STRATEGIC INVESTMENT AND

FINANCING DECISIONS

Importance of Capital Budgeting Decisions

Capital budgeting is a process used to determine
whether a firms proposed investments or projects are
worth undertaking or not.
The process of allocating budget for fixed investment
opportunities is crucial because they are generally long lived
and not easily reversed once they are made.
So we can say that this is a strategic asset allocation process
and management needs to use capital budgeting
techniques to determine which project will yield more return
over a period of time.
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Why capital budgeting decisions are

critical?

The foremost importance is that the capital is a limited

resource which is true of any form of capital, whether it
is raised through debt or equity.

The firms always face the constraint of capital

rationing.

This may result in the selection of less profitable

investment proposals if the budget allocation and
utilization is the primary consideration.

Why capital budgeting decisions are

critical?

So the management should make a careful decision

whether a particular project is economically acceptable
and within the specified limits of the investments to be
made during a specified period of time.

In the case of more than one project, management must

identify the combination of investment projects that will
contribute to the value of the firm and profitability.

This, in essence, is the basis of capital budgeting

Types of Investment decisions:

1. Expansion existing or new
2. Replacement and modernization
3. Mutually Exclusive Investments
If one investment
is undertaken then others has to
be excluded
4. Independent Investments
Independent investments serve different
purposes and do not compete with each other.
5. Contingent Investments
Contingent Investments are dependent projects the
choice of one investment necessitates undertaking
one or more other investments. Example to build a
factory in a remote place needs supporting
infrastructure also to be developed.

Project classification

Mandatory Investment.
Replacement Projects Expansion
Projects Diversification projects
Research & Development Projects
Miscellaneous Projects

Evaluation of investment opportunities

Discounted Cash Flow methods

Net Present value (PV)

Internal Rate of Return (IRR)

Profitability Index [or] Benefit Cost Ratio (PI)

Non-Discounted Cash Flow Methods

Payback (PB)

Discounted Payback

Accounting rate of return (ARR)

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Investment Evaluation criteria

Steps involved in evaluation of an investment.

1. Estimation of cash flow

2. Estimation of required rate of return ( opportunity cost )
3. Application of decision rule (Capital Budgeting Techniques)
. A sound appraisal technique is used to measure the economic worth of
an investment project.
. It should consider all cash flows
. Objective way of separating good projects from bad It should help
ranking of projects profitability vise.
. Bigger cash flows are preferable to smaller and early cash flows are
preferable.
. It should help choose among mutually exclusive projects which
maximizes the shareholders wealth.
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Following are the capital budgeting

techniques:

Net Present Value

Internal Rate of Return
Profitability Index
Payback Period

Internal Rate Of Return And Mutually

Exclusive Projects. Whats the
Concern?
While considering the mutually exclusive projects, IRR
technique can be misleading. Investment projects are said
to be mutually exclusive if only one project could be
accepted and others would have to be rejected.
NPV and IRR methods for project evaluation leads to
conflicting results under following conditions:
The pattern of cash inflows plays an important role in
project evaluation while using IRR method. i.e. The cash
flows of one project may increase over time, while those of
others may decrease and vice versa. The major drawback
with the IRR method is that for mutually exclusive projects,
it can give contradictory investment decision when
compared with NPV.
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Consider the following example.

In the above example A and B are mutually exclusive projects. Both
projects require an initial outlay of $ 1,000,000.00 but the pattern of cash
inflows is different. Cash inflows for Project A are increasing over the
period of time while for Project B these are declining. IRR decision rule
leads to select Project A as Project A IRR>Project B IRR. But decision on
the basis of NPV evaluation implies that project B is more viable. Thus on
the basis of mere IRR the company may select less profitable project.

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In the above example A and B are mutually exclusive

projects.
Both projects require an initial outlay of $ 1,000,000.00 but
the pattern of cash inflows is different.
Cash inflows for Project A are increasing over the period of
time while for Project B these are declining.
IRR decision rule leads to select Project A as Project A
IRR>Project B IRR.
But decision on the basis of NPV evaluation implies that
project B is more viable.
Thus on the basis of mere IRR the company may select
less profitable project.

