UJJ SFM ASI

7/24/2019 UJJ SFM ASI

1/23

STRATEGIC FINANCIAL MANAGEMENT

Investment decision under risk and uncertainty

Techniques o Investment decision

Risk ad!usted discounted rate " Certain equiva#ent actors

Sensitivity ana#ysis and other methods o ca$ita# %ud&etin&

Com$arative ana#ysis o dierent methods o ca$ita# %ud&etin& 'ith risk and

uncertainty


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Investment decision under risk and uncertainty

Meaning(

)A determination made %y directors and*or mana&ement as to ho'+

'hen +'here and ho' much ca$ita# 'i## %e s$ent on investment o$$ortunities,

The decision oten o##o's research to determine costs and returns or each

o$tion,-

.ecision makin& is one o the ma!or mana&ement unctions, It invo#vescommitment to action 'hich requires qua#ity decisions to %e made or the

$ur$ose o the day to day runnin& o an or&ani/ation, To arrive at a qua#itydecision+ there must %e a $#an, 0#annin& reers to settin& attaina%#e &oa#s 'hichre#ates to the uture,1ICMA 23345, The environment in 'hich decisions are

%ein& made are #aced 'ith uncertainties and inherent risks thus+ e6tra cautionsare needed in takin& investment decisions, 7oont/ and 8eihrich 123935 deineddecision makin& as these#ection o a course o action rom amon& a#ternatives, :#o'e 1233;5+ deineddecision makin&+ as the $rocess o se#ectin& a #o&ica# choice rom avai#a%#eo$tions,


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e6$ect that the risk invo#ved is equa##y hi&h, Every investor e6$ects somereturns that 'ou#d cover the or&ani/ation>s inancia# commitments to servicesand $roduction as the case may %e,


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Investors common#y $erorm investment ana#ysis %y makin& use oundamenta# ana#ysis+ technica# ana#ysis and &ut ee#,

Investment decisions are oten su$$orted %y decision too#s, The investment decisions taken %y cor$orate are kno'n as ca$ita#

%ud&etin& decisions, The ca$ita# %ud&etin& decisions invo#ve eva#uation o s$eciic investment

$ro$osa#s,


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Techniques o Investment decision

:n economic %asis+ A num%er o Investment .ecision techniques are used in$ractice, They may %e &rou$ed in the o##o'in& t'o cate&ories(

I, Investment .ecision 1Ca$ita# %ud&etin&5 techniques under certaintyD andIi, Investment .ecision 1Ca$ita# %ud&etin&5 techniques under uncertainty

Capital budgeting techniques under certainty

Ca$ita# %ud&etin& techniques 1Investment a$$raisa# criteria5 under certainty cana#so %e divided into o##o'in& t'o &rou$s(

Non.iscounted Cash F#o' Criteria(

1a5 0ay ack 0eriod 10051%5 Accountin& Rate : Return 1ARR5

.iscounted Cash F#o' Criteria( 1a5 Net 0resent a#ue 1N051%5 Interna# Rate o Return 1IRR51c5 0roita%i#ity Inde6 10I5

Non-Discounted Cash Flow Criteria:

! "ay #ack "eriod

"ayback periodin ca$ita# %ud&etin&reers to the $eriod o time required

to recou$ the unds e6$ended in an investment+ or to reach the%reakeven$oint,

For e6am$#e+ a 9333 investment 'hich returned 33 $er year 'ou#d

have a t'oyear $ay%ack $eriod, The time va#ue o moneyis not takeninto account,

0ay%ack $eriod intuitive#y measures ho' #on& somethin& takes to H$ayor itse#,H A## e#se %ein& equa#+ shorter $ay%ack $eriods are $reera%#e to#on&er $ay%ack $eriods,

0ay%ack $eriod is $o$u#ar due to its ease o use des$ite the reco&ni/ed

#imitations descri%ed %e#o',$imitation0ay%ack $eriod doesnt take into consideration the time va#ue o money

and thereore may not $resent the true $icture 'hen it comes to

eva#uatin& cash #o's o a $ro!ect,


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0ay%ack a#so i&nores the cash #o's %eyond the $ay%ack $eriod, Most

ma!or ca$ita# e6$enditures have a #on& #ie s$an and continue to $rovidecash #o's even ater the $ay%ack $eriod, Since the $ay%ack $eriodocuses on short term $roita%i#ity+ a va#ua%#e $ro!ect may %e over#ooked

i the $ay%ack $eriod is the on#y consideration,

Example:

