DBA 1764 - Strategic Investment

MBA
(DISTANCE MODE)
DBA 1764
STRATEGIC INVESTMENT AND
FINANCIAL DECISIONS
IV SEMESTER
COURSE MATERIAL
Centre for Distance Education
Anna University Chennai
Chennai 600 025
Author
Reviewer
Dr. Yamuna Krishna
Professor and Head
Department of Management Studies
Easwari Engineering College
Chennai - 89
ii
Dr. J. Gopu
Assistant Professor
B.S.A. Crescent Engineering College
Chennai - 48
Dr. H. Peeru Mohamed
Professor
Chennai - 600 025
Dr. A. Kannan
Professor
Department of Computer Science and Engineering
Chennai - 600 025
Copyrights Reserved
(For Private Circulation only)
Editorial Board
Dr. P. Narayanasamy
Professor
Department of Computer Science and Engineering
Chennai 600 025
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ACKNOWLEDGMENT
The author has drawn inputs from several sources for the preparation of this course material, to meet the
requirements of the syllabus. The author gratefully acknowledges the following sources.
Apte P.G, International Financial management, Tata McGraw Hill Publishers
Varshney & Bhattarcharya, International Marketing
Wali.B.M and Kalkumdrikas, A.B, Export Management, Strelling Publishers Pvt. Ltd
Prasanna Chandra, Financial Management, Tata McGraw Hill, 2003.
Prasanna Chandra, Projects: planning, Analysis, Financing implementation and review, TMH, New Delhi.
Bodie, Kane, Warcus : Investments, Tata McGraw Hill, New Delhi,2002.
Brigham E.F & Houston J.F. Financial Management, Vikas Publishing House, 2003.
M.Y. Khan and P.K.Jain, Financial Management Text and Problems, Tata McGraw hill Publishing Co,
2003.
Inspite of at most case taken to prepare the list of references any omission in the list is only accidental
and not purposeful.
J. Gopu
Author
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DBA 1764 STRATEGIC INVESTMENT AND FINANCIAL DECISIONS
UNIT I INVESTING DECISIONS
Project Investment Management Vs Project Management - Introduction to profitable projects Evaluation of
Investment Opportunities Investment decisions under conditions of uncertainty Risk analysis in investment
decision Types of investments and disinvestments
UNIT II CRITICAL 7 ANALYSIS OF APPRAISAL TECHNIQUES
Significance of information and data bank in project selections investment decisions under capital constrains
capital rationing Vs portfolio portfolio risk and diversified projects
UNIT III STRATEGIC ANALYSIS OF SELECTED INVESTMENT DECISIONS
Lease financing leasing Vs Operating Risk Leasing Vs Purchasing hire purchase and investment decisions
mergers and acquisitions in capital budgeting cash Vs equity for financial mergers
UNIT IV FINANCING DECISIONS
International capital structure capital structure theory
UNIT V FINANCIAL DISTRESS
Consequences, issues, bankruptcy, settlement, reorganization and liquidation in bankruptcy
REFERENCES
1. Apte P.G, International Financial management, Tata McGraw Hill Publishers
2. Varshney & Bhattarcharya, International Marketing
3. Wali.B.M and Kalkumdrikas, A.B, Export Management, Strelling Publishers Pvt. Ltd
4. Prasanna Chandra, Financial Management, Tata McGraw Hill, 2003.
5. Prasanna Chandra, Projects: planning, Analysis, Financing implementation and review, TMH, New Delhi.
6. Bodie, Kane, Warcus : Investments, Tata McGraw Hill, New Delhi,2002.
7. Brigham E.F & Houston J.F. Financial Management, Vikas Publishing House, 2003.
8. M.Y. Khan and P.K.Jain, Financial Management Text and Problems, Tata McGraw hill Publishing Co,
2003.
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CONTENTS
UNIT I
INVESTING DECISIONS
CHAPTER 1
INTRODUCTION TO PROFITABLE PROJECT
1.1 MEANING OF PROJECT 1
1.2 PROJECT CLASSIFICATION 1
1.2.1 Quantifiable and Non-Quantifiable Projects 2
1.2.2 Sectoral Projects 2
1.2.3 Techno-Economic Projects 2
1.2.4 Project identification and Selection 2
1.3 FEASIBILITY STUDY 4
1.4 PROJECT REPORT 4
1.5 PROFITABLE PROJECT COSTING TIPS 5
1.6 PROFITABLE PROJECT MANAGEMENT 6
1.7 BENEFITS OF GOOD PROJECTS MANAGEMENT 6
1.8 ESSENTIALS OF PROFITABLE PROJECT MANAGEMENT 7
1.8.1 Define Scope, Deadlines and Goals 7
1.8.2 Communicate, Communicate and Collaborate 7
1.8.3 Meet deadlines even if the firm must reduce scope 8
1.8.4 Run every project the same way 8
1.8.5 Chose proven projects technology, deploy it properly 8
1.8.6 Monitor real-time costs 9
1.8.7 Manage the client as much as the project 9
1.9 PROJECT MANAGEMENT AND PROJECT I9NVESTMENT
MANAGEMENT 9
CHAPTER 2
EVALUATION OF INVESTMENT OPPORTUNITIES
2.1 IMPORTANCE OF CAPITAL BUDGETING 11
2.2 FACTORS INFLUENCING CAPITAL EXPENDITURE DECISIONS 12
2.3 TYPES OF CAPITAL EXPENDITURE 12
2.4 CLASSIFICATION OF CAPITAL EXPENDITURE PROPOSALS 13
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2.5 SOME IMPORTANT ASPECTS OF CAPITAL EXPENDITURE
DECISIONS 13
2.6 METHODS OF CAPITAL BUDGETING (OR) METHODS OF
EVALUATIONSOF INVESTMENT PROPOSALS 15
2.6.1 Traditional Methods 15
2.6.2 Investment decisions, based on pay-back period 17
2.6.3 Disadvantages 18
2.6.4 Improvements in traditional approach to pay back period method 19
2.6.5 Non Traditional Methods (or) Modern Methods (or) Discounted
Cash Flow Methods (D.C.F.) 22
2.7 SOLVED EXAMPLES 31
CHAPTER 3
RISK ANALYSIS IN INVESTMENT DECISION
3.1 NATURE OF RISK 43
3.2 STATISTICAL TECHNIQUES FOR RISK ANALYSIS 44
3.2.1 Probability Defined 44
3.2.2 Assigning probability 45
3.3 RISK AND UNCERTAINTY 46
3.3.1 Expected Net Present Value 46
3.4 VARIANCE OR STANDARD DEVIATION: ABSOLUTE
MEASURE OF RISK 50
3.4.1 Coefficient of Variation: Relative Measure of Risk 51
3.5 CONVENTIONAL TECHNIQUES OF RISK ANALYSIS 52
3.5.1 Payback 52
3.5.2 Risk-Adjusted Discount Rate 53
3.5.3 Certainty Equivalent 55
3.6 SENSITIVITY ANALYSIS 58
3.7 DCF BREAK-EVEN ANALYSIS 60
3.8 SCENARIO ANALYSIS 63
3.9 SIMULATION ANALYSIS 64
3.10 DECISION TREES FOR SEQUENTIAL INVESTMENT DECISIONS 65
3.10.1 Steps in Decision Tree Approach 65
3.10.2 Usefulness of Decision Tree Approach 72
3.11 UTILITY THEORY AND CAPITAL BUDGETING 73
3.11.1 Risk Attitude 73
3.11.2 Benefits and Limitations of Utility Theory 74
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CHAPTER 4
TYPES OF INVESTMENTS AND DISINVESTMENTS
4.1 TYPES OF INVESTMENT DECISIONS 76
4.1.1 Expansion and Diversification 76
4.1.2 Replacement and Modernisation 76
4.1.4 Mutually Exclusive Investments 77
4.1.5 Independent Investments 77
4.1.6 Contingent Investments 77
4.2 DIFFERENT AVENUES FOR DIVESTMENT 77
UNIT II
CRITICAL ANALYSIS OF APPRAISAL TECHNIQUES
CHAPTER 5
FINANCIAL INFORMATION SYSTEM
5.1 ACCOUNTING SYSTEM 80
5.2 FINANCIAL INTELLIGENCE SYSTEM 80
5.3 FINANCIAL SOFTWARE PACKAGES 81
5.4 MANAGERIAL USE OF FINANCIAL INFORMATION SYSTEMS 82
5.5 INFORMATION AND PROJECT SELECTION 82
5.6 INFORMATION ASYMMETRY AND CAPITAL BUDGETING 83
5.6.1 Informational Asymmetry between Shareholders and Bond Holders 84
5.6.2 Informational Asymmetry between Current Shareholders and
Prospective Shareholders 84
5.6.3 Informational Asymmetry between Managers and Shareholders 85
CHAPTER 6
INVESTMENT DECISIONS UNDER CAPITAL RATIONING
6.1 SINGLE PERIOD CAPITAL RATIONING 88
6.1.1 Aggregation of projects or Feasible set approach 88
6.1.2 Cumulative Outlay Analysis based on IRR 89
6.1.3 Profitability Index 90
6.2 USE OF PROFITABILITY INDEX IN CAPITAL RATIONING 93
6.2.1 Limitations of Profitability Index 94
6.3 MULTI-CONSTRAINTS CAPITAL RATIONING 95
6.4 MULTI PERIOD CAPITAL RATIONING 96
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6.5 PROGRAMMING APPROACH TO CAPITAL RATIONING 98
6.5.1 Linear Programming (LP) 99
6.5.2 Integer Programming (IP) 100
6.5.3 Dual Variable 100
6.5.4 Extensions of Programming Approach 100
6.5.5 Limits to the Use of Programming Approach 101
6.6 CAPITAL RATIONING IN PRACTICE 101
6.7 CAPITAL RATIONING V/S PORTFOLIO 102
CHAPTER 7
PORTFOLIO AND RISK MANAGEMENT THROUGH DIVERSIFICATION
7.1 PORTFOLIO 103
7.2 PORTFOLIO MANAGEMENT 103
7.3 RETURNS 103
7.4 ATTRIBUTION 104
7.5 MODERN PORTFOLIO THEORY: AN OVERVIEW 104
7.6 TWO KINDS OF RISK 105
7.7 RISK AND RETURN 107
7.8 MEAN AND VARIANCE 107
7.9 DIVERSIFICATION 108
7.10 SYSTEMATIC RISK AND SPECIFIC RISK 108
7.11 APPLICATIONS OF MODERN PORTFOLIO THEORY IN
OTHER DISCIPLINES 109
7.12 COMPARISON WITH ARBITRAGE PRICING THEORY 109
7.13 DIVERSIFICATION 109
7.13.1 Horizontal diversification 110
7.13.2 Vertical diversification 110
7.14 RETURN EXPECTATIONS WHILE DIVERSIFYING 111
7.15 THE DIFFERENT TYPES OF DIVERSIFICATION STRATEGIES 111
7.15.1 Concentric diversification 111
7.15.2 Horizontal diversification 111
7.15.3 Conglomerate diversification (or lateral diversification) 112
7.16 RATIONALE OF DIVERSIFICATION 112
7.17 FIRM-PORTFOLIO APPROACH 112
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UNIT III
STRATEGIC ANALYSIS OF SELECTED INVESTMENT DECISIONS
CHAPTER 8
LEASING AND HIRE PURCHASE
8.1 LEASE FINANCING 121
8.1.1 Lease Defined 121
8.1.2 Types of Leases 122
8.1.3 Cash Flow Consequences of a Financial Lease 123
8.1.4 Myths about Leasing 125
8.1.5 Advantages of Leasing 126
8.1.6 Evaluating a financial lease 127
8.1.7 LEASING AND OPERATING RISK 128
8.1.8 LEVERAGED LEASE 128
8.2 HIRE PURCHASE FINANCING 129
8.2.1 Hire Purchase Financings v/s Lease Financing. 130
8.2.2 Installment Scale 130
8.3 LEASING V/S PURCHASING 130
8.3.1 Break-Even Lease Rental 136
CHAPTER 9
MERGER AND ACQUISITION
9.1 CORPORATE RESTRUCTURING 138
9.2 TYPE OF BUSINESS COMBINATION 139
9.3 MERGER OR AMALGAMATION 139
9.4 FORMS OF MERGER 141
9.5 MERGERS AND ACQUISITION TRENDS IN INDIA 142
9.6 MOTIVES AND BENEFITS OF MERGERS AND ACQUISITIONS 143
9.7 FINANCING A MERGER 144
9.7.1 Cash Offer 144
9.7.2 Share Exchange 145
9.8 TENDER OFFER AND HOSTILE TAKE OVER 151
9.9 DEFENSIVE TACTICS 152
9.10 CORPORATE STRATEGY AND ACQUISITIONS 152
9.11.1 Planning 153
9.11.2 Search and Screening 154
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9.11.3 Financial Evaluation 154
9.11.4 Integration 155
9.12 ACCOUNTING FOR MERGERS AND ACQUISITIONS 158
9.12.1 Pooling of Interests Method 158
9.12.2 Purchase Method 159
9.12.3 Leveraged Buy-Outs 160
9.13 DIVESTMENT 161
9.14 REGULATIONS OF MERGERS AND TAKEOVERS IN INDIA 163
9.14.1 Legal Measures against Takeovers 163
9.14.2 Refusal to Register the Transfer of Shares 163
9.14.3 Protection of Minority Shareholders Interests 163
9.15 SEBI GUIDELINES OF TAKEOVERS 164
9.16 LEGAL PROCEDURES 165
9.17 ACQUISITION AS A CAPITAL BUDGETING DECISION 166
UNIT IV
FINANCING DECISIONS
CHAPTER 10
CAPITAL STRUCTURE THEORIES
10.1 CAPITAL STRUCTURE THEORIES 170
10.1.1 Net Income Approach 173
10.1.2 Net Operating Income (Noi) Approach 176
10.1.3 Modigliani-Miller (mm) Approach 181
10.1.4 Traditional Approach 191
10.2 INCREASED VALUATION AND DECREASED
OVERALL COST OF CAPITAL 195
10.3. CONSTANT VALUATION AND CONSTANT OVERALL
COST OF CAPITAL 196
10.4 DECREASED VALUATION AND INCREASED OVERALL
COST OF CAPITAL 196
CHAPTER 11
DETERMINANTS OF OPTIMUM CAPITAL STRUCTURE
11.1 ELEMENTS OF CAPITAL STRUCTURE 200
11.1.1 Capital Mix 200
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11.1.2 Maturity and Priority 200
11.1.3 Terms and Conditions 201
11.1.4 Currency 201
11.1.5 Financial innovations 201
11.1.6 Financial market segments 202
11.2 FRAMEWORK FOR CAPITAL STRUCTURE: THE FRICT ANALYSIS 202
11.3 APPROACHES TO ESTABLISH TARGET CAPITAL STRUCTURE 203
11.3.1 EBIT-EPS Analysis 203
11.3.2 Valuation Approach 206
11.3.3 Cash Flow Analysis 206
11.4 PRACTICAL CONSIDERATIONS IN DETERMINING
CAPITAL STRUCTURE 211
11.4.1 Assets 211
11.4.2 Growth Opportunities 211
11.4.3 Debt- and Non-debt Tax Shields 212
11.4.4 Financial Flexibility and Operating Strategy 212
11.4.5 Loan Covenants 213
11.4.6 Financial Slack 213
11.4.7 Early repayment 213
11.4.8 Limits of financial flexibility 214
11.4.9 Sustainability and Feasibility 214
11.4.10 Control 215
11.4.11Widely held companies 215
11.4.12Closely held companies 215
11.4.13Marketability and Timing 216
11.4.14Capital market conditions 216
11.4.15Issue Costs 216
11.4.16Capacity of Raising Funds 217
11.4.17MANAGERS ATTITUDE TOWARDS DEBT 218
CHAPTER 12
INTERNATIONAL CAPITAL STRUCTURE
12.1 FOREIGN SUBSIDIARY CAPITAL STRUCTURE 219
12.2 PARENT COMPANY GUARANTEES AND CONSOLIDATION 224
12.3 JOINT VENTURES 226
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UNIT V
FINANCIAL DISTRESS
CHAPTER 13
FINANCIAL DISTRESS
13.1 TYPES OF BUSINESS FAILURE 229
13.2 MAJOR CAUSES OF BUSINESS FAILURE 230
13.3 THE BUSINESS FAILURE RECORD 231
13.4 CONSEQUENCES OF FINANCIAL DISTRESS 233
13.5 SOME INDICATORS OF FINANCIAL DISTRESS 234
13.6 BANKRUPTCY PREDICTION MODELS 235
13.6.1 Altman Model (U.S. - 1968) 235
13.6.2 Springate (Canadian - 1978) 236
13.6.3 Fulmer Model (U.S. - 1984) 236
13.6.4 Blasztk System (Canadian 1984) 237
13.6.5 Ca-Score (Canadian 1987) 237
13.7 ISSUES FACING A FIRM IN FINANCIAL DISTRESS 238
13.8 WHAT HAPPENS IN FINANCIAL DISTRESS? 239
13.9 RESPONSES TO FINANCIAL DISTRESS 239
13.10 VOLUNTARY SETTLEMENT TO SUSTAIN THE FIRM 240
13.10.1 Voluntary Settlement Resulting in Liquidation 240
13.11 INFORMAL REORGANIZATION 241
13.12 INFORMAL LIQUIDATION 243
13.13 REORGANIZATION IN BANKRUPTCY 243
13.14 PREPACKAGED BANKRUPTCIES 248
13.15 REORGANIZATION TIME AND EXPENSE 248
13.16 LIQUIDATION IN BANKRUPTCY 249
13.17 OTHER MOTIVATIONS FOR BANKRUPTCY 251
STRATEGIC INVESTMENT AND FINANCIAL DECISIONS
NOTES
1 ANNA UNIVERSITY CHENNAI
UNIT I
INVESTING DECISIONS
CHAPTER 1
INTRODUCTION TO PROFITABLE PROJECT
1.1 MEANING OF PROJECT
The very foundation of an enterprise is the project. Hence, the success or failure of an
enterprise largely depends upon the project. In simple words, a project is an idea or plan
that is intended to be carried out. The dictionary meaning of a project is that it is a scheme,
design, a proposal of something intended or devised to be achieved. According to Newman
a project typically has a distinct mission that it is designed to achieve and a clear termination
point, the achievement of the mission. Gillinger defines project as the whole complex of
activities involved in using resources to gain benefits.
According to Encyclopaedia of Management a project is an organised unit dedicated
to the attainment of a goal, the successful completion of a development project on time.
Now, a project can be defined as a scientifically evolved work plan devised to achieve a
specific objective within a specified period of time.
Here, it is also important to mention that while projects can differ in their size, nature,
objectives, time duration and complexity, yet they partake of the following three basic
attributes:
(i) A course of action
(ii) Specific objectives, and
(iii) Definite time perspective
Every project has a starting point, an end point with specific objectives.
1.2 PROJECT CLASSIFICATION
Project classification is a natural corollary to the study of project idea.
Different authorities have classified projects differently. Following are the major
classifications of projects:
DBA 1764
NOTES
1.2.1 Quantifiable and Non-Quantifiable Projects
Projects for which a plausible quantitative assessment of benefits can be made are
called quantifiable projects/ projects concerned with industrial development, power
generation, and mineral development fall in this category. On the contrary, non-quantifiable
projects are those in which a plausible quantitative assessment cannot be made. Projects
involving health education and defence are the examples of non-quantifiable projects.
1.2.2 Sectoral Projects
According to this classification, a project may fall in any one of the following sectors:
(i) Agriculture and Allied Sector (ii) Irrigation and Power Sector iii) Industry and Mining
Sector (iv) Transport and Communication Sector (v) Social Services Sector (vi)
Miscellaneous Sector The project classification based on economic sectors is found useful
in resource allocation more especially at macro levels.
1.2.3 Techno-Economic Projects
Projects classification based on techno-economic characteristics fall in this category.
This type of classification includes factors in intensity oriented classification, causation-
oriented classification and magnitude-oriented classification. These are discussed as follows:
a. Factor Intensity-Oriented Classification: Based on factor intensity classification,
projects may be classified as capital intensive or labour intensive. If large investment
is made in plant and machinery, the projects will be termed as capital intensive.
On the contrary, projects involving large number of human resources will be termed
as labour intensive.
b. Causation-Oriented Classification: Where causation is used as a basis of
classification, projects may be classified as demand based or raw material based
projects. The very existence of demand for certain goods or services makes the
project demand-based and the availability of certain raw materials, skills or other
inputs makes the project raw material-based.
c. Magnitude-Oriented Classification: In case of magnitude-oriented classification,
based on the size of investment involved in the projects, the projects are classified
into large scale, medium-scale or small-scale projects. Project classification based
on techno-economic characteristics is found useful in facilitating the process of
feasibility appraisal of the project
1.2.4 Project identification and Selection
The fact remains that in spite of increasing literature on entrepreneurship development,
comparatively little is known about how an entrepreneur identifies and selects a project
Hence, it is somewhat difficult to state in any categorical manner as to how an intending
entrepreneur should proceed to select his/her project. As a matter of fact, project selection
NOTES
is not a nebulous idea. It is a well outlined game plan. There is a definite procedure of
selecting a project. Basically, project selection consists of two main steps:
a. Project Identification
b. Project Selection
1.2.4.1 Project Identification
A project is a proposal for capital investment to develop facilities to provide goods
and services. The investment proposal may be for setting up a new unit, expansion or
improvement of existing facilities. The project, however, has to be amenable for analysis
and evaluation as an independent unit.
A project is a specific, finite task to be accomplished in order lo generates cash flows.
The projects undertaken after liberalisation are large and getting larger. They have increased
in size and complexity. Projects for tomorrow are not geared to the mass production of
simpler goods but customised ones produced by flexible manufacturing systems.
Project idea can be conceived either from input or output side. The former are material
based while the latter, demand oriented. Input based projects are identified on the basis of
information about agricultural raw materials, forest products, animal husbandry, fishing
products, mineral resources, human skills and new technical process evolved in the country
or elsewhere Output based projects are identified on the basis of needs of population as
revealed by family budget studies or industrial units as found by market studies and statistics
relating to imports and exports. Desk research surveying existing information is economical
and wherever necessary market surveys assessing demand for the output of project could
help not only in identification but in assessing viability of the project
Project identification is however, a continual process. With the opening up of the
economy, demand for sophisticated inputs is continuously rising. The quest for new
combinations of factors for optimising output and improving productivity to strengthen the
competitive position of Indian industry in the international market place is an ongoing process.
Further- the growing demand for complex, sophisticated, customised goods and services
in international markets has added a new dimension to project concept.
1.2.4.2 The stages of Project Selection
The identification of project ideas is followed by a preliminary selection stage on the
basis of their technical, economic and financial soundness. The objective at this stage is to
decide whether a project idea should be studied in detail and to determine the scope of
further studies. The findings at this stage are embodied in a pre-feasibility study or
opportunity study. For the purpose of screening and priority fixation, project ideas are
developed into pre-feasibility studies. Pre-feasibility studies give output of plant of economic
size, raw material requirement, sales realisation, total cost of production, capital input/
DBA 1764
NOTES
output ratio, labour requirement, power and other infrastructure facilities. The project
selection exercise should also ensure that it conforms to overall economic policy of the
government.
1.3 FEASIBILITY STUDY
After ensuring that a project idea is suitable for implementation, a detailed feasibility
study giving additional information on financing, breakdown of cost of capital and cash
flow is prepared. Feasibility study is the final document in the formulation of a project
proposal. Feasibility studies can be prepared either by the entrepreneur or consultants or
experts. The cost of feasibility study can be debited to project cost and can be counted as
part of promoters contribution.
The feasibility study should contain all technical and economic data that are essential
for the evaluation of the project. Before dealing with any specific aspect, feasibility study
should examine public policy with respect to the industry. After that, it should specify
output and alternative techniques of production in terms of process choice and ecology
friendliness, choice of raw material and choice of plant size. The feasibility study after
listing and describing alternative locations should specify a site after necessary investigation.
The study should include a lay-out plan along with a list of buildings, structures and yard
facilities by type, size and cost. Major and auxiliary equipment by type, size and cost along
with specification of sources of supply for equipment and process know-how has to be
listed. The study has to identify supply sources and present estimates, costs for
transportation, services, water supply and power. The quality and dependence of raw
materials and their source of supply have to be investigated and presented in the feasibility
study. Before presentation of the financial data, market analysis has to be covered to help
in establishing and determining economic levels of output and plant size.
Financial data should cover preliminary estimates of sales revenue, capital costs and
operating costs for different alternatives along with their profitability. Feasibility study should
present estimates of working capital requirement to operate the unit at a viable level. An
essential part of the feasibility study is the schedule of implementation and estimates of
expenditure during construction.
1.4 PROJECT REPORT
The feasibility study is followed by a project report firming up all the technical aspects
such as location, factory lay-out specifications and process techniques design. In a way,
project report is a detailed plan of follow-up of project through various stages of
implementation.
A project report should contain an examination of public policy with respect to the
industry, listing of equipment by type, size and cost and specification of sources of supply
for equipment, broad specification of outputs and alternative techniques of production in
NOTES
terms of choice of process, plant size and raw material, listing and description of alternative
location, capital costs, estimates of sales revenue and operating costs for different
alternatives, estimation of demand for product, sources of raw material supply, listing of
buildings and structures by type, size and cost, specification of supply sources and costs
for transportation services, water supply and power, preparation of layout, labor requirement
and cost, working capital requirement, plan for execution of project and expenditure during
construction, analysis of profitability, pollution control method and experience of promoters
in execution of projects in the past.
1.5 PROFITABLE PROJECT COSTING TIPS
Profit is the key to success. Therefore, the firm should ensure that every project
undertaken is profitable.
A useful project costing process can be the determining factor in business longevity.
Its not enough to just track the companys general information; the management also
needs to manage the details. Here are some guidelines for maintaining an effective process:
- Separate direct and indirect costs so that one can assess both gross and net profits.
Direct costs include direct materials and labor that relate to the product or service
the firm provide. Indirect costs encapsulate all operating expenses, such as
administrative labor, rent, marketing, office supplies, utilities and rent.
- Track the customers and projects so as to easily review income and expenses tied
to each project. The accounting system should have this capability. The income
and expenses to each job should be tied up appropriately. This enables to monitor
profitability as the job progresses.
- Record employee time to projects and spread out payroll expenses to each project.
While the firm may not be able to easily associate all payroll costs, associate as
many as possible to get the firm close to accurate project costing. If the accounting
system uses timesheets to populate payroll data, on the payroll date, the firm
should see the costs spread out for gross payroll by hours associated to the projects.
- Associate all subcontractor labor and material payments to each project when
entering the bills from the vendors. The firm should do this regardless of how the
bill its clients. The goal is to get a full costing of the project.
- Compare the estimated costs and revenues compared to the actual numbers in the
accounting system. This will allow the firm to assess its project management strengths
and weaknesses to help manage projects profitability.
- Knowledge is power and having a good project costing system will help to manage
projects wisely. The firm should use reports within its accounting system to ensure
that it operates with profitable projects. While it takes more time to track this
information, the value it receives can make the difference between profit and loss.
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NOTES
1.6 PROFITABLE PROJECT MANAGEMENT
With responsibilities in more than one initiative, the firm has multiple deadlines and
milestones to meet. The firm has more clients, more vendors, more requirements, more
costs to track, more information to share and more documents to file. Single project tools
and techniques usually lack the overall work view and other features the firm need to see
and manage priorities and progress. To avoid getting dragged down by multiple-project
chaos, it need to know and see more.
Systems engineered for multiple-project management and collaboration can help.
Still, methodology and culture, not software and technology, are the keys to success when
the firm regularly participate in more than one internal or client project.
Seven steps are essential to success in organizations that simultaneously manage multiple
initiatives. Effectiveness begins with good pre-project planning plus an understanding of
what a project is and what can be at stake.
Managing it almost always involves:
- Applying technical knowledge, people, communications skills, and management
talent.
- Attempting to meet contract requirements and customer commitments on time and
within budget.
- Trying meeting customer expectations.
Skillfully balancing time, resources and scope is often not enough. To stay ahead,
teams and companies frequently must beat schedules, improve costs and exceed
expectations.
1.7 BENEFITS OF GOOD PROJECTS MANAGEMENT
Collaboration right can be seen in staff morale and customer satisfaction. It also shows
up in financials: According to a study conducted by Pitney Bowes, Inc., and published in
Automation World, good project management practices saves 25 to 35 percent in time to
complete a project. Given todays salaries and related expenses, that adds up to a lot of
money.
Companies or teams that cannot manage multiple projects are unable to grow past a
certain point, usually about 15 people and $1 million in revenues. If the firm consistently
miss deadlines, blow budgets and fail to deliver complete solutions, others will not want to
give any new work or referrals.
Standard project management tools might not help. They tend to be rigid where the
work is fluid, resource rather than task oriented and lacking in communication and
collaboration functions.
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Every project is an opportunity to produce something new, to make a real difference.
The firm can introduce change, increase productivity, enhance its capabilities or of a client
or build new relationships.
What commonly goes wrong? No communication tools, unclear or poorly
communicated goals, no agreed milestones, inaccurate staffing, missing deadlines, surprises,
inconsistency from project to project.
Consistently following these seven key steps can directly improve the operations,
profitability and sanity.
1.8 ESSENTIALS OF PROFITABLE PROJECT MANAGEMENT
1.8.1 Define scope, deadlines and goals
The firm should clearly define each project before bringing in the full team. If the firm
is unsure of the objectives, scope and deadlines, the effort will begin in confusion.
Responsibilities and even resources can be worked out at the first meeting, but not without
a firm grasp of what is to be achieved, when and for how much.
The internal kickoff meeting is an opportunity to energize and unite the team to work
for a successful project outcome. It serves notice to all team members that the project has
begun. Have an agenda that includes a clear exchange between sales and the project team.
Communicate the project requirements.
Ensure everyone understands the work to be done and their part in the effort. Nodding
heads do not mean message received! Ask each member to state their responsibilities in
their own words before adjourning. No one should be guessing at what the client and
management want!
1.8.2 Communicate, Communicate and Collaborate
Lack of communication derails even the most brilliant teams and shining projects.
Ensuring key messages are received and understood as a matter of routine is the single
most important factor in a projects success. There cannot be enough communication
among team members and with the client. The management must talk, chat, discuss and
exchange ideas.
Communication should not just float off into space or rely on individual recollection.
Every organization can benefit from a tool that enables to capture all material information.
E-mail is unreliable, particularly when unacknowledged or lost in the spam. Investigate a
projects library and collaboration system.
A systematic approach to communication can be a boost to individuals or groups
reluctant to interact, like engineers and software programmers. An automated, accessible
and mandated communication and collaboration tool can be a wise investment!
DBA 1764
NOTES
1.8.3 Meet deadlines even if the firm must reduce scope
Time is becoming the new corporate metric, says management consultant Peter
Drucker. In an ideal world, the firm would completely finish every project on time. When
forced to choose, the best bet is usually to get something demons ratably done by deadline.
Today, time is as important as cost and quality. Time to market is critical. Time to respond
to a client request is critical. Time to incorporate change is critical. And time to install a
finished system is critical. In addition, work expands to fill the time available for completion.
When under a tight schedule, which the firm should be, keep in mind that clients remember
meeting schedule commitment, not reduced scope.
Communication matters here too. Involve the entire team in establishing and maintaining
schedules. Keep your milestones to ones that matter. It is better to have a few the firm
meet than many milestones it doesnt!
1.8.4 Run every project the same way
When it comes to projects, consistency is quality. It builds efficiencies, reduces costs
and improves quality. Consistency is the most cost-effective, least capital-intensive route
to profitability. The firm should have a common methodology to follow for every project,
regardless of the project content. Invest in technology that supports standards and
methodology, as this will reduce ongoing costs.
With or without a project application system, the project methodology should include:
a) A known location for communication, updates, documents and changes.
b) An acknowledgment system for important communications like change orders.
1.8.5 Chose proven projects technology, deploy it properly
Technology for projects management and collaboration should be field-proven. This
sounds obvious. Teams with few projects of experience often overemphasize technology.
Seeing some application as a primary driver of their solution, they lose focus of the primary
purpose of the technology: improving project delivery and completion.
Selecting projects management tools by technological parameters instead of functionality
is a mistake. Remember that advanced features are seldom used. The firm wants stable
technology that improves, not hinders, its work.
The firm needs sufficient training and implementation services at start-up. Typically
the biggest investment in application deployment is staff time. Good installation and proper
training accelerate the learning curve.
NOTES
1.8.6 Monitor real-time costs
Many project managers are flying blind on project costs. Perhaps they dont see it as
part of the job. Perhaps the accounting system doesnt produce reports until month- or
project-end when it is too late to make adjustments. Perhaps they have a latent desire to
change careers!
The firm should put in place a project management system that lets to see individual
project costs at any time. Move cost-tracking responsibility into project team rather than
leaving it up to accounting. This is easily done with the right system and speeds up overall
project execution.
Let all project members see and understand project costs to help the firm work
within budget. A system that allows the firm and the team to track project costs in real-time
keeps more projects on track.
1.8.7 Manage the client as much as the project
The good news is that the client wants the firm to take a leadership position. The bad
news is that the client wants the firm to take responsibility when the project goes awry. The
clients perspective can include:
a) The project team can figure out what needs to be done.
b) Anything that needs to get done was part of the implied scope.
c) 27
d) My project is the most important,
e) If I change my mind, the project team MUST accommodate the change in my
time frame
f) If the project is running over budget, I expect my partner to share the cost.
g) The client never remembers the voyage; just the destination.
h) Perception always wins over reality and good intentions.
1.9 PROJECT MANAGEMENT AND PROJECT INVESTMENT
MANAGEMENT
1) Project investment management is about investment and financing analysis of project,
whereas, project management is wholesome process which involves identification
project, finding out feasibility and execution of project.
2) In the feasibility analysis itself there are several feasibility studies are involved.
Project management requires all kinds feasibility analysis such as market feasibility,
technical feasibility, financial feasibility and operational feasibility. The project
investment management requires only the financial feasibility.
DBA 1764
NOTES
3) Project management requires technical, marketing and financial skill, whereas
project investment management requires only financial knowledge.
Summary
The very foundation of an enterprise is the project. Hence, the success or failure of an
enterprise largely depends upon the project. In simple words, a project is an idea or plan
that is intended to be carried out. The dictionary meaning of a project is that it is a scheme,
design, a proposal of something intended or devised to be achieved
The fact remains that in spite of increasing literature on entrepreneurship development,
comparatively little is known about how an entrepreneur identifies and selects a project
Hence, it is somewhat difficult to state in any categorical manner as to how an intending
entrepreneur should proceed to select his/her project. As a matter of fact, project selection
is not a nebulous idea. It is a well outlined game plan.
After ensuring that a project idea is suitable for implementation, a detailed feasibility
study giving additional information on financing, breakdown of cost of capital and cash
flow is prepared. Feasibility study is the final document in the formulation of a project
proposal. Feasibility studies can be prepared either by the entrepreneur or consultants or
experts. The cost of feasibility study can be debited to project cost and can be counted as
part of promoters contribution.
With responsibilities in more than one initiative, the firm has multiple deadlines and
milestones to meet. The firm has more clients, more vendors, more requirements, more
costs to track, more information to share and more documents to file. Single project tools
and techniques usually lack the overall work view and other features the firm need to see
and manage priorities and progress. To avoid getting dragged down by multiple-project
chaos, it need to know and see more.
Key Terms
Project
Quantifiable and Non-Quantifiable Projects
Sectoral Projects
Techno-Economic Projects
Questions
a) What do you mean by Project?
b) What are the classifications of Project?
c) Explain the concept of Project identification and selection
d) What are the profitable project costing tips?
e) Discuss the essentials of profitable project management
NOTES
CHAPTER 2
EVALUATION OF INVESTMENT OPPORTUNITIES
Simply speaking, project appraisal means the assessment of a project. Project appraisal
is a costs and benefits analysis of different aspects of proposed project with an objective
to adjudge its viability. An entrepreneur needs to appraise various alternative projects
before allocating the scarce resources for the best project. Thus, project appraisal help to
select the best project among available alternative projects. For appraising a project, its
economic, financial, technical, market, managerial and social aspects are analysed. There
are numerous capital budgeting techniques are available to evaluate worthiness of projects.
This chapter is devoted to explain basic capital budgeting techniques and next chapter will
explain risk adjusted capital budgeting techniques.
2.1. IMPORTANCE OF CAPITAL BUDGETING
Capital budgeting is the most vital activity which can make or mar a future financial
health. The following are the reasons for its importance.
(1) Huge amount of investment: Capital expenditure decisions can commit the firm
for huge investment over a period of time. A wrong decision can result in heavy
loss.
(2) Permanent and Irreversible Commitment of funds: Capital expenditure
decisions result in commitment of funds on long term basis. Once a project is
taken up and investment is made, it is not usually possible to reverse the decision.
The reversal will be at the cost of heavy loss.
(3) Long-term impact on profitability: The Capital expenditure decisions will shape
the future revenue streams and the profitability of operations.
(4) Growth and Expansion: Business firms grow, expand, diversity and acquire
stature in the industry through their capital budgeting activities. The success of
mobilization and deployment of funds determines the future of a firm.
(5) Cost over runs: If not meticulously implemented, delay in completion of projects
will automatically result in excess costs and heavy losses.
(6) Alternatives: Limited funds at the disposal of a firm have to be deployed in the
most profitable of the alternative projects. The elimination process is a difficult
one.
(7) Multiplicity of variables: Large number of factors affect the decisions on capital
expenditure. The make the capital expenditure decisions the most difficult to
make.
(8) Top Management Activity: The metamorphic impact of capital expenditure
decisions automatically thrusts them on the top management. Only senior managerial
personnel can take these decisions and bear responsibility for them.
DBA 1764
NOTES
2.2. FACTORS INFLUENCING CAPITAL EXPENDITURE DECISIONS
There are many factors, both financial and non-financial, which influence the capital
expenditure decisions. The following are some of the important factors.
(1) Availability of funds: This is the crucial factor affecting all capital expenditure
decisions. However attractive some projects may be, they cannot be taken up if
they are too big for a firm to mobilize the needed funds.
(2) Future Earnings: Every project has to result in cash inflows in future. The
extent of the revenues anticipated is the most significant factor which affects the
choice of a project.
(3) Legal compulsions: When statutory compulsion arises, cost and profit
considerations have to be secondary. For example, waste disposal plants have to
be installed to satisfy environmental laws in most of the countries in the world,
particularly in industries like leather and chemicals.
(4) Degree of uncertainty or risk: The level of risk involved in a project is vital for
deciding its desirability.
(5) Urgency: Projects which are to be immediately taken up for a firms survival have
to be treated differently from optional projects.
(6) Research and Development projects: Projects, which may result in invention of
new products or methods, etc., are a sort of investment with hope. They may
prove successful or not. But R & D is a must in most of the industries, particularly
in technology based industries.
(7) Obsolescence: If obsolete machinery and plant exist in a firm, their replacement
becomes a compulsion.
(8) Competitors Activities: When competitors perform certain activities, they may
compel a firm to undertake similar activities to withstand competition.
(9) Intangible Factors : Firms prestige, workers safety, social welfare, etc., influence
capital expenditure which may be deemed as emotional factors.
2.3. TYPES OF CAPITAL EXPENDITURE
Capital expenditure can be divided into two categories, depending on the benefit
expected from the expenditure.
(1) Capital Expenditure which increases revenue: It is the expenditure which
fetches additional income in future. It may be by taking up production of new
products or expanding the existing production facilities to increase production. In
both cases purchase of fixed assets becomes necessary.
(2) Capital expenditure which reduces costs: Expenditure which reduces the cost
of present products or processes or operations can increase the profitability of
existing operations. It may be done by purchase of improved machines and
equipment or tools.
NOTES
In the former case the risk is higher because the firm has to enter into new activities or
produce new products. The later is less risky because the firm is already in the line and
cost reduction is more feasible because of the known operations.
2.4 CLASSIFICATION OF CAPITAL EXPENDITURE PROPOSALS
Investment proposals which are usually considered by firms can be classified into the
following three types.
(a) Independent Proposals: These are proposals which are not interconnected. The
acceptance or rejection of a proposal has no effect on the acceptance or rejection
of any other proposal. Such proposals can be evaluated on the basis of the return
expected and the return required by the firms norms of return. Proposals which
satisfy the firms return standards can be taken up irrespective of other proposals.
(b) Dependent proposals or contingent proposals: When a proposal depends on
the acceptance of some other proposal, it is called a dependent proposal. For
example, purchasing a specific kind of computer printer depends on the proposal
to acquire a computer. In such cases it is preferable to consider both the proposals
simultaneously.
(c) Mutually exclusive proposals: If acceptance of one proposal results in the
automatic rejection of the other proposal or proposals, they can be termed as
mutually exclusive proposals. For example two different kinds of machines may
be considered for a particular task. If one of them is selected, the other machine is
automatically rejected.
2.5 SOME IMPORTANT ASPECTS OF CAPITAL EXPENDITURE DECISIONS
The following are some of the important aspects of investment proposals which need
careful consideration irrespective of the methods employed for project selection.
(1) Cash out flow needed for a proposal
The Amount of investment needed may be completely initial investment or it may be
needed in stages. The amount of cash out flow needed should be ascertained and if the
amount is within the firms reach, it becomes a possible project which may have to complete
with other similar projects on the basis of return and risk for final approval.
The following are taken into account while computing the cash out flow of a proposal.
(a) Cash cost of the new project or machine or equipment;
(b) Cost of Installation;
(c) Working capital needed to operate the machine or to implement the projects;
(d) Cash inflows from sale of old asset in case of replacement of assets;
(e) Tax effects of implementing the proposal: Excess cash out flows on account of tax
or savings in tax due to a proposal are to be adjusted in the calculation of overall
cash out flow.
DBA 1764
NOTES
The total net cash out flow on account of a proposal is deemed as the investment in
that proposal.
(2) Required return on investments
Every firm has to raise funds form different sources. The return demanded by sources
of funds is called Cost of Capital. So, funds invested in the investment proposals must
result in satisfactory return to cover the cost of capital and fetch reasonable profit to the
firm.
It is customary to develop norms or cut-off rates of return to assess investment
proposals. The norms or cut-off rates are specific percentage returns which must be
earned from investment proposals. So, all proposals with lower returns are rejected straight
away. Those proposals which are estimated to result in returns above the cut-off rate or
norm may be accepted, depending on the availability of funds and the return from other
similar proposals.
(3) Measurement of returns from Investment proposals
The returns from investment proposals may be measured in terms Profit or cash
inflows, Profit in the accounting sense is after deducting all routine expenses including
depreciation and tax. It is termed as Accounting Profit, Cash inflows are the funds
recovered from a project. They ignore depreciation and any other amortisation expenditure
relating to fixed Assets because they do not result in case out flows.
Modern capital budgeting has recognized the superiority of the cash flow concept of
measurement of returns over the traditional accounting concept of profit. However the
cash flows are discounted to ascertain their Present Value.
(4) Ranking of Investment Proposals
Most firms have limited funds at their disposal. The investments opportunities are
unlimited. So, it is necessary to Rank all the available investment proposals in the order
of their Profitability, combined with relative risk involved. Each method in capital budgeting
has its own mode of Ranking Projects.
(5) Assessment of Risk or Uncertainty involved in Projects
All investment proposals are subject to uncertainty because they have to be implemented
in future. However the extent of risk may differ from project to project. Higher risk may
result in higher returns. The risk Perception and the methods of dealing with risk is the
most crucial factor in successful capital expenditure decisions.
To conclude, determining the amount of investment needed, required return,
measurement of the return, comparative assessment of proposals by ranking and risk
perception of the projects are all common for various methods of capital Budgeting.
NOTES
2.6 METHODS OF CAPITAL BUDGETING (OR) METHODS OF
EVALUATIONS OF INVESTMENT PROPOSALS
At any given time, large number of investment proposals can be there and the funds
available or funds which can be raised are always limited. So, it is not possible take up all
the proposals of Investment. It is essential to select from amongst the competing proposals
those, which give the highest benefits.
The essence of capital Budgeting is the Balancing Act of matching the available
resources with the acceptable projects.
There are a large number of methods in practice all over the world in the sphere of
capital expenditure decisions. Which ever method is selected, it should:
(1) Provide a basis for distinguishing between acceptable and non-acceptable projects.
(2) Rank different proposals in order of priority.
(3) Have suitable approach to choose from among the alternatives available;
(4) Adopt Criterion which can assess any kind of project;
(5) Be logical by recognising the time value of money and the importance of returns.
The following is the popular classification of various methods of capital budgeting.
(A) Traditional methods:
(1) Pay back period method
(2) Improvement in traditional approach to pay-back period method.
(3) Accounting rate of return or average rate of return method.
(B) Non Traditional Methods (or) Discounted cash flow methods (D.C.F. Methods)
(4) Net Present Value (N.P.V) method
(5) Profitability Index (or) Excess present Value Index Method (P.I. Method)
(6) Internal rate of return (I.R.R.) method. Each of the above methods is explained
below:
2.6.1 Traditional Methods
These methods generally ignore Time Value of money and treat incomes estimated
for different future periods alike. These methods have been traditionally used in business
units.
2.6.1.1 Pay-Back Period Method
Pay-back period is also called pay-out period or pay-off-period. Pay-back period
is the time span in which a project pays for itself through surplus cash flows. It is the
period within which investment in fixed assets or projects can be recovered. It is the time
DBA 1764
NOTES
required for the Savings in costs or net cash inflows from a project to equal the investment
made therein. Thus, pay-back period is the period of time for the cost of a project to be
recovered from the additional earnings of the project itself.
For example, if a project required initial investment of Rs.1,00,000/- and it is estimated
to generate annual net cash inflow of Rs.2,00,000/- for 8 years, the pay-back period is 5
years because it takes 5 years to recoup Rs.1,00,000/- at the rate of Rs.20,000/- per
year.
Method of Calculation of pay-back period
(A) When cash inflows are uniform
If annual net cash inflows are uniform, the following formula can be used to ascertain
pay-back period.
inflow cash Annual
project in Investment ial asset/Init of Cost Initial
period back - Pay =
Note : Annual cash inflow is the net income from the asset or project after tax, but
before depreciation.
For Example: Initial Investment Rs.2,00,000 Annual Cash Inflow=Rs.50,000
years 4 X
50,000
2,00,000
period back - Pay =
The Investment is fully recovered in 4 years.
When cash inflows are not uniform
Pay-back period computed with the help of cumulative cash inflows when cash flows
are not uniform. Of course formula method cannot be used here. Starting from the 1
st
year, the net cash inflows are shown cumulatively. When the cumulative inflows are equal
to the investment, the total time period in years and months is noted. Here the pay-back
period is the time taken for the cumulative net cash inflows to equal the investments.
For example : If investment in a project is Rs.80,000 and the net cash inflows after tax
but before depreciation are estimated for the next 6 years as Rs.20,000, Rs.25,000,
Rs.20,000, Rs.35,000 and Rs.15,000 respectively, pay-back period is calculated as follows:
NOTES
At the end of the 4
th
year the cumulative cash inflow exceeds the investment of
Rs.80,000.
Years
30,000
15,000
years 3 period back - Pay + + =
years 3.5 Year
2
1
years 3 = + =
We may sum up the method of computing pay-back period as follows:
(1) Net cash inflows from the project for each of the years should be calculated. The
starting point may be Income or Savings before depreciation and tax. Depreciation
should be reduced and than tax should be subtracted. If there is a loss after
reducing depreciation in a particular year, tax will be nil. Then the depreciation
should be added back to ascertain cash inflow after tax, before depreciation.
Depreciation is reduced to ascertain correct amount of tax and it is added back
because it does not affect cash and is not paid out to outsiders.
(2) If cash inflows are uniform, pay back period can be ascertained with the help of
the formula:
inflow cash Annual
project in Investment asset / of Cost
period back - Pay =
(3) IF cash inflows are uneven or not uniform, pay-back period can be found with the
help of cumulative cash in-flows, where the period of time for the cumulative
cash inflows to equal the amount of investment is taken as the pay-back period.
2.6.2 Investment decisions, based on pay-back period
(a) Accept or Reject criterion: Management of a firm may establish a Norm or
Standard for acceptable pay-back period, usually based on cost of capital. It is
called cut-off point.
All projects whose pay-back period is higher than the norm or standard may be rejected
out right. The projects within the norm or standard pay-back period may be short listed
for further consideration. They are acceptable projects.
Year Cash inflows
Rs.
Cumulative Cash inflows
Rs.
1. 20,000 20,000
2. 25,000 45,000
3. 20,000 65,000
4. 30,000 95,000
DBA 1764
NOTES
(b) Ranking of Projects: Pay-back period can be used as the criterion to rank different
investment proposals, those with lower pay-back period being ranked higher and
vice versa. This method is very useful in case of Mutually exclusive projects,
Ranking can help in choosing projects in situations of limited funds being available.
(c) When pay-back period of two or more projects is equal, the project with higher
initial cash inflows is preferred over the projects with lower initial cash inflows.
Advantages of pay-back period method
(1) It is simple to understand and easy to calculate.
(2) Inherently, the method provides for uncertainty. Dealing with risk is a Built-in
feature of this method. Its focus on recovery of investment takes care of uncertainty
and risk to a great extent.
(3) Loss through obsolescence is minimized because short-term projects are preferred
through lower pay-back criterion.
(4) Profit is recognised only after the pay-back period. So, it acts as a guideline for
dividend policy in the case of new firms.
(5) The importance given to liquidity through the emphasis on early returns from projects
will enable a firm to manage with lower funds.
2.6.3 Disadvantages
(1) It ignores post-pay-back period returns. Thus many highly profitable projects may
be ignored.
(2) It is not concerned with the length of a projects lifetime. Particularly after pay-
back period. All projects which have longer gestation periods but very long periods
of profitable operation are ignored by this method.
(3) It completely ignores Time value of money. It treats the cash inflows in the first
year and the last year alike. Thus, the interest aspect and the risk aspect which
make cash inflows in the distant future less desirable than the immediate cash
inflows are not recognised in this method.
(4) It does not make use of cost of capital which is highly relevant for investment
analysis in the sense it represents the cost of funds to be invested.
(5) Standard pay back period or Norm for pay back is difficult to determine because
it is a subjective decision.
(6) The method treats each project in isolation where as in practice investment in
different assets is interrelated.
(7) Pay-back period method does not measure profitability of projects at all because
it is concerned with a short period of a projects life time.
Conclusion : In spite several demerits or shortcomings, pay-back period is the most
frequently used criterion for project analysis. It is particularly used by multinational
companies to assess projects in developing countries.
NOTES
The following are the reasons for its popularity.
(1) Most of the growing business units which take up new investment proposals are
usually not well endowed with funds. The built in liquidity preference of pay-back
period method attracts such firms.
(2) Its focus on recovery of investment is more suitable for the dynamic markets and
uncertain investment climate.
(3) The speed or haste which is the characteristic of the modern business world
prefers short term ventures which are the preferred projects under pay back
period method.
2.6.4 Improvements in traditional approach to pay back period method
The popularity of pay back period methods has promoted efforts to eliminate some
of its major draw backs. The following are some of the more popular improvements to
traditional pay back period concept.
(a) Post Pay back profitability method : A serious limitation of pay back period is
that it ignores the post pay-back returns of projects. To rectify the defect, post pay back
profitability is computed by ascertaining the amount of net cash inflows estimated in each
of the years, after the pay-back period. They are shown as a percentage of the investments
in the project.
100 x
Investment Initial
profits back pay Post
index ity profitabil back - pay Post =
Projects with higher index are preferable when two or more projects have more or
less similar pay-back period.
(b) Post pay-back period method: Here the length of the post pay-back period with
positive cash inflows is the criterion. It is also called surplus life over pay-back method.
Projects with longer post pay back periods with significant even cash flows are preferred.
(c) Pay-back Reciprocal method (or) Unadjusted rate of return method:
Pay-back reciprocal method is employed to estimate the rate of return of income generated
by a project. Such rate of return can be used as a criterion to rank different projects and
choose the ones with the highest rate of return. Pay-back reciprocal
100 x
Investment
flow cash Annual
return of rate unadjusted (or) =
This method can be employed only when the following two conditions are fulfilled:
(a) Annual Cash flows are uniform throughout a projects life time.
(b) The project under consideration has a long life, preferably at least twice the pay-
back period.
DBA 1764
NOTES
(d) Discounted Pay-back method: The most serious limitation of pay-back period
method is that it ignores time value of money by treating cash inflows in different future
years alike. To circumvent the limitation and to make pay-back period method more
effective, the discounting concept is infused into the traditional pay-back period method.
In this method, the estimated future net cash inflows are discounted at an appropriate
rate (usually cost of capital rate) to find their present values. The discounted cash flows are
used to ascertain pay-back period.
The discounted pay-back concept has radically changed the pay-back concept because
it is now far superior to other D.C.F methods. The discounted pay back period method
retains all the traditional advantages and eliminates the glaring draw back of pay-back
concept.
2.6.4.1 Accounting Rate Of Return Mehtod (Or) Average Rate Of Return Method
(A.R.R)
This method takes into account the total earnings expected from an investment proposal
over its full life time. The method is called Accounting rate of return method because it uses
the accounting concept of profit i.e., income after depreciation and tax as the criterion for
calculation of return. It should be noted that pay-back period method and also the discounted
cash flow methods make use of cash inflows of projects, whereas A.R.R. method is
based on profit.
2.6.4.1.1 Steps in the use of A.R.R. method
(a) Accounting rate of return is calculated separately for each of the projects under
consideration (Method of computing is explained later).
(b) Different projects are ranked in the order of rate of earnings.
(c) If there is no cut-off rate, projects with higher A.R.R. are accepted over those
with lower rates. The availability of investible funds may limit the acceptable rate
of return.
(d) A cut-off rate may be determined and all the projects with a lesser rate of return
than the cut-off rate are rejected out right. The cut-off rate is usually based on the
cost of capital of the firm i.e, the rate at which funds can be raised.
(e) Projects with higher rate of return than the cut-off rate are acceptable projects.
Based on the availability of funds, projects with the highest rates of return are
taken up first and then the others in order of their respective rates of return.
2.6.4.1.2 Computation of Accounting or Average Rate of Return
There are three variations of the accounting rate of return
(a). Total income method (or) Return per unit of investment methods
Here, the total income, after depreciation and tax, over the life time of a project is
shown as a percentage of net investment in the project (Original cost scrap value)
NOTES
Formula :
100 x
Value Scrap investment of cost Original
Tax) and on depreciati (after earnings Total
A.R.R =
(b). Annual return on original investment method
Formula :
100 x
Value Scrap investment Original
earnings net average Annual
A.R.R =
Average investment is again a disputed term. The following four alternative
interpretations of Average Investment are in practical use.
2
Investment Original
Investment e (i).Averag =
2
ect asset/Proj the of value Scrap - Investment Original
Investment ge (ii).Avera =
2
ect asset/Proj the of value Scrap Investment Original
Investment age (iii).Aver
+
=
Value capital g net workin
Scrap Additional
2
Investment - Investment
Scrap Original
Investment Average (iv) + + =
Alternative (iv) above is more logical and popular method of ascertaining average
investment, for the following reasons.
(1) Assuming straight line method of depreciation, average investment for the entire
life of the asset is 50% of its original cost, less scrap value.
(2) The working capital needed to operate the asset will always be tied up during the
full life time of the asset.
(3) The scrap value is reduced initially to ascertain depreciation rate. But the scrap
value is realized only at the end, tying up the amount of scrap value through the life
time of the asset.
It should be noted that computation of accounting rate of return is a difficult process
due to the alternative methods available. Whichever method is adopted, by a firm, the
same method should be consistently used so that all the investment proposals are assessed
on a uniform basis.
2.6.4.1.3 Advantages of Accounting Rate of Return method
(1) When the method of calculating is decided, it is easy to understand and operate.
(2) This method uses the entire earnings of an investment proposal, unlike the pay-
back period method.
(3) It gives a clear picture of the profitability of a project.
DBA 1764
NOTES
(4) As the basis for the method is accounting concept of profit, it can be readily
calculated from the data available in the firms accounting records.
(5) This method is based on Net earnings i.e. earnings after depreciation and tax,
unlike other methods. It provides a more comprehensive comparative assessment
of projects.
2.6.4.1.4 Disadvantages
(1) Like pay-back period method, this method also ignores the time value of money
and treats all incomes received, whether in the first year or last year, alike.
(2) Reliability of A.R.R. method is affected due to the various concepts of investment.
Different rates can be obtained, using different interpretations of the meaning of
investment.
(3) By considering profit as the criterion, cash flow aspect of projects is not properly
assessed.
(4) It is not useful to assess projects where investment is made in two or more
installments, at different times.
Due to the complications in calculating Investment and other shortcomings, accounting
or average rate of return method is not very popular in modern capital budgeting.
2.6.5 Non Traditional Methods (or) Modern Methods (or) Discounted Cash Flow
Methods (D.C.F.)
These methods, together, are called Present Value Methods or Time Adjusted
methods. They are based upon the technique of Discounted Cash Flow (D.C.F.).
They recognize the importance of Time Value of money.
2.6.5.1 Time Value of Money
This is an important concept which demarcates D.C.F. methods of Capital Budgeting
from the traditional methods. The essence of the concept is that money received earlier is
more valuable than that received later. The estimated future cash inflows and outflows of
a project should not be treated at their face value ignoring their Timing. Income expected
at the end of the first year of a project is definitely more valuable than the income which
may be earned in the 8
th
year of a project.
There are two reasons for assigning higher value to earlier incomes. These reasons
are like foundations for the concept of Time Value of Money.
(a) Interest Aspect: - Cash inflows received earlier can be invested else where or
even in banks and further income can be earned on them. Thus, the Compounding
benefit makes earlier cash inflows more valuable.
NOTES
(b) Uncertainty Aspect: - Cash inflows expected in earlier years may be deemed
more probable to materialize than those of the later years. The more distant in the
future an income is the more uncertain and hazy or nebulous it becomes.
In general, D.C.F. Technique provides quantitative, systematic and reliable shape to the
concept of Time Value of Money.
The basic defect of traditional methods, from the point of view of investment analysis
is that they neglect the Time Value of Money. The discounted cash flow technique rectifies
the defect of traditional methods by bringing all the future cash flows to the common parameter
of present value. The present value methods are increasingly becoming popular in capital
expenditure decisions due to their scientific basis and accuracy.
2.6.5.1.1 Main features of present value methods.
(1) The basic feature of all the present value methods is that they are based on
discounted cash flows. Both cash inflows and cash out flows are discounted to
ascertain their present value.
(2) They use cash flows and not the accounting concept of profit. Thus, cash inflows
after tax before depreciation are taken as the revenues.
(3) They take into account the interest factor by recognizing the value of earlier cash
flows compared to later cash flows.
(4) They consider the entire cash flows of an investment proposal throughout its
economic life.
2.6.5.1.2 Major steps in discounted cash flow methods:
The following are the major steps in all the present value method.
(a) Estimated cash inflows and outflows, after tax, but before depreciation, relating to
the project under consideration should be ascertained. They must be for the full
economic life of the project concerned.
(b) Both the cash inflows and outflows should be discounted at a predetermined
discounting rate. Usually, the discounting rate is the cost of capital rate of the firm.
But it can be any other rate also. Discounting factors can be obtained from present
value tables. They can also be calculated by using the following formula.
(
+
=
n
) r 1 (
1
ctor DiscountFa
Where
r = Discounting rate
n = No. of years
For example,
Discounting factor at 10% rate for a period of 2 years.
0826 .
121 .
1
) 1 . 1 (
1
2
= =
+
DBA 1764
NOTES
0.826 means that say Rs. 1,000 received after 2 years is equal to Rs. 826 today. Or, Rs.
826 invested today at 10% will bring Rs. 1,000 after 2 years.
(c) The Total of discounted cash inflows is compared with the total of the discounted
cash out flows.
There are three important present value methods of capital budgeting which are
explained below:
2.6.5.2 Net Present Value (NPV) Method
Net present value method is one of the discounted cash flow methods of capital
budgeting. It recognizes the time value of money and that cash flows arising at different
periods of time differ in value and are not comparable unless their equivalent present values
are found. The net present value of all inflows and outflows of cash occurring during the
entire life of a project is determined by discounting these flows by the firms cost of capital
or some other pre-determined rate.
The following are the steps in the net present value method:
(a) Appropriate discounting rate has to be determined. It is the minimum required
rate of return and is called cut-off rate or discount rate. The rate is generally
based on cost of capital which is suitably adjusted for the risk and uncertainty
involved in the project. Such addition to cost of capital is called Risk return.
(b) Present value of cash out flows should be found with the help of the discounting
rate. If the entire investment is made initially, there is no need to discount it. The
amount of investment itself is the present value of cash out flows. However any
investments to be made at some future points of time are to be discounted to find
their present value.
It should be remembered that any working capital should be taken as cash outflow in
the year in which commercial production actually starts on the project.
(c) Present value of estimated cash inflows should also be computed. The cash flows
should be the net cash flows after tax, before depreciation. The scrap value of the
project has to be taken as a cash inflow in the last year. Similarly working capital
locked up in the project has to be assumed as unlocked at the end of final year,
thus showing it as a cash inflow in the last year of the project.
(d) Net present value (NPV) is the difference between the present value of cash
inflows and the present value of cash out flows.
NPV = P.V. of cash inflows P.V. of cash out flows.
(e) Equation for calculation N.P.V. is as follows:
(i) When cash flows are conventional i.e. out flows are entirely initial and inflows
are in the future.
NOTES
(
(
+
+
+
+
+
+
+
= 1
4
) K 1 (
4
R
3
) K 1 (
3
R
2
) K 1 (
2
R
1
) K 1 (
1
R
NPV
(ii) When cash flows are non conventional, i.e. where there a series of cash out flows
and inflows in future:
(
(
+
+
+
+
+
+
+

