Page 193 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 9: Capital Budgeting

Weakness and Difficulties Notes

1. Being a subjective estimate it cannot be objective, precise and consistent, hence conclusions
based on such estimates are open to question.
2. It does not directly use the probability distribution of possible cash flows.

3. It cannot be consistently applied to various projects and over time.

Example:

Cash outflows 1,50,000
Cash inflows Year 1 70,000
Year 2 90,000

Year 3 60,000
Riskless rate of return 9%
Risk adjusted rate of return for the current project 20%
Certainty equivalent coefficients for future cash inflows:

Year 1 0.90
Year 2 0.80
Year 3 0.65
Solution:

NPV based on risk-adjusted rate of discount
70,000 90000 60000
= – 150,000 + + +
1.20 (1.20) 2 (1.20) 3
= – 150,000 + 58,333 + 62500 + 41667 = –150000 + 162500
= 12500, positive; hence project should be accepted
NPV based on certainty equivalent coefficient:
70,000 × 0.90 90000 × 0.80 60000 × 0.65
= – 150,000 + + 2 + 3
1.09 (1.09) (1.09)
= – 150000 + 57798 + 60601 + 30115
= – 150000 + 148514 = – 1486
= Negative; hence project should not be accepted.
Hence from the above illustration, it is clear that both the above methods may not yield identical
results.

9.7.4 Probability Distribution Approach

The probability distribution of cash flows over different periods provides valuable information
about expected value of return and the dispersion of probability distribution of possible returns.
On this basis, an accept-reject decision can be taken.
The application of probability distribution approach in analysing risk in capital budgeting
depends upon the behaviour of the cash flows whether the cash flows are (a) independent or

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