Estimate the $ay%ack $eriod or(

%ear & ' ( ) *

CF 93+333 J+33 J+33 @+333 2+333

Solution:

To ind the $ay%ack $eriod+ 'e need to ind the cumu#ative cash #o's irst

%ear & ' ( ) *

CF 93+333 J+33 J+33 @+333 2+333

CCF 93333 33 9333 2333 J333

The $ay%ack $eriod occurs 'hen the cumu#ative cash #o's chan&es rom ne&ative to

$ositive, That is+ it occurs %et'een years 2 and @, ecause 'e sti## have to recover 9333 ater

second year+ the $ay%ack $eriod is( 2 K 9333*@333 2,@@ years

15 Accountin& Rate o Return 1ARR5Accountin& Rate o Return+ short#y reerred to as ARR+ is the $ercenta&e oavera&e accountin& $roit earned rom an investment in com$arison 'ith the

avera&e accountin& va#ue o investment over the $eriod,


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Accountin& Rate o Return is a#so kno'n as the Avera&e Accountin& Return1AAR5 and Return on Investment 1R:I5,

Computation Method:

9, Estimate the net incomes

2, Estimate the %ook va#ues

@, Estimate avera&e net incomes

J, Estimate avera&e %ook va#ue 1i,e, or strai&ht#ine de$reciation+ avera&e

%ook va#ue is historica# va#ue sa#va&e va#ueO*25

Decision Rule:

8e acce$t the $ro!ect i the AAR is &reater than a $reset rate,

Pros and Cons:

0ros Cons

9, Easy to ca#cu#ate,

2, Needed inormation 'i## usua##y%e avai#a%#e,

9, It is not a true rate o return,

2, Time va#ue o money is i&nored,

@, Pses an ar%itrary cuto $oint,

J, ased on accountin& net incomeand %ook va#ues+ not cash #o's and

market va#ues,

Example:

Assume a com$any invests J33+333 in $ro!ect de$reciated usin& strai&ht#ine method over J

years 'ith /ero sa#va&e va#ue, The o##o'in& ta%#e sho's the revenues and o$eratin&

e6$enses, Ca#cu#ate AAR usin& J3Q ta6 rate(

%ear ' ( ) *


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+evenue 233+333 23+333 @33+333 @23+333

,perating .penses ?3+333 933+333 923+333 ?3+333

Solution:

First+ 'e ind the net income 'here de$reciation 1%ook va#ue sa#va&e va#ue5* useu# #ie,

.e$recation is J33+333*J 933+333

%ear ' ( ) *

+evenue 233+333 23+333 @33+333 @23+333

,perating .penses ?3+333 933+333 923+333 ?3+333

Depreciation 933+333 933+333 933+333 933+333

/a.es 0 &!* 1+-,-D2 J+333 23+333 @2+333 2+333

Net Income 4+333 @3+333 J;+333 B;+333

Avera&e net income 14+333 K @3+333 K J;+333 K B;+3335*J J3+33

Avera&e %ook va#ue 1J33+33335*2 233+333

Discounted Cash Flow Criteria:


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12 Net "resent 3alue1N05The net $resent va#ue 1N05 is the $resent va#ue o uture aterta6 cash #o's

minus initia# investment, It re#ects the dierence %et'een the market va#ue o

the $ro!ect and its cost,

Computation Method:

9, Estimate the e6$ected uture cash #o's,

2, Estimate the required return or $ro!ects o this risk #eve#,

@, Find the $resent va#ue o the cash #o's and su%tract the initia#

investment,

8here CFtis the cash #o' at time t+ ris the discount rate or the investment

and out#ay is the investment cash #o' at time 3,

Decision Rule:

8e acce$t the $ro!ect i the N0 is &reater than /ero, A $ositive N0 means

that the $ro!ect is e6$ected to add va#ue to the irm and 'i## thereore increasethe 'ea#th o the o'ners, Since our &oa# is to increase o'ner 'ea#th+ N0 is a

direct measure o ho' 'e## this $ro!ect 'i## meet our &oa#,

Pros and Cons:

