Tag: Workforce Diversity BMS Notes

Economic value added

Economic value added (EVA) is a measure of a company’s financial performance based on the residual wealth calculated by deducting its cost of capital from its operating profit, adjusted for taxes on a cash basis. EVA can also be referred to as economic profit, as it attempts to capture the true economic profit of a company.

As part of fundamental analysis, economic value added is an estimate of a firm’s economic profit, or the value created in excess of the required return of the company’s shareholders. EVA is the net profit less the capital charge for raising the firm’s capital. The idea is that value is created when the return on the firm’s economic capital employed exceeds the cost of that capital. This amount can be determined by making adjustments to GAAP accounting. There are potentially over 160 adjustments but in practice only several key ones are made, depending on the company and its industry.

EVA is the incremental difference in the rate of return (RoR) over a company’s cost of capital. Essentially, it is used to measure the value a company generates from funds invested in it. If a company’s EVA is negative, it means the company is not generating value from the funds invested into the business. Conversely, a positive EVA shows a company is producing value from the funds invested in it.

The formula for calculating EVA is:

EVA = NOPAT – (Invested Capital * WACC)

Where:

NOPAT = Net operating profit after taxes

Invested capital = Debt + capital leases + shareholders’ equity

WACC = Weighted average cost of capital

Total Market Value = Initial capital invested + Market value added

Market value added

Market value added (MVA) is the amount of wealth that a company is able to create for its stakeholders since its foundation. In simple terms, it’s the difference between the current market value of the company’s stock and the initial capital that was invested in the company by both bondholders and stockholders.

The market value added concept derives the difference between the market value of a business and the cost of the capital invested in it. When market value is less than the cost of invested capital, this implies that management has not done a good job of creating value with the equity made available to it by investors. Conversely, when market value is greater than the cost of invested capital, it indicates that company operations are well run.

Market value added (MVA) is the difference between the current market value of a firm and the capital contributed by investors. If MVA is positive, the firm has added value. If it is negative, the firm has destroyed value. The amount of value added needs to be greater so than the firm’s investors could have achieved investing in the market portfolio, adjusted for the leverage (beta coefficient) of the firm relative to the market.

Market value added (MVA) is a calculation that shows the difference between the market value of a company and the capital contributed by all investors, both bondholders and shareholders. In other words, it is the market value of debt and equity minus all capital claims held against the company. It is calculated as:

MVA = V – K

Where:

MVA is market value added

V is the market value of the firm, including the value of the firm’s equity and debt

K is the capital invested in the firm

MVA is closely related to the concept of economic value added (EVA), representing the net present value (NPV) of a series of EVA values.

Shareholder value is a business term, sometimes phrased as shareholder value maximization or as the shareholder value model, which implies that the ultimate measure of a company’s success is the extent to which it enriches shareholders. It became prominent during the 1980s and 1990s along with the management principal value-based management or “managing for value“.

Shareholder value is the value delivered to the equity owners of a corporation due to management’s ability to increase sales, earnings, and free cash flow, which leads to an increase in dividends and capital gains for the shareholders.

A company’s shareholder value depends on strategic decisions made by its board of directors and senior management, including the ability to make wise investments and generate a healthy return on invested capital. If this value is created, particularly over the long term, the share price increases and the company can pay larger cash dividends to shareholders. Mergers, in particular, tend to cause a heavy increase in shareholder value.

The term “Shareholder value“, sometimes abbreviated to “SV“, can be used to refer to:

• The market capitalization of a company;
• The concept that the primary goal for a company is to increase the wealth of its shareholders (owners) by paying dividends and/or causing the stock price to increase (i.e. the Friedman doctrine introduced in 1970);
• The more specific concept that planned actions by management and the returns to shareholders should outperform certain bench-marks such as the cost of capital concept. In essence, the idea that shareholders’ money should be used to earn a higher return than they could earn themselves by investing in other assets having the same amount of risk.

