Capital Budgeting (under Risk and Uncertainty) and Methods
A. SCENARIO ANALYSIS
Q1. ABC and co evaluating the proposal A1 and A2 both having cash outflow of Rs.
30000 each. However, these alternative proposals may result in different cash inflow
depending upon different economic condition i.e. good, average and poor. The following
information is available.
A1 A2
Economic life 10 years 15 years
Cash Flow (annual)
Good economic condition Rs. 8000 Rs. 6000
Average economic condition Rs. 6000 Rs. 5500
Poor economic condition Rs. 4500 Rs. 4500
Evaluate the proposals and advise the firm given that the minimum required rate of return
is 10%.
Q2. A project evaluation is thought to involve a medium degree of risk. The risk free
discounting rate is 4% and appropriate risk premium is 6%. The project costing is Rs.
1000, has following estimate NPV and the probabilities of different economic conditions:
Market Conditions NPV at 4% NPV at 10% Probability
(in Rs.) (in Rs.)
Good 1775 1487 0.1
Average 1220 989 0.2
Medium 665 492 0.4
Poor 110 -5 0.2
Bad -445 -503 0.1
Analyze the expected NPV and its variability.
B. STATISTICAL TECHNIQUE
Q3.XYZ and co. is evaluating a proposal having initial outlay of Rs. 140000/- and
economic life of 2 years. The cash inflows and the respective probabilities have been found
as follows:
Year 1 Year 2
Cash Flow Prob. Cash Flow Prob.
Rs. 100000 0.3 Rs. 140000 0.5
Rs. 80000 0.5 Rs. 70000 0.3
Rs. 10000 0.2 Rs. 60000 0.2
Evaluate the proposals given that the firm has minimum required rate of return 10%.
Q4.The following data in respect of a proposal having an outlay of Rs. 6000 has been
submitted before the company
Yea Inflo Pro Yea Inflo Pro Yea Inflo Pro
r w b. r w b. r w b.
1 1000 0.1 2 2000 0.2 1500 0.1
1500 0.2 2500 0.3 2200 0.1
2000 0.4 2700 0.2 2800 0.7
2500 0.2 2800 0.3 3500 0.1
3000 0.1
Evaluate the proposal, discounting rate
Q5.A company is evaluating two equal size mutually exclusive proposal X and Y for
which the respective cash flow together with associate probabilities as follows:
Project X Project Y
Cash Flow Prob. Cash Flow Prob.
2000 0.3 1000 0.1
4000 0.4 3000 0.1
6000 0.3 5000 0.4
7000 0.3
9000 0.1
Find out risk of the proposals in terms of Standard deviation.
Q6. A company is evaluating two equal size mutually exclusive proposal P1 and P2 for
which the respective cash flow together with associate probabilities as follows:
Project P1 Project P2
Cash Flow Prob. Cash Flow Prob.
150000 0.3 -400000 0.2
200000 0.3 300000 0.6
250000 0.4 400000 0.1
800000 0.1
Find out risk of the proposals in terms of Standard deviation and coefficient of variation.
Q7. A company is evaluating two equal size mutually exclusive proposal X and Y. Project
X cost 30000 and Project Y 36000. The respective cash flow together with associate
probabilities as follows:
Project X Project Y
Cash Flow Prob. Cash Flow Prob.
3000 0.1 3000 0.2
6000 0.4 6000 0.3
12000 0.4 12000 0.3
15000 0.1 15000 0.2
Compute
the expected ENPV
Find out risk of the proposals in terms of Standard deviation and coefficient of
variation.
Which project is more risky.
Q8. A company is evaluating two equal size mutually exclusive proposal X and Y for
which the respective cash flow together with associate probabilities as follows:
Project X Project Y
Cash Flow Prob. Cash Flow Prob.
12000 0.1 8000 0.1
14000 0.2 12000 0.25
16000 0.4 16000 0.3
18000 0.2 20000 0.25
20000 0.1 24000 0.1
Advise the company.
Q9. A company is evaluating two equal size mutually exclusive proposal X and Y. The
company uses a Certainty Equivalent approach to evaluate the proposal. the estimated cash
flow and certainty equivalent for both machines are as follows:
Project P1 Project P2
Year Cash CE Year Cash CE
Flow Flow
0 -30000 1 0 -400000 1
1 15000 0.95 1 25000 0.9
2 15000 0.85 2 20000 0.8
3 10000 0.7 3 15000 0.7
4 10000 0.65 4 10000 0.6
Risk free rate is 5%.
C. SENSITIVITY ANALYSIS
Q.10The following forecast are made about a proposal which is being evaluated by a
firm.Initial outlay: 12000 Cash flows: 4500 (Annual)
Life:4 Years Ke14%
PVAF (14%, 4Y) : 2.9137
D. DECISION TREE APPROACH
Q.11ABC and Company has fund of Rs. 2, 00,000 which expectedly not required for next few
years hence can be deposited in the bank @15% interest payable annually. Alternatively fund
can be used to install a new machine for the production of a new item. For this, the firm has two
options before it: Machine I costing the 1,80,000 which is expected to give annual cash inflow of
Rs. 1,00,000, 1,20,000 and 40,000 respectively for next three years. Machine II costing 1,90,000
which is expected to give annual cash inflows of Rs. 1,00,000, Rs. 1,00,000 and 50,000
respectively for next three years. Present the decision situation in a decision tree and evaluate the
option.
