boats at a cost of

Rs.300 lakhs. It has to decide whether to locate the plant in next to the sea
shore (Area
A) or in an inland area with no access to any waterway (Area B). If the project is
located in Area B then Gretel Limited receives a cash subsidy of Rs. 20 lakhs
from the Central Government. Besides, the taxable profit to the extent of 20%
is exempt for 10 years in Area B. The project envisages a borrowing of Rs. 200
lakhs in either case. The rate of interest per annum is 12% in area A and 10% in
Area B.
The borrowing of principal has to be repaid in 4 equal installments beginning
from the end of the 4th year.
With the help of the following information, you are required to suggest the
proper location for the project to the CEO of Gretel Limited. Assume straight
line depreciation with no residual value, income tax 50% and required rate of
return
Year ofEarnings
15%. before depreciation, Interest and Tax (EBIDT) (Rs. In lakhs)
Area A Area B
1 (6) (50)
2 34 (50)
3 54 10
4 74 20
5 108 45
6 142 100

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7 156 155
8 230 190
9 330 230
10 430 330
The PVIF @ 15% for 10 years are as below:
Year 1 2 3 4 5 6 7 8 9 10
PVIF 0.87 0.76 0.66 0.57 0.50 0.43 0.38 0.33 0.28 0.25
[Nov 2014, 10 Marks]

7. A company is considering two mutually exclusive projects X and Y. Projects X

costs `30,000 and Project Y `36,000. You have been given below the net
present value & probability distribution for each project
Project X
NPV Estimate Probability
`3000 0.1
`6000 0.4
`12000 0.4
`15000 0.1
Project Y
NPV Estimate Probability
`3000 0.2
`6000 0.3
`12000 0.3
`15000 0.2
1. Compute the expected net present value of Project X and Y.
2. Compute the risk attached to each project (SD).
3. Which project is more risky? Give reasons.
4. Compute the profitability index of each project.
---------------[May 1999, 14 Marks]----------------------[June 2009, 14 Marks]---------

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 Risk Analysis in Capital Budgeting

8. XYZ Ltd. an infrastructure company is evaluating a proposal to build, operate

and transfer a section of 35 km of road at a project cost of `200 crores to be
financed as follows. Equity share capital `50 crores, loans at the interest rate
of 15% p.a. from financial institutions `150 crores. The project after
completion will be open to traffic and a toll will be collected for a period of 15
years from the vehicles using the road. The company is also required to
maintain the road during the above 15 years and after the completion of that
period, it will be handed over to NHAI at zero value. It is estimated that the
toll revenue will be
`50 crores per annum and the annual toll collection expenses including
maintenance of roads will amount to 5% of the project cost. The company
considers writing off the total cost of the project in 15 years on a straight line
basis. For corporate income tax purposes the company is allowed to take
depreciation @ 10% on WDV basis.
The financial institutions are agreeable for the repayment of the loan in 15
annual installments- consisting of principle and interest.
Calculate project IRR and equity IRR. Ignore corporate tax.
[Nov 2001, 14 Marks]

9. A company named Roby’s cube decided to replace the existing computer

system of their organisation. Original cost of old system was `25,000 and it was
installed 5 years ago. Current market value of old system is `5,000.
Depreciation of the old system was charged with life of 10 years. Depreciation
of the new system will be charged with life of 5 years. Estimated salvage value
of the old system was Nil. Present cost of the new system is `50,000. Estimated
salvage value of the new system is `1,000. Estimated cost savings with new
system is
`5,000 per year. Increase in sales with new system is assumed at 10% per year
based on original total sales of `1,00,000. Company follows the straight line
method of depreciation. Cost of capital of the company is 10% whereas tax rate
is 30%. Advise the company for replacement option.

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10. DL Services is in the business of providing home services like plumbing,

sewerage line cleaning etc. There is a proposal before the company to
purchase mechanised sewerage cleaning line for a sum of `20 lacs. The life of
the machine is 10 years. The present system of the company is to use manual
labour for the job. You are provided with the following information.
Cost of the machine `20 lacs
Depreciation 20% straight line
Operating cost `5 lacs p.a.
Present system
Manual labour 200 Labour

Cost of Manual Labour `10,000 per labour p.a.