(
(
+
+
+
+
+
+
+
=
4
) K 1 (
4
I
3
) K 1 (
3
I
2
) K 1 (
2
I
1
) K 1 (
1
I
0
I
4
) K 1 (
4
R
3
) K 1 (
3
R
2
) K 1 (
2
R
1
) K 1 (
1
R
NPV
Where N.P.V. = Net present value
R = Future cash inflows at different times.
K = Cost of capital or discounting rate
I = Cash out flows at different times.
(f) Accept or Reject Criterion: N.P.V. is a clear cut accept/Reject criterion. If
the N.P.V. is positive, project is acceptable. If N.P.V. is negative, project should
be rejected.
Accept when NPV > zero
Reject when NPV > Zero
(g) To select between mutually exclusive projects, the projects can be ranked, on the
basis of the amount of N.P.V. since the amount of investment is almost same. The
project with the highest ranking, representing the maximum NPV is to be accepted.
The other mutually exclusive projects stand rejected automatically.
2.6.5.2.1 Merits of N.P.V. Method
(1) It recognizes the time value of money and thus better than the traditional methods.
(2) It considers the earnings over the entire life of the project which makes a true
assessment of profitability of a project possible.
(3) It tries to maximize the profits by favouring more profitable projects.
2.6.5.2.2 Demerits
(1) Compared to traditional methods it is complicated to understand and operate.
(2) Comparison of projects with unequal life times may be misleading because the
amount of N.P.V. alone is considered in this methods without any weightage for
the time span.
(3) Comparing different projects with different amounts of investments becomes difficult
in this method.
Generally, N.P.V. method is highly preferable to decide about a particular project whether
to accept or reject.
DBA 1764
NOTES
2.6.5.2.3 Computation of NPV incase of Replacement of Machine or Equipment
Proposals to replace existing machines or equipment or plant with new ones require
specific attention. The old machine may be useful for some more years and it may be
possible to replace it with a new machine which may result in cost savings or additional
revenues. The following are the points to be considered.
(a) Additional Investment: The difference between the purchase price and
installation expenditure of new machine and the current sale value of old equipment
is the additional investment required.
(b) Net operating savings of profit: The savings resulting from the installation of
new machine compared to the continuation of the old machine are to be computed.
The net savings is the income before depreciation and tax.
(c) Additional tax: From the net savings, difference in depreciation between new
and old machines should be reduced. On the balance, tax should be computed.
This is the additional tax to be paid because of the savings accruing due to the new
machine.
The additional tax should be reduced from net operating savings or profit to ascertain
the net additional annual cash inflows.
If NPV is positive, replacement is advisable. The basic point to remember is that the
old machine also can be used instead of replacing it. So, the incremental cash flows alone
should be considered for computation of N.P.V.
Computation of N.P.V. of Machine Replacement
Net additional cash inflows per annum x
cumulative discounting factor for savings in
the future years.
xx
Add: P.V. of Scrap value of New machine in the
last year of its life. (Scrap value x D.F.)
xx
Add: Tax benefit accruing at the end of Iast year
due to loss on disposal of old machine
(Loss on sale x Tax rate x D.F.)
xx
Add: Cash inflow due to sale of old machine at the
very beginning
xx
P.V. Total Cash inflows xx
Less: P.V. Cash outflow on New Machine xx
N.P.V. xx
NOTES
2.6.5.3 Profitability Index (P.I.) (or) Excess Present value Index Method:
The profitability index is also called Benefits cost Ratio
Though this is treated as a separate method due to the importance of results obtained
by its usages, it is only a refinement of the N.P.V. method. It shows the relationship
between P.V. of cash inflows and P.V. of cash outflows.
Formula:
Profitability Index (P.I.) =
outflows cash future of lue Present va
inflows cash future of lue Present va
(or) Benefit cost ratio (B/C)
2.6.5.3.1 Accept or reject criterion:
If the P.I. or B/C is more than 1 project is acceptable. Projects with P.I. of less than
1 are to be rejected out right.
Accept when P.I. > 1
Reject when P.I < 1
The profitability index method is especially suitable to rank a large amount of investment
proposals simultaneously. Based on the P.I., projects can be ranked, just like students are
given ranks based on the marks obtained in an exam.
Example: Project A P.V. of cash out flows Rs. 1,00,000 P.V. of cash inflows Rs.
1,20,000. Project B P.V. of cash outflows Rs. 40,000 P.V. of cash inflows Rs. 55,000.
Under the N.P.V. method, N.P.V. = Project A 1,20,000 1,00,000 =
Rs. 20,000 and project B 55,000 40,000 = Rs. 15,000. A looks to be better.
Under P.I. Method
P.I. of A = 1,200,000/1,00,000 =1.2
P.I. of B =55,000/40000 = 1.375
Project B with higher profitability index is definitely better than project A.
2.6.5.3.2 Merits and Demerits
P.I. Method possesses all the merits and demerits of N.P.V. method because P.I. is a
refinement of N.P.V. method. However it is more useful in ranking two or more projects.
Thus, P.I. is more suitable for comparative assessment of projects whereas N.P.V. is
appropriate to decide about a particular project.
DBA 1764
NOTES
2.6.5.4 Internal Rate of Return (IRR) Method
Internal rate of return is that rate of return at which the present values of cash inflows
and cash outflows are equal. Thus, at I.R.R. the total of discounted cash inflows equals
the total of discounted cash out flows. I.R.R. discounts the total cash flows to the level of
zero.
1
Outflows Cash
Inflows Cash
I.R.R. At =
I.R.R. is also known as Trial and Error yield method. Unlike N.P.V. and P.I. methods
where the cash flows are discounted at predetermined cut-off rate, there is no specific
discounting rate under I.R.R. method. Here, the cash flows of a project are discounted at
a suitable rate arrived at by Trial and Error. The rate equates the net present value to
Zero. Since the discounting rate is determined internally through Trial and error process, it
is called Internal rate of return method.
If we take the example of the results of one year: Initial cash outflows Rs.5,000, cash
inflows Rs.6,000 at the end of the year. I.R.R. can be computed as follows:
) 1 ( r
R
I
+
=
Where I = Cash outflow (investment)
R = Cash inflows
r = Rate of return on the investment (I.R.R.)

) 1 (
000 , 6
000 , 5
r +
=
000 , 6 000 , 5 000 , 5 = + r
000 , 1 000 , 5 = r

% 20 20 . 0
5000
1000
= = = r
It is easy to compute the I.R.R. for a single year. However, the same method can
be applied to determine I.R.R.
(a) When cash flows are conventional i.e. investment is fully initial, followed by future
cash inflows:
n
) r 1 (
4
R
....
4
) r 1 (
4
R
3
) r 1 (
3
R
2
) r 1 (
2
R
1
) r 1 (
1
R
I
+
+
+
+
+
+
+
+
=
(b) When cash flows are unconventional i.e. cash outflows as well as inflows are
over a series of future periods.
NOTES
(
(
+
+
+
+
+
+
+
+ =
(
(
+
+
+
+
+
+
+
n
) r 1 (
4
I
....
3
) r 1 (
3
I
2
) r 1 (
2
I
1
) r 1 (
1
I
0
I
n
) r 1 (
n
R
....
3
) r 1 (
3
R
2
) r 1 (
2
R
1
) r 1 (
1
R
Where I = Cash outflows at different times
R = Future Cash inflows at different times
r = Rate of return yield by the investment (I.R.R.)
In the above equations, I and R are the known factors. So, r is the only factor to be
found. However it is cumbersome to find the I.R.R. with the help of the above formula
because of the lengthy and complicated calculations involved.
It is customary to use the present value tables and ascertain I.R.R. with the help of
tabular values.
2.6.5.4.1 Accept or Reject criterion under I.R.R. Method
I.R.R. is the return that can be expected from the project which is under consideration.
The project is acceptable if cut-off rate or cost of capital is less than the I.R.R. and vice
versa.
Accept when IRR > Cut-off rate
Reject when IRR < Cut-off rate
2.6.5.4.2 Method of locating Tabular values for I.R.R
(1) When cash inflows are uniform
For all those projects which are expected to yield uniform future cash inflows, I.R.R.
can be computed by locating the factor in Annuity Table. The factor is calculated as
follows:
F = I Where : F = Factor to be located
C I = Original investment
C = Cash inflow per year.
Assuming: Initial investment Rs. 40,000, Annual cash inflow forecasted as Rs. 10,000
for 5 years. I.R.R. can be calculated as follows:
F=I/C = 40,000/10,000 =4
Factor 4 should be located in Table II in the line of 5 years. The I.R.R. would be
somewhere between 6% (Rs. 4.212 present value of annuity of Re.1) and 8% (Rs. 3.993
present value of annuity of /Re. 1) It indicates that I.R.R. is more than 6% but less than 8%
. Since Rs. 3.993 is very near to 4, the I.R.R. may be taken as 8%.
DBA 1764
NOTES
In fact Rs. 3993 when multiplied with the annual cash flow of 10,000 should be
almost equal to Rs. 40,000. 3.993 x 10,000 = Rs. 39,930 (or) nearly Rs. 40,000.
(2) When cash inflows are not uniform:
In case of uneven cash inflows, trial and error is the only way of ascertaining I.R.R.
The objective of the Trials will be to ascertain the rate of return which equates the P.V. of
cash inflows with P.V. of cash outflows. In this process, the cash inflows are to be
discounted by a number of Trial rates.
The first trial may be ascertained with the help of the following formula.
F = I/C
Where : F = Factor to be located
I = Original investment
C = Average Cash flow per year.
After locating the first trial rate, the second trial rate is determined on the basis of the
P.V. of cash inflow obtained through the first trial rate. If the P.V. of cash inflows is less
than the P.V. of cash outflows, the second trial rate should be lower than the first rate and
vice versa.
The above process should be replaced till the P.V. of cash inflows and P.V. of cash
outflows are more or less equal. The rate at which this is achieved is termed as Internal
rate of return.
2.6.5.4.3 Merits of I.R.R. Method
1. Like all the other D.C.F. based methods, I.R.R. also takes into account the time
value of money and can be applied where the cash inflows are even or unequal.
2. It also considers the profitability of a project over its entire economic life and thus
the true profitability of a project can be assessed.
3. Cost of capital or pre-determined cut-off rate is not a pre-requisite for applying
I.R.R. method. Hence it is better than the N.P.V. and P.I. methods in all those
situations where determining cost of capital is difficult.
4. I.R.R. provides for ranking of various proposals because it is a percentage return.
5. It provides for maximizing profitability.
2.6.5.4.4 Demerits
1. It is complicated method and may lead to cumbersome calculations.
2. The underlying assumption of I.R.R. that the earnings are reinvested at I.R.R. for
the remaining life of the project is not a justifiable assumption. From this point of
view, N.P.V. and P.I. which assume reinvestment at cost of capital rate are better.
NOTES
3. The results obtained through NPV or PI methods may differ from that obtained
through I.R.R. depending on the size, life and timings of the cash flows.
2.6.5.4.5 Comparison of I.R.R. with N.P.V. and P.I. Methods
Differences
1. Cost of capital or cut-off rate is determined in advance in NPV and PI. In I.R.R.,
the discounting rate is the unknown factor.
2. NPV and PI strive to ascertain the amount which can be invested in a project
which can earn the required rate of return. I.R.R. ascertains the maximum interest
that can be paid out of returns from the project.
3. The underlying assumption of the D.C.F. methods is that the cash inflows can be
reinvested. However NPV and PI assume the reinvestment at cost of capital rate
or the cut-off rate. I.R.R. assumes re-investment at the I.R.R. rate. The former is
more practical and justifiable than the later.
Generally, NPV and PI are considered to be more reliable for comparative analysis
of projects than the I.R.R. method.
2.7 SOLVED EXAMPLES
A. Pay Back Period
1. A project costs Rs. 5,00,000 and yields annually a profit of Rs. 80,000 after
depreciation at 12% p.a. but before tax at 50%. Calculate pay-back period.
Solution
inflow cash Annual
Investment Initial
= period Payback
Initial Investment (given) = Rs. 5,00,000
Annual cash inflow (W.N.1) = Rs. 1,00,000
1,00,000
000 , 00 , 5
= period back Pay
= 5 years.
DBA 1764
NOTES
W.N.1: Calculation of annual cash inflow
2. Calculate the pay-back period for a project which requires a cash outlay of Rs.
1,00,000 and generates cash inflows of Rs. 25,000, Rs. 35,000, Rs. 30,000 and
Rs. 25,000 in the first, second, third and fourth years respectively.
Solution:
Statement showing the cumulative cash inflows and pay-back period of projects
25,000
10,000
+ years 3 = period back - Pay
= 3.4 years
3. Balan wants to purchase a new machine. There are two alternative models X and
Y which require an equal investment of Rs. 1,00,000 and are expected to generate
net cash flows as under:
Rs.
Annual profit after depreciation, before tax 80,000
Less: Tax @ 50% 40,000
Annual Profit, after depreciation and tax 40,000
Add: Depreciation (5,00,000 x 12%) 60,000
Annual Cash inflow 1,00,000
Year Cash inflow (Rs.)
Cumulative Cash
inflow (Rs.)
1 25,000 25,000
2 35,000 60,000
3 30,000 90,000
4 25,000 1,15,000
Initial Investment 1,00,000
NOTES
Which machine should be chosen and why? Evaluate under Pay-back Period method
Solution:
Statement showing the cumulative cash inflows and pay-back period of projects
8,000
5,000
+ years 5 = X Project for period back - Pay
= 5.625 years
8,000
3,000
+ years 5 = Y Project for period back - Pay
= 5.375 years
Year Machine X (Rs.) Machine Y (Rs.)
1 50,000 20,000
2 20,000 24,000
3 20,000 30,000
4 5,000 16,000
5 - 7,000
6 8,000 8,000
Machine X Machine Y
Year
Cash
inflow
(Rs.)
Cumulative Cash
inflow (Rs.)
Cash
inflow
(Rs.)
Cumulative Cash
inflow (Rs.)
1 50,000 50,000 20,000 20,000
2 20,000 70,000 24,000 44,000
3 20,000 90,000 30,000 74,000
4 5,000 95,000 16,000 90,000
5 - 95,000 7,000 97,000
6 8,000 1,03,000 8,000 1,05,000
Initial
Investment
1,00,000 1,00,000

DBA 1764
NOTES
Machine Y should be chosen because of its Comparatively lower pay-back period.
B) A.R.R. ACCOUNTING RATE OF RETURN (OR) AVERAGE RATE OF
RETURN METHOD
4. A project requires an investment of Rs. 5,00,000 and has scrap value of Rs.20,000
after 5 years. It is expected to yield profits after taxes and depreciation during the
five years amounting to Rs.40,000, Rs.60,000, Rs.70,000, Rs.50,000 and
Rs.20,000. Calculate the average rate of return on investment.
Solution:
A.R.R on Original Investment
100 X
Investment Original
earnings net Average Annual
= Investment Original on A.R.R
5
years five of Earnings
= earnings net average Annual

5
2,40,000
=
= Rs. 48,000
Investment given = Rs. 5,00,000
Scrap Value = Rs. 20,000
Original Investment = Investment Scrap value
= 5,00,000 20,000
= Rs. 4,80,000
A.R.R on Original Investment =
100 x
000 , 80 , 4
000 , 48
= 10%
A.R.R On Average Investment
100 X
Investment Original
= Investment Average on A.R.R
5
NOTES
5
20,000 + 50,000 + 70,000 + 60,000 + 40,000
=
5
2,40,00
=
= Rs. 48,000
value Scrap Capital Networking Additional
2
value Scrap Investment Original Investment Average
+ +
=
5. A project costs Rs. 50,000 and has a scrap value of Rs.10,000. Its stream of
income before depreciation and taxes during the first five years is Rs. 10,000, Rs.
12,000, Rs.14,000, Rs. 16,000 and Rs. 20,000. Assume a 50% tax rate and
depreciation on straight line basis. Calculate the accounting rate of return.
Calculation of Income after Depreciation and Tax
A.R.R on Original Investment
100 X
Investment Original
5
5
6000 + 4000 + 3000 + 2000 + 1000
=
5
16,000
=
= Rs. 3,200
Years
Particulars
1 (Rs.) 2 (Rs.) 3 (Rs.) 4 (Rs.) 5 (Rs.)
10000
8000
12000
8000
14000
8000
16000
8000
20000
8000
2000
1000
4000
2000
6000
3000
8000
4000
12000
6000
Cash inflow before depreciation
and Tax
Less : Depreciation
(50,000-10,000)5
Less : Tax at 50%
Net Income after Depreciation
and Tax
1000 2000 3000 4000 6000

DBA 1764
NOTES
Investment given = Rs. 50,000
Scrap Value = Rs. 10,000
Original Investment = Investment Scrap value
= 5 0,000 10,000
= Rs. 40,000
100 X
40,000
3,200
= 8%
A.R.R On Average Investment
100 X
Investment Original
= Investment Average on A.R.R
5
5
6000 + 4000 + 3000 + 2000 + 1000
=
5
16,000
=
= Rs. 3,200
value Scrap Capital Networking Additional
2
value Scrap Investment Original Investment Average
+ +
=
2
0 + 0 + 10,000 - 50,000
=
= Rs. 20,000
A.R.R on Average Investment =
20,000
100 x 3,200
= 16%
C) DISCOUNTED CASH FLOW (DCF) METHODS
(A) NPV Net Present Value Method
6. Bombay traders are proposing to undertake a project at an initial outlay of
Rs.50,000 and expect to earn yearly net cash inflows of Rs.15,000 for a period of
6 years. The companys cost of capital is 10% Present value of Re.1 for 6 years at
10%p.a. interest is Rs. 4.3335
Determine the net present value.
NOTES
Present value of Cash Inflow = Cash inflow * PV Factor
= 15,000 * 4.335
Present Value = Rs. 65025
LESS: Initial Investment = Rs. 50,000
NPV = Rs. 15,025
7. Project X initially costs Rs. 25,000. It generates the following cash flows:
Solution
D) PROFITABILITY INDEX METHOD
8. Deepak Co. Ltd., is considering two alternatives for the purchase of a new machine
i.e., A and B each costing Rs. 4,00,000. Earnings after taxes are expected to
be as under.
Year Cash Inflows (Rs.) Present value of Re.1 at 10%
1 9000 .909
2 8000 .826
3 7000 .751
4 6000 .683
5 5000 .621
Year
Cash
Inflow
PV Factor
Present
value
1 9000 .909 8181
2 8000 .826 6608
3 7000 .751 5257
4 6000 .683 4098
5 5000 .621 3105
27249
25000
Total Present Value
LESS: Initial Investment
NPV 2249
DBA 1764
NOTES
Machine A
outflow cash Future of Value Present
inflow cash Future of Value Present
= Method Index ity Profitabil

4,00,000
5,18,400
=
= Rs. 1.296
Cash Flow
Year
Machine A Machine B P.V at 10%
Rs. Rs.
1 40,000 1,20,000 0.91
2 1,20,000 1,60,000 0.83
3 1,60,000 2,00,000 0.75
4 2,40,000 1,20,000 0.68
5 1,60,000 80,000 0.62
Year Cash Inflow PV Factor Present value
1 40000 0.91 36400
2 120000 0.83 99600
3 160000 0.75 120000
4 240000 0.68 163200
5 160000 0.62 99200
518400
400000
Total Present Value
NPV 118400
NOTES
Machine B
outflow cash Future of Value Present
inflow cash Future of Value Present
= Method Index ity Profitabil
4,00,000
5,23,200
=
= Rs. 1.308
Machine B is better due to higher Profitability Index.
E) INTERNAL RATE OF RETURN
9. A company is considering an investment proposal which needs an initial outlay of
Rs. 1,50,000. It is estimated to fetch net cash inflows of Rs. 60,000p.a for 4
years. Calculate the I.R.R of the project and decide its acceptability if the companys
cut-off rate for the investments is 18%.
When estimated cash inflows of a project are uniform, I.R.R can be calculated by
locating factor in Annuity Table II.
Factor to be located(F)= I .
C
where, F = Factor to be located
I = Original Investment
C = Cash flow per year
60,000
1,50,000
F=
= 2.5
1 120000 0.91 109200
2 160000 0.83 132800
3 200000 0.75 150000
4 120000 0.68 81600
5 80000 0.62 49600
523200
400000
Total Present Value
NPV 123200
DBA 1764
NOTES
Factor or 2.5 should be located in annuity table II in the line of 4 years.
The discounting percentage is somewhere between 22% and 20%.
Rs.2.494 present value of annuity of Re.1 is 22%
Rs.2.589 present value of annuity of Re.1 is 20%
Since, 2.494 is very near to 2.5,
I.R.R may be taken as 22%
The project can be accepted due to higher I.R.R than the cut-off rate of 18%
10. Initial Investment Rs. 60,000
Life of the asset = 4 years
Estimated net annual cash flows:
1
st
year Rs. 15,000
2
nd
year Rs. 20,000
3
rd
year Rs. 30,000
4
th
year Rs. 20,000
Calculate IRR by trial and error method.
Year P/V at 14% P/V at 15%
1 0.877 0.869
2 0.769 0.756
3 0.674 0.657
4 0.592 0.571
NOTES
Calculation of Present value of Cash Inflows @ 14%
Calculation of Present value of Cash Inflows @ 15%

Rate in Difference X
15% @ NPV - 14% @ NPV
14% @ NPV
+ 14% = I.R.R

1 X
715 + 595
595
+ 14% =
= 14.45%
1 15000 0.877 13055
2 20000 0.769 15380
3 30000 0.674 20220
4 20000 0.592 11840
60595
60000
Total Present Value
NPV 595
1 15000 0.869 13035
2 20000 0.756 15120
3 30000 0.657 19710
4 20000 03571 11420
59285
60000
Total Present Value
NPV -715
DBA 1764
NOTES
Review Questions
1) Why capital expenditures are deemed very important?
2) Discuss the phases of capital budgeting.
3) What is NPV? What are the limitations of NPV?
4) What is IRR and how is it calculated?
5) Evaluate payback as an investment criterion.
6) How Accounting Rate of Return is calculated? What are the pros and cons of
ARR?
NOTES
CHAPTER 3
RISK ANALYSIS IN INVESTMENT DECISION
In discussing the capital budgeting techniques, we have so far assumed that the
proposed investment projects do not involve any risk. This assumption was made simply
to facilitate the understanding of the capital budgeting techniques. In real world situation,
however, the firm in general and its investment projects in particular are exposed to different
degrees of risk. What is risk? How can risk be measured and analysed in the investment
decisions?
3.1 NATURE OF RISK
Risk exists because of the inability of the decision-maker to make perfect forecasts.
Forecasts cannot be made with perfection or certainty since the future events on which
they depend are uncertain. An investment is not risky if, we can specify a unique sequence
of cash flows for it. But the whole trouble is that cash flows cannot be forecasted accurately,
and alternative sequences of cash flows can occur depending on the future events. Thus,
risk arises in investment evaluation because we cannot anticipate the occurrence of the
possible future events with certainty and consequently, cannot make any correct prediction
about the cash flow, sequence. To illustrate, let us suppose that a firm is considering a
proposal to commit its funds in a machine, which will help to produce a new product. The
demand for this product may be very sensitive to the general economic conditions. It may
be very high under favourable economic conditions and very low under unfavourable
economic conditions. Thus, the investment would .be profitable in the former situation and
unprofitable in the latter case. But, it is quite difficult to predict the future state of economic
conditions. Because of the uncertainty of the economic conditions, uncertainty about the
cash flows associated with the investment derives.
A large number of events influence forecasts. These events can be grouped in different
ways. However, no particular grouping of events will be useful for all purposes. We may,
for example, consider three broad categories of the events influencing the investment
forecasts:
- General economic conditions This category includes events which influence the
general level of business activity. The level of business activity might be affected by
such events as internal and external economic and political situations, monetary
and fiscal policies, social conditions etc.
- Industry factors This category of events may affect all companies in an industry.
For example, companies in an industry would be affected by the industrial relations
in the industry, by innovations, by change in material cost etc.
DBA 1764
NOTES
- Company factors This category of events may affect only a company. The change
in management, strike in the company, a natural disaster such as flood or fire may
affect directly a particular company.
In formal terms, the risk associated with an investment may be defined as the variability
that is likely to occur in the future returns from the investment. For example, if a person
invests, say Rs 20,000 in short-term government bonds, which are expected to yield 9 per
cent return, he can accurately estimate the return on the investment. Such an investment is
relatively risk-free. The reason for this belief is that government will not fail and will pay
interest regularly and repay the amount invested. It is for this reason that the rate of interest
paid on government securities, such as short-term treasury bills, is the risk-free rate of
interest. Instead of investing Rs 20,000 in government securities, if the investor purchases
the shares of a company, then it is not possible to estimate future return accurately. The
return could be negative, zero or some extremely large figure. Because of the high degree
of the variability associated with the future returns, this investment would be considered
risky.
Risk is associated with the variability of future returns of a project. The greater the
variability of the expected returns, the riskier is the project. Risk can, however, be measured
more precisely. The most common measures of risk are standard deviation and coefficient
of variations.
3.2 STATISTICAL TECHNIQUES FOR RISK ANALYSIS
Statistical techniques are analytical tools for handling risky investments. These
techniques, drawing from the fields of mathematics, logic, economics and psychology,
enable the decision-maker to make decisions under risk or uncertainty. The concept of
probability is fundamental to the use of the risk analysis techniques. How is probability
defined? How are probabilities estimated? How are they used in the risk analysis techniques?
How do statistical techniques help in resolving the complex problem of analysing risk in
capital budgeting? We attempt to answer these questions in this section.
3.2.1 Probability Defined
The most crucial information for the capital budgeting decision is a forecast of future
cash flows. A typical forecast is single figure for a period. This is referred to as best
estimate or most likely forecast. But the questions are: To what extent can one rely on
this single figure? How is this figure arrived at? Does it reflect risk? In fact, the decision
analysis is limited in two ways by this single figure forecast. Firstly, we do not know the
chances of this figure actually occurring, i.e., the uncertainty surrounding this figure. In
other words, we do not know the range of the forecast and the chance or the probability
estimates associated with figures within this range. Secondly, the meaning of best estimates
or most likely is not very clear. It is not known whether it is mean, median or mode. For
NOTES
these reasons, a forecaster should not give just one estimate, but a range of associated
probabilitya probability distribution.
Probability may be described as a measure of someones opinion about the likelihood
that an event will occur. If an event is certain to occur, we say that it has a probability of
one. If an event is certain not to occur, we say that its probability of occurring is zero. Thus,
probability of all events to occur lies between zero and one. A probability distribution may
consist of a number of estimates. But in the simple form it may consist of only a few
estimates. One commonly used form employs only the high, low and best guess estimates,
or the optimistic, most likely and pessimistic estimates. For example, the annual cash flows
expected from a project could be Rs 200,000 or Rs 170,000 or Rs 80,000:
It can easily be seen that this is an improvement over the single figure forecast. But still
some more information can be disclosed. What does the forecaster feel about the occurrence
of these estimates? Are these forecasts likely equal? The forecast should describe more
accurately his degree of confidence in his forecasts; that is, he should describe his feelings
as to the probability of these estimates occurring. For example, he may assign the following
probabilities to his estimates:
The forecaster considers the chance or probability of the annual cash flows being
either Rs 200,000 (maximum) or Rs 80,000 (minimum) 20 per cent each. There is a 60
per cent probability that annual cash flows may be Rs 170,000. The additional information
provided by the forecaster is useful in assessing more clearly the impact of a variable,
which may assume different values, on the profitability of an investment. A pertinent question
is: How to obtain probability distributions?
3.2.2 Assigning probability
The classical probability theory assumes that no statement whatsoever can be made
about the probability of any single event. In fact, the classical view holds that one can talk
about probability in a very long run sense, given that the occurrence or non-occurrence of
Assumption Cash Flow (Rs.)
Best Guess 200,000
High Guess 170,000
Low guess 80,000
Assumption Cash Flow (Rs.) Probability
Best Guess 200,000 0.2
High Guess 170,000 0.6
Low guess 80,000 0.2
DBA 1764
NOTES
the event can be repeatedly observed over a very large number of times under independent
identical situations. Thus, the probability estimate, which is based on a very large number
of observations, is known as an objective probability.
The classical concept of objective probability is of little use in analysing investment
decisions because these decisions are non-repetitive and hardly made under independent
identical conditions over time. As a result, some people opine that it is not very useful to
express the forecasters estimates in terms of probability. However, in recent years another
view of probability has revived, that is, the personalistic view, which holds that it makes a
great deal of sense to talk about the probability of a single event, without reference to the
repeatability, long run frequency concept. It is perfectly valid, therefore, to talk about the
probability of rain tomorrow, the probability of sales reaching a certain level next year, or
the probability that earnings per share will exceed Rs 2.50 next year, or five years hence.
Such probability assignments that reflect the state of belief of a person rather than the
objective evidence of a large number of trials are called personal or subjective
probabilities.
3.3 RISK AND UNCERTAINTY
Risk is sometimes distinguished from uncertainty. Risk is referred to a situation where
the probability distribution of the cash flow of an investment proposal is known. On the
other hand, if no information is available to formulate a probability distribution of the cash
flows the situation is known as uncertainty. Most financial authors do not recognise this
distinction and use the two terms interchangeably. We too follow this approach.
3.3.1 Expected Net Present Value
Once the probability assignments have been made to the future cash flows, the next
step is to find out the expected net present value. The expected net present value can
be found out by multiplying the monetary values of the possible events (cash flows) by their
probabilities. The following equation describes the expected net present value.
flows cash net ected exp of values present of Sum value present net Expected =

