Advanced Capital Budgeting

Contents - Re-visit the basics

Compare various project evaluation methods

Unequal project lives

Capital Rationing

Capital budgeting during Inflationary conditions

Evaluation techniques under Risk & Uncertainty

Capital Budgeting ??• Capital Budgeting refers long term planning of capital expenditure.

• Heavy funds outlay, hence very risky decisions.

• Benefits of project are spread over several time periods in the

future.

• Cost-benefit analysis for profit maximization, (↑ risk, ↑ return)

• Decisions involve extensive estimations and future predictions.

• Long term commitment of funds under uncertain future conditions.

Critical Evaluation – Why ?? Very high initial investments

Effect of decisions are known only in the future

Decisions are irreversible, so acceptance of project very critical

Quantification of future events and cash flows complicated.

There are too many known / unknown factors which influence

the project. Hence, every cash flow is only a probable figure.

Consideration of risk and uncertainty is highly necessary.

Evaluation Methods Payback Period

Discounted Payback

Accounting Rate of Return (ARR)

Net Present Value (NPV)

Profitability Index (PI)

Internal Rate of Return (IRR)

Comparison of Appraisal Methods

NPV vs. PI – Both methods use the concept of time value of money. For given project, NPV and PI would give the same result,

i.e. Accept or Reject. However, in case of mutually exclusive projects NPV

method should be preferred. NPV indicates the economic contribution or surplus of the

project in absolute terms. Higher the NPV, better the project.

Comparison of Appraisal Methods

NPV vs. IRR – Both methods use the concept of time value of money. However, for certain situations both methods may give

conflicting results (w.r.t. accept / reject) Conflict arises in projects where cash outflows arise at different

pts. of time and huge differences between initial CFAT and later years CFAT.

Under situations of variance, NPV method should be adopted since it is directly linked to the wealth maximization principle.

Also, it is presumed that cash inflows are re-invested at the rate of IRR, while NPV method, re-investment is at the cut-off rate. Re-investment at the cut-off rate is more realistic / practical than re-investment at IRR rate.

Unequal Projects Lives In case of mutually exclusive projects, NPV is a correct method.

But, for projects with unequal lives, NPV may give incorrect results.

Hence, for comparison purposes, it is important to bring the projects at a same footing.

Therefore, Annual Equivalent Value (AEV) is computed by dividing the NPV by the PV Annuity factor over the project life.

The AEVs are compared and decision taken for selection of project.

AEV = NPV

PV Annuity Factor (r, n)

Capital Rationing Firms normally have fix annual budget for Capex. (max amt.)

Firms select a combination of projects within the budget to

maximize the profitability.

Such type of selection process is known as Capital Rationing.

Capital Rationing may be due to external and/ or internal constraints.

External factors include imperfections in capital market, such as lack

of market information, non-availability of easy funds etc.

Internal capital rationing consists of self-imposed restrictions by the

management, e.g. no borrowing policy, min. expected rate of return.

Capital Rationing (contd.)

Projects with positive NPV be selected to max. shareholders’ wealth.

Under capital rationing, there are two major decisions faced by the

management – maximize returns and / or full utilization of funds.

Thus, less profitable projects may be selected to utilize total funds or

major funds be remain unutilized in order to maintain high profits.

For capital rationing, PI should also be used along with NPV. Also,

capital rationing can be solved using linear programming (simplex).

Nature of project Indivisible Divisible

Meaning Investment made in full, no partial/ proportionate invt.

Partial invt. is possible and NPV calculated

Steps involved in decision making

Combination of projects to utilize max funds. Select max NPV projects.

Compute PI of projects and rank them. Select projects with max PI.

Inflation & Capital Budgeting

$ Inflation results in erosion of value of money over a period of time.

$ Since cash inflows of an investment occur over long future periods,

the impact of inflation must be considered during project evaluation.

$ Generally, managers think that inflation can be offset by increasing

the selling prices of its commodities.

$ The same is not always true, since input costs (being sensitive) rise

at a fast rate, and selling prices are ruled by Competition & Govt.