Agency theory and shareholder value

Agency theory is the study of problems characterized by disconnects between two cooperating parties: a principal and an agent. Agency problems arise in situations where there is a division of labor, a physical or temporal disconnect separating the two parties, or when the principal hires an agent for specialized expertise. In these circumstances, the principal takes on the agent to delegate responsibility to him. Theorists have described the problem as one of “separation and control”, agents cannot be monitored perfectly by the principal, so they may shirk their responsibilities or act out of sync with the principal’s goals. The information gap and the misalignment of goals between the two parties results in agency costs, which are the sum of the costs to the principal of monitoring, the costs to the agent of bonding with the principal, and the residual loss due to the disconnect between the principal’s interests and agent’s decisions.

Value-based management

As a management principle, value-based management (VBM), or managing for value (MFV), states that management should first and foremost consider the interests of shareholders when making management decisions. Under this principle, senior executives should set performance targets in terms of delivering shareholder returns (stock price and dividends payments) and managing to achieve them.

The concept of maximizing shareholder value is usually highlighted in opposition to alleged examples of CEO’s and other management actions which enrich themselves at the expense of shareholders. Examples of this include acquisitions which are dilutive to shareholders, that is, they may cause the combined company to have twice the profits for example but these might have to be split amongst three times the shareholders. Although the legal premise of a publicly traded company is that the executives are obligated to maximize the company’s profit, this does not imply that executives are legally obligated to maximize shareholder value.

As shareholder value is difficult to influence directly by any manager, it is usually broken down in components, so called value drivers. A widely used model comprises 7 drivers of shareholder value, giving some guidance to managers:

• Revenue
• Operating Margin
• Cash Tax Rate
• Incremental Capital Expenditure
• Investment in Working Capital
• Cost of Capital
• Competitive Advantage Period

Maximum Permissible Banking Finance in Indian Banking Sector. MPBF is mainly a method of working capital assessment. As per the recommendations of Tandon Committee, the corporate is discouraged from accumulating too much of stocks of current assets and are recommended to move towards very lean inventories and receivable levels. This is where MPBF comes into picture. There are 2 methods for MPBF calculation.

Major recommendations of the Tandon committee were as follows:

Assessment of need-based credit of the borrower on a rational basis on the basis of their business plans.

Bank credit would only be supplementary to the borrower’s resources and not replace them, i.e., banks would not finance one hundred percent of borrower’s working capital requirement.

Bank should ensure proper end use of bank credit by keeping a closer watch on the borrower’s business, and impose financial discipline on them.

Working capital finance would be available to the borrowers on the basis of industry wise norms (prescribe first by the Tandon Committee and then by Reserve Bank of India) for holding different current assets, viz.

• Raw materials including stores and others items used in manufacturing process.
• Stock in Process.
• Finished goods.
• Accounts receivables.

Credit would be made available to the borrowers in different components like cash credit; bills purchased and discounted working capital, term loan, etc., depending upon nature of holding of various current assets.

In order to facilitate a close watch under operation of borrowers, bank would require them to submit at regular intervals, data regarding their business and financial operations, for both the past and the future periods.

MPBF Calculation: (Total Current Assets – Other Current Liabilities) – 25/100*(Total Current Assets – Other Current Liabilities)

Or MPBF = 75/100*Working Capital Gap

Depending on the size of credit required, two methods of maximum permissible banking finance are in practice to fund the working capital needs of the corporate.

MPBF Method I:

For corporate whose credit requirement is less than Rs.10 lakhs, banks can find the working capital required. Working capital is calculated as difference of total current assets and current liabilities other than bank borrowings (called Maximum Permissible Bank Finance or MPBF). Banks can finance a maximum of 75 per cent of the required amount and the rest of the balance has to come out of long-term funds.

MPBF = 75% of (Current assets – Current liabilities other than bank borrowings)

The borrowing firm should provide the remaining 25% from long-term sources.

The minimum current ratio under this method works out to 1: 1.