0ros Cons

9, N0 &ives im$ortance to the timeva#ue o money,

2, In the ca#cu#ation o N0+ %oth atercash #o' and %eore cash #o' over the#ie s$an o the $ro!ect are considered,

@, 0roita%i#ity and risk o the $ro!ectsare &iven hi&h $riority,

J, N0 he#$s in ma6imi/in& the irm>s

va#ue,

9, N0 is diicu#t to use,

2, N0 can>t &ive accurate decision ithe amount o investment omutua##y e6c#usive $ro!ects is notequa#,

@, It is diicu#t to ca#cu#ate thea$$ro$riate discount rate,

J, N0 may not &ive correct decision

'hen the $ro!ects are o unequa# #ie,


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Example:

Estimate the N0 at 93Q discount rate or(

%ear & ' ( ) *

CF 93+333 J+33 J+33 @+333 2+333

Solution:

15 Interna# Rate o Return 1IRR5


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This is the most im$ortant a#ternative to N0D it is oten used in $ractice and is

intuitive#y a$$ea#in&, It is %ased entire#y on the estimated cash #o's and is

inde$endent o interest rates ound e#se'here,

Computation Method:


2, Estimate usin& tria# and error the discount rate that makes N0 3

8ritten out in an equation orm+

Decision Rule:

Acce$t the $ro!ect i the IRR i it is &reater than the required return,

Pros and Cons:

0ros Cons

9, 7no'in& a return is intuitive#y a$$ea#in& mana&ers #ike to hear returns,

2, It is a sim$#e 'ay to communicate the va#ueo a $ro!ect to someone 'ho does not kno'a## the estimation detai#s,

@, I the IRR is hi&h enou&h+ you may not needto estimate a required return+ 'hich oten is adiicu#t task,

9, Pnrea#istic assum$tion o reinvestmentat IRR un#ike N0 'hich assumesreinvestment at 8ACC 'hich is a rea#isticassum$tion,

2, IRR is not &ood or com$arin& t'omutua##y e6c#usive investments,

Example:

Estimate the IRR at 93Q discount rate or(

%ear & ' ( ) *

CF 93+333 J+33 J+33 @+333 2+333


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Solution:

Psin& tria# and error+ i 'e start 'ith discount rate o 9BQ

8e ind(

So 'e use a hi&her discount rateD #et>s say 'e a$$#y a discount rate o9;Q+ 'e ind(

Thereore+ the discount rate that makes N0 3 is %et'een 9BQ and 9;Q, 7ee$in& tria# and

error+ then IRR 9B,J@Q

1C5 0roita%i#ity Inde6 10I5The $roita%i#ity inde6 10I5 is very c#ose#y re#ated to net $resent va#ue 1N05, It

is the $resent va#ue o cash #o's dividend %y the initia# investments,


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Computation Method:


2, Estimate the required return or $ro!ects o this risk #eve#,

@, Find the $resent va#ue o the cash #o's and divide %y the initia#

investment,

8here CFtis the cash #o' at time t+ ris the discount rate or the investment

and out#ay is the investment cash #o' at time 3,

Decision Rule:

8e acce$t the $ro!ect i the 0I is &reater than one, 0I &reater than one means

that the $ro!ect is e6$ected to add va#ue to the irm and 'i## thereore increase

the 'ea#th o the o'ners,

Pros and Cons:

0ros Cons

9, 0I he#$s in ma6imi/in& the irm>s va#ue,

2, 0I is useu# in cases o ca$ita# rationin&,

9, 0I can>t &ive accurate decision i theamount o investment o mutua##ye6c#usive $ro!ects is not equa#,

2, It may not %e easy to understand,

Example:

Estimate the 0I at 93Q discount rate or(

%ear & ' ( ) *

CF 93+333 J+33 J+33 @+333 2+333


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Solution:

