ADVANCED FINANCIAL MANAGEMENT.

GROUP 7.

JESCA ANNE PENDO – HDB223-0573/2020

KAMAR MOSES ESINYEN – HDB223-0551/2020

RACHAEL WAITHIRA WANJIRU – HDB223-0525/2020

COLLINS ROBERTS SHIVIYA – HDB223-0581/2020

SAUDA ANSWAR ISMAIL – HDB223-0501/2020

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CAPITAL BUDGETING

Capital budgeting is the planning process used in corporate finance, corporate planning, and
accounting to assess whether an organization's long-term capital investments, such as new
machinery, replacement of existing machinery, new plants, new products, and research and
development projects, are financially worthwhile to fund with cash from the firm's capitalization
structures (debt, equity, or retained earnings). Allocating funds for significant capital, or
investment, expenditures is what this process entails. Increasing the value of the company to the
shareholders is one overarching objective that is consistent with the corporate finance field as a
whole.

Need for capital budgeting

Budgeting for capital projects is crucial because it fosters accountability and measurement. Any
company that wants to commit resources to a venture without fully comprehending the dangers
and potential rewards will be viewed as irresponsible by its owners or shareholders.
Additionally, if a company has a mechanism to assess the success of its investment choices, it is
unlikely that it would survive in the cutthroat commercial environment.

Companies frequently find themselves in a situation where their funding is constrained and their
options are limited. Decisions about how to divide up labor hours, capital, and resources are
typically up to management. As it describes the goals for a project, capital budgeting is crucial to
this process. These goals can be compared to those of other initiatives to see whether one or ones
is best.

Businesses—aside from nonprofits—are in operation to make money. Businesses may quantify

the long-term economic and financial profitability of any investment project through the capital
budgeting process. While predicting sales for the upcoming year may be simpler for a business,
it may be more challenging to predict how a five-year, $1 billion manufacturing headquarters
refurbishment would turn out. Therefore, firms require capital budgeting to evaluate risks, make
future plans, and anticipate difficulties before they arise.

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Methods used in capital budgeting

i) Analysis of Discounted Cash Flows

Companies frequently utilize discounted cash flow methodologies to evaluate both the timing
and implications of the dollar because a capital budget will frequently span multiple periods and
maybe many years. Currency values frequently decline over time. A fundamental idea in
economics dealing with inflation is that money now is worth more than money tomorrow
because money today can be used to make money tomorrow.

The inflows and outflows of a project are included in discounted cash flow as well. Most
frequently, businesses may have to make a one-time outflow of capital to start a project. Other
times, there might be a string of outflows that are used to pay for ongoing projects. Companies
may aim to determine a target discount rate or a certain net cash flow amount at the conclusion
of a project in either scenario.

ii) Payback analysis

Payback techniques of capital budgeting make plans based on the timing of when specific
benchmarks are reached rather than just looking at costs and profits. Some businesses seek to
monitor when the business becomes profitable or pays for itself. Others are more focused on the
exact moment that a capital project starts to generate a certain level of profit.

Capital budgeting necessitates the requirement for meticulous cash flow forecasts for payback
strategies. This strategy necessitates a little more timing attention because any variation in an
estimate from one year to the next may significantly affect when a company may meet a payback
metric. If a business wants to combine capital budget approaches, it can also combine the
payback method with the discounted cash flow analysis method.

iii) Throughput Analysis

Throughput analysis-based solutions for capital planning represent a vastly different approach.
Throughput methods examine revenue and expenditures across the board, not just for particular
initiatives. Operational or non-capital budgeting can also use throughput analysis through cost
accounting.

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Throughput methods entail taking the revenue of a company and subtracting variable costs. This
method results in analyzing how much profit is earned from each sale that can be attributable to
fixed costs. Once a company has paid for all fixed costs, any throughput is kept by the entity as
equity.

Companies may be seeking to not only make a certain amount of profit but want to have a target
amount of capital available after variable costs. These funds can be swept to cover operational
expenses, and management may have a target of what capital budget endeavors must contribute
back to operations.

The capital budgeting process typically involves the following steps:

Identification of investment opportunities: The first step is to identify potential investment

projects or expenditures that align with the company's strategic goals. This could include projects
such as acquiring new assets, expanding production capacity, developing new products, or
entering new markets.

Estimation of cash flows: Once investment opportunities are identified, the next step is to
estimate the expected cash flows associated with each project. This involves forecasting the
incremental revenues and costs over the project's expected life and considering factors such as
depreciation, taxes, working capital changes, and salvage values.

Evaluation of cash flows: After estimating the cash flows, various capital budgeting techniques
are used to evaluate the viability of the investment projects. Common methods include:

 Net Present Value (NPV): NPV calculates the present value of the project's expected cash
inflows and outflows by discounting them at the required rate of return. A positive NPV
indicates that the project is expected to generate more value than its cost and is
considered favorable.
 Internal Rate of Return (IRR): IRR is the discount rate that makes the present value of
cash inflows equal to the present value of cash outflows. It represents the project's rate of
return. If the IRR exceeds the company's required rate of return, the project is considered
acceptable.

