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1. The Finance function: Nature and Scope. Evolution of finance function – The new role in the contemporary
scenario – Goals of finance function – maximizing vs satisfying (School); Profit Vs Wealth Vs Welfare; the
agency relationship and costs – The new debate on maximizing Vs satisfying. Wealth maximization and Risk-
Return trade off.

Finance is the study of money management, the acquiring of funds (cash) and the
directing of these funds to meet particular objectives. Good financial management helps
businesses to maximize returns while simultaneously minimizing risks. Hardly anybody
wants to work in a field where there is no room for experience, creativity, judgment and a
pinch of luck but study of finance is not so. There are many reasons that the financial
manager’s job is challenging and interesting. Here are four important ones.

-Securities Markets
-Understanding Values
-Time and uncertainty
-Understanding People.
I. Securities Markets include Money Markets and Capital Markets.
Money Markets include:
* Markets for short-term claims with original maturity of one year or less.
* High-grade securities with little or no risk of default.
* Examples:
1. Treasury Bills.
2. Commercial Paper.
3. Certificates of Deposit.
Capital markets include:
* Market for long-term securities with original maturity of more than one year.
*Securities may be of considerable risk.
*Example:
1. Stocks
2. Corporate bonds
3. Government bond

Primary Markets

A primary market is a market for newly created securities. The proceeds from the sale of
securities in primary markets go to the issuing entity. A security can trade only once in
the primary market.
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Secondary Markets

A secondary market is a market for previously issued securities. The issuing firm is not
directly affected by transactions in the secondary markets. A security can trade an unlimited
number of times in secondary markets. The volume of trade in secondary markets is such
higher than in primary markets.

Investment Bankers

An investment banker specializes in marketing new securities in the primary market.

Examples of Investment bankers are: Merrill Lynch, Sigma Manufactures Merchant Bank,
etc.

Brokers and Dealers

These generally participate in the secondary markets. A broker helps investors in buying or
selling securities. A broker charges commissions, but never takes title to the security. A
dealer buys securities from sellers, and sells them to buyers.

Financial Intermediaries

These are institutions that assist in the financing of firms. Example include; commercial
banks and pension funds. These institutions invest in securities of other firms, but they are
themselves financed by other financial claims. On the other hand, it is a sort of indirect
financing in which savers deposit funds with the banks and financial institutions rather than
directly buying bonds or shares and the financial institutions, in turn lend the money to
ultimate borrowers. The Commercial Banks, Financial Institutions, Finance and Investment
Companies, Insurance Companies, Unit Trust, Pension Funds etc., are examples of financial
intermediaries.

II. Understanding Value

Understanding how capital markets work amounts to understanding how financial
assets are valued. This is a subject on which there has been remarkable progress over the past
10 to 20 years. New theories have been developed to explain the prices of bonds and stocks.
And, when put to the test, these theories have worked well. I, therefore, would like to give
more stress in this area because the implication of this is applying in almost all parts of the
corporate finance.
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III. Time and Uncertainty

The financial manager cannot avoid coping with time and uncertainty. Firms often
have the opportunity to invest in assets which cannot pay their way in the short run and which
expose the firm and its stockholders to considerable risk. The investment, if undertaken, may
have to be financed by debt, which cannot be fully repaid for many years. The firm cannot
walk away from such choices- someone has to decide whether the opportunity is worth more
than it costs and whether the additional debt burden can be safely borne.
IV. Understanding People
The financial manager needs the opinions and cooperation of many people. For
instance, many new investment ideas come from plant managers. The financial manager
wants these ideas to be presented fairly; therefore, the proposers should have no personal
incentives to be either overconfident or overcautious. Take another example. In some firms
the plant manager needs permissions from the head office to buy a company car but not to
lease it, and the line of least resistance may be to lease the car. In other firms the plant
manager needs permission from the head office to buy or lease, and the line of least
resistance may be to travel everywhere by cab. The financial manager has to be aware of
these effects and has to devise procedures that will avoid as far as possible any conflicts of
interest.

These are not the only reasons that financial management is interesting and also
challenging.
Concept of Finance
Different finance scholars have interpreted the term ‘finance’ in real world variably.
More significantly, as noted at the very outset of this chapter, the concept of finance has
changed markedly with change in times and circumstances. For convenience of analysis
different viewpoints on finance can be categorized into following three major groups:

F.1. The first category incorporates the views of all those who contend that finance concerns
with acquiring funds on reasonable terms and conditions to pay bills promptly. This
approach covers study of financial institutions and instruments from which funds can be
secured, the types and duration of obligations to be issued, the timing of the borrowing or sale
of stocks, the amounts required, urgency of the need and cost. The approach has the virtue of
shedding light on the very heart of finance function. However, the approach is too restrictive.
It lays stress on only one aspect of finance. The traditional scholars hold this approach of
finance
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F.2. The second approach holds that finance is concerned with cash. Since almost all
business transactions are expressed ultimately in terms of cash, every activity within the
enterprise is the primary concern of a finance manager. Thus, according to this approach,
finance manager is required to go into details of every functional area of business activity, be
it concerned with purchasing, production, marketing, personnel, administration, research or
other associated activities. Obviously, such a definition is too broad to be meaningful.

F.3. A third approach to finance, held by modern scholars, looks at finance as being
concerned with procurement of funds and wise application of these funds. Protagonists of
this approach opine that responsibility of a finance manager is not only limited to acquisition
of adequate cash to satisfy business requirements but extends beyond this to optimal
utilisation of funds. Since money involves cost, the central task of a finance manager while
allocating resources is to match the benefits of potential uses against the cost of alternative
sources so as to maximise value of the enterprise. This is the managerial approach of finance
which is also known as problem-centered approach, since it emphasizes that finance manager
in his endeavor to maximise value of the enterprise has to deal with vital problems of the
enterprise, viz., what capital expenditures should the enterprise make? What volume of the
funds should the enterprise invest? How should the desired funds be obtained?

Nature of Financial Management

Financial management is an integral part of overall management and not merely a staff
function. It is not only confined to fund raising operations but extends beyond it to cover
utilisation of funds and monitoring its uses. These functions influence the operations of other
crucial functional areas of the firm such as production, marketing and human resources.
Hence, decisions in regard to financial matters must be taken after giving thoughtful
consideration to interests of various business activities. Finance manager has to see things as
a part of a whole and make financial decisions within the framework of overall corporate
objectives and policies.

The financial management of a firm affect its very survival because the survival of the firm
depends on strategic decisions made in such important matters such as product development,
market development, entry in new product line, retrenchment of a product, expansion of the
plant, change in Another striking feature of financial management that explains its generic
nature is the imperativeness of the continuous review of the financial decisions. As a matter
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of fact, financial decision-making is a continuous decision-making process, which goes on

throughout the corporate life. Since a firm has to operate in an environment that is dynamic, it
has, therefore, to interact constantly with various environmental forces in addition to
changing conditions of the firm and adapt and adjust its objectives and strategies including
financial policies and strategies. A one-time financial plan not subjected to periodic review
and modifications in the context of changed conditions will be a fiasco because conditions
may change to such an extent that the plan is no longer relevant and acts as a hindrance rather
than help. Financial planning should, therefore, not be static. It has to be continuously
adapted to changing conditions. As you all are MBA students it is essential for you to know
the interface between finance and other functions let us discuss. You all are studying other
management subjects also let us relate those with finance.