The company has an after tax cost of funds of 10% p.a. Tax rate applicable is
35%
Based on the above you are required to: a) state whether it is advisable to
purchase the machine. b) Compute the savings/additional cost as applicable
if the machine is purchased.

[May 2008, 12 Marks]

11. XYZ Food Pvt. Ltd., a franchisee of Domino’s (World famous food chain for
delivering pizza at home) is considering a proposal of acquiring a fleet of
motorbikes for delivery of pizzas at home of customers. Since pizzas are also
delivered in late night and bikes are handled by different delivery boys (due
shift working) the use of fleet will be very heavy. Hence it is expected that the
motorbike shall be virtually worthless and scrapped after a period of 3 years.
However they are taken out of services before 3 years there will be a positive
‘abandonment’ cash flow.
The initial cost of the bike will be `1,00,000. The expected post tax benefit (cash
inflows) from the use of bike and abandonment cash inflows are as follows:

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 Risk Analysis in Capital Budgeting

Year Operating Cash Flows Abandonment cash flows at the end of the
year
1 42,000 62,000
2 40000 40,000
3 35,000 0
The cost of capital of XYZ Pvt. Ltd. is 10%. You are required to evaluate the
proposal of acquisition of bikes and recommend preferable life of the same.
[Nov 14 RTP]

12. A machine used on a production line must be replaced at least every four
years.
Costs incurred to run the machine according to its age are:
Age of the Machine (years)
Figures in (`) 0 1 2 3 4
Purchase Price 60,000
Maintenance 16,000 18,000 20,000 20,000
Repair 0 4,000 8,000 16,000
Scrap Value 32,000 24,000 16,000 8,000
Future replacement will be with identical machine with same cost. Revenue is
unaffected by the age of the machine. Ignoring inflation and tax, determine
the optimum replacement cycle. PV factors of the cost of capital of 15% for
the respective four years are 0.8696, 0.7561, 0.6575 and 0.5718.
[May 2012, 10 Marks]

13. Company Y is operating an elderly machine that is expected to produce a net

cash inflow of `40,000 in the coming year and `40,000 next year. Current
salvage value is `80,000 and next year’s value is `70,000. The machine can be
replaced now with a new machine, which costs `1,50,000, but is much more
efficient and will provide a cash inflow of `80,000 a year for 3 years.
Company Y wants to know whether it should replace the equipment now or
wait a year with the clear understanding that the new machine is the best of
the available alternatives and that it in turn be replaced at the optimal point.
Ignore tax. Take opportunity cost of capital as 10 per cent. Advise with
reasons.
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14. A company has an old machine having book value zero – which can be sold
for
`50,000. The company is thinking to choose one from following two
alternatives:
i. To incur additional cost of `10,00,000 to upgrade the old existing machine.
ii. To replace old machine with a new machine costing `20,00,000 plus
installation cost `50,000.
Both above proposals envisage useful life to be five years with salvage value
to be nil. The expected after tax profits for the above three alternatives are as
under:
Year Old Existing Machine Upgraded Machine New Machine
1 5,00,000 5,50,000 6,00,000
2 5,40,000 5,90,000 6,40,000
3 5,80,000 6,10,000 6,90,000
4 6,20,000 6,50,000 7,40,000
5 6,60,000 7,00,000 8,00,000
The tax rate is 40 per cent.
The company follows straight line method of depreciation. Assume cost of
capital to be 15 per cent.
P.V.F. of 15%, 5 = 0.870, 0.756, 0.658, 0.572 and 0.497. You are required to
advise the company as to which alternative is to be adopted.

15. A & Co. is contemplating whether to replace an existing machine or to spend

money on overhauling it. A & Co. currently pays no taxes. The replacement
machine costs `90,000 now and requires maintenance of `10,000 at the end
of every year for eight years. At the end of eight years it would have a salvage
value of `20,000 and would be sold. The existing machine requires increasing
amounts of maintenance each year and its salvage value falls each year as
follows:
Year Maintenance Salvage
Present 0 `40,000
1 `10,000 `25,000

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 Risk Analysis in Capital Budgeting

2 `20,000 `15,000
3 `30,000 `10,000
4 `40,000 0
The opportunity cost of capital is 15% and you are required to find out when
the company should replace the machine.

