Capital Budgeting:

Introduction:

According to Charles T Hormgrem

“Capital Budgeting is a long term planning for making and financing proposed capital
outlays.”

According to Pro. I.M. pandey “capital budgeting decision may be defined as the firm’s
decision to invest its current funds most efficiently in long run activities. In anticipation of an
expected flow of future benefits over series of years.

Capital budgeting decisions are essentially long-term investment decisions. They have to be
taken very carefully because once these decisions are taken and implemented they become
very expensive if they are to be reversed. The time factor involved in financial planning is of
fairly distant future and the capital expenditure can be recovered only over a fairly long
period of time. Due to this time element, capital budgeting decisions are subject to greater
degree of risks and uncertainty. The long term investment decisions therefore, must be based
on sound budgeting procedures. The nature of budgeting problem revolves round three basic
questions.

 How much money will be needed for expenditure in the coming period?
 How much money will be available at what cost?
 How should the available money be distributed amongst various projects?
For appraising the profitability of a project following criteria have been proposed:

1. The Payback Period Method

2. The Discounted Present Value Method
3. Internal Rate of Return Method

1. The Payback Period Method:

This is one of the most popular and simplest methods of evaluating investment proposals.
It takes into account the time period required to recover the origin cash outlay invested in
the project.

A Payback Period = Initial Investment Outlay

Annual Cash Flow

 For example If initial investment outlay is Rs 1,00,000/- and cash inflow per year is
Rs 25, 000/- then payback period is 1,00,000 = 4 years
25,000
 From among the several projects the one which has the shortest Payback Period
may be selected.

2. The Net Present Value Method:

In this method the cash flow is discounted and is compared with the present value of
investment outlay. If the entire investment outlay is to be made in the current year.
Present value of investment is equal to actual investment. If the present value of cash
flow of project is greater than the investment the NPV is greater and the project is
accepted. But if the present value of cash flow is less then the investment. The NPV is
negative and the project is rejected.

Discounted factor = 1 n
(1+r)
Net present value = p.v of cash flow – investment

3. Internal Rate of Return Method

Internal rate of return is a percentage discount rate used in capital investment appraisals
which brings the cost of a project and its future cash inflow into equality.
It is the rate of return which equates the present of anticipated net cash flows with the
initial outlay. The IRR is also defined as the rate at which the NPV is ZERO. The rate for
computing IRR depends as bank lending rate or opportunity cost of funds to invest which
is often called as personal discounting rate or accounting rate.
 Investment decision under risk and uncertainty:

Introduction:

This point is discuss the risk and uncertainty associated with the capital budgeting.the
importance of risk in capital budgeting can be overstressed. Profitability and risk are closely
related. Risk and profitability would have bearing on the investor’s perception of the firm before
and after the acceptance of a specific proposal. In acceptance of proposal the firms have more
risk and also have more profitability. This may have adverse implication for the market price of
the shares total value of the firm and his goal.

Definition:

Risk:

As already observed risk analysis should be incorporated in the capital budgeting exercise. in
general other thing being equal. A firm would be well advised to accept a project which is less
risky and reject those that involve mo0re risk. This recommendation is consistent with the
assumption that the management is averse to risk.

Risk is the variability in the actual returns in relation to estimated returns.

That is risk exists when the decision marker is in position to assign probabilities to various
outcomes. This happens when the decision maker has some historical data on the basis of which
he assigns probabilities to other projects of the same type.

Uncertainty:

Uncertainty exists when the decision marker has no historical data from which to develop a
subjective probability distribution and musk make intelligent guesses in order to developed the
subjective probability distribution.
There are two types of analysis of risk.

1. Sensitivity analysis
2. Simulation analysis

1. Sensitivity analysis:
Once measure which express a risk in more precise term is sensitivity analysis. It
provides information as to how Sensitivity the estimated project parameters namely the
expected cash flow the discount rate and project life are estimated errors.
Analysis:
Sensitivity analysis provides different cash flows estimated under three assumptions.
1. The worst (the most pacimistic)
2. The expected( the most likely)
3. The best ( the most optimistic)

2. Simulation analysis
Simulation is a statistically based behavioral approach used in capital budgeting to get a
feel for risk by applying predetermined probability distribution and random number to
estimated risky outcomes.
The advantage of simulation is that it is more comprehensive than Sensitivity analysis
instead of showing the impact on NPV for change in one key variable (change in sale
price or cost of capital ) at a point of time in sensitivity analysis, Simulation enables
distribution of probable value for change in all the key variable on run only.
Risk Evaluation Approaches
Once the nature of Risk is understood and its quantum estimated, it is to be incorporated
within the Decision – Making framework. This section examines the popular techniques
to handle risk.
1. Risk- adjusted Discount Rate approach
2. Certainty-Equivalent Approach
3. Probability Distribution Approach
4. Decision-tree Approach

1. Risk Adjusted Discount Rate approach

It is a method to incorporate Risk in the Rate employed in computing the Present

Value.

This approach is one of the simplest and the most widely use method for
incorporating risk in to the Capital Budgeting Decision. Under this method, the
amount of risk inherent in a project is incorporated in the discount Rate employed in
the present value calculation.

Risky Project would have high discount rate and safer project would have lower
discount Rate.

2. Certainty equivalents
The Certainty equivalents are risk adjusted factors that represent the percent of
estimated cash inflow that investors would be satisfied to receive for certain rather
than the cash inflows that are possible/uncertain for each year.
Investment decision are associated with risk as the future returns are uncertain in the
sense that the actual returns are likely to vary from the estimates.

