Strategic Financial Management

Units as per Syllabus

1. Introduction and Ethical Aspects in SFM

2. Risk Analysis & Classification

3. Investment Decision and Project Cash Flows

4. Capital Budgeting Decisions

5. Expansion and Financial Re-structuring

6. Corporate Governance and Valuation

Capital Budgeting Decisions

• Capital budgeting decisions under uncertainty and risky

situations
• Concept of probability & expected value
• Certainty Equivalent approach,
• Simulation and Decision tree analysis,
• Sensitivity analysis,
• Replacement decisions,
• Effect of inflation on CB decisions (case study).
Capital Budgeting Decisions
Capital Budgeting is a process that businesses
undertake to evaluate potential major projects or
investments.
Investment Decision Under Risk and Uncertainty
1. Certainty (No Risk)-The estimated returns are equal to
the actual return.

2. Uncertainty- An uncertain situation in one when

probabilities of occurrence of a particular event are not
known. In the case of uncertainty, future loss cannot be
foreseen. So, it cannot be planned in advance by
management

3.Risk- A risky situation is one in which the probabilities of a

particular event’s occurrence are known. In the case of risk,
chance of future loss can be foreseen due to past
experiences.
Concept of probability & expected value

• A probability is a number that reflects the chance or

likelihood that a particular event will occur. Probabilities
can be expressed as proportions that range from 0 to 1,
and they can also be expressed as percentages ranging
from 0% to 100%.
• In probability theory, the expected value is the mean of
the possible values of a random variable, weighted by
the probability of each outcome. It's a way to
summarize the information in a random variable into a
single numerical value.
The formula for expected value is:
EV: The expected value
P(X): The probability of the event
n: The number of repetitions of the
event
 TECHNIQUES OF CAPITAL BUDGETING
The main techniques of decision making under the
conditions of risk and uncertainty:

1.Risk-adjusted discount rate

2.Certainty equivalent method or approach

3.Statistical Methods
 Risk-adjusted discount rate

In this approach a risk premium is

added to the risk free discount rate.
Risk adjusted discount rate is then used
to calculate Net Present Value (NPV)in
the normal manner.
Risk-adjusted discount rate
 Risk-adjusted discount rate

An Investment project will cost Rs. 50,000

initially and it is expected to generate Cash
Flows through 1 to 4 years of Rs. 25,000,
Rs. 20,000, Rs. 10,000 and Rs. 10,000.
Assume risk free rate of 10% and Calculate
Risk Adjusted NPV (RANPV)
• If the project is risky and perceived to be 5%
over normal risk free rate.
 Concept of Cost of Capital

• Cost of Capital is the Minimum expected returns from an

investment. Also termed as Hurdle Rate
1. Type of Capital
2. Type of Project
3. Financial Policy of the Firm
4. Market Condition – Investment Opportunities
Opportunity cost is the returns foregone on the next best
alternative investment opportunity of comparable risk.
 Cost of Capital

• Risk Adjusted Discount Rate (E(ri)

 Certainty Equivalent method or approach

In this approach the forecasted cash

flows are reduced to some conservative
level considering the risk involved.

Certainty Equivalent Coefficient

Certain Net Cash Flow div by Risky net
Cash Flow
 Certainty Equivalent method or approach

A project costs ₹. 6000 and it has a

cash flow of ₹. 4000, 3000, 2000 and
1000 in the years 1 through 4. Assume
that the associated Certainty
Coefficients = 0.90, 0.70, 0.50 and 0.30
for years 1 to 4 respectively. The Risk
free discount rate is 10%. Find NPV.
Statistical Methods

a) Standard deviation method

b) Coefficient of variation method
c) Sensitivity analysis
d) Simulation method
e) Probability and expected value method
f) Decision Tree analysis
Certainty Equivalent Approach
There are two projects A and B. Each involves an
investment of Rs. 80000. The expected cash inflows and
the certainty coefficients are as follows:
Year Project A Project B
Certainty Cash Certainty
Cash Inflow
Coefficient Inflow Coefficient
1 50000 0.8 40000 0.9
2 40000 0.7 60000 0.8
3 40000 0.9 40000 0.7

