Probability Approach to NPV

National Paper Mills is considering expansion

into manufacture of glazed paper or craft paper.
Though both the projects can be undertaken but
due to capital constraints only one of them can
be implemented now. The glazed paper project
involves an outlay of Rs 25 crore while craft
paper project can be implemented with Rs 20
crore. The markets are uncertain and the
estimates of NPV for both the projects with
corresponding probabilities are as below:

Rs Lacs
Glazed paper
Probability
0.20
0.30
0.30
0.20

NPV
400.00
650.00
850.00
155.00

Craft paper
Probability
NPV
0.10
250.00
0.40
500.00
0.30
750.00
0.20
250.00

i) What is the expected NPV of each project?

ii) What is the risk of each project, as
measured from standard deviation and coefficient of variation
iii) What is the profitability index of each
project?
iv) What conclusion would you draw based on
expected NPV, its standard deviation, and coefficient of variation?
v) If firm faces constraint of capital which
project should be undertaken

Scenario Analysis
A firm is considering a capital investment of Rs
40 lacs fro a project that has life of 5 years The
cash flows are dependent upon the general
economic conditions. The project team has
considered 4 different scenarios of poor, average,
good and excellent with respective probabilities
of 20%, 30%, 30% and 20% respectively. the cash
flows fro three years under 4 different scenarios
are given below:

Rs lacs
Scenario
Prob. Year 1 Year 2
Year 3
Poor
0.20 12.00
15.00
18.00
Average
0.30 15.00
19.00
24.00
Good
0.30 20.00
25.00
35.00
Excellent 0.20 27.00
35.00
44.00
Assuming cost of capital at 12% find out the
following:

i) The NPV of the project under different

scenarios of poor, average, good and excellent.
ii) The expected NPV of the project.
iii) Risk as assessed from standard deviation
and co-efficient of variation.
iv) Find out the probabilities of NPV being
a) negative b) 80%, c) 90%, d) 100%, e) 110%
and f) 120% of the expected NPV.
v) The management does not accept any
proposal that has more than 20% chance of
providing negative NPV. Under such condition
what is your recommendation regarding
acceptance of the project?

Sensitivity Analysis
Sensitive Controls Limited have a project on
hand costing Rs 20 crore with a life of 10 years
The expected revenue id Rs 21 crore per annum
with variable cost estimated at 50%. The fixed
cost are Rs 2 crore while depreciation is on the
basis of SLM. The tax rate is 40% and the cost
of capital for the firm is 14%.

The management of the Sensitive Controls

Limited is apprehensive of the cash flow
estimates. The apprehension emanates from
uncertainty of revenue and the proportion of
the variable cost. Due to inherent risk in the
projections the management also believes that
the suppliers of capital for the project may not
be very comfortable with the returns equal to
the current cost of capital.

Find out the following:

i) The estimated annual cash flows of the
project.
ii) Assuming uniform cash flows of the project
for entire life and current cost of capital as
appropriate discount rate find the net present
value of the project.
iii) Find out the NPV of the project assuming
the revenues can change from 70% to 130% of
the expected revenue and plot the NPV with
respect to the level of revenue. Find out from
the plot the approximate minimum revenue that
the project must generate so as to keep the
NPV positive.

iv) Find out the NPV of the project assuming

that the variable cost can change from 35% to
65% of the expected revenue and plot the NPV
with respect to the variable cost as proportion
of expected revenue. What is the maximum
proportion of variable cost the project can
afford?
v) Find out the NPV of eth project for cost of
capital ranging between 11% and 17% and plot
the NPV with respect to cost of capital. What is
the maximum cost of capital that would keep
the project acceptable?

Decision Tree
Child Entertainment Ltd. (CEL) are in the
business of developing fancy toys that last
normally no more than 2 - 3 years They have
come out with another fancy toy that is
expected to last for two years The capital
investment is Rs 275 lacs.

During the first year CEL expects the post tax

cash flows of Rs 150 lacs with probability of 60%
or Rs 180 lacs with probability of 40% depending
upon the demand for the new toy.
During the second year the probabilities of
demand being low, medium and high are 40%,
40% and 20% respectively. If initial demand
during first year is high then the second year cash
flows are expected to be Rs 200 lacs, Rs 240 lacs
and Rs 290 lacs respectively.

However, if initial demand during first year is

low then the second year cash flows are
expected to be Rs 160 lacs, Rs 200 lacs and Rs
250 lacs respectively.
For the kind of business CEL is into the
appropriate discount rate for investment is 15%.
Advise whether CEL should go ahead with the
investment.

Risk Adjusted Discount Rate:

Refer to the previous example: If the firm

faces a capital constraint of Rs 500 lacs which
of the project would be accepted under a)
NPV criterion, b) PI criterion. What would be
the addition to the NPV in each case? Use cost
of capital as per CAPM for calculating NPVs.
Assume that projects can be implemented in
parts.

Certainty Equivalent