Page 160 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 6: Capital Budgeting

Notes
Example: Let us determine the risk adjusted net present value of the following:

A B C
Net cash outlays ( ) 1,00,000 1,20,000 2,10,000
Project life 5 years 5 years 5 years
Annual cash inflow ( ) 30,000 42,000 70,000
Co-efficient of variation 0.4 0.8 1.2

The company selects the risk-adjusted rate of discount on the basis of coefficient of variation:

Coefficient of variation Risk adjusted rate of discount PV factor 1 to 5 years at risk
adjusted rate of discount
0.00 10% 3.791
0.40 12% 3.605
0.8 14% 3.433
1.2 16% 3.274
1.6 18% 3.127
2.0 22% 2.864
More than 2.0 25% 2.689

Solution:

Project Net cash Coefficient Market Annual PV Factor (1- Discounted NPV
outflow of variation discount cash 5 years) at cash inflow
rate inflow market
discount Rate
A 1,00,000 0.4 12% 30,000 3,605 1,08,150 8,150
B 1,20,000 0.8 14% 42,000 3,433 1,44,186 24,186
C 2,10,000 1.2 16% 70,000 3,274 2,29,180 19,180

6.7.3 Certainty Equivalent Approach

Under this method, risk element is compensated by adjusting cash inflows rather than adjusting
the discount rate. The risk adjustment factor is expressed in terms of certainty - equivalent
coefficient i.e. the relationship between certain (riskless) cash flows and risky (uncertain) cash
flows. The certainty equivalent coefficient can assume a value between 0 and 1 and is inversely
related with risk. If risk is more, certainty is less and certainty coefficient small and vice-versa.
The coefficients can be determined by subjective or objective assessments of cash flows that will
rise certainly and cash flows that are likely to occur.

The second step under this approach after conversion of expected cash flows into certainty
equivalents, is to calculate their present values based on the risk-free rate of discount (which
appropriately reflects the time value of money). Finally, it has to be decided whether the project
would be accepted or not, based on either NPV or the IRR method.

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