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The cash outflow of the projects may differ. i.e. a project may need capital
outlay not only at the time of investment but after regular intervals during
its expected life. Consider the following example:

Project A requires an initial outlay at the beginning of the project while

Project B needs cash outflow in year 2 and year 4 also. Decision based
on IRR method leads to select project B but NPV of project B is less than
of Project A. again under such circumstances IRR method plays a
deceive role.
Summarizing the above discussion the timings and pattern of cash
flows can produce conflicting results in the NPV and IRR methods
of project evaluation.
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Capital Budgeting Process

Evaluation of Capital budgeting project involves six steps:

First, the cost of that particular project must be known.

Second, estimates the expected cash out flows from the project,
including residual value of the asset at the end of its useful life.

Third, riskiness of the cash flows must be estimated. This requires

information about the probability distribution of the cash outflows.

Based on projects riskiness, Management find outs the cost of capital at

which the cash out flows should be discounted.

Next determine the present value of expected cash flows.

Finally, compare the present value of expected cash flows with the
required outlay. If the present value of the cash flows is greater than the
cost, the project should be taken. Otherwise, it should be rejected.

OR

If the expected rate of return on the project exceeds its cost of capital,
that project is worth taking.
Firms stock price directly depends how effective are the firms capital
budgeting procedures. If the firm finds or creates an investment opportunity
with a present value higher than its cost of capital, this would effect firms
value positively.
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Types of Capital Budgeting

Decisions
Capital budgeting refers to the total process of generating,
evaluating, selecting and following up on capital expenditure
alternatives. The firm allocates or budgets financial resources
to new Investment proposals. Basically, the firm may be
confronted with three types of capital budgeting decisions:
1.

Accept-Reject Decision

2.

Mutually Exclusive Project Decision

3.

Capital Rationing Decision

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Accept-Reject Decision

This is a fundamental decision in capital budgeting.

If the project is accepted, the firm would invest in it;

if the proposal is rejected, the firm does not invest in it.

In general, all those proposals which yield a rate of return greater than
a certain required rate of return or cost of capital are accepted and the
rest are rejected.

By applying this criterion, all independent projects are accepted.

Independent projects are the projects that do not compete with one
another in such a way that the acceptance of one precludes the
possibility of acceptance of another.

Under the accept-reject decision, all independent projects that satisfy

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the minimum investment criterion should be implemented.
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Mutually Exclusive Project

Decision
Mutually Exclusive Projects are those which compete with
other projects in such a way that the acceptance of one will
exclude the acceptance of the other projects.
The alternatives are mutually exclusive and only one
may be chosen. Suppose a company is intending to
buy a new folding machine.
There are three competing brands, each with a different
initial investment and operating costs.
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Mutually Exclusive Project Decision

The three machines represent mutually exclusive
alternatives, as only one of these can be selected.
Moreover, the mutually exclusive project decisions are
not independent of the accept-reject decisions.
The project should also be acceptable under the latter
decision.
Thus, mutually exclusive projects acquire significance
when more than one proposal is acceptable under the
accept reject decision

Capital Rationing Decision

In a situation where the firm has unlimited funds, all
independent investment proposals yielding returns greater
than some pre-determined level are accepted.
However, this situation does not prevail in most of the
business forms in actual practice.
They have a fixed capital budget. A large number of
investment proposals compete for these limited funds.

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Capital Rationing Decision

The firm must, therefore, ration them. The firm allocates funds to
projects in a manner that it maximizes long-run returns.
Thus, capital rationing refers to a situation in which a firm has
more acceptable investments than it can finance.
It is concerned with the selection of a group of Investment proposals
out of many investment proposals acceptable under the accept-reject
decision.
Capital rationing employs ranking of acceptable Investment
projects. These projects can be ranked on the basis of a predetermined criterion such as the rate of return. The projects are
ranked in the descending order of the rate of return

