Chapter
Evaluation of Risky Proposals for
Investment Decisions
PART - 1
EXPECTED CASH FLOWS AND EXPECTED NPV
Q. 1. A project having a life of 3 years and involving an outlay of ` 50,000 has the
following benefits associated with it.
Year 1 Year 2 Year 3
Net cash flows (`) Prob. Net cash flows (`) Prob. Net cash flows (`) Prob.
15,000 0.3 10,000 0.2 15,000 0.3
25,000 0.4 20,000 0.6 25,000 0.4
35,000 0.3 30,000 0.2 35,000 0.3
Calculate Expected NPV.
Ans: 12,375;
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STANDARD DEVIATION
Q. 2. Cyber company is considering two mutually exclusive projects. Investment outlay
of both the projects is ` 5,00,000 and each is expected to have a life of 5 years. Under
three possible situations their annual cash flows and probabilities are as under:
`
Cash flows
Situation Probabilities Project A Project B
Good .3 6,00,000 5,00,000
Normal .4 4,00,000 4,00,000
Worse .3 2,00,000 3,00,000
The cost of capital is 9%, which project should be accepted? Explain with workings.
PVAF @ 9% for 5 years = 3.890;
Ans: Expected cash flows = 4,00,000; Expected NPV = 10,56,000; Standard
Deviation A = 1,54,919; B = 77,460;
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Q. 3. Skylark airways is planning to acquire a light commercial aircraft for flying class
clients at an investment of ` 50,00,000. The expected cash flows after tax for the next
three years are as follows:
Year 1 Year 2 Year 3
CFAT Probability CFAT Probability CFAT Probability
14,00,000 .1 15,00,000 .1 18,00,000 .2
18,00,000 .2 20,00,000 .3 25,00,000 .5
25,00,000 .4 32,00,000 .4 35,00,000 .2
40,00,000 .3 45,00,000 .2 48,00,000 .1
The company wishes to take into consideration all possible risk factors relating to an
airline operation. The company wants to know:
(1) The expected NPV of this venture assuming independent probability distribution with
8% risk free rate of interest.
(2) Standard deviation of each year.
PV factor @ 8% year 1 = .9259; 2 = .8573; 3 = .7938;
Ans: (1) 22.27; (2) Year 1 = 9.241; Year 2 = 9.93; Year 3 = 8.619;
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CO-EFFICIENT OF VARIATION (CV)
Q. 4. A Company is considering Projects X and Y with following information:
Project Expected NPV (`) Standard deviation
X 1,06,000 75,000
Y 2,40,000 1,35,000
(1) Which project will you recommend based on Risk?
(2) Explain whether your opinion will change, if you use coefficient of variation as a
measure of risk.
Ans: CV = X = .71; Y = .5626;
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Q. 5. A company is trying to choose between two investment proposals A and B. Project
A has a standard deviation of ` 6,500 while Project B has a standard deviation of ` 7,200.
The finance manager wishes to know which investment to choose, given each of the
following combinations of the expected values:
(1) Project A and Project B both have expected net present value of ` 15,000.
(2) Project A has expected NPV of ` 18,000 while for Project B it is ` 22,000.
(June 2022 MTP 2)
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Q. 5A. The management of Power Tech. Ltd. must choose whether to go ahead with either
of two mutually exclusive projects A and B. The expected profits are as follows:
Particulars Profit if there is Profit/ (loss) if here
Strong demand is weak demand
Option A (`) 4,000 (1,000)
Option B (`) 1,500 500
Probability of demand 0.3 0.7
What would be the decision based on expected values, if no information about demand
were available?
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Q. 5B. The management of Power Tech. Ltd. must choose whether to go ahead with either
of two mutually exclusive projects A and B. The expected profits are as follows:
Particulars Profit if there is Profit/ (loss) if here
Strong demand is weak demand
Option A (`) 10,000 (2,500)
Option B (`) 6,000 2,000
Probability of demand 0.3 0.7
(1) What would be the decision based on expected values, if no information about demand
were available?
(2) What is the value of perfect information about demand? (JUNE 2015)
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CERTAINTY EQUIVALENT APPROACH
Q. 6. The DREAM manufacturing company ltd. is considering on investment in one of the
two mutually exclusive proposals – projects X and Y, which require cash outlays of ` 8,
40,000 and ` 8, 75,000 respectively. The certainty-equivalent (C.E.) approach is used in
incorporating risk in capital budgeting decisions. The current yield on government bond
is 7% and this be used as the risk less rate and the risk adjusted discounted rate is 10%.
The expected net cash flows and their certainty-equivalents are as follows:
Year-end Project X Project Y
Cash flow (`) C.E. Cash flow (`) C.E.
