Page 157 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes

Task A machine purchased 6 years ago for 1,50,000 has been depreciated to a book
value of 90,000. It originally had a projected life of 15 years and zero salvage value. A
new machine will cost 2,50,000 and result in a reduced operating cost of 30,000 per year
for the next 9 years. The older machine could be sold for 50,000. The cost of capital is 10%.
The new machine will be depreciated on a straight-line basis over 9 years life with 25,000
salvage value. The company's tax rate is 50%; determine whether the old machine should
be replaced.

Self Assessment

Fill in the blanks:

10. The net cash outlay is the different amount of money that will be spent when the investment
is made in year………….... .
11. The cost of capital is an important element as basic input information in …………….
decisions.

6.6 Capital Decision under Risk and Uncertainty

In discussing the capital budgeting techniques, we have so far assumed that the proposed
investment projects do not involve any risk. The assumption was made simply to facilitate the
understanding of the capital budgeting techniques. In real life situations, the firm in general and
its investment projects in particular are exposed to different degrees of risk. What is risk and
how can risk be incorporated and measured in investment decisions in real world situation.

Nature of Risk

In the context of capital budgeting, the term, risk, refers to the chance that a project will prove
unacceptable - that is NPV < 0 or IRR < cost of capital. More formally, risk in capital budgeting
is the degree of variability of cash flows. Projects with a small chance of acceptability and a
broad range of expected cash flows are more risky than projects that have a high chance of
acceptability and a narrow range of expected cash flows.
In the capital budgeting projects, risk stems almost entirely from cash inflows, because the
initial investment i.e., cash outflow is generally known with relative certainty. These inflows
derive from a number of variables related to revenues expenditures and taxes.

Example: the level of sales, the cost of raw materials, labour rates, utility costs and tax
rates.
Risk is associated with the variability of future returns of a project. The greater the variability of
the expected returns, the riskier the project. Risk can however be measured more precisely.

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