Page 203 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 9: Capital Budgeting

The above gives very useful information about projects that appear equally desirable on Notes
the basis of most likely estimates of their cash flows. Project X is less risky than Project Y,
since the quantum of variation is relatively less in Project Y. The actual selection of the
project (assuming projects are mutually exclusive) will depend on decision makers’ attitude
towards risk. If he is conservative, he will choose Project X since there is no possibility of
suffering losses. On the other hand, if he is a risk-taker, he will choose Project Y, as there
is a possibility of higher returns as compared to Project X.
Advantages: Since sensitivity analysis provides more than one estimate of future return
of a project, it is superior to the single – figure forecast.

Limitation: The method does not disclose the chances of the occurrence of these variations.
To remedy this shortcoming of sensitivity analysis, so as to provide a more accurate
forecast, probability of the variation should be provided.

2. Probability assignment to expected cash flow: This method provides a more precise measure
of the variability of cash flows since it indicates the percentage chance of occurrence of
each possible cash flow. For example, if some expected cash flow has (0.6) probability of
occurrence, it means that the given cash flow is likely to be obtained in 6 out of 10 times.
The quantification of variability of returns involves two steps. First, depending on the
chances of occurrence of a particular cash flow estimate, probabilities are assigned. The
second step is to estimate the expected return on the project. The returns are estimated in
terms of expected monetary values based on a weightage average return, weights are the
probabilities assigned.

Example: From the following information regarding expected cash flows and then
probability for Project X, what is the expected return of the project assuming 10% as
discount rate – [Discount factor 10% year 1 – 0.909; year 2 – 0.826; year 3 – 0.751]

Year1 Year 2 Year 3
Cash flow Probability Cash flow Probability Cash flow Probability
( ) ( )
4,000 0.25 4,000 0.50 4,000 0.25
7,000 0.50 7,000 0.25 7,000 0.25
9,000 0.25 9,000 0.25 9,000 0.50

Solution: Cash flow
Year 1 = 4,000 × 0.25 + 7,000 × 0.50 + 9,000 × 0.25 = 6750
Year 2 = 4,000 × 0.50 + 7,000 × 0.25 + 9,000 × 0.25 = 6000

Year 3 = 4,000 × 0.25 + 7,000 × 0.25 + 9,000 × 0.50 = 7250
Calculation of Present Values:
Year 1 = 6750 × 0.909 = 6136, Year 2 = 6,000 × 0.826 = 4956
Year 3 = 7250 × 0.751 = 5445
Total 16,537

Advantages of the method: The assignment of probabilities and the calculation of expected
values, without doubt, taken into account the risk in terms of variability in explicit terms
of investment decisions.

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