(244)---SUMMARY OF THE REAL OPTIONS, INVESTMENT STRATEGY AND PROCESS

Summary of the Real Options, Investment Strategy and Process

• The most important aspects of the capital budgeting process are identification, evaluation, authorisation and control
• Identification of investment ideas is the most critical aspect of the investment process, and should be guided by the overall strategic considerations of the firm. It needs appropriate managerial focus. Each potential idea should be developed into a project.
• A company should have system for estimating cash flows of projects. A multi-disciplinary team of managers should be assigned the task of developing cash flow estimates.
• Once cash flows have been estimated, projects should be evaluated to determine their profitability. Evaluation criteria chosen should correctly rank the projects.
• Once the projects have been selected they should be monitored and controlled to ensure that they are properly implemented and estimates are realised. Proper authority should exist for capital spending. The top management may supervise critical projects involving large sums of money. The capital spending authority may be delegated subject to adequate control and accountability.
• A company should have a sound capital budgeting and reporting system for this purpose. Based on the comparison of actual and expected performance, projects should be reappraised and remedial action should be taken.
• Companies in practice have a total capital budgeting system including processes for project identification, development, evaluation, authorisation and control. Most companies prepare a capital budget, and integrate it with the overall budgeting system.
• Companies are increasingly using discounted cash flow techniques, but payback remains universally popular for its simplicity and focus on recovery of funds and liquidity.
• In practice, judgement and qualitative factors also play an important role in investment analysis. A number of companies pay more attention to strategy in the overall selection of projects.
• Strategic investments are large-scale expansion or diversification projects, and they involve either by their nature or by managerial actions valuable options. Such options include right to expand, right to abandon, right to delay, right to build new businesses, or right to disinvest or harvest.
• Real options create managerial flexibility and commitment. In principle, they can be valued in the same way as financial options are valued. But in practice, it is difficult to get all input parameters for valuing real options. Since large number of real assets are not trade in the market, it is quite difficult therefore to get information on the value of the underlying assets and the volatility.
• Since real options are valuable, managers must identify them, value them, monitor them and exercise them when it is optimal to do so. Managers generally strive to create flexibility and commitment by building real options into investment projects.

(243)---CAPITAL BUDGETING DECISION MAKING LEVELS

Capital Budgeting Decision Making Levels

For planning and control process, three levels of decision making have been identified:

• Operating capital budgeting
• Administrative capital budgeting
• Strategic capital budgeting

Capital budgeting decisions could be categorized into these three decision levels.

Operating capital budgeting

This may include routine minor expenditures, such as expenditure on office equipment. The lower or the middle level management can easily handle the operating capital budgeting decisions.

Administrative capital budgeting

This involves medium-size investments such as expenditure on expansion of existing line of business. Administrative capital budgeting decisions are semi-structured in nature, and they may also involve some options, such as option to delay. Generally, the senior management is assigned the responsibility of handling these decisions.

Strategic capital budgeting

This involves large investments such as acquisition of a new business or expansion in a new line of business. Strategic investments are unique and unstructured and involve simple or complex options, and they cast a significant influence on the direction and value of the business. Top management, therefore, generally handles such investments.

Keeping the view the different decision making levels, capital expenditures could be classified in a way, which would reflect the appropriate managerial efforts to be placed in planning and controlling them. One useful classification could be:

1. Strategic projects
2. Expansion in the line of business
3. General replacement projects
4. Expansion in the existing line business
5. Statutory required and welfare projects

Further, each of these categories could be sub-classified according to funds required by the projects.

Corporate strategy provides the focal point for the firm’s long run strategic planning. The capital budgeting system, particularly for large strategic projects, is determined in the context of strategic planning and, thus it is a top-down process. Corporate strategy and strategic planning play the most crucial role at the identification and evaluation phases. Operating and administrative capital budgeting decisions can be decided at lower/middle level management within the overall strategic framework and guidelines from top management. The capital budgeting system at lower/middle level will largely be a bottom-up process. It may be noted that external and internal environment provides a context to the company to establish and review its mission’s concerns, and multiple objectives, which, in turn, shape its corporate strategy.

(242)---FLEXIBILITY AND OPERATING OPTIONS

Flexibility and Operating Options

Most firms would like to build flexibility in their investment projects to be able to do several alternative things in different ways. The flexibility built into the investment projects involves a set of options. For example, a power generation company may either build a thermal power plant or a gas power plant or a power plant that could operate on both coal and gas. Building a plant that runs on both coal and gas will be quite expensive, but management will have the flexibility of using either gas or coal depending the fuel prices. The company will gain significantly when the prices of coal and gas are unrelated and vary considerably. The extra cost to create the manufacturing flexibility may be quite valuable to the company.

When company will benefit from the flexibility when it can choose from different raw materials to make the same product or it can use the same material to manufacture different products. Oil refineries and chemical plants quite often face these situations. Operations resulting from flexibility would prove to be very valuable when input or output prices fluctuate enormously. Companies need manufacturing flexibility to maintain their market shares and competitive position in highly fluctuate and unpredictable markets. For example, the quick changes in fashions have made it very difficult for the ready-made garments industry to meet the consumers’ changing demand without the flexibility of changing product-mix quickly. To meet the challenge and to have manufacturing flexibility, a large number of companies have invested heavily in sophisticated computer controlled machines that can easily handle product-mix changes almost instantly.

(241)---TIMING OPTION IN INVESTMENT APPRAISAL

Timing Option in Investment Appraisal

Suppose there is no abandonment option. Should the company reject the project as it has a negative net present value (NPV)? If the company management consider the project as a one time “now or never” opportunity, it will be tempted to reject the project. In fact, the company has the option to wait and see how economic conditions turn out to be in the future. If the economic conditions become favorable in the future, the company can undertake the project. The firms create a call option through its approach of wait and see. Deferring an investment helps the firm to receive useful information about the economic and riskiness of the project. With this information, the firm will be in a much better position to decide about the investment project. The timing options (or options to delay) are highly valuable, particularly those firms that operate in highly dynamic economic and competitive environment.

Example

Suppose The Center for Advanced Professional Studies (CAPS) institute is considering installing a solar system for heating water in hotels for students. The system will cost 25 million $ and it is expected to save electricity expenses at the current electricity rates by 2.1 million $ forever. At a cost of capital of 10%, the value of saving is 2.1/0.1 = 21 million $ and the net present value is 21-25 = -6 million $. Since net present value is negative, the project is unattractive for CAPS. Suppose the electricity rates will fluctuate and the saving may be either 1.2 million $ or 3.50 million $. If the saving are 1.2 million $, then the net present value is 1.2/0.1-25 = -13 million $. The project is unprofitable. On the other hand, if saving turn out to be 3.5 million $, then the net present value is: 3.5/0.1-25 = 10 million $. The project looks very attractive now. What should CAPS management do? Should it reject the project or should it wait and see how the electricity rates change? You may recognize that delaying the investment gives CAPS management a chance to see how the electricity rates behave. If the electricity rates increase, CAPS’s saving will be very high. Delaying the project is like as American option. What is value of this option to CAPS?

Valuing option to delay

In case of a stock option, we must note that a dividend payment before the call option matures reduces the ex-dividend price of the stock and the call option’s payoff at maturity. In then case of a non-dividend paying American call option, it should not be exercised before maturity since it is always more valuable until the maturity. This is not necessarily true is case of dividend paying stock. If dividends payments are vary large, it may be more advantages to the call option holder to exercise the option just before the ex-dividend date. An investment project’s cash flows have the same effect as the payment of dividends on the value of a stock option. The Black-Scholes method, adjusted for the payment of dividends, to value an American call option, but it will not give value of call option exactly. The Binomial method values the American call option more accurately.