Q.12 A firm of investment consultant has been asked by one of its client with respect to
investment of a sum of Rs. 1,00,000 for a period of 2 years. After a thorough analysis of different
opportunities, Option A and B have been short listed.
Option A will lead to return of 8%, 10% or 12% in the first year, but due to the nature of option,
there is a correlation between the returns of year 1 and year 2. The return of year 1 and
probabilities of the different returns in the year 2 are as follows:
Year 1 return Year 2 Return
8% 10% 12%
8% 0.6 0.3 0.1
10% 0.2 0.5 0.3
12% 0.1 0.2 0.7
At this stage the three different returns in the year 1 are considered to be equally likely. Option B
has a certain return of 9.5% per year. Evaluate the option s and draw a decision tree to represent
the alternative courses of action and outcome. On the basis of the expected value of returns
which option is preferable?
Q.13 PQR and Co. whose major product is X, is facing problems as the product X deteriorate
rapidly, it can be produced on a monthly basis only and cannot be stored from next month to the
next. At the start of each month, a production figure for the month is decided and necessary raw
material is procured. Unfortunately, the demand for the product X varies randomly and if the
demand for product X varies randomly and if the demand is more than the monthly budgeted
production, then sales are lost. If on the other hand, production is more than the actual sale, then
the goods unsold have no value. The selling price per unit is 2400 Rs. and the variable cost is
1500 Rs. per unit.
On the basis of sales experienced, it is found that the monthly demand for production X is
between 10 and 20 units. It may be assumed that the demand of 10 units is considered as low
demand, demand of 15 units as medium demand and demand of 20 units as high demand. These
demand levels have the probabilities of 0.3, 0.6 and 0.1 respectively. Present the above
information in decision tree and evaluate the production level given that the demand pattern does
not change.
Q.14 A firm is required to choose the between constructing a large or small factory to produce a
new line of products. The large plant would be needed if the future brings a high demand for new
products. But the large plant would have cash outflow of Rs. 10, 00,000. The present value of
cash inflows are Rs. 14,00,000 with high demand, 9,00,000 with medium demand and 6,00,000
with low demand. The smaller plant produces a lower return if demand is high but has positive
NPV at medium demand. It would cost Rs. 2, 00,000 as a cash outlay and would return a present
value inflow of 3, 20,000 with high demand, 2, 70,000 with medium demand and 1, 00,000 with
low demand. What is the NPV of each alternative if there is a 40 % chance of high demand and
medium demand while 20% chance of low demand?
Q15. A company is considering a new machine. The net cash flows have been estimated as
follows:
Year 1 Probability Year 2 Probability
Net Cash flow 10,000 0.4 8000 0.5
12000 0.5
Net Cash flow 12,000 0.6 16000 0.4
20000 0.6
The cost of machine is Rs. 20,000 with an estimated life of two years and cost of capital of the
firm is 12%. Use a decision tree approach to recommend whether the equipment should be
purchased or not.
Q16. A firm has an investment proposal, requiring an outlay of Rs. 40,000. The investment
proposal is expected to have 2 year economic life. With no salvage value. In year I there is a 0.4
probability that cash inflow after tax is 25,000 and the 0.6 probability that cash inflow after tax
will be 30,000. The probability assigned to cash inflows after tax for the year II are as follows:
Year I
Cash Inflow 25,000 30000
Year II
Cash Inflow Probability Cash Inflow Probability
12,000 0.2 20,000 0.4
16,000 0.3 25,000 0.5
22,000 0.5 30,000 0.1
The firm uses the discount rate of 10% for this type of investment
Required:
a). Construct the decision tree for proposed investment project
b). What NPV will the project yield if worst outcome is realized? What is the probability of
outcome of this NPV?
c). what is the best outcome and the probability of that occurrence.
d). Will the project be accepted.
.Q17. The Indian Yacht company has developed a new cabin cruiser which they have earmarked
for the medium to large boat market. A market analysis has a 30% probability of annual sales of
being 5000 boats, a 40% probability of 4,000 annual sales and 30% probability of 3,000 annual
sales. This company can go limited production where variable cost is 10,000 per boats and fixed
cost are 8, 00,000 annually. Alternatively they can go into full scale production where variable
cost are 9,000 per boat and fixed cost are 50, 00,000 annually. If the new boat is sold for 11,000
per boat should company go for limited or full scale production if objective is to maximize the
profits?
E. SIMULAITON ANALYSIS
Q18.ABC and Co. is evaluating the installation of new automatic machine in order to reducethe
labour costs. The new machine can also meet the demand for greater capacity needed tomeet the
demand for the product and hence resulting in increase in profits for at least threeyears.
However, due to uncertainty in the expected demand for the product, the cash flowcannot be
accurately estimated. The following probabilities have been assigned in thisreference.
Year 1 Year 2 Year 3
CF (in Rs) Prob. CF (in Rs) Prob. CF (in Rs) Prob.
