it is the planning process used to
determine whether an organization's long
term investments such as new machinery,
replacement machinery, new plants, new
products, and research development projects
are worth the funding of cash through the firm's
capitalization structure (debt, equity or retained
The potential that a chosen action or activity
(including the choice of inaction) will lead to a
loss (an undesirable outcome).
BEHAVIORAL APPROACHES FOR DEALING WITH
International Risk Considerations
Sensitivity analysis is the way of analyzing
change in the project’s NPV or IRR for a given
change in one of the variable. It indicates how
sensitive a project’s NPV and IRR is to change
in the particular variables.
The more sensitive is the NPV, the more critical is
THREE STEP IN THE SENSITIVITY ANALYSIS
Identification of all those variables, which have an
influence on project’s NPV or IRR
Definition of the underlying quantitative relationship
between the variables
Analysis of the impact of the change in each of the
variables on the project’s NPV
Simulation is a statistically based behavioral
approach that applies predetermined probability
distributions and random numbers to estimate risky
By tying the various cash flow components together
in a mathematical model and repeating the process,
the financial manager can develop a probability
distribution of projected returns
STEPS IN SIMULATION
Define the problem precisely
Introduce the variables associated with the
Construct a numerical model
Set up possible course of action for testing
Run the experiment
Consider the result and the possibilities to modify
the model or change data in puts
Decide what course of action to take
INTERNATIONAL RISK CONSIDERATIONS
Political risk is much more difficult to protect
Therefore, it is important for managers to account
for this risk before making an investment by
adjusting project cash inflows or using risk-adjusted
Other considerations in international capital
budgeting include taxes and transfer pricing.
Finally, it is important that firms view international
investments from a strategic view, rather than from
a strictly financial perspective.
CONVENTIONAL TECHNIQUES TO HANDLE RISK
There are mainly three popular conventional
techniques they are
Pay back technique
Risk adjusted discount rate
PAY BACK TECHNIQUE
Payback is one of the oldest and most
common procedures used and the explicit
recognition of risk in the project with an
investment. This method, applied in practice, as is
an attempt to measure the risk assessment in
investment decision as a possible method
The payback method is the amount of time
required for a firm to recover its initial investment in
a project, as calculated from cash inflows.
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.
PAYBACK PERIOD: PROS AND CONS OF
The payback method is widely used by large firms to evaluate small
projects and by small firms to evaluate most projects.
Its popularity results from its computational simplicity and intuitive
By measuring how quickly the firm recovers its initial investment,
the payback period also gives implicit consideration to the timing of
cash flows and therefore to the time value of money.
Because it can be viewed as a measure of risk exposure, many firms
use the payback period as a decision criterion or as a supplement to
other decision techniques.
The major weakness of the payback period is that the
appropriate payback period is merely a subjectively
It cannot be specified in light of the wealth maximization
goal because it is not based on discounting cash flows to
determine whether they add to the firm’s value.
A second weakness is that this approach fails to take fully into
account the time factor in the value of money.
A third weakness of payback is its failure to recognize cash
flows that occur after the payback period.
RISK ADJUSTED DISCOUNT RATE
An estimation of the present value of cash for high
risk investments is known as risk-adjusted
The risk adjusted discount rate approaches
attempts to handle the problem of risk and
uncertainty in a more direct and thoughtful way. As
we know investors are risk averse and so requires
a reward for under taking a risky investment, the
greater must be its expected return.
The Greater The Project Perceived Level Of
Risk, The Greater Is The Risk Premium
Risk adjusted discount rate = risk free rate +
ADVANTAGES AND DISADVANTAGES OF RISK ADJUSTED
There is no easy way deriving a risk adjusted discount
rate. Capital asset pricing model provides a basis of
calculating the risk adjusted discount rate. Its use has
yet to pick up in practice.
It does not make any risk adjusted in the numerator for
the cash flows that are forecast over the future years.
It is simple and can be easily understood.
It has a great deal of intuitive appeal for risk-averse
It incorporates an attitude towards uncertainty.
Under this techniques, the estimated cash flows are
adjusted by using risk free rate to assertain risk free
The expected cash flows of the project are converted in
to equivalent riskless amount
The smaller certainty equivalent will be used in the case
of an expected cash inflows and the larger certainty
equivalent used for payment
For example, if an investor, according to his “best
estimate” expects a cash flow of 60000$ next year, he
will apply an intuitive correction factor and may work
with 40000$ to be on safe side. There is a certainty-
equivalent cash flow.
EVALUATION OF CERTAINTY EQUIVALENT
The certainty equivalent approach explicitly
recognizes risk, but the procedure for reducing the
forecasts of cash flows is implicit and is likely to be
in consistent from one investment to another
DRAW BACKS OF CERTAINTY EQUIVALENT
1. the forecaster, expecting the reduction that will
be made in his forecasts, may inflate them in
anticipation. This will no longer give furcated
according to best estimate.
2. if forecasts have to pass through several layers
of management, the effect may be to greatly
exaggerate the original forecast or to make it ultra
3. by focusing explicit attention only on the gloomy
out comes, chances are increased for passing by
some good investments.
The simple sensitivity analysis assumes that
variable are independent of each other. In reality
the variable will be interrelated and they may
change in combination.
one way to examine the risk on investment is to
analyze the impact of alternative combination of
variable, called scenario analysis.
INFLATION AND CAPITAL BUDGETING.
There are two parameters entering the process of
the cash flows over the life of the project
discount rate .
They need to be consistent.
The problem of consistency of the cash flow and
discount rate may arise from inflation.
COMPARING PROJECTS WITH UNEQUAL LIVES
Many a times firms are required to choose
between two or more alternative technologies to
manufacture the same product.The selection of one
model from the two short listed is a situation that is
analogous to mutually exclusive projects, but these
have different lives.
Making a choice between two technologies is difficult
because the evaluation cannot be compared purely
on the basis of NPV or IRR for the reason that they
have different lives.Here two issues must be
We must reiterate here that normally we are
looking at the most cost effective options in such
evaluation.Therefore the perspective is to select a
technology that has least NPV of costs.
consistent with the going concern concept we
assume that the technology is required indefinitely
irrespective of which one is chosen and
therefore,would need to be replaced at the end of
the useful life.
Real options are the opportunities that are embedded in
capital projects that eneble managers to alter their cash
flows and risks in a way that affect project acceptability
There are 3 types of options
1 .option to delay the project
2. Option to expand the project
3.Option to abandon the project