=
+
=
n
0 t
t
t
k) (l
ENCF
ENPV
(1)
where ENPV is the expected net present value, ENCF
f
expected net cash flows (including
both inflows and outflows) in period t and k is the discount rate. The expected net cash
flow can be calculated as follows:
ENCF
t
= NCF
jt
x P
jt
NOTES
where NCF
jt
is net cash flow for jth event in period t and P
jt
probability of net cash flow
for jth event in period t.
Illustration 3.1 Expected Net Cash Flow: Single Period
The following are the possible net cash flows of Projects X and Y and their associated
probabilities. Both projects have a discount rate of 10 per cent. Calculate the expected net
present value for each project. Which project is preferable?
Table 3.1 gives the calculations of the expected value for Project X and Project Y.
Table 3.1 Calculation of Expected Value for Project X and Project V
It can be seen from Table 3.1 that Projects Y has a higher expected net cash flow, i.e.,
Rs 8,000 and, therefore, would be preferable to Project X which has an expected net cash
flow of Rs 6,000. Project Y will also have a higher net present value when the expected net
cash flows of the two projects are discounted at the same rate. If we assume a discount
Project X Project Y
Cash Flow Cash Flow
Possible
Event
(Rs) Probability (Rs) Probability
A 4,000 0.10 12,000 0.10
B 5,000 0.20 10,000 0.15
C 6,000 0.40 8,000 0.50
D 7,000 0.20 6,000 0.15
E 8,000 0.10 4,000 0.10
X Y
Possible
events
Net Cash
Flow
(Rs)
Proba-
bility
Expected
Value
Rs
Net
Cash
Flow
Rs
Proba-
bility
Expected
Value
Rs
A 4,000 0.10 400 2,000 0.10 200
B 5,000 0.20 1,000 10,000 0.15 1,500
C 6,000 0.40 2,400 8,000 0.50 4,000
D 7,000 0.20 1,400 6,000 0.15 900
E 8,000 0.10 800 4,000 0.10 400
ENCF 6,000 8,000

DBA 1764
NOTES
rate of 10 per cent and an equal initial cost of Rs 5,000 for each project, the net present
value for Project X is (0.909 x Rs 6,000 - Rs 5,000) = Rs 454. Project ys NPV is:
(0.909 x Rs 8,000 - Rs 5,000) = Rs 2,272.
Instead of one-year cash flow estimates if we have cash flow estimates for several
years, the mechanism for calculating the expected value just described can be simply
extended.
Illustration 3.2: Expected Net Present Value: Multiple Period
A company has determined the following probabilities for net cash flows for three
years generated by a project:
Calculate the expected net cash flows. Also calculate the present value of the expected
cash flow, using 10 per cent discount rate. Table 3.2 shows the calculation of the expected
net present value.
Table 3.2: Calculation of the Expected Value (Three-Year Period)
Year 1 Year 2 Year3
Cash Flow
(Rs)
Probability
Cash Flow
(Rs)
Probability
Cash Flow
(Rs)
Probability
1,000 0.1 1,000 0.2 1,000 0.3
2,000 0.2 2,000 0.3 2,000 0.4
3,000 0.3 3,000 0.4 3,000 0.2
4,000 0.4 4,000 0.1 4,000 0.1
Year 1 Year 2 Year 3
Cash
Flow
(Rs)
Probability
Expected
Value
(Rs)
Cash
Flow
(Rs)
Probability
Expected
Value
(Rs)
Cash
Flow
(Rs)
Probability
Expected
Value
(Rs)
1,000 0.1 100 1,000 0.2 200 1,000 0.3 300
2,000 0.2 400 2,000 0.3 600 2,000 0.4 800
3,000 0.3 900 3,000 0.4 1,200 3,000 0.2 600
4,000 0.4 1,600
3,000
4,000 0.1 400 4,000 0.1 400
ENCF 2,400 2,100

NOTES
The present value of the expected value of cash flow at 10 per cent discount rate has
been determined as follows:
0 Rs.6,286.5
2,100x0.71 6 2,400x0.82 09 3,000x0.09
(1.1)
2,100
(1.1)
2,400
(1.1)
3,000

k) (l
ENCF
k) (l
ENCF
k) (l
ENCF
(ENCF) PV
3 2 1
3
3
2
2
1
1
=
+ + =
+ + =
+
+
+
+
+
=
Illustration 3.3: Expected NPV
Suppose an investment project has a life of three years, and it would involve an
initial cost of Rs 10,000. Based on the possible economic conditions, the expected net
cash flows and associated probabilities are given in Table 3.3. If the discount rate is 15 per
cent, calculate the expected NPV.
Table 3.3: Expected Cash Flow
For each year, ENCF can be calculated as follows:
ENCF
1
= (5,000 x 0.2) + (3,000 x 0.7) + (1,000 x 0.1) = 3,200
ENCF
2
= (6,000 x 0.3) + (4,000 x 0.5) + (2,000 x 0.2) = 4,200
ENCF
3
= (8,000 x 0.4) x (6,000 x 0.3) + (3,000 x 0.3) = 5,900
Year Economic Conditions NCF (Rs) Probability
0 -10,000 1.0
1 High growth 5,000 0.2
Average growth 3,000 0.7
No growth 1,000 0.1
No growth 2,000 0.2
No growth 3,000 0.3
DBA 1764
NOTES
Cash outlay of Rs 10,000 in year 0 is expected to remain the same in all economic
conditions. The expected NPV can be calculated as follows:
Rs.159
10,000 8 5,900x0.65 6 4,200x0.75 0 3,200x0.87
10,000
(1.15)
5,900
(1.15)
4,200
(1.15)
3,200
ENPV
3 2
=
+ + =
+ + =
3.4 VARIANCE OR STANDARD DEVIATION: ABSOLUTE MEASURE OF
RISK
Although, through the calculation of the expected net present value, risk is explicitly
incorporated into the capital budgeting analysis, yet a better insight into the risk analysis
will be obtained if we find out the dispersion of cash flows, i.e., the difference between
the possible cash flows that can occur and their expected value. The dispersion of cash
flow indicates the degree of risk. A commonly used measure of risk is the standard deviation
or variance. Simply stated, variance measures the deviation about expected cash flow of
each of the possible cash flows. Standard deviation is the square root of variance. The
formulae to calculate variance and standard deviation are as follows:
Variance of NCF = (NCF
1
- ENCF)
2
Prob
1
+(NCF
2
- ENCF)
2
Prob
2
+ ...+ (NCF
n
-ENCF)
2
Prob
n
o(NCF) = (NCF
j
- ENCF)
2
P
j
(2)
As stated earlier, the square root of variance is standard deviation (o):

(NCF) (NCF)
2 2
=
(3)
Given the data for Projects X and Y in Illustration 3.1 and using Equations (2) and
(3) we can calculate variance and standard deviation as follows:
Project X:
2
(NCF) = (4,000- 6,000)
2
(0.1) + (5,000 + 6,000)
2
(0.2)
+ (6,000- 6,000)
2
(0.4) + (7,000 - 6,000)
2
(0.2)
+ (8,000-6,000)
2
(0.1) = 1,200,000
2
(NCF) = \1,200,000 = 1095.45
NOTES
Project Y:
2
(NCF) = (12,000- 8,000)
2
(0.1) + (10,000 - 8,000)
2
(0.15)
+ (8,000- 8,000)
2
(0.5) + (6,000 - 8,000)
2
(0.15)
+ (4,000 - 8,000)
2
(0.1) = 4,400,000
2
(NCF) = \4,400,000 = 2097.62
The calculation of standard deviation clearly shows that Project Y is riskier as it has a
higher standard deviation. Had the expected net present values of the two projects been
same, on the basis of the standard deviation as a measure of risk, Project X would have
been favoured. But the decision-maker is in a dilemma because Project Y not only has a
larger expected net present value, but also a larger standard deviation as compared to
Project X. To resolve such problems, instead of analysing risk in absolute terms, it may be
measured in relative terms.
3.4.1 Coefficient of Variation: Relative Measure of Risk
A relative measure of risk is the coefficient of variation. It is defined as the
standard deviation of the probability distribution divided by its expected value:

value Expected
deviation Standard
CV variation of t Coefficien = = (4)
The coefficient of variation is a useful measure of risk when we are comparing the
projects which have (i) same standard deviations but different expected values, or (ii)
different standard deviations but same expected values, or (iii) different standard deviations
and different expected values. In illustration 3.1, Project X has an expected value of Rs
6,000 and a standard deviation of Rs 1,095.45, while Project Y has an expected value of
Rs 8,000 and a standard deviation of Rs 2,097.62. Intuitively, Project Y may be preferred,
because of the larger expected net present value. But it is more risky as compared to
Project X. This is verified by calculating the coefficients of variation for the two projects.
The coefficient of variation for Project X is (1095.45/6,000) = 0.1826, while for Project
Y it is (2,097.62/ 8,000) =.0.2622.
Whether Project X or Project Y should be accepted will depend upon the investors
attitude towards risk. He would prefer Project Y if he is ready to assume more risk in order
to obtain a higher expected monetary value. In case he has a great aversion to risk, he
would accept Project X, for it is less risky.
DBA 1764
NOTES
3.5 CONVENTIONAL TECHNIQUES OF RISK ANALYSIS
A number of techniques to handle risk are used by managers in practice (see Exhibit
3.1). They range from simple rules of thumb to sophisticated statistical techniques. The
following are the popular, non-conventional techniques of handling risk in capital budgeting:
- Payback
- Risk-adjusted discount rate
- Certainty equivalent
These methods, as discussed below, are simple, familiar and partially defensible on
theoretical grounds. However, they are based on highly simplified and at times, unrealistic
assumptions. They fail to take account of the whole range of the effect of risky factors on
the investment decision-making.
3.5.1 Payback
Payback is one of the oldest and commonly used methods for explicitly recognising
risk associated with an investment project. This method, as applied in practice, is more an
attempt to allow for risk in capital budgeting decision rather than a method to measure
profitability. Business firms using this method usually prefer short payback to longer ones,
and often establish guidelines that a firm should accept investments with some maximum
payback period, say three or five years.
The merit of payback is its simplicity. Also, payback makes an allowance for risk by
(i) focusing attention on the near term future and thereby emphasising the liquidity of the
firm through recovery of capital, and (ii) by favouring short term projects over what may
be riskier, longer term projects.
It should be realised, however, that the payback period, as a method of risk analysis,
is useful only in allowing for a special type of risk the risk that a project will go exactly
as planned for a certain period and will then suddenly cease altogether and be worth
nothing. It is essentially suited to the assessment of risks of time nature. Once a payback
period has been calculated, the decision-maker would compare it with his own assessment
of the projects likely, and if the latter exceeds the former, he would accept the project. This
is a useful procedure, economic only if the forecasts of cash flows associated with the
project are likely to be unimpaired for a certain period. The risk that a project will suddenly
cease altogether after a certain period may arise due to reasons such as civil war in a
country, closure of the business due to an indefinite strike by the workers, introduction of
a new product by a competitor which captures the whole market and natural disasters
such as flood or fire. Such risks undoubtedly exist but they, by no means, constitute a large
proportion of the commonly encountered business risks. The usual risk in business is not
that a project will go as forecast for a period and then collapse altogether; rather the
NOTES
normal business risk is that the forecasts of cash flows will go wrong due to lower sales,
higher cost etc.
Further, even as a method for allowing risks of time nature, it ignores the time value of
cash flows. For example, two projects with, say a four-year payback period are at very
different risks if in one case the capital is recovered evenly over the four years, while in the
other it is recovered in the last year. Obviously, the second project is more risky. If both
cease after three years, the first project would have recovered three-fourths of its capital,
while all capital would be lost in the case of second project. Given the uncertainty element,
it may well be that a four-year payback period, based on fairly certain estimates might be
preferred to a three-year payback period, calculated with very uncertain estimates.
3.5.2 Risk-Adjusted Discount Rate
For a long time, economic theorists have assumed that, to allow for risk, the
businessman required a premium over and above an alternative, which was risk-free.
Accordingly, the more uncertain the returns in the future, the greater the risk and the greater
the premium required. Based on this reasoning, it is proposed that the risk premium be
incorporated into the capital budgeting analysis through the discount rate. That is, if the
time preference for money is to be recognised by discounting estimated future cash flows,
at some risk-free rate, to their present value, then, to allow for the riskiness, of those
future cash flows a risk premium rate may be added to risk-free discount rate. Such a
composite discount rate, called the risk-adjusted discount rate, will allow for both time
preference and risk preference and will be a sum of the risk-free rate and the risk-premium
rate reflecting the investors attitude towards risk. The risk-adjusted discount rate method
can be formally expressed as follows:
=
+
=
n
0 t
t
t
k) (l
NCF
NPV
(5)
where k is a risk-adjusted rate. That is:
Risk-adjusted discount rate = Risk-free rate + Risk premium
k=k
f
+k
r
(6)
Under CAPM, the risk-premium is the difference between the market rate of return
and the risk-free rate multiplied by the beta of the project.
The risk-adjusted discount rate accounts for risk by varying the discount rate depending
on the degree of risk of investment projects. A higher rate will be used for riskier projects
and a lower rate for less risky projects. The net present value will decrease with increasing
k, indicating that the riskier a project is perceived, the less likely it will be accepted. If the
risk-free rate is assumed to be 10 per cent, some rate would be added to it, say 5 per cent,
DBA 1764
NOTES
as compensation for the risk of the investment, and the composite 15 per cent rate would
be used to discount the cash flows.
Illustration 3.4: Risk-adjusted Discount Rate and NPV
An investment project will cost Rs 50,000 initially and it is expected to generate cash
flows in years one through four of Rs 25,000, Rs 20,000, Rs 10,000 and Rs 10,000.
What is the projects NPV, if it is expected to generate certain cash flows? Assume a 10
per cent risk-free rate. The net present value for the project, using a 10 per cent risk-free
discount rate, is:
Rs.3,599
0.10) (l
Rs.10,000
0.10) (l
Rs.10,000

0.10) (l
Rs.20,000
0.10) (l
Rs.25,000
Rs.50,000 - NPV
2 3
2 1
+ =
+
+
+
+
+
+
+
+ =
If the project is risky, then a higher rate should be used to allow for the perceived risk.
Assuming this rate to be 15 per cent, the net present value of the project will be:
845 Rs.
0.15) (l
Rs.10,000
0.15) (l
Rs.10,000

0.15) (l
Rs.20,000
0.15) (l
Rs.25,000
Rs.50,000 - NPV
2 3
2 1
=
+
+
+
+
+
+
+
+ =
Thus, we observe that the project would be accepted when no allowance for risk is
granted, but it is unacceptable if a risk-premium is added to the discount rate.
In contrast to the net present value method, if a firm uses the internal rate of return
method, then the internal rate of return for the project should be compared with the risk-
adjusted minimum required rate of return. If the internal rate of return is higher than this
adjusted rate, then the project would be accepted; otherwise, it should be rejected.
3.5.2.1 Evaluation of risk-adjusted discount rate
The following are the advantages of risk-adjusted discount rate method:
- It is simple and can be easily understood.
- It has a great deal of intuitive appeal for risk-averse businessman.
- It incorporates an attitude (risk-aversion) towards uncertainty.
NOTES
This approach, however, suffers from the following limitations:
- There is no easy way of deriving a risk-adjusted discount rate. As discussed earlier,
CAPM provides for a basis of calculating the risk-adjusted discount rate. Its use
has yet to pick up in practice.
- It does not make any risk adjustment in the numerator for the cash flows that are
forecast over the future years.
- It is based on the assumption that investors are risk-averse. Though it is generally
true, there exists a category of risk seekers who do not demand premium for
assuming risks; they are willing to pay a premium to take risks. Accordingly, the
composite discount rate would be reduced, not increased, as the level of risk
increases.
3.5.3 Certainty Equivalent
Yet another common procedure for dealing with risk in capital budgeting is to reduce
the forecasts of cash flows to some conservative levels. For example, if an investor,
according to his best estimate, expects a cash flow of Rs 60,000 next year, he will apply
an intuitive correction factor and may work with Rs 40,000 to be on safe side. There is a
certainty-equivalent cash flow. In formal way, the certainty equivalent approach may be
expressed as:
=
+
o
=
n
0 t
t
t
kf) (1
NCF
NPV
t
(7)
where NCF
t
= the forecasts of net cash flow without risk-adjustment
t
= the risk-adjustment factor or the certainty-equivalent coefficient
k
f
= risk-free rate assumed to be constant for all periods.
The certainty-equivalent coefficient, o
t
assumes a value between 0 and 1, and varies
inversely with risk. A lower o
t
will be used if greater risk is perceived and a higher o
t
will
be used if lower risk is anticipated. The decision-maker subjectively or objectively
establishes the coefficients. These coefficients reflect the decision-makers confidence in
obtaining a particular cash flow in period t. For example, a cash flow of Rs 20,000 may be
estimated in the next year, but if the investor feels that only 80 per cent of it is a certain
amount, then the certainty-equivalent coefficient will be 0.80. That is, he considers only Rs
16,000 as the certain cash flow. Thus, to obtain certain cash flows, we will multiply estimated
cash flows by the certainty-equivalent coefficients.
The certainty-equivalent coefficient can be determined as a relationship between the
certain cash flows and the risky cash flows. That is:
DBA 1764
NOTES
flow cash net Risky
flow cash net Certain
NCF
NCF
t
*
t
t
= =
For example, if one expected a risky cash flow of Rs 80,000 in period t and considers
a certain cash flow of Rs 60,000 equally desirable, then o
t
will be 0.75 = 60,000/80,000.
Illustration 3.5: Certainty Equivalent and NPV
A project costs Rs 6,000 and it has cash flows of Rs 4,000, Rs 3,000,
Rs 2,000 and Rs 1,000 in years 1 through 4. Assume that the associated o
t
, factors are
estimated to be: o
0
= 1.00, o
1
= 0.90, o
2
= 0.70, o
3
= 0.50 and o
4
= 0.30, and the risk-
free discount rate is 10 per cent. The net present value will be:
Rs.36 -
0.10) (l
(1,000) 0.30
0.10) (l
(2,000) 0.50

0.10) (l
(3,000) 0.70
0.10) (l
(4,000) 0.90
(-6,000) 1.0 - NFV
4 3
2 1
=
+
+
+
+
+
+
+
+ =
The project would be rejected as it has a negative net present value.
If the internal rate of return method is used, we will calculate that rate of discount,
which equates the present value of certainty-equivalent cash inflows with the present value
of certainty-equivalent cash outflows. The rate so found will be compared with the minimum
required risk-free rate. Project will be accepted if the internal rate is higher than the minimum
rate; otherwise it will be unacceptable.
3.5.3.2 Evaluation of certainty equivalent
The certainty-equivalent approach explicitly recognises risk, but the procedure for
reducing the forecasts of cash flows is implicit and is likely to be inconsistent from one
investment to another. Further, this method suffers from many dangers in a large enterprise.
First, the forecaster, expecting the reduction that will be made in his forecasts, may inflate
them in anticipation. This will no longer give forecasts according to best estimate. Second,
if forecasts have to pass through several layers of management, the effect may be to greatly
exaggerate the original forecast or to make it ultra conservative. Third, by focusing explicit
attention only on the gloomy outcomes, chances are increased for passing by some good
investments.
3.5.3.3 Risk-Adjusted Discount Rate vs. Certainty-Equivalent
The certainty-equivalent approach recognises risk in capital budgeting analysis by
adjusting estimated cash flows and employs risk-free rate to discount the adjusted cash
flows. On the other hand, the risk-adjusted discount rate adjusts for risk by adjusting the
discount rate. It has been suggested that the certainty equivalent approach is theoretically
NOTES
a superior technique over the risk-adjusted discount approach because it can measure risk
more accurately.
The risk-adjusted discount rate approach will yield the same result as the certainty-
equivalent approach if the risk-free rate is constant and the risk-adjusted discount rate is
the same for all future periods. Thus,
t
t
t
f
t t
k) (l
NCF
) k (l
NCF
+
=
+
(9)
To solve for o
t
o
t
NCF
t
(l + k)
t
= NCF
t
(l + k
f
)
t
t
t
f
t
t
t
t
t
k) (l
) k (l
k) (l NCF
kf) (l NCF
+
+
=
+
+
= o
(10)
For period t + 1, Equation (9) will become
l t
1 t
t
k) (1
kf) (1
1
+
+
+
+
= + o
(11)
Earlier, we have stated that the values of a
t
will vary between 0 and 1. Thus, if k
f
. and
k are constant for all future periods, then k must be larger than , to k
f
satisfy the condition
that o
t
varies between 0 and 1. As a result,
t+1
would be less than o
t
. To illustrate, let us
assume fk = 10 per cent k
f
= 5 per cent and t= 1, then
955 . 0
(1.10)
(1.05)
1
1
1
t
= = + o
When t = 2, then
911 . 0
(1.10)
(1.05)
2
2
2
= = o
Risk over time: It can be observed that o
t
will be a decreasing function of time with a
constant k. This implies that risk is an increasing function of time. This assumption may or
may not be true in the actual investment under consideration. We can think of an investment,
which may be more risky during the gestation period, and once established, the risk may
reduce. In such a situation, the use of a constant risk-adjusted discount rate is not valid.
But the increased or decreased risks over a period of time can easily be accounted for by
changing o
tt
factors when the certainty-equivalent approach is used. Therefore, the
certainty-equivalent approach is considered superior to the risk-adjusted discount rate.
Even if the assumption that risk increases with time is valid, the problem with the risk-
adjusted discount rate is to select the value of k, which properly measures the degree of
increasing risk. It is difficult to specify such a rate. With the certainty-equivalent approach,
the o
t
factors in each period will specify, the different degree of risk.
DBA 1764
NOTES
3.6 SENSITIVITY ANALYSIS
In the evaluation of an investment project, we work with the forecasts of cash flows.
Forecasted cash flows depend on the expected revenue and costs. Further, expected
revenue is a function of sales volume and unit selling price. Similarly, sales volume will
depend on the market size and the firms market share. Costs include variable costs, which
depend on sales volume and unit variable cost and fixed costs. The net present value or the
internal rate of return of a project is determined by analysing the after-tax cash flows
arrived at by combining forecasts of various variables. It is difficult to arrive at an accurate
and unbiased forecast of each variable. We cant be certain about the outcome of any of
these variables. The reliability of the NPV or IRR of the project will depend on the reliability-
of the forecasts of variables underlying the estimates of net cash flows. To determine the
reliability of the projects NPV or IRR, we can work out how much difference it makes if
any of these forecasts goes wrong. We can change each of the forecast, one at a time, to
at least three values: pessimistic, expected, and optimistic. The NPV of the project is
recalculated under these different assumptions. This method of recalculating NPV or IRR
by changing each forecast is called sensitivity analysis.
Sensitivity analysis is a way of analysing change in the projects NPV (or IRR) for a
given change in one of the variables. It indicates how sensitive a projects NPV (or IRR) is
to changes in particular variables. The more sensitive the NPV, the more critical is the
variable. The following three steps are involved in the use of sensitivity analysis:
- Identification of all those variables, which have an influence on the projects NPV
(or IRR).
- Definition of the underlying (mathematical) relationship between the variables.
- Analysis of the impact of the change in each of the variables on the projects NPV.
The decision-maker, while performing sensitivity analysis, computes the projects NPV
(or IRR) for each forecast under three assumptions: (a) pessimistic, (b) expected, and (c)
optimistic. It allows him to ask what if questions. For example, what (is the NPV) if volume
increase or decreases? What (is the NPV) if variable cost or fixed cost increases or
decreases? What (is the NPV) if the selling price increases or decreases? What (is the
NPV) if the project is delayed or outlay escalates or the projects life is more or less than
anticipated? A whole range of questions can be answered with the help of sensitivity analysis.
It examines the sensitivity of the variables underlying the computation of NPV or IRR,
rather than attempting to quantify risk. It can be applied to any variable, which is an input
for the after-tax cash flows. Let us consider an example.
Illustration 3.6: Sensitivity Analysis
The financial manager of XL Food Processing Company is considering the installation
of a plant costing Rs 10 million to increase its processing capacity. The expected values of
NOTES
the underlying variables are given in Tables 3.4 and 3.5 provides the projects after-tax
cash flows over its expected life of 7 years. Salvage value is assumed to be zero.
Table 3.4: Expected Values of Variables
The projects NPV at 12 per cent discount rate and IRR are as follows:
NPV = +4,973
IRR= 27.05%
Since NPV is positive (or IRR > discount rate), the project can be undertaken.
Table 3.5: Net Cash Flows of the Project
Note: Depreciation in the seventh year includes depreciation of the seventh year, Rs 415-
and the present value of depreciation beyond seventh year, Rs 902 = [.25/(.12+ .25)] x
Rs 1,335. Rs 1,335 is the book value at the end of seventh year.
1 Investment (Rs'000) 10,000
2 Sales volume (units '000) 1,000
3 Unit selling price (Rs) 15
4 Unit variable cost (Rs) 6.75
5 Annual fixed costs (Rs '000) 4,000
6 Depreciation (WDV) 25%
7 Corporate tax rate 35%
8 Discount rate 12%
Cash Flows (Rs.000)
Year 0 1 2 3 4 5 6 7
1.Investment -10,000
2.Revenue 15,000 15,000 15,000 15,000 15,000 15,000 15,000
3.Variable cost 6,750 6,750 6,750 6,750 6,750 6,750 6,750
4.Fixed cost 4,000 4,000 4,000 4,000 4,000 4,000 4,000
5.Depreciation 2,500 1,875 1,406 1,055 791 593 1,347
6. EBIT (2-3-4-5) 1,750 2,375 2,844 3,195 3,459 3,657 2,903
7. Tax 613 831 995 1,118 1,211 1,280 1,016
8. PAT (6-7) 1,138 1,544 1,848 2,077 2,248 2,377 1,887
9. .NCF (1+5+8) -10,000 3,638 3,419 3,255 3,132 3,039 2,970 3,234

DBA 1764
NOTES
How confident is the financial manager about his forecasts of various variables? Before
he takes a decision, he may like to know whether the NPV changes, if any, of the forecasts
goes wrong. A sensitivity analysis can be conducted with regard to volume, price, costs
etc. In order to do so, we must obtain pessimistic and optimistic estimates of the underlying
variables. Let us assume the pessimistic and the optimistic values for volume, price and
costs as shown in Table 3.6.
Table 3.6: Forecasts under Different Assumptions
If we change each variable (others holding constant), the projects NPVs are
recalculated in Table 3.7 (detailed calculations not shown).
Table 3.7: Sensitivity Analysis under Different Assumptions
Table 3.7 shows the projects NPV when each variable is set to its pessimistic, expected
and optimistic values. The most critical variables are sales volume and unit selling price. If
the volume declines by 25 per cent (to 750,000 units), NPV of the project becomes
negative (-Rs 1,146,000). Similarly, if the unit selling price falls by 15 per cent (to Rs
12.75), NPV is minus Rs 1,702,000.
3.7 DCF BREAK-EVEN ANALYSIS
Sensitivity analysis is a variation of the break-even, analysis. What you are asking is:
what shall be the consequences if volume or price or cost changes? You can ask this
question differently: How much lower can the sales volume become before the project
becomes unprofitable? What you are asking for is the breakeven point. Let us work with
Variable Pessimistic Expected Optimistic
Volume (units'000) 750 1,000 1,25
Units selling price (Rs) 12.75 15.00 16.5
Units variable cost (Rs) 7.425 6.75 6.075
Annual fixed costs
(Rs '000) 4,800 4,000 3,200
Variable Pessimistic Expected Optimistic
Volume 1,146 4,973 10,091
Units selling price 1,702 4,973 9,422
Units variable cost 2,970 4,973 6,975
Annual fixed costs 2,599 4,973 7,346
NOTES
the expected values of the variables in Illustration 3.6. We can measure the after-tax cash
flows as follows (assuming revenues and expenses are entirely, on cash basis):
NCF = (REV-EXP) (1 -7) + TDEP
In our example, the first part of the right-hand expression is an annuity:
[1000 (15 - 6.75) - 4000] (1 - 0.35) = Rs 2,763
and its present value at 12 per cent discount rate is:
2,763 * 4.5638 = 12,610
The salvage value is zero. Under the gross block of assets method, the depreciation
tax shield is available for ever (until the block of assets is sold). Hence, assuming indefinite
period of time, the present value of depreciation tax shield on plant of Rs 10,000 is as
follows:
000 , 10 X
12 . 25 .
25 . x 35 .
V 0 X
k d
Td
PVDTS
+
=
+
=
= Rs.2,365
Here by the break-even point we mean that point where NPV is zero. We can use
the following expression to determine break-even point:
NPV = PV of NCF - Investment = 0
= [{V(15-6.75) - 4,000} 0.65 * 4.5638
+ 2,365]-10,000 = 0 (1)
where V is the sales volume, 4.5638 is the present value factor of a 7-year annuity (at 12
per cent) and Rs 2,365 is the present value of the series of depreciation tax shield. We can
solve Equation (1) as follows:
NPV = 24.4734V- 11,866 + 2,365 - 10,000 = 0 24.4734
V =19,501
V=797
The project will start losing money if the sales volume goes below 797,000 units (i.e.,
if the sales decline by more than 20 per cent). Let us verify if NPV is zero at this sales
volume:
NPV = [(797(15 - 6.75) - 4,000) 0.65 x 4.5638 + 2,365]10,000
= 7,639 + 2,365-10,000 = 0
DBA 1764
NOTES
We can similarly work out the lowest selling price. Given other assumptions, how
low the units selling price can go before the projects NPV becomes negative? We can
solve the following equations:
NPV=[(100(p-6.75)-4,000)0.65x4.5638+2,365]-10,000
= 0
= 2,966.47/? - 20,024-11,866+ 2,365-10,000 = 0
= 29,66.47/>-39,525 = 0
p = 39,525/2,966.47 = 13.32
Let us verify:
NPV = [(1000(13.32-6.75)-4,000)0.65x4.5638+2,365] -10,000 = 7,625 + 2,365-
10,000 = 0
You should note that the DCF break-even point is different from the accounting
break-even point. The accounting breakeven point is estimated as fixed costs divided
by the contribution ratio. It does not account for the opportunity cost of capital, and fixed
costs include both cash plus non-cash costs (such as depreciation). Thus, you may be
operating above the accounting break-even point but still losing money because you have
ignored the opportunity cost of capital.
Pros and Cons of Sensitivity Analysis
Sensitivity analysis has the following advantages
- It compels the decision maker to identify the variables, which affect the cash flow
forecasts. This helps him in understanding the investment project in totality.
- It indicates the critical variables for which additional information may be obtained.
The decision maker can consider actions, which may help in strengthening the
weak spots in the project.
It helps to expose inappropriate forecasts, and thus guides the decision-maker to
concentrate on relevant variables.
Let us emphasise that sensitivity analysis is not a panacea for a projects all uncertainties.
It helps a decision-maker to understand the project better. It has the following limitations:
- It does not provide clear-cut results. The terms optimistic and pessimistic could
mean different things to different persons in an organisation. Thus, the range of
values suggested may be inconsistent.
NOTES
- It fails to focus on the interrelationship between variables. For example, sale volume
may be related to price and cost. A price cut may lead to high sales and low
operating cost.
3.8. SCENARIO ANALYSIS
The simple sensitivity analysis assumes that variables are independent of each other.
In practice, the variables will be interrelated and they may change in combination. One
way to examine the risk of investment is to analyse the impact of alternative combinations
of variables, called scenarios, on the projects NPV (or IRR). The decision-maker can
develop some plausible scenarios for this purpose. For instance, in our example, we can
consider three scenarios: pessimistic, optimistic and expected. In the expected scenario, it
may be possible to increase base volume of 1,000,000 units to 1,250,000 units (25 per
cent increase) if the company reduces selling price from Rs 15 to Rs 13.50 (10 per cent
reduction), resorts to aggressive advertisement campaign, thereby increasing unit variable
cost to Rs 7.10 (5 per cent increase) and fixed cost to Rs 4,400,000 (10 per cent increase).
Table 3.8 shows that this scenario generates a positive NPV of Rs 2,901,000. NPVs
under other scenarios are also shown in Table 3.8. More plausible scenarios could be
thought out and analysed to arrive at a final judgement about the project.
Table 3.8: Scenario Analysts: Summary Report
Note: NPV calculation for the expected scenario:
NPV = [(1250 (13.5 -7.1) -4400) 0.65 x4.5638 + 2,365] -10,000
= 10,679 + 2,222 - 10,000
= Rs, 3,044
The present value of the written-down value depreciation tax shield is Rs 2,365.
Base
Scenario Summary Values Pessimistic Optimistic Expected
Variables combinations:
Sales volume (units '000) 1,000 750 1,250 1,250
Selling price/unit (Rs) 15.00 12.75 16.50 13.50
Variable cost/unit (Rs) 6.75 7.43 6.75 7.10
Fixed cost (Rs '000) 4,000 4,800 3,200 4,400
Result:
NPV (Rs '000) 4,972 -10,038 19,026 3,044

DBA 1764
NOTES
3.9 SIMULATION ANALYSIS
We have explained in the previous sections that sensitivity and scenario analyses are
quite useful to understand the uncertainty of the investment projects. But both approaches
suffer from certain weaknesses. As we have discussed, they do not consider the interactions
between variables and also, they do not reflect on the probability of the change in variables.
The Monte Carlo simulation or simply the simulation analysis considers the
interactions among variables and probabilities of the change in variables.
1
It does not give
the projects NPV as a single number rather it computes the probability distribution of
NPV. The simulation analysis is an extension of scenario analysis. In simulation analysis a
computer generates a very large number of scenarios according to the probability distributions
of the variables. The simulation analysis involves the following steps:
- First, you should identify variables that influence cash inflows and outflows. For
example, when a firm introduces a new product in the market these variables are
initial investment, market size, market growth, market share, price, variable costs,
fixed costs, product life cycle, and terminal value.
- Second, specify the formulae that relate variables. For example, revenue depends
on by sales volume and price; sales volume is given by market size, market share,
and market growth. Similarly, operating expenses depend on production, sales
and variable and fixed costs.
- Third, indicate the probability distribution for each variable. Some variables will
have more uncertainty than others. For example, it is quite difficult to predict price
or market growth with confidence.
- Fourth, develop a computer programme that randomly selects one value from the
probability distribution of each variable and uses these values to calculate the
projects NPV. The computer generates a large number of such scenarios,
calculates NPVs and stores them. The stored values are printed as a probability
distribution of the projects NPVs along with the expected NPV and its standard
deviation. The risk-free rate should be used as the discount rate to compute the
projects NPV. Since simulation is performed to account for the risk of the projects
cash flows, the discount rate should reflect only the time value of money.
Simulation analysis is a very useful technique for risk analysis. Unfortunately, its practical
use is limited because of a number of shortcomings. First, the model becomes quite complex
to use because the variables are interrelated with each other, and each variable depends
on its values in the previous periods as well. Identifying all possible relationships and
estimating probability distribution is a- difficult task; its time consuming as well as expensive.
Second, the model helps in generating a probability distribution of the projects NPVs. But
it does not indicate whether or not the project should be accepted. Third, simulation analysis,
like sensitivity or scenario analysis, considers the risk of any project in isolation of other
projects. We know that if we consider the portfolio of projects, the unsystematic risk can
NOTES
be diversified. A risky project may have a negative correlation with the firms other projects,
and therefore, accepting the project may reduce the overall risk of the firm.
3.10 DECISION TREES FOR SEQUENTIAL INVESTMENT DECISIONS
We have so far discussed simple accept-or-reject decisions, which view current
investments in isolation of subsequent decisions. . But in practice, the present investment
decisions may have implications for future investment decisions, and may affect future
events and decisions. Such complex investment decisions involve a sequence of decisions
over time. It is argued that since present choices modify future alternatives, industrial
activity cannot be reduced to a single decision and must be viewed as a sequence of
decisions extending from the present time into the future. If this notion of industrial activity
as a sequence of decisions is accepted, we must view investment expenditures not as
isolated period commitments, but as links in a chain of present and future commitments.
2
An analytical technique to handle the sequential decisions is to employ decision trees.
3
In
this section, we shall illustrate the use of decision trees in analysing and evaluating the
sequential investments.
3.10.1 Steps in Decision Tree Approach
A present decision depends upon future events, and the alternatives of a whole sequence
of decisions in future are affected by the present decision as well as future events. Thus, the
consequence of each decision is influenced by the outcome of a chance event. At the time
of taking decisions, the outcome of the chance event is not known, but a probability
distribution can be assigned to it. A decision tree is a graphic display of the relationship
between a present decision and future events, future decisions and their consequences.
The sequence of events is mapped out over time in a format similar to the branches of a
tree.
While constructing and using a decision tree, some important steps should be
considered:
- Define investment The investment proposal should be defined. Marketing,
production or any other department may sponsor the proposal. It may be either to
enter a new market or to produce a new product.
- Identify decision alternatives The decision alternatives should be clearly identified.
For example, if a company is thinking of building a plant to produce a new product,
it may construct a large plant, a medium-sized plant, or a small plant initially- and
expand it later on or construct no plant. Each alternative will have different
consequences.
- Draw a decision tree The decision tree should be graphed indicating the decision
points, chance events and other data. The relevant data such as the projected
cash flows, probability distributions, the expected present value etc., should be
located on the decision tree branches.
DBA 1764
NOTES
- Analyse data -The results should be analysed and the best alternative should be
selected.
Illustration 3.7: Decision Tree Analysis: Water Purity Limited
Water Purity Limited has developed a scientifically more effective water filter than the
ones currently available in the market. One option before the company is to start production
on a large scale by installing a large plant costing Rs 50 lakh. Alternatively, it can initially
install a small plant at a cash outlay of Rs 10 lakh and then decide to expand the capacity
after a year at a cost of Rs 45 lakh if the initial demand is high. There is a 50-50 chance that
the initial demand will be high or low. If it is high, then there is a 70 percent chance that
demand in the subsequently ears wilt be high. If turns out to be low, it is expected to remain
low in subsequent years also.
The large plant is likely to generate net cash flow of Rs 10 lakh in year 1 if demand is
high and Rs 7 lakh if demand is low. With a high initial demand, net cash flows are expected
to be Rs 16 lakh in perpetuity if the subsequent demand is high and Rs 10 lakh if the
subsequent demand is low. The subsequent demand will remain low if the initial demand is
low and the expected cash flow in perpetuity will be Rs 7 lakh. The small plant is estimated
to yield net cash flows of Rs 4 lakh in year 1 if demand is high and Rs 2 lakh if demand is
low. If the initial demand is high, the company will expand its capacity and it is expected to
generate net cash flows of Rs 20 lakh in perpetuity if the subsequent demand is high and Rs
8 lakh if the subsequent demand is low, If the initial demand is low, the subsequent demand
will be low, and the expected net cash flow is Rs 2 lakh in perpetuity. What should Water
Purity Limited do?
Fig.3.1 Water Purity Ltd: Decision Tree Approach
H 0.5 Rs 10
H 0.7 Rs 16
L 0.3 Rs 10
L 1.0 Rs 7
H 0.7 Rs 20
L 0.3 Rs 8
L 1.0 Rs 2 L 0.5 Rs 2
L 0.5 Rs 7
Expand - Rs 45 Expand - Rs 45
H 0.5 Rs 4 Small plant - Rs 10
Large plant - Rs 50
D
1
D
2
NOTES
The problem of water filter in Illustration 3.7 is a sequential decision, and can be
depicted as a decision tree as shown in Figure 3.1. We may notice the following in Figure
3.1:
- decision points shown by squares
- chance events shown by circles
The decision points faced by the company are represented by squares. The company
has to first decide whether a large plant or a small plant should be built. After one year, it
has to decide whether the capacity should be expanded if the initial choice was to build a
small plant. The chances of initial and subsequent demand being high and low are shown
by circles, and are known as chance events. The expected net cash flows with associated
probabilities are shown on the branches of tree. The probabilities of demand after year 1
depend on the demand conditions in year 1. For example, there is a 70 per cent probability
that the subsequent demand will be high if demand in year 1 is high. What is the probability
that demand will be high in the first year as well as the subsequent years? This is given by
the joint probability of occurrences of high demand, i.e., 0.5x0.7 = 0.35.
In order to decide whether the company should build a large plant or a small plant,
we should first analyse the problem of plant expansion after the first year. This is called the
method of backward induction or rolling back. If the initial demand is high and the company
expands its plant, the expected net cash flow (ENCF) is:
ENCF = 0.7 x 20 + 0.3 x 8 = Rs 16.4 lakh
To calculate the net present value of the expected net cash flow, we need a discount
rate. Let us assume that Water Purity Limited has an opportunity cost of capital of 20 per
cent. Thus the expected net present value (ENPV) of expansion costing Rs 45 lakh at-the
end of year 1 is:
ENPV =
lakhs 37 . Rs 45
2 . 0
4 . 16
=
Note that ENCF of Rs 16.4 is perpetuity, and its value is found by simply dividing it
by the discount rate. What will be ENPV in year 1 if the company decides not to expand
that plant? In our illustration this is possible only if the initial demand is low. The expected
net cash flow will remain Rs 2 lakh in perpetuity. Thus ENPV in year 1 is:
ENPV =
10 . Rs 0
20 . 0
2
= =
and ENPV to day is
ENPV =
10 0
20 . 1
10 2
= =
+
DBA 1764
NOTES
We may note that when the initial demand is low no future decision is involved since
the company will not expand. We could directly calculate ENPV as follows:
ENPV =
0
2 . 0
2
10 = +
Since ENCF of Rs 2 lakh is perpetuity from the beginning.
Expansion is expected to yield a higher expected net present value if the initial demand
is high. What is ENPV today if the company decides in favour of expansion? The company
will have to incur an initial cost of Rs 10 lakh. The expected net cash flow in year 1 will be
Rs 4 + Rs 37 = Rs 41 lakh if demand is high and Rs 2 + Rs 10 =Rs 12 lakh if demand is
low. Thus ENCF today is:
ENCF = 0.5 x 41 + 0.5 * 12 = Rs 26.5 lakh and ENPV today is
ENPV=-10 +
2 . 1
5 . 26
Rs 12.08 lakh 1.2
Instead of building a small plant and then expanding later on, the company has the
option of building a large plant today. What is ENPV today if Water Purity Limited decides
to build a large plant? The present value of ENCF in year 1 with high initial demand is:
NPV = +
0.20
14.2
0.20
0.3x10 0.7x16
=
+
Rs 12.08 lakh 1.2
and demand low initial demand:
NPV =
0.20
14.2
0.20
0.3x10 0.7x16
=
+
= Rs.35 lakhs
Thus the net Cash flow in year 1 is Rs 10 + Rs 71 = Rs 81 lakh if demand is high and
Rs 7 + Rs 35 lakh = Rs 42 lakh if demand is low. Thus, ENCF today is:
ENCF = 0.5 x 81 + 0.5 x 42 - Rs 61.5 lakh and ENPV today is:
ENPV= -50 x
lakh Rs.1.25
1.2
61.5
=
In fact, there is no need to perform backward calculation in case of the large plant
since no future decision is involved. We can calculate ENPV today as follows:
ENPV = - 50 +
1.2
71 x 0.5 10 x 0.5 +
NOTES
+
(1.2) 0.2
(1x7) 0.5 10] x 0.3 16 [0.7xc x 0.5 + +
= - 50 +
2 . 1
53 5 . 8
50
1.2
0.2 / (10.6) 8.5 +
+ +
+
= + Rs. 1.25 lakh
Note that the expected net cash flow in perpetuity after year 1 are Rs 10.6 lakh
and their present value today is Rs 53 lakh. Thus the expected net cash flow in year 1 is:
8.5 + Rs53 = Rs61.5 and their present value is Rs 51.25 lakh.
Given ENPV calculations, the best alternative for Water Purity Limited seems to
build a small plant today and expand it after a year if the initial demand is high. This alternative
yields a higher ENPV than the other alternative. Let us consider another example of
sequential investment decision-making.
Illustration 3.8: Decision Tree Analysis: Supreme Engineering Limited
Supreme Engineering Limited (SEL) has developed a new product which has a 10
year expected life. A market study conducted by the company has revealed that a domestic
as well as an export market exists for the product. It is also indicated that a small plant will
suffice to cater to the domestic demand: However, a large plant will have to be built if
export demand also has to be met. The exact magnitude of the export market is not known.
The company has the option of building a small plant today, and then, after three years
decide to expand. The company may decide to expand if the initial demand consisting of
both domestic and export is high.
Table 3.9: Data for Alternative Investment Options
Plant
Size
Cash
Quality
Initial
(1-3) years
Subsequent (4-10 years)
Demand Prob NCF Demand Prob NCF
Large 50 H 0.6 10 H
L
0.8
0.2
12
10
L 0.4 8 H
L
0.2
0,.8
8
6
Small 20 H 0.6 4 H
L
0.8
0.2
4
3
Expansion
Large 30 H 0.8 13
Small 10 H
L
0.8
0.2
7
5