Interface between finance and other functions

Till now you might have understood about the pervasive nature of finance. Let us discuss in
greater detail the reasons why knowledge of the financial implications of their decisions is
important for the non-finance managers. One common factor among all managers is that they
use resources and since resources are obtained in exchange for money, they are in effect
making the investment decision and in the process of ensuring that the investment is
effectively utilized they are also performing the control function.
Marketing-Finance Interface
There are many decisions, which the Marketing Manager takes which have a significant
location, etc. In all these matters assessment of financial implications is inescapable impact
on the profitability of the firm. For example, he should have a clear understanding of the
impact the credit extended to the customers is going to have on the profits of the company.
Otherwise in his eagerness to meet the sales targets he is liable to extend liberal terms of
credit, which is likely to put the profit plans out of gear. Similarly, he should weigh the
benefits of keeping a large inventory of finished goods in anticipation of sales against the
costs of maintaining that inventory. Other key decisions of the Marketing Manager, which
have financial implications, are:

� Pricing
� Product promotion and advertisement
� Choice of product mix
� Distribution policy.
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Production-Finance Interface
As we all know in any manufacturing firm, the Production Manager controls a major part of
the investment in the form of equipment, materials and men. He should so organize his
department that the equipments under his control are used most productively, the inventory of
work-in-process or unfinished goods and stores and spares is optimized and the idle time and
work stoppages are minimized. If the production manager can achieve this, he would be
holding the cost of the output under control and thereby help in maximizing profits. He has to
appreciate the fact that whereas the price at which the output can be sold is largely
determined by factors external to the firm like competition, government regulations, etc. the
cost of production is more amenable to his control. Similarly, he would have to make
decisions regarding make or buy, buy or lease etc. for which he has to evaluate the financial
implications before arriving at a decision.

Top Management-Finance Interface

The top management, which is interested in ensuring that the firm's long-term goals are met,
finds it convenient to use the financial statements as a means for keeping itself informed of
the overall effectiveness of the organization. We have so far briefly reviewed the interface of
finance with the non-finance functional disciplines like production, marketing etc. Besides
these, the finance function also has a strong linkage with the functions of the top
management. Strategic planning and management control are two important functions of the
top management. Finance function provides the basic inputs needed for undertaking these
activities.

Economics - Finance Interface

The field of finance is closely related to economics. Financial managers must
understand the economic framework and be alert to the consequences of varying
levels of economic activity and changes in economic policy. They must also be able
to use economic theories as guidelines for efficient business operation. The primary
economic principle used in managerial finance is marginal analysis, the principle that
financial decisions should be made and actions taken only when the added benefits
exceed the added costs. Nearly all-financial decisions ultimately come down to an
assessment of their marginal benefits and marginal costs.
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Accounting - Finance Interface

The firm's finance (treasurer) and accounting (controller) activities are typically within the
control of the financial vice president (CFO). These functions are closely related and
generally overlap; indeed, managerial finance and accounting are often not easily
distinguishable. In small firms the controller often carries out the finance function, and in
large firms many accountants are closely involved in various finance activities. However,
there are two basic differences between finance and accounting; one relates to the emphasis
on cash flows and the other to decision making.

Role of a financial manager

Role and responsibilities of a finance manager have undergone a remarkable

transformation during the past four decades. Not too many years ago, finance manager
had a very limited role in a business enterprise. He was responsible only for maintaining
financial records, preparing reports on the company's status and performance and
arranging funds needed by the company so that it could meet its obligations in time.
Finance manager, as a matter of fact, was regarded as specialised staff officer in the
company concerned only with administering sources of funds.
He was called upon only when his specialty was needed. For example, when the company
experienced the problem of dearth of funds, the management expected the finance
manager to locate suitable sources of funds and procure additional funds. However, the
finance manager transcended his traditional role of garnering external funds for the
enterprise following technological changes in major industries, increased business
complexities, tightening money market conditions and despondent state of stock market,
and has now become part and parcel of general management. He occupies the role of an
executive who is actively associated with problems and decisions related to wise
application of funds. He deals with the total funds deployed by the organisation,
allocation of funds among varying projects and activities and with evaluation of results of
each allocation. He is, therefore, directly concerned with production, marketing and other
activities within a business enterprise whenever decisions are made that Involve
commitment of funds to new or ongoing uses. Role of finance managers has increased
tremendously and their tasks have become complicated following cataclysmic changes in
recent times in the entire global economic environment and the world market place
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resulting in globalisation of business and increased competitiveness" The multinational

corporations of today conduct their operations world-wide as if the entire world were a
single entity with a major thrust on quality, cost and speed." So as to cope with
challenges stemming out of globalisation of world economy and to exploit tremendous
potential opportunities, most of the developing countries including India have, of late,
decided to liberalise their economic policies and open the floodgates of their domestic
markets to multinationals. Various economic and financial policy reforms have been
introduced with a view to freeing business from the grip of administered growth and
demolishing the protecting walls of yesteryears. The combined impact of all these
measures has resulted in swelling wave of transnational from Japan, USA, Germany and
France pouring in India in every conceivable product segment posing serious challenges
to the very survival of Indian corporate who were hitherto operating in highly sheltered
and closed economy. In order to face these challenges and to ensure their survival many
Indian corporate giants have desperately formed strategic alliances with global majors and
some of them embarked hurriedly on internal restructuring.

Since ferocity of competition is likely to deepen further, it would be worthwhile for Indian
companies to take strategic measures for their survival and growth. They should formulate
strategy to achieve the competitive advantage and sustain their edge over the rivals. The focal
points of such strategy have to be on quality and cost which together contribute significantly
to organisational effectiveness.

In translating this strategy into action the finance manager has to play a very effective and
integrated role by helping the top management in making financial decisions to reduce cost,
improve productivity and maximise corporate value.

To handle the new responsibilities the finance manager must have clear conception of the
corporate objectives of his organization as he has to act in conformity with these objectives.
Furthermore, he has to evaluate the effectiveness of financial decisions in the light of some
standards. Corporate objectives of the organisation provide such standards. The finance
manager should also have stronger grasp of the nature, functions and scope of financial
management.
Further, he needs a variety of qualitative and quantitative skills so as to carry out his complex
and diverse responsibilities.
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Finance managers are presently facing some new challenges as indicated below:

TREASURY OPERATIONS: Short-term fund management must be more

sophisticated.
Finance managers could make speculative gains by anticipating interest rate
movements.
� FOREIGN EXCHANGE: Finance Managers will have to weigh the costs and benefits
of playing with foreign exchange particularly now that the Indian economy is going
global and the future value of the rupee visa a vis foreign currency has become
difficult to predict.
� FINANCIAL STRUCTURING: An optimum mix between debt and equity will be
essential. Firms will have to tailor financial instruments to suit their and investors'
needs. Pricing of new issues is an important task in the Finance Manager’s portfolio
now.
� MAINTAINING SHARE PRICES: In the premium equity era, firms must ensure that
share prices stay healthy. Finance managers will have to devise appropriate dividend
and bonus policies.
� ENSURING MANAGEMENT CONTROL: Equity issues at premium means
managements may lose control if they are unable to take up their share entitlements.
Strategies to prevent this are vital.
The Four Major Decisions in Corporate Finance/Financial management

The Allocation (Investment) decision

Where do you invest the scarce resources of your business?
What makes for a good investment?
The Financing decision
Where do you raise the funds for these investments?
Generically, what mix of owner’s money (equity) or borrowed money (debt)
do you use?
The Dividend Decision
How much of a firm’s funds should be reinvested in the business and how
much should be returned to the owners?
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The Liquidity decision

How much should a firm invest in current assets and what should be the
components with their respective proportions? How to manage the working
capital?
A firm performs finance functions simultaneously and continuously in the normal course of
the business. They do not necessarily occur in a sequence. Finance functions call for skilful
planning, control and execution of a firm’s activities.
Let us note at the outset hat shareholders are made better off by a financial decision that
increases the value of their shares, Thus while performing the finance function, the financial
manager should strive to maximize the market value of shares. Whatever decision does a
manger takes need to result in wealth maximisation of a shareholder.

