WHAT IS CAPITAL BUDGETING?

Capital budgeting is a long term planning for making and financing proposed capital outlay Capital budgeting refers to firms formal process for the acquisition and investment of capital. Capital budgeting refers to the total process of generating, evaluating, selecting and following up on capital expenditure alternatives Thus capital budgeting is a decision making process through which a business concern evaluates the purchase of various fixed assets for expansion, replacement Capital budgeting is a planning of capital expenditure which provide yields over a number of years. on the basis of this we can define capital budgeting as:-

Capital budgeting is a long term planning for making and financing proposed capital outlay.

Capital budgeting consists in planning, development of available capital for the purpose of maximizing the long term profitability of the concern

Capital budgeting refers to total process of generating, evaluating, selecting and following up on capital expenditure alternatives.

Thus, capital budgeting is a decision making process through which a business concern evaluates the purchase of various fixed assets for expansion replacements. Since future estimates are exposed to different kinds of risks, forecasts cannot be made with certainty. Risk arises in investment evaluation because it is difficult to anticipate the future events with certainty. Cash flows depend on future events and these are likely to change. A project may be evaluated because it has a very high demand in the present, but this would be different, if there is a shift in the future demands of a product due to economic and political changes or in customers preferences.

"To understand uncertainty and risk is to understand the key business problem and the key business opportunity-------DAVID B.HERTZ

The capital budgeting decisions that a financial manager makes require analyzing each project's: 1. 2. 3. Future cash flows Uncertainty of future cash flows Value of these future cash flows

When we look at the available investment opportunities, we want to determine which projects will maximize the value of the company and, hence, maximize owners' wealth. That is, we analyze each project, evaluating how much its benefits exceed its costs. The projects that are expected to increase owners' wealth the most are the best ones. In deciding whether a project increases shareholder wealth, we have to weigh its benefits and its costs. The costs are: The cash flow necessary to make the investment (the investment outlay) and The opportunity costs of using the cash we tie up in this investment. The benefits are the future cash flows generated by the investment. But we know that anything in the future is uncertain, so we know those future cash flows are not certain. Therefore, for an evaluation of any investment to be meaningful, we must represent how much risk there is that its cash flows will differ from what is expected, in terms of the amount and the timing of the cash flows. Risk is the degree of uncertainty. We can incorporate risk in one of two ways: we can discount future cash flows using a higher discount rate, the greater the cash flow's risk, or We can require a higher annual return on a project, the greater the cash flow's risk. And, of course, we must incorporate risk into our decisions regarding projects that maximize owners' wealth. In this reading, we look at the sources of cash flow uncertainty and how to incorporate risk in the capital budgeting decision. We begin by describing what we mean by risk in the context of long-lived projects. We then propose several commonly used statistical measures of capital project risk. Then we look at the relation between risk and return, specifically for capital projects. And we follow with how risk can be incorporated in the capital budgeting decision and how it is applied in practice.

Risk
Risk is the degree of uncertainty. When we estimate (which is the best we can do) what it costs to invest in a given project and what its benefits will be in the future, we are coping with uncertainty. The uncertainty arises from different sources, depending on the type of investment being considered, as well as the circumstances and the industry in which it is operating.

Uncertainty

Reasons of uncertainty
Economic conditions
Will consumers be spending or saving? Will the economy be in a recession? Will the government stimulate spending? Will there be inflation? Market conditions Is the market competitive? How long does it take competitors to enter into the market? Are there any barriers, such as patents or trademarks that will keep c o m p e t i t o r s away? Is there sufficient supply of raw materials and labor? How much will raw m a te ri als and labor cost in the future? Taxes What will tax rates be? Will Congress alter the tax system?

Interest rates

What will be the cost of raising capital in future years?

International conditions
Will the exchange rate between different countries' currencies change? Are the governments of the countries in which the company does business stable?

These sources of uncertainty influence future cash flows. To evaluate and select among projects that will maximize owners' wealth, we need to assess the uncertainty associated with a project's cash flows. In evaluating a capital project, we are concerned with measuring its risk.

TYPES OF RISK
The events that influence risk can be classified as:

(1)BROAD SPECTRUM RISK (MARKET RISK):

These are risks associated with the business activities and are affected by economic policies, government and monetary policies, fiscal policies and social changes. Risk in the market are due to demand and supply conditions, inflation, interest rate changes. These affect cash flows which will bring about a change in the profitability of a proposal.

