M.B.A. II Year 2011-12 Elective Subject

STRATEGIC INVESTMENT AND FINANCING DECISIONS1Importance 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.2Why 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.

3Why 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:Expansion existing or newReplacement and modernizationMutually Exclusive InvestmentsIf one investmentis undertaken then others has to be excludedIndependent InvestmentsIndependent investments serve different purposes and do not compete with each other.Contingent InvestmentsContingent 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.

Mandatory Investment.Replacement Projects ExpansionProjects Diversification projectsResearch & Development ProjectsMiscellaneous ProjectsProject classification6Discounted 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 PaybackAccounting rate of return (ARR)Evaluation of investment opportunities

10Steps involved in evaluation of an investment.

Estimation of cash flowEstimation of required rate of return ( opportunity cost )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 flowsObjective 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.Investment Evaluation criteria8Following are the capital budgeting techniques:

Net Present Value Internal Rate of ReturnProfitability Index Payback Period9Internal 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.10Consider 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.11In 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.12The 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.13Capital Budgeting ProcessEvaluation 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.ORIf 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.14Types of Capital Budgeting DecisionsCapital 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:

Accept-Reject Decision

Mutually Exclusive Project Decision

Capital Rationing Decision15Accept-Reject DecisionThis 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 the minimum investment criterion should be implemented.16Mutually Exclusive Project DecisionMutually 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.

20Mutually 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

21In 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.

Capital Rationing DecisionThe 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 pre-determined criterion such as the rate of return. The projects are ranked in the descending order of the rate of return

Capital Rationing DecisionIn 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?Why Cash Flows are preferred to accounting profits21For 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.22Why Cash Flows are preferred to accounting profitsIn 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.23Why Cash Flows are preferred to accounting profitsTypes of Investments and DisinvestmentsWhat 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.24Types of Investments and DisinvestmentsFinancial EvaluationFor 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.Decrease in CFAT duet osale of division (for 1,2,..n )Multiply by appropriate present value factor (as per cost of capital) relevent to division (given its risk level)Decrease in present value of theselling firm (a*b)Less: Present level due of obligations related to the liabilities of the division.Present value lost due to sale of divison(c-d)26Types of Investments and DisinvestmentsDecision 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 notgo for divestiture / demerger,27Investment Decisions under Conditions of UncertaintyUncertainty 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.29Other 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 distributionsare 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 bea loss, that constitute the real business risk.IInvestment Decisions under Conditions of Uncertainty 39In 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.Investment Decisions under Conditions of Uncertainty29Project (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 thereforenecessary 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.31uncertaintyriskProbability of occurrence of a particular event is knownProbability of occurrence of a particular event is not knownOutcome of a given event which are too unsure to be assigned probabilities or past date not availableSet of unique outcomes for a given event which can be assigned probabilities32certaintyLease purchase capital budgeting.Buying government securities etc.,Risk AnalysisMeasurement of Risk (uncertainty)Sensitivity Analysis with Assigning Probability.Precise measurement of risk standard Deviation & Coefficient of VarianceSimulation

Risk Valuation Approach

Judgmental evaluation.Payback period requirementRisk adjusted Discount Rate ApproachCertainty-Equivalent ApproachProbability Distribution Approach.Decision Tree Approach.

Risk and Real Options

Growth OptionAbandonment OptionTiming OptionFlexibility option

Project(Investment) selection under risk(uncertainty).35Measurement of Risk (uncertainty)

Sensitivity Analysis with Assigning Probability.Precise measurement of risk standard Deviation & Coefficient of VarianceSimulation36Sensitivity 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 projecttakes 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.Sensitivity Analysis with assigning probability37ParticularsProject AProject YInitial cash outflow time 0Rs 40,000Rs 40,000Cash inflow - time t= 1-15Worst60000Most likely80008000Best1000016000Required rate of return0.10.1Economic life15 years15 yearsProject X is less risky than project YDepending on the risk appetite of the investor the decision is takenThe 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.37Project X project yExpected cashinflowPVNPVPVNPVWorstRs 45,6365,636nil(40,000)Most Likely60,84820,84860,84820,848Best76,06036,0601,21,69681,696Step 1 -Quantify the return either by Objective method or by Subjective methodStep 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 ReturnWhere the weights are the probabilities assigned to the various expected events.38Possible NPV in RsProbability of NPVoccurrenceNPV x Probability in RsProject X5,6360.251,40920,8480.510,42436,0600.259,0151.00Project Y(40,000)0.25(10,000)20,8480.510,42481,6960.2520,4241.00Sensitivity analysis can also be used to ascertain how change in key like salesvolume, 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 NPV40Precise measurement of risk standard Deviation & Coefficient of VarianceThe 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.40Simulation.Is a statistical technique used to have and insight into risk in a capital budgeting decisions.This technique applies predetermined probability distributionsand 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.41Simulation.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.

RiskEvaluation Approach

Judgmental evaluation.Payback period requirementRisk adjusted Discount Rate ApproachCertainty-Equivalent ApproachProbability Distribution Approach.Decision Tree Approach.43After 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.Judgmental evaluation.44