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Investment Decision under conditions of

uncertainty: -

A common problem, which complicates the practical


investment decision – making is uncertainty. The rule of the game
is, as we shall emphasize, to be consistent in treating uncertainty in
the cash flows and discount rate.
Uncertainty is a fact of life all over the world. A double-digit
rate of uncertainty is a common feature in developing countries.
Because the cash flows of an investment project occur over a long
period of time, a firm should usually be concerned about the impact
of uncertainty on the projects profitability. The capital budgeting
results will be based if the impact of inflation is not correctly
factored in the analysis.
Business executives do recognize that inflation exists but they
do not consider it necessary to incorporate uncertainty in the
analysis of capital investment. They generally estimate cash flows
assuming units cost and selling price prevailing in year zero to
remain unchanged.
The working capital tied up in an investment project may also
increase during uncertainty conditions. Because of the increasing
input prices and manufacturing costs, more funds may have to be
tied up in inventories and receivable. The salvage value of the
project may also be affected by uncertainty. In the period of rising
prices, the firm may be able to sell an asset at the end of its useful
life at a good price.

Nature of Risk: - Risk exists because of the inability of the


decision-maker to make perfect forecasts. Forecasts cannot be
made with perfection or certainty since the future events on which
they depend are uncertain. An investment not risky if, we can

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specify a unique sequence of cash flows for it. But the whole trouble
is that cash flows can occur depending on the future events. Thus,
risk arises in investment evaluation because we cannot anticipate
the occurrence of the possible future events with certainty and
consequently, cannot make any correct prediction about the cash
flow sequence. The risks may considered into three broad
categories of the events influencing the investment forecasts.
(1) General Economic Conditions: - This category
includes events which influence the general level of business
activity. The level of business activity might be affected by
such events as internal and external economic and political
situations, monetary and fiscal policies, social conditions etc.
(2) Industry factors: - This category of events may affect all
companies in an industry. For ex, companies in an industry
would be affected by the industrial relations in the industry,
by innovations by change in material cost etc.
(3) Company factors: - This category of events may affect
only a company. The change in management, strike in the
company, a natural disaster such as flood or fire may affect
directly a particular company.
Risk and uncertainty: - Risk is sometimes distinguished from
uncertainty. Risk is referred to a situation where the probability
distribution of the cash flow of an investment proposal is known on
the other hand, if no information is available to formulate a
probability distribution of the cash flow the situation is known as
uncertainty.
Probability distribution of cash flows: - The most crucial
information for the capital budgeting decision is a forecast of future
cash flows. A typical forecast is single future for a period. This is
referred to as ‘best estimate’ or ‘most likely’ for cast. In fact, the
decision analysis is limited in two ways by this single figure fore
cast.

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Firstly, we do not know the chances of this figure actually
occurring i.e.; the uncertainty surrounding this figure. In other
words, we do not know the range of the forecast and the chance or
the probability estimates associated with figures within this range.
Secondly, the meaning of best estimates or most likely is not very
clear. It is not known whether is mean, median or mode. For these
reasons a forecast should not give just one estimate but a range of
associated probability – a probability distribution.
Probability may be described as a measure of someone’s
opinion about the likelihood that an event will occur. If an event is
certain to occur, we say that it has a probability of one of occurring.
If an event is certain not to occur, we say that its probability of
occurring is zero. Thus, probability of all events to occur lies
between zero and one. A probability distribution may consist of a
number of estimates. But in the simple form it may consist of only a
few estimates, one commonly used foam employs only the high, low
and best guess estimates or the optimistic, most likely and
pessimistic estimates.
Assigning probability: - The classical probability theory
assumes that no statement what so even can be made about the
probability of any single event. In fact, the classical view holds that
one can talk about probability in a very long run seas, given that the
occurrence or non-occurrence of the event can be repeatedly
observed over a very large number of times under independent
identical situations. Thus, the probability estimate, which is based
on a very large number of observations, is known as objective
probability.
The classical concept of objective probability is of little use in
analyzing investment decisions because these decisions are non-
repetitive and hardly made under independent identical conditions
over time. As a result some people opine that it is not very useful to
express the forecasters estimates in terms of probability. However,
in recent years another view of probability has received, that is, the