DBA 1764
NOTES
Further, the company has two options vis--vis its decision to expand: the small plant
could be expanded to a large size or a small size. The market study indicates that the
chance that the initial demand will be high is 0.60 and low 0.40. Given a high initial demand,
there is 0.80 probability that demand will be high in the subsequent years and 0.20 probability
of demand being low. Table 3.9 summarises the relevant data for various options. SEL
uses a 10 per cent discount rate for evaluating its investment proposals.
Fig. 3.2: Decision Tree for Supreme Engineering Ltd
The data contained in Table 3.9 is shown in the form of a decision tree in Figure 3.2.
In order to select the best alternative, we start at the last chronological decision on the tree.
At decision point 2 three options are involved: either the firm expands to a large size and
incurs an outlay of Rs 30 lakh or expands to a small size and incurs an outlay of Rs 10 lakh
or does not expand even if the initial demand is high. Let us consider expansion to large
size first. The annual expected net cash flow for 7 years is:
ENCF = 0.8 x 13 + 0.2 x 9 = Rs 12.2
and ENPV is:
ENPV = - 30 + 12.2 x PVAF at 10% for 7 years
= - 30 + 12.2 x 4.868
= + Rs 29.39 lakh
H 0.6 Rs 10
Large Plant
Rs 50
D
1
samll plant
- Rs 20
H 0.6 Rs 4
L 0.4 Rs 3
Do not
Expand
Expand
-Rs 10
Expand
-Rs 30
H 0.8 Rs 12
L 0.2 Rs 10
L 0.2 Rs 6
H 0.2 Rs 8
H 0.8 Rs 13
L 0.2 Rs 9
H 0.8 Rs 7
L 0.2 Rs 5
L 0.2 Rs 3
H 0.8 Rs 4
H 0.2 Rs 3
L 0.8 Rs 2
D
2
L 0.4 Rs 8
NOTES
For expansion to a small size. ENCF is:
ENCF = 0.8 x 7 + 0.2 x 5 = Rs 6.6 lakh
and ENPV is:
ENPV = - 10 + 6.6 x PVAF at 10% for 7 years = - 10 + 6.6 x 4.868
= + Rs 22.13 lakh
What will be ENPV if the initial demand is high and the firm does not want to expand?
For this option, ENCF at the end of year 3 is:
ENCF = 0.8 x 4 + 0.2 x 3 = Rs 3.8 lakh and ENPV is:
ENPV = - 0 + 3.8 x PVAF at 10% for 7 years
= - 0 + (3.8 x 4.868) = + Rs 18.50 lakh
If the initial demand is low, the firm will not expand. ENCF at the end of year 3 is:
ENCF = 0.2 ^ 3 + 8 x 0.2 = Rs 2.2 lakh
and ENPV is:
ENPV = - 0 + 2.2 x 4.686 = Rs 10.71 lakh
The optimum decision at point 2 is to expand the small plant to a large size since
ENPV is the highest. All other alternatives at decision point 2 can be eliminated and replaced
by ENPV of Rs 29.39 lakh. We can now roll back to decision point 1. If the initial demand
is high, the firm is expected to receive net cash flow of Rs 4 lakh each for year 1 and 2 and
Rs4 + Rs29.39 = Rs33.391akhinyear3. On the other hand if the initial demand is low, net
cash flow will be Rs 3 lakh each year for year 1 and 2 and Rs 3 +Rs 10.71 (i.e., present
value of ENCF if demand is low and the firm does not expand) = Rs 13.71 lakh in year 3.
Thus ENCF will be:
Years 1 & 2 0.6 X 4 + 0.4 X 3 = Rs.3.6 lakh
Year 3 0.6 x 33.39 + 0.4 x 13.71 = Rs.25.52 lakh
and ENPV is
ENPV = 3 2
) 1 . 1 (
52 . 25
) 1 . 1 (
6 . 3
) 1 . 1 (
6 . 3
20 + +
= - 20 + 3/6 x 0.909 + 3/6 x 0.826 + 25.52 x 0.751
= - 20 + 27.75 = Rs.5.41 lakh
DBA 1764
NOTES
3.10.2 Usefulness of Decision Tree Approach
The decision tree approach is extremely useful in handling the sequential investments.
Working backwardsfrom future to presentwe are able to eliminate unprofitable
branches and determine optimum decision at various decision points. The merits of the
decision tree approach are:
- Clarity It clearly brings out the implicit assumptions and calculations for all to see,
question and revise.
- Graphic visualisation it allows a decision maker to visualise assumptions and
alternatives in graphic form, which is usually much easier to understand than the
more abstract, analytical form.
However, the decision tree diagrams can become more and more complicated as the
decision-maker decides to include more alternatives and more variables and to look farther
and farther in time. It is complicated even further if the analysis is extended to include
interdependent alternatives and variables that are dependent upon one another; for example,
sales volume depends on market share which depends on promotion expenses, etc.
The diagram itself quickly becomes cumbersome and calculations become very time-
consuming or almost impossible.
EXHIBIT 3.1: RISK ANALYSIS IN PRACTICE
- Most companies in India account for risk while evaluating their capital expenditure
decisions. The following factors are considered to influence the riskiness of
investment projects:
price of raw material and other inputs
price of product
product demand
government policies
technological changes
project life
inflation
- Out of these factors, four factors thought to be contributing most to the project
riskiness are: selling price, product demand, technical changes and government
policies.
- The most commonly used methods of risk analysis in practice are:
sensitivity analysis
conservative forecasts
- Sensitivity analysis allows to see the impact of the change in the behaviour of
critical variables on the project profitability. Conservative forecasts include using
short payback or higher discount rate for discounting cash flows.
NOTES
- Except a very few companies, most companies do not use the statistical and other
sophisticated techniques for analysing risk in investment decisions.
3.11 UTILITY THEORY AND CAPITAL BUDGETING
We have earlier discussed the use of the concepts of expected value and standard
deviation for analysing risk in capital budgeting. On the basis of figures of the expected
values and standard deviations, it is difficult to say whether a decision-maker should choose
a project with a high expected value and a high standard deviation or a project with a
comparatively low expected value and a low standard deviation. The decision-makers
choice would depend upon his risk preference. Individuals and firms differ in their attitudes
towards risk. In contrast to the approaches for handling risk discussed so far, utility theory
aims at incorporation of decision-makers risk preference explicitly into the decision
procedure.
2
In fact, a rational decision-maker would maximise his utility. Thus, he would
accept the investment project, which yields maximum utility to him.
3.11.1 Risk Attitude
As regards the attitude of individual investors towards risk, they can be classified in
three categories:
- Risk-averse investors attach lower utility to increasing wealth. For them the value
of the potential increase in wealth is less than the possible loss from the decrease
in wealth. In other words, for a given wealth (or return), they prefer less risk to
more risk.
- Risk-neutral investors attach same utility to increasing or decreasing wealth. They
are indifferent to less or more risk for a given wealth (or return).
- Risk-seeking investors attach more utility to the potential of additional wealth to
the loss from the possible loss from the decrease in wealth. For earning a given
wealth (or return), they are prepared to assume higher risk.
It is well established by many empirical studies that individuals are generally risk
averters and demonstrate a decreasing marginal utility for money function. The utility
function for a risk-averse individual may resemble Figure 3.3 in which, the horizontal line
represents the potential gain or loss in rupees and the vertical line represents the attitudes
of the individual towards such gains and losses, as defined by his utility functions. The utility
values, measured on relative basis, are called utiles and are measured on an arbitrary
scale. The curve in Figure 3.3, which is upward sloping and convex to the origin, indicates
that an investor always prefers a higher return to a lower return, and that each successive
identical increment of money is worth less to him than the preceding one. In other words,
the marginal utility of money is declining, although it is positive.
DBA 1764
NOTES
Figure 3.3: Marginal utility of money
The utility theory approach can be applied to investment decisions provided the decision
makers utility functions could be defined. Let us assume that the owner of a firm is
considering an investment project, which has 60 per cent of probability of yielding a net
present value of Rs 10 lakh and 40 per cent probability of a loss of net present value of Rs
10 lakh. The projects expected net present value is:
ENPV = 10 x 0.6 + (- 10) x 0.4 = Rs 2 lakh
Should the project be accepted? Without considering the owners utility function, the
answer is affirmative since the project has a positive expected NPV of Rs 2 lakh. However,
the owner may be risk averse, and he may consider the gain in utility arising from the
positive outcome (positive PV of Rs 10 lakh) less than the loss in utility as a result of the
negative outcome negative PV of Rs.10 lakh). His utility function may be similar to the one
shown in Figure 3.3. Because of his risk averseness and given his utility function, the own
may reject the project in spite of its positive ENPV.
3.11.2 Benefits and Limitations of Utility Theory
The utility approach to risk analysis in capital budgeting has certain advantages. First,
the risk preferences of the decision-maker are directly incorporated in the capital budgeting
analysis. Second, it facilitates the process of delegating the authority for decision. If it is
possible to specify the utility function of the superiorthe decision maker, the subordinates
can be asked to take risks consistent with the risk preferences of the superior.
The use of utility theory in capital budgeting is not common. It suffers from a few
limitations. First, in practice, difficulties are encountered in specifying a utility function.
Whose utility function should be used as a guide in making decisions? For small firms, the
utility function of the owner or one dominant shareholder may be used to guide the decision-
making process of the firm.
2
Second, even if the owners or a dominant shareholders
NOTES
utility function be used as a guide, the derived utility function at a point of time is valid only
for that one point of time. Third, it is quite difficult to specify the utility function if the
decision is taken by a group of persons. Individuals differ in their risk preferences. As a
result, it is very difficult to derive a consistent utility function for the group.
Review Questions
1) List the techniques of risk analysis?
2) Discuss the steps involved in sensitivity analysis?
3) What are the pros and cons of sensitivity analysis?
4) Discuss the steps involved in scenario analysis.
5) How is financial break even analysis done?
6) Discuss the procedures for simulation analysis.
7) Discuss the steps involved in decision tree analysis.
8) Discuss the risk adjusted discount method.
9) Explain the certainty equivalent method.
DBA 1764
NOTES
CHAPTER 4
TYPES OF INVESTMENTS AND DISINVESTMENTS
4.1. TYPES OF INVESTMENT DECISIONS
There are many ways to classify investments. One Classification is as follows:
- Expansion of existing business
- Expansion of new business
- Replacement and modernisation
4.1.1 Expansion and Diversification
A company may add capacity to its existing product lines to expand existing operations.
For example, the Gujarat State Fertiliser (GSFC) may increase its plant capacity to
manufacture more urea. It is an example of related diversification. A firm may expand its
activities in a new business. Expansion of a new business requires investment in new products
and a new kind of production activity within the firm. If a packing manufacturing company
invests in a new plant and machinery to produce ball bearings, which the firm has not
manufactured before, this represents expansion of new business or unrelated diversification.
Sometimes a company acquires existing firms to expand its business. In either case, the
firm makes investment in the expectation of additional revenue. Investments in existing or
new products may also be called as revenue-expansion investments.
4.1.2 Replacement and Modernisation
The main objective of modernisation and replacement is to improve operating efficiency
and reduce costs. Cost savings will reflect in the increased profits, but the firms revenue
may remain unchanged. Assets become outdated and obsolete with technological changes.
The firm must decide to replace those assets with new assets that operate more economically.
If a cement company changes from semi-automatic drying equipment to fully automatic
drying equipment, it is an example of modernisation and replacement. Replacement decisions
help to introduce more efficient and economical assets and therefore are also called cost-
reduction investments. However, replacement decisions that involve substantial modernisation
and technological improvements expand revenues as well as reduce costs.
Yet another useful way to classify investments is as follows:
- Mutually exclusive investments
- Independent investments
- Contingent investments
NOTES
4.1.4 Mutually Exclusive Investments
Mutually exclusive investments serve the same purpose and compete with each other.
If one investment is undertaken, others will have to be excluded. A company may, for
example, either use a labour-intensive, semi-automatic machine, or employ a more capital-
intensive, highly automatic machine for production. Choosing the semi-automatic machine
precludes the acceptance of the lightly automatic machine.
4.1.5 Independent Investments
Independent investments serve different purposes and do not compete with each
other. For example, a heavy engineering company may be considering expansion of its
plant capacity to manufacture additional excavators and addition of new production facilities
to manufacture a new product light commercial vehicles. Depending on their profitability
and availability of funds, the company can undertake both investments.
4.1.6 Contingent Investments
Contingent investments are dependent projects; the choice of one investment
necessitates undertaking one or more other investments. For example, if a company decides
to build a factory on a remote, backward area, it may have to invest in houses, roads,
hospitals, schools etc. for employees to attract the work force. Thus, building of factory
also requires investment in facilities for employees. The total expenditure will be treated as
one single investment.
4.2 DIFFERENT AVENUES FOR DIVESTMENT
Self Off: A sell off is the sale of an asset, factory, division, product line or subsidiary by
one entity to another for a purchase consideration payable in cash or securities of the
buyer. It is simply a reverse merger from the point of view of the divesting firm. The
reasons for sell off could be that a product line or subsidiary may not fit in the core line of
operations of the seller. During 1994-95, Glaxo Ltd. sold away its production facilities,
brand value, research and development relating to baby food and glucose business to
Heinz Ltd. The purchase consideration was received in cash, a major portion of which
was distributed by Glaxo Ltd. as special dividend among its shareholders. Lakme Ltd. (a
Tata group company) sold its entire production facilities to Lever Lakme Ltd. (a subsidiary
of Hindustan Lever Ltd.)
Spin Off: In case of spin off, a part of the business is separated and instituted as a separate
firm. The existing shareholders of the firm get proportionate ownership (in terms of number
of shares).
So, there in no change in ownership and the shareholders directly own the spin-off
part instead of owning through being the shareholders of the original firm. The management
DBA 1764
NOTES
of the original firm gives up operating control of the separated business/ asset but the
shareholders retain the same percentage ownership in both firms. In fact the original
shareholders of the firm become the shareholder of two firms, i.e. the existing as well as
that of the new firm. The reasons for spin off may be:
i. The firm wants to give the separate identity to part / division.
ii. To avoid the take over attempt on the whole firm. If a predator is looking to take
over the control of the firm, the valuable division of the firm may be spun-off, so
that it is assessed separately by the market. This may make the separated division
un-attracted to the predator.
iii. To separate out the regulated and unregulated lines of business.
Carve Outs : It is a variant of spin off. In carve-out, the shares of the new company are
not given to the existing shareholders, rather are sold for cash in the market by making a
public offer. So, in carve out, the existing company, may sell either the majority stake or a
minority stake, depending upon whether the existing management wants to continue to
control or not the separated division.
Buy Outs : It is also known as Management Buy Out (MBO) In this case, the
management of the company buys a particular part of the business from the firm and then
incorporate the business as a separate entity. In certain cases, the management may buy
out the entire firm. In case, the existing management is short of funds to pay for buy-out,
then it can arrange debt funds from investors, banks or financial institutions. In such cases,
the buy- out is known as Leveraged Buy-Out (LBO). The LBO involves participation by
third party (lenders) and the management no longer needs to deal with a diverse group of
shareholders, but instead with the lender or lenders only. However, in LBO, there is a
dramatic increase in the debt ratio. Still, the LBO may be acceptable because of tax
deductibility of interest payment on the debt.
To sum up, mergers, acquisitions, demergers and divestments provide different means
to streamline the operations of business firm. In merger, the activity base of the firm expands
while in case of demergers, the base contracts. In both cases, however, proper evaluation
of different factors, financial as well as others is required. There need not be haste in any
such situation.
NOTES
UNIT II
CRITICAL ANALYSIS OF
APPRAISAL TECHNIQUES
CHAPTER 5
FINANCIAL INFORMATION SYSTEM
Financial information systems encompass all of the applications of the computer in
finance functions, that is, acquisition and management of funds, management control,
supported by accounting and financial; intelligence system. Thus like other information
systems, a financing information system has input, output, and database as shown in Figure
5.1.
Figure 5.1 Model of a financial information system
Input subsystems use financial data from both internal and external sources. Accounting
subsystem captures transaction data and processes these to prepare various account books.
Financial intelligence subsystem gathers relevant data from external sources, such as
shareholders, financial illustrations, government etc. All these data go to database. Output
subsystems of a financial information system consist of funds management subsystem and

Date flow
Information flow

Accounting
Subsystem
Financial
Intelligence
Subsystem

Data base
Funds
Management
Subsystem
Control
Subsystem
users
DBA 1764
NOTES
control subsystem. Funds management subsystem tracks information flow related to
acquisition, distribution, and administration of funds. Control subsystem helps in exercising
control related to financial aspects

of organisational operations.
5.1 ACCOUNTING SYSTEM
Every organisation, whether small or large, maintains an accounting system that
maintains and analyses book keeping records. It also prepares financial statements profit
and loss account and balance sheet which measure the impact of financial transactions and
other events pertaining to the business. Generally, a large business organisation has numerous
transactions every day. Unless these transactions are recorded and analysed individually, it
is not possible to determine the impact of each transaction in the financial statements.
However, since the spectrum of business transactions is so wide, it is not feasible to analyse
each transaction individually to measure its effect on financial statements. The basic purpose
of accounting is to ascertain the cumulative effect of the transactions in the form of financial
statements.
In order to ensure that accounting system maintains proper records, large organisations
install internal audit system. Internal audit is a review of various operations of an organisation
and of its records by staff specially appointed for this purpose. Internal audit may be
undertaken on periodic basis or continuous basis. Internal audit was formerly restricted to
financial transactions and financial records only. In large organisations, internal audit now
extends to such matters which are not directly of financial or accounting nature; it is used as
a control device. The functions of internal audit are not the authorisation and recording of
transactions, but its functions start after the functions related to authorisation and recording
of transactions are over. Internal audit is concerned with the examination of these records
and finding out the validity of these transactions.
5.2 FINANCIAL INTELLIGENCE SYSTEM
Since the finance functions control the money flow throughout an organisation,
information is needed to expedite this flow. The basic objective of the finance functions is
to raise funds at the lowest possible cost and to investment these funds to maximise returns
from them. In order to achieve this objective, financial intelligence system gathers information
about the most desirable sources of funds and investment opportunities for surplus funds.
Financial intelligence system gathers relevant information from financial environment
comprising specialised financial institutions, common banks, investing public, stock
exchanges, etc. for raising funds. It also monitors the monetary policy of the central bank
of the country (Reserve Bank of India in the case of India) as this policy has direct impact
on interest rates and availability of funds. For investing surplus funds that may be available
with the organisation, financial intelligence system tries to gather information about the
investment opportunities that may be available. Information may be collected from stock
exchanges, mutual funds and other financial market intermediaries.
NOTES
5.3 FINANCIAL SOFTWARE PACKAGES
More prewritten software has been developed in finance area as compared to any
other business functional area. The most probable reason for this is the pattern of computer
usage in business. The computer was first used in business to process accounting data like
payroll, accounts receivable payable, etc. Subsequently, computer use spread in other
areas. Financial software packages may be classified into four major categories accounting
data processing, personal productivity software, decision model packages, and financial
database service.
Accounting Data Processing: Prewritten accounting data processing packages perform
a number of activities ranging from transaction recording and processing to preparation of
final financial statements in the forms of profit and loss account and balance sheet. Various
types of accounts that can be prepared with these packages include accounts payable,
account receivable, general ledger, job accounting, job costing, payroll processing, tax
accounting, etc. Most commonly used accounting package in India is Tally, developed by
Bangalore-based Tally Solutions (formerly Peutronics). Tally is able to perform most of
the accounting functions.
Personal Productivity Software: Personal productivity software has the capability to be
used in different business functions. For example, electronic spreadsheet can be used in
many areas including finance. When spreadsheet is used in finance area, it shows various
financial data such as cost of production with detailed break-up in rows and various periods,
such as monthly, quarterly, yearly, etc. are shown in columns. Thus, spreadsheet can be
used to make comparative analysis of a financial phenomenon over a period of time.
Decision Model Packages: There are number of packages that produce different models
which can be used for financial decision making. Areas which are covered include profit
planning, evaluation of economic feasibility of a project, forecasting funds requirement,
deciding optimum financing mix, financial ratio analysis, etc. Some of the packages that are
available include Minitab, IDA SAS, SPSS, etc.
Financial Database Service: Financial database service is provided by different
organisations in different forms. First, financial database is provided in the form of CD-
ROM which can be used by the buying organisation, Such a CD-ROM includes industry
analysis, financial performance of various companies in the industry, etc. Second, financial
database created by service providers can be accessed through local/wide area network
or Internet after paying certain prescribed fee. In India, many organisations provide financial
database services which are relevant mostly for investment purposes. For example,
Cyberboltz provides financial information of companies listed on stock exchanges that
includes profit and loss accounts and balance sheet of each company for the last five years,
financial ratios, share price movements, charts, news headlines, etc. for an annual subscription
fee of Rs. 30,000 annually (as on September 30, 2001).
DBA 1764
NOTES
5.4 MANAGERIAL USE OF FINANCIAL INFORMATION SYSTEMS
In most of the organisations, financial information systems are used more as compared
to other functional areas as everyone in the organisation is related to finance either directly
or indirectly. Along with the finance department, all the departments of the organisation,
whether major like production, marketing, and human resources, or minor like legal and
secretarial, estate management, and other service departments use some part of the financial
information systems. Table 5.1 presents the various types of users of financial information
systems and their subsystems.
Table 5.1: Users of financial information systems
Financial information systems are used by corporate-level management which has
overall responsibility of maintaining financial health of the organisation. Financial information
systems at this level are used to provide guidelines to conduct finance functions as well as
to make final decisions on certain financial matters like financing mix and management of
earnings on the basis of recommendation of finance department. While finance director
uses all subsystems of financial information systems in varying proportion, managers
concerned with different aspects of finance use subsystems relevant to them.
All other departments use control subsystem of financial information systems along
with relevant additional subsystems. For example, a production director is also interested
in how funds are used in fixed assets and working capital relevant to production like
inventory. Other departments use financial information that is relevant to them.
5.5 INFORMATION AND PROJECT SELECTION
The project is selected after conducting feasibility study. Feasibility analysis warrants
a detailed analysis of technical, financial and other aspects. Feasibility analysis includes
various evaluations such technical, commercial, financial, social, environmental, managerial,
etc. It is needless to say that each of these dimensions is important and be analysed carefully.
For this purpose, detailed information and data are collected, analysed and interpreted. If
more than on projects are identified, then analysis is required for all such projects.
Funds management
User
Financing mix Funds usage Earning
Control
Corporate management X X X X
Finance director X X X X
Accounts manager X
Budgeting manager X X
Other departments X X

NOTES
To carry out these analyses different kinds of information are required. For example
market analysis requires following information
1) What is the total size of the market (demand)?
2) What is the existing level of capacity installed by competitors?
3) What is the growth pattern of the demand?
4) What is the expected market share to be captured by the project under way
To answer the above questions require in depth study of various factors like
consumption pattern, elasticity of demand, nature of competition, government policies.
This information may be gathered from
1) Situational analysis by way of informal talks to customers, retailers, wholesalers
and other participants of market.
2) Secondary sources such as economic surveys, industry reports, newspapers,
periodicals, National Sample surveys, Annual Reports of companies, RBI reports,
Publications of advertising agencies etc.
3) Primary sources, i.e. preparing a questionnaire, and getting necessary information
from the potential customers and other parties. Sometimes, the secondary
information is to be supplemented with the information collected from primary
sources.
The technical analysis is concerned with the details regarding input; production
technology, location, site and capacity of the plant; civil work; plant charts and layout.
The financial analysis requires information about cost of project, estimation of revenues
and costs, projected earnings, projected balance sheet, projected cash flow statement,
Break even analysis.
To make all the above analysis, the firm requires lot of information. The information
should be adequate and correct. If there is no information then decision can not made, and
if the information is not correct then decision will not be right one, which will end up in
project failure. Some of the information may be available within the company database
and some have to be collected from outside sources.
5.6 INFORMATION ASYMMETRY AND CAPITAL BUDGETING
The conventional approach to capital budgeting is accept projects which have positive
NPV. It does not make any difference whether the investment decision making is centralized
or decentralized; it is irrelevant whether the existing firm implements it or a newly set up
firm executes it; it does not matter what mix of financing is employed.
DBA 1764
NOTES
The behaviour of firms, however, is not always in conformity with what has been said
above. In the real world;
- Firms often ration capital and do not invest in all projects that have positive NPVs.
- A lot of attention is paid to the extent to which capital budgeting decisions are
centralized.
- The mix of financing is considered to be very important.
Why dose a discrepancy exist between what the conventional model says and how
the real world firms behave? Information asymmetries of various sorts seem to create such
a hiatus. Informational asymmetry exists if the transacting parties have unequal information,
ex ante or ex post.
We may classify informational asymmetry into three broad types:
1) Informational asymmetry between shareholders and bondholders.
2) Informational asymmetry between current shareholders and prospective
shareholders.
3) Informational asymmetry between managers and shareholders.
5.6.1 Informational Asymmetry Between Shareholders And Bond Holders
Informational asymmetry between shareholders and bondholders has two possible
distorting consequences.
Asset substitution moral hazard : Shareholders may ask the management
to Substitute riskier assets for safer assets,
At the expense of bondholders.
Underinvestment moral hazard : In firms with risky debt, shareholders
have an incentive to avoid investing in new
projects that have a positive NPV,
because they would not like the cash
flows of new projects to be diverted for
servicing existing risky debt.
5.6.2 Informational Asymmetry Between Current Shareholders And Prospective
Shareholders
When there is informational asymmetry between current shareholders and prospective
shareholders, the latter will not fully appreciate the future payoffs of various resource
commitments. As the firms stock price may not fully reflect the benefits of such resource
commitments, the new share holders will not fully share the cost of resource commitments
even though they partake in the benefits arising from them. If the firm is interested in
NOTES
maximizing the wealth of present shareholders, it may choose projects that are likely to be
different from those that would be chosen in a symmetric information setting. The common
distortions resulting from such informational asymmetry are:
- Preference for projects with shorter payback period.
- A greater degree of capital rationing.
- Centralization of capital budgeting.
- Accumulation of liquidity despite the existence of positive NPV projects.
5.6.3 Informational Asymmetry Between Managers And Shareholders
Managers are interested in maintaining and building their reputation. Since, as compared
to shareholders, they are typically better informed about the payoffs of projects they can
trade on the relative ignorance of the latter. This gives them latitude to choose investments
aimed at building their reputation rather than enhancing the wealth of shareholders. As
David Hirshleifer has suggested, the concern for managerial reputation may lead to three
kinds of distortions in investment decisions, namely:
Visibility Bias: Managers seek to improve short-term indicators of performance.
Resolution preference: Managers attempt to advance the arrival of good news
and delay the announcement of bad news.
Mimicry and Avoidance: Managers try to imitate the actions of superior managers
and avoid the actions of inferior managers.
These incentives may lead to the following investment biases :
- Squeezing of an investment to improve short-term cash flows.
- Premature liquidation of assets to show that they are worth a lot.
- Adoption of projects with earlier payoffs.
- Avoidance of worthwhile projects that carry risk of early failure to protect short
term reputation.
- Escalation of inferior projects to avoid admission of failure.
- Undertaking projects which are supposed to have benefits in the distant future to
protect short-term reputation.
- Conformity with other managers to avoid the odd manager label.
- Deviation from other managers to avoid seeming mediocre.
DBA 1764
NOTES
CHAPTER 6
INVESTMENT DECISIONS UNDER CAPITAL RATIONING
For capital budgeting decisions, the term capital rationing may be defined as a situation
where the firm has limited funds available for fresh investments. Many Profitable and
financially viable proposals may be available but cannot be undertaken in view of the
limited funds. A situation of capital rationing may occur when a firm is either unable or
unwilling to obtain additional funds in order to undertake financially viable capital budgeting
proposals. Thus a firm by choice or under compulsions sets absolute ceiling on its capital
spending in a period at a level that will cause it to reject or avoid some of the profitable
projects.
A firm should accept all investment projects with positive NPV in order to maximize the
wealth of shareholders. The NPV rule tells us to spend funds in the projects until the NPV of
the last (marginal) project is zero.
Consider the following investment projects:
The firm will get the highest NPV if it accepts A and B. Any project between B and C
should also be accepted by the firm. C is the marginal project; the firm may or may not accept
it since it does not increase or decrease NPV, D should be rejected, as its NPV is negative.
Thus, the firm may spend Rs 350,000 to obtain the maximum NPV for its shareholders.
Suppose the funds available with the firm are limited; it can spend only Rs 200,000. Then it
should accept only project A, which yields highest NPV and spends the entire budget. Because
of the capital constraint, however, the shareholders wealth will not be maximized. The IRR
rule also indicates the same decisions in the case of independent projects, although it can be
misleading in a number of situations. In the example, C earns a rate of return just equal to the
cost of capital (C has zero NPV); this is a marginal project. Thus, the IRR rule tells us to invest
funds in the projects until the marginal rate of return is equal to the cost of capital. Again,
because of the limited funds, project B, which yields a return (15%) higher than the cost of
capital (10%) will have to be foregone.
Cumulative
Projects Cash NPV IRR Cash Cumulative
Outlay at 10% Outlay NPV
(Rs '000) (Rs '000) (Rs '000) (Rs '000)
- A 200 18.2 20% 200 18.2
B 150 6.8 15% 350 25.0
C 100 0 10% 450 25.0
D 50 (2-3) 5% 500 22.7

NOTES
If a firm has different proposals with positive NPV but the initial funds required for the
implementation of all these proposals are not available or cannot be procured from the
capital market for one reason or the other, the firm is said to be operating under condition
of capital rationing. The capital rationing may be of two types.
1) Internal Capital Rationing. It is a situation where the firm has imposed limit on
the funds allocated for fresh investment though (i) the funds might otherwise be
available within the firm, or (ii) additional funds can be procured by the firm from
the capital market. Some firms may follow a policy of using only internally generated
funds (by ploughing back of profits) for new investments. Some firms avoid debt
capital because of the associated financial risk and avoid external equity because
of a desire not to loose control. This type of capital rationing implies that the firm
is not willing to grow further.
2) External Capital Rationing. It is a situation when the firm is willing to undertake
the financially viable proposals but is unable to do so because either it is not having
sufficient funds available at its disposal or the capital market conditions are not
conducive enough to let the firm raise the required funds form the market. The
external capital rationing may occur because of several reasons.
a) The Lack of Credibility. The capacity of the firm to raise funds and avoid
a capital rationing depends largely on the firms credibility with the capital
market. Obviously, a firm with good standing in the capital market is less
likely to face capital rationing constraints than a firm with credibility problems.
b) High Flotation cost. The larger the cost of issuing securities in the capital
market, the greater the chances that a firm will face the capital rationing. The
size of the flotation cost tends to vary inversely with the size of the issue, i.e.,
larger issues tend to have proportionately lower flotation cost. Smaller firms
are more likely to face capital rationing constraints than the larger firms because
the former have higher flotation cost. Further, the firms that are primarily
dependent on equity financing are more likely to face capital rationing.
c) Higher Marginal cost of Capital. A Firm faces a capital rationing because
the additional funds can be raised only at a higher cost than that the cost of
existing funds, and hence the firm faces an increasing marginal cost of funds.
Capital funds in such a case are assumed to be available at the market rate
of interest up to a certain limit only and thereafter for additional funds, the
cost of funds will also increase.
At this stage, it is also necessary to classify different projects into 2 classes, i.e.,
divisible projects and indivisible projects.
1) Divisible Projects : There are certain projects, which can either be taken in full
or can be taken in parts. For example, a building (having 5 floors) can be
constructed at a cost of Rs. 5 Crores. However, if the funds are not sufficiently
available then only a part of the building, say only 2 floors, can be constructed for
the time being. But all the proposals may not be divisible.
DBA 1764
NOTES
2) Indivisible Projects : There are certain proposals which are indivisible. These
proposals have a feature that either the proposal, as a whole, be taken in its totality
or not taken at all for example, a proposal to buy a helicopter cannot be taken
parts. Similarly, a multi-stage plant can only be installed fully but not in parts.
There can be many instances of indivisible projects.
A firm may have capital rationing in single period only or over number of years (known
a multi period capital rationing). The capital budgeting decisions in case of single period
and multi-period capital rationing can be analysed as follows:
6.1 SINGLE PERIOD CAPITAL RATIONING
This is simple types of capital rationing and occurs when a firm faces shortage of
funds in a particular year only and thereafter the funds may be available easily. Impliedly,
these limited capital funds can finance fewer than other wise available feasible proposals.
This necessitates restructuring the decision process to a certain extent. The simple way
out can be to rank the various proposals in descending order of attractiveness and then go
on accepting the proposals top down until the available funds are exhausted. But how to
rank the proposals? Which technique may be used to rank the proposals? Following are
some of the methods and procedures to deal with single period capital rationing.
6.1.1 Aggregation of projects or Feasible set approach.
Under this approach, the NPV of various proposals are put in different possible
combinations and then that combination is selected which has the maximum total NPV.
The following two points are worth noting;
i. That total outlay of the combination is within the limits of capital rationing, and
ii. The total NPV of the combination is the highest among all the combinations.
For example, a firm has a capital budget of Rs.10,00,000 and it has under consideration
the following four independent proposals:
Proposal Capital Outlay NPV
A
B
C
D
Rs. 4,50,000
4,00,000
3,00,000
2,00,000
Rs. 1,50,000
1,00,000
50,000
40,000
NOTES
The proposals can be combined in different groups as follows:
It may be noted that other combinations of these proposals are either not feasible
(because the total outlay is more than Rs.10,00,000) or are not good enough (because
they do not utilize the total funds of Rs.10,00,000). For example, a combination of A,B,C
is not feasible because the total outlay is Rs.1,50,000 which is more than the available
funds of Rs.10,00,000; a combination of A,C is not good enough because the outlay is
Rs.7,50,000 which leaves a sum of Rs.2,50,000. Out of the three feasible combinations
as given above the combination of A,C,D has the maximum NPV of Rs.2,70,000. It may
be noted that the other proposal B (though having NPV of Rs.1,00,000) has been left out
because the combined NPV of C,D is more than the NPV of B. Therefore, the firm
should adopt the combination of A,C,D.
However, if the firm is dealing with mutually exclusive proposals then it should be
noted that in no combination there should be any two mutually exclusive proposals. For
example, in the above case, if proposals B and C are mutually exclusive, the combination
B,C,D (outlay Rs.9,00,000 and NPV Rs.2,20,000) becomes not feasible and the firm will
have to select only out of two combinations, i.e., A,C,D and A, B. The Feasible Set
approach, thus can be summarized as follows:
a) Find out all the feasible combinations of different proposals in the light of the capital
funds constraints and proposals independence.
b) Find out the total NPV of each of these combinations and arrange these
combinations in order of decreasing NPVs.
c) Select the combinations with the highest NPV.
The above process of feasibility set approach can be easily applied if the number of
available projects is limited to, say, 5 or 6. However, if the number of available proposals
is more, then help of mathematical techniques may be taken. Thus, the above feasibility set
approach (based on the NPV technique) helps selecting those proposals which will result
in maximum contribution to the wealth of the shareholders.
6.1.2 Cumulative Outlay Analysis based on IRR.
In this method, the IRRs of different proposals are calculated. These proposals are
then ranked in order of decreasing IRR. The proposals whose IRR is less than the hurdle
rate are rejected out rightly. Out of other projects, the firm can select the proposals in the
descending IRR order so longer the funds are available.
Combination Total Outlay Total NPV
A,C,D
A,B
B.C.D.
Rs. 9,50,000
8,50,000
9,00,000
Rs. 2,70,000
2,50,000
2,20,000
DBA 1764
NOTES
For example, a firm is considering the following six proposals for implementation and
it has a total capital outlay of Rs.20,00,000 only.
Suppose, the firm has a cut-off rate of 15% then the projects 1,3,5,2 and 4 are
eligible. The project 6, which is giving an IRR of 12% is not eligible as the cut-off rate is
higher. Further, if the firm has unlimited funds, then it may undertake all these 5 projects
(having IRR > 15%). However, since the capital budget of the firm is restricted to
Rs.20,00,000, the firm should start from the top and should select proposals 1,3 and 5
requiring total capital outlay of Rs.18,00,000. The firm still has a balance of Rs.2,00,000
for investment purposes but the next proposal in the order, i.e., proposal 2 requires a
capital outlay of Rs.3,50,000. So, the firm cannot undertake the proposal 2. At this stage,
the firm has two options (i) to keep Rs.2,00,000 for investment during next year, or (ii) to
go down the list and find out a proposal which requires an outlay of Rs.2,00,000 or less
and also having the IRR of 15% or more. In the list given above, the next project is
number 4 which requires capital outlay of Rs.2,00,000 and is also eligible as the IRR is
16%. Thus, the projects to be selected by the firm are proposals 1,3,5 and 4. The total
outlay for these proposals in Rs.20,00,000.
6.1.3 Profitability Index
The PI has been defined as the ratio of PV of cash inflows to PV of cash outflows of
a proposal. Under this method, the PI of different proposals may be calculated and placed
in decreasing order. The firm may start from the top and go on accepting the proposals
subject to that (i) funds are available, and (ii) the PI is more that 1. Example 6.1 explains
the PI method as applied to capital rationing.
EXAMPLE 6.1
Following information is available in respect of XYZ Ltd., which has a capital budget
of Rs.20,00,000 for the current year
Proposal Capital Outlay IRR Cumulative Outlay
1
3
5
2
4
6.
Rs. 7,00,000
5,00,000
6,00,000
3,50,000
2,00,000
7,50,000
20%
19%
18%
17%
16%
12%
Rs. 7,00,000
12,00,000
18,00,000
21,50,000
23,50,000
31,00,000
NOTES
Find out the ranking of the proposals give that :
i. The projects are indivisible, and
ii. The projects are divisible.
Also evaluate the ranking and make a final selection
Solution:
(Note: The integers in the brackets denote the ranking of different proposals as per
different methods.)
It may be noted that different techniques give different ranking to different
proposals. The proposal F has not been assigned any ranking because it is having
negative NPC and its PI also less than 1. Now the firm has to select out of these
proposals so that the total capital outlay is within the budget constraint of Rs.20,00,000.
(a) When the projects are indivisible. The indivisible projects are those which can
be taken up in totality and the part acceptance is not possible.
The firm will select the proposals in order of decreasing PI so long as the funds are
available. At any stage, if the funds are not sufficient for the next proposal, then it can be
Proposal Capital Outlay Cumulative Outlay IRR
A
B
C
D
E
F
Rs. 7,00,000
2,50,000
5,00,000
2,00,000
5,50,000
7,50,000
Rs. 3,00,000
1,60,000
2,00,000
1,00,000
4,50,000
- 2,50,000
20.0%
17.0%
19.0%
17.5%
18.0%
12.0%
Proposal
Outlay (Rs.)
1
NPV (Rs.)
2
Inflow
(1+2)
PI
(1+2)+1
IRR
A
B
C
D
E
F
7,00,000
2,50,000
5,00,000
2,00,000
5,50,000
7,50,000
3,00,000
1,60,000
2,00,000
1,00,000
4,50,000
- 2,50,000
10,00,000
4,10,000
7,00,000
3,00,000
10,00,000
5,00,000
1.428(4)
1.640(2)
1.400(5)
1.500(3)
1.818(1)
0.667(0)
20.0%(1)
17.0%(5)
19.0%(2)
17.5%(4)
18.0%(3)
12.0%(0)
DBA 1764
NOTES
skipped and the firm can move onto the next highest PI proposal. The selection of different
projects in the given case under different methods can be attempted as follows:
The firm should select the proposals on the basis of Feasibility Set approach because
it is resulting in selecting of those proposals which are expected to bring maximum
contribution to the wealth, i.e., Rs. 11,10,000
(b) When the projects are divisible. In this case, the firm would be able to take up
the projects in descending PI order. If at any stage, the funds are not sufficient to take up
the entire next project, then it would be taken up in part. In case of divisible projects, it is
implied that the relationship between the capital outlay and the NPV is linear. For example,
if 30% of a project is undertaken, then the NPV generated by part implementation will be
30% of the total NPV of that proposal. In case of divisible projects, the selection is as
follows:
(i) Feasibility Set Approach
(ii) Incremental Outlay Approach

Feasibility Set
(Based on NPV)
Cumulative Outlay
(Based on IRR)
Profitability Index
Project Selected E,A,C,B A, C, E, D E,B,D,A
Total Outlay Rs. 20,00,000 Rs. 19,50,000 Rs. 17,00,000
Total NPV 11,10,000 10,50,000 10,10,000

Proposal Outlay Cumulative Outlay NPV
E Rs. 5,50,000 Rs. 5,50,000 Rs. 4,50,000
A 7,00,000 12,50,000 3,00,000
C 5,00,000 17,50,000 2,00,000
B 2,50,000 20,00,000 1,60,000
Total 11,10,000
A Rs. 7,00,000 Rs. 7,00,000 Rs. 3,00,000
C 5,00,000 12,00,000 2,00,000
E 5,50,000 17,50,000 4,50,000
D 2,00,000 19,50,000 1,00,000
B (50/250 50,000 20,00,000 32,000
Total 10,82,000
NOTES
(iii) Profitability Index Approach
Thus, if the projects are divisible, then the firm can achieve highest NPV of Rs.
11,30,000 by selecting proposals as per the profitability index approach. The above analysis
shows that the use of ranking technique depends on whether the projects are divisible or
not. In case of divisible projects, the PI may not be used. In such a case, the optimum
solution can only be obtained by considering the proposals as per Feasibility Set Approach.
Essentially, the firms should choose that group of project within the budget limit, which will
generate the highest aggregate NPV. Proposal can be ranked in declining order of their PI
until the budgeted amount has been exhausted. The firm should maximize the present value
benefits expected per rupee of investment.
The capital budgeting procedure under the simple situation of capital rationing may be
summarized as follows: The NPV rule should be modified while choosing among projects
under capital constraint. The objective should be to maximize NPV per rupee of capital
rather than to maximize NPV Projects should be ranked by their profitability index, and
top-ranked projects should be undertaken until funds are exhausted.
6.2 USE OF PROFITABILITY INDEX IN CAPITAL RATIONING
Under capital rationing, we need a method of selecting that portfolio of projects
which yields highest possible NPV within - the available funds. Let us consider a simple
situation where a firm has the following investment opportunities and has a 10% cost of
capital.
If the firm has no capital constraint, it should undertake all three projects because
they all have positive NPVs. Suppose there is a capital constraint and the firm can spend
E Rs. 5,50,000 Rs. 5,50,000 Rs. 4,50,000
B 2,50,000 8,00,000 1,60,000
D 2,00,000 10,00,000 1,00,000
A 7,00,000 17,00,000 3,00,000
C (300/500) 3,00,000 20,00,000 1,20,000
Total 11,30,000
Project C
0
C
1
C
2
C
3
NPV at 10% Profitability index
L -50 +30 +25 +20 12.94 1.26
M -25 +10 +20 +10 8.12 1.32
N -25 +10 +15 +15 7.75 1.31
DBA 1764
NOTES
only Rs 50,000 in year zero, what should the firm do? If the firm strictly follows the NPV
rule and starts with the highest individual NPV, it will accept the highest NPV Project L, which
will exhaust the entire budget. We can, however, see that Projects M and N together have
higher NPV (Rs 15,870) than project L (Rs 12,940) and their outlays are within the budget
ceiling. The firm should, therefore, undertake M and N rather than L to obtain highest possible
NPV. It should be noted that the firm couldnt select projects solely on the basis of individual
NPVs when funds are limited. The firm should intend to get the largest benefit for the available
funds. That is, those projects should be selected that give the highest ratio of present value to
initial outlay. This ratio is the profitability index (PI). In the example, M has the highest PI
followed by N and L. If the budget limit is Rs 50,000, we should choose M and N following
the PI rule.
The capital budgeting procedure under the simple situation of capital rationing may be
summarized as follows: The NPV rule should be modified while choosing among projects
under capital constraint. The objective should be to maximize NPV per rupee of capital
rather than to maximize NPV Projects should be ranked by their profitability index, and
top-ranked projects should be undertaken until funds are exhausted.
6.2.1 Limitations of Profitability Index
The capital budgeting procedure described above does not always work. It fails in
two situations:
- Multi-period capital constraints
- Project indivisibility
A serious limitation in using the PI rule is caused by the multi-period constraints. In
the above example, there is a budget limit of Rs 50,000 in year 1 also and the firm is anticipating
an investment opportunity O as in low is year 1. Thus, the decision choices today are as
follows:
Projects M and N have first and second ranks in terms of PI. They together have highest
NPV and also exhaust the budget in year 0; so the firm would choose them. Further, projects
M and N together are expected to generate Rs 20,000 cash flow next year. This amount with
the next years budget (i.e., Rs 20,000 + Rs 50,000 - Rs 70,000) is not sufficient to
accept Project O. Thus, by accepting projects M and N, the firm will obtain a total NPV of Rs
Project C
0
C
1
C
2
C
3
NPV at 10% Profitability index Rank
L -50 +30 +25 +20 12.94 1.26 III
M -25 +10 +20 +10 8.12 1.32 I
N -25 +10 +15 +15 7.75 1.31 II
O 0 -80 +60 +40 6.88 1.09 IV

