Capital budgeting

DISUSS ABOUT CAPITAL BUGETING AND GIVE THE SIGNIFICANCE OF IT.

INTRODUCTION

The capital budgeting means investment of funds in long term assets to get benefits
over a series of years generally company invests money for expansion modernization
replacement of long term assets,acquanization etc.

By these type of investment company can get return for long time .In economy , more
investment proposals might be present .Capital budgeting helps to evaluate these proposals.
Company can choose one best proposal which gives higher return .The capital budgeting is
important because of some reasons these reasons given below

1. Irreversible investment decision

Capital investment decisions are very important .These types of decisions can not be
reversed easily by ignoring loss, because such decisions involves purchasing of
building ,installation of machinery ,construction etc.
If company invests in these types of assets then it is difficult to resale it in second hand
market.

2. High degree of task

Investment decisions in particular assets are very risky. Many companies often fail in their
business. The reason is that future is uncertain & the company can get either loss or profit for
their investment. for the new player it is not easy task to survive in the market.

3. Complex task

Decisions relating to investment in long term assets is a complex [Link] a company

has more options for investment then company has to evaluate all the projects [Link]
wrong decision about investment might be prove harmful for the company.

4. Important decisions

Capital budgeting decisions are important investment decisions because it involves huge
investment of capital .It can affect the profitability of company. After the long analysis with
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advantage and disadvantages this type of decision should be taken otherwise it can give bad
effects on company

5. Affects future

Capital investment decision affects the business for long time. on the basis of capital
budgeting ,sales expenditure ,profits are depend. Future activities are depending on capital
budgeting related decisions. In future various activities are happen which is depend on capital
budgeting decision.

Which are the Kinds Of Capital Budgeting Decisions:

Capital budgeting refers to the total process of generating, evaluating, selecting and following
up on capital expenditure alternatives. The firm allocates or budgets financial resources to
new investment proposals. Basically the firm may be confronted with tress types of capital
decisions: (i) the accept- reject decision; (ii) the mutually exclusive choice decision; and (iii)
the capital rationing decision.

(i) The Accept- Reject Decision:

This is a fundamental decision in capital budgeting. If the project is accepted, the firm invests
in it; if the proposal is rejected, the firm does not invest in it. In general, all those proposals,
which yield a rate of return greater than a certain required rate of return or cost of capital is
accepted and the rest, are rejected. Under the accept- reject decision, all the independent
projects that satisfy the minimum investment criterion should be implemented.

(ii) Mutually Excusive Project Decisions:

Mutually exclusive projects are projects, which compete with other projects in such a way
that the acceptance of one will exclude the acceptance of the other projects. The alternatives
are mutually exclusive and only one may be chosen. Suppose, a company is intending to buy
a new folding machine. There are three competing brands, each with different initial
investment and operating costs. The three machines represent mutually exclusive alternatives,
as only one of the three machines can be selected. Mutually excusive investment decisions
acquire significance when more than one proposal is acceptable under the accept- reject
decision. Then some techniques have to be used to determine the “best” one. The acceptance
of this “best” alternative automatically eliminates the other alternatives.
Various Method in Capital Budgeting
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3) Capital rationing or ranking decisions: in case the firm has various profitable
investment proposals in that case the firm had only option to rank them as per their
profitability and then accept them.

 Pay back period method

Pay back period method is vary popular .It is a very traditional method. This method is
used to evaluate a particular project. It represent the no. of years required to recover the
invested amount .It means that, here more emphasis is given on time. If there are more
projects available, then project is selected from which investment amount can be recovered
quickly.

The formula

Pay back period = investment/constant cash flow

ADVANTAGES

1. Easy-
It is easy to calculate and understand .By this method, executives can take decisions for the
better investment.

2. Ranking

Through this payback period method,exicutives can give rank to various projects as per time
duration without much complication.

3. Liquidity

This project gives importance to the liquidity. It means that project is selected through
which invested amount can be recovered easily.

4. Attractive

This method is appropriate for the company which wants its money quickly. It helps the
companies to know the time period of recovery of their investment

5. in case of uncertainty
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 This method is useful for industries where technological changes and uncertainty
happens .Future can not be predicted properly beyond the time period.

DISADVANTAGES -

1. Ignores annual cash flow

It totally ignores the annual cash in flow after the payback period. Here company consider
the cash flaw till the money recovered of investment.

2. Does not consider the interest

This method ignores the cost of capital. It means that interest on investment is not
considered. Whenever company borrow money such interest cost will be occur but here this
factor is totally ignored.