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personality view, which holds that it makes a great deal of sense to
talk about the probability of a single event, without reference to the
repeatability, long run frequency concept. Such probability
assignments that reflect the number of trials are called personal or
subjective probabilities.
Techniques of Risk Analysis: - A number of techniques to
handle risk are used by managers in practice. They range from
simple rules of thumb of sophisticated statistical techniques. The
following are popular non-conventional techniques of handling risk
in capital budgeting.
• Pay back
• Risk – Adjusted rate of return
• Certainly equivalent
Pay back: - Pay back is one of the oldest and commonly, used
methods for explicitly recognizing risk associated with an
investment project. This method, as applied in practice, is more an
attempt to allow for risk in capital budgeting decision rather than a
method to measure profitability. Business firms using this method
usually prefer short pay back to longer ones, and often establish
guidelines that a firm should accept investments with some
maximum payback period, say three or five years.
Merits: -
(1)It’s simplicity.
(2) It makes an allowances for risk by (a) focusing attention on
the near term future and there by emphassing the liquidity of
the firm through recovery of capital, and (b) by favoring short
term projects over what may be riskier, longer term projects.
It should be realized, however, that the payback period, as a
method of risk analysis, is useful only in allowing for a special
type of risk, the risk that a project will go exactly as planned
for a certain period and will then suddenly cease altogether
and may be worth nothing.

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Risk – Adjusted Rate of Return: - For a long time,
economic theorists have assumed that, to allow for risk, the
businessman required a premium over and above an alternative,
which was risk free. Accordingly, the more uncertain the returns in
the future, the greater the risk and the greater the premium
required. Based on this reasoning, it is proposed that the risk
premium be incorporated into the capital budgeting analysis
through the discount rate. That is if the time preference for money
is to be recognized by discounting estimated future cash flows, at
some risk-free rate, to their present value then to allow for the
riskiness, of those future cash flows a risk premium rate may be
added to risk –free discount rate. Such a composite discount rate,
called the risk- adjusted discount rate. The risk – adjusted discount
rate method can be formally expressed as follows.
n NCFt
NPV = ∑ (1+K)t
t=0
Were, K is a risk – adjusted rate. That is;
Risk – adjusted discount rate = Risk-free rate + Risk premium
K = Kf +Kr
The Risk – adjusted discount rate accounts for risks by varying the
discount rate depending on the degree of risk of investment
projects. A higher rate will be used for riskier projects and a lower
rate for less risk projects. The net present value will decrease with
increasing K, indicating that the riskier a project is received, the less
likely it will be accepted.
Evaluation of Risk –adjusted discount rate: -
(1)It is simple and can be easily understood.
(2)It has a great deal of intitive appeal for risk-averse
businessman.
(3) It incorporates an attitude (risk-aversion) towards uncertainty.
Limitations: -

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(a) There is no easy way of deriving a risk-adjusted discount rate.
Its use has yet to pick up in practice.
(b) It does not make any risk adjustment in the numerator for the
ash flows that are forecast over the future years.
(c) It is based on the assumption that investors are risk-averse.
Though it is generally true, there exists a category of risk seekers
who do not demand premium for assuming risks, they are willing to
pay a premium to take risks.
Certainty Equivalent: - Yet another common procedure for
dealing with risk of capital budgeting is to reduce the forecasts of
cash flows to some conservative levels. There is a certainty –
equivalent cash flows. In formal way, the certainty equivalent
approach may be expressed as:
n
NPV = ∑ £t NCFt
(l+kf)t
t=0
Where, NCFt = The forecasts of net cash flow without risk-
adjustment.
£t = the risk – adjustment factor or the certainity equivalent co-
efficient.
Kf = Risk-free assumed to be constant for all periods.
The certainty equivalent co-efficient, £t assumes a value
between 0 and 1, and varies inverly with risk. A lower £t will be used
if greater risk is perceioved and a higher £t will be used if lower risk
is anticipated. The decision – make subjectively or objectively
establishes the co - efficient. These co – efficients reflect the
decision – makers confidence in obtaining a particular cash flow in
period t.
Thus, to obtain certain cash flows, we will multiply estimated
cash flows by the certainty equivalent co- efficients.
The certainty equivalent co-efficient can be determined as a
relationship between the certain cash flows and the risky cash flows.

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That is,
NCFt Certain net cash flow
£t = NCFt Risky net cash flow
Evaluation of certainty equivalent: - The certainty
equivalent approach explicitly recognizes risk, but the procedure for
reducing the forecasts of cash flows is implicit and is likely to be
inconsistent from one investment to another.
(A) The forecaster, expecting the reduction that will be
made in his forecasts, may inflate them in anticipation.
This will no longer give forecasts according to ‘best
estimate’.
(B) If forecasts have to pass through several layers of
management, the effect may be to greatly exaggerate
the original forecasts or to make it ultra conservative.
(C) By focusing explicit attention only on the gloomy
outcomes, chances are increased for passing by some
good investments.
Sensitive Analysis: - In the evaluation of an investment
project, we work with the forecasts of cash flows. Forecasted cash
flows depend on the expected revenue and costs. Further, expected
revenue is a function of sales volume and unit selling price.
Similarly, sales volume will depend on the market size and the
firm’s market share. Costs include variable costs, which depend on
sales volume, and unit variable cost and fixed costs. The net present
value or the internal rate of return of a project is determined by
analyzing the after-tax cash flows arrived at by combining forecasts
of various variables.
The reliability of the NPV or IRR of the project will depend on
the reliability of the forecasts of variables underlying the estimates
of net cash flows. To determine the reliability of the project’s NPV or
IRR, we can work out how much difference it makes if any of these
forecasts goes worng. This method of recalculating NPV or IRR by
changing each forecast is called sensitivity analysis.