NOTES
15,870. However, a careful examination of the projects cash flows reveals that if project L
is accepted now it is expected to generate a cash flow of Rs 30,000 after a year, which together
with the budget of Rs 50,000 is sufficient to undertake Project O next year. Projects L and O
have lower PI ranks than projects. M and V, but they have higher total NPV of Rs 19,820.
The PI rule of selecting projects under capital rationing can also fail because of project
indivisibility. It may be more desirable to accept many lower ranked smaller projects
than a single large project. The acceptance of a single large project, which may be top-
ranked, excludes the possibility of accepting small projects, which may have higher total NPV.
Consider the following projects:
Suppose that the firm has a budget ceiling of Rs 10 lakh (i.e., Rs 1 million). Following
the ranking by PI, the firm would choose A and C, These projects spend Rs 850,000 of the
total a budget and have a total NPV of Rs 180,000. The next best project E needs an investment
of Rs 200,000, while the firm has only Rs 150,000. If we examine the various combinations
of projects satisfying the budget limit, we find the package of C, E and D as the best. They
exhaust the entire budget and have a total NPV of Rs 189,000. Thus the firm can choose two
lower ranked, small projects, E and D, in place of the high ranked, large project, A. The
selection procedure will become very unwieldy if the firm has to choose the best package of
projects from a large number of profitable projects.
Our discussion has shown that the profitability index can be used to choose projects
under simple, one-period, capital constraint situation. It breaks down in the case of multi-
period capital constraints. It will also not work when any other constraint is imposed, or when
mutually exclusive projects, or dependent projects are being considered.
6.3 MULTI-CONSTRAINTS CAPITAL RATIONING
A Capital budgeting situation may have multi-constraints i.e. there may be different
limitations all of which are to be incorporated in the decision. These limitations may be in
terms of institutional constraints or expenditure constraints. For example, a finance manager
has to decide on the % of funds to be invested in different projects A,B,C,D and E. The
IRR (%) of these projects and constraints on investments are as follows :
Project Outlay (Rs) NPV (Rs.) PI Rank
A 500.00 1,10,000 1.22 1
B 150.000 (7,500) 0.95 6
C 350.000 70,000 1.20 2
D 450.000 81,000 1.18 4
E 200.000 38,000 1.19 3
F 400.000 20,000 1.05 5
DBA 1764
NOTES
Project A B C D E
IRR% 9.3 10.5 8.5 7.6 10.9
The finance manager has not been given a free hand. The investment limits are
Given these constraints, the overall objective is to maximize the yield (IRR). Let a
be the amount invested in Project A and b be the amount invested in Project B and so on.
IRR of the total investment can be presented as the weighted average of the different
IRRs. It can be presented as follows :
6.4 MULTI PERIOD CAPITAL RATIONING
When a firm faces limitations of funds in more than one period, then the above
techniques may not be of much help. In such a case, the firm may have to resort to some
sort of mathematical programming in order to identify the optimum selection of proposals.
For example, a firm is considering the following projects which involve cash outflows over
a period of more than 1 year.
Project A : At least 30% of the funds
B : Not more than 20% of the funds
C : At least 25% of the funds
B + C : Not more than 50% of the funds
D : At least 10% of the funds
E : Not more than 25%
Maximise X = 9.3 a + 10.5b + 8.5c + 7.6d + 10.9e
Subject to : a + b +c + d + e = 100
a > 30
b < 20
c > 25
b +c < 50
d > 10
e < 25
and a,b,c,d,e > 0
NOTES
Cash Flows (in Rs.000)
Cash flow occurring after year 3 will only be cash inflows. The firm has a limit of
investing Rs.1,20,000 in year o and Rs,2,00,000 in the year1. After 1, there will not be
any availability of fresh capital funds. Therefore, for the future needs capital must be met
out of funds generated by already implemented budgets. The cash generated by a project,
I.e., the cash inflow from a project can be reinvested in same or other projects in the same
year only. All the projects are divisible and the relation ship between the investment outlay
and the NPV is linear, and the firm has the objective of wealth maximisation by maximising
the NPV of the selected proposals. Say, the variables a,b,c,d,e and f represent the accept
proportion of the proposals A,B,C,D,E and F respectively. Now the firm will have the
objective of maximization of the NPV coming from the proportionate proposals which
have been accepted in view of the capital rationing. Mathematically, it can be expressed
as:
Maximize: 20a + 15b + 10c + 30d + 10c + 5f
The maximization is to be attained subject to constraints of capital funds available in
each year. These capital restraints can be presented as follows:
It may be noted that in year 2 and 3 no new capital funds will be available and the
capital needs must be met out of the cash inflows from existing projects only. Since, the
proportion of any proposal being selected must range between 0 and 1 only, therefore,
one more condition may be included in the above formulation, i.e,
0 < a, b, c, d, e, f < 1
Proposal Year 0 Year 1 Year 2 Year 3 Total NPV
A
B
C
D
E
F
-100
--
--
-40
--
-30
-50
-60
---
-60
-120
-10
70
10
-80
10
-10
10`
70
10
-80
10
-10
10
20
15
10
30
10
5
Year 0 : 100a + 40d + 30f + < Rs.1,20,000
Year 1 : 50a + 60b + 60d +120e + 10f + < Rs.2,00,000
Year 2 : 10a + 70b + 40c < 50d + 100e + 20f
Year 3: 80c + 10e < 70a + 10b + 10d + 10f
DBA 1764
NOTES
The above formulation can be solved with the help of simplex method to find out the
value of the variables a,b,c,d,e and f, i.e, the proportion of different proposals being
implemented.
In the above case, it was assumed that the cash inflows from the accepted proposals
can be reinvested during the same year only. If these cash inflows are not reinvested in the
same year for one or the other reason, then they will not be available next year. Let this
assumption be relaxed now. Suppose that the residual of cash inflows and capital can be
deposited for a year to earn interest @ 10% p.a and following are the amount of residuals
carried forward:
From year 0 to year 1 x
From year 1 to year 2 y
From year 2 to year 3 z
It may be noted that there is no need to take care of the residuals to be carried
forward from year 3 onwards, as there is no outflow thereafter. In the light of the above,
the capital constraints can now be written as :
6.5 PROGRAMMING APPROACH TO CAPITAL RATIONING
The limitations of the profitability index method make it necessary to have a better
method for investment decisions under capital rationing. Let us develop a general procedure for
solving the capital rationing problem. Reconsider the example in which we had a two-period
budget constraint. Our objective is to choose that package of projects, which gives us
maximum total net present value subject to the firms resources. Assume that we can invest in
X fraction of each of the four projects. Then NPV from L will be 12.94 X
L
, from M 8.12 X
M
,
and so on. The total NPV will be:
NPV = 12.94X
L
+ 8.12X
M
+ 7.75X
N
+ 6.88X
0
It should be clear that the values of Xs should be such that total NPV is maximum.
There are certain conditions for investing in various projects. For example, the total cash outlay
in each of the two periods should not exceed Rs 50,000. Thus, the following two constraints
should be satisfied while maximizing the NPV:
Year 0 : 100a + 40d + 30f + x < Rs.1,20,000
Year 1 : 50a + 60b + 60d +120e + 10f + < Rs.2,00,000 + 1.10x
Year 2 : 10a + 70b + 40c +z < 50d + 100e + 20f + 1.10y
Year 3 : 80c + 10e < 70a + 10b + 10d + 10f + 1.10z
NOTES
50X
L
+ 25X
M
+ 25X
N
+ 0X
o
< 50
-30X
L
~10X
M
IO XNV + 80X
o
< 50
It would be obvious to note that the investment in any project cannot be negative and we
cannot invest in more than one of each project. Thus we have:
0 < X
L
< 1
0<X
M
<1
0 < X
N
< 1
0 < X
0
< 1
We can summarize the decision problem as follows: Maximize
12.94X
L
+ 8.12X
M
+ 775X
N
+688X
0
Subject to
50X
L
+ 25X
M
+ 25X
N
+ 0X
0
< 50
-30X
L
- 10X
M
- 10X
N
+ 80X
o
< 50
0 < X
L
< 1
0<X
M
<1
0<X
N
<1
0 < X
0
< 1
6.5.1 Linear Programming (LP)
It may be realized that the above situation is a linear programming (LP) problem. It
can be easily solved with the help of a computer. (You can use Solver in Excel to solve linear
programming problems.) Using the LP model, the computer tells us that we should accept
Projects M and N entirely and a fraction equal to 0.875 of Project O; Project L should be
rejected. This is the optimal solution, and we shall obtain a maximum NPV equal to:
12.94x0 + 8.12x1 + 7.75x1 + 6.88x0.875
= 21.89 orRs21,890.
This answer is quite different from the one, which we obtained earlier. Our earlier answer
was that we should accept entire of Projects L and O, generating maximum NPV of Rs
19,820.
DBA 1764
NOTES
6.5.2 Integer Programming (IP)
It may be noted in this example that the LP solution requires us to accept a fraction of
Project O. Perhaps some projects can be divided. If Project O is divisible, it may be
appropriate to undertake a part of it and assume that cash flows will be reduced proportionately.
However, a large number of projects in practice are indivisible. When projects are not divisible,
we can use integer programming (IP) by limiting the Xs to be integers of either 0 to 1.
Integer programmers are difficult to solve. It may take unwieldy number of iterations for
the model to converge on a solution. Also, other restrictions may prove to be redundant on
account of integer restriction.
6.5.3 Dual Variable
One important advantage in using the programming models for solving the capital-rationed
capital budgeting decisions is the information about dual variables. Dual variables for the
budget constraints may be interpreted as opportunity costs or shadow prices. In the
example, dual variables for the budget constraints in periods 0 and 1 respectively, are 0.344,
and 0.086.
The dual variables of 0.344 for period 0 imply that NPV can be increased by Rs 0.344
if the budget in period 0 is increased by Re 1. In other words, the opportunity cost of the
budget constraint for period 0 is 34.4 per cent, and for period 1 it is 8.6 per cent. This implies
that the NPV could be increased if funds were shifted from period 1 to period 0. Thus,
dual variables provide information for deciding the shifting of funds from one period to another.
1
6.5.4 Extensions of Programming Approach
The use of LP or IP models can be extended to cope with other constraints. A firm
may like to provide for the carry over of unspent cash from one period to another. Let C
denote funds carried from period 0 to period 1 and let them earn interest at the rate i Then in
the example, we can rewrite budget constraint for the period 0 as;
50X
L
+ 25X
M
+ 25X
N
+ 0X
o
+ C = 50
and the constraint for period I will become
-30X
L
- 10X
M
- 10X
N
+ 80X
o
< 50 + (1 + i) C
We will also add one more restriction limiting C < 0 since carrying forward a negative
amount is equal to borrowing.
We can add more requirements (restrictions) in the model. In the example Projects M
and N could be assumed mutually exclusive, that is, either M or N be accepted. We can
incorporate this condition in an integer programmed by specifying that the total investment in
M and N cannot be greater than 1 and if M is 1 then N will be zero or if N is 1 then M will be
zero:
NOTES
Y
M
+X
N
<1, X
M
, X
N
=0 or 1
We can also account for contingent projects in the model. Assume that the acceptance
of Project O is contingent on the acceptance of Project L; that is, O cant be accepted unless
L is accepted. The following constraint will be added:
X
o
+X
L
< 0, X
0
, X
L
=0 or 1
In other words, if X
L
is 1, X
0
can be 0 or 1; but if X
L
is 0, X
0
must be 0.
In addition to financial constraints, non-financial constraints can also be included. For
example, four projects in the example may share 1,000 units of a common material. If Project
L requires 400 units, Project M 300 units, Project N250 units, and Project O 250 units, then
we need to add the following constraint:
400X
L
+ 300X
M
+ 250X
N
+ 250X
o
< 1,000 It should be clear that we could go on adding
any possible constraint.
6.5.5 Limits to the Use of Programming Approach
LP or IP models seem to be best suited for making investment decisions under limited
resources. However, these models are not in common use. There are at least two important
reasons for the unpopularity of these models. First, they are costly to use when large,
indivisible projects are involved. Second, these models assume that future investment
opportunities are known. The discovery of investment opportunities in practice is an unfolding
process.
6.6 CAPITAL RATIONING IN PRACTICE
How serious is the problem of capital rationing in practice? Do companies reject projects
due to shortage of funds? How do they select projects under capital rationing? Capital
rationing does not seem to be a serious problem in practice. It may arise due to the internal
constraint or the managements reluctance to raise external funds. When companies face the
problem of shortage of funds, they use simple rules of choosing projects rather than the
complicated mathematical models (see Exhibit 6.1).
EXHIBIT 6.1: DO COMPANIES FACE CAPITAL RATIONING PROBLEM IN
PRACTICE?
- In a study of Indian companies, it is revealed that most companies do not reject
projects on account of capital shortage. They face the problem of shortage of
funds due to the managements desire to limit capital expenditures to internally
generated funds or the reluctance to raise capital from outside.
- Most companies do not use mathematical approach to select projects under capital
following. The bases to choose projects under capital rationing are:
- profitability
DBA 1764
NOTES
- priorities set by management
- experience
- Some companies satisfy the criteria of profitability and strategic considerations for
allocating limited funds.
- Generally companies do not reject profitable projects under capital rationing; they
postpone them till funds become available in future.
6.7 CAPITAL RATIONING V/S PORTFOLIO
Capital rationing is allocation of available fund to list most profitable projects. In
capital rationing projects are listed according to profitability then available funds are allotted
to the projects to ensure maximum profitability. There may be lot of profitable projects but
only few projects are selected according availability of funds. In the portfolio all the funds
are not invested in one projects rather invested in few projects mainly to diversify the risk.
In the portfolio selection minimizing the risk is more important whereas in capital rationing
maximizing the profit is the main objective. In capital rationing capital constraint and other
constraints are analysed in detail. In portfolio both systematic risk and unsystematic risk
are considered.
Review Questions
1) What do you mean by capital rationing with reference to single period and multi-
period in capital budgeting?
2) Discuss the Linear programming model formulation for the capital rationing problem.
3) How does the Integer programming model handle project interdependencies like
mutual exclusiveness and contingency relationship?
NOTES
CHAPTER 7
PORTFOLIO AND RISK MANAGEMENT THROUGH
DIVERSIFICATION
7.1 PORTFOLIO
In finance, a portfolio is an appropriate mix of or collection of investments held by an
institution or a private individual.
Holding a portfolio is part of an investment and risk-limiting strategy called
diversification. By owning several assets, certain types of risk (in particular specific risk)
can be reduced. The assets in the portfolio could include stocks, bonds, options, warrants,
gold certificates, real estate, futures contracts, production facilities, or any other item that
is expected to retain its value.
In building up an investment portfolio a financial institution will typically conduct its
own investment analysis, whilst a private individual may make use of the services of a
financial advisor or a financial institution which offers portfolio management services
7.2 PORTFOLIO MANAGEMENT
Portfolio management involves deciding what assets to include in the portfolio, given
the goals of the portfolio owner and changing economic conditions. Selection involves
deciding what assets to purchase, how many to purchase, when to purchase them, and
what assets to divest. These decisions always involve some sort of performance measurement,
most typically expected return on the portfolio, and the risk associated with this return (i.e.
the standard deviation of the return). Typically the expected return from portfolios of different
asset bundles is compared.
The unique goals and circumstances of the investor must also be considered. Some
investors are more risk averse than others. Mutual fund have developed particular techniques
to optimize their portfolio holdings. See fund management for details.
7.3 RETURNS
There are many different methods for calculating portfolio returns. A traditional method
has been using quarterly or monthly money-weighted returns. A money-weighted return
calculated over a period such as a month or a quarter assumes that the rate of return over
that period is constant. As portfolio returns actually fluctuate daily, money-weighted returns
may only provide an approximation to a portfolios actual return. These errors happen
because of cash flows during the measurement period. The size of the errors depends on
three variables: the size of the cash flows, the timing of the cash flows within the measurement
period, and the volatility of the portfolio.
DBA 1764
NOTES
A more accurate method for calculating portfolio returns is to use the true time-weighted
method. This entails revaluing the portfolio on every date where a cash flow takes place
(perhaps even every day), and then compounding together the daily returns.
7.4 ATTRIBUTION
Performance Attribution explains the active performance (i.e. the benchmark-relative
performance) of a portfolio. For example, a particular portfolio might be benchmarked
against the S&P 500 index. If the benchmark return over some period was 5%, and the
portfolio return was 8%, this would leave an active return of 3% to be explained. This 3%
active return represents the component of the portfolios return that was generated by the
investment manager (rather than by the benchmark).
There are different models for performance attribution, corresponding to different
investment processes. For example, one simple model explains the active return in bottom-
up terms, as the result of stock selection only. On the other hand, sector attribution explains
the active return in terms of both sector bets (for example, an overweight position in Materials,
and an underweight position in Financials), and also stock selection within each sector (for
example, choosing to hold more of the portfolio in one bank than another.
7.5 MODERN PORTFOLIO THEORY: AN OVERVIEW
If you were to craft the perfect investment, you would probably want its attributes to
include high returns coupled with little risk. The reality, of course, is that this kind of investment
is next to impossible to find. Not surprisingly, people spend a lot of time developing methods
and strategies that come close to the perfect investment. But none is as popular, or as
compelling, as modern portfolio theory (MPT). It is one of the most important and influential
economic theories dealing with finance and investment, MPT was developed by Harry
Markowitz and published under the title Portfolio Selection in the 1952 Journal of Finance.
MPT says that it is not enough to look at the expected risk and return of one particular
stock. By investing in more than one stock, an investor can reap the benefits of diversification
- chief among them, a reduction in the riskiness of the portfolio. MPT quantifies the benefits
of diversification, also known as not putting all of your eggs in one basket.
For most investors, the risk they take when they buy a stock is that the return will be
lower than expected. In other words, it is the deviation from the average return. Each
stock has its own standard deviation from the mean, which MPT calls risk.
The risk in a portfolio of diverse individual stocks will be less than the risk inherent in
holding any single individual stocks (provided the risks of the various stocks are not directly
related). Consider a portfolio that holds two risky stocks: one that pays off when it rains
and another that pays off when it doesnt rain. A portfolio that contains both assets will
always pay off, regardless of whether it rains or shines. Adding one risky asset to another
can reduce the overall risk of an all-weather portfolio.
NOTES
In other words, Markowitz showed that investment is not just about picking stocks,
but about choosing the right combination of stocks among which to distribute ones nest
eggs
7.6. TWO KINDS OF RISK
Modern portfolio theory states that the risk for individual stock returns has two
components:
Systematic Risk - These are market risks that cannot be diversified away. Interest
rates, recessions and wars are examples of systematic risks.
Unsystematic Risk - Also known as specific risk, this risk is specific to individual
stocks and can be diversified away as you increase the number of stocks in your portfolio.
It represents the component of a stocks return that is not correlated with general market
moves.
For a well-diversified portfolio, the risk - or average deviation from the mean - of
each stock contributes little to portfolio risk. Instead, it is the difference - or covariance -
between individual stocks levels of risk that determines overall portfolio risk. As a result,
investors benefit from holding diversified portfolios instead of individual stocks.
Figure 1
The Efficient Frontier Now that we understand the benefits of diversification, the
question of how to identify the best level of diversification arises. Enter the efficient frontier.
For every level of return, there is one portfolio that offers the lowest possible risk,
and for every level of risk, there is a portfolio that offers the highest return. These
combinations can be plotted on a graph, and the resulting line is the efficient frontier. Figure
2 shows the efficient frontier for just two stocks - a high risk/high return technology stock
(Google) and a low risk/low return consumer products stock (Coca Cola).

Figure 1
DBA 1764
NOTES
Figure 2
Any portfolio that lies on the upper part of the curve is efficient: it gives the maximum
expected return for a given level of risk. A rational investor will only ever hold a portfolio
that lies somewhere on the efficient frontier. The maximum level of risk that the investor will
take on determines the position of the portfolio on the line.
Modern portfolio theory takes this idea even further. It suggests that combining a
stock portfolio that sits on the efficient frontier with a risk-free asset, the purchase of which
is funded by borrowing, can actually increase returns beyond the efficient frontier. In other
words, if you were to borrow to acquire a risk-free stock, then the remaining stock portfolio
could have a riskier profile and, therefore, a higher return than you might otherwise choose.
The theory demonstrates that portfolio diversification can reduce investment risk. In
fact, modern money managers routinely follow its precepts.
MPT has some shortcomings in the real world. For starters, it often requires investors
to rethink notions of risk. Sometimes it demands that the investor take on a perceived risky
investment (futures, for example) in order to reduce overall risk. That can be a tough sell to
an investor not familiar with the benefits of sophisticated portfolio management techniques.
Furthermore, MPT assumes that it is possible to select stocks whose individual performance
is independent of other investments in the portfolio. But market historians have shown that
there are no such instruments; in times of market stress, seemingly independent investments
do, in fact, act as though they are related.
Likewise, it is logical to borrow to hold a risk-free asset and increase investor portfolio
returns, but finding a truly risk-free asset is another matter. Government-backed bonds are
presumed to be risk free, but, in reality, they are not. Securities such as gilts and U.S.
Treasury bonds are free of default risk, but expectations of higher inflation and interest rate
changes can both affect their value.
NOTES
Then there is the question of the number of stocks required for diversification. How
many is enough? Mutual funds can contain dozens and dozens of stocks. Investment guru
William J. Bernstein says that even 100 stocks is not enough to diversify away unsystematic
risk. By contrast, Edwin J. Elton and Martin J. Gruber, in their book Modern Portfolio
Theory and Investment Analysis (1981), conclude that investor would come very close to
achieving optimal diversity after adding the twentieth stock.
The gist of MPT is that the market is hard to beat and that the people who beat the
market are those who take above-average risk. It is also implied that these risk takers will
get their comeuppance when markets turn down.
Then again, investors such as Warren Buffett remind us that portfolio theory is just
that - theory. At the end of the day, a portfolios success rests on the investors skills and
the time he or she devotes to it. Sometimes it is better to pick a small number of out-of-
favor investments and wait for the market to turn in your favor than to rely on market
averages alone.
7.7. RISK AND RETURN
The model assumes that investors are risk averse, meaning that given two assets that
offer the same expected return, investors will prefer the less risky one. Thus, an investor
will take on increased risk only if compensated by higher expected returns. Conversely, an
investor who wants higher returns must accept more risk. The exact trade-off will differ by
investor based on individual risk aversion characteristics. The implication is that a rational
investor will not invest in a portfolio if a second portfolio exists with a more favorable risk-
return profile i.e., if for that level of risk an alternative portfolio exists which has better
expected returns.
7.8. MEAN AND VARIANCE
It is further assumed that investors risk / reward preference can be described via a
quadratic utility function. The effect of this assumption is that only the expected return and
the volatility (i.e., mean return and standard deviation) matter to the investor. The investor
is indifferent to other characteristics of the distribution of returns, such as its skew (measures
the level of asymmetry in the distribution) or kurtosis (measure of the thickness or so-
called fat tail).
Note that the theory uses a parameter, volatility, as a proxy for risk, while return is an
expectation on the future. This is in line with the efficient market hypothesis and most of the
classical findings in finance such as Black and Scholes European Option Pricing (martingale
measure: shortly speaking means that the best forecast for tomorrow is the price of today).
Recent innovations in portfolio theory, particularly under the rubric of Post-Modern Portfolio
Theory (PMPT), have exposed several flaws in this reliance on variance as the investors
risk proxy.
DBA 1764
NOTES
7.9. DIVERSIFICATION
An investor can reduce portfolio risk simply by holding instruments which are not
perfectly correlated. In other words, investors can reduce their exposure to individual
asset risk by holding a diversified portfolio of assets. Diversification will allow for the same
portfolio return with reduced risk.
If all the assets of a portfolio have a correlation of 1, i.e., perfect correlation, the
portfolio volatility (standard deviation) will be equal to the weighted sum of the individual
asset volatilities. Hence the portfolio variance will be equal to the square of the total weighted
sum of the individual asset volatilities.
If all the assets have a correlation of 0, i.e., perfectly uncorrelated, the portfolio variance
is the sum of the individual asset weights squared times the individual asset variance (and
volatility is the square root of this sum).
If correlation is less than zero, i.e., the assets are inversely correlated, the portfolio
variance and hence volatility will be less than if the correlation is 0.
7.10 SYSTEMATIC RISK AND SPECIFIC RISK
Specific risk is the risk associated with individual assets - within a portfolio these risks
can be reduced through diversification (specific risks cancel out). Specific risk is also
called diversifiable, unique, unsystematic, or idiosyncratic risk. Systematic risk (a.k.a.
portfolio risk or market risk refers to the risk common to all securities - except for selling
short as noted below, systematic risk cannot be diversified away (within one market).
Within the market portfolio, asset specific risk will be diversified away to the extent possible.
Systematic risk is therefore equated with the risk (standard deviation of the market portfolio.
Since a security will be purchased only if it improves the risk / return characteristics of
the market portfolio, the risk of a security will be the risk it adds to the market portfolio. In
this context, the volatility of the asset, and its correlation with the market portfolio, is
historically observed and is therefore a given (there are several approaches to asset pricing
that attempt to price assets by modeling the stochastic properties of the moments of assets
returns - these are broadly referred to as conditional asset pricing models. The maximum
price paid for any particular asset (and hence the return it will generate should also be
determined based on its relationship with the market portfolio.
Systematic risks within one market can be managed through a strategy of using both
long and short positions within one portfolio, creating a market neutral portfolio.
NOTES
7.11. APPLICATIONS OF MODERN PORTFOLIO THEORY IN OTHER
DISCIPLINES
In the 1970s, concepts from Modern Portfolio Theory found their way into the field
of regional science. In a series of seminal works, Michael Conroy modeled the labor force
in the economy using portfolio-theoretic methods to examine growth and variability in the
labor force. This was followed by a long literature on the relationship between economic
growth and volatility.
More recently, modern portfolio theory has been used to model the self-concept in
social psychology. When the self attributes comprising the self-concept constitute a well-
diversified portfolio, then psychological outcomes at the level of the individual such as
mood and self-esteem should be more stable than when the self-concept is undiversified.
This prediction has been confirmed in studies involving human subjects.
7.12. COMPARISON WITH ARBITRAGE PRICING THEORY
The SML and CAPM are often contrasted with the arbitrage pricing theory (APT),
which holds that the expected return of a financial asset can be modeled as a linear function
of various macro-economic factors, where sensitivity to changes in each factor is represented
by a factor specific beta coefficient.
The APT is less restrictive in its assumptions: it allows for an explanatory (as opposed
to statistical) model of asset returns, and assumes that each investor will hold a unique
portfolio with its own particular array of betas, as opposed to the identical market portfolio.
Unlike the CAPM, the APT, however, does not itself reveal the identity of its priced factors
- the number and nature of these factors is likely to change over time and between economies.
7.13. DIVERSIFICATION
Diversification in finance is a risk management technique, related to hedging, that
mixes a wide variety of investments within a portfolio. Because the fluctuations of a single
security have less impact on a diverse portfolio, diversification minimizes the risk from any
one investment.
A simple example of diversification is the following: On a particular island the entire
economy consists of two companies: one that sells umbrellas and another that sells sunscreen.
If a portfolio is completely invested in the company that sells umbrellas, it will have strong
performance during the rainy season, but poor performance when the weather is sunny.
The reverse occurs if the portfolio is only invested in the sunscreen company, the alternative
investment: the portfolio will be high performance when the sun is out, but will tank when
clouds roll in. To minimize the weather-dependent risk in the example portfolio, the
investment should be split between the companies. With this diversified portfolio, returns
are decent no matter the weather, rather than alternating between excellent and terrible.
DBA 1764
NOTES
There are three primary strategies used in improving diversification:
Spread the portfolio among multiple investment vehicles, such as stocks, mutual funds,
bonds, and cash.
Vary the risk in the securities. A portfolio can also be diversified into different mutual
fund investment strategies, including growth funds, balanced funds, index funds, small cap,
and large cap funds. When a portfolio includes investments with varied risk levels, large
losses in one area are offset by other areas.
The investor should vary his securities by industry, or by geography. This will minimize
the impact of industry- or location-specific risks. The example portfolio above was diversified
by investing in both umbrellas and sunscreen. Another practical application of this kind of
diversification is mixing investments between domestic and international funds. By choosing
funds in many countries, events within any one countrys economy have less effect on the
overall portfolio.
Diversification reduces the risk of a portfolio, and consequently it can reduce the returns.
However, since diversification reduces the risk of an entire portfolio being diminished by
single investments loss, it is referred to as the only free lunch in finance
7.13.1. Horizontal Diversification
Horizontal diversification is when a portfolio is diversified between same-type
investments. It can be a broad diversification (like investing in several NASDAQ companies)
or more narrowed (investing in several stocks of the same branch or sector). In the example
above, the move to invest in both umbrellas and sunscreen is an example of horizontal
diversification. As usual, the broader the diversification the lower the risk from any one
investment.
7.13.2. Vertical Diversification
Vertical diversification is investment between different types of securities. Again, it
can be a very broad diversification, like diversifying between bonds and stocks, or a more
narrowed diversification, like diversifying between stocks of different branches. Continuing
the example from the introduction, a vertical diversification would be taking some money
from umbrella and sunscreen stock and investing it instead in bonds issued the government
of the island.
While horizontal diversification lessens the risk of investing entirely in one security,
vertical diversification goes beyond that and protects against market and/or economical
changes.
NOTES
7.14. RETURN EXPECTATIONS WHILE DIVERSIFYING
The average of all the returns in a diverse portfolio can never exceed that of the top-
performing investment, and will almost always be lower than the highest return. This is
unavoidable, and is the cost of the risk insurance that diversification provides. However,
strategies exist that allow the portfolios manager to maximize returns while still keeping
risk as low as possible.
7.15. THE DIFFERENT TYPES OF DIVERSIFICATION STRATEGIES
The strategies of diversification can include internal development of new products or
markets, acquisition of a firm, alliance with a complementary company, licensing of new
technologies, and distributing or importing a products line manufactured by another firm.
Generally, the final strategy involves a combination of these options. This combination is
determined in function of available opportunities and consistency with the objectives and
the resources of the company.
There are three types of diversification: concentric, horizontal and conglomerate:
7.15.1 Concentric Diversification
This means that there is a technological similarity between the industries, which means
that the firm is able to leverage its technical know-how to gain some advantage. For example,
a company that manufactures industrial adhesives might decide to diversify into adhesives
to be sold via retailers. The technology would be the same but the marketing effort would
need to change. It also seems to increase its market share to launch a new product which
helps the particular company to earn profit.
7.15.2 Horizontal Diversification
The company adds new products or services that are technologically or commercially
unrelated (but not always) to current products, but which may appeal to current customers.
In a competitive environment, this form of diversification is desirable if the present customers
are loyal to the current products and if the new products have a good quality and are well
promoted and priced. Moreover, the new products are marketed to the same economic
environment as the existing products, which may lead to rigidity and instability. In other
words, this strategy tends to increase the firms dependence on certain market segments.
For example company was making note books earlier now they are also entering into pen
market through its new product.
Horizontal integration occurs when a firm enters a new business (either related or
unrelated) at the same stage of production as its current operations. For example, Avons
move to market jewelry through its door-to-door sales force involved marketing new
products through existing channels of distribution. An alternative form of that Avon has also
DBA 1764
NOTES
undertaken is selling its products by mail order (e.g., clothing, plastic products) and through
retail stores (e.g., Tiffanys). In both cases, Avon is still at the retail stage of the production
process.
7.15.3 Conglomerate Diversification (or lateral diversification)
The company markets new products or services that have no technological or
commercial synergies with current products, but which may appeal to new groups of
customers. The conglomerate diversification has very little relationship with the firms current
business. Therefore, the main reasons of adopting such a strategy are first to improve the
profitability and the flexibility of the company, and second to get a better reception in
capital markets as the company gets bigger. Even if this strategy is very risky, it could also,
if successful, provide increased growth and profitability.
7.16 RATIONALE OF DIVERSIFICATION
According to Calori and Harvatopoulos (1988), there are two dimensions of rationale
for diversification. The first one relates to the nature of the strategic objective: diversification
may be defensive or offensive.
Defensive reasons may be spreading the risk of market contraction, or being forced
to diversify when current product or current market orientation seems to provide no further
opportunities for growth. Offensive reasons may be conquering new positions, taking
opportunities that promise greater profitability than expansion opportunities, or using retained
cash that exceeds total expansion needs.
The second dimension involves the expected outcomes of diversification: management
may expect great economic value (growth, profitability) or first and foremost great coherence
and complementarities with their current activities (exploitation of know-how, more efficient
use of available resources and capacities). In addition, companies may also explore
diversification just to get a valuable comparison between this strategy and expansion.
7.17 FIRM-PORTFOLIO APPROACH
In the chapter 3 we measured risk for a single, stand-alone investment proposal.
When multiple investment projects are involved, we may want to study their combined
risk. In that case, we need to use a measurement procedure that differs from that for a
single project. The approach we take corresponds to the portfolio approach in security
analysis. Now, however, we apply that approach to capital investment projects. Our
purpose here is only to show how to measure risk for combination of risky investments,
assuming that such a measure is desired.
If a firm adds a project whose future cash flows are likely to be highly correlate with
those of existing assets, the total risk of the firm will increase more than that the project
NOTES
which has a low degree of correlation with existing assets. Given the reality, a firm might
wish to seek out projects that could be combined to reduce firm risk.
Fig.7.3 Probability Distribution of NPV for Two Projects
Figure 7.3 shows the expected cash-flow patterns for two projects over the life term.
Proposal A is cyclical, whereas proposal B is mildly countercyclical. By combined these
two projects, we see that total cash-flow dispersion is reduced. The combining the projects,
in a way that will reduce risk as known as diversification, and the principle is the same as
for diversification of securities. We attempt to reduce deviations in return from the expected
value of return.
Expectation and Measurement of Portfolio Risk
The expected value of the net present value for a combination (portfolio) of
involvement projects,
, NPV
is simply the sum of the separate expected values of net
present value, where discounting takes place at the risk-free rate. The standard deviation
of the probability distribution of the portfolios net present values(
p
), however it is merely
the summation of the standard deviations of the individual projects making up the portfolio.
Instead, it is
p
= \
j,k
j,k
is the correlation between possible net present values for projects j and k
The covariance term is
j,k
= r
j,k
j,

,k
Where r
j,k
is the expected correlation coefficient between possible net present values
for projects j and k,
j,
is the standard deviation for project j and
,k
is the standard
deviation for project k. The Standard deviations of the probability distributions of possible
net present values for projects j and k are determined by the methods taken up in the
previous section. When j = k, the correlation coefficient is 1, and
j,

,k
becomes
j,
2
(that is, the covariance of project j s net present value with itself is its variance).
Proposal x
-500 -500 0 116 200 500
Proposal y
NET PRESENT VALUES ($)
P
R
O
B
A
B
I
L
I
T
Y

O
F

O
C
C
U
R
R
E
N
C
E
DBA 1764
NOTES
Fig. 7.4 Effect of Diversification on Cash Flows
An Illustration:
To illustrate these concepts, suppose that a firm has a single existing investment project,
1 and that it is considering investing in an additional project, 2. Assume further that the
projects have the following expected values of net present value, standard deviations, and
correlation coefficient.
The expected value of the net present value of the combination of projects is the sum of the
two separate expected values of net present value.
NPVp
= $12,000 + $8,000 = $20,000
The standard deviation for the combination is
p
= \r
j,k
j,

,k
= \ r
1.1
1
2
+ 2(r
1.2

1,

,2
)
+
r
2.2
2
2
= \ (1)(14,400)
2
+ (2)(.4)(14,000)(6,000)+(1)(6000)
2
=17,297
Thus, the expected value of net present value of the firm increased from $12,000 to
$20,000, and the standard deviation of possible net present values increases from $14,000
to $17,297 with the acceptance of project 2. The firms coefficient of variation= standard
deviation over expected value of net present value which is $14,000/$12,000 = 1.17
without project 2 and $17,297/$20,000 = .86 with the project. If we employ the coefficient
of variation as a measure of relative firm risk, we conclude that acceptance of project 2
would lower the risk of the firm.

Expected value of
Net present value
Standard Deviation
Correlation
Coefficient
Project 1
Project 2
$ 12,000
8,000
$14,000
6,000
between 1 and 2 .4

NOTES
By accepting projects with relatively low degrees of correlation with existing projects,
a firm diversifies and, in so doing, may be able to lower its overall risk. Note, the lower the
degree of positive correlation between possible net present values for projects, the lower
the standard deviation of possible net present values, all other things being equal. Whether
the coefficient of variation declines when an investment project is added also depends on
the expected value of net present value for the project.
Correlation Between Projects
The correlation between possible net present values for pairs of projects proves to
be the key ingredients in analyzing risk in a firm-portfolio context. When prospective
projects are similar to projects with which the company has had experience, it may be
feasible to compute the correlation coefficients using historical data. For other investments,
estimates of the correlation coefficients must be based solely on an assessment of the
future.
Management might have reason to expect only slight correlation between investment
projects involving research and development for an electronic tester and a new food product.
On the other hand, it might expect high positive correlation between investments in a milling
machine and a turret lathe if both machines were used in the production of industrial lift
trucks. The profit from a machine to be used in a production line will be highly, if not
perfectly, correlated with the profit for the production line itself.
The correlation between expected net present values of various investments may be
positive, negative, or 0, depending on the nature of the association. A correlation of 1
indicates that the net present values of two investments vary directly in the same proportional
manner. A correlation coefficient of 1 indicates that they vary inversely in exactly the
same proportional manner. And, a correlation of 0 indicates that they are independent or
unrelated. For most pairs of investments, the correlation coefficient lies between 0 and 1.
The reason for the lack of negatively correlated investment projects is that most investments
are correlated positively with the economy and, thus, with each other.
Estimates of the correlation coefficients must be as objective as possible if the total
standard deviation obtained is to be realistic. It is not unreasonable to expect management
to make fairly accurate estimates of these coefficients. When actual correlation differs
from expected correlation, the situation can be learning process, and estimates on other
projects can be revised.
Combinations of Risky Investments:
We now have a procedure for determining the total expected value and the standard
deviation of a probability distribution of possible net present values for a combination of
investments. For our purposes, we define a combination as including all of the firms
existing investment projects plug one or more projects under consideration. We assume,
then, that the firm has existing investment projects and that these projects are expected to
DBA 1764
NOTES
generate future cash flows. Thus, existing projects constitute a subset that is included in all
potential future combinations. We denote the portfolio of existing projects by the letter E.
Assume further that a firm is considering four new investment projects that are
independent of one another. If these proposals are labeled 1,2,3 and 4 we have the
following possible combinations of risky investments.
Thus, 16 project combinations are possible. One of these possibilities consists of the
rejection of all of the new projects under consideration, so that the firm is left with only its
existing projects combination E. The expected value of net present value, standard
deviation, and coefficient of variation for each of these combinations can be computed in
the manner described previously. The results can then be graphed.
Figure 7.5 is a scatter diagram of the 16 possible combinations. Here the expected
value of net present value is measured along the vertical axis, while risk (standard deviation
or alternatively, coefficient of variation) is measured on the horizontal axis. Each dot
represents a combination of projects. Collectively, these dots constitute the total set of
feasible combinations of investment opportunities available to the firm.
7.5 Scatter Diagram for Feasible Combination of Projects
E E + 1
E + 2
E + 3
E + 4
E + 1 + 2
E + 1 + 3
E + 1 + 4
E + 2 + 3
E + 2 + 4
E + 3 + 4
E + 1 +2 + 3
E + 1 + 2 + 4
E + 1 + 3 + 4
E + 2 + 3 + 4
E + 1 + 2 + 3 +4
E
X
P
E
C
T
E
D

V
A
L
U
E

O
F

N
E
T

P
R
E
S
E
N
T

V
A
L
U
E
STANDARD DEVIATION
NOTES
We see that certain dots dominate others in the sense that they represent either (1) a
higher expected value of net present value and the same level of risk, (2) a lower level of
risk and the same expected value of net present value, or (3) both a higher expected value
of net present value and a lower level of risk. The dominating combinations have been
specifically identified in figure 7.5 as dots A,B and C. (The dot E represents a portfolio
consisting of all existing projects). we observe here that the combination ultimately chosen
determines the new investment projects 1 and 4, investment projects 1 and 4 would be
accepted. Those investment proposals not in the combination finally selected would be
rejected. In our example projects 2 and 3 would be rejected. If the combination finally
selected consisted of only existing investment projects (E), all new investment proposals
under consideration would be rejected. The selection of any other combination implies
acceptance of one or more of the investment proposals under consideration.
The incremental expected value of net present value and level of risk can be determined
by measuring the horizontal and vertical distances from dot E to the dot representing the
combination finally selected. These distances can be thought of as the incremental
contribution of expected value of net present value and level of risk to the firm as a whole.
Summary
In finance, a portfolio is an appropriate mix of or collection of investments held by an
institution or a private individual. Holding a portfolio is part of an investment and risk-
limiting strategy called diversification. By owning several assets, certain types of risk (in
particular specific risk) can be reduced. The assets in the portfolio could include stocks,
bonds, options, warrants, gold certificates, real estate, futures contracts, production facilities,
or any other item that is expected to retain its value.
Portfolio management involves deciding what assets to include in the portfolio, given
the goals of the portfolio owner and changing economic conditions. Selection involves
deciding what assets to purchase, how many to purchase, when to purchase them, and
what assets to divest. These decisions always involve some sort of performance measurement,
most typically expected return on the portfolio, and the risk associated with this return (i.e.
the standard deviation of the return). Typically the expected return from portfolios of different
asset bundles is compared.
There are many different methods for calculating portfolio returns. A traditional method
has been using quarterly or monthly money-weighted returns. A money-weighted return
calculated over a period such as a month or a quarter assumes that the rate of return over
that period is constant.
The risk in a portfolio of diverse individual stocks will be less than the risk inherent in
holding any single individual stocks (provided the risks of the various stocks are not directly
related). Consider a portfolio that holds two risky stocks: one that pays off when it rains
and another that pays off when it doesnt rain
DBA 1764
NOTES
Modern portfolio theory states that the risk for individual stock returns has two components:
Systematic Risk - These are market risks that cannot be diversified away. Interest
rates, recessions and wars are examples of systematic risks.
Unsystematic Risk - Also known as specific risk, this risk is specific to individual
stocks and can be diversified away as you increase the number of stocks in your portfolio.
It represents the component of a stocks return that is not correlated with general market
moves.
An investor can reduce portfolio risk simply by holding instruments which are not
perfectly correlated. In other words, investors can reduce their exposure to individual
asset risk by holding a diversified portfolio of assets. Diversification will allow for the same
portfolio return with reduced risk
According to Calori and Harvatopoulos (1988), there are two dimensions of rationale
for diversification. The first one relates to the nature of the strategic objective: diversification
may be defensive or offensive.
Defensive reasons may be spreading the risk of market contraction, or being forced
to diversify when current product or current market orientation seems to provide no further
opportunities for growth. Offensive reasons may be conquering new positions, taking
opportunities that promise greater profitability than expansion opportunities, or using retained
cash that exceeds total expansion needs.
Key Terms
Portfolio
Modern Portfolio Theory
Portfolio Management
Diversification
Systematic risk and specific risk
Horizontal diversification
Vertical diversification
Concentric diversification
Horizontal diversification
Conglomerate diversification
NOTES
Questions
1. Define the term Portfolio
2. Explain the concept of Modern Portfolio Theory
3. What do you understand by Portfolio Management?
4. Explain the concept and the for Diversification
5. What do you understand by systematic risk and specific risk?
6. Explain the different types of diversification strategies
DBA 1764
NOTES
NOTES
UNIT III
STRATEGIC ANALYSIS OF
SELECTED INVESTMENT DECISIONS
CHAPTER 8
LEASING AND HIRE PURCHASE
The traditional financing is related to the liability side of the balance sheet. The firm
issues long-term debt or equity to meet its financing needs, and in the process expands its
capitalisation. The dangers of traditional financing are that equity becomes an expensive
method of financing because of decreasing corporate earning and low price-earning ratios.
The high rate of inflation causes long-term debt to be an expensive source of financing as
interest rates rise. The corporate finance managers, therefore, are developing financing
alternatives related to the asset side of the balance sheet. These alternatives may lower the
cost and redistribute the risk. Asset-based financing uses assets as direct security. There
are many possibilities. We shall discuss two most popular asset-based financing: (i) lease,
and (ii) hire purchase.
8.1. LEASE FINANCING
Leasing is widely used in western countries to finance investments. In USA, which
has the largest leasing industry in the world, lease financing contributes approximately one-
third of total business investments. In the changing economic and financial environment of
India, it has assumed an important role. what is lease financing? What are its advantages
and disadvantages? How can a lease be evaluated?
8.1.1 Lease Defined
Lease is a contract between a lessor, the owner of the asset and a lessee, the user of
the asset. Under the contract, the owner gives the right to use the asset to the user over an
agreed period of time for a consideration called the lease rental. The lessee pays the rental
to the lessor as regular fixed payments over a period of time at the beginning or at the end
of a month, quarter, half-year or year. Although generally fixed, the amount and timing of
DBA 1764
NOTES
payment of lease rentals can be tailored to the lessees profits or cash flows. In up-fronted
leases, more rentals are charged in the initial years and less in the latter years of the contract.
The opposite happens in back-ended leases. At the end of the lease contract, the asset
reverts to the lessor, who is the legal owner. It is the lessor not lessee, who is entitled to
claim depreciation on the leased asset. In long-term lease contracts, the lessee is generally
given an option to buy or renew the lease. Sometimes, the lease contract is divided into
two parts primary lease and secondary lease for the purposes of lease rentals. Primary
lease provides for the recovery of the cost of the asset and profit through lease rentals
during a period of about four or five years. A perpetual, secondary lease may follow it on
nominal lease rentals. Various other combinations are possible.
Although the lessor is the legal owner of a leased asset, the lessee bears the risk and
enjoys the returns. The lessee benefits if the leased assets operates profitably, and suffers
if the asset fails to perform. Leasing separates ownership and use as two economic activities,
and facilitates asset use without ownership.
A lessee can be individual or a firm interested in the use of an asset without owning.
Lessors may be equipment manufacturers or leasing companies who bring together the
manufacturers and the users. In USA, equipment manufacturers are the largest group of
lessors followed by banks. In India, independent leasing companies from the major group
in number in the leasing industry. Banks together with financial institutions are the largest
group in terms of the volume of business.
8.1.2 Types of Leases
Two types of leases can be distinguished:
- Operating lease
- Financial lease
- Sale-and-lease-back
Operating lease short-term cancellable lease agreements are called operating leases.
Convenience and instant services are the hallmarks of operating leases. Examples are: a
tourist renting a car, lease contracts for computers or office equipment, an operating lease
may run for 3 to 5 years. The lessor is generally responsible for maintenance and insurance.
He may also provide other services. A single operating lease contract may not fully amortise
the original cost of the asset; it covers a period considerably shorter than the useful life of
the asset. Because of the short duration and the lessees option to cancel the lease, the risk
of obsolescence remains with the lessor. Naturally, the shorter the lease period and/or
higher the risk of obsolescence, the higher will be the lease rentals.
Financial lease Long term, non-cancellable lease contracts are known as financial leases.
Examples are plant, machinery, land, buildings, ships, and aircraft. In India, financial leases
NOTES
are very popular with high-cost and high technology equipment. Financial leases amortise
the cost of the asset over the term of lease; they are, therefore, also called capital or full-
pay out leases. Most financial leases are direct leases. The lessor buys the asset identified
by the lessee from the manufacturer and signs a contract to lease it out to the lessee.
Sale-and-lease back Sale-and-lease-back is a special financial lease arrangement.
Sometimes, a user may sell an (existing) asset owned by him. Such sale-and-lease back
arrangements may provide substantial tax benefits. For example, in April 1989, Shipping
Credit and Investment Corporation of India (SCICI) purchased Great Eastern Shipping
Companys bulk carrier, Jag Lata, for Rs.12.5 Crore and then leased it back to Great
Eastern on a five-year lease, the rentals being Rs.28.13 lakh per month. The ships written-
down book value was Rs.2.5 Crore.
In financial lease, the maintenance and insurance are normally the responsibility of the
lessee. The lessee also bears the risk of obsolescence. A financial lease agreement may
provide for renewal of contract or purchase of the asset by the lessee after the contact
expires. The option of purchasing the leased asset by the lessee is not incorporated in the
lease contract in India, because if such an option is provided the lease is legally construed
to be a hire purchase agreement.
8.1.3 Cash Flow Consequences of a Financial Lease
A financial lease has cash flow consequences. It is a way of normal financing for a
company. Suppose a company has found it financially worthwhile to acquire an equipment
costing Rs.800 lakh. The equipment is estimated to last eight years. Instead of buying, the
company can lease the equipment for eight years at an annual (end-of-the period) lease
rental of Rs.160 lakh from the manufacturer. Suppose that the company will have to provide
for the maintenance, insurance and other operating expenses associated with the use of the
asset in both alternatives leasing or buying. Assume a straight-line depreciation for tax
purposes, a borrowing rate of 14 percent, and a marginal tax rate of 35 percent for the
company. The cash flow consequences of the lease (as compared to the buy option) are
shown in Table 8.1. They would be:
- Avoidance of the purchase price (P
O
) The company can acquire the asset without
immediately paying for it. Cash outflow saved is equivalent to a cash inflow; there
is a cash inflow of Rs.800 lakh.
- Loss of Depreciation Tax Shield (DTS) Depreciation is a deductible expense
and saves taxes. Depreciation tax shield is equal to the amount of deprecation
each year multiplied by the tax rate. The company will lose a series of depreciation
tax shields when it takes the lease. The straight-line depreciation will be Rs.800/
8=Rs.100 lakh, and the lost DTS will be: Rs.100x0.35=Rs.35lakh.
- After-tax payment of lease rentals (L
t
) There is a cash out-flow of Rs.160
lakh per year as lease payment. But these payments will yield tax of Rs.160 x 0.35
DBA 1764
NOTES
= Rs.56 lakh per year. Thus, the after-tax lease payments would be Rs.160 lakh
Rs.56 lakh = Rs.104 lakh per year.
The cash flow consequences of leasing depend on the tax status of a company; tax
shields are available only when the company pays taxes. In case it does not, then depreciation
is worth nothing to it. Also, tax shields would vary with the marginal tax rate for the company.
Table 8.1: Cash Flow Consequences of a Lessee
Exhibit 8.1: Commonly used lease Terminology
Two basic types of leases are i) financial lease and ii) operating lease. Financial lease
is further divided into i) leveraged lease, ii) sale-and-lease-back iii) Cross-border lease.
- Leveraged lease Leveraged lease involves lessor, lessee and financier. Lessor
(leasing company) provides equity equal to about 25 percent of the assets cost
while the remaining amount is provided by the financier (a bank or a financial
institution), mainly as loan. Leveraged lease is a popular method of financing expensive
assets.
- Sales-and-lease-back As discussed to the main text, the lessee first sells asset
owned by him to the lessor and then leases it back from the lessor. This provides
liquidity as well as possible tax gains to the lessee.
- Cross-border lease In case of cross-border or international lease, the lessor and
the lessee are situated in two different countries. Because the lease transaction
takes place between two parties of two or more countries, it is called cross-
border lease. It involves relationships and tax implications more complex than the
domestic lease. When the lease transaction takes place between three parties
manufacturer / vendor, lessor and lessee in three different countries, it is called
foreign-to-foreign lease.
Year
(1)