(2)INDUSTRY SPECIFIC RISKS:

An industry faces risk, which can be common parameters for the entire industry. An example may be taken of the cement industry, which is particularly affected by the policies of the government regarding subsidies, pricing of the product and taxation. Similarly an industry dealing with television manufacture may be faced with the problem of technology change.

(3)UNIQUE RISK OF THE INDIVIDUAL COMPANY:

A Company may face the risk of competition from similar products, for example a hair coloring company ay be faced with competitive colours from other companies by introducing new colours. The sales of one company will fall in favour of the other company.

(4)INTERNATIONAL RISKS: economic policies of different countries are related,

business is global, trade takes place between different countries and networking contracts are taking place. Consequently there are exchange rate risks and also political and economic risks involved in contracts. Risks have to be diversified or reduced in such a manner that the venture be continues to profitable.

ASSUMPTIONS OF RISKS

A firm is risk averse. A proposal will not be evaluated if risk can be detected
or identified. Additional risk is acceptable only when the increase in positive returns is expected to be very high.

When two proposals are evaluated the proposal with the lower risk will be
preferred.

When two proposals of the same risk class have been identified, then the
proposal with the greater positive returns will be preferred.

A firm does not have a shortage of funds and accepts all profitable projects
and rejects non-profitable risky projects.

The firm does not have the problem of capital rationing. The net investment of a proposal can be evaluated with certainity. The required rate of return indicates the risk and return of a proposal. The required rate of return of a firm is predetermined.

Methods:

The various methods for accounting for risk in capital budgeting are:Risk adjusted discount rate method Certainty equivalent method Sensitivity technique Probability technique Standard deviation method Co-efficient of variation method Decision tree analysis

RISK ADJUSTED CUT OFF RATE (RADR)

OR METHOD OF VARYING DISCOUNT RATE:

The simplest method of accounting for risk in capital budgeting is to increase the cut-off rate or discount factor by certain percentage on account of risk. The projects which are more risky and which have greater variability in expected returns should be discounted at a higher rate as compared to the projects which are less risky and are expected to have lesser variability in returns. For example, a 10% discount rate may be considered useful to calculate the cash flows of a project. In order to incorporate risk the discount rate can be increased. If it is a low risk, it can be increased to 11% and it is high risk then it can be increased to higher rates say 12% or 13% or even 15%. The difference between a proposal, which is at a risk less rate, and a risky one is called the risk premium or the risk adjusted discount rate. It considers both time and risk factors. Merits It is a simple technique and is compatible with both NPV and IRR. It helps to find out the expected future profits, which are, generated by a risky project. Demerits The assumption of the RADR is that the investors are risk averse. However people do assume risks and they are also willing to pay a premium to take risk. Thus incorporating risk is a subjective measure. The RADR does not adjust the future cash flows, which are also uncertain. The risk premium, which is added to the discount rate, has the limitation of the effect of compounding of risks. The financial management principles state that the discounting is important for taking time value and not risky conditions. RADR is useful only when risk increases with time, if risk does not increase the proposal cannot be calculated correctly.

The accept/reject decision through the RADR technique can be used both in NPV and IRR calculations. If NPV is used then the cash inflows should be higher than the cash outflows, at the risk adjusted discount rate, to be accepted as a good capital budget proposal. In case of IRR the internal rate of return should exceed riskadjusted rate of return.

CERTAINITY EQUIVALENT METHOD:

Another simple method of accounting for risk in capital budgeting is to reduce expected cash flows by certain amounts. It can be employed by multiplying the expected cash flows by certainty equivalent co-efficient as to convert the uncertain cash flows to certain cash flows. This approach is considered as an alternative method to RADR approach. It considers the adjustment of cash flows and not the discount rate. The approach is drawn directly from the concept of utility theory. This method forces the decision maker to specify at what point the firm is indifferent to the choice between a certain sum of money and the expected value of a risky sum. Under this approach, first determine a certainty equivalent adjustment factor, , as:

Once `s are obtained, they are multiplied by the original cash flow to obtain the equivalent certain cash flow. Then, the accept-or-reject decision is made, using the normal capital budgeting criteria. The risk-free rate of return is used as the discount rate under the NPV method and as the cut off rate under the IRR method.

