Capital Budgeting

CAPITAL BUDGETINGModule: 01

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MEANING

These are the decisions pertain to fixed/long term assets.

Capital budgeting is the process of evaluating and selecting long term investments that are consistent with the goal of the shareholders wealth maximization.

They involve a current outlay or series of outlays of cash resources in return for an anticipated flow of future cash inflows.

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CONTD. Capital expenditure management therefore, includes

additions, disposition, modification and replacement of fixed assets.

The basic features are:

Potentially large anticipated benefits A relatively high degree of risk

And a relatively long time period between the initial outlay and the anticipated returns.

The term capital budgeting is used interchangeably with capital expenditure decision, capital expenditure management, long term investment decision, management of fixed assets etc.

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IN OTHER WORDS Capital budgeting (or investment appraisal) is the

planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, research development projects acquiring a new company

are worth the funding of cash through the firm's capitalization structure (debt, equity or retained earnings).

It is the process of allocating resources for major capital, or investment, expenditures. One of the primary goals of capital budgeting investments is to increase the value of the firm to the shareholders.

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IMPORTANCE OF CAPITAL BUDGETING

These are the strategic investment decisions.

Capital budgeting decisions affect the profitability of a firm.

It have a bearing on the competitive position of the enterprise.

These changes could lead stockholders and creditors to revise their evaluation of the company.

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CONTD.

So, it is rightly said that the future destiny of the company determined on these crucial decisions.

An opportune investment decision can yield spectacular returns.

An ill-advised and incorrect decision can endanger the very survival even of the large firms.

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CONTD.

A few wrong decisions and the firm may be forced into bankruptcy.

Fixed asset employment Maintenance

Capital investment decisions, once made, are not easily reversible.

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DIFFICULTIES

The benefits from investments are received in some future period and the future is uncertain Cash flow estimate for 15 plus years.

Risk of obsolesce.

Risk of change in the customer preferences and tastes.

Difficulty in calculating in strict quantitative terms all the benefits relating to a investment decision.

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RATIONALE

Capital budgeting projects may include a wide variety of different types of investments, including but not limited to, expansion policies, or acquisition of companies.

When no such value can be added through the capital budgeting process and excess cash surplus exists and is not needed, then management is expected to pay out some or all of those surplus earnings in the form of cash dividends or to repurchase the company's stock through a share buyback program.

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CONTD.

These projects must also be financed appropriately.

If no positive NPV projects exist and excess cash surplus is not needed to the firm, then financial theory suggests that management should return some or all of the excess cash to shareholders (i.e., distribution via dividends).

Corporate management seeks to maximize the value of the firm by investing in projects which yield a positive net present value when valued using an appropriate discount rate in consideration of risk.

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TYPES OF CAPITAL BUDGETING DECISIONS

Those which expand revenues Adding additional product lines Expansion of present operations

Those which reduce costs Replacement proposals

- Fundamental difference: Cost reduction investment decisions are

subject to less uncertainty in comparison to the revenue affecting investment decisions.

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KINDS

Accept-reject Decision Mutually Exclusive Project Decisions Capital Rationing Decision

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ACCEPT-REJECT DECISION

It is the evaluation of capital expenditure proposal to determine whether they meet the minimum acceptable criteria.

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MUTUALLY EXCLUSIVE PROJECT DECISIONS

These are the projects that compete with one another; the acceptance of one eliminates the others from further consideration.

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CAPITAL RATIONING DECISION

Capital rationing is the financial situation in which a firm has only fixed amount to allocate among competing capital expenditure.

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EVALUATION TECHNIQUES: Traditional techniques Discounted Cash Flow Technique (DCF)

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TRADITIONAL TECHNIQUE: Average Rate of Return method (ARR) Payback method

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AVERAGE RATE OF RETURN METHOD (ARR)

The ARR method of evaluating proposed capital expenditure is also known as Accounting Rate of Return method.

It is based upon the accounting information rather than cash flows.Formula:

ARR = Average annual profits after taxes / Average investment over the life of the project * 100

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CONTD.

Average PAT = Adding up the after tax profits for each year of project’s life and dividing the result by the number of years.

In the case of annuity, the average after tax profits is equal to any year’ profits.

The average investment = Net working capital + Salvage value + ½ (Initial cost of machine – Salvage value)

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Determine the ARR from the following data of two machines A and B.

ParticularsMachine

AMachine

B

CostRs.

56,125Rs.

56,125

Annual estimated income after depreciation and income tax: Rs. Rs.