3 Consider only payback and not the time value of money

This method ignores the time value of money. The value of money changes with time
which is not considered here. The value of money is decrease day by day as discussed in
previous chapter but here this value of money is not considered.

3. No proper basis

There should be such time limit basis which can be use as a standard to select or reject the
project There is no proper basis for determining the minimum expectable time period. It
creates difficulty for management.

4. Not appropriate for long term projects

This method is not appropriate for too long projects because future is uncertain. in long
time cash flow cannot be predict properly.

Discounted Payback Period

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One of the major disadvantages of simple payback period is that it ignores the time value of
money. To solve this limitation, an alternative procedure called discounted payback period
may be followed, which accounts for time value of money by discounting the cash inflows of
the project.

Calculation Procedure

In discounted payback period we have to calculate the present value of each cash inflow
taking the start of the first period as zero point. For this purpose the management has to set a
suitable discount rate. The rest of the procedure is similar to the calculation of simple
payback period.

Advantages and Disadvantages

Advantage: Discounted payback period is more reliable than simple payback period since it
accounts for time value of money. It is interesting to note that if a project has negative net
present value it won't pay back the initial investment.
Disadvantage: It ignores the cash inflows from project after the payback period.

 AVERAGE RATE OF RETURN METHOD

ARR is also an good method to evaluate a project .On the basis of this mathod ,one can select
a project out of various projects available.

to calculate ARR-

ARR = avg annual net profit after tax/avg investment

-avg net profit = profit after tax/no. of years

-avg investment = investment at begging + investment at end

A project is accepted if ARR is higher than the minimum cut rate of ARR .A project with
high return is accepted .By this method, ranks can be given to the various projects. As per
rate of return, various merits & demerits are given below.

MERITS-

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1. Simple & easy to understand
2. Rate of return can be calculated quickly with the help of data.
3. It takes into consideration investment & the total earning from the project during the
lifetime.
4. Current performance of company can be measured
5. The return with other companies can be compared.

DEMARITS-

1. It ignores time value of money

2. It considers only rate of return & not the length of project.
[Link] ignores the benefits of selling an old assets.
[Link] does not determine the fair rate of return on investment.

 NET PRESENT VALUE METHOD

This method is one of the capital budgeting methods by which the project can be
evaluated .This method considers all the incomes whenever [Link] present value is
calculated with the help of various cash [Link] is the difference between the present
value of cash inflow from project & total investment amount.

NPV = present value of cash inflows - present value of invest

If there is a only a single project & positive NPV then project should be accepted. If there are
no. of projects available, then the project should be selected which is having high NPV.

Various merits & demerits of this method are given below.

MERITS-

1. It consideration the entire life of the project investment and income.

2. It gives importance to the time factor

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3. This method is useful to compare various projects. a project is selected in which highest
NPV is available.
[Link] method is also useful for management and shareholders .Investment in proper project
can give higher return which leads to increase in share price.

DEMERITS-

1. It is difficult to calculate & understand compared to payback period method.

2. In the selection of project forecasted data is taken into consideration which is not certain.
3. To forecast the life of project ,is not an easy task.
4. It considers discounting rate to find out NPV, but discounting rate is complicated.
Profitability Index

The profitability index can be calculated by dividing the present value of future cash flows
expected to be generated by a capital project by the initial cost, or initial investment, in the
project. If the result is less than 1.0, you do not invest in the project. If the result is greater
than 1.0, you do invest in the project. If the profitability index of a project is 1.2, for example,
you can expect a return of $1.20 for every $1.00 you invest in the project.

Here is the formula:

Profitability Index = Present Value of Future Cash Flows Generated by the

Project/Initial Investment in the Project

In other words, if the result is greater than 1.0 and the owner invests in the project, then the
company will benefit financially and make a profit if the business owner invests in the
project.

The profitability index is often used to rank a firm's possible investment projects. Since
company's usually have limited financial resources, they invest in only the most profitable
projects. If there are a number of possible investment projects available, the company can use
the profitability index to rank those projects from the highest profitability index to the lowest
to decide in which to invest.

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Advantages & Disadvantages

Advantages Of Profitability Index (PI)

1. PI considers the time value of money.
2. PI considers analysis all cash flows of entire life.
3. PI makes the right in the case of different amount of cash outlay of different project.
4. PI ascertains the exact rate of return of the project.

Disadvantages Of Profitability Index(PI)

1. It is difficult to understand interest rate or discount rate.
2. It is difficult to calculate profitability index if two projects having different useful life.

. Internal Rate of Return Method:

The internal rate of return (IRR) equates the present value cash inflows with the present value

of cash outflows of an investment. It is called internal rate because it depends solely on the

outlay and proceeds associated with the project and not any rate determined outside the

investment, it can be determined by solving the following equation:

IRR=A+C/

Advantages:
1. Like the NPV method, it considers the time value of money.