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  Payback Period: The payback period measures the time required to recover the initial
investment. Projects with shorter payback periods are generally considered more
favorable.
 Profitability Index: The profitability index is the ratio of the present value of cash inflows
to the present value of cash outflows. A value greater than 1 indicates a favorable
investment.
 Accounting Rate of Return (ARR): ARR compares the average accounting profit to the
average investment cost. It measures the profitability of the project based on accounting
figures.

Risk assessment: In addition to evaluating the financial viability, it's important to assess the
risks associated with each investment project. This includes considering factors such as market
risks, technological risks, regulatory risks, and project-specific risks. Risk assessment helps
determine the likelihood and potential impact of adverse events on the project's outcomes.

Decision-making and project selection: After evaluating the investment opportunities and
considering the associated risks, management makes a decision regarding which projects to
pursue. Projects with positive NPV, high IRR, shorter payback periods, and favorable risk
profiles are generally preferred.

Implementation and monitoring: Once the investment projects are selected, they are
implemented, and their progress is monitored. Regular monitoring helps ensure that the projects
are progressing as planned and any necessary corrective actions are taken.

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CAPITAL BUDGETING AND MARKET RISKS

When considering market risks in capital budgeting, it is important to assess their potential
impact on the investment projects being evaluated. Here are some key points to consider:

1. Economic conditions: Changes in the overall economic environment, such as recessions or

expansions, can impact the demand for products or services offered by a company. It's crucial to
consider how these changes might affect the cash flows of the investment project under
evaluation.

2. Interest rates: Fluctuations in interest rates can influence the cost of capital and financing
options available for a project. Higher interest rates may increase borrowing costs and reduce the
profitability of the investment. Conversely, lower interest rates can make borrowing more
affordable and potentially enhance project returns.

3. Market competition: Competitive forces can affect pricing, market share, and profitability.
Analyzing the competitive landscape helps assess the potential risks of market saturation, pricing
pressures, or the emergence of new competitors, which can impact the viability of an investment.

4. Technological advancements: Rapid technological changes can render certain projects

obsolete or less competitive. Evaluating the technological risks involved in an investment is
essential to ensure its long-term relevance and profitability.

5. Regulatory and political factors: Changes in regulations, government policies, or political

stability can significantly impact industries and businesses. It's important to consider these
factors and assess their potential influence on the investment project.

To mitigate market risks, companies may employ various strategies, including diversification,
hedging techniques, market research, and scenario analysis. Sensitivity analysis and stress testing
can also be valuable tools to understand the potential impact of market risks on investment
projects. This could include projects such as acquiring new assets, expanding production
capacity, developing new products, or entering new markets.

CERTAINITY EQUIVALENT.

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The certainty equivalent approach incorporates risk preferences by adjusting for the risk
associated with a particular investment. The certainty equivalent is defined as the amount of
certain cash flows that would provide the same utility as the uncertain cash flows of an
investment. It involves reducing the cash flow by a risk premium to adjust for the uncertainty
associated with the investment. This approach implies that investors are risk-averse and require
compensation for taking on risk and it is useful in decision-making because it enables investors
to compare projects with different levels of risk.

Examples of certainty equivalent calculations include the risk premium approach and expected
utility approach. The risk premium approach calculates the certainty equivalent by subtracting
the risk premium, which is the additional return investors demand for taking on risky projects
from the expected return of the risky project. The expected utility approach on the other hand,
involves calculating the expected utility of the risky project and comparing it to the utility of a
certain project to determine the amount investors are willing to pay for certainty.

However, its limitation in ignoring tail-end outcomes can be resolved with the application of the
risk-adjusted discount rate method, which takes into account the level of risk associated with
investments. The decision rule should be to accept projects that have positive net present value
when discounted by the risk-adjusted rate and reject those with negative net present value. In
such a way, a firm can minimize the impact of market risks on investment returns and enhance
shareholder value.

Using this method the NPV will be given by the following formula:

NPV = - Io

Ct= Forecasted cashflows (without risk adjustment)

αt= the risk-adjusted factor or the certainty equivalent coefficient

Io= Initial cash outflow (cost of project)

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Kf= risk-free rate (assumed to be constant for all period).

The certainty equivalent coefficient assumes a value between 0 and 1 and varies inversely with
risk. Therefore, a lower αt will be used if greater risk is perceived and a higher αt if lower risk is
anticipated.

The coefficient are subjectively established by the decision maker and represents the decision
maker's confidence in obtaining a particular cashflow in period t.

The certainty equivalent coefficient can be determined by the following formula.