+isk d4usted Discounted +ate 1+D+2

Accordin& to $andy 1233?5+ risk is the varia%i#ity that is #ike#y to occur in

the uture returns o a $ro!ect,

The %asic $rinci$#e o RA.R is that there shou#d %e adequate re'ard in

the orm o return to the irms 'hich decide to e6ecute risky %usiness

$ro!ects

Man %y nature is riskaverse and tries to avoid risk

To motivate irms to take u$ risky $ro!ects+ returns e6$ected rom the

$ro!ect sha## have to %e adequate+ kee$in& in vie' the e6$ectations o the

investors, Thereore risk $remium needs to %e incor$orated in discount

rate durin& the eva#uation o risky $ro!ect $ro$osa#s,

This method o risk ana#ysis ad!usts the cost o ca$ita# u$'ards as

$ro!ects %ecome more risky, Greater the risk+ hi&her the ad!usted discount

rate+ and thereore #o'er the $ro!ect>s riskad!usted N0

RA.R is more %rie#y descri%ed as (

RA.R Risk ree rate K risk $remium

Risk ree rate is com$uted %ased on the returns on &ovt, securities,

Risk $remium is the additiona# returns that the investors require or

assumin& the additiona# risk associated 'ith the $ro!ect to %e taken u$ or

e6ecution,

Thus+ $ro!ects are eva#uated on the %asis o uture cash #o' $ro!ections and

an

a$$ro$riate discount rate,Decision +ule:


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The risk ad!usted a$$roach can %e used or %oth N0 " IRR,

I N0 method is used or eva#uation+ the N0 'ou#d %e ca#cu#ated usin& risk ad!usted

rate, I N0 is $ositive+ the $ro$osa# 'ou#d qua#iy or acce$tance+ i it is ne&ative+ the

$ro$osa# 'ou#d %e re!ected,

In case o IRR+ the IRR 'ou#d %e com$ared 'ith the risk ad!usted required rate o

return, I the =r> e6ceeds risk ad!usted rate+ the $ro$osa# 'ou#d %e acce$ted+ other'ise not,

For e6am$#e+ i an investment $ro!ect has o##o'in& cash #o's+ its N0 usin& RA.R

'i## %e as o##o's(

Risk ree rate is 4Q and Risk ad!usted rate is 93Q,

%ear CF/

1+s!2

"3 5 '&6 "3 1+s!2

9 3333 3,?3? JJ3

2 J3333 3,;24 @@3J3

@ J333 3,B9 @@B?

PV 112285

Less( Investment 93333

N0 1@BB95

Merits:

It is sim$#e to ca#cu#ate and easy to understand,

It has a &reat dea# o intuitive a$$ea# or riskaverse %usinessman,

It incor$orates an attitude to'ards uncertainty,

Demerits:

The determination o a$$ro$riate discount rates kee$in& in vie' the dierin& de&rees o risk

is ar%itrary and does not &ive o%!ective resu#ts,


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Conce$tua##y this method is incorrect since it ad!usts the required rate o return, As a matter

act it is the uture cash #o's 'hich are su%!ect to risk,

This method resu#ts in com$oundin& o risk over time+ thus it assumes that risk necessari#y

increases 'ith time 'hich may not %e correct in a## cases,

The method $resumes that investors are averse to risk+ 'hich is true in most cases,


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%ear NCF

1+s!2

C

Coe77icient

d4usted

NCF

1+s!2

"3 5 86 "3

1+s!2

9 43+333 3,; J;+333 3,?2 J4?4

2 B3+333 3,4 J2+333 3,?3B @;3?J

@ J3+333 3,B 2;+333 3,;4J 2J9?2

PV 107982

Less( Investment 933333

N0 B?;2

Decision +ule:

I N0 method is used+ the $ro$osa# 'ou#d %e acce$ted i N0 o CE cash

#o's is $ositive+ other'ise it is re!ected,

I IRR is used+ the interna# rate o return 'hich equates the $resent va#ue o

CE cash in#o's 'ith the $resent va#ue o the cash out#o's+ 'ou#d %e

com$ared 'ith risk ree discount rate, I IRR is &reater than the risk ree rate+

the investment $ro!ect 'ou#d %e acce$ted other'ise it 'ou#d %e re!ected

Merits:

