by Probability technique refers to each event of future happenings are assigned with relative frequency probability. Probability means the likelihood of future event. The cash inflows of the future years further discounted with the probability. The higher present value may be accepted.
The most significant information is the prediction of future cash flows. No doubt a single figure is desired for a particular period which may be regarded as the best estimates most likely forecast for the period. But if only one figure is considered certain queries will arise before us.
Subjective Probability:
The objective probability referred to above is not widely used in capital budgeting decisions since the decisions are non-repetitive and hardly performed under independent identical conditions. That is why, at present, another view is being considered which is known as personal or subjective probabilities.
A Personal or Subjective Probability is based on personal judgement as there is no large number of independent and identical observations.
Objective Probability:
According to Classical Probability Theory, when the happening or non-happening of an event can be repeatedly performed over a very long period of time under independent and identical conditions, the probability estimates depending on a very large number of observations is called Objective Probability.
Two mutually exclusive investment proposals are being considered. The following information in available.
| Project A (Rs.) | Project B (Rs.) | |
| Cost | 10,000 | 10,000 |
| Cash inflows Year | Rs. | Probability | Rs. | Probability |
| 1 | 10,000 | .2 | 12,000 | .2 |
| 2 | 18,000 | .6 | 16,000 | .6 |
| 3 | 8,000 | .2 | 14,000 | .2 |
Assuming cost of capital at (or) advise the selection of the project:
Solution
Calculation of net project values of the two projects.
Project A
| Yr | P.V. Factor @ 10 % | Cash Inflow | Probability | Monetary Value | Present Value Rs. |
| 1 | 0.909 | 10,000 | .2 | 2,000 | 1,818 |
| 2 | 0.826 | 18,000 | .6 | 10,800 | 8,921 |
| 3 | 0.751 | 8,000 | .2 | 1,600 | 1,202 |
Total Present value = 11,941
Cost of Investment = 10,000
Net present value = 1,941
Project B
| Year | P.V. Factor @ 10 % | Cash Inflow | Probability | Monetary Value | Present Value Rs. |
| 1 | 0.909 | 12,000 | .2 | 2,400 | 2,182 |
| 2 | 0.826 | 14,000 | .6 | 8,400 | 6,938 |
| 3 | 0.751 | 14,000 | .2 | 2,800 | 2,103 |
Total present value = 11,223
Cost of investment = 10,000
Net present value = 1,223
As net present value of project A is more than that of project B after taking into consideration the probabilities of cash inflows project A is more profitable one.
