RISK AND UNCERTAINLY IN CAPITAL BUDGETINGCapital budgeting requires the projection of cash inflow and outflow of the future.The future in always uncertain, estimate of demand, production, selling price, cost etc.,cannot be exact.For example: The product at any time it become obsolete therefore, the future inunexpected. The following methods for considering the accounting of risk in capital budgeting.Various evaluation methods are used for risk and uncertainty in capital budgeting are asfollows:(i) Risk-adjusted cut off rate (or method of varying discount rate)(ii) Certainly equivalent method.(iii) Sensitivity technique.(iv) Probability technique(v) Standard deviation method.(vi) Co-efficient of variation method.(vii) Decision tree analysis.(i) Risk-adjusted cutoff rate (or Method of varying)This is one of the simplest method while calculating the risk in capital budgetingincrease cut of rate or discount factor by certain percentage an account of risk.Exercise 13 The Ramakrishna Ltd., in considering the purchase of a new investment.Two alternative investments are available (X and Y) each costing Rs. 150000. Cash inflowsare expected to be as follows:Cash InflowsYear Investment X Investment YRs. Rs. 1 60,000 65,000 2 45,000 55,000 3 35,000 40,000 4 30,000 40,000The company has a target return on capital of 10%. Risk premium rate are 2% and8% respectively for investment X and Y. Which investment should be preferred?Capital Budgeting 137SolutionThe profitability of the two investments can be compared on the basis of net presentvalues cash inflows adjusted for risk premium rates as follows:Investment X Investment YDiscount Cash Present Discount Cash PresentYear Factor10% + 2% Inflow Value Factor Inflow Values= 12% Rs. Rs. 10% + Rs.8%=18%1 0.893 60,000 53,580 0.847 85,000 71,9952 0.797 45,000 35,865 0.718 55,000 39,4903 0.712 35,000 24,920 0.609 40,000 24,3604 0.635 30,000 19,050 0.516 40,000 20,6401,33,415 1,56,485Investment XNet present value = 133415 – 150000= – Rs. 16585Investment YNet present value = 156485 – 150000= Rs. 6485As even at a higher discount rate investment Y gives a higher net present value,investment Y should be preferred.(ii) Certainly equivalent methodIt is also another simplest method for calculating risk in capital budgeting inforeduceds expected cash inflows by certain amounts it can be employed bymultiplying the expected cash inflows by certainly equivalent co-efficient in orderthe uncertain cash inflow to certain cash inflows.
Investment of funds –