Q1 What are the issues that need to be considered by an Indian Investor and incorporated within the Net Present Value (NPV) Model for the evaluation of Foreign Investment Proposals?
Answer:
Following are the issues that need to be considered in NPV Model for evaluation of foreign investment proposals:
Taxes on Income associated with foreign projects
a. Heavy Indirect Taxes
b. Difference in definition of taxable income from country to country
c. Tax treaties entered into with different countries
Political Risks:
a. Risk of seizure of property
b. Risk of nationalization of industry without paying full compensation
c. Restrictions on employment of foreign managerial personnel
d. Restrictions on imports of raw material
Economic Risk:
a. Fluctuation in Exchange Rates
b. Inflation
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Q2 Distinguish between Net Present Value and Internal Rate of Return.
Answer:
Q3 Write short note on Certainty Equivalent Approach.
Answer:
✓ CE is an approach for dealing with risk in capital budgeting to reduce the forecasts of cash flows to some conservative level.
✓ One of the ways of incorporating risk is Certainty Equivalent Method, where in the expected cash flows are adjusted to reflect the project risk.
✓ The cash flows are brought down because higher the risk less is the probability of those cash flows being certain.
✓ The certainty equivalent approach adjusts future cash flows rather than discount rate.
✓ Certainty equivalent coefficient lies between 0 and 1.
✓ CE coefficient of 1 indicates that the cash flow is certain or there is no risk.
Q4 What is Sensitivity Analysis in Capital Budgeting?
Answer:
✓ Sensitivity analysis is used in Capital Budgeting for measuring the risk.
✓ It helps in assessing information as to how sensitive are the estimated parameters of the project such as cash flows, discount rate, and the projects life to the estimation errors.
✓ It answers questions like:
i) What happens to the present value if cash flows are, say Rs. 50000 than the expected Rs. 80,000?
ii) And what will happen to NPV if economic life of the project is only 3 years rather than expected 5 years?
✓ Sensitivity analysis involves three steps:
i) Identification of all those variables having an influence on the projects NPV or IRR.
ii) Definition of the underlying quantitative relationship among the variables.
iii) Analysis of the impact of the changes in each of the variables on the NPV of the project.
✓ In Sensitivity Analysis, decisionmaker always asks himself the question – What IF?
Q5 Write short note on Social Cost Benefit Analysis.
Answer:
✓ Cost-benefit analysis is a process for evaluating the merits of a particular project or course of action in a systematic and rigorous way.
✓ Social cost-benefit analysis refers to cases where the project has a broad impact across
✓ It should therefore be emphasized that the costs and benefits considered by (social) `cost- benefit’ analysis are not limited to easily quantifiable changes in material goods, but should be construed in their widest sense, measuring changes in individual `utility’ and total `social welfare’ (though economists frequently ex-press those measures in money-metric terms).
✓ It should therefore be emphasized that the costs and benefits considered by (social) `cost- benefit’ analysis are not limited to easily quantifiable changes in material goods, but should be construed in their widest sense, measuring changes in individual `utility’ and total `social welfare’ (though economists frequently ex-press those measuresin money-metric terms).
✓ In its essence cost-benefit analysis is extremely, indeed trivially, simple: evaluate costs C and benefits B for the project under consideration and proceed with it if, and only if, benefits match or exceed the costs.
✓ Cost-Benefit Analysis(CBA) estimates and totals up the equivalent money value of the
benefits and costs to the community of projects to establish whether they are worthwhile. These projects may be dams and highways or can be training programs and health care systems.
Q6 What is Capital Rationing?
Answer:
✓ Capital Rationing means the utilization of existing funds in most profitable manner by selecting the acceptable projects in the descending order or ranking with limited available funds.
✓ The firm must be able to maximize the profits by combining the most profitable proposals.
✓ Capital rationing may arise due to external factors(hard capital rationing) such as high
borrowing rate and internal factors(soft capital rationing) such as limits imposed by
management on spending of funds.