$ Financial performance are based on financial statements that are

prepared conventionally, based on historical costs.

$ Hence, under inflation financial analysis may be vitiated, and may

result in exaggerating the profit figure. Replacement of depreciated

assets is affected due to historical costs and current funds required.

Inflation (contd.)$ A project is subjected to inflationary pressures from time to time,

ranging from 6 months to more than one or two years.

$ Following guidelines should be used for such project appraisals –

# Make provision for cost escalation, w.r.t. expected inflation rate

# Various sources of finance should be verified for probable revisions in

interest rates by lenders.

# Adjustments should be made in cash flows and profitability projection

# Assess the financial viability of the project at the revised rate and

justify the same for its economic feasibility. The rate of return should

also include the rate of inflation per annum

# Projects with early payback period should be preferred being less

risky i.e. less prone to inflation.

Risk & Uncertainty (contd.)

∞ ↑ Risk ≈ ↑ Returns

∞ Techniques to manage risk –

a) Payback

b) Risk-adjusted discount rate

c) Certainty Equivalent

d) Sensitivity analysis

e) Scenario analysis

f) Decision Tree analysis

g) Cash flow Probability

h) Standard Deviation

i) Simulation model

Techniques of Risk Mgt.A.Payback

• Oldest and commonly used method for recognizing risk associated

with investment projects.

• Payback criteria is primarily used for mitigating risk rather than

measure profitability. Suitable for capital deficiency, cautious mgt. etc

• Firms prefer shorter payback

• Payback ensures liquidity by quick recovery of capital.

• Reduction of risk element by eliminating longer projects.

• Payback only considers risks related to time, but ignores the time

value of money.

Techniques of Risk Mgt.B.Risk-Adjusted Discount Rate

• Expected rate of return consists of a risk-free rate (+) premium for

business risk (+) financial risk.

• Based on the above reasoning, risks related to time preference may

also be added to the risk-free rate.

• Such a composite rate is known as Risk-adjusted Discount Rate,

reflecting the management’s attitude towards risk involved in projects.

• Under this approach, a higher rate of discount is adopted for more

risky projects & lower discount rate for projects considered less risky.

• The approach is simple to understand, recognizes risk and uncertainty.

• However, no concrete way of deriving risk premium, i.e. computation

of the higher rate of discount. No risk adjustment made for cash flows

Techniques of Risk Mgt.C.Certainty Equivalent Approach

• According to Certainty Equivalent approach, adjustments for risk are

made to the cash flows itself, arising in the future.

• Cash flows are reduced to conservative level by applying a correction

factor termed as Certainty Equivalent Co-efficient (CEC).

• This correction factor is the ratio of risk-less (certain) cash flows to

risky cash flows, i.e. CEC = Risk-less cash flows / Risky cash flow

• CEC assumes a value between 0 and 1, and varies inversely with risk.

• CEC are subjectively / objectively established by the decision maker

and multiplied by the cash flows to arrive at adjusted cash flows.

• These adjusted cash flows are further used for project evaluation

through payback, NPV, IRR or any other method.

Techniques of Risk Mgt.C.Certainty Equivalent Approach (contd.)

• The Certainty Equivalent approach explicitly recognizes risk involved

in investment projects.

• However, process of reducing the cash flows is more subjective /

person dependent and can be inconsistent for different projects.

• This approach also suffers from the drawback of prior floating of the

cash flows, before adjusting the same for risk element. Such practices

defeat the whole purpose of certainty equivalent co-efficient.

• Certainty equivalent is a superior approach than risk-adjusted discount

rate method, because it can measure risk more accurately.

• Under risk-adjusted method, more the time - higher risk is associated,

that may not be true. Gestation time is riskier than future stability. In

such situations, CEC is better option than risk-adjusted discount rate.

Techniques of Risk Mgt.D.Sensitivity Analysis

• Sensitivity analysis measures how sensitive / responsive are the estimated parameters (cash flows, discount rate, project life etc.) of a project against the estimation errors / market forces / uncertainty.