Year 1 3,375 11,3752 5,375 9,3753 7,375 7,3754 9,375 5,3755 11,375 3,375

36,875 36,875Estimated life (years) 5 5Estimated salvage value 3,000 3,000

Depreciation has been charged on straight line basis.

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ACCEPT-REJECTION RULE:

As an accept-reject criterion, the actual ARR would be compared with a predetermined or a minimum required rate of return or cut off rate.

A project would qualify to be accepted if the actual ARR is higher than the minimum desired ARR, otherwise; it is liable to be rejected.

Alternatively, the ranking method can be used to select or reject proposals.

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CONTD.

The proposals under consideration may be arranged in the descending order of magnitude, starting with the proposal with the highest ARR and ending with the proposal having the lowest ARR

Obviously, projects having highest ARR would be preferred to the projects with lower ARR.

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EVALUATION OF ARR:

The most favorable attribute of the ARR method is its easy calculation.

What is required is only the figure of accounting profits after taxes which should be easily obtainable.

Moreover, it is simple to understand and use.

The total benefits associated with the project are taken into account while calculating the ARR.

Some methods, pay back for instance, do not use the entire stream of incomes.

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DEFICIENCIES This approach uses accounting income instead of

cash flows as cash flow approach is markedly superior to accounting earnings for project evaluation.

ARR ignores the time value of money. Whereby it treats cash flows of earlier years and later years equally.

The ARR criterion of measuring the worth of investment does not differentiate between the size of the investments required for each project. Competing investment proposals may have the

same ARR, but may require different average investments.

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CONTD. This method does not take into consideration any

benefits which can accrue to the firm from the sale or abandonment of equipment which is replaced by the new investment.

The new investment, from the point of view of correct financial decision making, should be measured in terms of incremental cash outflows due to new investments, that is, new investment minus sale proceeds of the existing equipment +/- tax adjustment.

But ARR method does not make any adjustment in this regard to determine the level of average investments.

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PAY BACK METHOD

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PAY-BACK METHOD (BP)

It is simplest and, perhaps, the most widely employed, quantitative method for appraising capital expenditure decisions.

This method answers the question: How many years will it take for the cash benefits

to pay the original cost of an investment, normally disregarding salvage value.

Cash benefits here represent CFAT ignoring interest payment.

Thus, the pay back method measures the number of years required for the CFAT to pay back the original outlay required in an investment proposal.

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TWO WAYS OF CALCULATING PB

When cash flow stream is in the nature of annuity for each year of the projects, i.e., CFATs are uniform. Formula:

PB= Investment / Constant annual cash flow

Eg:An investment of Rs.40,000 in a machine is expected to produce CFAT is Rs.8,000 for 10 years.

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CONTD.

The second method is used when a project’s cash flows are not uniform (mixed stream), but vary from year to year.

In such situation, PB is calculated by the process of cumulating cash flows till the time when cumulative cash flows become equal to the original investment outlay.

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EG:

Calculate PB from the following data:

Year Annual CFATs A (Rs.) B (Rs.)1 14,000 22,0002 16,000 20,0003 18,000 18,0004 20,000 16,0005 25,000 17,000

Initial outlay is Rs.56,125. CFAT in the fifth year includes Rs.3,000 salvage value as well.

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ACCEPT –REJECTION CRITERION

The payback period can be used as a decision criterion to accept or reject investment proposals.

One application of this technique is to compare the actual pay back with a predetermined pay back. that is, the pay back set up by the management in terms of the maximum period during which the initial investment must be recovered.

If the actual payback period is less than the predetermined pay back, the project would be accepted; if not, it would be rejected.

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CONTD.

The pay back can be used as a ranking method.

When mutually exclusive projects are under consideration they may be ranked according to the length of the payback period.

Thus, the project having the shortest pay back may be assigned rank one, followed in that order so that the reject with the longest payback would be ranked last.

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EVALUATION Its failure lies in the fact that it does not consider the

total benefits accruing from the project.

It does not measure correctly even the cash flows expected to be received within the payback period as it does not differentiate between the projects in terms of the timing or the magnitude of cash flows.

It considers only the recovery period as a whole.

This happens because it does not discount the future cash inflows but rather treats a rupee received in the second or third year as valuable as a rupee received in the first year.

To the extent the payback method fails to consider the pattern of cash flows, it ignores time value of money.

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EG: 2

Particulars Project A Project B

Total cost of the project 15,000 15,000

Cash I/F (CFATs)

Year 1 10,000 4,000

2 4,000 10,000

3 1,000 1,000

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CONTD.

