Multiple Investments & Risk Mgt.

Unit 3 - Advanced Capital Budgeting

Introduction

• Risk is inherent in every business activity

• Risks involved in capital budgeting decisions assumes even more importance because -

- costs & benefits associated with these decisions extend over long periods &

- these decisions are strategic in nature.

CLASSIFICATION OF CAPITAL EXPENDITURE PROPOSALS

(a) Independent Proposals: These are proposals which are not interconnected. Acceptance or rejection of a proposal has no effect on the acceptance or rejection of any other proposal. Such proposals can be evaluated on the basis of the return expected and the return required by the firm’s norms of return. Proposals which satisfy the firm’s return standards can be taken up irrespective of other proposals.

(b) Dependent proposals or contingent proposals: When a proposal depends on the acceptance of some other proposal, it is called a dependent proposal. For example, purchasing a specific kind of computer printer depends on the proposal to acquire a computer. In such cases it is preferable to consider both the proposals simultaneously.

(c) Mutually exclusive proposals: If acceptance of one proposal results in the

automatic rejection of the other proposal or proposals, they can be termed as

mutually exclusive proposals. For example two different kinds of machines may

be considered for a particular task. If one of them is selected, the other machine is automatically rejected.

Risk Evaluation Techniques

• Sensitivity Analysis

• Scenario Analysis

• Probability Tree Approach

• Simulation

• Portfolio Approach

The objective is to assess whether the new investment project increases the total risk of the firm.

Real Managerial Options

• NPV of a project is the present value of its expected future cash flows, discounted at a rate that reflects the riskiness of the expected future cash flows.

• Projects with positive NPVs are accepted.

• Once a project is accepted, mgt. may have the flexibility to make changes that will affect subsequent cash flows &/or project’s life.

• This is a real managerial (not financial) option

Managerial Option

• Definition: “Management flexibility to make future decisions that affect a project’s expected cash flows, life or future acceptance.”

• The objective is to respond to changing business environment and influence the outcome of the investment project.

• They are called real options as the assets involved are real, not just financial assets.

Types of Managerial Options• Option to Expand/ Growth Option: It is a choice

to expand production or vary output, if conditions turn favourable

• Option to Contract/Shutdown Option: It is a choice to contract production or vary output, if conditions turn unfavourable

• Option to Abandon: It is a choice to terminate a project prematurely.

• Option to Postpone/Investment Timing Option: It is a choice to wait till there is new information

Capital Rationing• Definition: “A situation where a constraint or

budget ceiling is placed on the total size of capital expenditure during a particular period.”

• “A situation in which a firm limits its capital expenditure to less than the amount required to fund the optimal capital budget.”

• It is the situation that exists if a firm has positive NPV projects but cannot find the necessary funding.

• Occurs when the firm cannot or will not fund profitable (all positive NPV) projects

Types of Capital Rationing

1. Soft Capital Rationing/Internal Cap. Rationing:

• Self-imposed restrictions by the mgt. in order to aid financial control.

• They do not reflect capital market imperfections.

2. Hard Capital Rationing/External Cap. Rationing:

• Deficiencies in the capital market (such as inadequate market information, rigid atti tude of money lenders, etc.) that make it very difficult for the firm to raise additional capital.

Methods of Project Selection under Capital Rationing

• Aggregation Method

• Profitability Index

• Postponement Analysis

Thank you!