MPBF Method II:

For corporate with credit requirement of more than Rs.10 lakhs this method is used. In this method, the borrower finances minimum of 25% of its total current assets out of long-term funds. The rest will be provided by the bank through MPBF. Thus, total current liabilities inclusive of bank borrowings could not exceed 75% of current assets.

MPBF = (75% of Current assets) – (Current liabilities other than bank borrowings)

The borrowing firm should raise finance to the extent of 25% of current assets from long-term sources.

The minimum current ratio under this method works out to 1.33: 1.

MPBF Method III:

MPBF = [75% of (Current assets – Core current assets)] – Current liabilities other than bank borrowings

The borrower should contribute 100% core current assets and 25% of balance current assets from long-term sources.

A minimum current ratio under this method works out to above 1.5: 1.

Cost of issuing Commercial Paper

Commercial paper is a commonly used type of unsecured, short-term debt instrument issued by corporations, typically used for the financing of payroll, accounts payable and inventories, and meeting other short-term liabilities. Maturities on commercial paper typically last several days, and rarely range longer than 270 days.

Commercial paper is usually issued at a discount from face value and reflects prevailing market interest rates.

• Investments in such securities are made by institutional investors and high net worth individuals (HNI) directly & by others through mutual funds or exchange-traded funds (ETF).
• It is not meant for the general public, and hence, there is a restriction on the advertisement to market the securities. A secondary market also exists for commercial papers, but the market players are mostly financial institutions.
• It is issued at a discount to the face value, and upon maturity, the face value becomes the redemption value. It is issued in large denominations, e.g., $100,000.
• The maturity of commercial paper ranges from 1 to 270 days (9 months), but usually, it is issued for 30 days or less. Some countries also have a maximum duration of 364 days (1 year). The higher the duration, the higher, is the effective rate of interest on these papers.
• There is no need to register the papers with the Securities Exchange Commission (SEC), and hence, it helps in saving the administrative expenses
• and results in lesser filings.

As per the Uniform Commercial Code (UCC), commercial papers are of four kinds:

Draft: A draft is a written instruction by a person to another to pay the specified amount to a third party. There are 3 parties in a draft. The person who gives the instructions is called “drawer.” The person who is instructed is called “drawee.” The person who has to receive the payment is called the “payee.”

Check: This is a special form of the draft where the drawee is a bank. There are certain special rules which apply to a check. Hence this is considered to be a different instrument.

Note: In this instrument, a promise is made by one person to pay another a certain sum of money to another. There are 2 parties in a note. The person who makes the promise and writes the instrument is called “drawer” or “maker.” The person to whom the promise is made and to whom payment is to be made is called “drawee” or “payee.” It is also known as “promissory note.” In most instances, a commercial paper is in the form promissory note.

Certificates of Deposit (CD): A CD is an instrument wherein the bank acknowledges the receipt of deposit. Further, it also carries details about maturity value, interest rate, and maturity date. It is issued by the bank to the depositor. It is a special form of the promissory note. There are certain special rules which apply to a CD. Hence this is considered to be a different instrument.

Formula for Yield Commercial Paper:

Yield = (Face Value – Sale Price/ Sale Price) * (360/Maturity Period) * 100

There are two types of commercial papers:

Secured Commercial Papers: These are also known as Asset-backed commercial papers (ABCP). These are collateralized by other financial assets. These are normally issued by creating a Structured Investment vehicle that is set up by the sponsoring organization by transferring certain financial assets. These papers are issued to keep off the instruments from the financial statement of the sponsor organization. Further, the rating agencies rate the issue on the basis of the assets kept in the Structured Investment Vehicle, ignoring the asset quality of the sponsor. During the financial crisis, ABCP holders were one of the biggest loss-makers.

Unsecured Commercial Papers: These are also known as traditional commercial papers. Most of these papers are issued without any collateral, and hence, they are unsecured. The rating of the issue depends upon the asset quality and all other aspects relating to that organization. Rating is done in the same manner in which it is done for the bonds. These are not covered by the deposit insurance, e.g., Federal Deposit Insurance Corporation (FDIC) insurance in the U.S., and hence, investors obtain insurance from the market separately as a backup.