Purchase
Price
Avoided
(P
O
)
(2)
Depreciation
(D)
(3)
Depreciation
Tax Shield
(DTS)
(4) = (3)
x 0.35
Before Tax
Lease Rentals
(BTLR)
(5)
After tax
Lease (ALR)
6=.65
x (5)
Net Cash
flow
(NCF)
(7)=(1)
+4+(5)
0
1
2
3
4
5
6
7
8
800
-100
-100
-100
-100
-100
-100
-100
-100
-100
-35
-35
-35
-35
-35
-35
-35
-35
-35
-160
-160
-160
-160
-160
-160
-160
-160
-160
-104
-104
-104
-104
-104
-104
-104
-104
-104
800
-139
-139
-139
-139
-139
-139
-139
-139

NOTES
There are many other terms used by the leasing industry. Some of them are defined
below:
- Closed and open ended lease In the close ended lease, the asset gets transferred
to the lessor at the end, and the risk of obsolescence, residual value etc. remain
with the lessor being the legal owner of the asset. In the open ended lease, the
lessee has the option of purchasing the asset at the end of lease.
- Direct lease It is a mix of operating and finance lease on a full payout basis and
provides for the purchase option to the lessee.
- Master lease Master lease provides for a longer than the assets life and holds
the lessor responsible for providing equipment in good operating condition during
the lease period.
- Percentage lease Percentage lease provides for a fixed rent plus some percent
of the previous years gross revenue to be paid to the lessor. This ensures protection
against the inflation.
- Wet and dry lease In the aircraft industry, when the lease involves financing as
well as servicing and fuel, it is called wet lease. Dry lease provides only for financing.
- Net net net lease In the triple net (net net net) lease, the lessee is obliged to take
care of maintenance, taxes and insurance of the equipment.
- Update lease Update lease is intended to protect the lessee against the risk of
obsolescence. The lessor agrees to replace obsolete asset with new one at specified
rent.
8.1.4 Myths About Leasing
We can now examine the truth about some myths on leasing.
Leasing provides 100 percent financing One misconception about leasing is that it
provides 100 percent financing for the asset as the lessee can avoid payment for acquiring
the asset. The lessee it is assumed can preserve his liquid resources for other purposes.
When a firm borrows to buy an asset, cash increases with borrowing and decreases by the
same amount with the purchase of the asset. It has the asset to use but a liability to repay
the loan and interest. In leasing also, the firm acquires the asset and incurs the liability to
make fixed payments in future. In practice, therefore, leasing like borrowing, commits the
company for a stream of payments in future.
Leasing provides off-the-balance-sheet financing: As the lessee may not be obliged
to disclose his lease liability on the balance sheet, it is believed that leasing does not affect
the debt-equity ratio while borrowing increases his debt-equity ratio. The myth goes,
therefore, that leasing provides off-the-balance-sheet financing leaving the firms debt raising
ability intact. This is a fallacious argument. First, a debt-equity norm puts a limit on the
firms total borrowings. In debt capacity depends on its debt servicing ability rather than
the balance sheet ratios. Contractual obligations of any form through a lease or loan, reduce
DBA 1764
NOTES
debt servicing ability and add to financial risk. Lenders recognise the lessees cash flow
burden arising from lease payments. As a lease use the firms debt capacity, it displaces
debt.
Leasing can certainly help companies which have enough debt servicing ability but
cannot borrow from banks or financial institutions on account of institutional norms or
debt-equity or regulations. Under no circumstances can a lease enhance the firms debt
capacity.
Leasing improves performance Another myth is that the return on investment (profits
divided by investment) will increase since a lease does not appear as an investment on the
books or the balance sheet. Besides, back-ended leases enable showing higher profits in
the initial years of the lease. Such performance ratios are illusory.
A firms value is affected by the value of its assets and liabilities rather than book
profits created through accounting adjustments. A lease will create value to the firm only if
the benefits from it are more than its costs.
Leasing avoids control of capital spending: Another misconception is that leasing does
not need capital expenditure screening as no investments are involved. Since a long-term
lease involves long-term financial commitments, it ought to be screened accordingly in any
good capital expenditure planning and control system. If leasing is not screened and is
used to circumvent capital expenditure screening and approval, it may add to the firms
risk, made it vulnerable to business fluctuations, and endanger its survival.
8.1.5 Advantages of Leasing
If all these myths are exploded, why then should a company lease instead of following
the straightforward alternative of a secured loan and purchase of the asset? The primary
consideration is the cost of the lease vs. cost of buying. They can be different. For, if a firm
is incurring losses or making low profits, it cannot take full advantage of the depreciation
tax shield on purchase of assets. It is, therefore, sensible for it to let the leasing company
(lessor) own the assets, take full advantage of tax benefits and expect that the lessor
passes on atleast some part of the benefits in the form of reduced lease rentals. Both the
lessor and the lessee may stand to gain financially. Apart from these tangible financial
implications, there are other real advantages to leasing.
Convenience and flexibility If an asset is needed for a short period, leasing makes
sense. Buying an asset and arranging to resell it after use is time consuming, inconvenient
and costly.
Long-term financial leases also offer flexibility to the user. In India, borrowing from
banks and financial institutions involve long, complicated procedures. Institutions often put
restrictions on borrowers, stipulate conversion of loan into equity and appoint nominee
NOTES
directors on the board. Financial leases are less restrictive and can be negotiated faster,
especially if the leasing industry is well developed. Yet another advantage of a lease is the
flexibility it provides to tailor lease payments to the lessees cash flows. Such tailored
payment schedules are helpful to lessee who has fluctuating cash flows.
New or small companies in non-priority sectors such as confectioneries, bottlers and
distilleries find it difficult to raise funds from banks and financial institutions in India.
Shifting of risk of obsolescence: When the technology embedded in assets, as in a
computer, is subject to rapid and unpredictable changes, a lessee can, through a short-
term cancellable lease, shift the risk of obsolescence to the lessor. A manufacturer-lessor,
or a specialised leasing company, is usually in a better position than the user to assume the
risk of obsolescence and manage the fast advancing technology. Specialised leasing
companies are emerging in India. In fact, in such situations, the lessee is buying an insurance
against obsolescence paying a premium in terms of higher lease rentals.
Maintenance and specialised services with a full-service lease, a lessee can look for
advantages in maintenance and specialised services. For example, computer manufacturers
who lease out computers are better equipped than the user to provide effective maintenance
and specialised services. Their cost too may be less than what the lessee would have to
incur if he were to maintain the leased asset. The lessor is able to provide maintenance and
other services cheaply because of his larger volume and specialisation. He may pass on a
part of that advantage to the lessee. What do not yet have in India many integrated
specialised leasing companies. In the face of such myths and realities, how does one evaluate
a lease?
8.1.6 Evaluating a Financial Lease
Leasing is a two-step decision for the lessee firm. First, it has to evaluate the economic
viability of the asset as an investment. If the asset has a positive net present value, the
company should proceed to acquire the asset. Once it has decided to do so, the firm can
compare the costs of financing the asset through leasing with that of normal sources of
financing.
When the firm finances the asset by normal financing, it takes the following two steps.
- Purchase the asset for the cash, for say, X.
- Purchases the necessary cash by selling package of financing instruments (debt
and / equity) taking into account its long-term target capital structure, for say, Y.
When the asset is leased the following two transactions takes place simultaneously:
- Purchase of the asset for cash, for say, A.
- Purchase of necessary cash, say B, by (i) giving up the assets depreciation tax
shield, and salvage value and (ii) by agreeing to make a stream of cash payments
as lease rentals to the lessor.
DBA 1764
NOTES
It is to the firms advantage to finance the asset by leasing if there is a positive difference,
in net present value terms, of B over Y. Thus, in evaluating a lease, a firm should be
concerned about how the value of the firm is affected if the lease is used as a substitute
for normal finance. The net present value of an asset (investment project) is found by
discounting the cash flows associated with the use of the asset by the firms cost of capital,
given its target debt-equity structure.
8.1.7 Leasing and Operating Risk
Anything which requires fixed commitment leads to operating risk. Lease rent is fixed
in nature, whether there is a production or not lease rental is to be paid. If it is purchase
equipment then wear and tear will be less when there is no production. Hence operating
risk is less in purchase decision. At the same time this fixed cost can be used as leverage.
The lease rental will be fixed when there is a increase in production. This will increase the
earning available to the equity shareholders. Ultimately wealth maximization can be achieved.
Hence the lease decision will be riskier when there is a fluctuation in the demand and
production schedule. It is also to be noted that lease decision eliminates the risk of
obsolescence. The leasing decision will not increase the liability side of balance sheet,
because it is a asset side financing. The debt and equity ratio which is one of the important
solvency ratios will not get affected by lease financing.
8.1.8 Leveraged Lease
Under a leveraged lease, four parties are involved: the manufacturer of the asset, the
lessor, the lender from whom the lessor borrows a substantial portion of the assets purchase
price, and the lessee. In a direct lease, the lessor buys the asset and becomes the owner by
making the full payment of the asset. In a leveraged lease, the lessor makes substantial
borrowing, even up to 80 percent of the assets purchase price. He provides the remaining
amount about 20 percent or so as equity to become the owner (Figure 8.1). The lessor
claims all tax benefits related to the ownership of the asset. Lenders, generally the large
financial institutions, provide loans on a non-recourse basis to the lessor. Their debt is
serviced exclusively out of the lease proceeds. To secure the loan provided by the lenders,
the lessor also agrees to give them a mortgage on the asset. Thus, lenders have the first
claim on the lease payments together with the collateral on the asset. Lenders will take
charge of the asset if the lessee is unable to make lease payments.
Leveraged lease are called so because the high non-recourse debt creates a high
degree of leverage. The effect is to amplify the return of the equity-holder (that is, the
lessor). But the risk is also quite high if the lease payments are not received. Leveraged
lease is quite useful for large capital equipment with long economic life, say, 20 years or
more. It is one of the popular means of financing large infrastructure projects.
NOTES
Fig 8.1: Leveraged Lease
8.2. HIRE PURCHASE FINANCING
Hire purchase financing is a popular financing mechanism especially in certain sectors
of Indian business such as the automobile sector. In hire purchase financing, there are three
parties: the manufacturer, the hiree and the hirer. The hiree may be a manufacturer or a
finance company. The manufacturer sells asset to the hirer who sells it to the hirer exchange
for the payment to be made over a specified period of time (Figure 8.2).
Figure 8.2: Hire purchase financing
A hire purchase agreement between the hirer and the hiree involves the following
three conditions:
- The owner of the asset (the hirer or the manufacturer) gives the possession of the
asset to the hirer with an understanding that the hirer will pay agreed instalments
over a specified period of time.
- The ownership of the asset will transfer to the hirer on the payment of all instalments.
- The hirer will have the option of terminating the agreement any time before the
transfer of ownership of the asset.
Thus, for the hirer, the hire purchase agreement is like a cancellable lease with a right
to buy the asset. The hirer is required to show the hired assed on his balance sheet and is
entitled to claim depreciation, although he does not own the asset until full payment has
been made. The payment made by the hirer is divided two parts: interest charges and
Equity Loan Lien on Asset
Manufacturer
Lessor
Lessee
Equity
Owners

Lenders
Sells Asset
Leases Asset

Manufacturer
Sells
asset to
Hirer
Hires
asset to
Hirer
DBA 1764
NOTES
repayment of principal. The hirer, thus, gets tax relief on interest paid and not the entire
payment.
8.2.1 Hire Purchase Financings v/s Lease Financing.
Both hire purchase financing and lease financing are a form of secured loan. Both
displace the debt capacity of the firm since they involve fixed payments. However, they
differ in terms of the ownership of the asset. The hirer becomes the owner of the assets as
soon as he pays the last installment. In case of lease, the asset reverts back to the lessor at
the end of lease period. In practice, the lessee may be able to keep the asset after the
expiry of the primary lease period for nominal lease rentals. The following are the differences
between hire purchase financing and lease financing:
Table 8.2: Difference between Leasing and Hire Purchase Financing
8.2.2 Installment Scale
In contrast to the acquisition of an asset on the hire purchase basis, a customer can
buy and own it out rightly on instalment basis. Instalment scale is a credit scale and the legal
ownership of the asset passes immediately to the buyer as soon as the agreement is made
between the buyer and the seller. The outstanding instalments are treated as secured loan.
As the owner of the asset, the buyer is entitled to depreciation and interest as deductible
expenses and claim salvage on the sale of the asset. Except for the timing of the transfer of
ownership, instalment sale and hire purchase are similar in nature.
8.3. LEASING V/S PURCHASING
Finance lease effectively transfers the risks and rewards associated with the ownership
of equipment from the lessor to the lessee. A lease can be evaluated either as an investment
decision or as a financing alternative. Given that an investment decision has already been
made, a firm (lessee) has to evaluate whether it will purchase the asset/equipment or acquire
Hire Purchase Financing Lease Financing
- Depreciation Hire is entitled to
claim depreciation tax shield.
- Depreciation Lessee is not entitled
to claim depreciation tax shield.
- Hire purchase payments Hire
purchase payments include interest
and repayment of principal. Hirer
gets tax benefits only on the
interest.
- Lease payments Lessee can charge
the entire lease payments for tax
purposes. Thus he/she saves taxes
on the lease payments.
- Salvage value Once the hirer has
paid all instalments, he becomes
the owner of the asset and can
claim salvage value.
- Salvage value Lessee does not
become owner of the asset.
Therefore, he has no claim over
the assets salvage value.

NOTES
it on lease basis. Since lease rental payments are similar to payments of interest on debt,
leasing in essence is an alternative to borrowing. The lease evaluation from the lessees
point of view, thus, essentially involves a choice between debt financing versus lease financing.
It is in this context that an evaluation of lease financing from the view point of lessee is
presented in this Section. The decision-criterion used is the Net Present Value of Leasing
[NPV(L)]/Net Advantage of Leasing (NAL). The discount rate used is the marginal cost
of capital for all cash flows other than lease payments and the tax cost of debt for lease
payments. The value of the interest tax shield is included as a foregone cash flow in the
computation of NPV(L)/NAL.
If the NAL/NPV(L) is positive, the leasing alternative should be used, otherwise the
borrowing alternative would be preferable. An alternative approach is to determine the
present values of the cash outflows after taxes under the leasing and the borrowing
alternatives. The decision-criterion is to select the alternative with the lower present value
of cash outflows.
The mechanics of computation of (i) present value of cash outflows associated with
the leasing and the borrowing alternatives and (ii) the NAL/NPV (L) is illustrated below.
Illustration 8.1
XYZ Ltd is in the business of manufacturing steel utensils. The firm is planning to
diversify and add a new product line. The firm either can buy the required machinery or get
it on lease.
The machine can be purchased for Rs.15,00,000. It is expected to have a useful life
of 5 years with salvage value of Rs.1,00,000 after the expiry of 5 years. The purchase can

NPV (L) NAL = Investment Cost
Less : Present value of lea se payment
(discounted by K
d
)
Plus: Present value of tax shield on lease payment
(discounted by Kc)
Less: Management fee
Plus: Present value of tax shield on management fee
(discounted by Kc)
Minus: Present value of depreciation shield
(discounted by Kc)
Minus: Present value of interest shield
(discounted by Kc)
Minus: Present value of residual / salvage value
(discounted by Kc)
Where Kc = post - tax marginal cost of capital
Kd = Pre-tax cost of long - term debt
DBA 1764
NOTES
be financed by 20 per cent loan repayable in 5 equal annual installments (inclusive of
interest) becoming due at the end of each year. Alternatively, the machine can be taken on
year-end lease rentals of Rs.4,50,000 for 5 years. Advise the company, which option it
should choose. For your exercise, you may assume the following.
(i) The machine will constitute a separate block for depreciation
- purposes. The company follows written down value method of
- depreciation, the rate of depreciation being 25 per cent.
(ii) Tax rate is 35 per cent and cost of capital is 18 per cent.
(iii) Lease rents are to be paid at the end of the year.
(iv) Maintenance expenses estimated at Rs.30,000 per year are to be borne by the lessee.
Solution
PV of Cash Outflows under Leasing Alternative
PV of Cash Outflows under Buying Alternative
Recommendation: The Company is advised to go for leasing as the PV of cash outflows
under leasing option is lower than under buy/borrowing alternative.
Year - end
Lease rent after taxes
[R (1-t)]
(Rs.4,50,000 (1-0.35)]
PVIF at 13%
(20 % (1-35)]
Total PV
1-5 Rs.2,92,500 3.517 Rs.10,28,723
Year
- end
Loan
installment
Tax advantage on Net cash
outflows (col.
2-col. 3 +
col.4)
PVIF
at 13%
Total PV Interest
(I x 0.35)
Depreciation
(D x 0.35)
1 2 3 4 5 6 7
1 5,01,505 1,05,000 1,31,250 2,65,255 0.885 2,34,751
2 5,01,505 90,895 98,437 3,12,173 0.783 244431
3 5,01,505 73, 968 73,828 3,53,709 0.693 .2,45,120
4 5,01,505 53,656 55,371 3,92,478 0.613 24,589
5 5,01,505 29,114 41,528 4,30,863 0.543 2,33,959
11,98,850
Less : PV of salvage value (Rs 1,00,000 x 0.543) 54,300
Less : PV of tax savings on short-term capital loss: Rs 3,55,958-Rs
1,00,000) x 0.35 = (Rs 89,585 x 0.543)
48,645
NPV of cash outflows 10,95,905

NOTES
Working Notes
Schedule of Debt Payment
* Difference between loan instalment and loan outstanding.
Schedule of Depreciation
Illustration 8.2 (Annual Lease Rentals)
The following details relate to an investment proposal of the Hypothetical Industries
Ltd (HIL):
- Investment outlay, Rs 180 lakh
- Useful life, 4 years
- Net salvage value after 4 years, Rs 18 lakh
- Annual tax relevant rate of depreciation, 40 per cent
- Net salvage after 3 years, Rs 30 lakh
The HIL has two alternatives to choose from to finance the investment:
Alternative I : Borrow and buy the equipment. The cost of capital of the HIL, 0.12;
marginal rate of tax, 0.35; cost of debt, 0.17 per annum.
Year
- end
Loan
installment*
Loan at the
beginning of the
year
Payments Loan
outstanding at
the end of the
year (col. 3
col.5)
Interest
(col 3 x
0.20)
Principal
repayment
(col. 2
col.4)
1 5,01,505 15,00,000 3,00,000 2,01,505 12,98,495
2 5,01,505 12,98,495 2,59,699 2,41,806 10,56,689
3 5,01,505 10,56,689 2,11,338 2,90,167 7,66,522
4 5,01,505 7,66,522 1,53,304 3,48,201 4,18,321
5 5,01,505 4,18,321 83,184 4,18,321 -

Year Depreciation
Balance at the
end of the year
1 Rs 15,00,000 x 0.25 = Rs 3,75,000 Rs 11,25,000
2 11,25,000 x 0.25 = 2,81,250 8,43,750
3 8,43,750 x 0.25 = 2,10,937 6,37,813
4 6,32,813 x 0.25 = 1,58,203 4,74,610
5 4,74,610 x 0.25 = 1,18,652 3,55,958
DBA 1764
NOTES
Alternative II : Lease the equipment from the Hypothetical Leasing Ltd on a 3-year
full-payout basis @ Rs 444/Rs 1,000 payable annually in arrear. The lease can be renewed
for a further period of 3 years at a rental of Rs 18/Rs 1,000 payable annually in arrear.
Which alternative should the HIL choose? Why?
Since the NAL is negative, the lease is not economically viable. The HIL should opt
for the alternative to borrow and buy.
Working Notes
1. Present value of lease rentals: = Rs (180 lakh x 0.444) x PVIFA
(17,3) = Rs.79.92 lakh x 22.10
= Rs. 176.61 lakh
2. Present value of tax shield on lease rentals: = Rs(180 lakh x 0.444 x 0.35) x
PVIFA (12,3) = Rs. 27.972 lakh x 2.402 = Rs. 67.19 lakh
3. Present value of tax shield on depreciation: = (72 x PVIF (12,1) + 43.2 x PVIF
(12,2) + 25.92 x PVIF (12,3) x 0.35 = (72 x 0.893) + (43.2 x 0.797) +
(25.92 x 0.712) x 0.35 = Rs.41.01 lakh
4. Present value of interest tax shield on displaced debt: = [30.03 x PVIF (12,1)
+ 4.54 x PVIF (12,2) + 11.61 x PVIF (12,3) x 0.35 = (30.03 x 0.893) + (4.54
x 0.797) + (11.61 x 0.712) x 0.35 = Rs. 18.29 lakh
(Displaced) Debt (Present Value of Lease Rentals) Amortisation Schedule (Rs.lakh)
Sl.No. Decision Analysis (Rs. Lakh)
1. Investment outlay 180.00
2. Less: Present value of lease rentals (working note 1) 176.61
3. Plus: Present value of tax shield on lease rentals (2) 67.19
4. Less: Present value of tax shield on depreciation (3) 41.01
5. Less: Present value of interest shield on displaced
debt (4)
18.29
6. Less : Present value of net salvage value (5) 12.81
NAL/NPV(L) 1.53
NOTES
*Equal to the present value of the lease rentals
5.Present value of net salvage value: = 18 x PVIF (12,3) = 18 x 0.712 = Rs.12.81
lakh
Illustration 8.3 (Monthly Lease Rentals)
For Illustration 8.2, assume the lease rental of Rs.35/Rs. 1,000 payable monthly in
advance. Compute the NAL / NPV (L). Should the HIL opt for the lease financing?
As the NAL is negative, the lease is not financially advantageous and the HIL should
not opt for it.
Working Notes
1. Present value of lease rentals: = Rs (180 x 0.035 x 12) x PVIFA
m
(17,3) = 75.6 x
I / d (12) x PVIFA (i, 3) where i = 0.17 = 75.6 x 1.09 (Table A-3) x 2.210 (Table
A-2) = Rs.182.10 lakh
2. Present value of tax shield on lease payments: = [(180 x 0.035 x 12) x PVIFA
(12,3) x 0.35)] = 75.6 x 2.402 x 0.35 = Rs.63.56 lakh
Year
Loan outstanding
at the beginning
Interest content
(at 17%)
Capital
content
Installment
amount
(176.61 2.210)
1 176.61 30.03 49.89 79.92
2 126.72 4.54 58.38 79.92
3 68.34 11.61 68.34 79.92

S.No Decision Analysis (Rs. Lakh)
1. Investment outlay Rs. 180.00
2. Less: Present value of lease rentals (working note 1) 182.10
3. Plus: Present value of tax shield on lease rentals (2) 63.56
4. Less: Present value of tax shield on depreciation (3) 41.01
5. Less: Present value of interest shield on displaced debt(4) 13.12
6. Less : Present value of net salvage value (5) 12.81
NAL 5.48

DBA 1764
NOTES
3. Present value of tax shield on depreciation: No change from the annual lease
payment (Rs.41.01 lakh)
4. Present value of interest tax shield on displaced debt: = [(24.15 x 0.893) + (15.39
x 0.787) + (5.16 x 0.712) x 0.35] = Rs.13.12 Lakh
Debt Amortisation Schedule
*Equal to the present value of the lease rentals
5. Present value of net salvage: No change from annual payment basis(Rs.12.81 lakh)
It can be seen that in case of monthly lease payment, the component of the lease-
related cash flow streams that will change are: (1) Lease rentals, (2) Tax shield on lease
rentals, and (3) Interest tax shield on displaced debt.
8.3.1 Break-Even Lease Rental
The break - even lease rental (BELR) is the rental at which the lessee is indifferent
between lease financing and borrowing and buying. Alternatively, BELR has NAL as Zero.
If reflects the maximum level of rental which the lesser would be willing to pay. If the BELR
exceeds the actual lease rental, the lease proposal would be accepted, otherwise rejected.
The computation of the BELR is shown in Illustration 8.4.
Illustration 8.4
For the HIL in Illustration 8.2, assume monthly lease payments in advance. Compute
the break-even monthly lease rental. Can the HIL accept a lease quote of Rs.35/Rs. 1,000
per month payable in advance?
The monthly break-even lease rental (B
i
) can be obtained when NAL = zero. Thus,
180-(12B
L
x 3.27 x 2.210) + (12 B
L
x 0.35 x 2.402) - 58.59 (11.49 x 0.893) x (7.35 x
0.797) x (2.43 x 0.712) x 0.35 B
1
- 12.81 = 0 B
L
= Rs.2.78 lakh
Monthly lease rental payable by HIL = Rs.180 lakh x 0.035 = Rs.6.30 lakh
Since the B
L
is less than the actual rental to be paid, the lease proposal cannot be
accepted.
Year
Loan outstanding
at the beginning
Interest content
(at 17%)
Capital
content
Installment amount
(182.10 2.409)
(1.09 x 2.210)
1 182.10 24.15 51.45 75.60
2 130.65 15.39 60.21 75.60
3 70.44 5.16 70.44 75.60

NOTES
Review Questions
1) Define a lease. How does it differ from hire purchase and instalment sale? What
are the cash flow consequences of a lease? Illustrate.
2) What are the myths and advantages of a lease?
3) What is a leveraged lease? What are its merits and demerits?
4) What is the hire purchase financing? How does it differ from the lease financing?
DBA 1764
NOTES
CHAPTER 9
MERGER AND ACQUISITION
Corporate restructuring includes mergers and acquisitions (M&A), amalgamation,
takes-overs, spin-offs, leveraged buy-outs, buy-back of shares, capital reorganisation,
sale of business units and assets etc. M&A are the most popular means of corporate
restructuring or business combinations. They have played an important role in the external
growth of a number of leading companies in the world over. In the United States, the first
merger wave occurred between 1890 and 1904 and the second began at the end of the
World War I and continued through the 1920s. The third merger wave commenced in the
latter part of World War II and continues to the present day. About two-thirds of the large
public corporations in the USA have merger or amalgamation in their history. In India,
about 1180 proposals for amalgamation of corporate bodies involving about 2,400
companies were filed with the High Courts during 1976-86. These formed 6 percent of
the 40,600 companies at work at the beginning of 1976. In the year 2003-04, 834 mergers
and acquisitions deals involved Rs.35,980 Crore. Mergers and acquisitions, the way in
which they are understood in the Western countries, have started taking place in India in
the recent years. A number of mega mergers and hostile takeovers could be witnessed in
India now.
There are several aspects relating to mergers and acquisitions that are worthy of
study. Some important questions are:
1. What are the basic economic forces that led to mergers and acquisitions? How do
these interact with one another?
2. What are the managers true motives for mergers and acquisitions?
3. Why do mergers and acquisitions occur more frequently at sometimes than a other
times? Which are the segments of the economy that stand to gain or lose?
4. How could merger and acquisition decisions be evaluated?
5. What managerial process is involved in merger and acquisition decisions?
6. What process is followed in integrating merging and merged firms post-merger?
9.1. CORPORATE RESTRUCTURING
Corporate Restructuring refers to the changes in ownership, business mix, assets mix
and alliances with a view to enhance the shareholder value. Hence, corporate restructuring
may involve ownership restructuring, business restructuring and assets restructuring. A
company can affect ownership restructuring through mergers and acquisitions, leveraged
buy-outs, buyback of shares, spin-offs, joint ventures and strategic alliances. Business
restructuring involves the reorganization of business units or divisions. It includes
diversification into new businesses, out-sourcing, divestment, brand acquisitions etc. Asset
restructuring involves the acquisition or sale of asset and their ownership structure. The
NOTES
examples of asset restructuring are sale and lease back of assets, securitization of debt,
receivable factoring, etc.
The basic purpose of corporate restructuring is to enhance the shareholder value. A
company should continuously evaluate its portfolio of businesses, capital mix and ownership
and assets arrangements to find opportunities for increasing the share-holder value. It
should focus on assets utilization and profitable investment opportunities, and recognize or
divest less profitable or loss making business/products. The company can also enhance
value through capital restructuring; it can design innovative securities that help to reduce
cost of capital.
Our focus here is no mergers and acquisitions, leveraged buy-outs and divestment.
We have discussed many other aspects of restructuring like buyback of shares, capital
structuring etc. earlier in this book.
9.2. TYPE OF BUSINESS COMBINATION
There is a great deal of confusion and disagreement regarding the precise meaning of
terms relating to the business combination viz. merger, acquisition, takeover, amalgamation
and consolidation. Sometimes, these terms are used in broad sense, encompassing most
dimensions of business combination, while sometimes they are defined in a restricted legal
sense. We shall define these terms keeping in mind the relevant legal framework in India.
9.3. MERGER OR AMALGAMATION
A merger is said to occur when two or more companies combine into one company.
One or more companies may merge with an existing company or they may merge to form
a new company. In merger, there is complete amalgamation of the assets and liabilities as
well as shareholders interests and businesses of the merging companies. There is yet
another mode of merger. Here one company may purchase another company without
giving proportionate ownership to the shareholders of the acquired company. Laws in
India use the term amalgamation for merger. For example, Section 21(A) of the Income
Tax Act, 1961 defines amalgamation as the merger of one or more companies (called
amalgamating company or companies) with another company (called amalgamated
company) or the merger of two or more companies to form a new company in such a way
that all assets and liabilities of the amalgamating company or companies become shareholders
of the amalgamated company. We shall use the terms merger and amalgamation
interchangeably.
Merger or amalgamation may take two forms:
- Merger through absorption
- Merger through consolidation
DBA 1764
NOTES
Absorption
Absorption is a combination of two or more companies into an existing company. All
companies except one lose their identity in a merger through absorption. An example of
this type of merger is the absorption of Tata Fertilisers Ltd. (TFL) by Tata Chemicals Ltd.
(TCL), an acquiring company (a buyer), survived after merger while TFL, an acquired
company (a seller), ceased to exist. TFL transferred its assets, liabilities and shares to
TCL. Under the scheme of merger, TFL shareholders were offered 17 shares of TCL
(market value per share being Rs.114) for every 100 shares of TFL held by them.
Consolidation
Consolidation is a combination of two or more companies into new company. In this
form of merger, all companies are legally dissolved and a new entity is created. In a
consolidation, the acquired company transfers its assets, liabilities and shares to the new
company for cash or exchange of shares. In a narrow sense, the terms amalgamation and
consolidation are sometime used interchangeably. An example of consolidation is the merger
or amalgamation of Hindustan Computers Ltd., Hindustan Instruments Ltd., Indian Software
Company Ltd., and Indian Reprographics Ltd. in 1986 to an entirely new company called
HCL Ltd.
Acquisition
A fundamental characteristic of merger (either through absorption or consolidation) is
that the acquiring or amalgamated company (existing or new) takes over the ownership of
other company and combines its operations with its own operations.
Acquisition may be defined as an act of acquiring effective control over assets or
management of a company by another company without any combination of businesses or
companies.
A substantial acquisition occurs when an acquiring firm acquires substantial quantity of
shares or voting rights of the target company. Thus, in an acquisition, two or more companies
may remain independent, separate legal entity, but there may be change in control of
companies. An acquirer may be a company or persons acting in concert that act together
for the purpose of substantial acquisition of shares or voting rights or gaining control over
the target company.
Takeover: Generally speaking take over means acquisition. A takeover occurs when the
acquiring firm takes over the control of the target firm. An acquisition or take-over does
not necessarily entail full, legal control. A company can have effective control over another
company by holding minority ownership. Under the Monopolies and Restrictive Trade
Practices Act, take over means acquisition of not less than 25 percent of the voting power
in a company. Section 372 of the Companies Act defines the limit of a companys investment
NOTES
in the shares of another company. If a company wants to invest in more than 10 percent of
the subscribed capital of another company, it has to be approved in the shareholders
general meeting and also by the central government. The investment in shares of other
companies in excess of 10 percent of the subscribed capital can result into their takeovers.
Takeover vs. acquisition Sometimes, a distinction between takeover and acquisition is
made. The term takeover is understood to connote hostility. When an acquisition is a
forced or unwilling acquisition, it is called a takeover. In an unwilling acquisition, the
management of target company would oppose a move of being taken over. When
managements of acquiring and target companies mutually and willingly agree for the takeover,
it is called acquisition or friendly takeover. An example of acquisition is the acquisition of
controlling interest (45 percent shares) of Universal Luggage Manufacturing Company
Ltd. by Blow Plast Ltd. Similarly, Mahindra and Mahindra Ltd., a leading manufacturer of
jeeps and tractors acquired a 26 percent equity stake in Allwyn Nissan Ltd. Yet another
example is the acquisition of 28 percent equity of International Data Management (IDM)
by HCL Ltd. In recent years, due to the liberalisation of financial sector as well as opening
up of the economy for foreign investors, a number of hostile take-overs could be witnessed
in India. Examples include takeover of Shaw Wallace, Dunlop, Mather and Platt and
Hindustan Dorr Oliver by Chhabrias, Ashok Leyland by Hindujas and ICICM, Harrison
Malayalam and Spencers by Goenkas. Both Hindujas and Chhabrias are non-resident
Indian (NRIs).
Holding Company A company can obtain the status of a holding company by acquiring
shares of other companies. A holding company is a company that holds more than half of
the nominal value of the equity capital of another company, called a subsidiary company,
or controls the composition of its Board of Directors. Both holding and subsidiary companies
retain their separate legal entities and maintain their separate books of accounts. Unlike
some countries like USA or UK, India it is not legally required to consolidate accounts of
holding and subsidiary companies.
9.4. FORMS OF MERGER
There are three major types of mergers:
Horizontal merger This is a combination of two or more firms in similar type of production,
distribution or area of business. Examples would be combining of two book publishers or
two luggage manufacturing companies to gain dominant market share.
Vertical merger: This is a combination of two or more firms involved in different stages
of production or distribution. For example, joining of a TV manufacturing (assembling)
company and a TV marketing company or the joining of a spinning company and a weaving
company. Vertical merger may take the form of forward or backward merger. When a
company combines with the supplier of material, it is called backward merger and when it
combines with the customer, it is known as forward merger.
DBA 1764
NOTES
Conglomerate merger: This is a combination of firms engaged in unrelated lines of business
activity. A typical example is merging of different businesses like manufacturing of cement
products, fertilizers products, electronic products, insurance investment and advertising
agencies. Voltas Ltd. is an example of a conglomerate company.
9.5. MERGERS AND ACQUISITION TRENDS IN INDIA
Economic reforms and deregulation of the Indian economy has brought in more
domestic as well as international players in Indian industries. This has caused increased
competitive pressure leading to structural changes of Indian industries. M&A is a part of
the restructuring strategy of Indian Industries. The first M&A wave in India took place
towards the end of 1990s. The data presented in the Table 9.1 reveal that substantial
growth in the M&A activities in India occurred in 2000-01. The total number of M&A
deals in 2000-01 was estimated at 1,177 which is 54 percent higher than the total number
of deals in the previous year. The amount involved in deals has shown variation; after falling
to Rs.23106 Crore in 2002-03 the amount increased to Rs.35,980 Crore in 2003-04.
Table 9.1: M&A in India
The total number of mergers in 2003-04 was 284 down from 381 mergers in the
previous period. From data in Table 9.2, it appears that mergers account for around one-
third of total M&A deals in India. It implies that takeovers or acquisitions are the dominant
feature of M&A activity in India, similar to the trend in most of the developed countries.
Along with the rise in M&A, there has also an increase in the number of open offers, albeit
at a lower place. The number of open offers rose to 109 in 2002-03 from 58 in 1998-99.
In 2003-04, 72 open offers involved Rs.1,122 crore much less than as compared to the
previous year.
Year
Deals
Number
Amount
(Rs. in Crore)
1998-99
1999-00
2000-01
2001-02
2002-03
2003-04
297
765
1,177
1,045
838
834
16,071
36,963
32,130
34,332
23,106
35,980
NOTES
Table 9.2: Share of Mergers in M&A in India
9.6. MOTIVES AND BENEFITS OF MERGERS AND ACQUISITIONS
Why do mergers take place? It is believed that mergers and acquisitions are strategic
decisions leading to maximisation of a companys growth by enhancing its production and
marketing operations. They have become popular in the recent times because of the
enhanced competition, breaking of trade barriers, free flow of capital across countries are
being deregulated and integrated with other economies. A number of reasons are attributed
for the occurrence of mergers and acquisitions. For example, it is suggested that mergers
and acquisition are intended to:
- Limit competition
- Utilise under-utilised market power
- Overcome the problem of slow growth and profitability in ones own industry.
- Achieve diversification
- Gain economies of scale and increase income with proportionately less investment.
- Establish a transnational bridgehead without excessive start-up costs to gain access
to a foreign market.
- Utilise under-utilised resources-human and physical and managerial skills
- Displace existing management
- Circumvent government regulations
- Reap speculative gains attendant upon new security issue or change in P/E ratio.
- Create an image of aggressiveness and strategic opportunism, empire building and
to amass vast economic power of the company.
Are there are real benefits merger? A number of benefits of mergers are claimed. All
of them are not real benefits. Based on the emprical evidence and the experiences of
certain companies, the most common motives and advantages of mergers and acquisitions
are explained below:
Year M&A Merger %
1998-99
1999-00
2000-01
2001-02
2002-03
2003-04
292
765
1177
1045
838
834
80
193
327
323
381
284
27.4%
25.2%
27.8%
30.9%
45.5%
34.1%
DBA 1764
NOTES
- Maintaining or accelerating a companys growth, particularly when the internal
growth is constrained due to paucity of resources;
- Enhancing profitability, through cost reduction resulting from economies of scale,
operating efficiency and synergy;
- Diversifying the risk of the company, particularly when it acquires those businesses
whose income streams are not correlated.
- Reducing tax liability because of the provision of setting-off accumulated losses
and unabsorbed depreciation of one company against the profits of another;
- Limiting the severity of competition by increasing the companys market power.
9.7. FINANCING A MERGER
Cash or exchange of shares or a combination of cash, shares and debt can finance a
merger or an acquisition. This means of financing may change the debt-equity mix of the
combined or the acquiring firm after the merger. When a large merger takes place, the
desired capital structure is difficult to be maintained, and it makes the calculation of the
cost of capital a formidable task. Thus, the choice of the means of financing a merger may
be influenced by its impact on the acquiring firms capital structure. The other important
factors are the financial condition and liquidity position of the acquiring firm, the capital
market conditions, the availability of long-term debt etc.
9.7.1 Cash Offer
A cash offer is a straightforward means of financing a merger. It does not cause any
dilution in the earnings per share and the ownership of the existing shareholders of the
acquiring company. It is also unlikely to cause wide fluctuations in the share prices of the
merging companies. The shareholders of the target company get cash for selling their shares
to the acquiring company. This may involve tax liability for them.
The management of sangam fertilizers company (SFC) is concerned about the fluctuating
sales and earnings. The variability of the companys earnings has caused its P/E at about
22 to be much lower than the industry average of about 45. Currently SFCs share is
selling for Rs.57.60 in the market. To boost its sales and bring stability to its earnings,
SFCs management has identified Excel Chemical Company as a possible target for
acquisition. Excel is known for its quality of products and national-wide markets. The
company has not been performing well in the recent past due to poor management. Its
sales have grown at 4 percent per year. The current price of Excels share is Rs. 24.90.
Let us assume that SFC decided to offer a price of Rs.42.40 per share to acquire
Excels shares. If SFC wants to pay cash for the shares, it would need Rs.1,060 crore in
cash. It can borrow funds as well as use its tradable (temporary) investment and surplus
cash for acquiring Excel. SFCs current debt is Rs.2,170 crore, which is 50 percent of its
book value equity. After merger, the combined firms debt would be Rs.2,465 crore
NOTES
(Rs.2,170 crore of SFC and Rs.295 Crore of Excel). The debt capacity of the combined
firm would depend on its target debt-equity ratio. Assuming that it is 1:1, then it can have
a total debt of Rs.4,330 crore (i.e. equal to the combined firms equity, which is pre-
merger equity of SFC). Thus, unutilised debt capacity is Rs.1,865 Crore (i.e. Rs.4330
Crore minus the combined debt of SFC and Excel, Rs.2465 crore). Further, both companies
have marketable investments of Rs.52 crore, which may also be available for acquisition.
Given SFC has unutilised debt capacity (Rs.1865 crore), it can borrow Rs.1060 crore to
acquire excel.
9.7.2 Share Exchange
A share exchange offer will result into the sharing of ownership of the acquiring
company between its existing shareholders and new shareholders (that is, shareholders of
the acquired company). The earnings and benefits would also be shared between these
two groups of shareholders. The precise extent of net benefits that accrue to each group
depends on the exchange ratio in terms of the market prices of the shares, the receiving
shareholders would not pay capital gains tax when they sell their shares after holding them
for the required period.
SFC, instead of paying cash, could acquire Excel through the exchange of shares.
For simplicity, let us assume that SFCs share price is fairly valued in the market. If the
company feels that its shares are either under-valued or over-valued in the market, it can
follow a similar procedure as in the case of Excel to calculate the value of its shares. SFCs
current price per share is Rs.57.80 and it has 157.50 crore outstanding shares. At its
current share price, the company must exchange: Rs.1,060 crore / Rs.57.80 = 18.34
crore shares to pay Rs.1060 crore to excel. After acquisition, SFC would hold about 10.4
percent of shares (i.e. 18.34/175.84). Excels shares are valued at Rs.1060 crore and the
value of SFCs shares at the current market price is Rs.9104 crore (157.5 crore x 57.80).
Thus, the post-merger value of the combined firm is Rs.10,164 crore and per share value
is Rs.10,164/175.84 = Rs.57.80. Thus there is no loss, no gain to SFCs shareholders.
DBA 1764
NOTES
Table 9.3: Impact of SFC and Excel Merger on EPS
SFC would be offering 18.34 shares for 25 crore outstanding shares of Excel, which
means 0.734 shares of SFC for one share of Excel or a swap ratio of 0.734:1. The book
value of SFCs share in 2004 is Rs.27.49 while that of Excel is Rs.29.20. Thus, SFC
alternatively could offer 0.94 shares for each outstanding share of Excel without diluting its
present book value. Since it is exchanging only 0.734 shares, its book value of equity
should increase.
Impact on Earnings per share Would SFCs EPS be diluted if it exchanged 18.34 crore
shares to Excel? Or, what is the maximum number of shares, which SFC could exchange
without diluting it EPS? Let us assume the earnings of both firms at 2004 level. We can
calculate the maximum number of SFCs shares to be exchanged for Excels shares without
diluting the former companys EPS after merger as shown in Table 9.3.
We can also directly calculate the maximum number of shares as follows:
Maximum number of share to be exchanged without EPS dilution
= Acquiring firms
post-merger earnings - Acquiring firms
Acquiring firms pre-merger shares
Pre-merger EPS
SFCs (the acquiring firm) PAT before merger,
PAT
a
(Rs. In crore)
403.00
Excels (the acquired firm) PAT if merged with SFC,
PAT
b
(Rs. In crore)
83.00
PAT of the combined firms after merger,
PAT
a
+ PAT
b
= PAT
c
(Rs. in crore)
486.00
SFCs EPS before merger (EPS
a
) (Rs.) 2.56
Maximum number of SFCs shares maintaining
EPS of Rs.2.56 : (486/2.56) (Crore)
189.84
SFCs (the acquiring firm) outstanding shares before merger
(N
a
) (crore)
157.50
Maximum number of shares to be exchanged without diluting
EPS : (189.84 157.50) (crore)
32.34
NOTES
PATa + PATb Na
EPS
a
= 403 + 83 157.5 = 32.34 Crore
2.56
Thus SFC (the acquiring firm) could exchange 1.294 (i.e. 32.34/25) of its shares for
one share of Excel (the acquired firm) without diluting its EPS after merger. Since it is
exchanging only 0.734 shares, its EPS after merger would be as shown below:
Table 9.4 summarizes the effect of the merger of Excel with SFC on EPS, market
value and price-earning ratio with an exchange ratio of 0.734.
Table 9.4 : Merger of Excel with SFC : Impact on EPS, Book Value, Market
Value and P/E Ratio
Notes:
a. In line 2 SFCs number of shares after merger would be: 15.75 + (0.734 x 25) =
175.84 crore.
b. In line 6, the value of Excels share is based on its evaluation by SFC reflecting future
growth and cost savings. At the current market value of Rs.24.90, the market
capitalisation in Rs.622.50 crore.
c. Market value per share after merger would be: Rs.10,164 / 175.84 = Rs.57.80.
SFCs PAT after merger (Rs.403 Crore + Rs.83 Crore) 486.00
Number of shares after merger (157.50 + 183.4) 175.84
SFCs EPS after merger: 486/175.84 2.76

SFC
(before
Merger)
Excel
SFC
(after
Merger)
1. Profit after tax (Rs. in Crore) 403.00 83.00 486.00
2. Number of shares (Crore) 157.50 25.00 175.84
3. EPS (Rs.) 2.56 3.32 2.76
4. Market value per share (Rs.) 57.80 24.90 57.80
5. Price-earnings ratio (times) 22.60 7.50 20.94
6. Total market capitalisation
(Rs. in crore)
9104 1060 10164

DBA 1764
NOTES
You may observe that for Excels (the acquired firm) pre-merger EPS of Rs.3.32, the
price paid is Rs.42.40. Thus, the price-earnings ratio paid to Excel is: Rs.42.40/3.32 =
12.2 times. Since the price-earnings ratio exchanged is less than SFCs (the acquiring firm)
price-earnings ratio of 22.6, SFCs EPS after merger increases. However, in terms of
value, there is no change. In fact, the post merger price-earnings ratio falls to : Rs.57.8/
Rs.2.76 = 20.94 times.
We can notice from Table 9.4 that after merger the market value per share is Rs.57.80
and total capitalisation increases to Rs.10,164 crore, more by Rs.437.50 crore of the sum
of the capitalization of individuals firms (Rs.57.80 x 157.50 crore plus Rs.24.90 x 25
crore) = Rs.9,104 crore + Rs.622.50 crore = Rs.9,726.50 crore. This increased wealth,
however, does not benefit the shareholders of SFC since it is entirely transferred to Excels
shareholders as shown below:
Total capitalisation of Excels shareholders after merger (Rs. in crore) 1060.00
Total capitalisation of Excels shareholders before merger (Rs. in crore) 622.50
Net gain (Rs. in crore) 437.50
Would the
shareholders of SFC gain if there was no economic gain from the merger and the exchange
ratio was in terms of the current market price of the two companies shares? The market
price share exchange ratio (SER) would be:
SER =
(2) 0.431
57.80
24.90

Pa
Pb

firm acquiring the of price Share
firm acquired of price Share
= = =
Bootstrapping: SFC would issue 10.77 (i.e. 25 x 0.431) shares to excel in terms of
current prices SER. Does the acquiring firm benefit if shares are exchanged in proportion
of the current share prices? Let us assume that there are no benefits of acquisition. Table
9.5 summaries the impact of the share exchange in terms of the current market prices
(without any gain from merger / acquisition). SER at current share prices implies that the
acquiring company (SFC) pays no premium to the acquired company (Excel).
NOTES
Table 9.5: Impact of the Acquisition of Excel by SFC: SER 0.431
Notes:
a. In line 2 SFCs number of shares after merger would be: 157.50 + (0.431 x 25)
= 168.30 Crore.
b. In line 6, the value of Excels share is taken as the current market price.
c. Market value per share after merger would be: Rs.9,726.50 / 168.30 = Rs.57.80.
There is no gain from the merger and the market value after acquisition of Excel
remains the same. However, SFC is able to increase its EPS from Rs.2.56 to Rs.2.89
after acquisition. The reason is that its profit after tax increases by 20.6 percent after
acquisition while the number of shares increases by 6.9 percent only. The price-earnings
ratio declines to 20 (P/E = Rs.57.8/2.89 = 20) as there is no change in the market value
per share and EPS increases after merger. This is known as the bootstrapping phenomenon
and it creates an illusion of benefits from the merger. Once again, it may be noticed that the
price-earnings ratio exchanged by the acquiring firm (SFC), Rs.24.9 / Rs.3.32 = 7.50 is
less than its price-earnings ratio, and this resulted in higher EPS for the acquiring firm.
In case of Excels capitalisation by SFC, there is expected to be increase in Excels
capitalisation due to improvement in profit margin and operating efficiencies. We have
seen earlier that if the exchange ratio is 0.734, the entire gain is transferred to the shareholders
of Excel. Possibly, Excels shares would remain under valued, is SFC does not acquire
it. Can a negotiation take place so that the shareholders of SFC also gain from the increased
wealth from merger? Let us assume economic gain (Rs.1060 Rs.622.5 = Rs.437.5
crore) and SER in terms of the current market value of two companies, i.e. 0.431. The
effect is shown in Table 9.6.