3. Probability Distribution Approach

 The probability distribution of cash flows over time provides valuable information
about the expected value of return and dispersion of the probability distribution of
possible returns.
The application of this theory in analyzing risk in capital budgeting depends upon the
behavioural of the cash flows from the point of view of behavioural cash flows being.
 Independent
 Dependent

 Independent cash flow:

Independent cash flow is cash flows not affected by cash flows in the preceding or
following year.
 Dependent cash flow:
Dependent cash flow are cash flow in period depend upon the cash flows in the
preceding period.

4. Decision tree approach:

Decision tree is a pictorial representation in tree from which indicates the magnitude,
probability and inter relationship of all possible outcomes
Decision tree approach is another useful alternative for evaluating risky investment
proposals. The outstanding features of this method are that it takes into account the
impact of all probabilistic estimates of potential outcomes.
 CASE STUDY OF PELLON COMPANY LIMITED

During Union negotiation this year, the pellon Company Ltd management realized that it must
offer its employees retirement benefit. The company is considering offering one of the following:

Plan A: An increase in the amount of the company’s share of the annual contribution to the
funded pension plan now in existence.

Plan B: Elimination of the existing pension plan and its replacement by a new plan calling for
variable payback where the amount of the company’s payment would depend upon the level of
profits for the year.

The actual cashflow of the pension plan to pellon would depend upon many factors, such as age
of employees, number of years they have been with the company, and employee’s current
earnings. However, the prime causes of uncertainty for the new retirement offers are that since
employees are given options as to the extent to which they wish to participate in the pension
plan, their individual decision would determine the amount of employer’s contribution under
plan A. This uncertainty would, however, be resolved in the first year of the new plan. For plan
B, the level of future profits would be the main consideration. However, the success or failure of
a new product line to be introduced in the last part of the coming year would greatly reduce the
uncertainity.

The management of Pellon Company Limited wish to make a Two-year cost comparison for the
two plans, and has, therefore, made the following cashflow and probability estimates:
Project A Project B

Probability Second YearYear

First
Cashflow
0.1 Rs.600,000
0.3 Rs.7,50,000
0.6 Rs.9,00,000
Probability
0.2 Rs.5,00,000
0.5 Rs.7,50,000
0.3 Rs.10,00,000

In the second year for Plan A, uncertainty is negligible, since all employees would have
selected their participation in the programme. The management estimates the second year
cash flow of Plan A to be Rs.6,00,000 greater than its first year cash flow.

First Year Cash flow Probability Second Year cash flow

( 1 ) Rs.5,00,000 0.60 Rs.5,00,000
Rs.5,00,000 0.40 Rs.7,50,000
( 2 ) Rs.7,50,000 0.50 Rs.8,50,000
Rs.7,50,000 0.50 Rs.10,50,000
( 3 ) Rs.10,00,000 0.40 Rs.11,00,000
Rs.10,00,000 0.60 Rs.13,00,000

( a ) Construct a decision tree for management to use in evaluating the two plans.
Assuming that all cashflow are incurred at the end of the year for they apply and that 10
percent discount ( Risk Free )Rate is appropriate, compute the PV of costs for each plan
at each branch terminal of tree. Also, find the expected PV of costs for each project as a
weighted average of these terminal PVs.

( b ) Which project is more risky?

( c ) Which plan should the firm offer to the union?

Decision tree approach: ( amount in Rs lakh)

 NPV at 10% Joint Expected

Probability 1st year 2nd year path rate of Discount Probability NPV

0.1 6.0 1 112.0 1 15.35 0.1 1.53

0.3 1
7.5 13.5
2 17.9 0.3 5.37

0.6 9.0 1 15.0 3 20.57 0.6 12.34

19.24
Decision
point
5.0
0.6 4 8.63 0.12 1.04

0.2 5.0

7.5
0.4 5 10.69 0.08 0.86

0.5 8.5 6 13.82 0.25 3.45

0.5 7.5

10.5
0.5 7 15.06 0.25 3.76

0.4 11.00 8 18.17 0.12 2.18

0.3 10.0
13.00
0.6 9 19.82 0.18 3.56

14.85
Determination of the value of coefficient of variation. (Amount in Rs lakh)

Plan A: Plan B:

NPV(Rs in Probability Expected

Lakh) NPV
15.35 0.1 1.53
17.9 0.3 5.37
20.57 0.6 12.34
NPV 19.24
NPV(Rs in
Lakh)
8.63 0.12 1.04
10.69 0.08 0.86
13.82 0.25 3.45
15.06 0.25 3.76
18.17 0.12 2.18
19.82 0.18 3.56
NPV 14.85

As such the plan A is more risky and more return.

Determination of standard deviation about the expected NPV: ( amount in Rs lakh)

Project A:

NPVi NPV NPV-NPV 2 Pi 2

(NPV-NPV) (NPV-NPV)* Pi
15.35 19.24 3.89 15.13 0.1 1.51
17.9 19.24 1.34 1.80 0.3 0.54
20.57 19.24 1.33 1.77 0.6 1.06
3.11
Coefficient of variation = 3.11 = 1.26

VB = standard deviation
Expected net present value

= 1.76 = 0.091
19.24

Project B: (amount in Rs lakh)

NPVi NPV NPV-NPV 2 Pi 2

(NPV-NPV) (NPV-NPV)* Pi
8.63 14.85 6.22 38.69 .12 4.64
10.69 14.85 4.16 17.31 0.08 1.38
13.82 14.85 1.03 1.06 0.25 0.26
15.06 14.85 -0.21 0.04 0.25 0.01
18.17 14.85 -3.32 11.02 0.12 1.32
19.82 14.85 -4.97 24.70 0.18 4.45
12.08

Coefficient of variation = 12.08 = 3.47

VB = standard deviation = 3.47 = 0.233

Expected net present value 14.85