It is sim$#e to ca#cu#ate,

It is conce$tua##y su$erior to timead!usted discount rate a$$roach %ecause it

incor$orates risk %y modiyin& the cash #o's 'hich are su%!ect to risk,

Demerits:


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This method e6$#icit#y reco&ni/es risk+ %ut the $rocedure or reducin& the

orecast o cash #o's is im$#icit and #ike#y to %e inconsistent rom one

investment to another,

The orecaster e6$ectin& reduction that 'i## %e made in his orecast+ may

in#ate them in antici$ation, This 'i## no #on&er &ive orecasts accordin& to

)%est estimate-,

I orecast have to $ass throu&h severa# #ayers o mana&ement+ the eect may

%e to &reat#y e6a&&erate the ori&ina# orecast or to make it u#tra conservative,

y ocusin& e6$#icit attention on#y on the oomy outcomes+ chances are

increased or $assin& %y some &ood investments,

9ensitivity nalysis nd ,ther Methods ,7 Capital #udgeting

9ensitivity nalysis

8hi#e eva#uatin& any ca$ita# %ud&etin& $ro!ect+ there is a need to orecast

cash #o's, The orecastin& o cash #o's de$ends on sa#es orecast and

costs, The Sa#es revenue is a unction o sa#es vo#ume and unit se##in& $rice,

Sa#es vo#ume 'i## de$end on the market si/e and the irm>s market share,

The N0 and IRR o a $ro!ect are determined %y ana#y/in& the aterta6

cash #o's arrived at %y com%inin& various varia%#es o $ro!ect cash #o's+

$ro!ect #ie and discount rate, The %ehavior o a## these varia%#es are very

much uncertain,

The sensitivity ana#ysis he#$s in identiyin& ho' sensitive are the

various estimated varia%#es o the $ro!ect, It sho's ho' sensitive is a

$ro!ect>s N0 or IRR or a &iven chan&e in $articu#ar varia%#es,

The more sensitive the N0+ the more critica# is the varia%#es,

9teps:

The o##o'in& three ste$s are invo#ved in the use o sensitivity ana#ysis,

9, Identiy the varia%#es 'hich can in#uence the $ro!ect>s N0 or IRR,

2, .eine the under#yin& re#ationshi$ %et'een the varia%#es,


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@, Ana#y/e the im$act o the chan&e in each o the varia%#es on the $ro!ect>s

N0 or IRR,

The 0ro!ect>s N0 or IRR can %e com$uted under o##o'in& three

assum$tions in

sensitivity ana#ysis,

9, 0essimistic 1i,e, the 'orst5+

2, E6$ected 1i,e, the most #ike#y5

@, :$timistic 1i,e, the %est5

Merits:

The sensitivity ana#ysis has the o##o'in& advanta&es(

It com$e#s the decision maker to identiy the varia%#es aectin& the cash

#o'

orecasts 'hich he#$s in understandin& the investment $ro!ect in tota#ity,

It identiies the critica# varia%#es or 'hich s$ecia# actions can %e taken,

It &uides the decision maker to concentrate on re#evant varia%#es or the

$ro!ect,

Demerits:

The sensitivity ana#ysis suers rom o##o'in& #imitations(

The ran&e o va#ues su&&ested %y the technique may not %e consistent, The

terms

=o$timistic> and =$essimistic> cou#d mean dierent thin&s to dierent $eo$#e,

It ai#s to ocus on the interre#ationshi$ %et'een varia%#es, The study o

varia%i#ity o one actor at a time+ kee$in& other varia%#es constant may not

much sense, For e6am$#e+ sa#es vo#ume may %e re#ated to $rice and cost,

:ne

can not study the eect o chan&e in $rice kee$in& quantity constant,


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9cenario nalysis:

In sensitivity ana#ysis+ ty$ica##y one varia%#e is varied at a time, I varia%#es

are interre#ated+ as they are most #ike#y to %e+ it is he#$u# to #ook at some

$#ausi%#e scenarios+ each scenario re$resentin& a consistent com%ination o

varia%#es,

"rocedure:

