UNIT-III

CORPORATE INVESTMENT STRATEGY

Risk and Uncertainty

Risk is inherent in almost every business decision. More so in capital budgeting (Investment)
decisions as they involve costs and benefits extending over a long period of time during
which many things can change in unanticipated ways.

Risk exists because of the inability of the decision-maker to make perfect forecasts. Risk
refers to variations in the forecasts, the difference between expected return and actual return
is known as risk, in investment decisions risk means variations in the actual returns arising
from a project or machinery in its economic life, in relation to the estimated returns of
project.

Risk: A risky situation is one in which the probabilities of a particular event’s occurrence are
known. In the case of risk, chance of future loss can be foreseen due to past experience.

Uncertainty: An uncertain situation is one when probabilities of occurrence of a particular

event are not known. In the case of uncertainty, the future loss cannot be foreseen. So, it
cannot be planned in advance by management. More uncertainty means more risk, less
uncertainty means less risk.

Sources of risk (Financial Management by Prasanna Chandra, Page No: 327- 327)

There are several sources of risk in a project. The important ones are:

 Project specific risk: It is the risk that arises due to estimation of errors in earnings
and cash flows
 Competitive risk: Risk arise due to the competitors actions that affects company’s
earnings and cash flows of the project.
 Industry specific risk: Here the firm earnings and cash flows are affected due to the
industry specific factors like un expected changes in government policies, consumer
behavior etc.
 Market risk: Market risk affects the earnings and cash flows of all projects due to
unexpected changes in macro economic factors like GDP growth rate, Interest rate
and Inflation etc.
 International risk: This type of risk exists only in international (Foreign) projects,
whose earnings and cash flows are affected due to the unexpected changes in
exchange rates.

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TECHNIQUES OF INVESTMENT APPRAISAL UNDER RISK AND UNCERTAINITY
(Financial Management by [Link], Page No: 248-258), (Financial Management by Prasanna Chandra, Page
No: 326-346)

1. Sensitivity Analysis: It is a technique to assess the risk, this technique measures the
change in the profitability of a project (NPV and ROI cash inflows) caused by changes in
the factors that affects the cash inflows of the project, if a small change in one factor leads
to major change in the profitability of the proposed investment. It considered the project is
sensitive in other words the project is more risky. In simple Sensitivity Analysis is a tool
used in financial modeling to analyze how the different values of a set of independent
variables(Asset clause, Duration of the investment etc) affect a specific dependent
variable(Return/ Cash inflows/Profit) under certain specific conditions.

Example: For example, a financial analyst wants to find out the effect of a company’s net
working capital on its profit margin. The analysis will involve all the variables that have
an impact on the company’s profit margin, such as the cost of goods sold, workers’ wages,
managers’ wages, etc. The analysis will isolate each of these fixed and variable costs and
record all the possible outcomes.

Decision: Other things being equal project that is less sensitive is preferable than project is
more sensitive. Large is the difference between the pessimistic and optimistic cash inflows
it consider more risky then reject.

Sensitivity analysis is observing by assessing cash inflows of projects by considering three

assumptions.

 The pessimistic: Worst

 The optimistic: The best
 Most likely: Expected

Advantages

 It is a popular method of assessing risk

 It analyze the sensitivity of a project
 It helps to assess the impact of sensitivity on a project ROI or cash inflows or NPV.

Limitations

 If two or more variables are simultaneously affects the projects profitability it is

useless.
 It involves complex process

2. Scenario analysis: In sensitivity analysis one variable is varied at a time. In scenario

analysis, several variables are varied simultaneously. Most commonly, three are
considered: expected scenario, pessimistic scenario, and optimistic scenario. In simple
Scenario analysis is a method of predicting future values of portfolio investments based on
potential events. In other words, it’s a method of estimating what will happen to portfolio
values if a specific event happens or doesn’t happen.

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 Example: Looking at an investment example, let’s assume that Jacob is a financial analyst
in a prominent investment firm. He uses scenario analysis to determine different
reinvestment rates of the portfolios expected returns considering the worst-case and best-
case scenarios. For example, interest rates going up 2 points might be the best case and
interest rates going down 5 points might be the worst case. He can then give a probability
to each outcome and see the investment risk spread. Based on the risk Jacob is willing to
accept, he can make his investment decisions

3. Break-even analysis: In sensitivity analysis we ask what will happen to the project
(Investment) if sales decline or costs increase or something else happens. As a financial
manager, you will also be interested in knowing how much should be produced and sold at
a minimum to ensure that the project does not lose money. Such an exercise called break-
even analysis. It is important because it denoted the minimum volume of production to be
undertaken to avoid losses.
4. Simulation analysis/Method of statistical trails/ Monte Carlo’s simulation: Sensitivity
analysis and scenario analysis both approaches suffer from certain weaknesses. As we
discussed, they do not consider the interactions between variables and also, they do not
reflect on the probability of the change in variables. Simulation analysis is an extension of
scenario analysis. In simulation analysis a computer generates a very large number of
scenarios according to the probability distributions of the variables and assesses the impact
of risk, allowing for better decision making under uncertainty.

