capital budgetting 2

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PRESENTATION TO

FIN 6000 CLASS -SUMMER 2012

INSTRUCTOR: Prof. F.M. Gatumo

2012 F.M. Gatumo FIN 6000 Summer 2012


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PERSONAL BANKING PRODUCTS

CAPITALBUDGETING

PRESENTATION FOCUS



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CAPITAL BUDGETING TECHNIQUES UNDER RISK

At the end of this chapter, the student should beable to:define business risksClassify the various types of risks inherent in a

businessCompute the expected returns of a business inpercentages and absolute terms( E(Ra)

Compute the risk of a business using the standarddeviation as a measure( a) Compute the coefficient of variation

2012 F.M. Gatumo FIN 6000-Summer 2012


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PREAMBLE

An investment is an outlay of massive amount of funds withexpectation of cash inflows that exceed the cash outflows. Theevent sacrifices current consumption with the hope ofimproving future consumption.

Investments are expected to address the constraints that anorganization faces in the market place. Investments must beundertaken to ensure that the existing organizational strengthsare reinforced, weaknesses are minimized through increasedinvestment, investments are made towards the organizationsopportunities and that investments must be made to shield theorganization from perceived threats



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strengths weaknesses opportunities threats

Invest(growthcompanies,

large marketshare,competitiveadvantages

Invest tominimizeweaknesses

through theoryon constraints(COT)

Invest(targeted investment)

Invest (shieldand hedgeand

overcome) OR DIVEST


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In line with the Boston Consulting Group (BCG), a companywill invest in the STARS, STAGS and DIVEST in the DOGS andMILK DRY in the CASH COWS

Market Share

H L

H Growth

L


Stars Stags

Cash Cows Dogs


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Asnoff diversification model does offer us a logicalpattern of a companys growth

New markets Old markets


New products Diversification Product diversification

Old products Old products Penetration


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2012 F.M. Gatumu FIN 6000 Summer 2012

In the above model, investments will be in the diversification

where investment will be in new products (new plant andmachinery) and investment in developing new lines ofdistribution.In the case of the market diversification and the productdiversification the organization must invest into new productplant and machinery or retool the existing machinery and ordevelop new markets by creating new lines of distributionInvestments are undertaken in the midst of numerous risksThese risks are business risk, financial risk, default risk,cash flow risk, credit risk, inflation risk, interest rate risk andexchange rate risk, to name but a few.


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These risks are caused by changes in the market place thatimpact the projected cash inflows of a business ororganization. These changes are caused by:market changes- changes in the customer consumptionpattern, lifestyles, fashion changescompetition many manufacturers and suppliers ofsubstitutes at very attractive prices and diversified productschanging macroeconomic variables that cause the marketsrisks( systematic risks) and the extent to which the publicsector build public governance structureschanges in the organization( governance structures) and itsmicroeconomic variables



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1 Presumption of Risk All investments presume some degree of risk. The types of risk

are twofold:Systematic. These are risks that are externally driven. They arecaused by misalignment of macroeconomic variables. Themacroeconomic variables referred to are:

Interest rates, inflation rates, exchange rates, fiscal andmonetary policies, the balance of trade and balance ofpayments, the GDP, the savings and investment levels, thesocial capital formation and the politics.

These risks are addressed through good Public governance



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Presumption of Risk Cont

Unsystematic; these are a series of risks that arecaused by poor corporate governance. It resultsfrom failure of a company to address key aspects ofits existence. Lack of shared values, structures,systems, and leadership and communication

systems will cause a company to embrace very largespreads in its predicted cash flows and its attainedcash flows.

A corporation can minimize the unsystematic risksby proactively creating and nurturing goodcorporate governance structures.

The normal curve aids in demonstrating theconcept of risk or spread or volatility



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+-1 ---------68%+-2 ---------95%+-3 ---------99%


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The study provides a series of parameters thatinvestors must compute and apply in arriving atoptimal investment decisions. The parameters to becomputed are:

Expected returns ( pi Ri)Total risk = square root ( pi)( Ri-E(Ri) 2 Coefficient of variation / E( Ri)Covariance A and B( COV AB)Rho (AB)



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Beta( A) = Market risk E(Rp)= wiE(Ri) PAB= square root x 22 + (1-x) 22 +2x(1-

x)x(1 -x) where x refers to investment A while 1-x refer to investment B

Coefficient of variation of portfolio



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3. A successful investment is undertaken underinterdisciplinary team that examines all aspects ofthe investment so as to assure success of theinvestments.

The staticians and the marketers will examine thepotential states of the world and ascertain thepossible probabilities of occurrence of net cashflows and the possible % returns.. The process is

eclectic in nature. This is the process used by theactuarial scientists to arrive at the states of theworld and the occurrences of an event.



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The use of the capital budgeting techniques underrisk provides the investor a broader view ofinvestments and enables the investor to hedgeagainst potential risks whether they are systematic

or unsystematic.The investor, through the use of capital budgetingtechniques under risk is able to classify risks into:

Systematic Unsystematic risks



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The unsystematic risk can be diversified away through

diversification of investments. The investor require to monitorthe Rho(P).If an investor has up to 15 investments, it can beshown that the unsystematic risks will be zero.The total variance of an investment is established from

2 ARrm2+ E2

The last component comprise of the error term .WilliamSharpe has shown that when a security is properly diversified,the error term is zero.It is important for the investor to compute the parametersthat will provide him/her with the discounting rates. Theserates must be the same as the expected returns of theinvestments. These are measures of marginal returns.



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Example 1.

Suppose investment in A promises a return of 10%, and

probability is 40%, while second promise of 20% has aprobability of 60%.Establish the various investment parameters.


Pi Ri Pi*Ri

0.4 0.1 0.04

0.6 0.2 0.12

E(RA) 0.16


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Example 2.

Suppose Alex invests in project B. Suppose also Alex is 30%

sure of obtaining net cash flows of ksh 1,000 and is 70% sure ofreceiving net cash flows of ksh 500.

Compute his expected returns in absolute terms

Note the investor has only one parameter to assist him/hermake the investment decision.


Pi Rb Pi*Rb

0.3 1000 300

0.7 500 350

Expected re turn KES 650


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Example 1 Using the above examples we can compute the relevant

risk of the in vestments.


Pi Ri E(Ri) Ri-E(Ri) (Ri-E(Ri))2 Pi(Ri-e(Ri))2

0.4 0.1 0.16 0.06 0.0036 0.00144

0.6 0.2 0.16 0.04 0.0016 0.00096

Variance 0.00240

Risk 0.049

A 4.9%


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Example 2

Pi Rb E(Rb) Rb-E(Rb) ( Rb-E(Rb)) 2 Pi(Rb-E(Rb)) 2

0.3 1000 650 350 122500 36750

0.7 500 650 -150 22500 15750

Variance of B 52500

Risk of B 229



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Example 3

Coefficient of variation

A 4.9/0.16=0.31

B 229/650=0.35

Investments are selected on the basis of coefficient of

variation. The less the better for an investment.

The use of the risk can be assessed from the statisticalmeasurement variables as shown below.



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NORMAL DISTRIBUTION IN AN INVESTMENT

VALUE AT RISK- VAR OF AN INVESTMENTZ (90%) -------1.645

Z (95%) -------1.960

Z (98%) ------ 2.330

Z (99%) -------2.576



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END

THANK YOU !!

2012 FM G t FIN 6000 S 2012

capital budgetting 2

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