16. Examine Well Ltd. has a limit of `10, 00,000 available for investment in the
current year. The cost of capital of the firm is 10%. There is no capital
rationing in future. The company has five indivisible projects for evaluation.
Project Initial Cost NPV@ 10%

I 3,50,000 1,75,000
II 4,00,000 2,25,000

III 6,50,000 3,80,000

IV 4,80,000 3,15,000

V 2,30,000 90,000

Suggest an optimum investment plan if

i. There is no alternative investment for surplus funds, or
ii. The surplus funds can be invested to produce 12% in perpetuity.

17. A company engaged in manufacturing of toys is considering a line of stationery

items with an expected life of 5 years. From past experience the company has
a conservative view in its investment in new products. Accordingly the
company considers the stationery items an abnormally risky project. The
company’s management is of the view that normally required rate of return
of 10% will not be sufficient and hence the minimum required rate of return
should be 15%. The initial investment in the project will be of `1,10,00,000
and expected free cash flows to be generated from the project is `30,00,000
for 5 years. Determine whether the project should be accepted or not.

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18. Determine the risk adjusted net present value of the following projects
X Y Z

Net Cash outlays 210000 120000 100000

Project life 5 years 5 years 5 years
Annual cash inflow 70000 42000 30000
Coefficient of variation 1.2 0.8 0.4
The company selects the risk adjusted discount factor on the basis of the
coefficient of variation as follows:
Coefficient of variation RADR Present value factor of 1-5 years @ RADR
0.0 10% 3.791
0.4 12% 3.605
0.8 14% 3.433
1.2 16% 3.274
1.6 18% 3.127
2.0 22% 2.864
More than 2 25% 2.689

--------------------- [Nov 2005, 6 Marks] -----------[May 1999, 6 Marks]-----------------

19. New projects Ltd. is evaluating 3 projects P-I, P-II, P-III. Following information
is available in respect of these projects.
P-I P-II P-III
Cost Inflows `15,00,000 `11,00,000 `19,00,000
Year 1 6,00,000 6,00,000 4,00,000
Year 2 6,00,000 4,00,000 6,00,000
Year 3 6,00,000 5,00,000 8,00,000
Year 4 6,00,000 2,00,000 12,00,000
Risk Index 1.80 1.00 0.60
Minimum required rate of return of the firm is 15% and applicable tax rate is
40%. The risk free interest rate is 10%

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Required
1. Find out the risk adjusted discounted rate (RADR) for these projects.
2. Which project is best?
[Nov 2009, 10 Marks]

20. The globe manufacturing Company Ltd. is considering an investment in one of

the two mutually exclusive proposals – Project X and Project Y, which require
cash outlays of `3,40,000 and `3,30,000 respectively. The certainty-
equivalent approach is used in incorporating risk in capital budgeting
decisions. The current yield on government bond is 8% and this is to be used
as the riskless rate. The expected net cash flows and their certainty
equivalents are as follows:
Year Project X Project Y
Cash flow C.E. Cash flow C.E.
1 1,80,000 0.8 1,80,000 0.9
2 2,00,000 0.7 1,80,000 0.8
3 2,00,000 0.5 2,00,000 0.7
Required:
1. Which project should be accepted?
2. If risk adjusted discount rate method is used, which project would be
analysed with higher rate?

21. The following information applies to a new project:

Initial investment `125,000
Selling price per unit `100
Variable cost per unit `30
Fixed cost for the period `1,00,000
Sales Volume 2,000
Life 5 years
Discount rate 10%
Required: Projects NPV and show how sensitive the results are to various
factors.

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22. XYZ Ltd. is considering a project for which the following estimates are
available:

Initial cost of the outlay `10,00,000

Selling price /unit `60
Cost/unit `40
Sales Volume
Year 1 20000 units
Year 2 30000 units
Year 3 30000 units
Discount rate 10% p.a.

You are required to measure the sensitivity of the project in relation to each
of the following parameters
I. Selling price/unit.
II. Unit cost.
III. Sales volume.
IV. Initial outlay.
V. Project lifetime.