Investment Decision
Investment decision or capital budgeting involves the decision of allocation of capital or
commitment of funds to long-term assets that would yield benefits in the future. Two
important aspects of the investment decision are:

(a) The evaluation of the prospective profitability of new investments, and

(b) The measurement of a cut-off rate against that the prospective return of new investments
could be compared. Future benefits of investments are difficult to measure and cannot be
predicted with certainty. Because of the uncertain future, investment decisions involve risk.
Investment proposals should, therefore, be evaluated in terms of both expected return and
risk. Besides the decision for investment managers do see where to commit funds when an
asset becomes less productive or non-profitable.

There is a broad agreement that the correct cut-off rate is the required rate of return or the
opportunity cost of capital. However, there are problems in computing the opportunity cost of
capital in practice from the available data and information. A decision maker should be aware
of capital in practice from the available data and information. A decision maker should be
aware of these problems.
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Financing Decision
Financing decision is the second important function to be performed by the financial
manager. Broadly, her or she must decide when, where and how to acquire funds to meet the
firm’s investment needs. The central issue before him or her is to determine the proportion of
equity and debt. The mix of debt and equity is known as the firm’s capital structure. The
financial manager must strive to obtain the best financing mix or the optimum capital
structure for his or her firm. The firm’s capital structure is considered to be optimum when
the market value of shares is maximised. The use of debt affects the return and risk of
shareholders; it may increase the return on equity funds but it always increases risk. A proper
balance will have to be struck between return and risk. When the shareholders’ return is
maximised with minimum risk, the market value per share will be maximised and the firm’s
capital structure would be considered optimum. Once the financial manager is able to
determine the best combination of debt and equity, he or she must raise the appropriate
amount through the best available sources. In practice, a firm considers many other factors
such as control, flexibility loan convenience, legal aspects etc. in deciding its capital
structure.

Dividend Decision
Dividend decision is the third major financial decision. The financial manager must decide
whether the firm should distribute all profits, or retain them, or distribute a portion and retain
the balance. Like the debt policy, the dividend policy should be determined in terms of its
impact on the shareholders’ value. The optimum dividend policy is one that maximises the
market value of the firm’s shares. Thus if shareholders are not indifferent to the firm’s
dividend policy, the financial manager must determine the optimum dividend – payout ratio.
The payout ratio is equal to the percentage of dividends to earnings available to shareholders.
The financial manager should also consider the questions of dividend stability, bonus shares
and cash dividends in practice. Most profitable companies pay cash dividends regularly.
Periodically, additional shares, called bonus share (or stock dividend), are also issued to the
existing shareholders in addition to the cash dividend.

Liquidity Decision
Current assets management that affects a firm’s liquidity is yet another important finances
function, in addition to the management of long-term assets. Current assets should be
managed efficiently for safeguarding the firm against the dangers of illiquidity and
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insolvency. Investment in current assets affects the firm’s profitability. Liquidity and risk. A
conflict exists between profitability and liquidity while managing current assets. If the firm
does not invest sufficient funds in current assets, it may become illiquid. But it would lose
profitability, as idle current assets would not earn anything. Thus, a proper trade-off must be
achieved between profitability and liquidity. In order to ensure that neither insufficient nor
unnecessary funds are invested in current assets, the financial manager should develop sound
techniques of managing current assets. He or she should estimate firm’s needs for current
assets and make sure that funds would be made available when needed.

It would thus be clear that financial decisions directly concern the firm’s decision to
acquire or dispose off assets and require commitment or recommitment of funds on a
continuous basis. It is in this context that finance functions are said to influence production,
marketing and other functions of the firm. This, in consequence, finance functions may affect
the size, growth, profitability and risk of the firm, and ultimately, the value of the firm. To
quote Ezra Solomon

The function of financial management is to review and control decisions to commit or

recommit funds to new or ongoing uses. Thus, in addition to raising funds, financial
management is directly concerned with production, marketing and other functions, within an
enterprise whenever decisions are about the acquisition or distribution of assets.

Various financial functions are intimately connected with each other. For instance, decision
pertaining to the proportion in which fixed assets and current assets are mixed determines the
risk complexion of the firm. Costs of various methods of financing are affected by this risk.
Likewise, dividend decisions influence financing decisions and are themselves influenced by
investment decisions.

In view of this, finance manager is expected to call upon the expertise of other functional
managers of the firm particularly in regard to investment of funds. Decisions pertaining to
kinds of fixed assets to be acquired for the firm, level of inventories to be kept in hand, type
of customers to be granted credit facilities, terms of credit should be made after consulting
production and marketing executives.

However, in the management of income finance manager has to act on his own. The
determination of dividend policies is almost exclusively a finance function. A finance
manager has a final say in decisions on dividends than in asset management decisions.
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Financial management is looked on as cutting across functional even disciplinary boundaries.

It is in such environments that finance manager works as a part of total management. In
principle, a finance manager is held responsible to handle all such problem: that involve
money matters. But in actual practice, as noted above, he has to call on the expertise of those
in other functional areas to discharge his responsibilities effectively.

Objective: Maximize the Value of the Firm

Brealey & Myers: "Success is usually judged by value: Shareholders are made better off by
any decision which increases the value of their stake in the firm... The secret of success in
financial management is to increase value."

Copeland & Weston: The most important theme is that the objective of the firm is to
maximize the wealth of its stockholders."

Brigham and Gapenski: Management's primary goal is stockholder wealth maximization,

which translates into maximizing the price of the common stock.

The Objective in Decision Making

In traditional corporate finance, the objective in decision-making is to maximize the value of
the firm. A narrower objective is to maximize stockholder wealth. When the stock is traded
and markets are viewed to be efficient, the objective is to maximize the stock price. All other
goals of the firm are intermediate ones leading to firm value maximization, or operate as
constraints on firm value maximization.

The Criticism of Firm Value Maximization

Maximizing stock price is not incompatible with meeting employee needs/objectives. In

particular:
• - Employees are often stockholders in many firms
• - Firms that maximize stock price generally are firms that have treated employees well.
Maximizing stock price does not mean that customers are not critical to success. In most
businesses, keeping customers happy is the route to stock price maximization.
Maximizing stock price does not imply that a company has to be a social outlaw.
Why traditional corporate financial theory focuses on maximizing stockholder wealth?
Stock prices are easily observable and constantly updated (unlike other measures of
performance, which may not be as easily observable, and certainly not updated as frequently).
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If investors are rational, stock prices reflect the wisdom of decisions, short term and long
term, instantaneously. As it is, it is believed that market discounts all the information in the
form of market price of the share.

