CAPITAL BUDGETING UNDER

RISK AND UNCERTAINTY

LEARNING OBJECTIVES:
•Evaluate investment projects using “Certainty Equivalent” method;
•Carry out sensitivity projects analysis of a project’s outcomes;
•Calculate the Expected Net Present Value (ENPV) of projects;
•Draw decision trees with a view to solving future alternative sequential
problem; and
• Discuss and state the qualitative factors affecting capital investment
decisions.
 TECHNIQUES
 Payback period
 Finite Horizon
 Certainty Equivalent
 Risk Adjusted Discount Rate
 Sensitivity Analysis and Simulation
 Expected NPV
 Standard Deviation and Variance
 Co-efficient of Variation
 Decision Tree
PAYBACK PERIOD
 In the payback period method, the shorter the
time required to return the project’s initial outlay,
the better. In its simplest form, the payback
method completely ignores returns after the
payback, the distribution of return within the
payback period, and discount rates. The payback
period method is based on the rationalisation of
“the sooner, the surer”and focuses attention on
the near future, thereby emphasising the liquidity
of the firm through the early recovery of capital.
FINITE HORIZON
 In the finite horizon method, returns
beyond a particular date are ignored, while
returns within a certain period are
subjected to analysis. The longer the
horizon the less this will matter and the
nearer the method becomes a straight
forward discounting cash flow method.
ASSUMPTIONS FOR USING THIS
METHOD
 Cash flows of future years for conventional projects
would normally be the net cash inflows.
 The inability to forecast cash flows of distant future
years is unavoidable.
 The present values of distant future cash flows will
be significant and immaterial since they will tend to
zero. For example, a project with a ten year life
span may be evaluated with cash flows of only the
first five years.
CERTAINTY EQUIVALENT
 Under the certainty equivalent method, a
risk adjusted factor known as crtainty
equivalent to co-efficient is used to adjust
for the risk effect in the project’s cash flow.
Multiplying a period’s cash flow with the
co-efficient produces the certainty
equivalent cash flow which is discounted to
appraise the project.
Example:
 A project costs ₱70,000 and it has cash
flow of ₱50,000 and ₱35,000 in years 1 to
3. assume the certainty equivalent co-
efficient are estimated to be 1.00, 0.85, 0.75
and 0.6 for years 0-3, respectively, and the
risk-free discount rate is 10%. Calculate the
net present value.
 The sales price should not fall by more than 2.6%
of ₱29.22k, otherwise the project will not be
viable.

NPV of NCF
PV of Variable Cost 100%
PV of variable cost
Yrs Variable Cost DCF@10% PV of Variable Contribution
1 80,000 0.909 72,720
2 120,000 0.826 99,120
3 60,000 0.751 45,060
216,900
 ₱8,450.00
100%
 ₱216,000

 3.9%

For the project to remain viable, the unit cost of the

product should not fall by more than 3.9%. The
variable cost should not be less than ₱19.22(₱20
less 78k) per unit.
(c) Sales of Volume

NPV of NCF 100%

PV of Variable Cost

PV of variable cost
Yrs Variable Cost DCF@10% PV of Variable
Contribution
1 80,000 0.909 72,720
2 120,000 0.826 99,120
3 60,000 0.751 45,060
216,900
 ₱ 8,450
 ₱108,450 100%


 = 7.79%
 The sales volume of the product should
not be reduced by more than 7.79% every
year for the project to be worthwhile.
(d) Initial outlay:
 For the project to be viable, the initial
outlay of the project should not increase
by more than 8.45%.
Expected NPV
 This is based on the principle of expected
value. Once probabilities are assigned to
future outcomes of net cash flow for a
period, the expected value would be
calculated and discounted. The expected
NPV arithmetically takes account of the
expected variability of two or more possible
outcomes by averaging possible outcomes
weighted by their respective possibilities.
 Example:
 For example, a project runs for three years with
the following distribution of returns in each
year, viz;
 Year 1 Year 2 Year 3
 Return Probability
 The project will cost the company P42
million to establish. Calculate the
expected NPV if the discount rate is 10%.
Standard Deviation and Variance
 Standard deviation is an absolute measure
of risk. It measure the dispersion of the
cashflow and spread about the mean
value. The Standard Deviation NPV