2. It considers cash flows over the entire life of the project.

3. It satisfies the users in terms of the rate of return on capital.

4. Unlike the NPV method, the calculation of the cost of capital is not a precondition.

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5. It is compatible with the firm’s maximising owners’ welfare.

Limitations:
1. It involves complicated computation problems.

2. It may not give unique answer in all situations. It may yield negative rate or multiple rates
under certain circumstances.

Incremental IRR

Incremental IRR (Internal Rate of Return) is a financial metric used to evaluate the profitability of
two mutually exclusive projects or investments. It helps to determine the rate of return at which the
net present value (NPV) of the difference in cash flows between two projects equals zero.

In simpler terms, the Incremental IRR measures the return of the "incremental" investment — the
difference in the initial outlay and the cash flows between two projects. Here's how it's typically
calculated:

1. Calculate the cash flows of both projects: List the cash inflows and outflows for both
projects over time.
2. Find the incremental cash flows: Subtract the cash flows of the smaller project (or the less
expensive one) from the cash flows of the larger project (or the more expensive one).
3. Calculate the Incremental IRR: Use the incremental cash flows to calculate the IRR, which
is the rate that makes the NPV of the incremental cash flows equal to zero.

The formula for Incremental IRR is:

NPVincremental=0=∑Incremental Cash Flows(1+r)tNPV_{\text{incremental}} = 0 = \sum \frac{\

text{Incremental Cash Flows}} {(1 + r)^t} NPV incremental=0=∑(1+r)tIncremental Cash Flows

Where:

 Incremental Cash Flows\text{Incremental Cash Flows}Incremental Cash Flows are the cash flows
from the larger project minus the smaller project.
 rrr is the rate of return (Incremental IRR).
 ttt is the time period.

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 Example:

 Project A costs $1,000 and generates $400 annually for 5 years.

 Project B costs $1,500 and generates $500 annually for 5 years.

The incremental investment between Project B and Project A is $500 ($1,500 - $1,000), and the
incremental cash flow is $100 per year ($500 - $400).

By calculating the IRR of the incremental cash flows, you can determine whether the additional
investment in Project B provides a sufficient return compared to Project A. If the Incremental IRR is
higher than the required rate of return, Project B may be considered a good investment.

Why Use Incremental IRR?

It helps decision-makers choose between two mutually exclusive projects when one is more
expensive than the other, and they want to know if the additional investment yields an appropriate
return.

 INTRODUCTION TO RISK ANALYSIS IN CAPITAL BUDGETING

While discussing the capital budgeting techniques we have assumed

that the investment proposals do not involve any risk and cash
flows of the project are known with certainty. This assumption was
taken to simplify the understanding of the capital budgeting
techniques. However, in practice, this assumption is not correct.
Infact, investment projects are bare to various degrees of risk.
There can be three types of decision making:
(i) Decision making under certainty: When cash flows are certain
(ii) Decision making involving risk: When cash flows involve risk and
probability can be assigned.
(iii) Decision making under uncertainty: When the cash flows are
uncertain and probability cannot be assigned.
8.1.1 Risk and Uncertainty
Risk is the variability in terms of actual returns comparing with the
estimated returns. Most common techniques of risk measurement
are Standard Deviation and Coefficient of variations. In case of risk,
probability distribution of cash flow is known. When no information
is known to formulate probability distribution of cash flows, the

situation is referred as uncertainty. However, these two terms

are used interchangeably.

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 8.1.2 Reasons for adjustment of Risk in Capital Budgeting decisions
Main reasons for considering risk in capital budgeting decisions are as
follows
1. There is an opportunity cost involved while investing in a project
for the level of risk. Adjustment of risk is necessary to help make
the decision as to whether the returns out of the project are
proportionate with the risks borne and whether it is worth
investing in the project over the other investment options
available.
2. Risk adjustment is required to know the real value of the Cash
Inflows. Higher risk will lead to higher risk premium and also
expectation of higher return.

8.1 SOURCES OF RISK

Risk arises from different sources, depending on the type of
investment being considered, as well as the circumstances and the
industry in which the organisation is operating. Some of the sources of
risk are as follows
1. Project-specific risk
2. Company specific risk-
3. Industry-specific risk-.
4. Market risk –
5. Competition risk
6. Risk due to Economic conditions
7. International risk .