Why not profit maximization?

Profitability objective may be stated in terms of profits, return on investment, or profit to-
sales ratios. According to this objective, all actions such as increase income and cut down
costs should be undertaken and those that are likely to have adverse impact on profitability of
the enterprise should be avoided. Advocates of the profit maximisation objective are of the
view that this objective is simple and has the in-built advantage of judging economic
performance of the enterprise. Further, it will direct the resources in those channels that
promise maximum return. This, in turn, would help in optimal utilisation of society's
economic resources. Since the finance manager is responsible for the efficient utilisation of
capital, it is plausible to pursue profitability maximisation as the operational standard to test
the effectiveness of financial decisions. However, profit maximisation objective suffers from
several drawbacks rendering it an ineffective decisional criterion. These drawbacks are:

(a) It is Vague

It is not clear in what sense the term profit has been used. It may be total profit before tax or
after tax or profitability rate. Rate of profitability may again be in relation to Share capital;
owner's funds, total capital employed or sales. Which of these variants of profit should the
management pursue to maximise so as to attain the profit maximisation objective remains
vague? Furthermore, the word profit does not speak anything about the short-term and long-
term profits. Profits in the short-run may not be the same as those in the long run. A firm can
maximise its short-term profit by avoiding current expenditures on maintenance of a
machine. But owing to this neglect, the machine being put to use may no longer be capable of
operation after sometime with the result that the firm will have to defray huge investment
outlay to replace the machine. Thus, profit maximisation suffers in the long run for the sake
of maximizing short-term profit. Obviously, long-term consideration of profit cannot be
neglected in favor of short-term profit.
(b) It Ignores Time Value factor
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Profit maximisation objective fails to provide any idea regarding timing of expected cash
earnings. For instance, if there are two investment projects and suppose one is likely to
produce streams of earnings of Rs. 90,000 in sixth year from now and the other is likely to
produce annual benefits of Rs. 15,000 in each of the ensuing six years, both the projects
cannot be treated as equally useful ones although total benefits of both the projects are
identical because of differences in value of benefits received today and those received a year
two years after. Choice of more worthy projects lies in the study of time value of future flows
of cash earnings. The interest of the firm and its owners is affected by the time value or.
Profit maximisation objective does not take cognizance of this vital factor and treats all
benefits, irrespective of the timing, as equally valuable.
(c) It Ignores Risk Factor

Another serious shortcoming of the profit maximisation objective is that it overlooks risk
factor. Future earnings of different projects are related with risks of varying degrees. Hence,
different projects may have different values even though their earning capacity is the same. A
project with fluctuating earnings is considered more risky than the one with certainty of
earnings. Naturally, an investor would provide less value to the former than to the latter. Risk
element of a project is also dependent on the financing mix of the project. Project largely
financed by way of debt is generally more risky than the one predominantly financed by
means of share capital. In view of the above, the profit maximisation objective is
inappropriate and unsuitable an operational objective of the firm. Suitable and operationally
feasible objective of the firm should be precise and clear cut and should give weightage to
time value and risk factors. All these factors are well taken care of by wealth maximisation
objective.

That is why we have Wealth Maximisation as an Objective

Wealth maximisation objective is a widely recognised criterion with which the performance a
business enterprise is evaluated. The word wealth refers to the net present worth of the firm.
Therefore, wealth maximisation is also stated as net present worth. Net present worth is
difference between gross present worth and the amount of capital investment required to
achieve the benefits. Gross present worth represents the present value of expected cash
benefits discounted at a rate, which reflects their certainty or uncertainty. Thus, wealth
maximisation objective as decisional criterion suggests that any financial action, which
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creates wealth or which, has a net present value above zero is desirable one and should be
accepted and that which does not satisfy this test should be rejected.

The wealth maximisation objective when used as decisional criterion serves as a very useful
guideline in taking investment decisions. This is because the concept of, wealth is very clear.
It represents present value of the benefits minus the cost of the investment. The concept of
cash flow is more precise in connotation than that of accounting profit. Thus, measuring
benefit in terms of cash flows generated avoids ambiguity. The wealth maximization
objective considers time value of money. It recognizes that cash benefits emerging from a
project in different years are not identical in value. This is why annual cash benefits of a
project are discounted at a discount rate to calculate total value of these cash benefits. At the
same time, it also gives due weightage to risk factor by making necessary adjustments in the
discount rate. Thus, cash benefits of a project with higher risk exposure is discounted at a
higher discount rate (cost of capital), while lower discount rate applied to discount expected
cash benefits of a less risky project. In this way, discount rate used to determine present value
of future streams of cash earning reflects both the time and risk. In view of the above
reasons, wealth maximization objective is considered superior profit maximisation objective.
It may be noted here that value maximisation objective is simply the extension of profit
maximisation to real life situations. Where the time period is short and magnitude of
uncertainty is not great, value maximisation and profit maximisation amount almost the same
thing.

Objective redefined
Although shareholder wealth maximization is the primary goal, in recent years many
firms have broadened their focus to include the interests of stakeholders as well as
shareholders. Stakeholders are groups such as employees, customers, suppliers,
creditors, and owners who have a direct economic link to the firm. Employees are
paid for their labor, customers purchase the firm's products or services, suppliers are
paid for the materials and services they provide, creditors provide debt financing, and
owners provide equity financing. A firm with a stakeholder focus consciously avoids
actions that would prove detrimental to stakeholders by damaging their wealth
positions through the transfer of stakeholder wealth to the firm. The goal is not to
maximize stakeholder well being, but to preserve it. The stakeholder view tends to
limit the firm's actions in order to preserve the wealth of stakeholders. Such a view is
often considered part of the firm's "social responsibility." It is expected to provide
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long-run benefit to shareholders by maintaining positive stakeholder relationships.

Such relationships should minimize stakeholder turnover, conflicts, and litigation.
Clearly, the firm can better achieve its goal of shareholder wealth maximization with
the cooperation of- rather than conflict with-its other stakeholders.

The Agency Issue

The control of the modern corporation is frequently placed in the hands of
professional non-owner managers. We have seen that the goal of the financial
manager should be to maximize the wealth of the owners of the firm and given them
decision-making authority to manage the firm. Technically, any manager who owns
less than 100 percent of the firm is to some degree an agent of the other owners. In
theory, most financial managers would agree with the goal of owner wealth
maximization. In practice, however, managers are also concerned with their personal
wealth, job security, and fringe benefits, such as country club memberships,
limousines, and posh offices, all provided at company expense. Such concerns may
make managers reluctant or unwilling to take more that, moderate risk if they perceive
that too much risk might result in a loss of job and damage to personal wealth. The
result is a less-than-maximum return and a potential loss of wealth for the owners.
How do we resolve the agency problem?

