Skip to main content

What is Risk and Uncertainty in Capital Budgeting?


Risk: It is variability between actual return and estimated return in a certain future. The decision maker draws a probability of certain return based on historical data.

Uncertainty: The decision makers are not able to draw probability of an outcome in uncertain future. The facts are unknown in uncertain future.

Risks associated with Projects are:
Stand-Alone risk: It is a risk associated with single project alone.
Corporate risk: It is a risk of a choosing a project which effects the overall company profits or positions.
Market risk: It is a risk of choosing a project which effects the shareholders position         in company.
Liquidity risk: To face difficulty in converting an investment into cash. It means investors are not able to get fair value on selling its investment when they need cash immediately.
Inflation risk: It is a loss of purchasing power. It means the quantity of goods you bought in Rs. 5 now you can buy in Rs.8. Due to the time variation the value of  money decrease this is known as inflation.

Methods to calculate Risk and Uncertainty in Capital Budgeting:
·         Sensitivity
·         Simulation
·         Scenario Analysis
·         Break Even Analysis
·         Decision Tree
·         Risk-Adjusted Discount Rate
·         Probability Distribution Approach
·         Certainty Equivalent

Sensitivity analysis:  It gives answer of “what if” question. It means how change in one variable affect the outcome of a project if other things remain same. It shows how sensitive NPV is if we change one variable (like sale value) then it affects the NPV value.

Example: There are 3 projects A, B and C and the required rate of return is 9% per annum. The expected cash inflows in different cases are as follows:


Particulars
Project A
Project B
Project C
Initial Cash Flows
(20,000)
(20,000)
(20,000)
Worst
18,000
14,000
16,000
Most Likely
32,000
36,000
32,000
Best
40,000
42,000
35,000
Project Period
5
5
5

Particulars
Cash Inflows
Discount rate 9%
Present Value
NPV
Worst
18,000
1.538
11703.51
-8296.48
Most likely
32,000
1.538
20806.24
806.24
Best
40,000
1.538
26007.80
6007.80

Particulars
Cash Inflows
Discount rate 9%
Present Value
NPV
Worst
14,000
1.538
9102.73
-10897.26
Most Likely
31,000
1.538
20156.04
156.04
Best
42,000
1.538
27308.19
7308.19

Particulars
Cash Inflows
Discount rate 9%
Present Value
NPV
Worst
16,000
1.538
10403.12
-9596.87
Most Likely
32,000
1.538
20806.24
806.24
Best
35,000
1.538
22756.82
2756.82








Find out which project is better among these three projects with the help of NPV sensitivity analysis method.
Project A: Cash Outflow = Rs. 20, 000
Project B: Cash Outflow = Rs. 20,000
Project C: Cash Outflow = Rs. 20,000

Observations of above tables are as follows:

1) In worst case project A is better than project B and C according to NPV.
2) In most likely case project A and C provide same NPV Rs.806.24. Any one of two can accepted.
3) In best case project B NPV Rs.7308.19 is better than project A and C in which NPV is Rs.6007.80 and Rs.2756.82 respectively and project A is better than C.

Therefore, according to the above observations if decision maker is risk taker project B is good and if conservative project A is good. Project C is better only in most likely case.

Comments

Post a Comment

Popular posts from this blog

How to calculate Cost of Preference Share Capital?

Cost of Preference Share Capital:  An amount paid by company as dividend to preference shareholder is known as Cost of Preference Share Capital. Preference share is a small unit of a company’s capital which bears fixed rate of dividend and holder of it gets dividend when company earn profit. Dividend payable is not a tax deductible amount. So, there is no tax adjustments required for comparing with cost of debt. Formula for Cost of Preference Share: Irredeemable Preference Share Redeemable Preference Share K p  = Dp/NP K p  = D p +((RV-NP)/n )/ (RV+NP)/2 Where, K p  = Cost of Preference Share D p  = Dividend on preference share NP = Net proceeds from issue of preference share (Issue price – Flotation cost) RV = Redemption Value N = Period of preference share Example:  A company issues 20,000 irredeemable preference share at 8% whose face value is Rs.50 each at 4% discount. Find out the Cost of ...
88 comments
Read more

What is the difference between Cheque book and Pass book?

 Cheque book is issued by bank in customers / account holder request. With the help of this book account holder can withdraw cash from his/her account. Bank does not charge any fee to issued cheque book to its customer. But afterward bank charges some amount for using bank facility like cheque book, Debit card etc.So, Automatic some definite amount deducted from customer bank account. Pass book is  also issued by bank to its customer. It helps to record all the bank related activity according to date that is withdrawal and deposit. It is recorded by bank but the book is kept by customer to know the current balance of  his /her account.  Point of difference Pass book Cheque book What is the meaning of pass book and cheque book? Passbook is a book in which all withdrawal and deposit against customer account is recorded.   Cheque book is a book of cheques which are used to withdrawal the money to b...
Post a Comment
Read more

Numericals with solutions of Net income Approach

Net income approach questions and answers:   Questions:  Find out the value of the firm with the help of given information: Particulars Amount Earnings before interest and tax 3, 50, 000 Cost of equity 10% Cost of debt 7.2% Debenture 1,00,000 Find out the overall cost of capital with the help of net income approach. (Assume tax rate-10%) Solution: Particulars Amount Earnings before interest and tax 3, 50, 000 Less: Interest @7.2% 7, 200 Earnings before tax 3, 42, 800 Less: Tax@10% 34, 280 Net income 3, 08, 520 Cost of equity 10% Market value of equity (S =net income/ cost of equity) 30, 85, 200 Market value of debt (B) 1, 00, 000 Value of the firm (S+B) 31, 85, 200 Questions:  Find out the overall cost of capital if the equity capitalisation rate is 12...
Post a Comment
Read more