• All the techniques of capital budgeting require the estimation of future cash inflow and outflows.• The future cash flow are estimated based on the following factors – Expected economic life of the project, salvage value, selling price of the project, capacity of the project, production cost, depreciation cost, rate of taxation and future demand of the product
Methods for measuring risk in capital budgeting• Risk adjusted cut off rate method/varying discount rate method• Certainty equivalent method• Sensitivity technique• Probability technique• Standard deviation method• Co-efficient of variation method• Decision tree analysis
Measurement of risk• Risk adjusted cut off rate/method of varying discount rate: – Projects which are more risky and greater variability in returns should be discounted at higher rate, than with less risky projects with less returns. – Discount rate is the minimum Desired rate of return. it is generally the cost of capital of the firm
• Beta company ltd is considering the purchase of a new investment. Two alternative investments are available (A and B) each costing Rs 100,000. The company has a target return on capital of 10%. Risk premium rates are 2% and 8% respectively for investment A and B. Which invt should be preferred. Cash inflows are expected to be as follows.• Cash flows YR Investment A Investment B 1 40000 50000 2 35000 40000 3 25000 30000 4 20000 30000
Certainty equivalent method• It is to reduce expected cash flow by certain amounts.• It can be employed by multiplying the expected cash flows by certainty equivalent co- efficient as to convert the uncertain cash flows to certain cash flows.
• There are two projects X and Y. Each involves an investment of Rs40000. The expected cash inflows and the certainty coefficients are as under. Risk free cut off rate is 10%. Suggest which of the two projects should be preferred. Project X Project Y Yr Cash Certainty Cash Certainty Inflow coefficient inflow coefficient 1 25000 .8 20000 .9 2 20000 .7 30000 .8 3 20000 .9 20000 .7
Sensitivity technique• When cash inflows are very sensitive under different circumstances, more than one forecast of the future cash inflows can be made.• Inflows may be regarded as “Optimistic, Most likely and Pessimistic”.• The cash inflows may be discounted to find NPV, and if NPV differs widely in three different situation, then there is a great risk in project and the investors decision to accept or reject a project will depend upon his risk bearing abilities.
• Mr.Risky is considering two mutually exclusive projects A and B. You are required to advise him about the acceptability of the projects from the following information. The cut off rate may be assumed to be 15% Project A Project BCost of the investment 50000 50000Forecast cash inflow p.a for5 yr:Optimistic 30000 40000Most likely 20000 20000Pessimistic 15000 5000