STATISTICAL TECHNIQUES
Probability Assignment

The probability assignment technique in capital budgeting is a

method used to assess and incorporate uncertainty or risk in the
decision-making process for investments or projects. In capital
budgeting, investments often involve uncertain future cash flows. The
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 probability assignment technique allows for a more realistic evaluation
by assigning probabilities to different possible outcomes (including
both inflows and outflows) in period t and k is the discount rate.
(a) Expected Net Present Value- Single period
ILLUSTRATION 1
Possible net cash flows of Projects A and B at the end of first year and their probabilities
are given as below. Discount rate is 10 per cent. For both the project initial investment
is ` 10,000. From the following information, CALCULATE the expected net present
value for each project. State which project is preferable?

Possible Project A Project B

Event
Cash Flow Probability Cash Flow Probability
(`) (`)
A 8,000 0.10 24,000 0.10
B 10,000 0.20 20,000 0.15
C 12,000 0.40 16,000 0.50
D 14,000 0.20 12,000 0.15
E 16,000 0.10 8 ,000 0.10

SOLUTION
Calculation of Expected Value for Project A and Project B

Project A Project B
Possibl Ne Probabilit Expecte Cash Probabilit Expecte
e t y d Flow y d Value
Event Cas Value (`) (`)
h
Flo (`)
w
(`)
A 8,000 0.10 800 24,00 0.10 2,400
0
B 10,000 0.20 2,000 20,000 0.15 3,000
C 12,000 0.40 4,800 16,000 0.50 8,000
D 14,000 0.20 2,800 12,000 0.15 1,800
E 16,000 0.10 1,600 8,000 0.10 800
ENCF 12,000 16,000
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 The net present value for Project A is (0.909 × ` 12,000 – `
10,000) = ` 908 The net present value for Project B is (0.909 ×
` 16,000 – `10,000) = ` 4,544.

Risk Adjusted Discount Rate

The use of risk adjusted discount rate (RADR) is based on the

concept that investors demands higher returns from the risky
projects. The required rate of return on any investment should
include compensation for delaying consumption plus compensation
for inflation equal to risk free rate of return, plus compensation for
any kind of risk taken. If the risk associated with any investment
project is higher than risk involved in a similar kind of project, discount
rate is adjusted upward in order to compensate this additional risk
borne.

NPV =
n
NCF - I
t = 0 1+k t

Where,
NCFt = Net cash flow
K = Risk adjusted
discount rate. I =
Initial Investment
A risk adjusted discount rate is a sum of risk free rate and risk
premium. The Risk Premium depends on the perception of risk by the
investor of a particular investment and risk aversion of the Investor.
So Risks adjusted discount rate = Risk free rate+ Risk premium
Risk Free Rate: It is the rate of return on Investments that bear no
risk. For e.g., Government securities yield a return of 6 % and bear
no risk. In such case, 6 % is the risk-free rate.
Risk Premium: It is the rate of return over and above the risk-free
rate, expected by the Investors as a reward for bearing extra risk. For
high risk project, the risk premium will be high and for low risk
projects, the risk premium would be lower.

ILLUSTRATION 5
An enterprise is investing ` 100 lakhs in a project. The risk-free rate of return is 7%. Risk
premium expected by the Management is 7%. The life of the project is 5 years. Following
are the cash flows that are estimated over the life of the project.
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 Year Cash flows (` in lakhs)
1 25
2 60
3 75
4 80
5 65

CALCULATE Net Present Value of the project based on Risk free

rate and also on the basis of Risks adjusted discount rate.
SOLUTION
The Present Value of the Cash Flows for all the years by discounting
the cash flow at 7% is calculated as below:
Year Cash flows Discounti Present value of
` in lakhs ng Factor Cash Flows ` In
@7% Lakhs
1 25 0.935 23.38
2 60 0.873 52.38
3 75 0.816 61.20
4 80 0.763 61.04
5 65 0.713 46.35
Total of present value of Cash flow 244.34
Less: Initial investment 100.00
Net Present Value (NPV) 144.34

Now when the risk-free rate is 7% and the risk premium expected by
the Management is 7%. So the risk adjusted discount rate is 7% +
7% =14%.
Discounting the above cash flows using the Risk Adjusted Discount
Rate would be as below:

Year Cash flows Discounting Present Value of

` in Lakhs Factor@14% Cash Flows ` in
lakhs
1 25 0.877 21.93
2 60 0.769 46.14
3 75 0.675 50.63
4 80 0.592 47.36
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 5 65 0.519 33.74
Total of present value of Cash flow 199.79
Initial investment 100.00
Net present value (NPV) 99.79

Advantages of Risk-adjusted discount rate

1) It is easy to understand.
2) It incorporates risk premium in the discounting factor.