From this conflict of owners and managers arises what has been called the agency
problem-the likelihood that managers may place personal goals ahead of corporate
goals. Two factors-market forces and agency costs-act to prevent or minimize agency
problems.
Market Forces One market force is major shareholders, particularly large
institutional investors, such as mutual funds, life insurance companies, and pension
funds. These holders of large block of a firm's stock have begun in recent years to
exert pressure on management to perform. When necessary they exercise their voting
rights as stockholders to replace under performing management.
Another market force is the threat of takeover by another firm that believes that it
can enhance the firm's value by restructuring its management, operations, and
financing. The constant threat of takeover tends to motivate management to act in the
best interest of the firm's owners by attempting to maximize share price.
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Agency Costs To minimize agency problems and contribute to the maximization of owners'
wealth, stockholders incur agency costs. These are the costs of monitoring management
behavior, ensuring price. The most popular, powerful, and expensive approach is to structure
management compensation to correspond with share price maximization. The objective is to
compensate managers for acting in the best interests of the owners. This is frequently
accomplished by granting stock options to management. These options allow managers to
purchase stock at a set market price; if the market price rises, the higher future stock price
would result in greater management compensation. In addition, well-structured compensation
packages allow firms to hire the best managers available. Today more firms are tying
management compensation to the firm's performance. This incentive appears to motivate
managers to operate in a manner reasonably consistent with stock price maximization. against
dishonest acts of management, and giving managers the financial incentive to maximize
share.

Social Responsibility

Maximizing shareholder wealth does not mean that management should ignore social
responsibility, such as protecting the consumer, paying fair wages to employees, maintaining
fair hiring practices and safe working conditions, supporting education, and becoming
involved in such environmental issues as clean air and water .It is appropriate for
management to consider the interests of stakeholders other than shareholders. These
stakeholders include creditors, employees, customers, suppliers, communities in which a
company operates, and others. Only through attention to the legitimate concerns of the firm’s
various stakeholders can the firm attain its ultimate goal of maximizing shareholder wealth.

2. The Investment Decision: Investment decision process – Project generation, project evaluation, project
selection and project implementation. Developing Cash Flow Data. Using Evaluation Techniques – Traditional
and DCF methods. The NPV Vs IRR Debate. Approaches for reconciliation.

Investment is an activity of spending resources (money, labour and time) on creating

assets that can generate income over a long period of time or which enhances the returns on
the existing assets. Investments that generate returns over a number of years can be classified
as:

Investment in financial assets: Bank deposits, deposits with companies, contribution to

provident fund (in excess of compulsory deduction), shares and debentures, government
bonds, purchase of NSC, personal lending etc.
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Investment in physical assets: Purchase of land, building, machinery, plants etc.

Investment in human capital: Expenditure on skill formation through education and

training that increases productivity and earning capacity of a person.

Miscellaneous investment: Expenditure on replacement of depreciated and obsolete

machinery, product diversification, R&D, installation of safetymeasures for employees,
pollution control for public health and safety and meeting legal requirements etc.

Techniques of Investment Analysis

The investment decisions are commonly known as capital budgeting or capital expenditure
decisions. Capital Budgeting means planning for capital expenditure in acquisition of capital
assets such as new building, new machinery or a new project as a whole. Thus capital
budgeting involves the following steps.

1. Consideration of investment proposals including alternatives.

2. Application of suitable evaluation technique for selecting the project.
3. Estimation of profits, cash flows and analysis of cost benefit of the project or scheme.
4. Estimation of available funds and utilization thereof.
5. The objective is to maximize the profits with the utilization of available funds.
In the investment decisions, the cash flow is very important. Each proposal involves two
types of cash flows.

1. Investment i.e., cash outflow

2. Cash inflow as a result of new investment.
Capital investments mean the acquisition of durable assets and includes

1. Modification and Replacement of existing facilities.

2. General Plant improvement.
3. Quality improvement.
4. Additional capacity.
5. New products or expansion of existing products.
6. Cost reduction.
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7. Research and development.

8. Exploration.
9. Mechanization Process.
10. Replacement of manual work by machinery
The various methods for evaluation of capital expenditure proposals are as follows:

According to Traditional Approach or Non-Discounted Cash flows Approach:

1. Pay-back period (PB)

2. Average Rate of Return (ARR)
According to Modern Approach or Discounted Cash flows Approach:

1. Net present Value (NPV)

2. Profitability Index (PI)
3. Internal Rate of Return (IRR)
4. Discounted Payback Period (DPP)
Non-Discounted Cash flow Approach:

1. Payback Period Method (PBP)

Payback period is defined as the length of time required for the stream of cash
proceeds produced by an investment to equal the original cash outlay required by the
investment. It is the number of years required to recover the investment.

Computation of PBP: When Cash inflows are even:

Payback period = Initial Investment in projects / Annual cash inflow

When Cash inflows are uneven:

Incase of unequal cash inflow, it can be found out by cumulative cash flow
frequencies i.e. adding up the annual cash inflow till the total is equal to the investment.
Many firms use the payback period as a decision criterion because it is easy to calculate.
Cash inflow is the sum of net profit after tax and depreciation which is a non-cash expense.

Acceptance Rule

Management of the firm may establish a normal standard for acceptable pay back period,
usually based on the project which gives shortest payback period is to be selected.
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Advantages

1. It is a very simple measure of economic feasibility.

2. It is very easy to apply, calculate and interpret.
3. It is easy to understand.
4. It emphasizes the liquidity and solvency of a firm.
5. For projects involving uncertain returns, it is appropriate to select a measure that
concentrates on early returns.
6. The payback period is a meaningful indicator of economic feasibility in case of the
firms where the risk of obsolescence is high. In comparison to other projects, risky
projects are expected to pay for themselves faster.
7. It weighs early returns heavily and ignores distant return.
8. It takes less time to calculate and hence the cost of analysis is low.
9. This criterion emphasizes early Pay-off and hence the projects with shortest payback
period will be selected.
Limitations

1. The main limitation is that this method fails to take into account the time value
of money. All cash flows are treated and weighted equally regardless of the time
period of their occurrence.

2. It does not measure the profitability of a project. It ignores the cash inflow beyond
the payback period. Thus it is a biased indicator of economic value.
3. It does not differentiate between projects requiring different cash investments and
thus it does not provide a meaningful and comparable criterion.
4. It does not show the economic return on investment.
5. It fails to consider the magnitude of cash inflows i.e. varying cash-flow patterns.
3. Accounting rate of return Or Average rate of return (ARR)

This method take into account the total earnings expected from an investment proposal its
full life time. The method is called accounting rate of return method, because it uses the
accounting concept of profit i.e., income after deprecation and tax as criterion for
calculation of return.

Computation of A.R.R

a.) Total income method;

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ARR = Net Profit after Depreciation &Tax / Original investment – scrap value x 100

b.) Average investment method;

Accounting Rate of Return = Net Profit after depreciation &Tax / Average
investment x 100

Average investment is again a dispute term. The following four alternatives used;

Average investment = Original investment/ 2 or Original investment – scrap value/

2 or Original investment + scrap value/ 2 or Original investment – scrap value /2
+Additional Working Capital + scrap

Advantages

1. It is simple to understand and use.

2. It places emphasis on the profitability of the project, rather than on liquidity as in the
case of payback method.
3. It considers the entire stream of incomes over the entire life of the project.
4. It can be calculated by using the accounting data without another set of workings like
cash flow etc.
Limitations

1. The serious limitation is that this method also ignores the time value of money.
2. It gives equal weight to both near money and distant money. It does not consider the
differential timing of receipts.
3. Cash inflow is not taken into account. Only net profit tax is considered.
4. It does not consider the length of project life.
5. This method is not consistent with the objective of maximizing the market values per
share value do not depend upon the average rate of return.
Acceptance Rule

The project which has greater ARR should be accepted.