Why Cash Flows are preferred to

accounting profits
In any project, the timing of cash outflows and inflows are very important.
There is time value for money.
Any project should be appraised based on the timing of cash flows.
There is a difference between $5,000 received in the 1st year and the same
amount received after 10 years.
Hence the importance of time value of money.
The cash flow method considers the timing of cash inflows and outflows and
discounts those flows according to the time of occurrence.
Whereas, accounting profits ignore the time value of money.
As per the accounting profit, profit is generated once you sell the goods and
not when you realize payment for it.
If you receive the payment in advance or at the time of sale, you can very well
re-invest in the business when a good opportunity arises. Isnt it?
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Why Cash Flows are preferred to

accounting profits
For capital budgeting analysis, investment is in the form of cash outflow.
So, naturally the management needs to compare the costs(outflows) and
benefits(inflows) arising out of the project.
This can be effectively measured only by means of cash flow method. You
need cash to buy an asset. It is an outflow.
But accounting profit method, ignores expenditure of buying asset at the time of
purchase.
It records the expenditure of an asset over the entire economic life of the project in
the form of depreciation, which is a non-cash item.
Hence, even in this case, time value is ignored. The accounting profit does not
reflect the requirement of cash at outflow and inflow stages of time.
Moreover, this does not actually reflect the actual outflows and inflows. So, only the
cash flow method is the right choice for evaluating a capital budgeting decision.
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Why Cash Flows are preferred to

accounting profits

In cash flow method, there is only one way of calculation: cash

outflows and cash inflows would be considered.

Whereas, accounting profit calculation involves several ways of

calculation.

There are various principles in accounting which can be

followed and ultimately would result in different profit
calculations.

For example, one may depreciate an asset using straight-line method,

residual method, units of usage method etc.

In another case, you may value an inventory either by using LIFO,

FIFO or average cost method.

All these will result in different profits in respective calculations and

cash flow method avoids all these differences.

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Types of Investments and

Disinvestments

What is DIVESTITURE / DEMERGER / DIVESTING ?

Unlike the merger in which all assets are sold, a DIVESTITURE

/ DEMERGER / DIVESTING involves selling of some of the
assets only.
These assets may be in the form of plant, division, product line,
subsidiary etc.
DIVESTITURE / DEMERGER / DIVESTING are done may be due to
causing losses or yielding very low returns.
By selling such unproductive / non-performing assets and utilizing
cash proceeds in expanding / rejuvenating other leftover assets /
operating units, the firm is likely to augment the profits of the
demerged / divesting firm.
Evidently the motive for the demerger or divestiture is often
positive.
In technical terms it is aptly referred to as REVERSE SYNERGY. 2

Types of Investments and

Disinvestments
Financial
Evaluation
For financial evaluation it can be considered as REVERSE CAPITAL
BUDGETTING in that the selling firm receive cash by divesting as asset.
These cash inflow received are then compared with the present value of the
Cash Inflow After Tax (CFAT) sacrified on account of parting of a division.
In other words in has cash inflows in time zero.
For future years it has been deprived of cash inflows after taxes which the division
would have generated.
Given the basic conceptual framework of capital budgeting the following format can
be used.

(a) Decrease in CFAT duet o sale of division (for 1,2,..n )

(b) Multiply by appropriate present value factor (as per cost of capital)
relevent to division (given its risk level)
(c) Decrease in present value of the selling firm (a*b)
(d) Less: Present level due of obligations related to the liabilities of the
division.
(e) Present value lost due to sale of divison(c-d)
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Types of Investments and

Disinvestments
Decision Criteria
Selling firm should go for divestiture / demerger, if its divestiture
proceeds received from selling division are more than the
present value the demerger division otherwise would ;have
provided;
in case the present value lost due to sale of division is greater
than the sale proceeds obtained from it , the firm should not go
for divestiture / demerger,

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I nvestment Decisions under

Conditions of Uncertainty
Uncertainty and Risk Difference
Risk refers to a situation wherein the possible future outcomes of a
present decision are plural; however, the dimensions and
probabilities of these outcomes are known in advance.
Uncertainty refers to a situation wherein the possible future outcomes
are also plural; however, their dimensions and/or the probabilities
cannot be objectively specified in advance.
In terms of this concept, risk simply refers to a situation in
which the uncertainties are probabilistically quantified. The
magnitude of the risk is undefined.