Limitations of Risk-adjusted discount rate

1) Difficulty in finding risk premium and risk-adjusted discount rate.

2) Though NPV can be calculated but it is not possible to
calculate Standard Deviation of a given project.

8.1.1 Certainty Equivalent (CE) Method for Risk Analysis

Certainty equivalent method –Definition: As per this ,
“approach to dealing with risk in a capital budgeting context. It
involves expressing risky future cash flows in terms of the certain
cashflow which would be considered, by the decision maker, as their
equivalent, that is the decision maker would be indifferent between
the risky amount and the (lower) riskless amount considered to be its
equivalent.”
The certainty equivalent is a guaranteed return that the
management would accept rather than accepting a higher but
uncertain return. This approach allows the decision maker to
incorporate his or her usefulness function into the analysis. In this
approach a set of risk less cash flow is generated in place of the
original cash flows.

Steps in the Certainty Equivalent (CE) approach

Step 1: Remove risks by substituting equivalent certain cash flows from
risky cash flows. This can be done by multiplying each risky cash flow by
the appropriate  t
value (CE coefficient)
= Certain cash flow
α1
Risky or expected cash flowt
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 Suppose on tossing out a coin, if it comes head you
will get
`10,000 and if it comes out to be tail, you will win nothing. Thus, you
have 50% chance of winning and expected value is `5,000. In such
case if you are indifferent at receiving `3,000 for a certain amount
and not playing then `3,000 will be certainty equivalent and 0.3
(i.e. 3,000/10,000) will be certainty equivalent coefficient.
Step 2: Discounted value of cash flow is obtained by applying risk less
rate of interest. Since you have already accounted for risk in the
numerator using CE coefficient, using the cost of capital to discount
cash flows will tantamount to double counting of risk.
Step 3: After that normal capital budgeting method is applied
except in case of IRR method, where IRR is compared with risk free
rate of interest rather than the firm’s required rate of return.
Certainty Equivalent Coefficients transform expected values of
uncertain flows into their Certainty Equivalents. It is important to note
that the value of Certainty Equivalent Coefficient lies between 0 & 1.
Certainty Equivalent Coefficient 1 indicates that the cash flow is
certain or management is risk neutral. In industrial situation, cash
flows are generally uncertain and managements are usually risk
averse. Under this method

n
∝t×NCF
NPV = �t (1 + k)t −
I
t=1

Where,
NCFt = the forecasts of net cash flow for year ‘t’ without risk-adjustment
αt = the risk-adjustment factor or the certainly equivalent coefficient.

Kf = risk-free rate assumed to be constant for

all periods. I = amount of initial Investment.
ILLUSTRATION 6
If Investment proposal is `45,00,000 and risk free rate is 5%, CALCULATE net
present value under certainty equivalent technique.

Year Expected cash flow Certainty

(`) Equivalent
coefficient

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 1 10,00,000 0.90
2 15,00,000 0.85
3 20,00,000 0.82
4 25,00,000 0.78

SOLUTION

10,00,000×(0.90) 15,00,000×(0.85) 20,00,000×(0.82)

25,00,000×(0.78)
NPV = + + +
- 45,00,000
(1.05) (1.05)2 (1.05)3 (1.05)4

= ` 5,34,570
Advantages of Certainty Equivalent Method

1. The certainty equivalent method is simple and easy to understand

and apply.
2. It can easily be calculated for different risk levels applicable
to different cash flows. For example, if in a particular year, a
higher risk is associated with the cash flow, it can be easily
adjusted and the NPV can be recalculated accordingly.
Disadvantages of Certainty Equivalent Method

1. There is no objective or mathematical method to estimate

certainty equivalents. Certainty Equivalents are subjective and
vary as per each individual’s estimate.

2. Certainty equivalents are decided by the management based on

their perception of risk. However, the risk perception of the
shareholders who are the money lenders for the project is
ignored. Hence it is not used often in corporatedecision
[Link] TECHNIQUES
8.1.2 Sensitivity Analysis
Definition of sensitivity analysis: As per CIMA terminology,” A
modeling and risk assessment procedure in which changes are made
to variables or factors in order to determine the effect of these
changes on the planned outcome. Particular attention is thereafter
paid to variables identifies as being of special significance”
Sensitivity analysis put in simple terms is a modeling technique which
is used in Capital Budgeting decisions which is used to study the
impact of changes in the variables on the outcome of the
project. In a project, several variables like weighted average cost of
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 capital, consumer demand, price of the product, cost price per unit
etc. operate simultaneously. The changes in these variables impact
the outcome of the project. It therefore becomes very difficult to
assess change in which variable impacts the project outcome in a
significant way. In Sensitivity Analysis, the project outcome is studied
after taking into change in only one variable. The more sensitive is
the NPV, the more critical is that variable. So, Sensitivity analysis is a
way of finding impact in the project’s NPV (or IRR) for a given
change in one of the variables.

