Probability Technique

13th October 2021 0 By indiafreenotes

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.