(240)---ABANDONMENT OPTION IN INVESTMENT EVALUATION

Abandonment Option in Investment Evaluation

Most investments relating to expansions or diversification's require large amount of funds. Once the decision has been made and funds have been committed, these decisions cannot be reserved without incurring huge losses. When uneconomical investment projects are sold or discarded, it is quite difficult to get a good value. In case of some projects the firm may have to incur substantial dismantling cost. In such projects, which may turn out to be quite unprofitable under adverse economic conditions, the firm may like to have the option to abandon gives flexibility to the firm to exit without much loss.

Example

Chemical company is considering building a new plant to diversify into the production of urea. The company has two proposals with regard to technology. Proposal A is to build a custom designed, integrated plant using the latest technology that produces urea and by-products in the most economical way. A less expensive and less profitable scheme, proposal B, is to build a standard plant for manufacturing urea. If economic conditions turn out to be unprofitable, and the firm wants to exit from the urea business, it will be difficult for the firm to sell the plant built under proposal A, but it may be able to sell the plant built under proposal B because of its low investment cost. The government policy has a major impact on the company’s decision. If the current government policy of imports restrictions and fixing the price of urea equal to the cost plus 12% profit on net worth at 85% capacity continuous, proposal A is the better choice. On the contrary, if the current policy changes and the government allow imports and market-determined urea prices, the company may prefer proposal B now so that it has an option to abandon the project by selling it to a larger player in the urea market. Proposal B has, in effect, a put option attached to it, giving the flexibility to abandon the proposed operation in favor of some other activity.

Valuing the option to abandon

How do we value the option to abandon? Suppose the present value of proposal B is 100 million $ without the abandonment option. If the market conditions turnout to be favorable and demand for urea is high, the value of the project at year one increases by 30% to 130 million $. On the contrary, if the market conditions are unfavorable and demand is low, the projects value declines by 40% to 60 million $. Suppose if chemical company does not want to continue with the project, it can sell it for 80 million $. You can recognize that id demand for urea is law at year 1, and then the project value is 60 million $, and it is beneficial for chemical company to abandon the project and realize 80 million $. The value of option when the company exercises it will be 20 million $. (80 million – 60 million). However, chemical company will continue with the project if demand is high, as the company will loss value by exercising the option.

(239)---GROWTH OPTIONS

Growth Options

In practice managers may accept investment projects that have navigate or significant NPV, but may enable companies to find opportunities to find opportunities in the future that add considerable profitability and value. These projects are said to have Growth Options. examples of Growth Options in clued an initial investment in a new market with the intention to expand later on, investment in research and development to develop possible new technology and product, carrying out an expensive advertisement campaign to push sales, acquisition of a patent to have protected returns acquiring rights over a copper mine, or acquiring a vacant land to develop it in the future. Such investments’ are called strategic since they define the Competitive position of the form. Options to expand are useful for achieving the future growth. Such options allow the firm to make future investments later on if the business conditions are favorable. The advantage of making investment in stages, rather than at once, is that the firm gains knowledge about the project’s true profitability and collects information that may help to unravel uncertainty surrounding the project. Option to expand in the future or make investment in stages provides the manufacturing and marketing flexibility to the firm.

Valuing Patent

Patents give valuable options to firm to achieve growth and create value. Firms, through research and development efforts, can develop technology, products or services and can patent them. A patent allows a firm to have exclusive rights for certain number of years to develop and market a product or service. Thus, patent may be viewed as a call option. A firm will develop the product only if it creates values; that is, the present value of cash inflows exceeds the cost of introducing the product.

(238)---STRATEGIC REAL OPTIONS

Strategic real options

They are a number of investments that may contain elements that could provide valuable opportunities to a firm in the future. Some investments may not be profitable but for the attractive opportunities that they are capable of creating in the future. For example, a chemical company may invest in R & D that may help it to develop new chemical and exploit it to introduce new products in the market. Similarly, a fast moving consumer products company may interest in a brand to leverage sales of it is other products. A fertilizer company may install a small plant to manufacture and sell caprolectum to see the reaction of the market, and scale up the plant in future if demand is high. These opportunities are highly valuable and must be identified future opportunities or flexibility is more valuable than investments without such Strategic elements.

real options are Strategic elements in investments that help creating flexibility of operations, or that have the potential of generating profitable opportunities in the future for the firm. Real options provide discretion to managers to take certain investment decisions, without any obligation, for a given price. We may clarify that real options are not confined to real assets only. Patent, R & D brands etc are examples of assets that have a value to that owner. The capital investments should be viewed as strategic investments that incorporate real options. Hence the value of capital investments will also include the value of the strategic elements in the investment. Valuing real options is real challenge for managers.

The option pricing theory provides a framework for the valuing Strategic investments. The methods of the valuing real options are the same as the financial options although it is difficult to identify the values of certain inputs in case of real options. An investment with real option consists two values the value of cash flows from the projects assets plus the value of any future opportunity arising form holding the asset. Like in a financial option an exchangeable asset underlies a real option. For an example, the underlying asset in the case of an option to expand is the value added to expansion. The cost of expansion is the exercise price.

Some capital investments have embedded options. Managers must recognize and value these options and exercise them when it is advantages to do so. Of firm can attain flexibility and make commitments by internationally creating a simple option in to investment projects. It can obtain flexibility by creating long positions in call or put options. for example, right to expand or right to enter a new venture in the future at a given price is a long position in call option, and right to abandon or right to liquidate in the future at a given price is a long position in put option. A firm may agree to disinvest or some large investment projects may involve complex options. There may be options on options, or options may be interdependent or mutually exclusive. Managers must play an active role in identifying or creating options, valuing them, monitoring them and using them appropriately to create values for the company.

(237)---STRATEGIC MANAGEMENT IN INVESTMENT

Strategic Management in Investments

Strategic Management has emerged as a systematic approach in properly positioning companies in the complex environment by balancing multiple objectives. In practice, therefore, a comprehensive Capital expenditure planning and, control system will not simply focus on profitability, as assumed by modern Finance theory, but also on growth, competition, balance of products, total risk diversification, and managerial capability and flexibility. there are umpteen examples in the developing countries like India where unprofitable ventures are not divested even by the private sector companies because of there desirability from the point of view of consumer and employees, in particular and society, in general. Such considerations are not at all less important than Profitability since the ultimate survival of companies (and certainly that of management) hangs on them. One must appreciate the dynamics of complex forces influencing resource allocating in practice; it is not simply the use of the most refined DCF techniques.
Certain other practical considerations are as follows.

• Apart from the profitability of the project, other features like its (project's) critical utility in the production of the main product, strategic importance of capturing the new product first, adapting to the changing market environments, have a definite there bearing on investment decisions.
• Take technological their developments play a critical role in guiding investment decisions. Government policies and concessions also have a bearing on these.
• Investment in production equipment is the given top priority among the existing of products and the new project. Capital investment for expansion in existing lines where market potential is proved is given first priority capital investment for buildings, furniture, cars, office equipment etc., is done on the basis of availability of funds and immediate needs.

For problem solving under complexities and the relevance of strategic considerations in investment planning, it also implies that resource allocation is not simply a matter of choosing the most profitable new projects as shown by the DCF analysis. What is being stressed is that the strategic framework provides a higher level screening and an integrating perspective to the whole system of capital expenditure planning and control. Once strategic questions have been answered, Investment proposals may be subjected to the DCF evaluation.

