1. • All the techniques of capital budgeting require
the estimation of future cash inflow and
outflows.
• The future cash flow are estimated based on
the following factors
– Expected economic life of the project, salvage
value, selling price of the project, capacity of the
project, production cost, depreciation cost, rate of
taxation and future demand of the product

2. Methods for measuring risk in capital
budgeting
• Risk adjusted cut off rate method/varying
discount rate method
• Certainty equivalent method
• Sensitivity technique
• Probability technique
• Standard deviation method
• Co-efficient of variation method
• Decision tree analysis

3. Measurement of risk
• Risk adjusted cut off rate/method of varying
discount rate:
– Projects which are more risky and greater
variability in returns should be discounted at
higher rate, than with less risky projects with less
returns.
– Discount rate is the minimum
Desired rate of return.
it is generally the cost of capital
of the firm

4. • Beta company ltd is considering the purchase of a
new investment. Two alternative investments are
available (A and B) each costing Rs 100,000. The
company has a target return on capital of 10%. Risk
premium rates are 2% and 8% respectively for
investment A and B. Which invt should be preferred.
Cash inflows are expected to be as follows.
• Cash flows
YR Investment A Investment B
1 40000 50000
2 35000 40000
3 25000 30000
4 20000 30000

5. Certainty equivalent method
• It is to reduce expected cash flow by certain
amounts.
• It can be employed by multiplying the
expected cash flows by certainty equivalent
co- efficient as to convert the uncertain cash
flows to certain cash flows.

6. • There are two projects X and Y. Each involves
an investment of Rs40000. The expected cash
inflows and the certainty coefficients are as
under. Risk free cut off rate is 10%. Suggest
which of the two projects should be preferred.
Project X Project Y
Yr Cash Certainty Cash Certainty
Inflow coefficient inflow coefficient
1 25000 .8 20000 .9
2 20000 .7 30000 .8
3 20000 .9 20000 .7

7. Sensitivity technique
• When cash inflows are very sensitive under
different circumstances, more than one forecast
of the future cash inflows can be made.
• Inflows may be regarded as “Optimistic, Most
likely and Pessimistic”.
• The cash inflows may be discounted to find NPV,
and if NPV differs widely in three different
situation, then there is a great risk in project and
the investors decision to accept or reject a project
will depend upon his risk bearing abilities.

8. • Mr.Risky is considering two mutually exclusive
projects A and B. You are required to advise
him about the acceptability of the projects
from the following information. The cut off
rate may be assumed to be 15%
Project A Project B
Cost of the investment 50000 50000
Forecast cash inflow p.a for
5 yr:
Optimistic 30000 40000
Most likely 20000 20000
Pessimistic 15000 5000