[May 2007, 16 Marks]

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23. Unnat ltd. is considering investing `50,00,000 in a new machine. The

expected life of machines is five years and has no scrap value. It is expected
that 2,00,000 units will be produced and sold each year at a selling price of
`30.00 per unit. It is expected that the variable costs to be `16.50 per unit
and fixed costs to be `10,00,000 per year. The cost of capital of Unnat ltd. is
12% and acceptable level of risk is 20%
You are required to measure the sensitivity of the project’s net present value
to a change in the following project variables.
a) Sale Price.
b) Sales Volume.
c) Variable Cost.
And discuss the use of sensitivity analysis as a way of evaluating project risk.
On further investigation it is found that there is a significant chance that the
expected sales volume of 2,00,000 units per year will not be achieved. The
sales manager of Unnat Ltd. suggests that sales volumes could depend on
expected economic stats that could be assigned the following probabilities.
State of Economy Annual Sales (in units) Prob.
Poor 1,75,000 0.30
Normal 2,00,000 0.60
Good 2,25,000 0.10
Calculate expected net present value of the project and give your decision
whether company should accept the project or not.

24. The Easygoing Company Limited is considering a new project with initial
investment, for a product “Survival”. It is estimated that IRR of the project is
16% having an estimated life of 5 years.
Financial Manager has studied that project with sensitivity analysis and informed
that annual fixed cost sensitivity is 7.8416%, whereas cost of capital (discount
rate) sensitivity is 60%.
Other information available are:
Profit Volume Ratio (P/V) is 70%,
Variable cost `60/- per unit
Annual Cash Flow `57,500/-
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Ignore Depreciation on initial investment and impact of taxation.

Calculate
I. Initial Investment of the Project.
II. Net Present Value of the Project.
III. Annual Fixed Cost.
IV. Estimated annual unit of sales.
V. Break Even Units.
Cumulative Discounting Factor for 5 years
8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18%
3.993 3.890 3.791 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127

25. S Ltd finds an opportunity to invest in a 2 year project and will cost `1 lakh.
The estimated cash flows for the first year are given below
Cash Flows Probability
`40000 30%
`60000 40%
`80000 30%
The second year cash flows with conditional probability are
Scenario 1
Cash Flows Probability
`20000 20%
`50000 60%
`80000 20%
Scenario 2
Cash Flows Probability
`70000 30%
`80000 40%
`90000 30%
Scenario 3
Cash Flows Probability
`80000 10%
`100000 80%

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 Risk Analysis in Capital Budgeting

`120000 10%
The relevant cost of capital is 8% find the project’s NPV.

26. ABC and Co. is considering a proposal having an initial outlay of `1,50,000 and
a life of 2 years. The firm’s required rate of return is 10%. It is expected that
the cash inflow for year 2 is affected by the cash flow of year 1. Other details
of the cash inflows are as follows:
Year 1 Year 2
Cash Inflows Probability Cash Inflows Probabilities
1,00,000 0.4 1,40,000 0.5
60,000 0.3
70,000 0.2
60,000 0.6 2,00,000 0.6
1,20,000 0.3
80,000 0.1
Evaluate the proposal.

27. XY Ltd. has under its consideration a project with an initial investment of
`1,00,000. Three probable cash inflow scenarios with their probabilities of
occurrence have been estimated as below:
Annual cash inflow (`) 20,000 30,000 40,000
Probability 0.1 0.7 0.2
The project's life is 5 years and the desired rate of return is 20%. The
estimated terminal values for the project assets under the three probability
alternatives, respectively are `0, `20,000 and `30,000.
You are required to:
a) Find the probable NPV
b) Find the worst case NPV and the best case NPV and
c) State the probability of occurrence of the worst case, if the cash flows are
perfectly positively correlated over time.
[May 2010, 12 Marks]