(236)---INVESTMENT DECISIONS AND CORPORATE STRATEGY

Investment Decisions and Corporate Strategy

Recently, a lot of emphasis has been placed on the view that a business firm facing a complex and changing environment will benefit immensely in terms of improved quality of decision making if capital budgeting decisions are taken in the context of its overall corporate strategy. This approach provides the decision maker with a central theme or a big picture to keep in mind at all times as a guideline for effectively allocating corporate financial resources. As argued by a chief financial officer.

Allocating resources to investments without a sound concept of divisional and corporate strategy is a lot like throwing darts in a dark room.

Similarly, an American businessman argues as follows.

“We have erred long by exaggerating the improvement in decision making that might result from the adoption of discounted cash flow (DCF) or other refined evaluation techniques. What is need are approximate answer to the precise problems rather than precise answer to the approximate problems. There is little value in refining an analysis that does not consider the must appropriate alternative and does not utilize sound assumptions. Management should spend its time improving the quality of assumptions and assuring that the all strategic questions. Have been asked, rather than implementing and using more refine evaluation techniques
In fact a close linkage between capital expenditures, at least major ones, and strategic positioning exists which has led some researchers to conclude that the set of problems companies refers as capital budgeting is a task for general management rather than financial analyst. Some recent empirical works amply support the practitioners concern for strategic considerations in capital expenditure planning and control. It is therefore a myopic point of view to ignore strategic dimensions or to assume that they are separable from the problem of efficient resource allocation addressed by capital budgeting theory.

Must companies in Asia consider strategy as an important factor in investment evaluation? What are the specific experiences of the companies in Asia in this required? Examples of six companies showing how they defined their corporate strategy are given as follows:

• To remain market leader by highest quality and remunerative prices. This company undertook the production of a new range of product (which was marginally profitable) for competitive reasons.
• To have moderate growth for saving taxes and to set up plants for forward and backward integration.
• Our strategy is to grow, diversify and expand in related fields of technology only. Any project which is within strategy and satisfied profitability yardsticks is accepted. This company found a low profit chemical production proposal acceptable since it came within its technological capabilities.
• Strategic involves analysis of the company’s present position, nature of its relationship with the environmental forces; company’s business philosophy and evaluation of company’s strong and weak points.
• To take up new projects for expansion in the fields, which are closer to present projects or technology? This company rejected a profitable project while it accepted a marginally profitable project since it was very close to its current heat transfer technology.
• To stay in industrial intermediate and capital goods line and in the process to achieve three fold profits in real terms over five years. This company rejected a highly profitable project since it was a consumer durable and accepted a marginal project.

One more example is that of an Indian subsidiary of a giant multinational that looks for projects in high technology, priority sector. This company even sold one of its profitable non-priority sector division to a sister concern to maintain its high-tech priority sector profile.

(235)---MANAGEMENT FLEXIBILITY AND COMMITMENT FOR INVESTMENT DECISIONS

Management Flexibility and Commitment for Investment Decisions

Most often we hear managers and investors saying

• “Our plans and decisions are always clouded by uncertainty”
• “Investment commitments have tremendous competitive value, although you have to pay a cost”
• “There is nothing like now never; we become wiser by writing for uncertainty decisions”
• “Flexibility helps to capture future opportunities”
• “Relinquishing an on-going project or liquidating a business may be a good opportunity to bail out a firm”

They consider these issues as strategic. In practice, managers and investors consider strategic aspects of investment projects as critical for making the investment decisions. They will always like to have right to expand; right to exit; right to exchange investment since these rights provided flexibility to managers. Because of uncertainty, managers Endeavour to build flexibility into a capital investment. Managers also like to commit doing things in response to competitive, technological, or environmental forces. They like to do things differently from others. These commitments that may be contingent upon certain events taking place provide managers with flexibility, operating freedom and opportunities to proactively gain an advantage over competition. The discounted cash flow method of investment analysis is unable of handling managerial flexibility and commitments and other strategic aspects in investment projects.

(234)---QUALITATIVE FACTORS AND JUDGMENT IN INVESTMENT APPRAISAL

Qualitative Factors and Judgment in Investment Appraisal

In theory, the use of sophisticated techniques is emphasized since they maximize value to shareholders. In practice, however, companies, although tending to shift to the formal methods of evaluation, give considerable importance to qualitative factors. Most companies in Asia are guided, one time or other, by three qualitative factors:

1. Urgency
2. Strategy
3. Environment

All investors think that regency is the most important consideration while a large number thinks that strategy plays a significant role. Some investors also consider intuition, security and social considerations as important qualitative factors. Companies and investors in USA consider qualitative factors like employees’ morals and safety, investor and customer image, or legal matters important in investment analysis.

Due to the significance of qualitative factors, judgment seems to play an important role. Some typical response of companies and investors are:

• Vision of judgment of the future plays an important role. Factors like market potential, possibility of technology change, trend of government policies etc., which are judgmental, play important role.
• The opportunities and constraints of selecting a project, its evaluation of qualitative and quantitative factors, and the weight age on every bit of pros and cons, cost-benefit analysis, etc., are essential elements of judgment. Thus, it is inevitable for any management decision.
• Judgment and intuition should definitely be used when a decision of choice has to be made between two or more, closely beneficial projects, or when it involves changing the long-term strategy of the company. For routine matters, liquidity and profits should be preferred over judgment.
• It (judgment) plays a very important role in determining the reliability of figures with the help of qualitative methods as well as other known financial matters affecting the projects.
  We feel that what businessmen call intuition or (simply) judgment is in fact informed judgment based on experience. A firm growing in a favorable economic environment will be able to identify profitable opportunities without making net present value or internal rate of return computation. Businessmen often act more intelligently than they talk.

(233)---QUALITATIVE FACTORS AND JUDGEMENT IN CAPITAL BUDGETING

Qualitative Factors and Judgment in Capital Budgeting

In theory, the use of sophisticated techniques is emphasized since they maximize value to shareholders. In practice, however, companies, although tending to shift to the formal methods of evaluation, give considerable importance to qualitative factors. Most companies in Asia guided one time or other, by three qualitative factors:

1. Urgency
2. Strategy
3. Environment

All companies think that urgency is the most important consideration while a large number thinks that strategy plays a significant role. Some companies also consider intuition, security and social considerations as important qualitative factors. Companies in USA consider qualitative factors like employees’ morals and safety, investor and customer image, or legal matters important in investment analysis.

Due to the significance of qualitative factors, judgment seems to play an important role. Some typical responses of companies about the role of judgment are:

• Vision of judgment of the future plays an important role. Factors like market potential, possibility of technology change, trend of government policies, which are judgmental, play importance role.
• The opportunities and constraints of selecting a project, its evaluation of qualitative and quantitative factors, and the weight age on every bit of pros and cons, cost-benefit analysis, are essential elements of judgment. Thus, it is inevitable for any management decision.
• Judgment and intuition should definitely be used when a decision of choice has to be made between two or more, closely beneficial projects, or when it involves changing the long-term strategy of the company.
• It plays a very important role in determining the reliability of figures with the help of quantitative methods as well as other known financial matters affecting the projects.

We feel that what businessman call intuition or simply judgment is in fact informed judgment based on experience. A firm growing in a favorable economic environment will be able to identify profitable opportunities without making net present value or internal rate return computation. Businessmen often act more intelligently than they talk.

(232)---CAPITAL INVESTMENT CONTROL AND MONITORING

Capital Investment Control and Monitoring

A capital investment reporting system is required to review and monitor the performance of investment projects after complication and during their life. The follow-up comparison of the actual performance with original estimates not only ensures better forecasting but also helps to sharpen the techniques for improving future forecasts. Based on the follow-up feedback, the company may reappraise its projects and take remedial action.