Discounted Cash flow Approach

1. Net Present Value Method (NPV)

This method follows the DCF Technique and recognizes the time value of money. It
is an index used to ascertain the economic worthiness of the investment proposals. If the
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investment i.e. cash outflow is made in the initial year, then it is present value will be equal to
the amount of cash actually spent. If the cash outflow is made in the second and subsequent
year also, its present value also should be found out by applying the appropriate rate of
interest which is the firm’s cost of capital. It is the minimum rate of return expected to be
earned by the firm on the investment proposals. Similarly all the cash inflows (i.e. Net profit
after tax +Depreciation) are also to be discounted at the above rate in order to find out the
present value of cash inflows occurring in the future periods. Then the net present value is to
be found out by subtracting the present value of cash outflows from the present value of cash
inflows. It is defined as the difference between the present value of cash outflow and present
value of cash inflows occurring in the future periods over the entire life of the project.

Calculation of NPV

NPV= CF/ (1+k) t

Where, CF= Annual cash flow of the project

K= required rate of return

t = year of the project

Acceptance Rule

If the NPV is positive or at least equal to zero, the project can be accepted

NPV> 0 should accepted

NPV< 0 should be rejected

NPV is positive = cash inflows are generated at a rate higher than the minimum

required by the firm.

NPV is Zero = Cash inflows are generated at a rate equal to the minimum Required.

NPV is Negative = Cash inflows are generated at a rate lower than the minimum Required by
the firm.

The market value per share will increase if the project with positive NPV is selected

Merits of NPV Method

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1. The important one is that it recognizes the time value of money.

2. It uses the discount rate which is the firm’s cost of capital.
3. It considers all cash flows over the entire life of the project.
4. By accepting the Project with the highest positive NPV, the profit will be maximized.
Hawkins and Pearce state that NPV, the profit theoretically unassailable. If one
wishes to maximize profits, the use of NPV always finds the correct collection of
projects.
5. Hence it is consistent with the objective of maximizing the wealth of shareholders.
6. It is superior to the other methods.
7. It is simple to find out the acceptable projects.
Limitations

1. It is difficult to calculate.
2. It is difficult to workout the cost of capital especially the cost of equity capital.
3. Unless the cost of capital is known, this method cannot be used.
4. It may not give correct answer when the projects with different investments are
compared, in such cases, profitability index method will be better.
5. It may mislead when dealing with alternative projects or limited funds under the
conditions of unequal lives.
6. NPV method favors long lived projects.
7. Both NPV and IRR methods may often give contradictory results in the case of
alternative proposals which are mutually exclusive.
8. It may give different ranking in case of complicated projects as compared to
9. It assumes that intermediate cash inflows are reinvested at the firm’s cost of Capital
which is not always true.
2. Profitability Index (PI) Or Benefit Cost ratio

PI is found out by comparing the total of present value of future cash inflows and the

total of the present value of future cash outflows. This is other wise called excess present

value index or benefit cost ratio. This can be put in the form of the following formula.

Computation of PI

PI = Present value of Cash inflows / Present value of Cash out flows

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Acceptance rule

PI > 1 = accept the project

PI < 1 = reject the project

PI = 1 =may be accepted

3. Internal Rate of Return

Internal rate of return is the rate of which is the sum of discounted cash inflows equal
the sum of discounted cash outflows. The Internal Rate of Return (IRR) is defined as “the
rate of interest or return which renders the discounted present value of its expected future
managerial yields exactly equal to the investment cost of project”. In other words it is the
rate at which equals the aggregate discounted cash inflow with the aggregate discounted cash
outflows. It is the rate of discount which reduces the net present value of an investment to
zero. It can be stated in the form of a ratio.

Computation of IRR

a) Where cash inflows are uniform the internal rate of return can be calculated by locating the
factor in annuity table. The factor is calculated as follows.

F= I / C

Where, F = factor to be located in annuity table

I = Investment or cash outflow

C = Cash inflows per year

(b) When cash inflows are not uniform the IRR is calculated by making trail calculations in
an attempt to compute the current interest rate which equates the present value of cash
inflows with the present value of cash outflows. After determining the present value of a
project at two or three trail rate of return, the trail rate of return at which the present value is
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very closely to initial cost of the project is roughly taken as the initial rate of return. If greater
accuracy in the IRR is desired, then the exact IRR can be determined as follows.

IRR= Lower trail rate + (NPV at lower rate/ Diff.between the NPV at trail rate

Lower trail rate and the NPV at higher) * diff. between the higher &lower trail rate.

Merits of IRR Method:

1. Like all other DCF based method, IRR also take into account the time value of money
and can be applied where the cash inflows are even or unequal.
2. It also considers the profitability of the project over its economic life and thus the
true profitability of a project can be accessed.
3. Cost of capital or pre determined cut off rate is not a pre requisite for applying IRR
method hence it is better than NPV and PI methods. In all those situations where
determining cost of capital is difficult.
4. IRR provides a ranking of various proposals because it is percentage return.
5. It provides for maximizing profitability.
Demerits of IRR method:

1. It is a complicated method and may lead to cumbersome calculations

2. The underlying assumption of IRR that the earnings are reinvested at IRR for the
remaining life or the project is not a justifiable assumption. Form this point of view
NPV &PI which assure re investment at cost of capital are better.
3. The results obtained through NPV or PI methods may differ from that obtained
through IRR depending on the size, life and timing of the cash flows.
Comparison and Contrast of IRR and NPV Technique

Comparison of both the techniques

1. Both techniques use Discounted Cash Flow (DCF) method.

2. Both recognize the time value of money.
3. Both take into account the cash inflows over the entire life of the project.
4. Both are consistent with the objective of maximizing the wealth of shareholders.
5. Both are difficult to calculate.
6. Both techniques may often give contradictory result in the case of alternative
proposals which are mutually exclusive.
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Contrast i.e., points of difference

1. Interest rate NPV uses the firm’s cost of capital as Interest rate. Unless the cost of
capital is known, NPV method cannot be used. Calculating cost of capital is not
required for computing IRR.
2. NPV may mislead when dealing with alternative projects or limited funds under the
conditions of unequal lives. IRR allows a sound comparison of the project having
different lives and different timings of cash inflows.
3. 3. NPV may give different ranking in case of complicated project as compared to
IRR.
4. NPV assumes that intermediate cash flows are re-invested at firm’s cost of capital
whereas IRR assumes that intermediate cash inflows are reinvested at the internal rate
of the project.
5. The results of IRR method may be inconsistent compared to NPV method, if the
projects differ in their (1) expected lives or (2) investment or (3) timing of cash
inflow.
6. IRR method favors short-lived project so long as it promises return in excess of cut-
off rate whereas NPV method favors long-lived projects.
7. IRR may give negative rate or multiple rates under certain circumstances. NPV does
not suffer from the limitation of multiple rates.
4. Discounted Pay Back Period (DPBP)

Like Pay Back Period, but cash flow should be in present value and apply formula as
PBP.

3. Capital budgeting and Risk: Capital budgeting decision under conditions of risk and uncertainty;
Measurement of Risk – Risk adjusted Discount Rate, Certainty Equivalents and Beta Coefficients, Probability
tree approach – Sensitivity analysis.