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28. Following are the estimates of the net cash flows and probabilities of a
project of M/s X ltd.
Year P=0.3 P=0.5 P=0.2
Initial investment 0 4,00,000 4,00,000 4,00,000
Estimated net after tax cash 1 to 5 1,00,000 1,10,000 1,20,000
flows per year
Estimated after tax 5 20,000 50,000 60,000
salvage
value
Required rate of return for the project is 10%
Find:
i) The expected NPV of the project
ii) The best case and worst case NPVs
iii) The probability of occurrence of the
worst case, if the cash flows are
a. Perfectly dependent over time
b. Independent overtime
iv) Standard deviation and coefficient of variation assuming that there are
only three streams of cash flow, which are represented by each column
of the table with the given probabilities.
v) Coefficient of variation of X Ltd. on its average project which is in the
range of 0.95 to 1.0. If the coefficient of variation of the project is
found to be less risky than average, 100 basis points are deducted
from the company’s cost of capital to calculate the NPV again.
[Nov 2006, 16 Marks]

29. L & R Limited wishes to develop new virus-cleaner software. The cost of the
pilot project would be `2,40,000. Presently, the chances of the product being
successfully launched on a commercial scale are 50%. L&R can invest the sum
of `20 lacs to market the product. Such an effort can generate perpetually,
an annual net after tax cash income of `4 lacs. Even if the commercial launch
fails, they can make an investment of smaller amount of `12 lacs with the
hope of gaining perpetually a sum of `1 lac. Evaluate the proposal, adopting
the decision tree approach. The discount rate is 10%.

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30. Big oil is wondering whether to drill for oil in X country. The prospects are as
follows:

Depth Total cost Cumulative PV of oil (if found)

of well (Millions probability Millions of dollars
(feet) of dollars) of finding oil
2000 4 0.5 10
4000 5 0.6 9
6000 6 0.7 8

Draw a decision tree showing the successive drilling decisions to be made by

Big Oil. How deep should it be prepared to drill?

31. You own an unused gold mine that will cost `10,00,000 to reopen. If you
open the mine, you expect to be able to extract 1000 ounces of gold a year
for each of three years. After that the deposit will be exhausted. The gold
price is currently `5,000 an ounce, and each year the price is equally likely to
rise or fall by `500 from its level at the start of the year. The extraction cost
is `4,600 an ounce and the discount rate is 10%.
Required:
a) Should you open the mine now or delay by one year in the hope of a rise
in the gold price?
b) What difference would it make to your decision if you could shut down
the mine at any stage? Show the value of abandonment option.
[Nov 2004, 20 Marks]

32. Project X and Project Y are under the evaluation of XY & Co. The estimated
cash flows and their probabilities are as below:
Project X: Investment at year “0” `70 lacs
Probability 0.30 0.40 0.30
Year `in lacs ` in lacs `in lacs
1 30 50 65
2 30 40 55

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3 30 40 45
Project Y: Investment at year “0” `80 lacs
Probability Annual cash flows through life (` in lacs)
0.20 40
0.50 45
0.30 50
Required:
a. Which project is better based on NPV @ discount rate of 10%?
b. Compute the standard deviation of present value distribution and analyse
the inherent risk of the projects.
[May 2005, 12 Marks]

33. Skylark Airways is planning to acquire a light commercial aircraft for flying class
clients at an investment of `50,00,000. The expected cash flow after tax for
the next 3 years
CFAT is as follows:
Probability CFAT Probability CFAT Probability
Year 1 Year 2 Year 3
14,00,000 0.1 15,00,000 0.1 18,00,000 0.2
18,00,000 0.2 20,00,000 0.3 25,00,000 0.5
25,00,000 0.4 32,00,000 0.4 35,00,000 0.2
40,00,000 0.3 45,00,000 0.2 48,00,000 0.1
The company wishes to take into consideration all possible risk factors
relating to airline operations. The company wants to know:
(i) The expected NPV of this venture assuming independent probability
distribution with 6% risk free of interest.
(ii) The possible deviation in the expected value.
(iii) How would standard deviation of the present value distribution help in
capital budgeting decisions?
[Nov 2002, 14 Marks]