Asian companies practice control of capital expenditure through the use of regular project reports. Some companies require quarterly reporting, others need monthly, half-yearly and yet a few companies require quarterly reporting, others need monthly, half-yearly and yet a few companies require continues reporting. In most of the companies, the evaluation reports include information on expenditure to date, stage of physical complication, and approved and revised total cost.

Most of the companies in reappraising investment proposals consider comparison between actual and forecast capital cost, saving and rate of return. They perceive the following advantages of reappraisal:

1. Improving in profitability by positioning the projects as per the original plan.
2. Ascertainment or errors in investment planning which can be avoided in future.
3. Guidance for future evaluation of projects.
4. Generation of cost consciousness among the project team.

A few companies abandon the project if it becomes uneconomical. The power of review is generally invested with the top executives of the companies in Asia.

(231)---CAPITAL INVESTMENT PLANNING AND CONTROL

Capital Investments Planning and Control

Capital Rationing

Asian companies, by and large, do not have to reject profitable investment opportunities for lack of funds, despite the capital markets not being so well developed. This may be due to the existence of the government –owned financial system, which is always ready to finance profitable projects. Asian companies do not use any mathematical technique to allocate resources under capital shortage which may sometimes arise on account of internally imposed restrictions or management’s reluctance to raise capital outside. Priorities for allocating resources and determined by management, based on the strategic need for and profitability of projects.

Authorization

It may not be feasible in practice to specify standard administrative procedures for approving investment proposals. Screening and section procedures may differ from one company to another. When large sums of capital expenditures are involved, the authority for the final approval may rest with top management. The approval authority may be delegated for certain types of investments projects. Delegation may be effected subject to the amount of outlay, prescribing the section criteria and holding the authorized person accountable for results.
Funds are appropriated for capital expenditures after the final selection of investment proposals. The formal plan for the appropriation of funds is called the capital budget. Generally, the senior management tightly controls the capital expenditures. Budgetary controls may be rigidly exercised, particularly when a company is facing liquidity problem. The expected expenditure should become a part of the annual capital budget, integrated with the overall budgetary system.

Top management should ensure that funds are spent in accordance with appropriations made in the capital budget. Funds for the purpose of project implementations made in the capital budget. Funds for the purpose of projects implementation should be spent only after seeking formal permission from the financial manager or any other authorized person.

In Asian, as in UK, the power to commit a company to specific capital expenditure and to examine proposals is limited to a few top corporate officials. However, the duties of processing the examination and evaluation of a proposal are somewhat spread throughout the corporate management staff in case of a few companies.

Senior management tightly controls capital spending. Budgetary control is also exercised rigidly. The expected capital expenditure proposals invariably become a part of the annual capital budget in all company. Some companies also have formal long range plans covering a period of 3 to 5 years. Some companies feel that long range plans have a significant influence on the evaluation and funding of capital expenditure proposals.

(230)---RECOGNITION OF RISK IN PROJECT EVALUATION

Recognition of Risk in Project Evaluation

The assessment of risk is an important aspect of an investment evaluation. In theory, a number of techniques are suggested to handle risk. Some of them, such as the computer simulation technique are not only quite involved but are also expensive to use. How do companies handle risk in practice?

Companies in Asian countries consider the following as the four important contributors of investment risk

1. Selling price
2. Product demand
3. Technological changes
4. Government policies

Asian countries are fast changing from sellers’ market to buyers’ market as competition is intensifying in a large number of products; hence uncertainty of selling price and product demand are being realized as important risk factors. Uncertainty government policies, of course, are a continuous source of investment risk in developing countries in Asia.

Sensitivity analysis and conservative forecasts are two equally important and widely used methods of handling investment risk in Asian countries. Each of these techniques is used by a number of Asian companies with other methods while many other companies use either sensitivity analysis or conservative forecasts with other methods. Some companies also use shorter payback and inflated discount rates (risk-adjusted discount rates).

In USA, risk adjusted discount rate is more popular than the use of payback and sensitivity analysis. The contrasts in risk evaluation practices in Asian countries, on the other hand, and USA and UK, on the other, are sharp and significant. Given the complex nature of risk factors in developing countries, risk evaluation cannot be handling through a single number such as the net present value (NPV) calculation based on conservative forecasts or risk-adjusted discount rate. Managers must know the impact on project profitability of the full range of critical variables. An American businessmen states: “the appear to be more corporations using sensitivity analysis than surveys indicate. In some cases firms may not know that what they are undertaking is called ‘sensitivity analysis’ , and it probably is not in the sophisticated, computer oriented sense...Typically, analysts or middle level managers eliminate the alternative assumptions and solutions in order to simplify the decision making process for higher management.

(229)---CUT-OFF RATE

Cut-off Rate

In the implementation of a sophisticated project evaluation system, the use of a minimum required rate of return is necessary. The required rate of return or the opportunity cost of capital should be based on the riskiness of cash flows of the investment proposal; it is compensation to investors for bearing the risk in supplying capital to finance investment proposals.

Not all companies in Asian countries specify the minimum acceptable rate of return. Some of them compute the weighted average cost of capital (WACC) as discount rate. Unfortunately, all companies do not follow correct methodology of calculating the weighted average cost of capital (WACC). Almost all companies use the book value weights.

Business executives in Asian countries are becoming increasingly aware of the importance of the cost of capital, but they perhaps lack clarity about its computation. Arbitrary judgment of management also seems to play a role in the assessment of the cost of capital. The fallacious tendency of equating borrowing rate with minimum required rate of return also persists on the case of some companies. In USA, a little more than 50% companies have been found using weighted average cost of capital (WACC) as cut-off rate. In UK, only a very small percentage of firms were found attempting any calculation of the cost of capital. As in USA and UK, companies in Asian countries have a tendency to equate the minimum rate with interest rate or cost of specific source of finance. The phenomenon of depending on management judgment for the assessment of the cost of capital is prevalent as much in USA and UK as in Asian countries.

(228)---METHODS OF PROJECT EVALUATION

Methods of Project Evaluation

As regards the use of evaluation methods, most companies use payback criterion. In addition to payback and or other methods, companies also use internal rate of return (IRR) and net present value (NPV) methods. A few companies use accounting rate of return (ARR) method. Internal rate of return (IRR) is the second most popular technique.

The major reason for payback to be more popular than the discounted cash flow method techniques is the executives’ lack of familiarity with discounted cash flow techniques. Other factors are lack of technical people and sometimes unwillingness of top management to use the discounted cash flow techniques. One large manufacturing and marketing organization, for example, thinks that conditions of its business are such that the discounted cash flow techniques are not needed. By business conditions the company perhaps means its marketing nature, and its products being in seller’s markets. Another company feels that replacement projects are very frequent in the company, and therefore, it is not necessary to use the discounted cash flow techniques for such projects. Both these companies have fallacious approaches towards investment analysis. They should subject all capital expenditures to formal evaluation.