Risk free cut off rate is 10%. State which project is better
and why?
SD and Coefficient of variance
SD and Coefficient of variance
 Sensitivity Analysis
• The financial manager of XL Foods Company is considering
the installation of a Plant costing ₹ 1 Cr to increase it’s
processing capacity. The expected values of the underlying
variables are given below:
1 Investment (₹ ‘000) 14,000
2 Sales Volume I, V (Units ‘000) 1,000
3 Unit Selling Price (UPS ₹) 20
4 Unit Variable Cost (UVC ₹) 10
5 Annual Fixed Costs FC (‘000) 5,000
6 Depreciation at Straight Line (‘000) 2,000
7 Corporate Tax rate 30%
8 Discount Rate, k 12%
• The following table provides the cash flows over the
expected project life of seven years under 3 different
assumed conditions:
Variable Pessimistic Expected Optimistic
Volumes (‘000) 850 1000 1,150
Unit Selling Price 17 20 23
(₹)
Unit Variable Cost 11.50 10 8.50
(₹)
Annual FC (‘000) ₹ 5750 5000 4250

Salvage value is Zero.

Compare NPVs using Sensitivity Analysis
Sensitivity to Volume
Expected Pessimisti Optimistic
c
Volume (‘000) 1000 850 1,150
Unit Selling Price 20 20 20
Less: Variable Cost 10 10 10
Contribution 10 10 10
Total Contribution (‘000) 10,000 8,500 11,500
Less FC (‘000) 5,000 5,000 5,000
PBT (‘000) 5,000 3,500 6,500
Less Tax @ 30% 1500 1,050 1,950
(PBT*0.3)
Profit After Tax (‘000) 3500 2,450 4,550
Add Savings from Depn 600 600 600
2000*30% (‘000)
Net Cash Flows (‘000) 4,100 3,050 5,150
Discount Factor 1-7 yrs 4.564 4.564 4.564
PV CF 18,712 13,920.2 23,505
Less Initial CF 14,000 14,000 14,000
Sensitivity to USP
Expected Pessimisti Optimistic
c
Volume (‘000) 1000 1000 1,000
Unit Selling Price 20 17 23
Less: Variable Cost 10 10 10
Contribution 10 7 13
Total Contribution (‘000) 10,000 7000 13000
Less FC (‘000) 5,000 5000 5000
PBT (‘000) 5,000 2000 8000
Less Tax @ 30% 1500 600 2400
(PBT*0.3)
Profit After Tax (‘000) 3500 1400 5600
Add Savings from Depn 600 600 600
2000*30% (‘000)
Net Cash Flows (‘000) 4,100 2000 6200
Discount Factor 1-7 yrs 4.564 4.564 4.564
PV CF 18,712 9128 28297
Less Initial CF 14,000 14000 14000
Sensitivity to UVC
Expected Pessimisti Optimistic
c
Volume (‘000) 1000 1000 1,000
Unit Selling Price 20 20 20
Less: Variable Cost 10 11.5 8.5
Contribution 10 8.5 11.5
Total Contribution (‘000) 10,000 8500 11500
Less FC (‘000) 5,000 5000 5000
PBT (‘000) 5,000 3500 6500
Less Tax @ 30% 1500 1050 1,950
(PBT*0.3)
Profit After Tax (‘000) 3500 2,450 4,550
Add Savings from Depn 600 600 600
2000*30% (‘000)
Net Cash Flows (‘000) 4,100 3,050 5,150
Discount Factor 1-7 yrs 4.564 4.564 4.564
PV CF 18,712 13,920.2 23,505
Less Initial CF 14,000 14,000 14,000
Sensitivity to FC
Expected Pessimisti Optimistic
c
Volume (‘000) 1000 1000 1,000
Unit Selling Price 20 20 20
Less: Variable Cost 10 10 10
Contribution 10 10 10
Total Contribution (‘000) 10,000 10,000 10,000
Less FC (‘000) 5,000 5750 4250
PBT (‘000) 5,000 4250 5750
Less Tax @ 30% 1500 1275 1725
(PBT*0.3)
Profit After Tax (‘000) 3500 2975 4025
Add Savings from Depn 600 600 600
2000*30% (‘000)
Net Cash Flows (‘000) 4,100 3575 4625
Discount Factor 1-7 yrs 4.564 4.564 4.564
PV CF 18,712 16316 21109
Less Initial CF 14,000 14000 14000
Scenario Analysis

A Company has developed the following cash flow

forecast for their new Project.
₹ in million
Year 0 Year 1 - 10

Initial Investment (400)

Sales 440
Variable Costs (75% of Sales) 330
Fixed Cost 20
Depreciation (SLM) 40
PBT 50
Taxes @ 20%
The range of values that variables can take under three
scenarios: Pessimistic, Expected and Optimistic are as
below:
₹ in million
Pessimistic Expected Optimistic