Steps in simulation analysis

- First, we should identify variables that influence cash inflows and outflows.
- Specify the formulae that relate 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.
- Indicate the probability 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.
- Develop a computer programme that randomly selects one value from the probability
distribution of each variable and uses these values to calculate the project’s NPV. The
computer generates a large number of such scenarios, calculates NPV s and stores
them.

5. Decision tree analysis/ Probability tree analysis: It is one of the important techniques
of capital budgeting which is used to tackle risky capital investment proposals. Decision
tree is a graphical presentation of the relationship between a present decision and future
events, future decisions and their consequences in the form of branches of a tree.

Steps in decision tree analysis

 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.

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  Identify decision alternatives: The decision alternatives should be clearly defined.
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.
 Drawing the decision tree: The decision tree should be graphed indicating the
decision points, chance evens and other data. The relevant data such as the projected
cash flows, probability distributions, the expected present value etc., should be
located on the decision tree branches.
 Analyze data: The results should be analyzed and the best alternative should be
selected.

Advantages

 Easy to understand
 Clearly brings out the implicit assumptions and calculations for all to see,
question and revise.

Limitations

 Decision tree become more complex

 Involves large calculations
 It is time consuming
 It needs more information
 It does not make the decision which alternative is possible it just provide
whether the investment is financially feasible or not.

6. Risk adjusted discount rate: RADR is the discount rate that is used to convert future
cash inflows into present value, it is equal to the risk free rate of return plus risk premium
for investing in a project. RADR method needs the determination of both risk free rate
and risk premium rate. RADR consider both time and discount factors. Risk free rate is
the rate at which the future cash inflows should be discounted in case there is zero risk,
but risk premium rate is the extra return expected by the investor over and above the
normal rate.
Formula for RADR = Risk free interest rate + Risk premium
Decision rule: This method is used in two discounted cash flow techniques, i.e. Net
Present Value (NPV) and Internal Rate of Return (IRR) method.

In case of NPV method

If NPV > 0 - Accept
If NPV < 0 - Reject
If NPV = 0 - Consider/may accept
In case of IRR method
If IRR > RADR - Accept
If IRR< RADR - Reject
If IRR = RADR - Consider/may accept

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 Advantages
 It is simple to calculate and easy to understand
 It gives psychological satisfaction to the decision maker
 Since it adds some premium for risk.
Limitations
 It is difficult to arrive at RADR
 It assumes that risk increases with time at a constant rate, which is not valid.

7. Certainty equivalents (CEA): CEA is the ratio of riskless cash flow to risky cash flow,
risk less cash flow is one which the management is prepared to accept unless there is risk.
Generally the cash flows of riskless project is less than that of risky project. Under this
method, the estimated cash flows are brought down to a certain level by applying
correction factors (certainty equivalent coefficient). In Simple words in RADR approach
we adjust discount rate but in CEA the risk of a project is assessing by adjusting cash
inflows instead of adjusting discount rate.
Decision rule: This method is used in two discounted cash flow techniques, i.e. Net
Present Value (NPV) and Internal Rate of Return (IRR) method.

In case of NPV method

If NPV of certainty equivalent > 0 – Accept

If NPV of certainty equivalent < 0 – Reject
If NPV of certainty equivalent = 0 –May accept/ Consider

In case of IRR method

If IRR > risk free rate – Accept
If IRR < risk free rate – Reject
If IRR = risk free rate – May accept/Consider

Advantages
 It is simple to calculate and easy to understand
 It is superior to RADR since it does not assume that the risk increases with the
time increase.
Limitations
 It is difficult to consider increasing risk capacity
 It is inconvenient and difficult to specify a services Certainty equivalent
coefficient.

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RISK ADJUSTED NET PRESENT VALUE

Risk adjusted net present value is little different from normal net present value. In normal net
present value, we just use normal cut off rate for calculating present value of cash inflows
and present value of cash outflow. But for calculating risk adjusted net present value (ENPV),
we use risk adjusted return on investment as cut off rate. This risk adjusted return on
investment is more than normal cut off rate because we include some margin for unexpected
risk. This excess will be of risk premium rate. To calculate ENPV is very useful to evaluate
risky assets alternatives. This is also called expected net present value.

