CAPITAL BUDGETING DECISIONS WITH

UNCERTAIN CASH FLOW

It

is generally assumed that all the future cash flows are known with certainty, but future cash flows are often uncertain or difficult to estimate. number of techniques are available for handling this complication much of them are too technical involving computer simulations and advanced mathematical skills

EXAMPLE

:1

Consider the case of investments in automated equipment. Suppose: discount rate = 12% no. of years =10 and the discounted cash flow analysis of the tangible costs and benefits shows a negative net present value of $226,000. In this case, the amount of additional cash flow needed to make the project financially attractive can be computed as follows:

Net present value excluding the intangible benefits

$(226,0 00)

Present value factor for an annuity at 12% for 10 years

( Future Value and Present Value) 5.650

Negative net present value = $226,000 / Present value factor (5.650) = $40,000

INTERPRETATION :
Thus,

if the intangible benefits worth at least $40,000 a year then the company should purchase automated equipment.

If

in the judgment of management, these intangible benefits are not worth $40,000 a year, then the automated equipment should not be purchased.

EXAMPLE : 2
Condition : When salvage value is difficult to estimate. suppose that all of the cash flows from an investment in a supertanker have been estimated (other than its salvage value ). no. of years= 20 discount rate=12%, and the net present value of cash flows is negative $1.04 million. How large should be the salvage value to make this investment attractive?

Net present value excluding salvage value (negative)

$(1,040,000)

Present value factor for an annuity at 12% for 20

years Future Value and Present Value Tables

0.104

Negative net present value = $1,040,000 / Present value factor (0.104) = $10,000,000

INTERPRETATION
Thus,

if the salvage value of the tanker is at least $10 million, the net present value would be positive and the investment should be made.

However,

if management believes that the salvage value is unlikely to be as large as $10 million, the investment should not be made.

RANKING INVESTMENT PROJECTS

While considering investment opportunities, managers make two types of decisions : screening decisions and preference decisions.

Screening decisions:
Screening decisions are taken while deciding whether a proposed project meets some preset standard of
acceptance. For example, a firm may have a policy of accepting projects only if they promise a return of, say, 20% on the investment. The required rate of return is the minimum rate of return a project must yield to be acceptable.

Preference decisions:
Preference decisions are taken while selecting a course of action from among several competing courses of action. For example, a firm may be considering several different machines to replace an existing machine on the assembly line. The choice of which machine to purchase is a preference decisions. Preference decisions are more difficult to make than screening decisions because investment funds are usually limited. Internal rate of return method or the net present value method can be used in making preference decisions. However, if the two methods are in conflict, it is best to use the net present value method, which is more reliable.

EXAMPLE
Assume that a company is considering two competing investments, as shown below:

INTERPRETATION
Each

project has a net present value of $1,000, but the projects are not equally desirable. When funds are limited, the project requiring an investment of only $5,000 is much more desirable than the project requiring an investment of $80,000. To compare the two projects on a valid basis, the present value of the cash inflows should be divided by the investment required, the result is called the profitability index.