Initial Investment 420 400 360

Sales 350 440 500

Variable Costs (as a % of

80% 75% 70%
Sales)

Fixed Cost 25 20 18
Cost of Capital (%) 11 10 9

What will be the NPVs under the different scenarios

 ₹ in
Millions
Expected Pessimistic Optimistic
Initial Investment (400) (420) (360)
Sales 440 350 500
Less: Variable Cost (% of Sales 330 280 350
Contribution 110 70 150
Less FC 20 25 18
Less Depn (SLM) 40 42 36
PBT 50 3 96
Less Tax @ 20% (PBT*0.2) 10 0.6 19.2
Profit After Tax 40 2.4 76.8
Add Depn 40 42 36
Net Cash Flows 80 44.6 112.8
Discount Rate 10% 11 9
Discount Factor 1-10 yrs 6.1446 5.8892 6.4177
PV CF 491.57 262.66 723.92
Less Initial CF 400 420 360
NPV 91.57 -157.34 363.92
Intial investment 80,000
life time of the project 10 years
Discount rate 15%
variable costs 54000
fixed cost 12000
tax 40%
Depreciation 12000
consider five different scenarios denoted as Excellent, Good, Normal, Bad and Worst. Under each of these
scenarios following variables changes
Basis Excellent Good Normal Bad Worst
Demand Level 10% (+) 5% (+) 30000 5% (-) 10% (-)
SP per unit 5% (+) 5% (+) 3.2 5% (-) 10% (-)
over heads 5% (-) 5% (-) 12000 10% (+) 20% (+)
Variable 54000

If probability of the above scenarios are as follows 15%, 20%, 30%, 20%, and 15% respectively, what is
the expected NPV?
Particulars Excellent Good Normal Bad Worst
Initial Investment (₹) 80,000 80,000 80,000 80,000 80,000
No of units produced 33000 31500 30000 28,500 27,000
Selling Price per Init 3.36 3.36 3.2 3.04 2.88
Sales value (units*sp) 1,10,880 1,05,840 96,000 86,640 77760
Less: Variable cost 59,400 56,700 54,000 51,300 48,600
Contribution 51,480 49,140 42,000 35,340 29,160
Less: fixed cost 11,400 11,400 12,000 13,200 14,400
CFBIT 40,080 37,740 30,000 22,140 14,760
Less Tax @ 40% 16032 15096 12,000 8,856 5,904
CFAT 24048 22,644 18,000 13,284 8,856
Add Tax Savings on 4800 4800 4,800 4800 4800
Depn 28,848 27,444 18,084
22,800 13,656
Annual Net Cash Flows 15%
Discount Rate 15% 15% 5.0188 15% 15%
Discount Factor 1-10 yrs 5.0188
1,44,782.3 5.0188 5.0188
90759.98 5.0188
68536.73
PV CF 4 1,37,735.9 1,14,428.6
80,000
Less Initial CF 80,000 5
80,000 4 80,000 80,000
64,782.34 57,735.95 34,428.64 10,759.98 -11,463.27
 Expected NPVs

Particulars Excellent Good Normal Bad Worst

NPV 64,782.34 57,735.95 34,428.64 10,759.98 -11,463.27
Probability for scenario 0.15 0.2 0.3 0.2 0.15
Expected NPV 9717.35 11547.18 10329.96 2151.96 -1719.49
Simulation method

• The Monte Carlo simulation or simply the simulation

analysis considers the interactions among
variables and probabilities of the change in
variables.

• It computes the probability distribution of NPV.

Simulation method

The simulation analysis involves the following steps: –

First, you should identify variables that influence cash

inflows and outflows.

Second, specify the formulae that relate variables. –

Third, indicate the probability distribution for each

variable. –

Fourth, develop a computer programme that randomly

selects one value from the probability distribution of each
variable and uses these values to calculate the project’s
Simulation
Calculate Cumulative Probabilities
Calculate Random No. intervals
 Simulation
The new machine is having a cost of Rs. 40,000 and the scrap
value of the old machine is estimated to be Rs. 14000. Evaluate
the proposal given that the discount factor is 14%. Analyze the
risk inherent in this situation by simulating the NPV values.
Random numbers for 4 sets of cash flows are given hereunder.
On the basis of simulation exercise, also find out the expected
NPV and the probability that the NPV of the proposal will be less
Random Numbers for the cash
than 0. flows are as follows:
Year 1 Year 2 Year 3
Set Set Set Set Set
Cash Cash Cash Yr
P
P P 1 2 3 4 5
Flows Flows Flows
6000 0.3 6000 0.1 6500 0.3 1 4 5 6 0 4
8000 0.4 11000 0.2 10500 0.5 2 2 0 8 1 2
9500 0.3 16000 0.4 15750 0.2
3 7 0 4 3 7
22000 0.3
 Calculate Random No. intervals
Year 1 Year 3

Cumulative Random No.