Another flaw of the pay back method is that it does not take into consideration the entire life of the project during which cash flows are generated.

As a result, projects with large cash inflows in the later part of their lives may be rejected in favor of less profitable projects which happen to generate a larger proportion of their cash inflows in the earlier part of their lives.

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EG:Particulars Project A Project B

Total cost of the project 40,000 40,000Cash I/F (CFATs)

Year 1 14,000 10,0002 16,000 10,0003 10,000 10,0004 4,000 10,0005 2,000 12,0006 1,000 16,0007 Nil 17,000

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CONTD.

In a politically unstable country, for instance, a quick return to recover the investment is the primary goal, and subsequent profits are almost unexpected surprises.

After going through all these examples, we can conclude that the PB method should more appropriately be treated as a constraint to be satisfied than as a profitability measure to be maximized.

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DCF/ TIME-ADJUSTED TECHNIQUES

These techniques take into consideration of the time value of money.

There is a discount rate at which the project future cash inflows are discounted back..

They take into account all benefits and costs occurring during the entire life of the project.

The techniques are: NPV IRR MIRR Terminal Value method Profitability Index (PI)

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CONTD.

DCF techniques recognizes that cash flow streams at different time periods differ in value and can be compared only when they are expressed in terms of a common denominator, that is, present values.

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NET PRESENT VALUE (NPV)

NPV is found by subtracting a projects initial investment from the present value of its cash inflows discounted at the firm's cost of capital.

Symbolically:

COo = Cash outflow at t=0

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CONTD.

If cash outflows is also expected to occur at some time other than at initial investment:

Symbolically:

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JSW Steels is considering an investment proposal to instal an equipment for its one of the plants at a cost of Rs.30,00,000.

The facility has life expectancy of 6 years and no salvage value. The tax rate is 35%. Assume the firm uses straight line depreciation

and same is allowed for tax purposes. The estimated cash flows before depreciation and tax (CFBT) from the investment is as follows:

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COMPUTE NPV AT 12%

Year CFBT1 6450002 6680003 7680004 8400005 3230006 634000

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Problems

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DECISION RULE

If NPV is > Zero Accept the project

If NPV is < Zero Reject the project.

Zero NPV implies that the firm is indifferent to accepting or rejecting the project.. However, in practice it is rare if ever such a project will be accepted..!!

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CASH FLOWS IN REPLACEMENT SITUATION Cash outflows in a Replacement Situation:

Depreciation base of new machine in Replacement Situation:

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CONTD.

Base for incremental Depreciation:

Depreciation base of new machine xxxxxLess: Dep. Base of old machine xxxxx

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OR

Cost of New Machine xxxxxLess: Present realizable value of old machine xxxxx

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SALVAGE VALUE AND ITS TAX IMPLICATIONS

Salvage value (SV) < Book value (BV) Loss

Net proceeds= SV + Tax savings on STCL

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SALVAGE VALUE AND ITS TAX IMPLICATIONS CONTD.

Salvage value (SV) > Book Value (BV) but SV < Original Value (Investment Cost) Ord. profit Net proceeds= Salvage value – Tax on profit

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SALVAGE VALUE AND ITS TAX IMPLICATIONS CONTD.

Salvage value (SV) > Original value Ordinary profit and Capital Gain

Net proceeds= Salvage value – Tax on ordinary profit – Tax on capital gain

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DECISION RULE CONTD.

As a decision criterion, this method can also be used to make a choice between mutually exclusive projects.

On the basis of the NPV method, the various proposals would be ranked in order of the NPVs.

The project with the highest NPV would be assigned the first rank, followed by others in the descending order.

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EVALUATIONMerits of NPV: The most significant, advantage is that it explicitly

recognizes the time value of money.

It also fulfills the second attribute of a sound method of appraisal in that it considers the total benefits arising out of the proposal over its lifetime.

A changing discount rate can be built into the NPV calculations by altering the denominator.

As normally discount rate changes when the project’s duration is longer.

This method is particularly useful for selection of mutually exclusive projects and for the mutually exclusive projects NPV is the perfect technique.

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CONTD.

Drawbacks: It is difficult to calculate as well as understand

and use in comparison with the traditional techniques.

Calculation of the required rate of return to discount the cash flows.

NPV method is the absolute measure. This method will favor the project which has higher PV (or NPV). But it is likely that this project may also involve a larger initial outlay.

Thus, in case of projects involving different outlays, the PV method may not give dependable results..

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CONTD.

NPV method gives the same decision for two different projects with different project life.