• Hence, Sensitivity Analysis is a way of analysing the changes in project’s NPV (or IRR) for a given change in one of the variables. Higher sensitive the NPV, more critical is the variable.

• Three important steps in sensitivity analysis are –

i. Identification of variables having influence on project’s NPV.

ii. Definition of the underlying (mathematical) relationship between the variables.

iii. Analysis of the impact of the change in each of the variable on the project’s NPV. (‘management by exception’)

Techniques of Risk Mgt.D.Sensitivity Analysis

• During sensitivity analysis, the decision maker computes the

project’s NPV (or IRR) under three assumptions – Pessimistic Most Likely Optimistic

• Most important question in sensitivity analysis – “What If ?”

Techniques of Risk Mgt.E.Scenario Analysis

• Simple sensitivity analysis assumes that the variables are

independent.

• However, in practice the variables may be inter-related

• For e.g. increase in sales quantity. reduction in selling

prices, increase in variable costs etc.

• Hence, Scenario Analysis considers impact of alternative

combinations of variables.

Techniques of Risk Mgt.F.Decision Tree Analysis

• During capital budgeting, decision makers have to identify & evaluate

the various alternative courses of action, leading to the final decision.

• However, present investment decisions may have implications on

future decisions, and may affect future events. Hence, a series of

decisions should be judged, ranging from present to the future.

• Decision Tree is an technique to evaluate such sequential decisions.

• When a sequential series of conditional decisions are required to be

taken under uncertainty, a decision tree model facilitates visualization

and evaluation of all possible options for action.

• A decision tree is a graphic display of the relationship between a

present decision vis-à-vis future events, decisions & its consequences.

Techniques of Risk Mgt.F.Decision Tree (contd.)

• Basic steps for decision tree–

o Investment proposal should be defined

o Clearly identify decision alternatives

o Decision tree should be drawn indicating the decision points,

events and other data such as projected cash flows, probabilities.

o Analyse the results and select the best alternative.

• Decision tree clearly brings out the implicit assumptions, calculations

for all to check and revise accordingly.

• Visualization of alternatives in graphic form is easier to comprehend.

• This approach not suited to increased variables, alternatives etc.

Techniques of Risk Mgt.G.Probability of Cash Flows

• The most crucial information for capital budgeting decision is the

forecast of future cash flows.

• However, future is uncertain and hence we need to provide a range of

probabilities associated with the cash flow estimates.

• Probability can be described as a measure of someone’s opinion about

the likelihood of occurrence of an event. (optimist, normal, pessimist)

• Under this approach, probabilities are assigned to future cash flows

and further analysis is carried out for payback, NPV, IRR etc.

• This approach recognizes the risk associated with estimation of future

cash flows and provides for reduction in the same via probabilities.

• But, assigning probabilities is subjective and may lack consistency.

Techniques of Risk Mgt.H.Standard Deviation & Co-efficient of Variation

• Assigning probabilities to cash flows exhibits the risk element in

capital budgeting decisions.

• However, a better approach to risk analysis is to measure the spread /

dispersion of the cash flows, through Standard Deviation or Variance.

• Standard Deviation is the deviation from the mean cash flows. Higher

the std. deviation, higher the risk and vice versa.

• Co-efficient of Variation is a relative measure of risk. It is useful for

comparing projects with same std. deviation but different values or

same values but different std. deviations etc. ↑ CV implies ↑ risk

• Co-efficient of Variation (CV) = Std. deviation

expected value (mean)

• Final selection of project depends on investors’ attitude towards risk.

Techniques of Risk Mgt.I. Simulation Model

• Use of simulation models are an outcome of the deficiency of decision

tree method for managing large quantum of data and alternatives.

• Simulation is a quantitative procedure whereby a series of organized

experiments are conducted to predict the probable outcome of the

given alternatives.

• It implies construction of a model to represent a real-life situation,

which allows substitution of critical variables within the model.

• Simulation makes use of probabilities and random number series to

predict the uncertain events and its influence on the final outcome of

the project.