The practice of companies in Asian countries regards the use of evaluation criteria is similar to that in USA. Almost four-fifths of US firms use either the internal rate of return or net present value models, but only about one-fifth use such discounting techniques without using the payback period or average rate of return methods. The tendency of US firms to use native techniques as supplementary tools has also been reported in recent studies. However, firms in USA have come to depend increasingly on the discounted cash flow techniques, particularly internal rate of return. The British companies use both discounted cash flow techniques and return on capital, sometimes in combination sometimes solely, in their investment evaluation; the use of payback is widespread. In recent years the use of discounted cash flow methods has increased in UK, and net present value (NPV) is more popular than internal rate of return (IRR). However, this increase has not reduced the importance of traditional methods such as payback and return on investment. Payback continuous to be employed by almost all companies

One significant difference between practice in Asian countries and USA is that payback is used in Asian countries as a “primary” method and IRR/NPV as a “secondary” method, while it is just reverse in USA. Asian countries managers feel that payback is a convenient method of communicating on investment’s desirability, and it best protects the recovery of capital-a secure commodity in the developing countries.

(227)---PROJECT EVALUATION

Project Evaluation

The evaluation of projects should be performed by a group of experts who have no axe to grind. For example, the production people may generally interested in having the most modern type of equipments and increased production even if productivity is expected to be low and goods cannot be sold. This attitude can bias their estimates of cash flows of the proposed projects. Similarly, marketing executives may be too optimistic about the sales prospects of goods manufactures and overestimate the benefits of a proposed new product. It is, therefore, necessary to ensure that projects are scrutinized by an impartial group and that objectivity is maintained in the evaluation process.

A company in practice should take all care in selecting a method or methods of investment evaluation. The criterion selected should a true measure of the investments profitability (in terms of cash flows), and it should lead to the net increase in the companies wealth (that is, its benefits should exceed its cost adjusted for time value and risk). It should also be seen that the evaluation criteria do not discriminate between the investment proposals. They should be capable of ranking projects correctly in terms of profitability. The net present value method is theoretically most desirable criterion as it is a true measure of profitability; it generally ranks projects correctly and is consistent with the wealth maximization criterion. In practice, however, managers’ choice may be governed by other practical considerations also.

A formal financial evaluation of proposed capital expenditures has become a common practice among companies. A number of companies have a formal financial evaluation of almost three froths of their investment projects. Most companies subject more than 50% of the projects to some kind of formal evaluation. However, projects, such as replacement or worn-out equipment, welfare and statutorily required projects below certain limits, small value items like office equipment or furniture, replacement of assets of immediate requirements, etc., are not often formally evaluated.

(226)---DEVELOPING CASH FLOW ESTIMATES

Developing Cash Flow Estimates

Estimation of cash flows is a difficult task because the future is uncertain. Operating managers with the help of finance executives should develop cash flow estimates. The risk associated with cash flows should also be properly handled and should be taken into account in the decision making process. Estimation of cash flows requires collection and analysis of all qualitative and quantitative data, both financial and non-financial in nature. Large companies would generally have a management information system providing such data.

Executives in practice do not always have clarity about estimating cash flows. A large number of companies do not include additional working capital while estimating the investment project cash flows. A number of companies also mix up financial flows with operating flows. Although companies claim to estimate cash flows on incremental basis, some of them make no adjustment for sale proceeds of existing assets while computing the project’s initial cost. The prevalence of such conceptual confusion has been observed even in the developing countries. For example, in the seventies, a number of UK companies were treating depreciation as cash flows.

In the past, most Indian companies chose an arbitrary period of 5 or 10 years for forecasting cash flows. This was so because companies in India largely depend on government owned financial institutions for financing their projects, and these institutions required 5 to 10 years forecasts of the project cash flows.

(225)---IDENTIFICATION OF INVESTMENT OPPERTUNITIES

Identification of Investment Opportunities

Investment opportunities have to be identified or created; they do not occur automatically. Investment proposals of various types may originate at different levels within a firm. Most proposals of various types may originate at different levels within a firm. Most proposals, in the nature of cost reduction or replacement or process or product improvements take place at plant level. The contribution of top management in generating investment ideas is generally confined to expansion or diversification projects. The proposals may originate systematically or haphazardly in a firm. The proposal for adding new product may estimate from the marketing department or from the plant manager who thinks be a better way of utilizing idle capacity. Suggestions for replacing an old machine or improving the production techniques may arise at the factory level. In view of the fact that enough investment proposals should be generated to employ the firm’s funds fully well and efficiency, a systematic procedure for generating proposals may be evolved by a firm.

In a number of companies, the investment ideas are generated at the plant level. The contribution of the broad in idea generation is relatively insignificant. However, some companies depend on the board for certain investment ideas, particularly those that are strategic in nature. Other companies depend on research carters for investment ideas.

Companies use a variety of methods used are:

• Management sponsored studies for project identification
• Formal suggestion schemes
• Consulting advice
  

Most companies use a combination of methods. The offer of financial incentives for generating investment idea is not a popular practice. Other efforts employed by companies in searching investment ideas are:

• Review of researches done in the country or abroad,
• Conducting market surveys,
• Deputing executives to international trade fairs for identifying new products and technology.
  

Once the investment proposals have been identified, they are be submitted for scrutiny. Many companies specify the time for submitting the proposals for scrutiny.

(224)---CAPITAL INVESTMENT PLANNING AND CONTROL

Capital Investment Planning and Control

At least five phases of capital expenditure planning and control can be identified:

• Identification or origination of investment opportunities
• Development of forecasts of benefits and costs
• Evaluation of the net benefits
• Authorization for progressing and spending capital expenditure
• Control of capital projects
  

The available literature puts the maximum emphasizes on the evaluation phase. Two reasons may be attributed to this bias. First, this phase is easily amenable to a structured, quantitative analysis. Second, it is considered to be the most important phase by academicians. Practitioners, on the other hand, consider other phases to be more important.

The capital investment planning and control phases are discussed are our future postings.

(223)---REAL OPTIONS INVESTMENTS

Real Options Investments

Capital expenditure or investment planning and control involve a process of facilitating decisions covering expenditures on long term assets. Since a company’s survival and profitability hinges on capital expenditures, especially the major ones, the importance of the capital budgeting or investment process cannot be over-emphasized. A number of managers think that investment projects have strategic elements, and the investment analysis should be conducted within the overall framework of corporate strategy. Some managers feel that qualitative aspects of investment projects should be given due importance.

Capital investments

Strictly speaking, capital investments should include all those expenditures, which are expected to produce benefits to the firm over a long period of time, and encompass both tangible and intangible assets. Thus research and development expenditures are a capital investment. Similarly, the expenditure incurred in acquiring a patent or brand is also a capital investment. In practice, a number of companies follow the traditional definition, covering only expenditures on tangible fixed assets as capital investments. Large expenditures on research and development, advertisement, or employees trading, which tend to create valuable intangible assets, may cannot be included in the definition of capital investments since most of them are allowed to be expended for tax purposes in the year in which they are incurred. From the point of view of sound decision-making, these expenditures should be treated as capital investments and subjected to proper evaluation.

A number of companies follow the accounting convention to prepare asset wise classification of capital expenditures, which is hardly of much use in decision making. Some companies classify capital expenditures in a manner, which could provide useful information for decision making. Their classification is,

1. Replacement
2. Modernization
3. Expansion
4. New project
5. Research and development
6. Diversification
7. Cost reduction

(222)---RISK ANALYSIS IN CAPITAL BUDGETING

Summary Two – Risk analysis in capital budgeting

• Simulation analysis overcomes the limitations of sensitivity or scenario analysis. The analyst specifies probability distributions for variables and computer generates several hundred scenarios, probability distribution for the projects’ net present value along with the expected net present value and standard deviation.
• Yet another technique of resolving risk in capital budgeting, particularly when the sequential decision making is involved, is the decision tree analysis. The decision tree provides a way to represent different possibilities so that we can be sure that the decisions we make today, talking proper account of what we can do in the future.
• To draw the decision tree, branches from points marked with squares are used to denote different possible decisions, and branches from points marked with circles denote different possible outcomes. In a decision tree analysis, one has to work out the best decisions at the second stage before one can choose the best first stage decision.
• Decision trees are variable because they display links between today’s and tomorrow’s decisions. Further, the decision maker explicitly considers various assumptions underlying the decision. The use of decision tree is, however, limited because it can become complicated.
• One important theory, which provides insight into risk handling in capital budgeting, is the utility theory. It aims at including a decision maker’s risk preferences explicitly into the capital expenditure decision. The underlying principle is that an investor prefers a higher return to a lower return, and that each successive identical increment of money is worthless to him than the preceding one. The decision maker’s utility function is derived to determinate the decision’s utility value.
• The direct use of the utility theory in capital budgeting is not common. It is very difficult to specify utility function in practice. Even if it is possible to derive utility function, it does not remain constant over time. Problems are also encountered when decision is taken by group of people. Individuals differ in their risk preferences.