RISK AND UNCERTAINTY

Risk is inherent in almost every business decision. More so, in Capital Budgeting
decisions as they involve costs and benefits extending over a long period of time during
which many things can change in unanticipated ways. For the sake of expository
convenience, we assumed so far that all investments being considered for inclusion in the
capital budget had the same risk as those of the existing investments of the firm. Hence the
average cost of capital was used for evaluating every project. Investment proposals, however,
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differ in risk. A research and development project may be more risky than an expansion
project and the latter tends to be more risky than a replacement project. In view of such
differences, variations in risk need to be evaluated explicitly in capital investment appraisal.

Risk analysis is one of the most complex and slippery aspects of capital
budgeting. Many different techniques have been suggested and no single technique can be
deemed as best in all situations.

2. SOURCES OF RISK

The first step in risk analysis is to uncover the major factors that contribute to the risk of the
investment. Four main factors that contribute to the variability of results of a particular
investment are cost of project, reinvestment of cash flows, variability of cash flows and the
life of the project.

(a) Size of the Investment

A large project involving greater investments entails more risk than the small project because
in case of failure of the large project the company will have to suffer considerably greater
loss and it may be forced to liquidation. Furthermore, cost of a project in many cases is
known in advance. There is always the chance that the actual cost will vary from the original
estimate. One can never foresee exactly what the construction, debugging, design and
developmental costs will be. Rather than being satisfied with a single estimate it seems more
realistic to specify a range of costs and the probability of occurrence of each value within the
range. The less confidence the decision-maker has in his estimates, the wider will be the
range.

(b) Re-investment of Cash Flows

Whether a company should accept a project that offers a 20 per cent return for 2 years or one
that offers 16 per cent return for 3 years would depend upon the rate of return available for
reinvesting the proceeds from the 20 per cent 2-year period. The danger that the company
will not be able to return funds as they become available is a continuing risk in managing
fixed assets and cash flows.
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(c) Variability of Cash Flows

It may not be an easy job to forecast the likely returns from a project. Instead of basing
investment decision on a single estimate of cash flow it would be desirable to have range of
estimates.

(d) Life of the Project

Life of a project can never be determined precisely. The production manager should base the
investment decision on the range of life of the project.

WHAT MEASURE OF RISK IS RELEVANT IN CAPITAL BUDGETING

Before we began our discussion of how to adjust for risk, it is important to determine just
what type of risk we are to adjust for. In capital budgeting, a project’s risk can be looked at
three levels. First, there is the project standing alone risk, which is a project’s risk ignoring
the fact that much of this risk will diversified away as the project is combined with the firm’s
other projects and assets. Second, we have the Project’s contribution-to-firm risk, which is
the amount of risk that the project contributes the firm as a whole: this measure considers the
fact that some of the project’s risk will be diversified away as the project is combined with
the firm’s other projects and assets, but ignores the effects of diversification of the firm’s
shareholders. Finally, there is systematic, which is the risk of project from the viewpoint of a
well-diversified shareholder, this measure considers the fact that some of a project’s risk will
be diversified away as the project is combined with the firm’s other projects, and, in addition,
some of the remaining risk will be diversified away by shareholders as they combine this
stock with other stocks in their portfolios. Should we be interested in the project standing
alone risk? The answer is no. Perhaps the easiest way to understand why not is to look at an
example. Let’s take the case of research and development projects at Johnson&Jonson. Each
year, Johnson&Jonson takes on hundreds of new R&D projects, knowing that they only have
about a 10 percent probability of being successful. If they are successful, the profits can be
enormous; if they fail, the investment is lost. If the company has only one project, and it is an
R&D project, the company would have a 90 percent chance of failure. Thus, if we look at
these R&D projects individually and measure their project standing risk, we would have to
judge them to be enormously risky. However, if we consider the effect of the diversification
that comes about from taking several hundred independent R&D projects a year, all with a 10
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percent chance of success, we can see that each R&D project does not add much in the way
of risk to Jonson & Jonson. In short, because much of a project’s risk is diversified away
within the firm, project standing alone risk is an inappropriate measure of the level of risk of
a capital budgeting project. Should we be interested in the project’s contribution-to-firm risk?
Once again, the answer is no, provided investors are well diversified, and there is no chance
of bankruptcy. From our earlier discussion, we saw that, as shareholder, if we combined our
stocks with other stocks to form a diversified portfolio, much of the risk of our security
would be diversified away. Thus, all that affects the shareholders is the systematic risk of the
project and, as such, it is all that is theoretically relevant for capital budgeting.

METHODS OF INCORPORATING RISK INTO CAPITAL BUDGETING

The application of capital budgeting techniques has been assumed that the financial
manager makes investment decisions under conditions of certainty and hence they are risk-
free. This assumption implies that the NPV of an investment proposal is considered to be a
fixed quantity and not a random variable, capable of assuming values other than the one
specified. It is for this reason that once a positive value of the NPV of an investment proposal
is obtained, it can be unequivocally stated that it is an acceptable proposal. Reality, however,
is far from this, for the World is one of change and uncertainty. Thus, when we calculate that
an investment would yield a particular rate of return per annum, we are aware that unforeseen
events, like new and better technology, changes in the raw materials and so on may invalidate
our estimates. Thus, some risk would usually be associated with a project so that variations in
the cash may be observed, and that the degree of risk would vary with the different projects.
There are many ways in which risk can be taken into account while investment decision-
making. Some of the popular techniques used for this purpose are as follows.

General Techniques

1. Risk Adjusted Discount Rate

2. Certainty Equivalent Coefficient
Quantitative Techniques

1. Sensitivity Analysis
2. Probability Assignment
3. Standard deviation
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4. Coefficient of variation
5. Decision Tree
6. Simulation Analysis
Risk-adjusted discount rates.

A finance manager being risk averter when given choice between two projects promising the
same rate of return but different in risk would prefer the one with the least perceived risk. He
will require compensation for bearing risk so that overall value of the company remains
unaffected by assumption of the risky project. The rates requires determination of Risk free
rate and Risk premium rate. Risk free rate is the rate at which the future cash flows should be
discounted had there been no risk. Risk premium is the extra return expected by the investor
over the normal rate on the account of project being risky.

Calculation of RADR

Risk Adjusted discount rate = Risk free rate + Risk premium

By using the RADR, present value of cash flows should be found out to subtract from
Investment in order to find out NPV.

Merits

1. It is simple to calculate and easy to understand.

2. It incorporates the risk-averse attitude of investor.
Demerits

1. The determination of appropriate discount rates keeping in view the differing degrees
of risk is arbitrary.
2. Conceptually this method is incorrect since it adjusts the wrong element.
3. The method presumes that the investors are averse to risk.
Certainty Equivalent Approach

Under this method, adjusting cash inflows rather than adjusting the discount rate compensates
risk element. The expected uncertain cash flow of each year are modified by multiplying
them with what is known as “certainty equivalent coefficient’ (CEO) to remove the element
of uncertainty. This coefficient is determined by management’s preferences with respect to
risk.
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Calculation of Certainty Equivalent Coefficient

Certainty Equivalent Coefficient = Riskless Cash flow / Risky Cash flow

For example, assume that the expected cash flow from an investment at the end of the first
year is Rs.10, 000 risky cash flow and with certain cash flow of Rs.7, 000, then Rs.7, 000 is
certainty equivalent of the risky cash flows of Rs.10, 000. The ratio

7,000/10,000 = 0.7 is called the certainty equivalent coefficient. Then calculate Present Value
of Cash flows to determine NPV.