Benefits:

• No security is required.
• Interest rate is typically less than that required by banks or finance companies.
• Commercial paper dealer often offers financial advice.
• It is a simple instrument.
• Very less documentation between the issuer and the investor.
• It is flexible in terms of maturities of the underlying promissory note.
• It can be tailored to match the cash flow of the issuer.
• A good credit rated company can diversify its sources of finance from banks to the short-term money market at a cheaper cost.
• For the investors, higher returns obtained than if they invest their funds in any bank.
• For the companies, they are better known to the financial world and hence placed in a better position to borrow long-term funds in future.
• There is no limitation on the end-use of funds raised through commercial papers.
• They are highly liquid.

Cost of issuing Trade Credit

A trade credit is an agreement or understanding between agents engaged in business with each other that allows the exchange of goods and services without any immediate exchange of money. When the seller of goods or services allows the buyer to pay for the goods or services at a later date, the seller is said to extend credit to the buyer.

Trade credit is usually offered for 7, 30, 60, 90, or 120 days, but a few businesses, such as goldsmiths and jewelers, may extend credit for a longer period. The terms of the sale mention the period for which credit is granted, along with any cash discount and the type of credit instrument being used.

Invest means owning an asset or an item with the goal of generating income from the investment or the appreciation of your investment which is an increase in the value of the asset over a period of time. When a person invests, it always requires a sacrifice of some present asset that they own, such as time, money, or effort.

In finance, the benefit from investing is when you receive a return on your investment. The return may consist of a gain or a loss realized from the sale of a property or an investment, unrealized capital appreciation (or depreciation), or investment income such as dividends, interest, rental income etc., or a combination of capital gain and income. The return may also include currency gains or losses due to changes in the foreign currency exchange rates.

Low-Risk Investments

Low-risk investment plans, essentially are those in which there are approximately zero risks involved. These low-risk investment plans usually provide consistent and reliable growth of value, with minimal losses. Such types of investment include:

• Public Provident Fund (PPF)
• Post Office Monthly Income Schemes
• Senior Citizen Savings Scheme (SCSS)
• Employee Provident Fund (EPF)
• Sukanya Samriddhi Yojana
• Tax Saving FDs
• Sovereign Gold Bonds
• Life Insurance
• Bonds

Medium Risk Investments

Investments plans classified as medium or moderate risk options not only provide opportunities t avail of diversified and balanced investment returns but also help you accept a certain level of market volatility. These medium-risk investment options, thus help diversify your investment portfolio by including a mix of equity and debt instruments, which then generates stable returns with minimal risks. Examples of these medium risk investment plans include:

• Hybrid debt-oriented funds
• Arbitrage funds
• Monthly Income Plans

High-Risk Investments

Investment plans categorized as high-risk are suitable for investors who wish to sustain long-term capital growth. While most of these high-risk investment plans are likely to incur fluctuations throughout the investment tenure, they provide ample opportunities to create substantial returns. These high-risk investment plans usually include:

• Direct equities
• Unit Linked Insurance Plans
• Mutual Funds

Stocks

Investments in equity markets or stocks provide avenue for wealth creation over a long period of time. It takes a great deal of research and prudence to identify the right stocks to invest in. You also need to time your entry and exit prudently, and it involves continuous monitoring of investments. Capital appreciation happens over long period of time and is dependent upon market volatility. The good news is that in the long run, some of the stocks has been shown to deliver greater inflation-adjusted returns when compared with many other classes of assets.

Bonds

Bond is one of the types of debt investments available in India. Investors lend money to the issuer company in exchange of a bond and in return of the bond, the issuer is obliged to pay interest on the principal amount. The issuer is required to repay money borrowed along with a fixed rate of interest on the amount borrowed. Nowadays, variable rate of interest is also quite common.

Certificate of Deposit

Certificate of Deposit is a money market instrument which is issued against the funds deposited by an investor. It is invested with the bank in a dematerialized form for a certain period of time. Certificate of Deposit is issued by Federal Deposit Insurance Corporation (FDIC) and regulated by the Reserve Bank of India (RBI).