Eg: Project A: Life is 5 years, NPV is Rs.12,000 Project B: Life is 10 years, NPV is Rs.12,000

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INTERNAL RATE OF RETURN (IRR)

This method is also known as yield on investment, marginal efficiency of capital, rate of return, time adjusted rate of return and so on..

This method also considers the time value of money by discounting the cash steams.

The basis of the discount factor, however, is different in both cases.

In case of the NPV, the discount rate is the required rate of return and being a predetermined rate, usually the cost of the capital.

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CONTD.

So here in this case total benefits out of the project is found out on a percentage basis, which is called as internal rate of return of the project. The IRR is usually the rate of return that a

project earns.

IRR is the discount rate that equates the present values of cash inflows with the initial investment associated with a project, there by causing NPV=0.

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CONTD.

It is defined as the discount rate which equates the aggregate present value of the net cash inflows (CFAT) with the aggregate present value of cash outflows of a project.

In other words, it is that rate which gives the project NPV of zero.

Symbolically,

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CONTD.

For unconventional cash flows, the equation is would be:

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EXAMPLE

A project costs Rs.36,000 and is expected to generate cash inflows of Rs.11,200 annually for 5 years. Calculate the IRR of the project.

A project costs Rs.2,30,000 and is expected to generate cash inflows of Rs.66,000 annually for 6 years. Calculate IRR of the project.

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EG:

Calculate IRR from the following data:

Year Annual CFATs A (Rs.) B (Rs.)1 14,000 22,0002 16,000 20,0003 18,000 18,0004 20,000 16,0005 25,000 17,000

Initial outlay is Rs.56,125.

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INITIAL OUTLAY IS RS.30,00,000

Year CFATs1 6450002 6680003 7680004 8400005 3230006 634000

CALCULATE IRR FROM THE FOLLOWING DATA:

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ACCEPT – REJECTION DECISION

It involves comparison of the actual IRR with the required rate of return also known as the cut-off rate or hurdle rate.

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MODIFIED INTERNAL RATE OF RETURN

The Reinvestment rate assumption:

NPV assumes that the cash flows are reinvested at the firms cost of capital.

IRR assumes that the intermediate cash flows are reinvested at the IRR rate.

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EXAMPLE

Cash inflows

Project Initial Investment Year 1 Year 2

A Rs. 100 Rs. 200 0

B Rs. 100 0 Rs. 400

Assume 10% cost of capital for calculation of NPV

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MIRR

So, to eliminate this deficiency of the IRR, MIRR has formulated where it is modified to the extent that the intermediate cash inflows will be compounded by the cost of capital rate.

Formula:

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CALCULATE MIRR FROM THE FOLLOWING:

Year Annual CFATs1 14,0002 16,0003 18,0004 20,0005 25,000

Initial investment is Rs.56,125 and Cost of capital is 10%

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PROFITABILITY INDEX (PI)

Another method in time adjusted technique. It is also called as benefit-cost ratio. It is similar to the NPV method.

The PI approach measures the PV of returns per rupee invested, while the NPV is based on the difference between the PV of future cash inflows and PV of cash outlays.

NPV ignores the size of the investment in the project while giving the conclusion.

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In other words, PI is a relative measure.

It is defied as the ratio which is obtained by dividing the PV of cash future cash inflows by the PV of cash outlays.

Symbolically,

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ACCEPT-REJECTION

Accept if PI>1 Reject if PI<1 Ranking method can also be adopted.

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EVALUATION

Projects with different initial investment would be ranked same in NPV method (shortcoming).

But it is not in case of PI method.

It is appropriate to say that NPV and PI should be used in combination to make investment decision.

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CAPITAL RATIONING It is a process of making investment decisions on

viable projects where funds are limited. Investments decisions are made given a fixed amount of capital to be invested in viable projects.

If a company doesn’t have sufficient funds to undertake all projects with a positive NPV, this is a capital rationing situation.

The project selection under this method involves two stages: Identification of the acceptable projects Selection of the combination of projects

This can be done based on PI or IRR

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TYPES

Soft rationing Hard rationing

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SOFT RATIONING It is caused by internally generated factors of the

company. It is a self imposed capital rationing by the management of the company.

Management may put a maximum budget limit to be spent within a specific period.

Examples/causes of soft capital rationing a self imposed budgetary limit where the management puts a ceiling on the maximum amount to be spent on investments.

Management may decide against issuing more equity finance in order to maintain control over the company’s affairs by existing shareholders.

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CONTD.