(221)-RISK ANALYSIS IN CAPITAL BUDETING (SUMMARY)

Summary one – Risk analysis in capital budgeting

• Risk arises in the investment evaluation because the forecasts of cash flows can go wrong. Risk can be defined as variability of returns of an investment project. Standard deviation is a commonly used measure of variability.• Statistical techniques are used to measured and incorporate risk in capital budgeting. Two important statistics in this regard are the expected monetary value and standard deviation. The decision maker instead of working with one single forecast can work with a range of values and their associated probabilities. The expected monetary value is the weighted average of returns where probabilities of possible outcomes are used as weights.
• Decision maker in practice may handle risk in conventional ways. For example, they may use a shorter payback period, or use conservative forecasts of cash flows, or discounted net cash flows at the risk adjusted discount rates.
• A more useful technique is the sensitivity analysis. It is a method of analyzing change in the projects net present value for a given change in one variable at a time. It helps in asking what if questions and calculates net present value under different assumptions.
• Scenario analysis is the extension of sensitivity. It considers a few combinations of variables and calculates net present value for each of them. It is a usual practice to calculate net present value for each of them. It is a usual practice to calculate net present value under normal, optimistic pessimistic scenario.
• Sensitivity or scenario analysis forces the decision maker to identify underlying variables, indicates critical variables and helps in strengthening the project by pointing out its weak links. Its limitations are that it cannot handle a large number of interdependent variables and at times, fails to give unambiguous results.

(220)---BENIFITS AND LIMITATIONS OF UTILITY THEORY

Benefits and Limitations of Utility Theory

The utility theory approach to risk analysis in capital budgeting has certain advantages. First, the risk preferences of the decision maker are directly incorporated in the capital budgeting analysis. Second, it facilitates the process of delegating the authority for decision. If it is possible to specify the utility function of the superior- the decision marker, the subordinates can be asked to take risks consistent with the risk preferences of the superior.

The use of utility theory in capital budgeting is not common. It suffers from a few limitations. First, in practice, difficulties are encountered in specifying a utility function. Whose utility function should be used as a guide in making decisions? For small firms, the utility function of the owner or one dominate share holder may be used to guide the decision making process of the firm. Second, even if the owners’ or a dominant share holders’ utility function be used as a guide, the derived utility function at a point of time is valued only for that one point of time. Third, it is quite difficult to specify the utility function if the decision is taken by a group of persons. Individuals differ in their risk preferences. As a result, it is very difficult to derive a consistent utility function for the group.

(219)---UTILITY THEORY AND CAPITAL BUDGETING

Utility Theory and Capital Budgeting

On the basis of figures of the expected values and standard deviations, it is difficult to say whether a decision maker should choose a project with a high expected value and a high standard deviation or a project with a comparatively low expected value and a low standard deviation. The decision makers’ choice would depend upon his risk preference. Individuals and firms differ in their attitudes towards risk. In contrast to the approaches for handling risk, utility theory aims at incorporation of decision makers’ risk preference explicitly into the decision procedure. In fact, a rational decision maker would maximize his utility. Thus, he would accept the investment project, which yields maximum utility to him.

Risk attitude

As regards the attitude of individual investors towards risk, they can be classified in three categories.

• Risk-averse investors attach lower utility to increasing wealth. For them the value of the potential increase in wealth is less than the possible loss from the decrease in wealth. In other words, for a given wealth or return, they prefer less risk to more risk.
• Risk-neutral investors attach same utility to increasing or decreasing wealth. They are indifferent to less or more risk for a given wealth or return.
• Risk-seeking investors attach more utility to the potential of additional wealth to the loss from the possible loss the from the decrease in wealth. For earning a given wealth or return, they are prepared to assume higher risk.
  

It is well established by many empirical studies that individuals are generally risk averts and demonstrate a decreasing marginal utility for money function.

(218)---USEFULNESS OF DECISION TREE APPROACH

Usefulness of Decision Tree Approach

The decision tree approach is extremely useful in handling the sequential investments. Working backwards from future to presents we are able to eliminate unprofitable branches and determine optimum decision at various decision points. The merits of the decision tree approach are:

• Clarity. It clearly brings out the implicit assumptions and calculations
• Graphic visualisation. It allows a decision maker to visualise assumptions and alternatives in graphic form, which is usually much easier to understand than the more abstract, analytical form.

However, the decision tree diagrams can become more and more complicated as the decision maker decides to include more alternatives and more variables and to look farther and farther in time. It is complicated even further if the analysis is extended to include interdependent alternatives and variables that are dependent upon one another; for example, sales volume depends on market share which depends on promotion expenses. The diagram itself quickly becomes cumbersome and calculations become very time consuming or almost impossible.

(217)---DECISION TREES FOR SEQUENTIAL INVESTMENT DECISIONS

Decision Trees for Sequential investment Decisions

In the simple accepted or reject decisions, we can use simple techniques. In practice, the present investment decisions may have implications for future investment decisions. Such complex investment decisions involve a sequence of decisions over time. It is argued that “since present choices modify future alternatives, industrial activity cannot be reduced to a single decision and must be viewed as a sequence of decisions extending from the present time into the future. If this notion of industrial activity as a sequence of decisions is accepted, we must view investment expenditures not as isolated period commitments, but as links in a chain of present and future commitments. An analytical technique to handle the sequential decisions is to employ decision trees. Here we shall illustrate the use of decision trees in analyzing and evaluating the sequential investments.

Steps in decision tree approach

A present decision depends upon future events, and the alternatives of a whole sequence of decisions in future are affected by the present decision as well as future events. Thus, the consequence of each decision is influenced by the outcome of a chance event. At the time of taking decisions, the outcome of the chance event is not known, but a probability distribution can be assigned to it. A decision tree is a graphic display 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 similar to the branches of a tree.

While constructing and using a decision tree, some important steps should be considered:

• Define investment. The investment proposal should be defined. Marketing, production or any other department may sponsor the proposal. It may be either to enter a new market or to produce a new product.
• Identify decision alternatives. The decision alternatives should be clearly identified. For example if a company is thinking of building a plant to produce a new product, it may construct a large plant, a medium sized plant or a small plant initially and expand it later on or construct no plant. Each alternative will have different consequences’.
• Draw a decision tree. The decision tree should be graphed indicating the decision points, chance even and other data. The relevant data such as the projected can flows, probability distribution, and the expected present value; should be located on the decision tree branches.
• Analyze data. The result should be analyzed and the best alternative should be selected.

(216)---SIMULATION ANALYSIS

Simulation Analysis

The sensitivity analysis and scenario analyses are quite useful to understand the uncertainty of the investment projects. But both approaches suffer from certain weakness. They do not consider the interactions between variables and also, they do not reflect on the profitability of the change in variables.

