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Risk and Uncertainty in Capital

Budgeting

All the techniques of capital budgeting require
the estimation of future cash inflows and cash
outflows. The future cash flows are estimated
based on the following factors:
Expected economic life of the project.
Salvage value of the asset at the end of its life.
Capacity of the project.
Selling price of the product.
Production cost
Depreciation and tax rate
Future demand for the product etc.,


But due to uncertainties about the future
most of the above factors cannot be exact. For
example, the product becomes absolute,
technology becomes obsolescence, in these
situations taking investment decisions
becomes difficult. But some allowances for
the element of risk have to be provided.

The following methods are suggested for
accounting for risk in capital budgeting.
(i) General Techniques:
Risk adjusted discount rate;
Certainty equivalent coefficient.
(ii) Quantitative Techniques:
Sensitivity analysis
Probability assignment
Standard deviation
Coefficient of variation
Decision tree analysis

Risk adjusted discount rate

The risk adjusted discount rate is based on the
presumption that investors expect a higher rate of
return on risky projects as compared to less risky
projects. The rate requires is determined by i) risk free
rate and ii) risk premium rate. Risk free rate is the rate
at which the future cash inflows should be discounted
and there been no risk. Risk premium rate is the extra
return expected by the investor over the normal rate
on account of the project being risky. Therefore risk
adjusted discount rate is a composite discount rate that
takes into account both the time and risk factors. A
higher discount rate will be used for more risky
projects and lower rate for less risky projects.

From the following data, state which project
is better

Year Cash inflows

Project X Project Y
0 -10,000 -10,000
1 5,000 6,000
2 4,000 6,000
3 2,000 4,000
Riskless discount rate is 5%. Project X is less
risky as compared to Project Y.
Management considers risk premium rates at
5% and 10% respectively appropriate for
discounting the cash inflows.
Solution:
Project Risk adjusted discount rate
X 5% + 5% = 10%
Y 5% + 10% = 15%
Year Discounted Cash inflows
Project X Project Y
0 -10,000 -10,000
1 4,545 5,218
2 3,320 4,536
3 1,502 2,630
--------- ---------
NPV - 633 2,384
--------- ---------
Project Y is superior to Project X.
since NPV is positive it may be accepted.
Sensitivity analysis

Where cash inflows are very sensitive under
different circumstances, more than one forecast
of the future cash inflows may be made. These
inflows may be regarded as 'Optimistic', 'Most
Likely' and 'Pessimistic'. Further cash inflows may
be discounted to find out the NPV under these
three different situations. If the NPV under the
three situations differ widely it implies that there
is a great risk in the project and the investor's
decision to accept or reject a project will depend
upon his risk bearing abilities.

Mr. Tanu is considering tow mutually exclusive projects A and
B. You are required to advise him about the acceptability of
the projects from the following information.


Project A
Rs.
Project B
Rs.
Cost of the Investment
Forecast Cash Inflows per
annum for 5 years
Optimistic
Most Likely
Pessimistic
(The cut-off rate is 15%)
50,000


35,000
25,000
20,000
50,000


40,000
20,000
5,000
Project A Project B
Annual
cash
inflow
Discou
nt
factor
@
15%
Present
Value
NPV Annua
l cash
inflow
Discou
nt
factor
@
15%
Present
Value
NPV
Optimistic
Most Likely
Pessimistic
35,000
25,000
20,000
3.3522
3.3522
3.3522
1,17,327
83,805
67,044
67,327
33,805
17,044
40,000
20,000
5,000
3.3522
3.3522
3.3522
1,34,088
67,044
16,761
84,088
17,044
-33,239
The NPV calculated above indicate that
Project B is more risky as compared to
Project A. at the same time during favorable
conditions, it is more profitable.
Probability Technique

A probability is a relative frequency with
which an event may occur in the future. When
future estimates of cash inflows have different
probabilities the expected monetary values
may be computed by multiplying cash inflow
with the probability assigned.

Illustration

The ABC company Limited has given the
following possible cash inflows for two of their
projects X and Y out of which one they wish to
undertake together with their associated
probabilities. Both the projects will require an
equal investment of Rs. 5,000.

You are required to give your considered opinion
regarding the selection of the project.
Project X Project Y
Possible event Cash inflows Probability Cash inflows Probability
A
B
C
D
E
4,000
5,000
6,000
7,000
8,000
.10
.20
.40
.20
.10
12,000
10,000
8,000
6,000
4,000
.10
.15
.50
.15
.10
Project X Project Y
Possible event Cash inflows Probability Cash
inflows
Probability
A
B
C
D
E
4,000
5,000
6,000
7,000
8,000
.10
.20
.40
.20
.10
12,000
10,000
8,000
6,000
4,000
.10
.15
.50
.15
.10
Computation of Expected Monetary values for Project X and
Project

Project X Project Y

Cash inflows Probability Expected value Cash inflows Probability Expecte
d value
A
B
C
D
E
4,000
5,000
6,000
7,000
8,000
Total
.10
.20
.40
.20
.10
Rs. 400
1,000
2,400
1,400
800
6000
12,000
10,000
8,000
6,000
4,000
Total
.10
.15
.50
.15
.10
1,200
1,500
4,000
900
400
8,000
The expected monetary value of Project Y is higher than the
expected monetary value of Project X. Hence Project Y is
preferable to project X.
Decision Tree Analysis

Decision tree analysis is another technique which
is helpful in tackling risky capital investment
proposals. Decision tree is a graphic display of
relationship between a present decision and
possible future events, future decisions and their
consequences. The sequence of event is mapped
out over time in a format resembling branches of
a tree. In other words, it is a pictorial
representation in tree form which indicates the
magnitude, probability and interrelationship of all
possible outcomes.