Formula of ENPV = Present value of Cash Inflows (With risk adjusted ROI) - Present value
of Cash outflow (With risk adjusted ROI)

RISK ADJUSTED INTERNATIONAL RATE OF RETURN

Risk adjusted internal rate of return is another method for appraisal of investment decisions,
of discounted cash flow analysis. This method is also known as yield on investment/ Time
adjusted rate of return. The internal rate of return is defined as the discount rate which
equates the cumulative present value of the net cash inflows with the aggregate present value
of cash flows of a project. In simple words IRR is the rate of return at which NPV is zero or
actual return of an investment.

CAPITAL RATIONING (Financial Management by Khan and Jain, Page No: 10.12-10.15)
(Fundamentals of Financial Management by [Link] Bose, Page No: 526-527)

Capital rationing is a situation where a company has more investment proposals than it can
finance. Thus capital rationing refers to a situation where a company cannot undertake all
profitable projects (i.e. positive NPV projects) it has identified because of shortage of capital.
Usually, a company is forced to reject some of the viable projects having profit on account of
paucity of funds. However, in practice, the company fixes the size of the annual capital
expenditure budget on the basis of the volume of funds available and other considerations. In
such an event, the company has not only to select profitable projects but has also to rank the

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projects from the highest to lowest priority. A cut-off point is then fixed. Proposals above the
cut-off point should be chosen and those below the cut-off point should be rejected or
delayed. The company usually fixes the cut-off point keeping in view the number of projects,
the objectives of the firm and the availability of capital to finance the capital expenditure. The
objective to select the combination of projects would be the maximisation of the total Net
Present Value (NPV).

Definition of Capital Rationing

 The capital rationing refers to the choice of investment proposals under financial
constraints in terms of given size of capital expenditure budget.
 Capital rationing is a situation where a constraint or budget ceiling is placed on the
total size of capital expenditures during a particular period. Often firms draw up their
capital budget under the assumption that the availability of financial resources is
limited.

Types of Capital Rationing

Based on the source of restriction imposed on the capital, there are two types of capital
rationing viz. hard capital rationing and soft capital rationing.

 Soft Capital Rationing: It is internal to the firms in that different divisions/units of a

firm are allocated a fixed amount of capital budget each year. (In simple it is when the
restriction is imposed by the management).
 Hard Capital Rationing: It refers to the situation when a business firm cannot raise
required finances to execute all potential available profitable investment projects. (In
simple it is when the capital infusion is limited by external sources).

Steps in Project selection under capital rationing

 Ranking projects in accordance with profitability index or internal rate of return.

 Selections of the combination of projects in descending order of profitability under
the budget figures are exhausted. Keeping in view the objective of maximizing the
value of the concern

Methods of selecting investment projects under capital rationing

Methods of selecting investment projects under capital rationing situation will depend upon
whether the projects are indivisible or divisible.
 Indivisible projects: In case the project is to be accepted/rejected in its entirety, it is
called an indivisible project. (In simple select combination of Profitable projects)
 Divisible projects: A divisible project, on other hand, can be accepted/rejected in
part. (In simple select only one most profitable project)

Assumptions of Capital Rationing

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  The primary assumption of capital rationing is that there are restrictions on capital
expenditures either by way of ‘all internal financing’ or ‘investment budget
restrictions’.
 Firms do not have unlimited funds available to invest in all the projects.

Advantages of Capital Rationing

Capital rationing is a very prevalent situation in companies. There are few advantages of
practicing capital rationing:

 Budget: The first and an important advantage are that capital rationing introduces a
sense of strict budgeting of corporate resources of a company. Whenever there is an
injunction of capital in the form of more borrowings or stock issuance capital, the
resources are properly handled and invested in profitable projects.
 No wastage: Capital rationing prevents wastage of resources by not investing in each
and every new project available for investment.
 Fewer projects: Capital rationing ensures that less number of projects are selected by
imposing capital restrictions. This helps in keeping the number of active projects to a
minimum and thus manages them well.
 Higher returns: Through capital rationing, companies invest only in projects where
the expected return is high, thus eliminating projects with lower returns on capital.
 More stability: As the company is not investing in every project, the finances are not
over-extended. This helps in having adequate finances for tough times and ensures
more stability and increase in the stock price of the company.