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34. XY Ltd. which specializes in manufacturing garments is planning for expansion

to handle a new contract which it expects to obtain. An investment bank has
approached the company and asked whether the Co. had considered venture
Capital financing. In 2001, the company borrowed `100 lacs on which interest
is paid at 10% p.a. The Company shares are unquoted and it has decided to
take your advice in regard to the calculation of the value of the Company that
could be used in negotiations using the following available information and
forecast.
Company’s forecast turnover for the year to 31st March, 2005 is `2,000 lacs which
is mainly dependent on the ability of the Company to obtain the new
contract, the chance for which is 60%, turnover for the following year is
dependent to some extent on the outcome of the year to 31st March, 2005.
Following are the estimated turnovers and probabilities:
Year - 2005 Year – 2006
Turnover (in lacs) Prob. Turnover (in lacs) Prob.
2,000 0.6 2,500 0.7
3,000 0.3
1,500 0.3 2,000 0.5
1,800 0.5
1,200 0.1 1,500 0.6
1,200 0.4
Operating costs inclusive of depreciation are expected to be 40% and 35% of
turnover respectively for the years 31st March, 2005 and 2006. Tax is to be
paid at 30%. It is assumed that profits after interest and taxes are free cash
flows. Growth in earnings is expected to be 40% for the years 2007, 2008 and
2009 which will fall to 10 % each year after that. Industry average cost of
equity (net of tax) is 15%.
[Nov 2007, 10 Marks]

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Practice Problems
35. A pencil manufacturing company is considering the introduction of a line of a
gel pen with an expected life of 5 years. In the past the firm has been quite
conservative in its investment in new projects, sticking primarily to standard
pencils. In this context the introduction of a line of gel pen is considered an
abnormal risky project. The CEO of the company is of the opinion that the
normal required rate of return for the company of 12% is not sufficient.
Therefore the minimum acceptable rate of return on this project should be
18%. The initial outlay of the project is `10,00,000 and the expected free
cash flows from the projects are given below.
Year Cash Flow
1 `2,00,000
2 `3,00,000
3 `4,00,000
4 `3,00,000
5 `2,00,000

Advice whether the project should be accepted or not.

36. Investment proposal - `45,00,000

Year Expected Cash Flow Certainty Equivalent Co-efficient
1 `10,00,000 0.90
2 `15,00,000 0.85
3 `20,00,000 0.82
4 `25,00,000 0.78
Assuming i = 5%, calculate NPV.

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37. XYZ PLC employs certainty-equivalent approach in the evaluation of risky

investments. The finance department of the company has developed the
following information regarding a new project:
Year Expected CFAT CE Coefficient
0 (£200000) 1.0
1 £160,000 0.8
2 £140,000 0.7
3 £130,000 0.6
4 £120,000 0.4
5 £80,000 0.3
The firm’s cost of equity capital is 18%; its cost of debt is 9% and the riskless
rate of interest in the market on the treasury bonds is 6%. Should the project
be accepted?

38. XYZ Ltd. is considering a project “A” with an initial outlay of `14,00,000 and
the possible three cash flows attached to the project are as follows.
(`000)
Year 1 Year 2 Year 3
Worst case 450 400 700
Most likely 550 450 800
Best case 650 500 900
Assuming the cost of capital as 9%, 1) determine whether the project should
be accepted or not. 2) The manager of XYZ Ltd. is confident about the
estimates of the first 2 years but not sure about the third year’s high cash
flow. What will happen to NPV in the first case if third year turns out to be
bad? [SM_2.34_9]

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39. Alpha Limited is considering five capital projects for the years 2012 and 2013.
The company is financed by equity entirely and its cost of capital is 12%. The
expected cash flows of the projects are as follows:
Project 2012 2013 2014 2015
A (70) 35 35 20
B (40) (30) 45 55
C (50) (60) 70 80
D - (90) 55 65
E (60) 20 40 50
Note: Figures in brackets represent cash outflows.
All projects are divisible i.e. size of investment can be reduced, if necessary in
relation to availability of funds. None of the projects can be delayed or
undertaken more than once.
Calculate which project Alpha Limited should undertake if the capital
available for investment is limited to `1,10,000 in 2012 and with no limitation
in subsequent years. For your analysis, use the following present value
factors:
Year 2012 2013 2014 2015
Factor 1.00 0.89 0.80 0.71