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Sensitivity analysis is a way of analyzing change in the
project’s NPV (or IRR) for a given change in one of the variables. It
indicates how sensitive a project’s NPV (or IRR) is to changes in
particular variables. The more sensitive the NPV, the more critical is
the variable. The following are three steps are involved in the use of
sensitivity analysis.
(1) Identification of all those variables, which have an influence
on the project’s NPV or (IRR).
(2) Definition of the underlying (mathematical) relationship
between the variables.
(3) Analysis of the impact of the change in each of the variables
on the project’s NPV.
The decision-maker, while performing sensitivity analysis, computes
the project’s NPV (or IRR) for each forecast under three
assumptions.
(1)Pessimistic
(2)Expected
(3)Optimistic
Pros and cons of sensitivity analysis: -
Advantages: -
(A) It compels the decision maker to identify the variables,
which affect the cash flow forecasts. This helps him in
understanding the investment project in totality.
(B) It indicates the critical variables for which additional
information may help in strengthening the weak spots in
the project.
(C) It helps to expose in appropriate forecasts, and thus guides
the decision-maker to concentrate on relevant variables.
Disadvantages: -
(a) It does not provide clear cut results. The term ‘optimistic’
and ‘pessimistic’ could mean different things to different
persons in an organization. Thus, the range of values
suggested may be inconsistent.

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(b) It fails to focus on the interrelationship between variables.
For example, sales volume may be related to price and
cost. A price cut may lead to high sales and low operating
costs.
Simulation Analysis: - We have explained in the previous sections
that sensitivity analysis is quite useful to understand the uncertainty
of the investment projects. This approach suffer from certain
weakness they do not consider the interactions between variables
and also, they do not reflect on the probability of the change in
variables.
The Monte Carlo simulation or simply the simulation analysis
considers the interactions among variables and probabilities of the
change in variables. It does not give the project’s NPV as a single
number rather it computes the probability distribution of NPV. The
simulation analysis is an extension of scenario analysis. In
simulation analysis a computer generates a very large number of
scenarios according to the probability distributions of the variables.
The simulation analysis involves the following steps:
(1) Identify the variables that influence cash inflows and
outflows. For example, when a firm introduces a new
product in the market these variables are initial
investment, market size, market growth, market
share, price, variable costs, fixed costs, product life
cycle and terminal value.
(2) Specify the formula that relates variables. For ex.
Revenue depends on by sales volume and price;
sales volume is given by market size, market share,
and market growth. Similarl6y, operating expenses
depend on production, sales and variable and fixed
costs.
(3) Indicate the probability distribution for each variable.
Some variables will have more uncertainty than

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others. For ex., it is quite difficult to predict price or
market growth with confidence.
(4) Develop a computer programme that randomly
selects one value from the probability distribution of
each variable and uses these values to calculate the
project’s NPV. The computer generates a large
number of such scenarios, calculates NPVs and stores
them. The stored values are printed as a probability
distribution of the project’s NPVS along with the
expected NPV and its standard deviation. The risk –
free rate should be used as the discount rate to
compute the project’s NPV. Since simulation is
performed to account for the risk of the project’s
cash flows, the discount rate should reflect only the
time value of money.
DECISION TREES FOR SEQUENTIAL INVESTMENT DECISIONS:
-
In practice, the present investment decisions may have
implications for future investment decisions, and may affect future
events and decisions. Such complex investment decisions involve a
sequence of decisions over time. It is angued that since present
choices modify future alternatives; industrial activity cannot be
reduced to a single decision and must be viewed as a sequence of
decisions extending from the present time into the future.
If this notion of industrial activity as a sequence of decisions is
accepted we must view investment expenditures not as isolated
period commitments but as links in a chain of present and future
commitments. An analysis technique to handle the sequential
decisions is to employ decision trees.
STEPS IN DECISION TREE APPROACH: - present decision
depends upon future events, and the alternatives of a whole
sequence of decisions in future are affected by the present decision