Steps involved in Sensitivity Analysis

Sensitivity Analysis is conducted by following the steps as below:

1. Finding variables, which have an influence on the NPV (or IRR) of the
project
2. Establishing mathematical relationship between the variables.
3. Analysis the effect of the change in each of the variables on the
NPV (or IRR) of the project.

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ILLUSTRATION 7
X Ltd is considering its New Product ‘with the following details

Sr. No. Particulars Figures

1 Initial capital cost ` 400 Cr
2 Annual unit sales 5 Cr
3 Selling price per unit ` 100
4 Variable cost per unit ` 50
5 Fixed costs per year ` 50 Cr
6 Discount Rate 6%

Required:

1. CALCULATE the NPV of the project.

2. COMPUTE the impact on the project’s NPV of a 2.5 per cent
adverse variance in each variable. Which variable is having
maximum effect .Consider Life of the project as 3 years.
SOLUTION
1. Calculation of Net Cash Inflow per year:
Particulars Amount (`)
A Selling Price Per Unit (A) 100
B Variable Cost Per Unit (B) 50
C Contribution Per Unit (C = A-B) 50
D Number of Units Sold Per Year 5 Cr.
E Total Contribution (E = C × D) ` 250 Cr.
F Fixed Cost Per Year ` 50 Cr.
G Net Cash Inflow Per Year (G = E ` 200 Cr.
- F)

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 Calculation of Net Present Value (NPV) of the Project:

Year Year Cash Discountin Present Value

g @ 6%
Flow (` in (PV) (` in
Cr.) Cr.)
0 (400.00) 1.000 (400.00)
1 200.00 0.943 188.60
2 200.00 0.890 178.00
3 200.00 0.840 168.00
Net Present Value (188.60 + 178 + 168) - 134.60
400=
Here NPV represent the most likely outcomes and not the actual
outcomes. The actual outcome can be lower or higher than the
expected outcome.
2. Sensitivity Analysis considering 2.5 % Adverse Variance in each variable
Changes Base
Initial Selling Variabl Fixed Units
in Cash Price e Cost Cost sold per
variabl Flow per Per Per year
e increas Unit Unit Unit reduced
ed to Reduc increas increas to
` 410 ed to ` ed to ed to 4.875
crore 97.5 ` 51.25 ` crore
51.25
Particular Amoun Amount Amount Amount Amount Amount
s t ` ` ` ` `
`
A Selling 100 100 97.5 100 100 100

Price Per
Unit (A)
B Variable 50 50 50 51.25 50 50
Cost Per
Unit (B)
C Contribution 50 50 47.5 48.75 50 50
Per Unit (C
= A-B)

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 D Number of 5 5 5 5 5 4.875
Units Sold
Per Year

(in

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 Crores)
E Total 250 250 237.5 243.75 250 243.75
Contributio
n (E = C ×
D)
F Fixed Cost 50 50 50 50 51.25 50
Per Year

(in
Crores)
G Net 200 200 187.5 193.75 198.7 193.75
Cash 5
Inflow Per
Year ( G = E
- F)
H (G × 2.673) 534.6 534.6 501.19 517.89 531.2 517.89
0 0 6
I Initial 400 410 400 400 400 400

Cash Flow
J NPV 134.6 124.6 101.19 117.89 131.2 117.89
0 0 6
K Percentage - - - - -
Change 7.43% 24.82% 12.41 2.48% 12.41%
%
in NPV
The above table shows that the by varying one variable at a time
by 2.5% while keeping the others constant, the impact in
percentage terms on the NPV of the project. Thus it can be seen
that the change in selling price has the maximum effect on the
NPV by 24.82 %.
Advantages of Sensitivity Analysis:

Following are main advantages of Sensitivity Analysis

Advantages of Sensitivity Analysis:

1. Simple and Easy to Understand: It is a straightforward technique that can be easily

implemented with basic spreadsheet tools.
2. Highlights Key Variables: It identifies the variables that have the greatest impact on the
© The Institute of Chartered Accountants of India
project’s success, helping to prioritize risk management efforts.
 3. Helps in Decision Making: Provides valuable insights into how different assumptions affect the
project, allowing decision-makers to make more informed choices.
4. Incorporates Uncertainty: Unlike traditional analysis that uses a single estimate, sensitivity
analysis accounts for variability in the input variables.