40. Trouble Free Solutions (TFS) is an authorized service center of a reputed

domestic air conditioner manufacturing company. All complaints/ service
related matters of Air conditioner are attended by this service center. The
service center employs a large number of mechanics, each of whom is
provided with a motor bike to attend the complaints. Each mechanic travels
approximately 40000kms per annual. TFS decides to continue its present
policy of always buying a new bike for its mechanics but wonders whether the
present policy of replacing the bike every three year is optimal or not. It is of
believe that as new models are entering into market on yearly basis, it wishes
to consider whether a replacement of either one year or two years would be
better option than present three year period. The fleet of bike is due for
replacement shortly in near future.
The purchase price of latest model bike is `55,000. Resale value of used bike at
current prices in market is as follows:
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Period `
1 year 35,000
2 year 21,000
3 year 9,000
Running and Maintenance expenses (excluding depreciation) are as follows:
Year Road, Taxes & Insurance Petrol, Maintenance and Repair
1 3,000 30,000
2 3,000 35,000
3 3,000 43,000
Using opportunity cost of capital as 10% you are required to determine
optimal replacement period of bike.
---------------- [May 2004, 10 Marks]-----------[June 2009, 10 Marks]---------------------

41. A firm has capital budget constraint of `30, 00,000. The expected outlay and
cash flows of various projects is as follows:
Project Outlay NPV
A 18 7.5
B 15 6
C 12 5
D 7.5 3.6
E 6 3
Projects B & C are mutually exclusive while other projects are
interdependent. Determine which possible combination the firm should
select.

42. Initial
Determine NPV
Outlay `40000
of the project with the following information:
of project
Annual revenues (Without inflation) `30000
Annual costs excluding depreciation (Without inflation) `10000
Useful life 4 years
Salvage value Nil
Tax Rate 50%
Cost of Capital (Including inflation premium of 10%) 12%

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43. X Ltd. is a taxi operator. Each taxi cost to company `4,00,000 and has a useful
life of 3 years. The taxi’s operating cost for each of 3 years and salvage value
at the end of year is as follows:
Year 1 Year 2 Year 3
Operating Cost 1,80,000 2,10,000 2,38,000
Resale Value 2,80,000 2,30,000 1,68,000
You are required to determine the optimal replacement period of taxi if cost
of capital of X Ltd. is 10%.

44. X Ltd. an existing profit making company is planning to introduce a new

product with a projected life of 8 years. Initial equipment cost will be `120
lakhs and additional equipment costing `10 lakhs will be needed at the
beginning of the third year. At the end of the 8th year the original equipment
will have a resale value equivalent to the cost of removal, but the additional
equipment would be sold for `1 lakh. Working capital of `15 lakhs will be
needed. The 100% capacity of the plant is 4,00,000 units per annum, but the
production and sales volume expected are as under.
Year Capacity
1 20%
2 30%
3-5 75%
6-8 50%
A sale price of `100 per unit with a profit volume ratio of 60% is likely to be
obtained. Fixed operating cash cost is likely to be `16 lakhs per annum. In
addition to this the advertisement expenditure will have to be incurred as
under:
Year 1 2 3-5 6-8
Expenditure in ` lakhs each year 30 15 10 4
The company is subject to 50% tax, straight line method of depreciation
(permissible for tax purposes also) and taking 12% as appropriate after tax
cost of capital, should the project be accepted?
[May 2002, 14 Marks]

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 Risk Analysis in Capital Budgeting

45. An Aeroflot airline is planning to procure a light commercial aircraft for flying class
clients at an investment of `50 lakhs. The expected cash flow after tax for next
three years is as follows:
Year 1 Year 2 Year 3
CFAT Prob. CFAT Prob. CFAT Prob.
15 0.1 15 0.1 18 0.2
18 0.2 20 0.3 22 0.5
22 0.4 30 0.4 35 0.2
35 0.3 45 0.2 50 0.1
The company wishes to consider all possible risk factors relating to an airline.
The company wants to know-
(i) The expected NPV of this proposal assuming independent probability
distribution with 6 per cent risk free rate of interest.
(ii) The possible deviation on expected values.