Limitations of capital rationing

Capital rationing comes with its own set of disadvantages as well. Let us describe the
problems that rationing can lead to:

 Efficient capital markets: Under efficient capital markets theory, all the projects that
add to company’s value and increase shareholders’ wealth should be invested in.
However, by following capital rationing and investing in only certain projects, this
theory is violated.
 The cost of capital: In addition to limits on budget, capital rationing also places
selective criteria on the cost of capital of shortlisted projects. However, in order to
follow this restriction, a firm has to be very accurate in calculating the cost of capital.
Any miscalculation could result in selecting a less profitable project.
 Un-maximising value: Capital rationing does not allow for maximising the
maximum value creation as all profitable projects are not accepted and thus, the NPV
is not maximized.

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  Small projects: Capital rationing may lead to the selection of small projects rather
than larger scale investments.
 Intermediate cash flows: Capital rationing does not add intermediate cash flows
from a project while evaluating the projects. It bases its decision only the final returns
from the project. Intermediate cash flows should be considered in keeping the time
value of money in mind.

Process of Capital Rationing

The method of capital rationing can be bifurcated in four steps. The steps are
 Evaluation of all the investment proposals using the capital budgeting techniques
of Net Present Value(NPV), Internal Rate of Return (IRR) and Profitability Index (PI)
 Rank them based on various criterion viz. NPV, IRR, and Profitability Index
 Select the projects in descending order of their profitability till the capital budget
exhausts based on each capital budgeting technique.
 Compare the result of each technique with respect to total NPV and select the best out
of that.

Example: A company has the following investment proposals.

Proposals Initial Outlay Profitability Index

1 2,00,000 1.46
2 2,50,000 0.98
3 2,50,000 2.31
4 3,50,000 1.32
5 2,00,000 1.25

Solution: In this illustration all proposals except No.2 give profitability index exceeding one
and are profitable investments. The total outlay required to be invested in all other
(profitable) projects is Rs.10,00,000 (1+3+4+5) but total funds available within the concern
are Rs.8,00,000 and hence, the concern has to de capital rationing and select the most
profitable combination of projects within the total cash outlay of Rs.8,00,000. Project No.5
which has the lowest profitable index among the profitable proposals cannot be taken.

EVALUATION OF LEASE vs BORROWING DECISION (Financial Management by

[Link], Page No: 455-459 & Financial Management by Prasanna Chandra, Page No: 711-722)

Leasing

Leasing is widely used in western countries to finance investments. In USA, which has the
largest leasing industry in the world, lease financing contributes approximately one-third of
total business investments. In the changing economic and financial environment of India, it
has assumed an important role. Land, buildings, and animals has been known from times
immemorial, the leasing of industrial equipments is a relatively recent phenomenon,
particularly on the Indian scene.

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Meaning of lease

 A lease represents a contractual arrangement whereby the lessor grants the lessee the
right to use an asset in return for periodical lease rental payments.
 Lease is a contract between a lessor, the owner of the asset, and a lessee, the user of
the asset. Under the contract, the owner gives the right to use the asset to the user over
an agreed period of time for a consideration called lease rental.

Types of Leases
 Financial lease Vs operating lease: Finance lease and operating lease are the
different accounting methods for the lease where in case of Finance lease all the risk
and rewards related to the asset under consideration gets transferred to lessee whereas
in case of Operating lease all the risk and rewards related to the asset under
consideration stays with the lessor. Financial lease is a long term contract and
operating lease is short term.
Key differences between financial lease and operating lease

Basis for Comparison Financial Lease Operating Lease

A commercial contract in which A commercial contract where
the lessor lets the lessee use an the lessor allows the lessee to
Meaning asset instead of periodical use an asset in place of
payments for the usually long periodical payments for a
period. small period;
A financial lease is a long-term Operating lease is a short-
What it’s all about?
concept. term concept.
The ownership is transferred to the The ownership remains with
Transferability
lessee. the lessor.
It is a contract for a short
The term of the lease It is a contract for the long term.
term.
The contract is called a loan The contract is called the
Nature of contract
agreement/contract. rental agreement/contract.
In the case of an operating
In the case of a financial lease, the
lease, the lessor would need
Maintenance lessee would need to take care and
to take care and maintain the
maintain the asset.
asset.
It lies on the part of the
Risk of obsolescence It lies on the part of the lessee.
lessor.
In the case of an operating
Usually, during the primary terms,
lease, the cancellation can be
Cancellation it can’t be done; but there can be
made during the primary
exceptions.
period.
The expenses for the asset such as
Even the lease rent deduction
Tax advantage depreciation, financing are allowed
from the tax is allowed.
for a tax deduction to a lessee.
In a financial lease, the lessee gets In an operating lease, the
Purchasing option an option to purchase the asset he lessee is not given any such
has taken on a lease. option.