Merits

1. It is simple to calculate.
2. It incorporates risk at the right place i.e. in the cash flow which are subject to change.
Demerits

1. It involves use of subjective approach while determining expected riskless cash flows,
which may vary from management to management and therefore could give varying
results.
2. It is a general technique and doesn’t make use of the statistical methods in any way to
incorporate risk.
Quantitative Techniques

Sensitivity Analysis

In the evaluation of an investment project, we work with the forecasts of cash flows.
Forecasted cash flow depends on the expected revenue and costs. Further, expected revenue
is a function of sales volume and unit selling price. Similarly, sales volume depends on the
market size and the firm’s market share. Costs include variable costs, which depend on sales
volume, and unit variable cost and fixed costs. Costs include variable costs, which depend on
sale volume, and unit variable cost and fixed cost. The net present value or the internal rate of
return of a project is determined by analyzing the after-tax cash flows arrived at by
combining forecasts of various variables. It is difficult to arrive at an accurate and unbiased
forecast of each variable. We can’t be certain about the outcome of any of these variables.
The reliability of the NPV or Internal Rate of Return (IRR), we can work out how much
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difference it makes if any of these forecasts goes wrong. We can change each of the forecasts,
on at a time, to at least three values: Pessimistic, Expected, and Optimistic. The NPV of the
project is recalculated under these different assumptions. This method of recalculating NPV
or IRR by changing each forecast is call Sensitivity analysis is a way of analyzing change in
the project’s NPV (or IRR) for a given change in one of the variables. It indicates how
sensitive a project’s NPV (or IRR) is to changes in particular variables. The more sensitive
the NPV, the more critical is the variable. The following three steps are involved in the use of
sensitivity analysis:

1. Identification of all those variables, which have an influence on the project’s NPV
or IRR.
2. Definition of the underlying (mathematical) relationship between the variables.
3. Analysis of the impact of the change in each of the variables on the project’s
NPV.
The decision-maker, while performing sensitivity analysis, computes the project’s NPV (or
IRR) for each forecast under three assumptions:

(a) Pessimistic; (b) Most likely (c) Optimistic outcome associated with the project. It
explains how sensitive the cash flow is under these different situations. A whole range of
question can be answered with the help of sensitivity analysis. It examines the sensitivity of
the variables underlying the computation of NPV or IRR, rather than attempting to quantify
risk. It can be applied to any variable, which is an input for the after-tax cash flows.

Calculation of Sensitivity Analysis

In order to arrive decision about the selection of a project the net present value of cash
inflows of each of the projects.

Probability Assignment

While using the certainty equivalent approach, the risk-free discount rate may be
easily approximated (may be, for instance, by the interest rate on government bonds) but
difficulties may arise in determining the trade-off between risk and return for the purpose of
converting a particular distribution of NPV into its certainty equivalent. In a similar manner,
in using the risk-adjusted discount rate method, the determination of the risk-premium to be
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added to the risk-free rate of return would pose difficulty. In using either of these approaches
it is important that we should be able to measure the degree of risk associated with the
project(s) in question. In the statistical distribution approach, the degree of risk associated
with a project is sought to be measured in terms of the variance (or standard deviation) of the
NPV distribution, and the investment decisions are taken considering the expected (mean)
value, and its standard deviation, of the net present value distribution. This information about
the project risk may also be usefully employed for calculating certainty-equivalent for the
uncertain returns form the investment proposal, as also it is a major factor in calculating the
size of the risk-adjusted discount rate to use. The derivation of the probabilistic information
about investment proposals owes its origin to the work of Frederick Hillier. In this method of
considering risky investment proposals, the net cash flow from an investment in each period
is viewed as a random variable which can assume any one of the possible values. The method
requires that probability distribution of cash flows for each of the years be obtained and
considered.

Calculation of Probability Assignment

Assign probability distribution values to find out expected value of cash flows and apply
discounting factor to know the NPV of the events.

Standard Deviation

The probability assignment approach for risk analysis in capital budgeting does not
provide the decision maker with a precise value indicating about the variability of cash flows
and therefore the risk. Standard deviation is the measure of dispersion. It may be defined as
the square root of squared deviations calculated from the mean. A project having longer
standard deviation will be more risky as compared to a project having smaller standard
deviation.

Steps to calculate Standard deviation

1. Mean value of cash flow is computed.

2. Deviations between the mean value and the possible cash flows are found out.
3. Deviations are squared.
4. Squared Deviations are multiplied by the assigned probabilities which give weighted
squared deviations.
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5. The weighted squared deviations are totaled and their square root is found out. The
resulting figure is the standard deviation.
Formula

σ = √ Σ pdcf2

Coefficient of variation

Standard deviation is an absolute measure. It is best for comparison particularly where

projects involve different cash out lays or different expected values. In such case relative
measure of dispersion should be calculated. Coefficient of variation is one of such measures.

Calculation of Coefficient of variation

Coefficient of variation = Standard deviation / Mean Cash flow

The greater Coefficient of variation of projects has higher risk as well as higher return.

Decision Tree Analysis

The Decision-tree Approach (DT) is another useful alternative for evaluating

investment proposals. The outstanding feature of this method is that it takes into account the
impact of all probabilistic estimates of potential outcomes. In other words, every possible
outcome is weighted in probabilities terms and then evaluated. The DT approach is especially
useful for situations in which decisions at one point of time also affect the decisions of the
firm at some later date. Another useful application of the DT approach is for projects, which
require decisions to be made in sequential parts. A decision tree is a pictorial representation
in tree from which indicates the magnitude, probability and inter-relationship of all possible
outcomes. The format of the exercise of the investment decisions has an appearance of a tree
with branches and, therefore, this method is referred to as the decision-tree method. A
decision tree shows the sequential cash flows and the NPV of the proposed project under
different circumstances.

Constructing a decision tree

1. Definition of the proposal.

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2. Identification of alternatives.
3. Graphing the decision tree.
4. Forecasting cash flows.
5. Evaluating results.
Simulation Approach
In considering risky investments, we can also use simulation to approximate then
expected value of net present value, the expected value of internal rate of return, or the
expected value of profitability index and the dispersion about the expected value. By
simulation we mean testing the possible results of an investment proposal before it is
accepted. The testing itself is based on a model coupled with probabilistic information.
Making use of a simulation model first proposed by Monto Carlo, we might consider

Sensitivity analysis indicates the sensitivity of the criterion of merit ( NPV, IRR, or
any other) to variations in basic factors and provides information of the following type. If the
quantity produced and sold decreases by 1 percent, other things being equal, the NPV falls by
6 percent. Such information, though useful, may not be used for developing the probability
profile of a criterion of merit by randomly combining values of variable which have a bearing
on the chosen criterion.

Procedure: The steps involved in simulation analysis are as follows:

1. Model the Project. The model of the project shows how the net present value is
related to the parameters. And the exogenous variables.
2. Specify the values of parameters an the probability distribution of the exogenous
variables.
3. Select a value, at random, from the probability distribution of each of the exogenous
variables.
4. Determine the net present value corresponding to the randomly generated values of
exogenous variables and pre-specified parameter values.
5. Repeat step 3 and 4 a number of times to get a large number of simulated net present
values.
6. Plot the frequency distribution of the net present value.
In real life situations, simulation is done only on the computer because of the
computational tedium involved.
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