Real Estate

Investing in real estate involves purchasing residential or commercial properties to allow your capital to appreciate or to generate regular rental income. This way, you get to enjoy a steady stream of income in the form of rent. Another strategy is to purchase real estate units, hold them, and then sell them at a later point in time for a higher price, thus earning a significant return on your initial investment.

Mutual Funds

Mutual funds (MFs) invest in market-linked instruments such as stocks, bonds, or a mix of both equity and debt instruments. You can choose between equity funds, debt funds, and balanced funds depending on your financial goals and requirements. Furthermore, you can also invest small amounts periodically in MFs using a Systematic Investment Plan (SIP).

Fixed Deposits (FD)

Mutual funds (MFs) invest in market-linked instruments such as stocks, bonds, or a mix of both equity and debt instruments. You can choose between equity funds, debt funds, and balanced funds depending on your financial goals and requirements. Furthermore, you can also invest small amounts periodically in MFs using a Systematic Investment Plan (SIP).

Public Provident Fund (PPF)

Considered to be one of the safest types of investment in India, Public Provident Fund (PPF) is an instrument backed by the government. You can invest in PPF by opening an account with any bank or post office. While opening the account, the minimum investment amount is as low as Rs.100 in some of the banks (can vary for every bank). Thereafter, the annual limits for PPF deposits range from a minimum of Rs.500 to a maximum of Rs.1.5 lakh. The amount invested in your PPF account comes with a lock-in period of 15 years and is eligible for tax deductions under section 80C of the Income Tax Act, 1961.

Unit Linked Insurance Plans (ULIP)

Unit Linked Insurance Plans (ULIPs) are among types of investments that come with tax benefits as well. It’s an instrument that offers you the advantage of investment combined with insurance. The premium you pay to remain invested is divided into two portions. One part goes towards providing you a protective life cover, while the other is invested in market-linked instruments or funds. ULIPs also provide deductions under Income Tax Act 1961 as per prevailing tax laws, since the premium paid is deductible, and the maturity benefits and long-term capital gains are tax-free.

National Pension System (NPS)

The National Pension System (NPS) is another investment plan backed by the government of India. It’s a product that focuses on saving for the long term, making it the perfect addition to your retirement investment plan. The amount you park in this scheme is invested in a variety of other investment vehicles like equity, deposits, government securities, corporate bonds, and other funds. You can remain invested till you reach the age of 60.

Senior Citizens’ Savings Scheme

Senior Citizens’ Savings Scheme (SCSS) is one of the types of investments backed by the Government of India. Indian residents over 60 years of age can open an SCSS account and invest in this scheme for a block of 5 years. Thereafter, the investment can be extended by another 3 years, if needed. You can deposit up to Rs.15 lakh in your SCSS account in multiples of Rs.1,000 only. Deposits up to Rs.1 lakh can be made in cash. However, deposits over Rs.1 lakh need to be made using a demand draft or cheque. Investments in SCSS also qualify for deduction under section 80C, up to a limit of Rs.1.5 lakh.

Economic management of the country is possible through its monetary and financial controls which need to be properly planned, monitored and controlled. Financial planning brings about synchronization between the use of human resources and other resources in the country.

Banking management is one of the important tools for identification and implementation of monetary policy. Analysis of banks performance and implementation of monetary policies show us what policies are working and what policies are not and then put them on the table of bank managers and financial institutions.

A bank is a financial institution licensed to receive deposits and make loans. Two of the most common types of banks are commercial/retail and investment banks.  Depending on type, a bank may also provide various financial services ranging from providing safe deposit boxes and currency exchange to retirement and wealth management.

Above all, central banks are responsible for currency stability.  They control inflation, dictate monetary policies, and oversee money demand and supply in the market.  Commercial or retail banks offer various services including, but not limited to, managing money deposits and withdrawals, providing basic checking and saving accounts, certificates of deposit, issuing debit and credit cards to qualified customers, supplying short-and long-term loans such as car loans, home mortgages or equity line of credits.  Investment banks gear their services toward corporate clients.  They provide services such as merger and acquisition activity and underwriting among other investment services.

