Capital Budgeting: Final Paper 2: Strategic Financial Management, Chapter 2: Capital Budgeting, Part 2
Capital Budgeting: Final Paper 2: Strategic Financial Management, Chapter 2: Capital Budgeting, Part 2
Capital Budgeting: Final Paper 2: Strategic Financial Management, Chapter 2: Capital Budgeting, Part 2
Calculation of NPV
2
Capital Budgeting Under Risk and
Uncertainty
3
Methods of Incorporating Risk:
Risk in capital
Budgeting
4
1.Risk Adjusted Discount Rate
• The use of risk adjusted discount rate is based on the concept that
investors demands higher returns from the risky projects.
1
• The required rate of return on any investment should include
compensation for delaying consumption equal to risk free rate of
2 return, plus compensation for any kind of risk taken on.
5
Contd.
Risk Adjusted Discount Rate for Project 'k' is given by
rk = i + n + dk
Where,
If the project's risk adjusted discount rate (rk) is specified, the project is accepted if N.P.V. is positive.
N.P.V. = ∑At / (1 + rk)t – Initial Investment
t= Year 1 to Year k
6
Illustration I
A company engaged in manufacturing of toys is considering a line of stationary items
with an expected life of five years.
The company’s management is of view that normally required rate of return of 10% will
not be sufficient and hence 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.
7
Solution I:
PART I
= 30,00,000 x 3.352
= 1,00,56,000
= 1,00,56,000 - 1,10,00,000
= - 9,44,000
8
Solution - 2
PART II
9
Illustration I
A pencil manufacturing company is considering the introduction of a line of gel pen with an expected life of five 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 opinion that the normal required rate of return for the company of 12% is not sufficient.
Therefore, the minimum acceptable rate of return of this project should be 18%.
The initial outlay of the project is Rs10,00,000 and the expected free cash flows from the projects are given below:
= (-) 1,29,442
Firms used different discount rate related to risk factor for different
types of investment projects. Discount rate is low for routine
replacement investments, moderate for expansion investments and
high for new investments.
11
Illustration II:
Determine the risk adjusted net present value of the following projects:
X Y Z
Net cash outlays (Rs) 2,10,000 1,20,000 1,00,000
Project life 5 years 5 years 5 years
Annual Cash inflow (Rs) 70,000 42,000 30,000
Coefficient of variation 1.2 0.8 0.4
The Company selects the risk-adjusted rate of discount on the basis of the coefficient of variation:
12
Solution II:
13
Illustration III:
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 15,00,000 11,00,000 19,00,000
Inflows – 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
Minimum required rate of return of the firm is 15% and applicable tax rate is 40%.
The risk free interest rate is 10%.
Required:
(i) Find out the risk-adjusted discount rate (RADR) for these projects.
(ii) Which project is the best?
14
Solution III:
(i) The risk free rate of interest and risk factor for each of the projects are given. The risk adjusted discount rate
(RADR) for different projects can be found on the basis of CAPM as follows:
(ii) The three projects can now be evaluated at 19%, 15% and 13% discount rate as follows:
Project P-I
Contd..
15
Solution: III Contd.
Project P-II
Contd..
16
Solution: III Contd.
Project P-III
17
Limitations
18
2.Certainty Equivalent Approach
• Allows the decision maker to incorporate his or her utility function into the
analysis
1
• Set of risk less cash flow is generated in place of the original cash
flows.
2
• Certainty Equivalent Coefficients transform expected values of uncertain
flows into their Certainty Equivalents. It is important to note that the value
3 of Certainty Equivalent Coefficient lies between 0.5 & 1. .
19
Steps in the Certainty Equivalent
(CE) approach
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 α t value (CE coefficient)
NPV = n
21
Illustration IV:
Investment Proposal – 45,00,000
22
Solution IV:
N. P. V.
=
10,00,000(0.90)/(1.05) +
15,00,000(0.85)/(1.05)2 +
20,00,000(0.82)/(1.05)3 +
25,00,000(0.78) / (1.05)4-
45,00,000
= 5,34,570
23
Illustration V:
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:
24
Solution V:
Determination of NPV :
25
Lesson Summary
26
Thank You