CF Cumulative Random No.
Probability Interval CF
Probability Interval
6000 0.3 0-2
6500 0.3 0-2
8000 0.7 3-6
10500 0.8 3-7
9500 1.00 7-10
15750 1.00 8-10
Year 2

Cumulative Random No.

CF
Probability Interval
6000 0.1 0

11000 0.3 1-2

16000 0.7 3-6

22000 1.00 7-10

 Simulation Trials
Runs Year 1 Year 2 Year 3 NPV
Random Random
Value Value Random No. Value
No. No.
4 8000 2 11000 7 10,500
1 -3430.4

2 5 8000 0 6000 0 6500 -9977.9

3 6 8000 8 22000 4 10,500 5034.1

4 0 6000 1 11000 3 10500 -5184.8

5 4 8000 2 11000 7 10500 -3430.4

Considering 4 out of 5 times run the NPV is negative, the new machine is not
recommended.
 Decision Tree Analysis
Decision tree analysis is a method for
• visualizing the potential outcomes of a decision
• by creating a flowchart or graph.

It's a useful tool for making better decisions, and can be

used in many areas, including project management,
budget planning, and operations
Decision Tree Analysis
A company is considering buying an equipment for a new process. The equipment will
cost Rs 2,45,700. The company has made the following estimates of the after-tax cash
flows over the equipment's possible life of two years:
Year 1 Year 2
NCF Prob. NCF Prob.
153,500 0.5 122,800 0.7
184,300 0.3
125,000 0.5 240,500 0.4
307,000 0.6
The outcome of year 2 is dependent on the outcome of year 1. Use a decision tree
approach to answer the following questions (assume 12 per cent discount rate):
(a) What is the equipment’s expected net present value?
(b) If the worst outcome occurs, then what would be the project’s net present value?
(c) What net present value will be realised if the best outcome occurs? What is its
probability?
 Year 0 Year 1 Year 2 Paths Joint Probability

1,22,80 1 0.35
0.7 0
1,53,500
0.5 0.3
1,84,30 2 0.15
-2,45,700 0
2,40,50 3 0.20
0.4 0
0.5
1,25,000

0.6 3,07,00 4 0.30

0
1.00

Construction of Decision Tree

 Computation of NPV for each Path and ENPV
@12% Disc Rate

Pat PV of 1st Yr PV of 2nd Yr PV CF NPV Sum of

Joint Prob
h CF CF A+B PVCF- ENPV
C
A B Initial NPVxC
1 1,37,060 97,896 2,34,956 -10744 0.35 -3760

2 1,37,060 1,46,924 2,83,984 38284 0.15 5743

3 1,11,612.5 1,91,727 3,03,339 57639 0.20 11528

4 1,11,612.5 2,44,740 3,56,353 1,10,653 0.30 33196

Expected NPV 46706

PV Factor @ 12% 1 yr =
0.8929
2 yr =
0.7972
 Replacement Decision
• An existing company has a machine which has been in operation
for two years, its estimated remaining life is 4 years with no
residual value in the end. Its current market value is 3 lakhs. The
management is considering a praposal to purchase a new
machine which givesParticulars
increased output. The details areNew
Existing asMachine
under:
Machine
Purchase Price 6,00,000 10,00,000
Estimated life 6 years 4 years
Residual value 0 0
Annual operating days 300 300
Operating hours per day 6 6
Selling prise per unit 10 10
Material Cost per unit 2 2
Output per hour in units 20 40
Labour cost 20 30
Fixed O/H excluding depn 100000 60000
• Assume Cost of Capital = 10% and company uses
written down value of depn at 20%.
• Advise replacement decision to the management.
 Effect of Inflation on CB decisions

• Inflation in capital budgeting

1. Nominal Cash Flow
2. Real Cash Flows
3. Nominal Discount Rate (NDR)
4. Real Discount Rate (RDR)
• Initial outlay of 24 Lakhs, Life 4 years. Annual PBDT ₹. 10
Lakhs, Tax rate 40%, Inflation rate 5%, Real Discount rate
(Cost of capital) 10%.

Calculate NPV assuming depreciation is charged on SLM.