Merits: It incorporates risk associated with cash inflows, which are uncertain. It is superior to the RADR because it does not compound the future risk.

Demerits: It is a subjective approach because the risk expected from cash flows may vary and the correct discount rate is difficult to apply. It does not use statistical method for adjusting risk.

What are the similarities and differences between the riskadjusted discount rate and the certainty equivalent methods for incorporating risk into the capital-budgeting?
The primary difference between the certainty equivalent approach and the riskadjusted discount rate approach is where the adjustment for risk is incorporated into the calculations. The certainty equivalent approach penalizes or adjusts downwards the value of the expected annual free cash flows, while the risk-adjusted discount rate leaves the cash flows at their expected value and adjusts the required rate of return, k, upwards to compensate for added risk. In either case the net present value of the project is being adjusted downwards to compensate for additional risk. An additional difference between these methods is that the risk-adjusted discount rate assumes that risk increases over time and that cash flows occurring later in the future should be more severely penalized. The certainty equivalent method, on the other hand, allows each cash flow to be treated individually.

SENSITIVITY TECHNIQUE
This approach helps to take decisions of accepting or rejecting a project through the estimation of net present value. If the three situations i.e. Optimistic Most Likely Pessimistic` are given when the cash flow estimates are given then the net present value will decide which of the projects should be selected. These are also evaluated in conditions of finding out about a project when there ia a change in one of the variable by analyzing after tax cash flows of combined forecast of the variables. Forecasts of many calculated NPVs under various alternative functions are compared to see how sensitive NPV is to changing conditions. It may be found that a certain variable or group of variables, once their assumptions are changed or relaxed, drastically alters the NPV. This results in a much riskier asset than was originally forecast. Merits: It is simple method and can be followed without any specific attention to training the personnel. Since the net present value approach is used, it provides an objective judgment of the proposals under evaluation.

Demerits: The probabilities, which are assigned , are prepared in a subjective manner. Each individual provides his own estimate and the basis of assigning probabilities varies from person to person. It does not give clear results because it does not focus on the interrelationships between variables.

STEPS FOR ANALYZING SENSITIVITY ANALYSIS:

Identify the variables, which have an influence on the NPV or IRR of a proposal. The mathematical relationship of the variable should be defined. Analysis of change in the variables through the NPV. On the basis of the results, the acceptance or rejection of a proposal.

PROBABILITY TECHNIQUE:
A probability is the relative frequency with which an event may occur. When future estimates of cash flows have different probabilities the expected monetary values may be computed by multiplying cash inflow with the probabilities assigned. The monetary values of the inflows may be discounted to find out the present values. The project that gives higher net present values may be accepted.

STANDARD DEVIATION METHOD:

If two projects have the same cost and their net present values are also the same, standard deviations of the expected cash inflows of the two projects may be calculated to judge the comparative risk of the projects. The projects having a higher standard deviation is said to be more risky as compared to the other. It can be calculated as:-

(d )
n

COEFFICIENT OF VARIATION METHOD:

Coefficient of variation is a relative measure of dispersion. If the projects have the same cost but different net present values, relative measure, i.e. coefficient of variation should be computed to judge the relative position of risk involved. It can be calculated as:-

Coefficient of variation= Standard Deviation * 100 Mean

DECISION TREE APPROACH:

In modern business there are complex investment decisions which involve sequence of decisions over time. Such sequential decisions can be handled buy plotting decisions trees. A decision tree is a graphic representation of the relationship between a present decision and future events, future decisions and their consequences. The sequence of events is mapped out over time in a format resembling branches of a tree and hence the analysis is known as a decision tree analysis. In this method, cash flows are assigned probabilities. Every future probability in terms of cash flows is evaluated after giving them weights in probability terms. It takes the impact of all potential cash flows.

STEPS INVOLVED IN DECISION TREE ANALYSIS ARE:

1. Identification of the problem 2. Finding out the alternatives 3. Exhibiting the decision tree indicating the decision points, chance events and other relevant data 4. Specification of probabilities and monetary values for cash inflows and 5. Analysis of the alternatives.

Merits: (1) It visually lays out all the possible outcomes of the proposed project and makes management aware of the adverse possibilities, and (2) The conditional nature of successive years` cash flows can be expressly depicted.

Demerits: (1) Most problems are too complex to permit year-by-year depiction and (2) It does not recognize risk.

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