Simulation analysis considers the interactions among variables and profitability of the change in variables. It does not give the projects net present value as a single number rather it computes the profitability distribution of value. The simulation analysis is an extension of scenario analysis. In simulation analysis a computer generates a very large number of scenarios according to the profitability distributions of the variables. The analysis involves the following steps:

• First, you should identify variables that influence cash inflows and outflows. For example, when a firm introduces a new product in the market these variables are initial investment, market size, market growth, market share, price, variable costs, fixed costs, product life cycle, and terminal variable.
• Second, specify the formulae that relative variables. For example, revenue depends on by sales volume and price; sales volume is given by market size, market share, and market growth. Similarly, operating expenses depend on production, sales and variable and fixed costs.
• Third, indicate the profitability distribution for each variable. Some variables will have more uncertainty than others, For example, it is quite difficult to predict price or market growth with confidence.
• Fourth, develop a computer programme that randomly selects one variable from the profitability distinction of each variable and uses these values to calculate the projects’ net present value. The computer generates a large number of such scenarios, calculates net present values and stores them. The stored values are printed as a profitability distribution of the projects’ values along with the expected value and its standard deviation. The risk-free rate should be used as the discount rate to compute the projects’ value. Since simulation is performed to account for the risk of the projects’ cash flows, the discount rate should reflect only the time value of money.

That analysis is a very useful technique for risk analysis. Unfortunately, its practical use is limited because of a number of shortcomings. First, the model becomes quite complex to use because the variable depends are interrelated with each other, and each variable depends on its values in the previous periods as well. Identifying all possible relationships and estimating probability distribution is a difficult task; its time consuming as well as expensive. Second, the model helps to generating a profitability distribution of the projects’ net present values. But it does not indicate whether or not the project should be accepted. Third, considers the risk of any project in isolation of other projects.

(215)---SENSITIVITY ANALYSIS

Sensitivity Analysis

In the evaluation of an investment project, we work with the forecasts of cash flows. Fore casted cash flows depend on the expected revenue and costs. Further, expected revenue is a function of sales volume and unit selling price. Similarly, sales volume will depend on the market size and firms’ market share. Costs include variable costs, which depend on sales volume, and unit variable cost and fixed costs. The net present value or the internal rate of return of a project is determined by analyzing the after tax cash flows arrived at by combining forecasts of various variables. It is different to arrive at an accurate and unbiased forecast of each variable. We can’t’ be certain about the outcomes of any of these variables. The reliability of the net present value or internal rate of return of the project will depend on the reliability of the forecasts of each variable underlying the estimates of net cash flows. To determine the reliability of the projects’ net present value or internal rate of return, we can work out how much difference it makes if any of these forecasts goes wrong. We can change each of the forecasts, one at a time, to at least three values, expected, and optimistic. The net present value of the project is recalculated under these different assumptions. This method of recalculating net present value or internal rate of return by changing each forecast is called sensitivity analysis.

Sensitivity analysis is a way of analyzing change in the projects’ values for a given change in one of the variables. It indicates how sensitive a projects’ value is to changes in particular variables. The more sensitivity of the value, the more critical is the variable. The following three steps are involved in the use of sensitivity analysis:

• Identification of all those variables, which have an influence on the projects value
• Definition of the underlying (mathematical) relationship between the variables
• Analysis of the impact of the change in each of the variables on the projects value

The decision maker, while performing sensitivity analysis computes the projects net present value or internal rate of return for each forecast under three assumptions.

1. Pessimistic,
2. Expected,
3. Optimistic.

It all allows him to ask “what if”. For example, what if volume increase or decreases? What if variable cost or fixed cost increases or decreases? What if the selling price increase or decreases? What if the project is delayed or outlay escalates or the projects life is more or less than anticipated? A whole range of questions can be answered with the help of sensitivity analysis. It examines the sensitivity of the variables underlying the computation of net present value or internal rate of return, rater than attempting to quantify risk. It can be applied to any variable, which is an input for the after tax cash flows.

(214)---RISK ADJUSTED DISCOUNT RATE

Risk Adjusted Discount Rate

For a long time, economic theorists have assumed that, to allow for risk, the businessman required a premium over and above an alternative, which was risk-free. Accordingly, the more uncertain the returns in the future, the grater the risk and grater the premium required. Based on this reasoning, it is proposed that the risk premium be incorporated into the capital budgeting analysis through the discount rate. That is, if the time preference for money is to be recognized by discounting estimated future cash flows, at some risk free rate, to their present value, then, to allow for the riskiness, of those future cash flows a risk premium rate may be added to risk-free discount rate. Such a composite discount rate, called the risk-adjusted discount rate, will allow for both time preference and risk preference and will be a sum of the risk-free rate and risk-premium rate reflecting the investors’ attitude towards risk. The risk-adjusted discount rate method can be formally expressed as follows:

Risk-adjusted discount rate = Risk free rate + Risk premium

Under capital asset pricing model, the risk premium is the difference between the market rate of return and the risk free rate multiplied by the beta of the project.

The risk adjusted discount rate accounts for risk by varying the discount rate depending on the degree of risk of investment projects. A higher rate will be used for riskier projects and a lower rate for less risky projects. The net present value will decrease with increasing risk adjusted rate, indicating that the riskier a project is perceived, the less likely it will be accepted. If the risk free rate is assumed to be 10%, some rate would be added to it, say 5%, as compensation for the risk of the investment, and the composite 15% rate would be used to discount the cash flows.

Advantages of risk adjusted discount rate

• It is simple and can be easily understood.
• It has a great deal of intuitive appeal for risk-averse businessman.
• It incorporates an attitude towards uncertainty.

Disadvantages

This approach, however, suffers from the following limitations:

• There is no easy way deriving a risk adjusted discount rate. Capital asset pricing model provides a basis of calculating the risk adjusted discount rate. Its use has yet to pick up in practice.
• It does not make any risk adjusted in the numerator for the cash flows that are forecast over the future years.
• It is based on the assumption that investor are risk-averse. Through it is generally true, there exists a category of risk seekers who do not demand premium for assuming risks; they are willing to pay premium to take risks. Accordingly, the composite discount rate would be reduced, not increased, as the level of risk increases.

(213)---CERTAINTY EQUIVALENT METHOD FOR RISK ANALYSIS

Certainty Equivalent Method for Risk Analysis

Yet another common procedure for dealing with risk in capital budgeting is to reduce the forecasts of cash flows to some conservative levels. For example, if an investor, according to his “best estimate” expects a cash flow of 60000$ next year, he will apply an intuitive correction factor and may work with 40000$ to be on safe side. There is a certainty-equivalent cash flow. In formal way, the certainty equivalent approach may be expressed as:

Net present value = (the risk adjusted factor X the forecasts of net cash flow) / (1 + Risk free rate)

The certainty equivalent coefficient, the risk adjustment factor assumes a value between zero and one, and varies inversely with risk. A lower risk adjustment rate will be used if lower risk is anticipated. The decision maker subjectively or objectively establishes the coefficients. These coefficients reflect the decision makers’ confidence in obtaining a particular cash flow in period. For example, a cash flow of 20000$ may be estimated in the next year, but if the investor feels that only 80% of it is a certain amount, then the certainty-equivalent coefficient will be 0.8. That is, he consider only 16000$ as the certain cash flow. Thus, to obtain certain cash flows, we will multiply estimated cash flows by the certainty-equivalent coefficients.