SFC
(before
Merger)
Excel
SFC
(after
Merger)
3. EPS (Rs.) 2.56 3.32 2.89
(Rs. in crore)
9104 622.50 9726.50
DBA 1764
NOTES
Table 9.6: Impact of the Acquisition of Excel by SFC: SER 0.431
Notes:
a. In line 2 SFCs number of shares after merger would be: 157.50 + (0.431 x 25)
= 168.30 Crore.
b. In line 6, the value of Excels share is taken as Rs.1060 crore, which is based on
its evaluation by SFC reflecting future growth and cost savings.
c. Market value per share after merger would be Rs.10,164/168.30 = Rs.60.39.
We may observe from Table 9.6 that the market value of SFCs share is expected to
be higher (Rs.60.39) after merger as compared to the before-merger value (Rs.57.80).
Shareholders of both Excel and SFC, as shown below, share the net increase in wealth.
Thus the distribution of the merger gain between the shareholders of the acquiring and
target companies can be calculated as follows:
- The price-earnings ratios of the acquiring and the acquired companies.

SFC
(before
Merger)
Excel
SFC
(after
Merger)
3. EPS (Rs.) 2.56 3.32 2.89
(Rs. in crore)
9104 1060 10164.00
(Rs. in crore)
Gain to SFCs (the acquiring firm) shareholders:
(P
ab
P
a
) = (60.39 57.80) x 157.50
409.00
Gain to Excels (the acquired firm shareholders):
P
ab
x (SER) N
b
P
a
x N
b
= 60.39 x 10.78 24.90 x 25
28.50
Total gain:
P
ab
x (N
a
+ (SER)N
b
) (P
a
x N
a
+ P
b
x N
b
)
= 60.39 (157.5 + 0.431 x 25) (57.8 x 157.5 + 24.9 x 25)
437.50
NOTES
- The ratio of share exchanged by the acquiring company for one share of the acquired
company.
- The pre-merger earnings growth rates of acquiring and the acquired companies.
- The level of profit after-tax of the merging companies.
- The weighted average of the earnings growth rates of the merging companies.
9.8. TENDER OFFER AND HOSTILE TAKE OVER
A tender offer is a formal offer to purchase a given number of a companys shares at
a specific price. The acquiring company asks the shareholders of the target company to
tender their shares in exchange for a specific price. The price is generally quoted at a
premium in order to induce the shareholders too tender their shares. Tender offer can be
used in two situations. First, the acquiring company may directly approach the shareholders
by means of a tender offer. Second, the tender offer may be used without any negotiations,
and it may be tantamount to a hostile takeover. The shareholders are generally approached
through announcement in the financial press or through direct communication individually.
They may or may not react to a tender offer. Their reaction exclusively depends upon their
attitude and sentiment and the difference between the market price and the offered price.
The tender offer may or may not be acceptable to the management of the target company.
In USA, the tender offers have been used for a number of years. In India, one may see
only one or two instances of tender offer in the recent years.
In September 1989, Tata Tea Ltd. (TTL), the largest integrated tea company in India,
made an open offer for controlling interest to the shareholders of the Consolidated Coffee
Ltd. (CCL). TTLs Chairman, Darbari Seth, offered one share in TTL and Rs.100 in cash
(which is equivalent to Rs.140) for a CCL share that was then quoting at Rs.88 on the
Madras Stock Exchange. TTLs decision is not only novel in the India corporate sector
but also a trendsetter. TTL had notified in the financial press about its intention to buyout
some tea estates and solicited offers from the shareholders concerned.
The management of the target company generally do not approve of tender offers.
The major reason is the fear of being replaced. The acquiring companys plans may not be
compatible with the best interests of the shareholders of the target company.
The management of the target company can try to convince its shareholders that they
should not tender their shares since the offer value is not enough in the light of the real value
of shares, i.e., the offer is too low comparative to its real value. The management may use
techniques to dissuade its shareholders from accepting tender offer. For example, it may
lure them by announcing higher dividends. If this helps to raise the share price due to
psychological impact or information content, then the shareholders may not consider the
offer price tempting enough. The company may issue bonus shares and/or rights shares
and make it difficult for the acquirer to acquire controlling shares.
DBA 1764
NOTES
The target company may also launch a counter-publicity programme by informing
that the tender is not in the interest of the shareholders. If the shareholders are convinced,
then the tender offer may fail. The target company can follow delay tactics and try to get
help from the regulatory authorities such as the Securities and Exchange Board of India
(SEBI), or the Stock Exchanges of India.
9.9. DEFENSIVE TACTICS
A target company in practice adopts a number of tactics to defend itself from hostile
takeover through a tender offer. These tactics include a divestiture or spin-off, poison pill,
greenmail, white knight, crown jewels, golden parachutes, etc.
- Divestiture In a divestiture the target company divests or spins off some of its
businesses in the form of an independent, subsidiary company. Thus, it reduces the
attractiveness of the existing business to the acquirer.
- Crown jewels: When a target company uses the tactic of divestiture it is said to
sell the crown jewels. In some countries such as UK, such tactic is not allowed
once the deal becomes known and is unavoidable.
- Poison Pill An acquiring company itself could become a target when it is bidding
for another company. The tactics used by the acquiring company to make itself
unattractive to a potential bidder is called poison pills. For example, the acquiring
company may issue substantial amount of convertible debentures to its existing
shareholders to be converted at a future date when it faces a takeover threat. The
task of the bidder would become difficult since the number of shares to have
voting control of the company will increase substantially.
- Greenmail: Greenmail refers to an incentive offered by management of the target
company to the potential bidder for not pursuing the takeover. The management of
the target company may offer the acquirer for its shares a price higher than the
market price.
- White knight: A target company is said to use a white knight when its management
offers to be acquired by a friendly company to escape from a hostile takeover.
The possible motive for the management of the target company to do so is not to
lose the management of the company. The hostile acquirer may replace the
management.
- Golden parachutes: When a company offers hefty compensations to its mergers
if they get ousted due to takeover, the company is said to offer golden purchases.
This reduces their resistance to takeover.
9.10. CORPORATE STRATEGY AND ACQUISITIONS
In our earlier discussion, we made distinctions between merger and acquisition or
takeover. However, they generally involve similar analyses and evaluations. A merger or
acquisition might be considered successful if it increases the shareholder value. Though it is
quite difficult to say how the firm would have performed without merger or acquisition, but
NOTES
the post-merger poor performance would be attributed as a failure of merger or acquisition.
What are the chances that mergers or acquisitions would succeed? Empirical evidence
shows that there is more than fifty percent chance that they would succeed.
There are several reasons responsible for the failure of a merger or acquisition. They
include:
- Excessive premium An acquirer may pay high premium for acquiring its target
company. The value paid may far exceed the benefits. This happens when acquirer
becomes too eager to acquire the target for prestige or increasing the size of its
empire.
- Faulty evaluation At times acquirers do not carry out the detailed diligence of
the target company. They make a wrong assessment of the benefits from the
acquisition and land up paying a higher price.
- Lack of research Acquisition requires gathering a lot of data and information and
analyzing it. It requires extensive research. A shoddily carried out research about
the acquisition causes the destruction of the acquirers wealth.
- Failure to manage post-merger integration Many times acquirers are unable
to integrate the acquired companies in their businesses. They overlook the
organisational and cultural issues. They do not have adequate understanding of the
culture of the acquired companies which creates problem of integration and synergy.
To avoid these problems the acquiring company needs to have an acquisition and
merger strategy. All acquisitions must be seen as strategic. The acquisition should be well
planned; target companies should be carefully selected after adequate screening. The
acquiring company must understand the organisational climate and culture of the target
company while performing the due diligence.
There are four important steps involved in a decision regarding merger or acquisition
- Planning
- Search and Screening
- Financial evaluation
- Integration
9.11.1 Planning
A merger or acquisition should be seen in the over-all strategic perspective of the
acquiring company. It should fit with the strategy and must contribute in the growth of the
company and in creating value for shareholders and other stakeholders. The acquiring
company must assess its strengths and weaknesses and likely opportunities arising from
the acquisitions in order to identify the target companies. The acquiring firm should review
its objective of acquisition in the context of its strengths and weaknesses, and corporate
DBA 1764
NOTES
goals. This will help in indicating the product-market strategies that are appropriate for the
company. It will also force the firm to identify business units that should be dropped and
those that should be added or strengthened.
The following two steps are involved in the planning process:
- Acquisition strategy: The Company should have a well articulated acquisition
strategy. It should be growth-oriented. It should spell out the objectives of
acquisition and other growth options. The acquisition strategy should be formulated
after an assessment of the companys own strengths and weaknesses.
- Assessment approaches and criteria: The Company should spell out its
approach to acquisitions and the criteria to be applied to acquisitions.
The planning of acquisition will require the analysis of industry-specific and the firm-
specific information. The acquiring firm will need industry data on market growth, nature of
competition, ease of entry, capital and labour intensity, degree of regulation etc. About the
target firm the information needed will include the quality of management, market share,
size, capital structure, profitability, production and marketing capabilities etc.
9.11.2. Search and Screening
Search focuses on how and where to look for suitable candidates for acquisition.
Screening process shortlists a few candidates from many available. Detailed information
about each of these candidates is obtained. Merger objectives would be the basis for
search and screening. The objectives may include the attaining faster growth, improving
profitability, improving managerial effectiveness, gaining market power and leadership,
achieving cost reduction etc. These objectives can be achieved in various ways rather than
through mergers alone. The alternatives to merger include joint ventures, strategic alliances,
elimination of inefficient operations, cost reduction and productivity improvement, hiring
capable managers etc. If merger is considered as the best alternative, the acquiring firm
must satisfy itself that it is the best available option in terms of its own screening criteria and
economically most attractive.
9.11.3 Financial Evaluation
Financial evaluation is the most important part of due diligence. Due diligence would
also include evaluation of the target companys organisational climate and culture,
competencies and skills of employees etc. Financial evaluation of a merger is needed to
determine the earnings and cash flows, areas of risk, the maximum price payable to the
target company and the best way to finance the merger. The acquiring firm must pay a fair
consideration to the target firm for acquiring its business. In a competitive market situation
with capital market efficiency, the current market value is the correct and fair value of the
share of the target firm. The target firm will not accept any offer below the current market
value of its share. The target firm may, in fact, expect the offer price to be more than the
NOTES
current market value of its share since it may expect that merger benefits will accrue to the
acquiring firm. A merger is said to be at a premium when the offer price is higher than the
target firms pre-merger market value. The acquiring firm may pay the premium if it thinks
that it can increase the target firms profits after merger by improving its operations and
due to synergy. It may have to pay premium as an incentive to the target firms shareholders
to induce them to sell their shares so that the acquiring firm is enabled to obtain the control
of the target firm.
9.11.4 Integration
The most difficult part of the merger or acquisition is the integration of the acquired
company into the acquiring company. In the case of a hostile takeover, the acquiring
company may get disappointed to find the inferior quality of the acquired firms assets and
employees. The difficulty of integration also depends on the degree of control desired by
the acquirer. The acquirer may simply desire financial consolidation leaving the entire
management to the existing managers. On the other hand, if the intention is total integration
of manufacturing, marketing, finance, personnel etc. integration becomes quite complex.
A horizontal merger or acquisition requires a detailed planning for integration.
- Integration plan After the merger or acquisition, the acquiring company should
prepare a detailed strategic plan for integration based on its own and the acquired
companys strengths and weaknesses. The plan should highlight the objectives
and the process of integration.
- Communication The integration plan should be communicated to all employees.
The management should also inform the employees about their involvement in
making the integration smooth and easy and remove any ambiguity and fears in the
minds of the staff.
- Authority and responsibility The first step that the acquiring company should
take is to take all employees into confidence and decide the authority and
responsibility relationships. The detailed organisational structure can be decided
upon later on. This is essential to avoid any confusion and indecisiveness.
- Cultural integration People management is the most critical step in integration. A
number of mergers and acquisitions fail because of the failure of management to
integrate people from two different organisations. Management should focus the
culture integration of the employees. A proper understanding the cultures of two
organisations, clear communication and training can help to bridge the cultural
gaps.
- Skill and Competencies up-gradation If there is difference in the skills and
competencies of employees of the merging companies, management should prepare
a plan for skill and competencies up-gradation through training and implement it
immediately. To make an assessment of the gaps in the skills and competencies,
the acquiring company can conduct a survey of employees.
DBA 1764
NOTES
- Structural adjustments After receiving the cultural integration and skills up-
gradation, management may design the new organization structure and redefine
the roles, authorities and responsibilities. Management should be prepared to make
adjustments to accommodate the aspirations of the employees of the acquired
company.
- Control systems Management must ensure that it is in control of all resources
and activities of the merged firms. It must put proper financial control in place so
that resources are optimally utilized and wastage is avoided.
- Peter Drucker provides the following five rules for the integration process:
- Ensure that the acquired firm has a common core of unity with the parent. They
should have overlapping characteristics like shared technology or markets to exploit
synergies.
- The acquirer should think through what potential skill contribution it can make the
acquiree.
- The acquirer must respect the products, markets and customers of the acquired
firm.
- The acquirer should provide appropriately skilled top management for the acquiree
with in a year.
- The acquirer should make several cross-company promotions within a year.
Post-merger Integration: Integrating VSNL with Tata Group
Tata Group acquired VSNL in February 2002. Tata Group is the most respected
group of companies in private sector. VSNL is a public sector company. These two
companies belonged to two different environments, systems and culture. Both had committed
people but with capabilities and expectations. Hence the task of integration was quite
difficult and demanding. Tata Groups primary focus to protect its market position in the
ILD business, get the national long-distance business launched as soon as possible, and
work on making the operations of the company more market/customer focussed and
efficient. The integration process involved the following steps:
- The Tata Group constituted multiple task forces for the purpose of prioritising
tasks and achieving the objectives.
- The Group simultaneously focused on the integration of operations, processes and
technology and people.
- The people issue was considered as important as the integration of operations,
processes and technology.
- A special programme called Confluence was conducted for the senior management
team from VSNL. They were informed about Tata Groups the mission, value
systems and practices. Similar programmes were organised for more than 500
employees.
NOTES
- A people driven organisational restructuring was undertaken at headquarters
simultaneously as the employees were being trained. Employees from different
backgrounds, disciplines and levels discussed about the organisational roles,
structure and responsibility relationship. After the headquarters, the focus was to
the regional and branch offices for the similar initiatives.
- Several new functions were created. Weak were strengthened and supplemented
by sales and marketing people brought in from other Tata Group Companies.
These areas included carrier relations to work with domestic and international
telecom carriers, OSP or outside plant to implement the countrywide fibre optic
backbone for NLD, and customer services.
- The employees were trained to take up the new roles and challenges, and to
strengthen their marketing skills to focus on customer. Training programmes were
organised on functional areas.
- A management development programme was conducting focusing on critical
commercial skills like business management, people and performance management,
negotiating skills, and planning and budgeting skills. A key part of this exercise was
that Tata Group executives, who are operating managers, were invited to share
their experiences as managers with the VSNL teams.
- Information about initiatives or changes was communicated through new processes.
The house magazine Patrika was supplemented with a monthly wallpaper called
VSNL Buzz, which shared information about important developments within the
company new customer wins, major milestones achieved, new technical and
product developments etc. to make the employee feel proud to be part of the
VSNL and Tata family.
- Periodic briefing sessions, at which members of the management spoke on the
recent performance and achievements in the company, were also started.
- The existing processes could not give the company the competitive edge in the
marketplace. Hence, VSNL is restructuring a few of internal processes, ranging
from product development to service delivery. It has also begun leveraging the
experience and processes available in the Tata Group telecom companies in
marketing, customer acquisition and customer services. Many of these are
applicable to VSNL, though with fine-tuning to meet specific requirements.
- The first areas to be re-engineered will be those that impact the customer. A structure
is planned that is aligned with the industry best practices in customer care.
- Customer service is being broken down into four functions. The first is the customer
access point, the call centre or the public office. The second is the backend that
handles the issues, queries or complaints received by the front office. The third
function is credit and collection; the fourth is that of order management.
Mr. Srinath, Director (Operations), VSNL says: We realise that our most valuable
asset, across all our businesses, is people. They are the respiratory of business experience
and culture and the outward face of the company to the client. This combination of structures
skills and processes, supported by the right tools, should provide our employees a healthy
DBA 1764
NOTES
work environment to enable them to reach their full potential, while facilitating the companys
drive to achieve all its objectives in the marketplace.
9.12. ACCOUNTING FOR MERGERS AND ACQUISITIONS
Mergers and acquisitions involve complex accounting treatment. A merger, defined
as amalgamation in India, involves the absorption of the target company by the acquiring
company, which results in the uniting of the interests of the two companies. The merger
should be structured as pooling of interest. In the case of acquisition, where the acquiring
company purchases the shares of the target company, the acquisition should be structured
as a purchase.
9.12.1 Pooling of Interests Method
In the pooling of interests method of accounting, the balance sheet items and the
profit and loss items of the merged firms are combined without recording the effects of
merger. This implies that asset, liabilities and other items of the acquiring and the acquired
firms are simply added at the book values without making any adjustments. Thus, there is
no revaluation of assets or creation of goodwill. Thus, there is no revaluation of assets or
creation of goodwill. Let us consider an example as given in Illustration 9.3.
Illustration 9.3: Pooling of Interest
Firm T merges with Firm S. Firm S issues shares worth Rs.15 crore to Firm Ts
shareholders. The balance of both companies at the time of merger are shown in Table
9.7. The balance of firm S after merger is constructed as the addition of the book values of
the assets and liabilities of the merged firms. It may be noticed that the shareholders funds
are recorded at the book value, although Ts shareholders received shares worth Rs.15
crore in Firm S. They now own Firm S along with its existing shareholders.
Table 9.7: Pooling of Interests Method: Merger of Firm S and T
Firm T Firm S Combined Firm
Assets
Net fixed assets
Current assets

24
8

37
13

61
21
Total 32 50 82
Liabilities
Shareholders Fund
Borrowings
Current liabilities

10
10
6

18
20
12

28
36
18
Total 32 50 82
NOTES
9.12.2 Purchase Method
Under the purchase method, the assets and liabilities of the acquiring firm after the
acquisition of the target may be updated at their exiting carrying amounts or at the amounts
adjusted for the purchase price paid to the target company. The assets and liabilities after
merger are generally revalued under the purchase method. If the acquirer pays a price
greater than the fair market value of assets and liabilities, the excess amount is shown as
goodwill in the acquiring companys books. On the contrary, if the fair value of assets and
liabilities is less than the purchase price paid, then this difference is recorded as capital
reserve. Let us consider an example as given in Illustration 9.4.
Illustration 9.4: Purchase Method
Firm S acquires Firm T by assuming all its assets and liabilities. The fair value of Firm
Ts fixed assets and current assets is Rs.26 crore and 7 crore. Current liabilities are valued
at book value while the fair value of debt is estimated to be Rs.15 Crore. Firm S raises
cash Rs.15 crore to pay Ts shareholders by issuing shares worth Rs.15 crore to its own
shareholders. The balance sheets of the firms before acquisition and the effect of acquisition
are shown in Table 9.8. The balance sheet of firm S (the acquirer) after acquisition is
constructed after adjusting assets, liabilities and equity.
Table 9.8: Purchase Method: Merger of Firm S and T
(Rs. in Crore)
The goodwill is calculated as follows:
Firm T Firm S Combined Firm
Assets
Net fixed assets
Current assets
Goodwill

24
8
-

37
13
-

63
20
3
Total 32 50 868
Liabilities
Shareholders Fund
Borrowings
Current liabilities

10
16
6

18
20
12

33
35
18
Total 32 50 86
DBA 1764
NOTES
Payment to Ts shareholdersFair value of fixed assetsFair value of current assetsLess: Fair
value of borrowingsLess: Fair value of current liabilitiesFair value of net assetsGoodwill
267156 Rs.1512Rs.3
9.12.3 Leveraged Buy-Outs
A leveraged buy-out (LBO) is an acquisition of a company in which the acquisition is
substantially financed through debt. When the managers buy their company from its owners
employing debt, the leveraged buy-out is called management buy-out (MBO). Debt typically
forms 90-70 percent of the purchase price and it may have a low credit rating. In USA, the
LBO shares are not bought and sold in the stock market and the equity is concentrated in
the hands of a few investors. Debt is obtained on the basis of the companys future earnings
potential. LBOs generally involve payment by cash to the seller.
LBOs are very popular in USA. It has been found there that in LBOs, the sellers
require very high premium, ranging from 50 to 100 percent. The main motivation in LBOs
is to increase wealth rapidly in a short span of time. A buyer would typically go public after
four or five years, and make substantial capital gains.
9.12.3.1 LBO Targets
Which companies are targets for the leveraged buy-outs? The following firms are
generally the target for LBOs:
- High growth, high market share firms
- High profit potential firms
- High liquidity and high debt capacity firms
- Low operating risk firms
In LBOs, a buyer generally looks for a company that is operating in a high growth
market with a high market share. It should have a potential to grow fast, and be capable to
earning superior profits. The demand for the companys product should be known so that
Payment to Ts shareholders
Fair value of fixed assets
Fair value of current assets
Less: Fair value of borrowings
Less: Fair value of current liabilities
Fair value of net assets
Goodwill

26
7
15
6
Rs.15

12
Rs.3
NOTES
its earnings can be easily forecasted. A typical company for a leveraged buy-out would be
one that has high profit potential, high liquidity and low or no debt. Low operating risk of
such companies allows the acquiring firm or the management team to assume a high degree
of financial leverage and risk.
9.12.3.2 Risk and Rewards
Why is a lender prepared to assume high risk in a leveraged buy-out? A lender provides
high leverage in a leveraged buy-out because he may have full confidence in the abilities of
the managers-buyers to fully utilise the potential of the business and convert it into enormous
value. His perceived risk is low because of the soundness of the company and its assumed,
predictable performance. He would also guard himself against loss by taking ownership
position in the future and retaining the right to change the ownership of the buyers if they fail
to manage the company. The lender also expects a high return on his investment in a
leveraged buy-out since the risk is high. He may, therefore, stipulate that the acquired
company will go public after four or five years. A major portion of his return comes form
capital gains.
MBOs / LBOs can create a conflict between the (acquiring) manages and shareholders
of the firm. The shareholders benefits will reduce if the deal is very attractive for the
managers. This gives rise to agency costs. It is the responsibility of the board to protect the
interests of the shareholders, and ensure that the deal offers a fair value of their shares.
Another problem of LBOs could be the fall in the price of the LBO target companys
debt instruments (bonds/debentures). This implies a transfer of wealth from debenture
holders to share holders since their claim gets diluted. Debenture holders may, thus, demand
a protection in the event of a LBO / MBO. They may insist for the redemption of their
claims at par if the ownership/control of the firm changes.
9.13. DIVESTMENT
A divestment involves the sale of a companys assets, or product lines, or divisions or
brand to the outsiders. It is reverse of acquisition. Companies use divestment as a means
of restructuring and consolidating their businesses for creating more value for shareholders.
It sells the part of business for a higher price than its current worth. The remaining business
might also find it true value. Thus divestment creates reverse synergy.
The following are some of the common motives for divestment:
- Strategic change Due to the economic and competitive changes, a company
may change its product-market strategy. It might like to concentrate its energy to
certain types of businesses where it has competencies and competitive advantage.
Hence it may sell businesses that more fit with the new strategy.
- Selling cash rows Some of the companys businesses might have reached
saturation. The company might sell these businesses which are now cash cows.
DBA 1764
NOTES
It might realise high cash flows that it can invest in stars that have high growth
potential in future.
- Disposal of unprofitable businesses Unprofitable businesses are a drain on the
companys resources. The company would be better of discarding such businesses.
- Consolidation A company might have become highly diversified due to unplanned
acquisitions in the past. It might sell its unrelated businesses, and consolidate its
remaining businesses as a balanced portfolio.
- Unlocking value Sometimes stock market is not able to value a diversified
company properly since it does not have full disclosure of information for the
businesses separately. Once the businesses are separated, the stock market correct
values the businesses.
Sell-off
There are two types of divestment: sell-off and spin-off. When a company sells part
of its business to a third party, it is called sell-off. It is a usual practice of a large number of
companies to sell-off is to divest unprofitable or less profitable businesses to avoid further
drain on its resources. Sometimes the company might sell its profitable, but non-core
businesses to ease its liquidity problems.
Spin-offs
When a company creates a new from the existing single entity, it is called spin-off.
The spin-off company would usually be created as a subsidiary. Hence, there is no change
in ownership. After the spin-off, shareholders hold shares in two different companies.
Spin-off may have the following advantages:
1. When the businesses are legally and physically separated, shareholders would
have information about separate businesses. They would be able to value separate
businesses more easily. Management would now know which business is a poor-
performing business. Quick managerial action could be initiated to improve the
performance.
2. There may be improvement in the operating efficiency of the separate businesses
as they would receive concentrated attention of the respective managements.
3. Spin-offs could reduce the attractiveness for acquisition when the new company
is clearly and under performer. As a part of a single entry, it might be obvious that
the business unit is an under-performer.
4. Spin-off (and sell-off as well) makes it possible for companies to allocate their
resources to growth opportunities that have the potential of creating high values
for shareholders in the future.
NOTES
9.14. REGULATIONS OF MERGERS AND TAKEOVERS IN INDIA
Mergers and acquisitions may degenerate into the exploitation of shareholders,
particularly minority shareholders. They may also stifle competition and encourage monopoly
and monopolistic corporate behaiour. Therefore, most countries have legal framework to
regulate the merger and acquisition activities. In India, mergers and acquisitions are regulated
through the provision of the Companies Act, 1956, the Monopolies and Restrictive Trade
Practice (MRTP) Act, 1969, the Foreign Exchange Regulation Act (FERA), 1973, the
Income Tax Act, 1961, and the Securities and Controls (Regulations) Act, 1956. The
Securities and Exchange Board of India (SEBI) has issued guidelines to regulate mergers,
acquisitions and takeovers.
9.14.1 Legal Measures against Takeovers
The companies act restricts an individual or a company or a group of individuals from
acquiring shares together with the shares held earlier, in a public company to 25 percent of
the total paid-up capital. Also, the Central Government needs to be intimated whenever
such holding exceeds 10 percent of the subscribed capital. The companies act also provides
for the approval of shareholders and the Central Government when a company, by itself or
in association of an individual or individuals purchases shares of another company in excess
of its specified limit. The approval of the Central Government is necessary if such investment
exceeds 10 percent of the subscribed capital of another company. These are precautionary
measures against the takeover of the public limited companies.
9.14.2 Refusal to Register the Transfer of Shares
In order to defuse situation of hostile takeover attempts, companies have been given
power to refuse to register the transfer of shares. If this is done, a company must inform the
transferee and the transferor within 60 days. A refusal to register transfer is permitted if:
- a legal requirement relating to the transfer of shares have not be complied with or
- the transfer is in contravention of the law; or
- the transfer is prohibited by a court order or
- The transfer is not in the interests of the company and the public.
9.14.3 Protection of Minority Shareholders Interests
In a takeover bid, the interests of all shareholders should be protected without a
prejudice to genuine takeovers. It would be unfair if the same high price is not offered to all
the shareholders of prospective acquired company. The large shareholders (including financial
institutions, banks and individuals) may get most of the benefits because of their accessibility
to the brokers and the takeover dealmakers. Before the small shareholders know about
the proposal, it may too late for them. The Companies Act provides that a purchaser can
force the minority shareholder to sell their shares if:
DBA 1764
NOTES
- the offer has been made to the shareholders of the company;
- the offer has been approved by atleast 90 percent of the shareholders of the
company whose transfer is involved, within 4 months of making the offer; and
- the minority shareholders have been intimated within 2 months from the expiry of
4 months referred above.
If the purchaser is already in possession of more than 90 percent of the aggregate
value of all the shares of the company, the transfer of the shares of minority shareholders is
possible if:
- the purchaser offers the same terms to all shareholders and
- The tenders who approve the transfer, besides holding atleast 90 percent of the
value of shares, should also form atleast 75 percent of the total holders of shares.
9.15. SEBI GUIDELINES OF TAKEOVERS
The salient features of some of the important guidelines as follows:
Disclosure of share acquisition / holding Any person who acquires 5% or 10%
or 14% shares or voting rights of the target company should disclose of his holdings at
every stage to the target company and the stock exchanges within 2 days of acquisition or
receipt of intimation of allotment of shares.
Any person who holds more than 15% but less than 75% shares or voting rights of
target company, and who purchases or sells shares aggregating to 2% or more shall within
2 days disclose such purchase or sale along with the aggregate of his shareholding to the
target company and the stock exchanges.
Any person who holds more than 15% shares or voting rights of target company and
a promoter and person having control over the target company, shall within 21 days from
the financial year ending March 31 as well as the record date fixed for the purpose of
dividend declaration, disclose every year his aggregate shareholding to the target company.
Public announcement and open offer An acquirer who intends to acquire shares which
along with his existing shareholding would entitle him to exercise 15% or more voting
rights, can acquire such additional shares only after making a public announcement to
acquire atleast additional 20% of the voting capital of target company from the shareholders
through an open offer.
An acquirer who holds 15% or more but less than 75% of shares or voting rights of
a target company, can acquire such additional shares as would entitle him to exercise more
than 5% of the voting rights in any financial year ending March 31 only after making a
public announcement to acquire atleast additional 20% shares of target company from the
shareholders through an open offer.
NOTES
An acquirer, who holds 75% shares or voting rights of a target company, can acquire
further shares or voting rights only after making a public announcement to acquire atleast
additional 20% shares of a target company from the shareholders through an open offer.
Offer price The acquirer is required to ensure that all the relevant parameters are taken
into consideration while determining the offer price and that justification for the same is
disclosed in the letter of offer. The relevant parameters are:
- Negotiated price under the agreement which triggered the open offer.
- price paid by the acquirer for acquisition, if any, including by way of allotment in a
public or rights or preferential issue during the twenty six week period prior to the
date of public announcement, whichever is higher;
- the average of the weekly high and low of the closing prices of the shares of the
target company as quoted on the stock exchange where the shares of the company
are most frequently traded during the twenty six weeks or the average of the daily
high and low prices of the shares as quoted on the stock exchange where the
shares of the company are most frequently traded during the two weeks preceding
the date of public announcement, whichever is higher.
In case the shares of Target Company are not frequently traded then parameters
based on the fundamentals of the company such as return of net worth of the company,
book value per share, EPS etc. are required to be considered and disclosed.
Disclosure The offer should disclose the detailed terms of the offer, identity of the offerer,
details of the offers existing holdings in the offeree company etc. and the information
should be available to all shareholders at the same time and in the same manner.
Offer document The offer document should contain the offers financial information, its
intention to continue the offeree companys business and to make major change and long-
term commercial justification for the offer.
The objectives of the Companies Act and the guidelines for takeover are to ensure
full disclosure about the mergers and takeovers and to protect the interests of the
shareholders, particularly the small shareholders. The main thrust is that public authorities
should be notified within two days.
In a nutshell, an individual or company can continue to purchase the shares without
making an offer to other shareholders until the shareholding exceeds 10 percent. Once the
offer is made to other shareholders, the offer price should not be less than the weekly
average price in the past 6 months or the negotiated price.
9.16. LEGAL PROCEDURES
The following is the summary of legal procedures for merger or acquisition laid down
in the companies act, 1956.
DBA 1764
NOTES
- Permission for merger Two or more companies can amalgamate only when
amalgamation is permitted under their memorandum of association. Also, the
acquiring company should have the permission in its object clause to carry on the
business of the acquired company. In the absence of these provisions in the
memorandum of association, it is necessary to seek the permission of the
shareholders, board of directors and the Company Law Board before affecting
the merger.
- Information to the stock exchange The acquiring and the acquired companies
should inform the stock exchanges where they are listed about the merger.
- Approval of board of directors The boards of directors of the individual
companies should approve the draft proposal for amalgamation and authorize the
managements of companies to further pursue the proposal.
- Application in the High Court An application for approving the draft amalgamation
proposal duly approved by the boards of directors of the individual companies
should be made to the High Court. The High Court would convene a meeting of
the shareholders and Creditors to approve the amalgamation proposal. The notice
of meeting should be sent to them atleast 21 days in advance.
- Shareholders and creditors meetings The individual companies should hold
separate meetings of their shareholders and creditors for approving the
amalgamation scheme. Atleast 75 percent of share holders and creditors in separate
meeting, voting in person or by proxy, must accord their approval to the scheme.
- Sanction by the High Court After the approval of shareholders and creditors,
on the petitions of the companies, the High Court will pass order sanctioning the
amalgamation scheme after it is satisfied that the scheme is fair and reasonable. If
it deems so, it can modify the scheme. The date of the courts hearing will be
published in two newspapers, and also, the Regional Director of the company
Law Board will be intimated.
- Filing of the court order After the court order, it is certified true copies will be
filed with the Registrar of Companies.
- Transfer of assets and liabilities The assets and liabilities of the acquired
company will be transferred to the acquiring company in accordance with the
approved scheme, with effect from the specified date.
- Payment by cash or securities As per the proposal, the acquiring company will
exchange shares and debentures and/or pay cash for the shares and debentures of
the acquired company. These securities will be listed on the stock exchange.
9.17. ACQUISITION AS A CAPITAL BUDGETING DECISION
In case of a merger situation, it is implied that the acquirer firm is ready to pay the
price (in cash or in terms of shares because it is expecting inflows in terms of sale of assets
or in terms of operating cash flows for a number of years. These inflows and outflows (all
in PV terms) can be compared to find out the NPV of the proposal. The procedure for
finding out the NPV of the merger proposition may be found as follows.
NOTES
Following is the balance sheet of T Ltd
There is an unrecorded liability of Rs. 2,50,000. A Ltd has agreed to acquire T Ltd.,
the purchase consideration payable being :
a. to issue, 1,00,000 equity shares of Rs. 10 each at a market price of Rs. 30 per share.
b. 10% debentures to be issued to discharge the 12% debentures of T Ltd.
c. to pay Rs. 50,000 for liquidation expenses.
The production facilities of T Ltd will be in operation for a period of 10 years. The
fixed assets of T Ltd. are expected to be sold to generate after tax cash flows of Rs.
7,50,000 at that time. During this 10 years period, the operations of T Ltd are expected to
generate annual operating cash flows of Rs. 10,00,000. The minimum required rate of
return from the proposal is 10% should A Ltd. go ahead with the proposal?
Solution :
The NPV of the proposal may be found as follows :
MV of Capital issued
+ MV of debentures issued
+ Liabilities undertaken
+ Expense payable
-Sale proceed from sale of assets
Total cost of acquisition
Less PV of series of operating cash flows
Less PV of terminal sale of assets
Net Present Value
* * * *
* * * *
* * * *
* * * *
* * * *
* * * *
* * * *
* * * *

* * * *

* * * *
* * * *
Liabilities Amount (Rs) Assets Amount (Rs)
Enquity Share Capital
Reserves
12% Debentures
Current Liabilities
27,000.00
8,00,00.00
10,00,000.00
8,00,000.00
Fixed Assets
Inventories
Debtors
Underwriting
Expenses
25,00,000.00
8,00,000.00
18,00,000.00
2,00,000.00
53,00,000.00 53,00,000.00
DBA 1764
NOTES
Cost of Acquisition :
MV of Equity share capital (1,00,000 x Rs.30) Rs. 30,00,000.00
10% Debentures 10,00,000.00
Current Liabilities 8,00,000.00
Unrecorded Liabilities 2,50,000.00
Liquidation Expenses 50,000.00
Total Cost 51,00,000.00
PV of Inflows (WACC = 10%)
PV of Sales Proceed (Rs. 7,50,000 x .386) 2,89,500.00
PV of Annual Inflows (Rs. 10,00,000 x 6.14) 61,45,000.00
Total PV of Inflows 64,34,500.00
Net Present Value (Rs. 64,34,500 Rs. 51,00,000) Rs. 13,34,500
As the NPV of the proposal is positive, A Ltd. may go ahead with the merger proposal.
Review Questions
1) Define and distinguish between the concepts of Merger, Takeover and
Amalgamation. Illustrate your answer with suitable examples in the Indian context.
2) Explain the concepts of horizontal, vertical and conglomerate merger with examples.
3) What are the advantages and disadvantages of Mergers and Takeovers?
4) What are the important reasons for mergers and takeovers?
5) Discuss in brief the legislation applicable to mergers and takeovers in India. What
are the objectives of such legislation?
6) Explain and illustrate the impact of mergers on earnings per share, market price
per share and book value per share of the acquiring company.
7) What do you understand by leveraged buy-out and management buy-out? Explain
the steps involved in the evaluation of LBO?
NOTES
UNIT IV
FINANCING DECISIONS
CHAPTER 10
CAPITAL STRUCTURE THEORIES
Given the objective of the firm to maximise the value of the equity shares, the firm
should select a financing-mix/capital structure/financial leverage which will help in achieving
the objective of financial management. As a corollary, the capital structure should be examined
from the viewpoint of its impact on the value of the firm. It can be ultimately expected that
if the capital structure decision affects the total value of the firm, a firm should select such
a shareholders financing-mix as will maximise the shareholders wealth. Such a capital
structure is referred to as the optimum capital structure. The optimum capital structure may
be defined as the capital structure or combination of debt and equity that leads to the
maximum value of the firm. The importance of an appropriate capital structure is, thus,
obvious. There is a viewpoint that strongly supports the close relationship between leverage
and value of a firm. There is an equally strong body of opinion which believes that financing-
mix or the combination of debt and equity has no impact on the shareholders wealth and
the decision on financial structure is irrelevant. In other words, there is nothing such as
optimum capital structure.
In theory, capital structure can affect the value of a company by affecting either its
expected earnings or the cost of capital, or both. While it is true that financing-mix cannot
affect the total operating earnings of a firm, as they are determined by the investment
decisions, it can affect the share of earnings belonging to the ordinary shareholders. The
capital structure decision can influence the value of the firm through the earnings available
to the shareholders. But the leverage can largely influence the value of the firm through the
cost of capital. In exploring the relationship between leverage and value of a firm in this
chapter we are concerned with the relationship between leverage and cost of capital from
the standpoint of valuation. While section one deals with the assumptions, definition and
symbols relating to capital structure theories, the next four Sections of the this chapter
explain the major capital structure theories, namely: (i) Net Income Approach, (ii) Net
Operating Income Approach, (iii) Modigliani-Miller (MM) Approach, and (iv) Tradi-tional
Approach. The last Section summarises the main points.
DBA 1764
NOTES
10.1. CAPITAL STRUCTURE THEORIES
Assumptions
1. There are only two sources of funds used by a firm: perpetual riskless debt and
ordinary shares.
2. There are no corporate taxes. This assumption is removed later.
3. The dividend-payout ratio is 100. That is, the total earnings are paid out as dividend
to the shareholders and there are no retained earnings.
4. The total assets are given and do not change. The investment decisions are, in
other words, assumed to be constant.
5. The total financing remains constant. The firm can change its degree of leverage
(capital structure) either by selling shares and use the proceeds to retire debentures
or by raising more debt and reduce the equity capital.
6. The operating profits (EBIT) are not expected to grow.
7. All investors are assumed to have the same subjective probability distribution of
the future expected EBIT for a given firm.
8. Business risk is constant over time and is assumed to be independent of its capital
structure and financial risk.
9. Perpetual life of the firm.
Definitions and Symbols
In addition to the above assumptions, we shall make use of some symbols in our
analysis of capital structure theories:
S = total market value of equity
B = total market value of debt
I = total interest payments
V = total market value of the firm (V = S + B)
NI = net income available to equity holders.
We shall also make use of some basic definitions:
1. Cost of debt (k
i
) =
B
I
(10.1)
2. Value of debt (B)
i
k
I
(10.2)
Cost of equity capital (k
e
) =
g
P
D
0
1
+
(10.3)
NOTES
where D
1
= net dividend; P
o
= current market price of shares and g is the expected
growth rate. According to assumption (3), the percentage of retained earnings is zero.
Since g = br, where r is the rate of return on equity shares and b is the retention rate, g =
0, the growth rate is zero. This is consistent with assumption (6). In operational terms D
1
,
= E
1
, g = 0. Therefore,
k
e
=
0
1
0
1
0
1
P
E
0
P
E
g
P
E
= + = +
(10.4)
where E
l
= earnings per share. Equation 10.4 is on a per share basis. Multiplying
both the numerator and the denominator by the number of shares outstanding (N) and
assuming there are no income taxes, we have
S N (x) Po
K
e
NI o I EBIT N ) ( E
=

(10.5)
shares equity of ue market val Total
holders equity to available income Net

=
(10.6)
or
Thus k
e
may be defined on either per share or total basis.
From equations 10.5 and 10.6 follow the equations of determining the value of equity
shares on per share basis and total basis.
(i) Per share basis P
0
=
e
1
k
E
(10.7)
(ii) Total basis S = P
o
N =
e
k
I - EBIT
(10.8)
(iii) Overall cost of capital or weighted average cost of capital:
K
0
= W
i
k
1
+ W
2
k
e
(When W
1
and W
2
are relative weights)
= e i
K
S B
S
K
S B
B
(
+
+
(
+
V = (
0
K
EBIT
(10.9)
DBA 1764
NOTES
V =
e i
K
I EBIT
K
I
+
(10.10)
Alternatively:
Another useful way of measuring the cost of equity capital is described below:
We know K
0
is the weighted average of the cost of equity and the cost of debt.
Symbolically
k
0
=
e i
K
I EBIT
K
I
+
= k
i
|
.
|
\
|
+ |
.
|
\
|
V
S
k
V
B
e
= k
e
S/V
(B/V) k - k
i o
(10.11)
We know that V = B + S. Therefore, equity ratio, S/V can be expressed as:
S B
B
1
S B
S
V
S
+
=
+
=
(10.12)
Substituting the value of Eq.10.12 in Eq. 10.11, we have
k
e
= k
0
k
i