Addressing this basic need is the main motivation behind establishing this department at Avicenna University. This may help knowledge development at the country’s monetary and financial institutions addressing needs of banks, monetary and financial institutions in private and public sectors that need quality human resources.

Financial management banking is a field where students will get familiar with the analytical and descriptive aspects of money, banking, basics of management, financial and human resources management, legal discussions and accounting. The graduates of this field has various kinds of employment opportunities in banks and furthermore they will also be working in the national banking (financial and monetary planning, organizational structure, management of branches, credits, information, investment, public relation, and other services and also international banking (imports, credits, documents, arbitrages and other affairs).

Students of this field can use series of decision-making models and quantitative methods like statistics ad researches to determine policies and strategic programs for success of financial institutions.

According to the finance and development department of the International Monetary Fund (IMF), financial services are the processes by which consumers or businesses acquire financial goods.1 For example, a payment system provider offers a financial service when it accepts and transfers funds between payers and recipients. This includes accounts settled through credit and debit cards, checks, and electronic funds transfers.

Companies in the financial services industry manage money. For instance, a financial advisor manages assets and offers advice on behalf of a client. The advisor does not directly provide investments or any other product, rather, they facilitate the movement of funds between savers and the issuers of securities and other instruments. This service is a temporary task rather than a tangible asset.

Financial goods, on the other hand, are not tasks. They are things. A mortgage loan may seem like a service, but it’s actually a product that lasts beyond the initial provision. Stocks, bonds, loans, commodity assets, real estate, and insurance policies are examples of financial goods.

Financial Management and Banking Field Objectives

• Training and developing the capacities of human resources in the area of financial management and banking.
• Developing technical capacities of human resources for addressing the needs of market, institutions and banks at the private and public sector.
• Preparation of students for higher education including master and PHD degree in the relevant field.

Some of the reasons why banking tops the list of pillars required in financial literacy.

• Safeguard your cash.
• Facilitate financial transactions.
• Insure your liquid assets.
• Earn interest.
• Borrow loans.
• Invest your money.
• Use debit and credit card services.
• Receive your paycheck quickly using direct deposit.
• Manage your finances; Record keeping and budgeting.
• Establish a credit history to generate a FICO credit score instrumental in borrowing funds and building wealth.

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.

Assuming cost of capital at (or) advise the selection of the project:

Solution

Calculation of net project values of the two projects.

Project A

Total Present value = 11,941

Cost of Investment = 10,000

Net present value   = 1,941

Project B

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.

Under this method, the cut off rate or minimum required rate of return [mostly the firm’s cost of capital] is raised by adding what is called ‘risk premium’ to it. When the risk is greater, the premium to be added would be greater.

For example, if the risk free discount rate [say, cost of capital] is 10%, and the project under consideration is a riskier one, then the premium of, say 5% is added to the above risk-free rate.

The risk-adjusted discount rate would be 15%, which may be used either for discounting purposes under NPV, or as a cut off rate under IRR.

Advantages of Risk-adjusted Discount Rate:

• It has a great deal of intuitive appeal for risk adverse decision-makers.
• It is easy to understand and simple to operate.
• It incorporates an attitude towards uncertainty.

Disadvantages:

• A uniform risk discount factor used for discounting all future returns is unscientific as the degree of risk may vary over the years in future.
• There is no easy way to derive a risk-adjusted discount rate.
• It assumes that investors are risk averse. Though it is generally true, there do exist risk-seekers in real world situation that may demand premium for assuming risk.

The Ramakrishna Ltd., in considering the purchase of a new investment. Two alternative investments are available (X and Y) each costing Rs. 150000. Cash inflows are expected to be as follows:

Cash Inflows

The company has a target return on capital of 10%. Risk premium rate are 2% and 8% respectively for investment X and Y. Which investment should be preferred?