The certainty-equivalent coefficient can be determined as a relationship between the certain cash flows and the risky cash flows. That is:

Risk adjustment factor = certain net cash flow / Risky net cash flow

For example, if one expected a risky cash flow of 80000$ in period and certain cash flow of 60000$ equally desirable, then risk adjustment factor will be 0.75 = 60000/80000.
If the internal rate of return method is used, we will calculate that rate of discount, which equates the present value of certainty equivalent cash outflows. The rate so found will be compared with the minimum required risk free rate. Project will be accepted if the internal rate is higher than the minimum rate; otherwise it will be unacceptable.

Evaluation of certainty equivalent

The certainty equivalent approach explicitly recognizes risk, but the procedure for reducing the forecasts of cash flows is implicit and is likely to be inconsistent from one investment to another. Further, this method suffers from many dangers in a large enterprise. First, the forecaster, expecting the reduction that will be made in his forecasts, may inflate them in anticipation. This will no longer give forecasts according to “best estimate”. Second, if forecasts have to pass through several layers of management, the effect may be to greatly exaggerate the original forecast or to make it ultra conservative. Third, by focusing explicit attention only on the gloomy outcomes, chances are increased for passing by some good investments.

(212)---CONVENTIONAL TECHNIQUES OF RISK ANALYSIS IN CAPITAL BUDGETING

Conventional Techniques of Risk Analysis in capital budgeting

A number of techniques to handle risk are used by managers in practice. They range from simple rules of thumb to sophisticated statistical techniques. The following are the popular, non-conventional techniques of handling risk in capital budgeting.

• Payback
• Risk-adjusted discount rate
• Certainty equivalent

These methods, as discussed below about payback first, but all of them are simple, familiar and partially defensible on theoretical grounds. However, they are based on highly simplified and at times, unrealistic assumptions. They fail to take account of whole range of the effect of risky factors on the investment decision-making.

Payback

Payback is one of the oldest and commonly used methods or explicitly recognizing risk associated with an investment project. This method, as applied in practice, is more an attempt to allow for risk in capital budgeting decision rather than a method to measure profitability. Business firms using this method usually prefer short payback to longer ones, and often establish guidelines that a firm should accept investments with some maximum payback period, say three or five years.

The merit of payback is its simplicity. Also payback makes an allowance for risk by focusing attention on the near term future and thereby emphasizing the liquidity of the firm through recovery of capital, and by favoring short term projects over what may be riskier, longer term projects.

It should be realized, however, that the payback period, as a method of risk analysis, is useful only in allowing for a special type of risk, the risk that a project will go exactly as planned for a certain period and will then suddenly cease altogether and be worth nothing. It is essentially suited to the assessment of risks of time nature. Once a payback period has been calculated, the decision-maker would compare it with his own assessment of the projects likely, and if the letter exceeds the former, he would accept the project. This is a useful procedure, economic only if the forecasts of cash flows associated with the project are likely to be unimpaired for a certain period. The risk that a project will suddenly cease altogether after a certain period life may arise due to reasons such as civil war in a country, closure of the business due to an indefinite strike by the workers, introduction of a new product b a competitor which captures the whole market and nature disasters such as flood or fire. Such risks undoubtedly exist but they, by no means, constitute a large proportion of the commonly encountered business risks. The usual risk in business is not that a project will go as forecast for a period and then collapse altogether; rather the normal business risk is that the forecasts of cash flows will go wrong due to lower sales, higher cost.

(211)---STATISTICAL TECHNIQUES FOR RISK ANALYSIS

Statistical Techniques for Risk Analysis

Statistical techniques are analytical tools for handling risky investments. These techniques, drawing from the fields of mathematics, logic, economics and psychology, enable the decision-maker to make decisions under risk or uncertainty.

The concept of probability is fundamental to the use of the risk analysis techniques. Hoe is probability defined? How are probabilities estimated? How are they used in the risk analysis techniques? How do statistical techniques help in resolving the complex problem of analyzing risk in capital budgeting? We attempt to answer these questions in our posts.

Probability defined

The most crucial information for the capital budgeting decision is a forecast of future cash flows. A typical forecast is single figure for a period. This referred to as “best estimate” or “most likely” forecast. But the questions are: To what extent can one rely this single figure? How is this figure arrived at? Does it reflect risk? In fact, the decision analysis is limited in two ways by this single figure forecast. Firstly, we do not know the changes of this figure actually occurring, i.e. the uncertainty surrounding this figure. In other words, we do not know the range of the forecast and the chance or the probability estimates associated with figures within the range. Secondly, the meaning of best estimates or most likely is not very clear. It is not known whether it is mean, median or mode. For these reasons, a forecaster should not give just one estimate, but a range of associate probability- a probability distribution.

Probability may be described as a measure of someone’s option about the likelihood that an event will occur. If an event is certain to occur, we say that it has a probability of one of occurring. If an event is certain not to occur, we say that its probability of occurring is zero. Thus, probability of all events to occur lies between zero and one. A probability distribution may consist of a number of estimates. But in the simple form it may consist of only a few estimates. One commonly used form employs only the high, low and best guess estimates, or the optimistic, most likely and pessimistic estimates.

Assigning probability

The classical probability theory assumes that no statement whatsoever can be made about the probability of any single event. In fact, the classical view holds that one can talk about probability in a very long run sense, given that the occurrence or non-occurrence of the event can be repeatedly observed over a very large number of times under independent identical situations. Thus, the probability estimate, which is based on a very large number of observations, is known as an objective probability.

The classical concept of objective probability is of little use in analyzing investment decision because these decisions are non-respective and hardly made under independent identical conditions over time. As a result, some people opine that it is not very useful to express the forecaster’s estimates in terms of probability. However, in recent years another view of probability has revived, that is, the personal view, which holds that it makes a great deal of sense to talk about the probability of a single event, without reference to the repeatability, long run frequency concept. Such probability assignments that reflect the state of belief of a person rather than the objective evidence of a large number of trials are called personal or subjective probabilities.

(210)---RISK ANALYSIS IN CAPITAL BUDGETING

Risk Analysis in Capital Budgeting

Introduction

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

Nature of risk

Risk exists because of the inability of the decision maker to make perfect forecasts. Forecasts cannot be made with perfection or certainty since the future events on which they depend are uncertain. An investment is not risky if, we can specify a unique sequence of cash flows for it. But whole trouble is that cash flows cannot be forecast accurately, and alternative sequences of cash flows can occur depending on the future events. Thus, risk arises in investment evaluation because we cannot anticipate the occurrence of the possible future events with certainty and consequently, cannot, make are correct prediction about the cash flow sequence. To illustrate, let us suppose that a firm is considering a proposal to commit its funds in a machine, which will help to produce a new product. The demand for this product may be very sensitive to the general economic conditions. It may be very high under favorable economic conditions and very low under unfavorable economic conditions. Thus, the investment would be profitable in the former situation and unprofitable in the later case. But, it is quite difficult to predict the future state of economic conditions, uncertainty about the cash flows associated with the investment derives
A large number of events influence forecasts. These events can be grouped in different ways. However, no particular grouping of events will be useful for all purposes. We may, for example, consider three broad categories of the events influencing the investment forecasts.

• General economic conditions

This category includes events which influence general level of business activity. The level of business activity might be affected by such events as internal and external economic and political situations, monetary and fiscal policies, social conditions etc.

• Industry factors

This category of events may affect all companies in an industry. For example, companies in an industry would be affected by the industrial relations in the industry, by innovations, by change in material cost etc.

• Company factors

This category of events may affect only a company. The change in management, strike in the company, a natural disaster such as flood or fire may affect directly a particular company.