10,000 0.3 10,000 0.1 10,000 0.3
15,000 0.4 20,000 0.2 20,000 0.5
20,000 0.3 30,000 0.4 30,000 0.2
40,000 0.3
The new machine having cost of Rs. 70,000 and the scrap value of the old machine isestimated
to be Rs. 28,000. Evaluate the proposal given that discount factor is 15%. Alsoanalyse the risk
inherent in this situation by simulating the NPV values. Random numbers for5 sets of cash flow
are given hereunder. On the basis of simulation exercise, also find out theexpected NPV and the
probability that the NPV of the proposal will be less than 0.
Random Numbers
Year Set 1 Set 2 Set 3 Set 4 Set 5
1 4 7 6 5 0
2 2 4 8 0 1
3 7 9 4 0 3
Q19. The Management of ABC Company is considering the question of marketing a
newproduct.ThefixedcostrequiredinthenewprojectisRs4000.Threefactorsareuncertainviz.the
sellingprice,variablecostandannualsalesvolume.Theproducthasalifeofonlyone year. The
management has the data on these three factors as under.
SellingPrice(i Prob. Variablecost( Prob. Sales volume Prob.
n Rupee) in Rupee)
3 0.2 1 0.3 2000 0.3
4 0.5 2 0.6 3000 0.3
5 0.3 3 0.1 5000 0.4
Considerthefollowingsequenceofthirtyrandomnumbers:81,32,60,04,46,31,67,25,24,10, 40, 02,
39, 68, 08, 59, 66, 90,12,64, 79, 31, 86, 68, 82, 89, 25, 11, 98, 16.
Usingthesequence(first3randomnumbersforthefirsttrailetc.)simulatetheaverageprofitfor the
above project on the basis of 10 trails.
F. CAPITAL RATIONING
Q20. ABC Ltd has a capital budget of Rs. 20,00,000 for the year 1. It has before it the following
6 proposals for which the necessary information is provide hereunder.
Proposal Outlay NPV IRR
A 7,00,000 3,00,000 20%
B 2,50,000 1,60,000 17%
C 5,00,000 2,00,000 19%
D 2,00,000 1,00,000 17.5%
E 5,50,000 4,50,000 18%
F 7,50,000 -2,50,000 12%
Find out the ranking of proposals given that
(i) The projects are indivisible.
(ii) The projects are divisible.
Also evaluate the ranking and make a final selection.
Q21. The total available budget for company is Rs. 20 Crores. The projects listed below have
been ranked in order of profitability. The firm has already accepted Project X whose cost is
assumed to be 13 crores and it has profitability index of 1.4.
Project Cost (in Crores) Profitability index
A 6 1.5
B 5 1.25
C 7 1.2
D 2 1.15
E 5 1.1
TOTAL 25
Which Projects, including X should be acquired by the company?
Q22. ABC Ltd is considering its capital investment programme for 2020 and 2021. The company
is financed entirely by equity shares and has a cost of capital of 15%. The firm has shortlisted
various proposals for which the expected cash flow are given below.
Projects Year
2020 2021 2022 2023
A -60,000 +30,000 +25,000 +25,000
B -30,000 -20,000 +25,000 +45,000
C -40,000 -50,000 +60,000 +70,000
D - -80,000 +45,000 +55,000
E -50,000 +10,000 +30,000 +40,000
None of the above project can be delayed. All projects are divisible and outlays can be reduced
by any proportion and the inflows will also be then reduced proportionately No projects can be
undertaken more than once. The firm is able to invest surplus fund at 10% p.a. You are required
to:
1. Prepare calculations showing which project be undertaken if the funds are expected to be
available without limits during all future periods.
2. Show how decision would vary if the funds available are limited to Rs. 1, 00,000 during
2020 and no limit thereafter.
G. CAPITAL BUDGETING UNDER INFLATION:
Q23.ABC and Co. has the following information relating to an investment proposal: The
initial outlay of Rs. 2400000 is expected at year 0 with a life of year 4. The firm has an
annual profit before tax and depreciation of 1000000 and pays the tax @ 40%. The annual
cash inflow ( profit after tax + depreciation) of 840000 is expected. Assuming that real
discounting rate is 5%.
Calculate: 1. The NPV of the project under no inflation. 2. The NPV under inflation of 5%.
Q24. Evaluate the feasibility of the project or otherwise of a project keeping in view the
following information: (i) The nominal rate of return is 14%. (ii) The expected rate of
inflation over life is 7%. (iii) the expected cash flows of the project are:
Year 0 1 2 3 4
Cash flow (10000) 3000 3000 3000 3000
H. REPLACEMENT DECISIONS
Q25. A delivery Van must be replaced every four years and related cash flows are as follows:
Particulars Year
0 1 2 3 4
Cost of Van 1,500 - - - -
Maintenance - 400 450 500 500
Cost
Repairs - - 100 200 400
Scrap Value - 800 600 400 200
The firm is faced with the decision: Should the Van be kept for four years and then scrapped
away for Rs. 2,00,000? Or should it replaced earlier. The firm discount rate is 15%.