✓ Either the internal rate of return method or the net present value method may be used in ranking investments.
✓ Where there is a multi period capital rationing linear programming techniques should be used to maximize NPV.
Q7 Write short note on Risk Adjusted Discount Rate.
Answer:
✓ RADR, where the various project risks are dealt with by changing the discount rate.
✓ The project having
i) average risk is discounted at the organization's cost of capital,
ii) higher risk is discounted at the rate higher than the cost of capital,
iii) low risk is discounted at the rate lower than the cost of capital.
✓ Here discount rate is adjusted to incorporate the risk of the project
✓ RADR when underlying consideration is Risk Premium
rk = if + n + dk
Where,
if = risk free rate of interest, n = adjustment for firms normal risk, dk = risk premium
✓ RADR when underlying consideration is Risk Factor
rk = if + (Ke − if) x Risk Factor
Where, Ke = Cost of equity of the firm
Q8 Distinguish between Risk Adjusted Discounted Rate (RADR) and Certainty Equivalent Approach (CEA).
Answer:
Q9 What is hard and soft capital rationing?
Answer:
Hard Capital Rationing: When the external environment imposes a condition as to availability of financial resources for a firm to deploy on its capital projects, the resulting paucity of capital forces rationing of the resources to deserving projects. This situation is called hard capital rationing. External capital rationing is nothing but the hard capital rationing.
Soft Capital Rationing: Sometimes restrictions are imposed by the executive board of the company, even though funding is available from the external environment. Such situation iscalledasthesoftcapitalrationing.Internalcapitalrationingisnothingbutsoftcapitalrationing.
Q10 What are the Steps in Simulation Analysis?
Answer:
1. Modeling the project: The model shows the relationship of NPV with parameters and exogenous variables.
2. Specify values of parameters and probability distributions of exogenous variables.
3. Select a value at random from probability distribution of each of the exogenous variables.
4. Determine NPV corresponding to the randomly generated value of exogenous variables and pre specified parameter variables.
5. Repeat steps (3) & (4) a large number of times to get a large number of simulated NPVs.
6. Plot frequency distribution of NPV.
Q11 Many companies calculate the internal rate of return of the incremental after -tax cash-flows from financial leases. What problems do you think this may give rise to? To what rate should the internal rate of return be compared? Discuss.
Answer:
Main problems faced in using Internal Rate of Return can be enumerated as under:
(1) The IRR method cannot be used to choose between alternative lease bases with different lives or payment patterns.
(2) If the firms do not pay tax or pay at constant rate, then IRR should be calculated from the lease cash-flows and compared to after-tax rate of interest. However, if the firm is in a temporary non-tax paying status, its cost of capital changes over time, and there is no simple standard of comparison.
(3) Another problem is that risk is not constant. For the lessee, the payments are fairly riskless and interest rate should reflect this. The salvage value for the asset, however, is probably much riskier. As such two discount rates are needed. IRR gives only one rate, and thus, each cash-flow is not implicitly discounted to reflect its risk.
(4) Multiple roots rarely occur in capital budgeting since the expected cash–flow usually changes sign once. With leasing, this is not the case often. A lessee will have an immediate cash inflow, a series of outflows for a number of years, and then an inflow during the terminal year. With two changes of sign, there may be, in practice frequently two solutions for the IRR.
Q12 How would standard deviation of the present value distribution help in Capital Budgeting decisions?
Answer:
Standard deviation is a statistical measure of dispersion; it measures the deviation from a central number i.e. the mean.
In the context of capital budgeting decisions especially where we take up two or more projects giving somewhat similar mean cash flows, by calculating standard deviation in such cases, we can measure in each case the extent of variation. It can then be used to identify which project is least riskier in terms of variability of cash flows.
A project, which has a lower coefficient of variation will be preferred if sizes are heterogeneous. Besides this, if we assume that probability distribution is approximately normal we are able to calculate the probability of a capital budgeting project generating a net present value less than or more than a specified amount.