Solution

The profitability of the two investments can be compared on the basis of net present values cash inflows adjusted for risk premium rates as follows:

Investment X

Net present value = 133415 – 150000

=  – Rs. 16585

Investment Y

Net present value = 156485 – 150000

=  Rs. 6485

As even at a higher discount rate investment Y gives a higher net present value, investment Y should be preferred.

The Capital budgeting is based on Cash flows. These cash flows are estimated cash flows. The estimation on future returns, cash flows, is done on the basis of various assumptions. The actual returns in terms of cash inflows depend on a variety of factors such as price, sales volume, effectiveness of advertising campaign, competition, cost of raw material, manufacturing cost and so on. Each of these, in term, depends on other variables like the state economy, the rate of inflation, govt policy and so on. Risk in the variability in the actual returns in relation to estimated return as forecast at the time of initial capital budgeting decisions.

It was assumed that those investment proposals did not involve any kind of risk, i.e., whatever the proposal is undertaken, there would not be any change in the business risk which are apprehended by the suppliers of capital. Practically, in real world situation, this seldom happens.

We know that decisions are taken on the basis of forecast which again depends on future events whose happenings cannot be anticipated/predicted with absolute cer­tainly due to some factors, e.g., economic, social, political etc. That is why question of risk and uncertainty appear before the business world although it varies from one investment proposal to another.

For example, some proposal may not even involve any risk, e.g., investment in Government bonds and securities where there is a fixed rate of return exists, some may be less risky, e.g., expansion of the existing business, others may be more risky, e.g., setting up a new operation.

That is, different investment proposals have different degrees of risk. It should be remembered that if there is any change in business risk complexion, there remains also a change in the apprehension of the creditors and the investors about the firm as well In short, if the acceptance of any proposal proves the firm more rising, creditors and investors will not be interested or will not consider it with favour which, in other words, adversely affect the total valuation of the firm.

Therefore, while evaluating investment proposals care should be taken about the effect that their acceptance may have on the firm’s business risk as apprehended by the creditors and/or investors. As such, the firm should always prefer a less risky investment proposal than a more risky one.

The riskiness of an investment proposal may be defined as the variability of its possible terms, i.e., the variability which may likely be occurred in the future returns from the project. For example, if a person invests Rs 25,000 to short-term Govern­ment securities, carrying 12% interest, he may accurately estimate his future return year after year since it is absolutely risk-free.

On the contrary, instead of investing Rs 25,000 m short-term Government security, if he wants to purchase the shares of a company, then it is not at all possible for him to estimate the future returns accurately, since the dividend rates of a company may widely vary, viz., from 0% to a very high figure.

Therefore, as there is a high degree of variability relating to future returns, it is relatively risky as compared to his investment in Government securities. Thus, the risk may be defined as the variability which may likely to accrue in future between the estimated/expected returns and actual returns. The greater is the variability between the two, the risker the project and vice-versa.

Risk:

It involves situations in which the probabilities of a particular event which occurs are known, i.e., chance of future loss can be foreseen.

Uncertainty:

The difference between risk and uncertainty, therefore, lies in the fact that variability is less in risk than in uncertainty. The risk situation is one in which the probability of occurrence of a particular event is known. These probabilities are not Known under uncertainty situation.

Risk refers to a set of unique outcomes for a given event which can be assigned probability, while uncertainty refers to the outcomes to a given event which are too unsure to be assigned probabilities. However, in practical terms, risk and uncertainty are used interchangeably.

In brief, risk with reference to capital Budgeting, results from the variation between the estimated and actual return. The greater the variability between the two, the riskier is the project.

Various evaluation methods are used for risk and uncertainty in capital budgeting are as follows:

(i) Risk-adjusted cut off rate (or method of varying discount rate)

(ii) Certainly equivalent method.

(iii) Sensitivity technique.

(iv) Probability technique

(v) Standard deviation method.

(vi) Co-efficient of variation method.

(vii) Decision tree analysis.