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as well as future events. Thus, the consequence of each decision is
influenced by the outcome of a chance event.
Equivalence of NPV and IRR: - It is important to distingwish
between conventional and non-conventional investments in
discussing the comparison between NPV and IRR methods. A
conventional investment can be defined as one whose cash flows
take the pattern of an initial cash outlay followed by cash inflows.
Conventional projects have only one change in the sign of cash
flows. For ex., the initial outflow followed by inflows, i.e.: - + + +. A
non – conventional investment on the other hand, is one, which has
cash flows mingled with cash inflows through out the life of the
project. Non – conventional investments have more than one
change in the signs of cash flows.
In case of conventional investments, which are economically
independent of each other? NPV and IRR methods result in same
accept or reject decision if the firm is not constrained for funds in
accepting all profitable projects. Same projects would be indicated
profitable by both methods.
All the projects with positive not present values would be
accepted if the NPV method is used, or projects with internal rates
of return higher than the required rate of return would be accepted
if the IRR method were followed. The last or marginal project
acceptable under the NPV method is the one, which has zero net
present value: while using the IRR method this project will have an
internal rate of return equal to the required rate of return. Projects
with positive net present values would also have internal rate of
return higher than the required rate of return and the marginal
project will have zero present value only when its internal rate of
return is equal to the required rate of return.
We know that NPV is:
n
NPV = ∑ CT -C0
(l+K)t
t=1

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and IRR is that rate of r which satisfies the following equation: -

n
NPV = ∑ Ct -C0=0
(l+r)t
t=1

Substracting Equation (4) from Equation (1), we get

n
NPV = ∑ Ct Ct
(l+k)t (l+r)t
t=1

Profitability index: -Yet another time – adjusted method of


evaluating the investment proposals is the benefit cost (B/C) ration
or profitability index (PI). Profitability index is the ratio of the
present value of cash inflows, at the required rate of return, to the
initial cash outflow of the investment. The formula for calculating
benefit cost ratio or profitability index is as follows.

PV of cash inflows PV(Ct) n


Ct

PI = = = ∑
/C0
Initial cash outlay C0 t=1
(1+K)t

Acceptance rule: -
 Accept the project when PI is greater than one.
PI>1
 Reject the project when PI is less than one. PI<1
 May accept the project when PI is equal to one.
PI=1
 The project with positive NPV will have PI greater
than one. PI less than one means that the
project’s NPV is negative.

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Evaluation of PI Method: -
(1) Time of Value: - It recognizes the time value of money.
(2) Value maximization: - It is consistent with the shareholder
value maximization principle. A project with PI greater than
one will have positive NPV and if accepted, it will increase
share-holder’s wealth.
(3) Relative Profitability: - In the PI method, since the present
value of cash inflows is divided by the initial cash outflow it
is a relative measure of a project’s profitability.
Like NPV method, PI criterian is also requires calculation
of cash flows and estimate of the discount rate. In
practice, estimation of cash flows and discount rate
pose problems.
Merits: -
(a) Considers all cash flows.
(b) Recognizes the time value of money.
(c) Relative measures of profitability.
(d) Generally consistent with the wealth maximization
principle.
Demerits: -
(a) Requires estimates of the cash flows which is tedious task.
(b)At times fails to indicate correct choice between mutually
exclusive projects.
Evaluation of PI method: -
1. Time value.
2. Value maximization.
3. Relative profitability.
Non-Discounted cash flow criteria: -
Pay-Back (PB): - The number of years required to recover
the initial outlay of the investment is called pay back.

Initial Investment CO
PB = =

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Annual cash flow C

Acceptance rule: -

- Accept if PB < Standard pay back.


- Reject if PB > Standard pay back.
Merits: -
1. Easy to understand and compute and inexpensive to
use.
2. Emphasizes liquidity.
3. Easy and Crude way to cope with risk.
4. Uses cash flows information.
Demerits: -
1. Ignores the time value of money.
2. Ignores cash flows occurring after pay back period.
3. Not a measure of profitability.
4. No objective way to determine the standard pays back.
5. No relation with the wealth maximization principle.
Discount pay back: - The number of years required in recovering
the cash outlay on the present value basis is the discounted payable
period. Except using discounted cash flows in calculating payback,
this method has all the demerits of pay back method.
Accounting rate of return (ARR): - An average rate of return
found by dividing the average net operating profit by the average
investment.

Average net operating profit after tax


ARR =
Average Investment
Acceptance rule: -
- Accept if ARR > minimum rate
- Reject if ARR < minimum rate
Merits: -

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a. Uses accounting data with which executives are familiar.
b. Easy to understand and calculate.
c. Gives more weight age to future receipts.
Demerits: -
a. Ignores the time value of money.
b. Does not use cash flows.
c. No objective way to determine the minimum acceptable
rate of return.

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