Q13 Write short notes on Real Options in Capital Budgeting.
Answer:
Real options are the options companies have when making capital investment decisions. A company has the option to invest in such a project but can delay the decision. It can also put an existing operation on hold; it can expand an investment or reduce it.
The traditional analytical methods of project evaluation (IRR,NPV etc.) assume managements passive commitment to a certain operating strategy, viz. initiate the project immediately and operate it continuously at a set scale until the end of its pre specified expected useful life. These methods typically ignore the synergistic effects that an investment project can create. Sometimes the performance of one project will allow you to perform a second project that would not have been possible without the first (e.g. many research and development projects). Similarly, there could be significant value in waiting for additional information that could make an impact on the success of a project. Therefore the existing analytical methods usually underestimate investment opportunities because they ignore management’s flexibility to alter decisions as new information becomes available.
The real option methodology is an approach to capital budgeting that relies on option pricing theory to evaluate projects. Insights from option based analysis can improve estimates of project value and therefore has potential in many instances to significantly enhance project management. However Real Options approach is intended to supplement, and not replace, capital budgeting analysis based on standard DCF methodologies.
✓ Goods & Services: social gain/losses from outputs and inputs of a project are measured by the willingness of the consumers to pay for the goods.
Answer:
✓ Goods & Services: social gain/losses from outputs and inputs of a project are measured by the willingness of the consumers to pay for the goods.
✓ Labor : Social cost of labor is lower than market wage because of massive un/under employment along with traditions, changes in life style etc. Removal of labor from farms should not cause reduction in agricultural output as other members work harder to offset the loss. Employing labor on nonfarm activities is costless. Shadow wage is zero.
✓ Foreign Exchange: Existence of extensive trade controls leads to official undervaluation of foreign exchange. Official exchange rate understates the benefit of exports and costs of imports in terms of domestic resources. An upward adjustment is necessary.
✓ Social Rate of Discount: Market rate of interest does not reflect society’s preference for current consumption over future consumption. Choice of social discount rate is based on value judgment about weights to be attached to the welfare of future generations compared to that of present generations.
✓ Shadow Price of Investment: Society as a whole gives importance to future generations than that accorded by private decisionmakers. Imperfections of capital markets lead to less than optimal total investment.
Q15 Distinguish between Financial Options and Real Options
Answer:
Q16 Comment briefly on social cost benefit analysis in relation to evaluation of an industrial project.
Answer:
Social Cost-Benefit Analysis of Industrial Projects: This refers to the moral responsibility of both PSU and private sector enterprises to undertake socially desirable projects – that is, the social contribution aspect needs to be kept in view.
Industrial capital investment projects are normally subjected to rigorous feasibility analysis and cost benefit study from the point of view of the investors. Such projects, especially large ones often have a ripple effect on other sections of society, local environment, use of scarce national resources etc. Conventional cost-benefit analysis ignores or does not take into account or ignores the societal effect of such projects. Social Cost Benefit (SCB) is recommended and resorted to in such cases to bring under the scanner the social costs and benefits.
SCB sometimes changes the very outlook of a project as it brings elements of study which are unconventional yet very relevant. In a study of a famous transportation project in the UK from a normal commercial angle, the project was to run an annual deficit of more than 2 million pounds. The evaluation was adjusted for a realistic fare structure which the users placed on the services provided which changed the picture completely and the project got justified. Large public sector/service projects especially in under-developed countries which would get rejected on simple commercial considerations will find justification if the social costs and benefits are considered.
SCB is also important for private corporations who have a moral responsibility to undertake socially desirable projects, use scarce natural resources in the best interests of society, generate employment and revenues to the national exchequer. Indicators of the social contribution include
(a) Employment potential criterion;
(b) Capital output ratio – that is the output per unit of capital;
(c) Value added per unit of capital;
(d) Foreign exchange benefit ratio.
Corporate actions.
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