46. From the following details relating to project, analyse the sensitivity of the
project to changes in initial project cost, annual cash inflow, and cost of
capital.
Initial project cost `1,20,000
Annual cash inflow `45,000
Project life 4 years
Cost of capital 10%
To which of the three factors the project is more sensitive? (Annuity factors
of 10% 3.169 and for 11% 3.109)
[Nov 2009, 10 Marks]

47. XYZ ltd. is evaluating a new project which involves expenditure of `20,000 and
this will be payable in two equal installments at the time of acquisition and a
year later. The scrap value of the plant is `4000 in present day’s prices. The
life of the project is estimated at 3 years. The annual cash inflows are
`25,000 in real terms. The annual cash outflows are estimated to be `18,000
in year 1 and `19,000 p.a. thereafter stated in terms of year 1 prices. The
inflation rate is 8% p.a. and all cash flows rise with general inflation except
the annual cash
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outflows which will be subject to inflation of 10% p.a. The appropriate money
discount rate (i.e. nominal discount rate or inflation adjusted discount rate)
may be taken at 18%. Find out the NPV of the project.

48. XYZ Ltd. is planning to procure a machine at an investment of `40 lakhs. The
expected cash flow after tax for next three years is as follows:
(` in lakh)
Year 1 Year 2 Year 3
CFAT Probability CFAT Probability CFAT Probability
12 0.1 12 0.1 18 0.2
15 0.2 18 0.3 20 0.5
18 0.4 30 0.4 32 0.2
32 0.3 40 0.2 45 0.1
The company wishes to consider all possible risks factors relating to the
machine.
The company wants to know
1. The expected NPV of this proposal assuming independent probability
distribution with 7% risk free rate of interest
2. The possible deviations on expected values.
[May 2013, 8 Marks]

49. A manufacturing unit engaged in the production of automobile parts is

considering a proposal of purchasing one of the two plants, details of which
are given below:
Plant A Plant B
Cost `20,00,000 `38,00,000
Installation Charges `4,00,000 `2,00,000
Life 20 years 15 years
Scrap Value after Full Life `4,00,000 `4,00,000
Output per minute (units) 200 400

The annual costs of the two plants are as follows:

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 Risk Analysis in Capital Budgeting

Plant A Plant B
Running hours per annum 2500 2500
Costs
Wages 1,00,000 1,40,000
Indirect Materials 4,80,000 6,00,000
Repairs 80,000 1,00,000
Power 2,40,000 2,80,000
Fixed Cost 60,000 80,000
Will it be advantageous to buy Plant A or Plant B? Substantiate your answer
with the help of comparative unit cost of the plants. Assume interest on
capital at 10 percent. Make other relevant assumptions.

50. ABC & Co. has the following information relating to an investment proposal:
The initial outlay of `24,00,000 is expected at year 0 with a life of 4 years. The
firm has an annual profit before tax and depreciation of `10,00,000 and pays
tax @ 40%. The annual cash inflows (i.e. profit after tax + dep) of `8,40,000 is
expected. Assuming that the real discount rate is 5%, find out NPV of the
proposal given that
a. There is no inflation
b. There is an inflation of 5% and the annual profits keep pace with the
inflation.

51. The textile manufacturing Company Ltd. is considering an investment in one

of the two mutually exclusive proposals – Project M and Project N, which
require cash outlays of `8,50,000 and `8,25,000 respectively. The certainty-
equivalent approach is used in incorporating risk in capital budgeting
decisions. The current yield on government bond is 6% and this is to be used
as the riskless rate. The expected net cash flows and their certainty
equivalents are as follows:

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Year Project M Project N

Cash flow C.E. Cash flow C.E.
1 4,50,000 0.8 4,50,000 0.9
2 5,00,000 0.7 4,50,000 0.8
3 5,00,000 0.5 5,00,000 0.7
Present value factors of `1 discounted at 6% at the end of year 1, 2 and 3 are
0.943, 0.890 and 0.840 respectively.
Required:
1. Which project should be accepted?
2. If risk adjusted discount rate method is used, which project would be
analyzed with higher rate?
------------------ [Nov 2003, 12 Marks]--------------[Nov 1999, 6
Marks]-----------------

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