The ste$s invo#ved in scenario ana#ysis are as o##o's (

9, Se#ect the actor around 'hich scenarios 'i## %e %ui#t, The actor chosen

must %e the #ar&est source o uncertainty or the success o the $ro!ect, Itmay %e the state o the economy or interest rate or techno#o&ica#

deve#o$ment or res$onse o the market,

2, Estimate the va#ues o each o the varia%#es in investment ana#ysis

1investment out#ay+ revenues+ costs+ $ro!ect #ie+ and so on5 or each scenario,

@, Ca#cu#ate the net $resent va#ue and*or interna# rate o return under each

scenario,

Illustration:

A com$any is eva#uatin& a $ro!ect or introducin& a ne' $roduct, .e$endin& on

the res$onse o the market the actor 'hich is the #ar&est source o uncertainty

or the success o the $ro!ect the mana&ement o the irm has identiied three

scenarios (

Scenario 9 ( The $roduct 'i## have a moderate a$$ea# to customers across the

%oard at a modest $rice,Scenario 2 ( The $roduct 'i## strony a$$ea# to a #ar&e se&ment o the

market 'hich is hi&h#y $ricesensitive,

Scenario @ ( The $roduct 'i## a$$ea# to a sma## se&ment o the market

'hich 'i## %e 'i##in& to $ay a hi&h $rice

#est and orst case analysis:


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In the a%ove i##ustration+ an attem$t 'as made to deve#o$ scenarios in 'hich the

va#ues o varia%#es 'ere interna##y consistent, For e6am$#e+ hi&h se##in& $rice

and #o' demand ty$ica##y &o hand in hand, Firms oten do another kind o

scenario ana#ysis are considered, est case and 'orst case ana#ysis, In this kind

o ana#ysis the o##o'in& scenarios are considered(

#est scenario (


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Simu#ation ana#ysis is an e6tension o scenario Ana#ysis, Instead o ar%itrari#y

s$eciyin& a re#ative#y sma## num%er o scenarios+ a com$uter &enerates severa#

thousand $ossi%#e com%inations o varia%#es via $ro%a%i#ity distri%utions

accordin& to the historica# data, The entire $ro%a%i#ity distri%ution o outcomes

can %e constructed rom the simu#ation resu#ts,

Merits:

An increasiny $o$u#ar too# o risk ana#ysis+ simu#ation oers certain

advanta&es(

It aci#itates the ana#ysis and a$$raisa# o hi&h#y com$#e6+ mu#tivariate

investment $ro$osa#s 'ith the he#$ o so$histicated com$uter $acka&es,

It can co$e u$ 'ith %oth inde$endence and de$endence amon&st varia%#es, It

orces decisionmakers to e6amine the re#ationshi$ %et'een varia%#es,

Demerits:

Simu#ation is not a#'ays a$$ro$riate or easi%#e or risk eva#uation,

The mode# requires accurate $ro%a%i#ity assessments o the key varia%#es, For

E6am$#e+ it may %e kno'n that there is a corre#ation %et'een sa#es $rice and

o#ume so#d+ %ut s$eciyin& 'ith mathematica# accuracy the nature o the

Re#ationshi$ or mode# $ur$oses may %e diicu#t,

Constructin& simu#ated inancia# mode#s can %e timeconsumin&+ cost#y and

Requires s$ecia#i/ed ski##s+ thereore, It is #ike#y to %e used to ana#y/e very

Im$ortant+ com$#e6+ and #ar&esca#e $ro!ects,

It ocuses on a $ro!ect>s standa#one risk, It i&nores the im$act o

.iversiication+ i,e,+ s overa## cor$orate risk,

Simu#ation is inherent#y im$recise, It $rovides a rou&h a$$ro6imation o the

0ro%a%i#ity distri%ution o net $resent va#ue 1or any other criterion o merit5,


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#reak ven nalysis

Sa#es vo#ume is usua##y taken as the ana#y/ed varia%#e, The deinitions o

)%reakeven-(

9, Accountin&ased reakEven Ana#ysis+ A $ro!ect that %reaks even &ives you

your investment %ack, It does not cover the o$$ortunity cost o the ca$ita#

1initia# investment5

2, N0ased 1or Economic5 reakEven Ana#ysis+ It is more $ro$er#y %ecause

the o$$ortunity cost o the ca$ita# is taken into consideration, The N0 at the

economic %reakeven $oint is /ero,

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