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  Sale and Lease Back: In a sale-leaseback, an asset that is previously owned by the
seller is sold to someone else and then leased back to the first owner for a long
duration.
Example: X owns a land. Under the leaseback transaction, X will sell the land to Y
and will get a lease on the same land from Y for a long term.

 Direct Lease: Direct leasing refers to the lease where the lessor purchases the
equipment with its own funds or funds raised in the capital market and leases it
directly to the lessee.
 Bipartite Lease: There are two parties to the transaction, [Link]
supplier cum lessor 2. The lessee.
 Tripartite Lease: It involves three different parties; the equipment supplier,
the lessor and the lessee. Most of the equipment lease transactions fall under
this category. In this form of lease

 Single Investor Lease: There are two parties in a single investor lease – lessor and
lessee. The lessor arranges the money to finance the asset or equipment through
equity or debt. The lender is entitled to recover money from the lessor only and not
from the lessee in case of default by a lessor. Lessee is entitled to pay the lease
rentals only to the lessor.

 Leveraged Lease: A Leveraged Lease is a lease arrangement that brings tax benefits
to the lessor and lessee both. In this, the lessor borrows (full or partial) money to
purchase an asset, and then lease that asset to the lessee.
Example: Company A is looking for equipment costing $2 million for a project that
would continue for two years. Since the equipment is costly and Company A would
use it for just two years, they are planning to lease it.
Company B also wants to buy this equipment and is ready to lease it to Company A
for two years. However, Company B has only $500,000, and thus, it approaches
Company C for a loan to buy the equipment. This is a transaction of a leveraged
lease. Here Company C is the lender, Company B is lessor, and Company A is the
lessee.

 Domestic Lease and International Lease: A lease transaction is classified as a

domestic lease if all parties to the transaction to the equipment supplier, the lessor and
the lessee are domiciled in the same country. On the other hand, if the parties are
domiciled in different countries, the transaction is classified as an International Lease
Transaction.

Players in Leasing Financial Institutions

 Commercial Banks
 Foreign banks
 Non-banking Finance Companies (NBFCs)
 Foreign Institutional Investors (FIls):

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Advantages of Lease Financing

 Convenience
 Benefits of standardization
 Better utilization of taxes
 Fewer restrictive covenants
 Lower cost of obsolescence risk
 Expeditious implementation
 Matching of lease rentals to cash flow capabilities
 Hundred percent financing
 Circumvention of certain controls
 Favorable financial ratios

Disadvantages of lease financing

 Lease expenses
 Limited financial benefits
 Reduce return for equity holders
 Debt
 Limited access of other loans
 Processing and documentation
 No ownership
 Maintenance of the asset
 Limited tax benefits

Evaluation of Lease Vs Borrowing decision (Financial Management by [Link], Page No: 458-
459)

Borrowing vs. Lease. A loan is the borrowing of money while a lease is a term rental
agreement for the use of specific equipment.

Why firms go for debt?

 Debt is usually less expensive than giving up equity.

 Debt can be cheaper than your opportunity cost.

 Paying interest on debt reduces tax burden.

 Debt encourages discipline.

Leasing is a two-step decision for the lessee firm first; it has to evaluate the economic
viability of the asset as an investment. If the asset has a positive net present value, the
company should proceed to acquire the asset. Once it has decided to do so, the firm can
compare the costs of financing the asset through leasing with that of normal source of
financing.

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(In simple Lessee can evaluate the attractiveness of a lease. If the net advantage (NPV)
of leasing over borrowing is positive, it means that the lessee is better off with lease financing
than borrowing and owning the asset)

The evaluation of lease financing decisions from the point of view of the lessee involves the
following steps:

 Calculate the present value of net-cash flow of the buying option, called NPV (B).

 Calculate the present value of net cash flow of the leasing option, called NPV (L)

 Decide whether to buy or lease the asset or reject the proposal altogether by applying
the following criterion:

Decision rule

 If NPV (Buying) is positive and greater than the NPV (Leasing), purchase the asset.

 If NPV (Leasing) is positive and greater than the NPV (Buying), lease the asset.

 If NPV (Buying) as well as NPV (Lease) are both negative, reject the proposal
altogether.

In simple NPV is positive for leasing- leasing is advisable

If NPV is negative for leasing- borrowing / acquisition is advisable
If both case Leasing and Borrowing NPV is negative- stop the proposal

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