1 4,50,000 .8 4,50,000 .9
2 5,00,000 .7 4,50,000 .8
3 5,00,000 .5 5,00,000 .7
Required:
Which project should be accepted?
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Q. 7. VATSAN ltd. is considering a project with the following expected cash flows:
Initial investment ` 1, 00,000
Year 1 2 3
Expected cash inflows 70,000 60,000 45,000
Due to uncertainty of future cash flows, the management decides to reduce the cash
inflows to certainty equivalent (CE) by taking only 80% for 1st year, 70% for 2nd year and
60% for 3rd year respectively.
The cost of capital is 10%.
Required:
Is it worthwhile to take up the project?
(Given: P.V. factor (10%, 3 years): .909, .826 and .751
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Q. 8. The DREAM manufacturing company ltd. is considering on investment in one of the
two mutually exclusive proposals – projects X and Y, which require cash outlays of ` 3,
40,000 and ` 3, 30,000 respectively. The certainty-equivalent (C.E.) approach is used in
incorporating risk in capital budgeting decisions. The current yield on government bond
is 8% and this be used as the risk less rate. The expected net cash flows and their
certainty-equivalents are as follows:
Year-end Project X Project Y
Cash flow C.E. Cash flow C.E.
(Rs.) (Rs.)
1 1,80,000 .8 1,80,000 .9
2 2,00,000 .7 1,80,000 .8
3 2,00,000 .5 2,00,000 .7
Present value factors of Rs. 1 discounted at 10% at the end of year 1, 2 and 3 are .9091,
.8264 and .7513 respectively. Required:
Which project should be accepted?
Ans: NPV = X = (18,264); Y = 41,458;
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EXPECTED NPV
Q. 9. A company is considering two mutually exclusive projects X and Y. Project X costs
` 3,00,000 and project Y ` 3,60,000. You have been given below the NPV and probability
distribution for each project:
Project X Project Y
NPV estimate (`) Probability NPV estimate (`) Probability
30,000 0.1 30,000 0.2
60,000 0.4 60,000 0.3
1,20,000 0.4 1,20,000 0.3
1,50,000 0.1 1,50,000 0.2
Required:
1. Compute the expected NPV of projects X and Y.
2. Compute the risk attached to each project i.e., Standard Deviation of each probability
distribution.
3. Which project do you consider riskier?
4. Compute the profitability index of each project. (JUNE 2014)
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RISK ADJUSTED DISCOUNT RATE
Q. 10.
Investment 100 lakhs
Risk free rate of return 7%
Risk premium 7%
Life of project 5 years
Year Cash inflows in lakhs
1 25
2 60
3 75
4 80
5 65
Calculate NPV by using risk adjusted discount rate.
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Q. 11. Determine the risk adjusted NPV of the following projects:
A B C
Net cash outlays (`) 1,00,000 1,20,000 2,10,000
Project life 5 years 5 years 5 years
Annual cash inflow (`) 30,000 42,000 70,000
Coefficient of variation .4 .8 1.2
The company selects the risk-adjusted rate of discount on the basis of the co-
efficient of variation:
Coefficient of variation Risk adjusted rate of Present value factor 1 to
discount 5 years at risk adjusted
rate of discount
0 10% 3.791
.4 12% 3.605
.8 14% 3.433
1.2 16% 3.274
1.6 18% 3.127
2 22% 2.864
More than 2 25% 2.689
Ans: NPV = A = 8,150; B = 24,186; C = 19,180;
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SENSITIVITY ANALYSIS
Q. 12. Investment ` 1,00,000, Life 3 years, Annual cash inflows ` 2,00,000, Annual cash
outflows ` 1,50,000, Appropriate Discount rate 10%.
Analyze the sensitivity of different variables with respect to the NPV.
Ans: Sensitivity = Initial investment = 24.3%; Net cash inflow = 19.55%; Life =
21.67%; Discount rate = 23.4%;
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Q. 13. The following forecast are made about a proposal which is being evaluated by a
firm.
Initial outflow ` 12,000
Life 4 years
Cash inflows ` 4,500 (annual)
Ke 14%
PVAF (14%, 4Y) 2.9137
Analyze the sensitivity of different variables with respect to the NPV.
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Q. 14. The following forecast are made about a proposal which is being evaluated by a
firm.
Initial outflow ` 2,00,00,000
Life 5 years
Annual Cash inflows ` 60,00,000
Ke 10%
PVAF (10%, 5Y) 3.791
11% 3.696
Analyze the sensitivity of Initial cash outflow, annual cash inflow and cost of capital. To
which of the 3 factors, the project is most sensitive if the variable is adversely affected
by 10%.
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