Limitations of Sensitivity Analysis:

1. Single Variable Focus: Sensitivity analysis typically examines the effect of changing one variable
at a time, which may not fully capture the effect of simultaneous changes in multiple variables
(though this can be addressed by scenario analysis).
2. Doesn’t Account for Probabilities: It doesn’t consider the likelihood of different outcomes. It
simply shows the effect of changes in variables, but doesn’t indicate how probable those
changes are.
3. Over-simplification: While sensitivity analysis is useful, it may oversimplify complex,
interdependent relationships between variables, and may not account for all sources of risk.

8.1.3 Scenario Analysis

Scenario Analysis is a risk management tool used in capital budgeting to

evaluate and assess the potential outcomes of a project or investment under
different assumptions or conditions. Unlike sensitivity analysis, which
changes one variable at a time, scenario analysis involves changing multiple
variables simultaneously to model and assess different future scenarios
(e.g., best case, worst case, and most likely case).

The primary goal of scenario analysis is to understand the range of

possible outcomes for a project, accounting for both the upside (optimistic)
and downside (pessimistic) risks, as well as the most probable scenario. It
helps decision-makers understand the project's potential performance under
various conditions, allowing them to make more informed, risk-adjusted
investment decisions.

Key Components of Scenario Analysis

1. Identify Key Variables:

o Similar to sensitivity analysis, you begin by identifying the key variables that affect the
project’s cash flows and overall financial performance. These could include:
 Sales price and volume
 Costs (variable and fixed)
 Discount rate
 Initial investment
 Economic conditions (interest rates, inflation, etc.)
 Regulatory environment
o The difference here is that scenario analysis focuses on how combinations of these
© The Institute ofvariables
Charteredinteract in different
Accountants scenarios.
of India
 2. Define Possible Scenarios:
o The next step is to define different scenarios that represent possible future states of the
world for the project. These scenarios typically include:
 Best-case scenario: The most optimistic outlook, where variables work in favor
of the project (e.g., higher sales, lower costs).
 Worst-case scenario: The most pessimistic outlook, where variables work
against the project (e.g., lower sales, higher costs).
 Most likely scenario: The expected outcome based on the most realistic
assumptions or forecasts.

Sometimes, additional scenarios like a moderate case or break-even case may also be
created to explore intermediate outcomes.

3. Estimate Cash Flows for Each Scenario:

o For each scenario, estimate the expected cash flows over the life of the project based on
the assumptions for each of the identified variables.
o For example, in the best-case scenario, you might assume higher sales and lower
production costs, leading to higher expected cash flows.

4. Calculate Financial Metrics (e.g., NPV, IRR) for Each Scenario:

o For each scenario, calculate the project’s Net Present Value (NPV), Internal Rate of
Return (IRR), or other financial metrics.
o These calculations take into account the projected cash flows for each scenario and
discount them at an appropriate rate (usually the company's cost of capital or a project-
specific discount rate).

Advantages
 Future planning – gives investors a look into the expected returns and
risks involved when planning for future investments. The goal of any
business venture is to increase revenue over time, and it is best to use
predictive analysis when deciding to include an investment in a portfolio.
 Practical – Companies can avoid or decrease potential losses that result
from uncontrollable factors by being aggressively preventive during
worst-case scenarios by analyzing events and situations that may lead to
unfavorable outcomes. Here scenario analysis is active as consider all
situation of economy.
 Avoiding risk and failure – To avoid poor investment decisions,
scenario analysis enables businesses or independent investors to assess
investment prospects. Scenario analysis takes the best and worst
probabilities into account so that investors can make an informed
decision.
 Projecting investment returns or losses – The analysis makes use of
tools to calculate the values or figures of potential gains or losses from
an investment. This gives concrete, measurable data that investors can
base the approaches they take on, for (hopefully) a better outcome.
© The Institute of Chartered Accountants of India
Drawbacks of Scenario Analysis?
  Requires a high level of skill – Scenario analysis tends to be a
demanding and time-consuming process that requires high-level skills
and expertise.
 Unforeseen outcomes – Due to the difficulty in forecasting what may
occur in the future, the actual outcome may be fully unexpected and not
foreseen in the financial modeling.
 Cannot model every scenario – It may be very difficult to imagine all
possible scenarios and assign probabilities to them. Investors must
understand that there are risk factors associated with the outcomes, and
they must consider a certain amount of risk tolerance in order to be able
to attain the desired goal.