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Investment Decisions under Conditions

of Uncertainty
Other writers consider the spread of the distribution (standard deviation) as a
measure of risk, especially in its standardized form (standard deviation
divided by the mean of the distribution).
However, these criteria are inadequate as a measure of risk because it is the
possibility of making a loss that is of fundamental importance to the businessman.
Although the two distributions
are of similar shape, distribution B
indicates that the uncertainty of the
outcome is a matter of making more
or less profit; distribution A on the
other hand indicates a very real
possibility of making either a profit
or a loss. It is the consequences,
should the outcome turn out to be
a loss, that constitute the real
business risk.
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I nvestment Decisions under

Conditions of Uncertainty
In the Oxford dictionary the word risk is defined, inter
alia, as 'the chance or hazard of commercial loss'.
In terms of this definition, risk is a function of two
uncertain possibilities concerning the future
outcome of a commercial decision, namely:
the amount of the possible loss,
the chance of this loss occurring.
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Project (Investment) selection under

risk (uncertainty)
Once information about expected return and variability or
return(measured in terms of range or standard deviation
or some other risk index) has been gathered
The next question is
Should the project be accepted or rejected - hence
incorporate the following risk in the decision process:

Judgmental evaluation.
Payback period requirement
Risk-adjusted discount rate and
Certainty equivalent.

The trade off between risk and profitability would have a bearing on the
investors perception of the firm before and after the acceptance of a specific
pro-proposal. If the acceptance of proposal for instance makes a firm more
risky the investors would not look to it with favor.

This may have an adverse implication for the market price of shares, total
valuation of the firm and its goal.

It is therefore necessary to incorporate the risk factor in the analysis of capital

budgeting (or selecting a project).

The term RISK with reference

to capital budgeting
/investment decision may therefore be defined as the
variability in the actual return emanating from a project
over its working life in relation to the estimated return as
forecast at the time of the initial capital budgeting decision.

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Risk Analysis

uncertainty

Probability of
occurrence of a
particular event
is not known

Outcome of a given
event which are too
unsure to be assigned
probabilities or past date
not available

risk

Probability of
occurrence of a
particular event
is known

certainty

Lease purchase capital

budgeting.
Buying government
securities etc.,

Set of unique outcomes

for a given event which
can be assigned
probabilities

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Project(Investment) selection under

risk(uncertainty)
Measurement of Risk (uncertainty)
1. Sensitivity Analysis with Assigning Probability.
2. Precise measurement of risk standard Deviation & Coefficient of
Variance
3. Simulation
Risk Valuation Approach
4.
5.
6.
7.
8.
9.

Judgmental evaluation.
Payback period requirement
Risk adjusted Discount Rate Approach
Certainty-Equivalent Approach
Probability Distribution Approach.
Decision Tree Approach.

Risk and Real Options

10. Growth Option
.11. Abandonment Option
12. Timing Option

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Measurement of Risk (uncertainty)

1. Sensitivity Analysis with Assigning
Probability.
2. Precise measurement of risk standard
Deviation & Coefficient of Variance
3. Simulation

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Sensitivity Analysis with assigning

probability
Sensitivity analysis expresses risk in more precise terms.
The expected cash flow, discount rate and the project life
are to estimation errors.
Sensitivity analysis comes in evaluating a project takes
care of estimation errors by using a number of possible
outcomes in evaluating a project.
Sensitivity analysis provide different cash flow estimates
under three assumptions (1) the worst the most
pessimistic (2) the expected the most likely (3) the best
the most optimistic.
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Particulars

Project A

Project Y

Initial cash outflow time

0
Cash inflow - time t= 115
Worst

Rs 40,000

Rs 40,000

6000

8000

8000

10000

16000

Required rate of return

0.1

0.1

Economic life

15 years

15 years

Most likely
Best

project

Project X

Expected cash
inflow

PV

NPV

PV

NPV

Worst

Rs 45,636

5,636

nil

(40,000)

Most Likely

60,848

20,848

60,848

20,848

Best

76,060

36,060

1,21,696

81,696

Project X is less risky than project Y

Depending on the risk appetite of the investor the decision is taken

The above analysis gives more than one estimate but does not give the
probabilities of each (worst, Most likely and Best) occurring.

