Capital Budgeting

Techniques
Traditional Non risk based - Non-discounting
techniques
Pay Back Period (PBP)
Accounting Returns on Investment (ARR)

Modern Non risk based - discounting techniques

Net Present Value (NPV)
Internal Rate of Return (IRR)
Multiple IRR
Modified Internal Rate of Return (MIRR)

Present value Index (PI)

Equivalent Annuity (EA)

Non risk based techniques assumes that all projects were assumed to be equally risky,
acceptance of any project would not alter the firms overall risk
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Capital Budgeting
Techniques
Risk based techniques

Sensitivity analysis
Scenario analysis
Certainty equivalent model
Decision tree analysis
Break even analysis
Simulation
Risk adjusted discount rate
Real options

Decision Analysis
Logical and systematic approach for
analyzing decision problems
Steps.,
Identify criteria for choosing among competitive
alternatives
Structure decision problem, listing alternatives and
uncertain events in chronological order and
representing them in a decision tree
Assess the likelihood of the various uncertain events
and assign values to the various outcomes of the
decision problem
Analyze the information provided in the first three
steps to determine which alternative to undertake
Determine if the decision is sensitive to changes in
probabilities or other assumptions you have made

Decision Tree
Chronological sequence of options and
uncertain events in a decision tree
Maximizing expected monetary value
(EMV)
EMV = probability * net cash flow
Outcome depends on external event
making it uncertain
Probabilities..,
Likelihood of uncertain events
Precise numerical language for communicating
judgments about the uncertain future
Explicit in pronouncements
Are formed based on researches

Decision Tree
Probability in DTA is objective
Decision method folding back the tree or
backwards induction
Deals with uncertain inputs parameter
values that are subject to uncertainty
known only after a decision is made
Probability tree
Visual tool that can represent key
elements in a model for decision making
under uncertainty and help organize those
elements by distinguishing between
decisions (controllable variables) and
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Payoff Tables
Cost or revenue
Is a measure of economic result
Regret = for any state and any specific
action, the regret is the monetary
difference between the best possible
payoff for that state and payoff for the
specific action
Expected value = weighted average
outcome, where the weights are
probabilities of each state
States in Merck decision = 2 x 2 x 4 x 8 =
128

Decision Tree
Risk profile = distribution associated with a
particular action
Useful in situations where there are multiple
sources of uncertainty and sequence of decisions
to make
Expected value of perfect information (EVPI) =
measures the difference, or the gain due to
perfect information
EVPI = measures the difference between certain payoff that
could be realized under a condition of certainty and the
expected payoff under a condition involving risk
EVPI = EPC EMV
EPC = expected payoff under certainty
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Character of Decision Theory

Problems

List of alternatives
Must be a set of ME and collectively exhaustive decision that are
available to the decision maker

List of possible future states of nature

Set of possible future conditions, or events, beyond the control of
the decision maker that will be the primary determinants of the
eventual consequences of the decision
Must be ME and collectively exhaustive

Payoffs associated with each alternative / state of nature

combination

Estimated values
Profits revenues costs other measure of value
May be monthly daily yearly weekly
May be present value of future cash flows

Assessment of the degree of certainty of possible future

events
Decision criterion
Maximize expected payoff
Minimize opportunity cost

Approaches to Decision Making

Under Complete Uncertainty

Maximin
Maximax
Minimax regret
Hurwicz
Equal likelihood

Deciding Between Projects with

Same Present Value
Duration can be used
Duration = tPt / Pt
t = period
Pt = cash flows received in a period

If interest rate is expected to increase (shift

in yield curve and not a twist), should prefer
investment with shorter duration, since its
present value would decline by less as result
of the interest rate increase and vice versa

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Duration - Example
Discount Rate
Time
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15

8%
4
$160
200
350
395
432
440
442
444
446
448
450
451
451
452
(2,000)

CF
5
280
280
280
280
280
280
280
280
280
280
280
280
280
280
280

8
($350)
(60)
60
350
700
1,200
2,250

NPV

4
148.15
171.47
277.84
290.34
294.01
277.27
257.90
239.88
223.11
207.51
193.00
179.10
165.83
153.89
-630.48
2448.82
448.82

PVCF
5
259.26
240.05
222.27
205.81
190.56
176.45
163.38
151.28
140.07
129.69
120.09
111.19
102.96
95.33
88.27
2396.65

tPVCF
8
4
5
8
-324.07
148
259
-350
-51.44
343
480
-120
47.63
834
667
180
257.26
1161
823
1400
476.41
1470
953
3500
756.20
1664
1059
7200
1312.85
1805
1144
15750
1919
1210
2008
1261
2075
1297
2123
1321
2149
1334
2156
1338
2154
1335
-9457
1324
2474.84 12552.27 15804.64 27560.00
Duration
5.13
6.59
11.14
396.65
474.84
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