ILLUSTRATION 8
XYZ Ltd. is considering a project “A” with an initial outlay of ` 14,00,000 and the
possible three cash inflow attached with the project as follows:

(` 000)

Particular Year 1 Year 2 Year 3

Worst case 450 400 700
Most likely 550 450 800
Best case 650 500 900
Assuming the cost of capital as 9%, determine NPV in each scenario. If XYZ Ltd is
certain about the most likely result but uncertain about the third year’s cash flow,
ANALYSE what will be the NPV expecting worst scenario in the third year.

SOLUTION
The possible outcomes will be as follows:
Year PVF @ 9% Worst Case Most likely Best case
Cash PV Cash PV Cash PV
Flow Flow Flow
`000 `000 `000 `000 `000 `000
0 1 (1400) (1400) (1400) (1400) (1400) (1400)
© The Institute of Chartered
1 Accountants
0.917 of India
450 412.65 550 504.35 650 596.05
2 0.842 400 336.80 450 378.90 500 421.00
 3 0.772 700 540.40 800 617.60 900 694.80
NPV -110.15 100.85 311.85

Now suppose that CEO of XYZ Ltd. is bit confident about the
estimates in the first two years, but not sure about the third year’s
high cash inflow. He is interested in knowing what will happen to
traditional NPV if 3rd year turn out the bad contrary to his
optimism.
The NPV in such case will be as follows:
5,50,000 4,50,000 7,00,000
= − `14,00,000+ +2
(1+0.09) (1+0.09) +
(1+0.09)3
= −`14,00,000 + ` 5,04,587 + ` 3,78,756 + ` 5,40,528 = ` 23,871

The decision-tree approach

The decision-tree approach is useful analytical technique in capital budgeting to

evaluate risky investment proposal involving sequential decisions. The
technique enables the decision maker to study the various decisions points in
relation to subsequent chance, events and choose, from among the alternatives,
in an objective and consistent manner. Since the format of the problem of the
investment decision has an appearance of a tree with branches, the method is
known as decision-tree method.

The decision-tree shows the magnitude, probability and inter-relationship of all

possible out-comes of an investment proposal. In a nut-shell, a decision-tree is a
graphic display of the relationship between a present decision and future
events, future decisions and their consequences. It contains squares and circles.
The square represent decision points and the circles represent chance events
modes.

Steps involved in decision tree analysis

The following are the important steps involved in constructing and using a
decision- tree in capital budgeting :

©
(i)The
ToInstitute
identify of Chartered
and defineAccountants of India
the investment proposal.
(ii) To identify the decision alternatives. For example, if a company is
considering setting up a plant, it has the option of setting up a large plant, a
medium size plant or a small plant initially and expand it later on or no plant at
all.

(iii) To draw various branches of the tree showing the decision points, chance
events and other data.

(iv) To enter on the decision-tree branches the relevant data such as the
projected cash-flows, probabilities and the expected payoffs.

(v) To analyze the result and by backward induction determine optimal decisions
at various decision points and eliminate alternative branches on the basis of
dominance.

The following example will illustrate the procedure. Suppose a firm has an
investment proposal requiring an outlay of US $1,00,000. If the proposal is
successfully implemented, the expected cash-inflows will amount to US
$1,40,000. However, if the proposal fails, the firm will suffer a loss of US
$15,000 on account of expenses, etc., for initiating the proposal. The life of the
proposal is estimated to be 1 year and its salvage value is nil. Now, Estimated
Profit = US $1,40,000 – 1,00;000 – 15,000 = US $25,000

Probability of Success = .5

Probability of Failure = .5

The expected pay off has been computed by the backward induction method
and shown against chance node 2 as + US $5,000 being a positive amount the
investment is worthwhile.

Advantages/Usefulness
© The Institute of Chartered Accountants of India
of Decision Tree
Analysis
Decision tree is a useful method of risk analysis, the probability of occurrences
for various outcomes and the inter-relationship between the outcomes. It is
useful in the following circumstance:

(1) The decision-tree approach is very useful in handling the sequential

investments. Working backwards from the future to the present-the decision
maker is able to eliminate unprofitable branches and ascertain optimum
decision at various decision points.

(2) This approach clearly brings out the implicit assumptions and calculations for
all to see, question and revise.

(3) The decision-tree enables a decision maker to visualize assumptions and

alternatives in a graphic form, which is usually much easier to understand.

Disadvantages of Decision Tree analysis

Some disadvantages are also associated with Decision Tree analysis approach.
The diagrams tend of Decision Tree analysis become more and more
complicated with the inclusion of more alternative variables and by looking into
a very distant future.

Complications increase still further if the analysis is extended to include

interdependent alternatives and variables. They make the decision-tree diagram
cumbersome and complex and calculations become very time consuming and
difficult.

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