Hence probabilities of each occurring can be assigned, Which will give more
accurate measure of the variability of cash flow.
For instance if means that some expect cash flow has 0.6 probability of
occurrence it means that the given such flow is likely to be obtained in 6
out of 10 times.
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Step 1 -Quantify the return either by Objective method or by Subjective method

Step 2 Estimate the expected return on the project. The return are expressed in
terms of expected monetary values.
The expedited value of a project is a Weighted Average Return
Where the weights are the probabilities assigned to the various expected events.
Possible NPV in Rs

Probability of NPV
occurrence

NPV x Probability in Rs

0.25
0.5
0.25
1.00

1,409
10,424
9,015

0.25
0.5
0.25
1.00

(10,000)
10,424
20,424

Project X
5,636
20,848
36,060
Project Y
(40,000)
20,848
81,696

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Sensitivity analysis can also be used to ascertain how change in key like sales
volume, sale price, variable costs, operating fixed costs, cost of capital etc.,
Assume a company with NPV of Rs 5 L for a capital outlay of Rs 25L.
The manager wants to find if the sale price will be 5 % then what will happen.
Assume by such an analysis will cause NPV negative.
It signals that the project is highly risky.

So the objective of sensitivity analysis is to determine how

sensitive; the NPV is to change in any key variables and to
identify which variable has the most significant impact on the
NPV

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Precise measurement of risk standard

Deviation & Coefficient of Variance
The standard deviation and variance are two such measures which tell us about
the variability associated with the expected the expected risk.
Standard Deviation is an absolute measure which can be applied when the
project involves the same outlay.
If the project to be compared involve different outlays the coefficient of variation is
the correct choice, being a relative measure.
Further to calculate the value of standard deviation, we provide weight to the
square of each deviation by its probability of occurrence.
Coefficient of Variance: Standard Deviation / Expected cash flow.
Standard Deviation can be misleading in comparing the uncertainty f alternative
projects, if they differ in size, The coefficient of variation is a correct technique in
such cases.
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Simulation

Is a statistical technique used to have and insight into risk in

a capital budgeting decisions.
This technique applies predetermined probability distributions
and random numbers to estimate risky outcomes.
Simulation model is similar to sensitivity analysis as it
attempts to answer what if analysis.
The advantage of simulation is that it is more comprehensive
than sensitivity analysis.
Simulation enables the distribution of probable value (say
NPV) for change in all the key variables, in one
iteration/run only.
Hence it provides more information and better understanding
about the risk associated with investment decisions to the
manager.
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Simulation

The computer calculates a random value of project

returns (say NPV) for each variabnle identified for the
model. For each set/iteration/run of random values
(consisting of all the variables listed in the model), a
new series of cash flows (cash inflows and out
flows) is generated and so also of NPV.
This is repeated numerous times.
This iteration exercise enables the decision maker to
develop a probbability distribution of the net present value
of the proposed investment project.
The value of standard deviation then can be used to
assess the level of risk associated with the project.

Risk Evaluation Approach

1. Judgmental evaluation.
2. Payback period requirement
3.Risk adjusted Discount Rate
Approach
4.Certainty-Equivalent Approach
5.Probability Distribution Approach.
6.Decision Tree Approach.
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Judgmental evaluation.
After through analysis managers decide judgmentally
whether the project should accepted or rejected under
the given risk (uncertain) conditions.
The decision may based on the collective view of some
group like the capital budgeting committee or the executive
committee or the board of directors.
If judgment decision making appears highly subjective or
haphazard, consider how most of us making important
decisions in our personal life.
We rarely use formal selection methods or quantitative
techniques for choosing a carrier, a spouse or an
employer.
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