Capital budgeting decision

To determine the extent of dispersion of the cash flow from the average we use the measure of dispersion i.e S. D and coefficient of variation. These measure the risk that the cash flow may or may not be realized.

EXAMPLE

Suppose there are 3 states, very optimistic, optimistic and pessimistic and they have cash flows of 500,300, and 200 respectively.

Very optimistic has a probability of occurrence 0.10, optimistic 0.25 and pessimistic 0.65.

Required;

• Find the mean
• Standard deviation
• Coefficient of variation

COMMON PROCEDURES FOR ADJUSTING FOR RISKS IN CAPITAL BUDGETING:

1. Certainty equivalent factors

This technique incorporates risks in cash flows by adjusting them to a minimum level which is regarded as risk free. These factors are determined for each cash flow and range from zero to one certainty equivalent factors reflects the perception of the managers towards risk.

𝛼𝑖 = Certainty equivalent factor associated with cash flows in period i

𝐴𝑖 = Risk cash flow for period i

K = Risk free rate of return determined from government securities like treasury bills

n = Useful life of a project

Io = Initial investment

A certainty equivalent factors associates with this cash flows are 1.00, 0.95, 0.80, 0.72 and 0.60 respectively. The risk free rate of return as determined by the government treasury bills is 8% while the required rate of return of the firm is 12%. Determine the NPV using;

i. Risky cash flows

ii. Risk adjusted cash flows.