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Annual Capital Charge Method:

This method is quite different from all the previous methods. The previous methods consider only cash inflows or revenues. But the Annual capital charge method is based on cost or Expenditure for the evaluation of a project. Procedure: The Annual capital charge must be calcuated as under: 1. Present value of initial cost and subsequent operatingcosts must be found out at the cost of capital given in the problem. 2. The total of all present values calculated in (one) above must be divided by Annuity present value factor for n years at the given rate of discount.

3. When the amount of step one is divided by the factor arrived at in the step two, we get Annual capital charge. It can be shown as under:

Present value of initial cost and subsequent costs Annual capital charge=------------------------------------------------------------------------------Annuity present value Factor ( for n years at r rate of Discount or interest) 4. When there are two or more projects, the project with Less annual capital charge must be selected for investment. Problem on Annual capital charge method: 1. For the completion of a project, there are two methods. The initial costs and subsequent costs of those two methods are given below: Initial Costs: A method = rs.1000000 B method = rs.800000 Subsequent costs: A method B method Year Rs. Rs. 1 ----100000 ---- 75000 2 ----125000 ---- 100000 3 ----150000 ---- 120000 4 ----175000 ---- 140000 5 ----200000 ---100000

6 7


225000 200000



Assuming the cost of capital at 12%, determine the method to be chosen for the completion of the project underAnnual capital charge method. Answer: Annual capital charge: A method B method Annuity discount factor: For 7years at 12% For 5years at 12% = 4.564 = 3.605 = 310010 rs. = 326728 rs.

Capital Budgeting and Risk:

Introduction: While taking a decision about the investment to be made in a project, an individual or a firm will forecast cashflows from the project. But the estimated cashflows and the actual cashflows from the project will not be the same. Frequently these two cashflows will differ because of unexpected developments in economic, social, fiscal, political and other factors. Thus the element of Risk creeps in. Meaning and Definition of Risk: The term Risk means danger. But in capital budgeting decisions the term Risk may be defined as the variability that is likely to occur in future between the estimated and the actual returns. The returns are calculated as under: [Return(i.e.Net present value) = present value of cash inflows present value of cash outflows]

Difference between Risk and Uncertainity:

The two terms Rsik and Uncertainity are different from one another. In the case of Risk, the possibility of future loss can be anticipated on the basis of past experience. For example fall in demand for tractors on account of poor harvest, can be estimated as 40% fall or 30% fall etc,. On the other hand, the future loss cannot be estimated in the case of Uncertainity. For example a firm investing in a foreign country may not see a revolution and take over by an unfriendly group or party. This happened in cuba in the late 1950s . Kinds of Risks: Risk is of two types namely ------ 1. Unsystematic Risk and 2. Systematic Risk 1. Unsystematic Risk: The Risk which can be eliminated through diversification of investment in different Assets is called Unsystematic Risk. It is also called Avoidable risk or Diversifiable risk or Unique Risk etc,.It is a risk which is related to a particular asset only. This risk of one asset in a portfolio is cancelled by the risk of another asset in the same portfolio. This risk applies to a particular company only. Examples of Unsystematic risk ar egiven below: a. Strike declared by the workers in a company. b. The research and development officer of a company leaves it to join elsewhere. c. A big competitor enters the market. d. The company loses a big contract in a bid. e. The company is not able to obtain adequate quantity of raw material from the suppliers etc,. 2. Systematic Risk: The Risk which cannot be eliminated through diversification is called Systematic Risk. It is also called Unavoidable risk or Non diversifiable risk or Market Risk. This risk applies to all assets in a portfolio. The reasons for this risk are not applicable to the entire country *(i.e. all companies in the country). Examples of such risk are: a. Change in the interest rate policy of the government. b. Corporate tax rate increased by the government. c. Increase in inflation rate. d. Reatrictive credit policy declared by RBI.

[ Total Risk = Unsystematic Risk + Systematic Risk ] Graphically these two types of Risks can be shown as under:

Y ---Risk --unsystematic risks

-I I I I I I

systematic risks I X

No.of Assets.

Incorporation of Risk Factor:

Every business unit estimates cash flows or returns from a project before making investment in it. While estimating the cash inflow, the firm must take into consideration Risk Factor also. Some of the popular techniquesused for incorporating the Risk factor in capital budgeting decisions are given below: 1. 2. 3. 4. 5. 6. 7. Risk Adjusted discount rate method. Certainity equivalent co-efficient method. Sensitivity Analysis method Probability Assignment method. Standard Deviation method. Co-efficient of variation method Decision Tree analysis method.

1. Risk Adjusted Discount Rate method: under this method, the Normal discount Rate is increased to cover Risk also. It means that the Rate of discount includes two rates viz1. Risk free rate and 2. Risk premium rate. Risk Free rate is the rate at which the future cashflows should be discounted if there is no risk in the project. Risk Premium rate is the extra return expected by the investor for investing in a risky project. Thus Risk adjusted discount rate is a composite discount rate which takes into consideration both Time and Risk factors. For more risky,projects, a higher disocunt rate is used and for less risky projects, a low discount rate is used. Example: Suppose Risk free discount rate is 5% and Risk premium rate is 10%. Then the Risk adjusted discount rate is 15% [5%+10% = 15%]. At 15%, cashflows will be discounted to know the present values of cash flows. Evaluation: Though it is a simple method,Bias will creep in in determining the Risk adjusted discount rate. For the same risk, one investor may adjust 10% and another investor may adjust 15%.