Management may opt not to raise more equity so as to avoid dilution in the Earning per share.

Management may decide not to raise additional debt due to the following reasons: To avoid increase in interest payment commitment

To control the gearing or operating leverage so as to minimize the financial risk or business risk.

If a company is small or family owned, its managers may limit the investment funds available to maintain constant growth through retained earnings as opposed to rapid expansion.

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HARD RATIONING

Hard rationing refers to the situation when a business firm cannot raise required finances to execute all potential available profitable investment projects.

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EXAMPLE

A company with 12% cost of funds and limited investment funds of Rs.4,00,000 is evaluating the desirability of several investment proposals.

Project Initial

investment (Rs.)

Life (in years)

Year end inflows

A 300000 2 187600B 200000 5 66000C 200000 3 100000D 100000 9 20000E 300000 10 66000

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CONTD.

1. Rank the projects according to the PI and NPV

2. Determine the optimal investment package.

3. Which projects should be selected, if the company has Rs.5,00,000 as the size of its capital budget?

4. Determine the optimal investment package in the above situations, assuming that the projects are divisible.

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RISK ANALYSIS OF PROJECT’S CASH-FLOWS

A project with high profitability is assumed to have high perceived risk.

So there should be trade off between risk and profitability to the investors.

If the acceptance of a proposal, for instance, makes a firm more risky, the investors would not look to it with favor.

This may have adverse implication on the market price of shares, total valuation of the firm and its goal.

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RISK

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

Risk refers to a set of unique outcomes for a given event which can be assigned probabilities, while uncertainty refers to the outcomes of a given event which are too unsure to be assigned probabilities.

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SENSITIVITY ANALYSIS

It provides information as to how sensitive the estimated project parameters, namely, the expected cash flow, the discount rate and the project life are to estimation errors.

The analysis on these lines is important as the future is always uncertain and there will always be estimation errors.

Sensitivity analysis takes care of estimation errors by using a number of possible outcomes in evaluation a project.

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CONTD.

The method evaluate a project using a number of estimated cash flows to provide to the decision maker an insight into the variability of the outcomes.

This provides different cash flow estimates under 3 assumptions:

The worst (pessimistic), The expected (most likely), and The best (most optimistic) outcomes

associates with the project

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SENSITIVITY ANALYSIS CONTD.

This analysis can also be used to ascertain how change in key variables such as sales volume, sales price, variable costs, fixed costs cost, cost of capital and so on affect the expected outcome of the proposed investment project.

For the purpose of analysis, only one variable is considered, holding the effect of other variables constant, at a point of time.

Like impact of sales price +/- 5% on NPV.

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CONTD.

Like wise, this analysis can be used to see the effect of increase in variable costs, say 5% increase in variable costs converts the status of positive NPV to negative NPV.

The project is said to be highly sensitive if the small change brings out a magnified change in NPV.

So ideally this technique will help in the assessing the risk associated with proposed project.

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SCENARIO ANALYSIS

Scenario analysis is akin to sensitivity analysis but is broader in scope.

Sensitivity analysis analyses the impact of only one variable at a time, the scenario analysis evaluates the impact on the project’s profitability of simultaneous changes in more than one variable at a time.

Such as cash inflows, cash outflows and cost of capital.

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The decision maker begins with the base case i.e., with most likely scenario and then to worst case scenario and lastly the best case scenario.

Each scenario will affect the firm’s cash inflows, cash outflows, cost of capital and NPV.

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SIMULATION

It attempts to answer “what if” questions.

Simulation model is akin to sensitivity analysis but its more comprehensive than sensitivity.

Instead of showing the impact on the NPV for change in one key variable say, change in sales price or cost of capital at one point of time in sensitivity analysis,

simulation enables the distribution of probable values of NPV, for change in all the key variables, in one iteration/run only.

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So it provides more information and better understanding about the risk associated with investment decisions to the finance manger.

To be effective, simulation requires a sophisticated computing package as it then enables to try out a large no. of outcomes with much ease.

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RISK EVALUATION APPROACHES

Risk adjusted discount rate approach Certainty equivalent approach Probability distribution approach Decision tree approach

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REFERENCES

Financial Management – MY Khan and PK Jain, TMH, 6th Edition

Financial Management – IM Panday, Vikas, 10th Edition

Principles of Corporate Finance – Brealey, Myres, Allen and Mohanty, TMH, 8th Edition

Fundamentals of Financial Management – Van Horne & Wachowicz – Pearson, LPE

http://forio.com/simulation/harvard-capital-demo/#

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