αt = certain net cashflow /risky net cashflow

For example, if an investor expects a risky cashflow of Sh 100,000 in period t and considers a
certain cashflow of Sh 80,000 equally desirable, the αt will be:

αt = 80,000/100000 = 0.8

Illustration

Assume a project costs Sh 30,000 and yields the following uncertain cashflows:

Year 1 - 12000

Year 2 - 14000

Year 3 - 10000

Year 4 - 6000

Assume also that the certainty equivalent coefficients have been estimated as follows:

α0 = 1.00

α1 = 0.90

α2 = 0.70

α3 = 0.50

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α4 = 0.30

The risk-free discount rate is given as 10%

Required

Compute the NPV of the project

Solution:

NPV = - Io

= 0.9 (12,000) + 0.7 (14,000) + 0.5 (10,000) + 0.3 (6,000) - 30,000

1 + 0.1 (1 + 0.1)² (1 + 0.1)3 (1 + 0.1)4

Using the present value interest factor tables:

Year Certain Cashflows PVIF10% PV

0 (30,000) 1.00 (30,000)

1 0.9 (12,000) 0.9, 817.2

2 0.7 (14,000) 0.826 8,094.8

3 0.5 (10,000) 0.751 3,755.0

4 0.3 (6,000) 0.683 1,229.4

NPV (7,103.6)

The project has a negative NPV and therefore should not be undertaken.

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Note that if risk was ignored the NPV would have been Sh 4,080 and the project would have
been accepted.

Merits of certainty equivalent approach

1. This method explicitly recognizes risk.

2. It recognizes that cashflows further away into the future are less certain (therefore a lower αt)

Demerits

1. The method of determining αt is subjective and is likely to differ from project to project.2. The
forecaster, expecting the reduction that will be made to his forecasts, may inflate them in
anticipation.

3. When 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.

RISK ADJUSTED DISCOUNTING RATE.

The risk-adjusted discounting rate (RADR) is a calculation that adjusts a project's discount rate
based on its risk. This is necessary because it is assumed that riskier projects have a higher
required rate of return to compensate for the increased chance of failure. To calculate the RADR,
one must first estimate the project's beta, which measures its volatility compared to the market as
a whole. This beta is then multiplied by the market risk premium to arrive at the project's
required rate of return. The RADR is then calculated by adding this required rate of return to the
risk-free rate of interest.

The risk adjusted discounting rate (RADR) is a method of determining the appropriate discount
rate for a risky investment by taking into account the expected risk premium associated with that
investment. Essentially, the RADR provides a way of factoring in market risks when evaluating
investments and estimating their net present value (NPV). The calculation of the RADR involves
adding an extra premium to the risk-free rate of return, which can vary depending on the specific
risks associated with the investment.

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The calculation of a risk adjusted discounting rate takes into consideration both the time value of
money and the risk associated with future cash flows. By adjusting the discount rate to account
for the level of risk present in the investment, financial managers can more accurately evaluate
investment opportunities and make informed decisions.

This approach uses different discount rates for proposals with different risk levels. A project that
carries a normal amount of risk and does not change the overall risk composure of the firm
should be discounted at the cost of capital. Investments carrying greater than normal risk will be
discounted at a higher discount rate.

The NPV of the project will be given by the following formula.

NPV = - Io

Where Ct is cashflows at period t

K is the risk adjusted discount rate

Io is initial cash outflow (cost of project)

Note that Kf + φ

Where Kf = the risk-free rate and φ = the risk premium

The following diagram shows a possible risk-discount rate trade off scheme. Risk is assumed to
be measured by the coefficient of variation, C.V)

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The normal risk for the firm is represented by a coefficient of variation of 0.30. An investment
with this risk will be discounted at the firm's normal cost of capital of 10%. As the firm selects
riskier projects with, for example, a C.V. of 0.90, a risk premium of 5% is added for an increase
in C.V. of 0.60 (0.90 - 0.30). If the firm selects a project with a C.V. of 1.20, it will now add
another 5% risk premium for this additional C.V. of 0.30 (1.20 - 0.90). Notice that the same risk
premium was added for a smaller increase in risk. This is an example of being increasingly risk
averse at higher levels of risk and potential return.

Advantages of Risk-adjusted discount rate

(a) It is simple and can be easily understood.

(b) It has a great deal of intuitive appeal for risk-averse businessmen.

(c) It incorporates an attitude (risk-aversion) towards uncertainty.

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Disadvantages

(a) There is no easy way of deriving a risk-adjusted discount rate.

(b) It does not make any risk adjustments in the numerate - for the cashflows that are

forecast over the future years.

(c) It is based on the assumption that investors are risk averse.

(d) This method can be complex and time-consuming to calculate and the subjective nature of
assigning a risk premium can result in different values for the same investment.

Bibliography
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Dayananda.D. (2002). 'Capital Budgeting.' Financial Appraisal of Investment Projects,
Cambridge University Press

Frank J. F. (2002). 'Capital Budgeting.' Theory and Practice’. Published.

Frank J. F. (2004) 'Capital Budgeting.' Theory and Practice, Published

Pinkasovitch. A (2022)” An introduction to capital budgeting” Investopedia

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