S B
B
1 /
S B
B
+
+
=
S B
B S B
/
S B
kiB ) S B ( ko
+
+
+
+
(10.13)
=
S B
B S B
/
S B
kiB S k koB
o
+
+
+
+
(10.14)
Simplifying equation.10.14, we have
k
e
=
S
B k S k koB
i 0
+
k
e
= k
0
+ (k
0
-k
i
) B/S (10.15)
While exploring mo-relationship between capital structure and value of the firm, our
concern is with the cost of equity capital (k
t
), cost of debt (k) and overall cost of capital
(k
0
) when the capital structure/leverage changes, as measured by the change in the
relationship between total value of debt and debt to total of ordinary shares (B/S).
NOTES
10.1.1 Net Income Approach
According to the Net Income (NI) Approach, suggested by the Durand, the capital
structure decision is relevant to the valuation of the firm. In other words, a changing the
financial leverage will lead to a corresponding change in the cost of capital as well as the
total value of the firm. If, therefore, the degree of financial leverage as measured by the
ratio of debt to equity is increased, the weighted average cost of capital will decline, while
the value of firm as well as the market price of ordinary shares will increase. Conversely,
decrease in the leverage will cause an increase in the overall cost of capital and a decline
both in the value of the firm as well as the market price of equity shares.
The NI Approach to valuation is based on three assumptions: first, there are no
taxes; second, that the cost of debt is less than the equity capitalisation rate or the cost of
equity; third, that the use of debt does not change the risk perception of investors. That
the financial risk perception of the investors does not change with the introduction of debt
or change in leverage implies that due to change in leverage, there is no change in either the
cost of debt or the cost of equity. The implication of the three assumptions underlying the
NI Approach is that as the degree of leverage increases, the proportion of a cheaper
source of funds, that is, debt in the capital structure increases. As a result, the weighted
average of capital tends to decline, leading to an increase in the total value of the firm.
Thus, with the cost of debt and cost of equity being constant, the increased use of debt
(increase in leverage), will magnify the shareholders earnings and, thereby, the market
value of the ordinary shares.
The financial leverage is, according to the NI Approach, an important variable to the
capital structure of a firm. With a judicious mixture of debt and equity, a firm can evolve
an optimum capital structure which will be the one at which value of the firm is the highest
and the over a cost of capital the lowest. At that structure, the market price per share
would be maximum.
If the firm uses no debt or if the financial leverage is zero, the overall cost of capital
will be equal to the equity-capitalisation rate. The weighted average cost of capital will
decline and will approach the cost of debt as the degree of average reaches one. The NI
Approach is illustrated in Example 10.1.
Example 10.1
A companys expected annual net operating income (EBIT) is Rs 50,000. The company
has Rs. 2,00,000, 10% debentures. The equity capitalisation rate (k
e
) of the company is
12.5 per cent.
DBA 1764
NOTES
Solution
With no taxes, the value of the firm, according to the Net Income Approach is depicted
in Table 10.1.
TABLE 10.1 VALUE OF THE FIRM (NET INCOME APPROACH)
Increase in Value
In order to examine the effect of a change in financial-mix on the firms overall (weighted
average) cost of capital and its total value, let us suppose that the firm has decided to raise
the amount of debenture by Rs 1,00,000 and use the proceeds to retire the equity shares.
The ki and k
e
would remain unaffected as per the assumptions of the NI Approach. In the
new situation, the value of the firm is shown in Table 10.2.
Net operating income (EBIT)
Less interest on debentures (I)
Earnings available to equity holders (NI)
Equity capitalisation rate (k
e
)
Market value of equity (S) = Nl/k
e
Market value of debt (B)
Total value of the firm (S + B) = V
Overall cost of capital = k
0
= EBIT/V
Alternatively: k
0
= k
1
(B/V) + k
e
(SIV) where k
i
and k
g
are
cost of debt and
cost of equity respectively =
RS. 50,000
20,000
30,000
0.125
2,40,000
2,00,000
4,40,000
11.36 PER CENT

11.36 PER CENT
Less interest on debentures (/)
Equity capitalisation rate (Ke)
Market value of equity (S) = Ni/K
e
Market value of debt (B)
Total value of the firm (S+B) =V

K
o
=
Rs. 50,000
30,000
20,000
0.125
1,60,000
3,00,000
4,60,000

10.9 percent
NOTES
Thus, the use of additional debt has caused the total value of the firm to increase and
the overall cost of capital to decrease.
Decrease in Value
If we decrease the amount of debentures in the original Example 10.1, the total value
of the firm, according to the NI Approach, will decrease and the overall cost of capital will
increase. Let us suppose that the amount of debt has been reduced by Rs 1,00,000 to Rs
1,00,000 and a fresh issue of equity shares is made to retire the debentures. Assuming
other facts as given in Example 10.1, the value of the firm and the weighted average cost of
capital are shown in Table 10.3.
Thus, we find that the decrease in leverage has increased the overall cost of capital
and has reduced the value of firm.
Market Price
Thus, according to the NI Approach, the firm can increase/decrease its total value
(V) and lower/increase its overall cost of capital (k
o
) as it increases/decreases the degree
of leverage. As a result, the market price per share is affected. To illustrate, assume in
Example 10.1 that the firm with Rs 2,00,000 debt has 2,400 equity shares outstanding.
The market price per share works out to Rs 100 (Rs 2,40,000, 2,400). The firm issues Rs
1,00,000 additional debt and uses the proceeds of the debt to repurchase/retire Rs 1,00,000
worth of equity shares of 1,000 shares. It, then, has 1,400 shares outstanding. We have
observed in Example 10.1 that the total market value of the equity after the change in the
capital structure is Rs 1,60,000 (Table 10.2). Therefore, the market price per share is Rs
114.28 (Rs 1,60,000, 1,400), as compared to the original price of Rs 100 per share.
Likewise, when the firm employs less amount of debt, the market value per share declines.
To continue with Example 10.1, the firm raises Rs 1,00,000 additional equity capital by
Less interest on debentures (I)
e
)
Market value of equity (B) (S) = Nl/k
e

Market value of debt (S)
Total value of the firm (S + B) = V
K
o
=
Rs.50,000
Rs. 10,000
Rs. 40,000
0.125
Rs.3,20,000
Rs. 1,00,000
Rs.4,20,000
11.9
percent
DBA 1764
NOTES
issuing 1,000 equity shares of Rs 100 each and uses the proceeds to retire the debenture
amounting to Rs 1,00,000. It would then have 3,400 shares (2,400 old + 1,000 new)
outstanding. With this capital structure, we have seen in Example 10.1 that the total market
value of equity shares is Rs 3,20,000 (Table 10.3). Therefore, the market price per share
has declined to Rs 94.12 (Rs.3,20,000/- 3,400) from Rs 100 before a change in the
leverage.
We can graph the relationship between the various factors (k
e
, k
i
, K
0
) with the degree
of leverage (Fig. 10.1).
The degree of leverage (B/V) is plotted along the X-axis, while the percentage rates
of k
1
k
e
and k
O
are on the Y-axis. This graph is based on Example 10.1. Due to the
assumptions that k
e
and k
}
remain unchanged as the degree, of leverage changes, we find
that both the curves are parallel to the X-axis. But as the degree of leverage increases, k
0
decreases and approaches the cost of debt when leverage is 1.0, that is, (k
0
= k). It will
obviously be so owing to the fact that there is no equity capital in the capital structure. At
this point, the firms overall cost of capital would be minimum. The significant conclusion,
therefore, of the NI Approach is that the firm can employ almost 100 per cent debt to
maximise its value.
FIG 10.1: NET INCOME APPROACH
10.1.2 Net Operating Income (Noi) Approach
Another theory of capital structure, suggested by Durand, is the Net Operating Income
(NOI) Approach. This Approach is diametrically opposite to the NI Approach. The essence
of this Approach is that the capital structure decision of a firm is irrelevant. Any change in
leverage will not lead to any-change in the total value of the firm and the market price of
shares as well as the overall cost of capital is independent of the degree of leverage. The
NOI Approach is based on the following propositions.
NOTES
10.1.2.1 Overall Cost of Capital/Capitalisation Rate (k
0
) is Constant
The NOI Approach to valuation argues that the overall capitalisation rate of the
firm remains constant, for all degrees of leverage. The value of the firm, given the level of
EBIT, is
V =
o
K
EBIT
In other words, the market evaluates the firm as a whole. The split of the
capitalisation between debt and equity is, therefore, not significant.
10.1.2.2. Residual Value of Equity
The value of equity is a residual value which is determined by deducting the total
value of debt (S) from the total value of the firm (V). Symbolically, Total market value of
equity capital (S) = V - B.
10.1.2.3 Changes in Cost of Equity Capital
The equity capitalisation rate cost of equity capital (k
e
), increases with the degree
of leverage. The increase in the proportion of debt in the capital structure relative to equity
shares would lead to an increase in the financial risk to the ordinary shareholders. To
compensate for the increased risk, the shareholders would expect a higher rate to return
on their investments. The increase in the equity capitalisation rate (or the lowering of the
price-earnings ratio, that is, P/E ratio) would match in the increase in the debt equity ratio.
The
(
+ =
S
B
) K K ( K wouldbe K
1 o o 2
10.1.2.3.4 Cost of Debt
The cost of debt (K
i
) has two parts: (a) Explicit cost which is represented by the
rate of interest. Irrespective of the degree of leverage, the firm is assumed to be able to
borrow at a given rate of interest. This implies that the increasing proportion of debt in the
financial structure does not affect the financial risk of the lenders and they do not penalise
the firm by charging higher interest; (b) Implicit or hidden cost. As shown in the assumption
relating to the changes in k
e
, increase in the degree of leverage or the proportion of debt to
equity causes an increase in the cost of equity capital. This increase in K
e
, being attributable
to the increase in debt, is the implicit part of K
i.
Thus, the advantage associated with the use of debt, supposed to be a cheaper
source of funds in terms of the explicit cost, is exactly neutralised by the implicit cost
DBA 1764
NOTES
represented by the increase in K
e
; As a result, the real cost of debt and the real cost of
equity, according to the NOI Approach, are the same and equal K
o.
Optimum Capital Structure
The total value of the firm is unaffected by its capital structure. No matter what the
degree of leverage is, the total value of the firm will remain constant. The market price
of shares will also not change with the change in the debt-equity ratio. There is nothing
such as an optimum capital structure. Any capital structure is optimum according to the
NOI Approach.
The effect of NOI Approach on value of the firm, k
e
, and the market price per
share is illustrated in Example 10.2.
Example 10.2
Assume the figures given in Example 10.1: operating income Rs 50,000; cost of
debt, 10 per cent- and outstanding debt, Rs 2,00,000. If the overall capitalisation rate
(overall cost of capital) is 12.5 per cent what would be the total value of the firm and the
equity capitalisation rate.
Solution
The computation is depicted in Table 10.4.
Table 10.4 Total Value of the Firm (Net Operating Income Approach)
Net operat ing income (EBIT)
Overall c apit ali sat ion rat e (k
0
)
Tot al market value of t he fi rm ( V) = EBIT/K
0
Tot al val ue of debt ( B)
Tot al market value of equi t y (S ) = ( V- B)
Equit ycapi t al i sat i on r ate,
k
e
=
s hares equit y ueof market val Total
hold ers equi ty t o a vailabl e Earnings
B V
1 EBIT
=

=
000 , 00 , 2 .
000 , 20 . 000 , 50 .
Rs
Rs Rs

Al ternat i vel y, K
e
=k
o

+ (
k
o
- K
i
) B/ S: 0.125 +( 0.125 - 0.10)

(
000 , 00 , 2 ,
000 , 00 , 2 .
Rs
Rs

The wei ght ed aver age cost of capi t al t o veri fy t he val i di t y
of the NOI Approach
K
o
= Ki ( B/ V) +Ke (S/ V) = 0. 10
(
+
(
000 , 00 , 4 ,
000 , 00 , 2 .
1 5 . 0
0 00 , 00 , 4 ,
0 00 , 00 , 2 .
Rs
Rs
Rs
Rs

Rs. 50,000
0. 125
4,00,000
2,00,000
2,00,000

0.15

0.15

0.125

NOTES
Thus, we find that the overall cost of capital is 12.5 per cent as per the requirement of
the NOI Approach.
In order to examine the effect of leverage, let us assume that the firm increases the
amount of debt from Rs 2,00,000 to Rs 3,00,000 and uses the proceeds of the debt to
repurchase equity shares. The value of the firm would remain unchanged at Rs 4,00,000,
but the equity-capitalisation rate would go up to 20 per cent as shown in Table 10.5.
Table 10.5 Value of the Firm (NOI Approach)
Let us further suppose that the firm retires debt by Rs 1,00,000 by issuing fresh
equity shares of the same amount. The value of the firm would remain unchanged at Rs
4,00,000 and the equity-capitalisation rate would come down to 13.33 per cent as
manifested in the calculations in Table 10.6.
Table 10.6 Total Value of the Firm (NOI Approach)
Overall capitalisation rate (k
0
)
Total market value of the firm (V) = EBIT/K
0
Total value of debt (B)
Total market value of equity (S) = (V- B)
K
e
=
0000 , 00 , 1 .
000 , 30 . 000 , 50 .
Rs
Rs Rs

Alternatively K
e
= 0.125 + (0.125 0.10)
(
000 , 00 , 1 .
000 , 00 , 3 .
Rs
Rs

K
o
= 0.10
(
+
(
000 , 00 , 4 .
000 , 00 , 1 .
20 . 0
000 , 00 , 4 .
000 , 00 , 3 .
Rs
Rs
Rs
Rs

Rs.50,000
0.125
Rs.4,00,000
Rs.3,00,000
Rs. 1,00,000
0.20

0.20
0.125
Overall capitalisation rate (k
0
)
Total market value of the firm (V) = EBIT/K
O

Total value of debt (B)
Total market value of equity (S) = (V- B)
K
e
=
0000 , 00 , 3 .
000 , 10 . 000 , 50 .
Rs
Rs Rs

Alternatively K
e
= 0.125 + (0.125 0.10)
(
000 , 00 , 3 .
000 , 00 , 1 .
Rs
Rs

K
o
= 0.10
(
+
(
000 , 00 , 4 .
000 , 00 , 3 .
133 . 0
000 , 00 , 4 .
000 , 00 , 1 .
Rs
Rs
Rs
Rs

Rs. 50,000
0.125
Rs. 4,00,000
Rs, 1,00,000
Rs. 3,00,000
0.133

0.133

0.125

DBA 1764
NOTES
The significant feature is that the equity-capitalisation rate, k
e
, increases with the increase
in the degree of leverage. It has gone up from 15 per cent to 20 per cent with the increase
in leverage from 0.50 to 0.75. The equity capitalisation rate decreases with the decrease in
the degree of leverage. It has come down from 15 per cent to 13.33 per cent with the
decrease in leverage from 0.50 to 0.25.
Market Price of Shares
In Example 10.2, let us suppose the firm with Rs 2 lakh debt has 2,000 equity shares
(of Rs 100 each) outstanding. The firm has issued additional debt of Rs 1,00,000 to
repurchase its shares amounting to Rs 1,00,000; it has to repurchase 1,000 shares of Rs
100 each from the market. It, then, has 1,000 equity shares outstanding, having total
market value of Rs 1,00,000. The market price per share, therefore, is 100 (Rs 1,00,000
1,000) as before.
In the second situation the firm issues, 1,000 equity shares of Rs 100 each to retire
debt aggregating Rs. 1,00,000. It will have 3,000 equity shares outstanding, having total
market value of Rs 3,00,000, thus, giving a market price of Rs 100 per share. Thus, we
note that there is no change in the market price per share due to change in leverage.
We have portrayed the relationship between the leverage and the various costs, viz.
k
i
, k
e
and k
0
in Fig. 10.2. The graph is based on Example 10.2. Due to the assumption that
k
0
and k remain unchanged as the degree of leverage changes, we find that both the curves
are parallel to the X-axis. But as the degree of leverage increases, the k
e
increases
continuously.
Fig 10.2 Net Operating Income Approach
NOTES
10.1.3 Modigliani-Miller (Mm) Approach
The Modigliani-Miller Thesis relating to the relationship between the capital structure,
cost of capital and valuation is akin to the NOI Approach. The NOI Approach, as explained
above, is definitional or conceptual and lacks behavioral significance. The NOI. Approach,
in other words, does not provide operational justification for the irrelevance of the capital
structure. The MM proposition supports the NOI Approach relating to the independence
of the cost of capital and the degree of leverage at any level of debt-equity ratio. The
significance of their hypothesis lies in the fact that it provides behavioral justification for
constant overall cost of capital and, therefore, total value of the firm. In other words, the
MM Approach maintains that the weighted average (overall) cost of capital does not
change, with a change in the proportion of debt to equity in the capital structure (or degree
of leverage). They offer operational justification for this and are not content with merely
stating the proposition.
10.1.3.1 Basic Propositions
There are three basic propositions of the MM Approach:
I The overall cost of capital (k
0
) and the value of the firm (V) are independent of its
capital structure. The k
Q
and V are constant for all degrees of leverage. The total
value is given by capitalising the expected stream of operating earnings at a discount
rate appropriate for its risk class.
II The second proposition of the MM Approach is that the k
e
is equal to the
capitalisation rate of a pure equity stream plus a premium for financial risk equal to
the difference between the pure equity-capitalisation rate (K
e
) and K
i
times the
ratio of debt to equity. In other words, k
e
increases in a manner to offset exactly
the use of a less expensive source of funds represented by debt.
III The cut-off rate for investment purposes is completely independent of the way in
which an investment is financed.
We are interested mainly in exploring the relationship between leverage and valuation.
Our focus, therefore, is on proposition (I).
10.1.3.2 Assumptions
The proposition that the weighted average cost of capital is constant irrespective of
the type of capital structure is based on the following assumptions:
a) Perfect capital markets: The implication of a perfect capital market is that (i)
securities are infinitely divisible; (ii) investors are free to buy/sell securities; (iii)
investors can borrow without restrictions on the same terms and conditions as
firms can T(iv) There are no transaction costs; (v) information is perfect, that is,
each investor has the same information which is readily available to him without
cost; and (vi) investors are rational and behave accordingly.
DBA 1764
NOTES
b) Given the assumption of perfect information and rationality, all investors have the
same expectation of firms net operating income (EBIT) with which to evaluate the
value of a firm.
c) Business risk is equal among all firms within similar operating environment. That
means, all firms can be divided into equivalent risk class or homogeneous risk
class. The term equivalent homogeneous risk class means that the expected
earnings have identical risk characteristics. Firms within an industry are assumed
to have the same risk characteristics. The categorisation of firms into equivalent
risk class is on the basis of the industry group to which the firm belongs.
(a) The dividend pay out ratio is 100 per cent.
(b) There are no taxes. This assumption is removed later.
Proposition I The basic premise of the MM Approach (proposition I) is that, given
the above assumptions, the total value of a firm must be constant irrespective of the degree
of leverage (debt-equity ratio). Similarly, the cost of capital as well as the market price of
shares must be the same regardless of the financing-mix.
The operational justification for the MM hypothesis is the arbitrage process. The
term arbitrage refers to an act of buying an asset/security in one market (at lower prices)
and selling it in another (at higher price). As a result, equilibrium is restored in the market
price of a security in different in markets. The essence of the arbitrage process is the
purchase of securities assets whose prices are lower (undervalued securities) and, sale of
securities whose prices are higher, in related markets which are temporarily out of equilibrium.
The arbitrage process is essentially a balancing operation. It implies that a security cannot
sell at different prices.
The MM Approach illustrates the arbitrage process with reference to valuation in
terms of two firms which are exactly similar in all respects except leverage so that one of
them has debt in its capital structure while the other does not. Such homogeneous firms
are, according to Modigliani and Miller, perfect substitutes. The total value of the
homogeneous firms which differ only in respect of leverage cannot be different because of
the operation of arbitrage. The investors of the firm whose value is higher will sell their
shares and instead buy the shares-of-the firm whose value is lower. Investors will be able
to earn the same return at lower outlay with the same perceived risk or lower risk. They
would, therefore, be better off. The behaviour of the investors will have the effect of (i)
increasing the share prices (value) of the firm whose shares are being purchased; and (ii)
lowering the share prices (value) of the firm whose shares are being sold. This will continue
till the market prices of the two identical firms become identical. Thus, the switching operation
(arbitrage) drives the total value of two homogeneous firms in all respects, except the
debt-equity ratio, together. The arbitrage process, as already indicated, ensures to the
investor the same return at lower outlay as he was getting by investing in the firm whose
total value was higher and yet, his risk is not increased. This is so because the investors
NOTES
would borrow in the proportion of the degree of leverage present in the firm. The use of
debt by the investor for arbitrage is called as home-made or personal leverage. The
essence of the arbitrage argument of Modigliani and Miller is that the investors (arbitragers)
are able to substitute personal leverage or home-made leverage for corporate leverage,
that is, the use of debt by the firm itself.
The operation of the arbitrage process is illustrated in Example 10.3.
Example 10.3
Assume there are two firms, L and U, which are identical in all respects except that
firm L has 10 per cent, Rs 5,00,000 debentures. The earnings before interest and taxes
(EBIT) of both the firms are equal, that is, Rs 1,00,000. The equity-capitalisation rate (k
e
)
of firm L is higher (16 per cent) than that of firm U (12.5 per cent).
Solution
The total market values of firms L and U are computed in Table 10.7.
Table 10.7 Total Value of Firms L and U
Thus, the total market value of the firm which employs debt in the capital structure (L)
is more than that of the unlevered firm (U). According to the MM hypothesis, this situation
cannot continue as the-arbitrage process, based on the substitutability of personal leverage
for corporate leverage will operate and the values of the two firms will be brought to an
identical level.
Arbitrage Process The modus operandi of the arbitrage process is as follows:
Firms
L U
EBIT
Less Interest
Earnings available to equity holders
Equity Capitalization rate (K
e

Total market value of equity (S)
Total market value of debt (B)
Total market value (V)
Implied overall capitalisation rate/cost of
capital (K
0
) = EBIT /V
Debt equity rate = BVS
Rs.1,00,000
Rs. 50,000
Rs. 50,000
0.16
Rs.3,12,500
Rs. 5,00,000
Rs.8,12,500
0.123

1.6
Rs.1,00,000
---
Rs,1,00,000
0.125
Rs.8,00,000
--
Rs.8,00,000
0.125

---

DBA 1764
NOTES
Suppose an investor, Mr X, holds 10 per cent of the outstanding shares of the levered
firm (L). His holdings amount to Rs 31,250 (i.e. 0.10 x Rs 3,12,500) and his share in the
earnings that belong to the equity shareholders would be Rs 5,000 (0.10 x Rs 50,000).
He will sell his holdings in firm L and invest in the unlevered firm (U). Since firm U has
no debt in its capital structure the financial risk to would be less than in firm L. To reach the
level of financial risk of firm L, he will borrow additional funds equal to his proportionate
share in the levered firms debt on his personal account. That is, he will substitute personal
leverage (or home-made leverage) for corporate leverage. In other words, instead of the
firm using debt, Mr X will borrow money. The effect, in essence, of this is that he is able to
introduce leverage in the capital structure of the unlevered firm by borrowing on his personal
account. Mr X in our example will borrow Rs 50,000 at 10 per cent rate of interest. His
proportionate holding (10 per cent) in the unlevered firm will amount to Rs 80,000 on
which he will receive a dividend income of Rs 10,000. Out of the income of Rs 10,000
from the unlevered firm (U), Mr X will pay Rs 5,000 as interest on his personal borrowings.
He will be left with Rs 5,000 that is, the same amount as he was getting from the levered
firm (L). But his investment outlay in firm U is less (Rs 30,000) as compared with that in
firm L (Rs 31,250). At the same time, his risk is identical in both the situations. The effect
of the arbitrage process is summarised in Table 10.8.
Table 10.8 Effect of Arbitrage
(A) Mr. Xs position in firm L (levered) with 10 per cent
equity holding
(i) Investment outlay
Dividend income
Rs.31,250
Rs. 5,000
(B) Mr. Xs position in firm LU(unlevered) with 10 per
cent equity holding
(i) Total funds available (own funds, Rs.31,250 +
borrowed funds, Rs.50,000)
(ii) Dividend income
81,250
80,000
(i) Dividend income Rs.10,000
Lease interest payable on borrowed funds 5,000

5,000
(c) Mr Xs position in firm U if he invests the total funds
available
(i) Investment costs
(ii) Total income
(iii) Dividend income (net) Rs.10,156.25 Rs.5,000)

81,250.00
10,156.25
5,156.25
NOTES
It is, thus, clear that Mr X will be better off by selling his securities in the levered firm
and buying the shares of the unlevered firm. With identical risk characteristics of the two
firms, he gets the same income with lower investment outlay in the unlevered firm. He will
obviously prefer switching from the levered to the unlevered firm. Other investors will also,
given the assumption of rational investors, enter into the arbitrage process. The consequent
increasing demand for the securities of the levered firm will lead to an increase in the
market price of its shares. At the same time, the price of the shares of the levered firm will
decline. This will continue till it is possible to reduce the investment outlays and get the
same return. Beyond this point, switching from firm L to firm U or arbitrage will not be
identical is the point of equilibrium. At this point, the total value of the two firms would be
identical. The cost of capital of the two firms would also be the same. Thus, it is unimportant
what the capital structure of firm L is. The weighted cost of capital (k
Q
) after the investors
exercise their home-made leverage is constant because investors exactly offset the firms
leverage with their own.
10.1.3.3 Arbitrage Process: Reverse Direction
According to the MM hypothesis, since debt financing has no advantage, it has no
disadvantage .either. In other words, just as the total value of a levered firm cannot be
more than that of an unlevered firm, the value of an unlevered firm cannot be greater than
the value of a levered firm. This is because the arbitrage process will set in and depress the
value of the unlevered firm and increase the market price and, thereby, the total value of
the levered firm. The arbitrage would, thus, operate in the opposite direction. Here, the
investors will dispose of their holdings in the unlevered firm and obtain the same return by
acquiring proportionate share in the equity capital and the debt of the levered firm at a
lower outlay without any increase in the risk. This is illustrated in Example 10.4.
Example
Assume that in Example 10.3, the equity-capitalisation rate (K
e
) is 20 per cent in the
case of the levered firm (L), instead of the assumed 16 per cent. The total values of the two
firms are given in Table 10.9.
DBA 1764
NOTES
Table 10.9 Total Value of Firms L and U
Since both firms are similar, except for financing-mix, a situation in which their total
values are different, cannot continue, as arbitrage will drive the two values together.
Suppose, Mr Y has 10 percent shareholdings of firm U. He earns Rs. 10,000 (0.10
x Rs 1,00,000). He will sell his securities in firm U and invest in the undervalued levered
firm L. He can purchase 10 per cent of firm Ls debt at a cost of Rs 50,000 which will
provide Rs.5000 interest and 10 per cent of Ls equity at a cost of Rs 25,000 with an
expected dividend of Rs 5,000 (0.10 x Rs 50,000). The purchase of a 10 per cent claim
against the levered firms income costs Mr Y only Rs 75,000, yielding the same expected
income of Rs 10,000 from the equity shares of the unlevered firm. He would prefer the
levered firms securities as the outlay is lower. Table 10.10 portrays the reverse arbitrage
process.
Table 10.10 Effect of Reverse Arbitrage Process
L U
EBIT
Less interest
Income to equity holders
Equity-capitalisation rate (K
e
)
Market value of equity
Market value of debt
Total value (V)
(K
o
)
B/S
Rs.1,00,000
50,000
50,0000
0.25
2,50,000
5,00,000
7,50,000
0.133
2
Rs.1,00,000
--
1,00,000
0.125
8,00,000
--
8,00,000
0.125
0

(A) Mr. Y current s position in firm U
investment outlay
Dividend income

Rs.80,000
Rs. 10,000
(B) Mr. Ys sells his holding in firm U and purchases 10 per cent of
the levered firms equity and debentures

Investment

Income
Debt
Equity

Total
Rs.50,000
25,000
----------
75,000
Rs.5,000
5,000
10,000

Y would prefer alternative B to A, he is able to earn the same
income with a smaller outlay.

Investment

Income
Debt
Equity

Total
He augments his income by Rs.666.70
Rs.53333.00
26,667.00
-------------
80,000

Rs.5,333.30
5,333.40
10,666.70

NOTES
The above illustrations establish that the arbitrage process will make the values of
both the firms identical. Thus, Modigliani and Miller show that the value of a levered firm
can neither be greater nor smaller than that of an unlevered firm; the two must be equal.
There is neither an advantage nor a disadvantage in using debt in the firms capital structure.
The principle involved is simply that investors are able to reconstitute their former position
by off-setting changes in corporate leverage with personal lever-age. As a result the
investment opportunities available to them are not altered by changes in the capital structure
of the firm.
10.1.3.4 Limitations
Does the MM hypothesis provide a valid framework to explain the relationship between
capital structure, cost of capital and total value of a firm? The most crucial element in the
MM Approach is the arbitrage process which forms the behavioural foundation of, and
provides operational justification to, the MM hypothesis. The arbitrage process, in turn, is
based on the crucial assumption of perfect substitutability of personal/home-made leverage
with corporate leverage. The validity of the MM hypothesis depends on whether the
arbitrage process is effective in the sense that personal leverage is a perfect substitute for
corporate leverage. The arbitrage process is, however, not realistic and the exercise based
upon it is purely theoretical and has no practical relevance.
10.1.3.5.1 Risk Perception
In the first place, the risk perceptions of personal and corporate leverage are different.
If home-made and corporate leverages are perfect substitutes, as the MM Approach
assumes, the risk of which an investor is exposed, must be identical irrespective of whether
the firm has borrowed - (corporate leverage) or the investor himself borrows proportionate
to his share in the firm debt. If not, they cannot be perfect substitutes and consequently the
arbitrage process will not be effective. This risk exposure to the investor is greater with
personal leverage than with corporate leverage. The liability of an investor is limited in
corporate enterprises in the sense that he is liable to the extent of his proportionate
shareholdings in case the company is forced to go into liquidation. The risk to which he is
exposed, therefore, is limited to his relative holding. The liability of an individual borrower
is, on the other hand, unlimited as even his personal property is liable to be used for-
payment to the creditors. The risk to the investor with personal borrowing is higher. In
Example 10.3, for instance, Mr Xs liability (risk), when the firm has borrowed (levered
firm), is Rs 31,250, that is, his 10 per cent share in firm L. If he were to borrow equal to his
proportionate share in the firms debt (Rs 50,000), his total liability will be Rs 80,000.
Thus, investments in a levered firm (corporate leverage) and in an unlevered firm (personal
leverage) are not on an equal footing from the viewpoint of risks to the investors. Since
investors can reasonably be expected to prefer an arrangement which, while giving the
same return, ensures lower risk, the personal and corporate leverages cannot be perfect
substitutes.
DBA 1764
NOTES
10.1.3.5.2 Convenience
Apart from higher risk exposure, the investors would find the personal leverage
inconvenient. This is so because with corporate leverage the formalities and procedures
involved in borrowing are to be observed by the firms while these will be the responsibility
of the investor-borrower in case of personal leverage. That corporate borrowing is more
convenient to the investor means, in other words, that investors would prefer them rather
than to do the job themselves. The perfect substitutability of the two types of leverage is,
thus, open to question.
10.1.3.5.3 Cost
Another constraint on the perfect substitutability of personal and corporate leverage
and, hence, the effectiveness of the arbitrage process is the relatively high cost of borrowing
with personal leverage. If the two types of leverage are to be perfect substitutes, the cost
of borrowing ought to be identical for both: borrowing by the firm and borrowing by the
investor-borrower. If the borrowing costs vary so that they are higher/lower depending on
whether the borrowing is done by a firm or an individual, the borrowing arrangement with
lower cost will be preferred by the investors. That lending costs are not uniform for all
categories of borrowers is, as an economic proposition, well recognised. As a general
rule, large borrowers with high credit-standing can borrow at a lower rate of interest
compared to borrowers who are small and do not enjoy high credit-standing. For this
reason, it is reasonable to assume that a firm can obtain a loan at a cost lower than what the
individual investor would have to pay. As a result of higher interest charges, the advantage
of personal leverage would largely disappear and the MM assumption of personal and
corporate leverages being perfect substitutes would be of doubtful validity. In fact, borrowing
by a firm has definite superiority over a personal loan from the viewpoint of the cost of
borrowing. Investors can be expected to definitely prefer corporate borrowing as they
would not be in the same position by borrowing on personal account.
10.1.3.5.4 Institutional Restrictions
Yet another problem with the MM hypothesis is that institutional restrictions stand
in the way of a smooth operation of the arbitrage process. Several institutional investors
such as Life Insurance Corporation of India, Unit Trust of India, commercial banks and so
on are not allowed to engage in personal leverage. Thus, switching the option from the
unlevered to the levered firm may not apply to all investors and, to that extent, personal
leverage is an imperfect substitute for corporate leverage.
10.1.3.5.5 Double Leverage
A related dimension is that in certain situations, the arbitrage process (substituting
corporate leverage by personal leverage) may not actually work. For instance, when an
investor has already borrowed funds while investing in shares of an unlevered firm. If the
NOTES
value of the firm is more than that of the levered firm, the arbitrage process would require
selling the securities of the overvalued (unlevered) firm and purchasing the securities of the
levered firm. Thus, an investor would have double leverage both in the personal portfolio
as well as in the firms portfolio. The MM assumption would not hold true in such a Institution.
10.1.3.5.6 Transaction Costs
Transaction costs would affect the arbitrage process. The effect of transaction/ flotation
cost is that the investor would receive net proceeds from the sale of securities which will be
lower than his investment holding in the levered/unlevered firm, to the extent of the brokerage
fee and other costs. He would, therefore, have to invest a larger amount in the shares of the
unlevered/ levered firm, than his present investment, to earn the same return.
Personal leverage and corporate leverage are, therefore, not perfect substitutes. This
implies that the arbitrage process will be hampered and will not be effective. To put it
differently, the basic postulate of the MM Approach is not valid. Therefore, a firm may
increase its total value and lower its weighted cost of capital with an appropriate degree
of leverage. Thus, the capital structure of the firm is not irrelevant to its valuation and the
overall cost of capital. In brief, imperfections in the capital market retard perfect
Functioning of the arbitrage: As a consequence, the MM Approach does not appear
to provide a valid framework for the theoretical relationship between capital structure,
cost of capital and valuation of a firm.
10.1.3.5.7 Taxes
Finally, if corporate taxes are taken into account, the MM Approach will fail to explain
the relationship between financing decision and value of the firm. Modigliani and Miller
themselves, as shown below, are aware of it and have, in fact, recognised it.
10.1.3.5.8 Corporate Taxes
As already mentioned, MM agree that the value of the firm will increase and cost of
capital will decline with leverage, if corporate taxes are introduced in the exercise. Since
interest on debt is tax-deductible, the effective cost of borrowing is less than the contractual
rate of interest. Debt, thus, provides a benefit to the firm because of the tax-deductibility
of interest payments. Therefore, a levered firm would have greater market value than an
unlevered firm. Specifically, MM state that the value of the levered firm would exceed that
of the unlevered firm by an amount equal to the levered firms debt multiplied by the tax
rate. Symbolically,
V
i
= V
u
+ B
t
DBA 1764
NOTES
Vi = value of levered firm V
u
= value of unlevered firm B = amount of debt t = tax
rate Since the value of the levered firm is more than that of the unlevered firm, it is implied
that the overall. Cost of capital of the former would be lower than that of the latter.
Equation 10.14 also implies that the market value of a levered firm (V) is equal to the
market value of an unlevered firm (V
u
) in the same risk class plus the discounted present
value of the tax saving resulting from tax-deductibility of interest payments.
Example 10.5
The earnings before interest and taxes are Rs 10 lakh for companies L and U. They
are alike in all respects except that Firm L uses 15 per cent debt of Rs 20 lakh; Firm U
does not use debt. Given the tax rate of 35 per cent, the stakeholders of the two firms will
receive different amounts as shown in Table 10.11.
Table 10.11 Effect of Leverage on Shareholders
The total income to both debt holders and equity holders of levered Company L is
higher. The reason is that while debt holders receive interest without tax-deduction at the
corporate level, equity holders of Company L have their incomes tax after tax-deduction.
As a result, total income to both types of investors increases by the interest payment times
the rate, that is, Rs 3,00,000 x 0.35 = Rs 1,05,000.
Assuming further that the debt employed by Company L is permanent, the advantage
to the firm is equivalent to the present value of the tax shield, that is, Rs 7 lakh (Rs 1,05,000/
0.15). Alternatively, it can be determined with reference to equation 10.15
where t = Corporate tax
r = Rate of interest on debt
B = Amount of debt = 0.35 x Rs 20 lakh = Rs 7 lakh.
Company L Company U
EBIT
Less interest
Earnings before taxes
Less taxes
Income available for equity-holders
Income available for debt-holders and equity-
holders
Rs.10,00,00
3,00,000
7,00,000
2,45,000
4,55,000
7,55,000
Rs.10,00,000
----------------
10,00,000
3,50,000
6,50,000
6,50,000

NOTES
It may be noted that value of levered firm (as shown by equation 10.14) reckons
this tax shield due to debt.
The implication of MM analysis in, this case is that the value of the firm is maximised
when its capital structure contains only debt. In other words, a firm can lower its cost of
capital continually with increased leverage. However, the extensive use of debt financing
would expose business to high probabilities of default; it would find it difficult to meet the
promised payments of interest and principal. Moreover, the firm is likely to incur costs and
suffer penalties if it fails to make payments of interest and principal when they become due.
Legal expenses, disruption of operations, and loss of potentially profitable investment
opportunities may result. As the amount of debt in the capital structure increases, so does
the probability of incurring these costs. Consequently, there are disadvantages of debt;
and excessive use of debt may cause a rise in the cost of capital owing to the increased
financial risk and may reduce the value of the firm. Again, we find that MMs proposition
is unjustified when leverage is extreme, that is, when the firm uses 100 per cent debt and
no equity. Clearly, the optimal capital structure is not one which has the maximum amount
of debt, but, one which has the desired amount of debt, determined at a point and/or range
where the overall cost of capital is minimum. Modigliani and Miller also recognise that
extreme leverage increases Financial risk as also the cost of capital. They suggest that
firms should adopt target debt ratio so as not to violate limits of leverage imposed by
the creditors. This suggestion indirectly admits that there is a safe limit for the use of debt
and firms should not use debt beyond that limit/point. It implies that the cost of capital rises
beyond a certain level on the use of debt. There is, therefore, an optimal capital structure.
10.1.4 Traditional Approach
The preceding discussions clearly show that the Net Income Approach (NI) as
well as Net Operating Income Approach (NOI) represent two extremes as regards the
theoretical relationship between financing decisions as determined by the capital structure,
the weighted average cost of capital and total value of the firm. While the NI Approach
takes the position that the use of debt in the capital structure will always affect the overall
cost of capital and the total valuation, the NOI Approach argues that capital structure is
totally irrelevant. The MM Approach supports the NOI Approach. But the assumptions of
MM hypothesis are of doubtful validity. The Traditional Approach is midway between the
NI and NOI Approaches. It partakes of some features of both these Approaches. It is
also known as the intermediate Approach. It resembles the NI Approach in arguing that
cost of capital firm are not independent of the capital structure. But it does not subscribe
to the view (of NI Approach) that value of a firm will necessarily increase of average. In
one respect it shares a feature with the NOI Approach that beyond a certain degree of
leverage, the overall cost increases leading to a decrease in the total value of the firm. But
it differs from the NOI Approach in that it does not argue that the weighted average cost of
capital is constant for all degrees of leverage. In one respect it shares a feature with the
DBA 1764
NOTES
NOI approach that beyond a certain degree of leverage, the over all cost increases leading
to a decrease in the total value of the firm. But it differs from the NOI approach in that it
does not argue that the weighted average cost of capital is constant for all degrees of
leverage.
The crux of the traditional view relating to leverage and valuation is the through
judicious use of debt equity proposition, a firm can increase its total value and thereby
reduced its overall cost of capital. The rational behind this view is that debt is relatively
cheaper source of funds as compared to ordinary shares. With a change the leverage, that
is, using more debt in place of equity, a relatively cheaper source of funds replaces a
source of funds which involves a relatively higher cost. This obviously causes a decline in
the overall cost of capital. If the debt-equity ratio is raised further, the firm would become
financially more risky to the investors who would penalise the firm by demanding a higher
equity capitalisation rate (k
e
). But the increase in k
e
may not be so high as to neutralise
the benefit of using cheaper debt. In other words, the advantages arising out of the use of
debt is so large that, even after allowing for higher k
e
the benefit of use of the cheaper
source of funds is still available. If, however, the amount of debt is increased further, two
things are likely to happen: (i) owing to increased financial risk, k
e
will record a substantial
rise; (ii) the firm would become very risky to the creditors who also would like to the
compensated by a higher return such that k
i
will rise. The use of debt beyond the certain
point will, therefore, have the effect of raising the weighted average cost of capital and
conversely the total value of the firm. Thus, up to a point/degree of leverage, the use of
debt will favourably affect the value of a firm; beyond the point, use of debt will adversely
affect it. At the level of debt-equity ratio, the capital structure is an optimal capital structure.
Optimum capital structure, the marginal real cost of debt, define to include both implicit
and explicit, will be equal to the real cost of equity. For a debt; equity ratio before that
level the marginal real cost of debt would be less than that of equity capital, while beyond
that level leverage, the marginal real cost of debt would exceed that of equity.
There are, of course, variations to the traditional approach. According to one of
these, the equity capitalisation rate (k
e
) rises only after a certain level of leverage and not
before, so that the use of debt does not necessarily increase the k
e
. This happens only after
a certain degree of leverage. The implication is that a firm can reduce its cost of capital
significantly with the initial use of leverage.
Another of the variant of the Traditional Approach suggests that there is no one
single capital structure, but, there is a range of capital structures in which the cost of capital
(k
0
) is the minimum and the value of the firm is the maximum. In this range, changes in
leverage have very little effect on the value of the firm.
The modulus operandi of the Traditional Approach is illustrated in Example 10.6.
NOTES
Example 10.6
Let us suppose that a firm has 20 per cent debt and. 80 per cent equity in its
capital structure. The cost of debt and the cost of equity are assumed to be 10 per cent
and 15 per cent respectively. What is the overall cost of capital, according to the traditional
approach?
Solution
The overall cost of capital (k
0
) = ki, i.e.
(
+
(
100
80
0.15 i.e. ke
100
20
14 per cent
Further, suppose, the firm wants to increase the percentage of debt to 50. Due to
the increased financial risk, the k
i
and k
e
will presumably rise. Assuming, they are 11 per
cent (k
e
) and 16 per cent (k
e
), the cost of capital (k
0
) would be : 0.11
(
+
(
100
50
16 . 0
100
50
= 13.5 per cent
It can, thus, be seen that with a rise in the debt-equity ratio, k
t
and k
t
increase, but,
k
0
has declined presumably because these increases have not fully offset the advantages of
the cheapness of debt.
Assume further, the level of debt is raised to 70 per cent of the capital structure of
the firm. There would consequently be a sharp rise in risk to the investors as well as
creditors. The k
e
would be, say, 20 per cent and the k
i
14 per cent. k
o
= 0.14
(
+
(
100
30
16 . 0
100
70
= 15.8 per cent
The overall cost of capital has actually risen when the firm tries to employ more of
what appeared, at the previous debt-equity ratio, to be the least costly source of funds,
that is, debt. Therefore, the firm should take into account the consequences of raising the
percentage of debt to 70 per cent on the cost of both equity and debt.
The above illustration eloquently demonstrates that the increasing use of debt does
not always lower k
0
. In fact, excessive use of debt greatly increases financial risk and
completely offsets the advantage of using the lower-cost debt. Therefore, the firm should
consider the two off-setting effects of increasing the propor-tion of debt in the capital
structure: the rise in k
i
, and ke and the decrease or increase in k
0
and total value (V),
generated by using a greater proportion of debt. The traditional Approach is illustrated in
Example 10.7.
DBA 1764
NOTES
Example 10.7
Assume a firm has EBIT of Rs 40,000. The firm has 10 per cent debentures of Rs
1,00,000 and its current equity capitalisation rate is 16 per cent. The current value of the
firm (V) and its overall cost of capital would be, as shown in Table 10.12.
Table 10.12 Total Value and Cost of Capital (Traditional Approach)
The firm is considering increasing its leverage by issuing additional Rs 50,000 debentures
and using the proceeds to retire that amount of equity. If, however, as the firm increases
the proportion of debt, k. would rise to 11 per cent and k
e
to 17 per cent, the total value of
the firm would increase and k
0
would decline as shown in Table 10.13.
Table 10.13 Total Value and Cost of Capital (Traditional Approach)
Less interest (I)
e
)
Total Market value of equity (S) = NI/k
e

Total Market value of debt (B)
Total value of the firm (V) = S + B
Overall cost of capital, k
Q
= EBIT/V
Debt-equity ratio (B/S) = (Rs 1,00,000 + Rs.1,87,500)
Rs 40,000
10,000
30,000
0.16
1,87,500
1,00,000
2,87,500
0.139
0.53
Less Interest (I)
e
)
Total Market value of equity (S) = NI/K
e

Total Market value of debt (B)
Overall cost of capital, = EBIT/V
Debt-equity ratio (B/S)
Rs 40,000
16,500
23,500
0.17
1,38,235
1,50,000
2,88,235
0.138
1.08
NOTES
Let us further suppose that the firm issues additional Rs 1,00,000 debentures instead
of Rs 50,000 (that is, having Rs 2,00,000 debentures) and uses the proceeds to retire that
amount of equity. Due to increased financial risk, k. would rise to 12.5 per cent and k
e
to
20 per cent, the total value of the firm would decrease and k
0
would rise as is clear from
Table 10.14.
Table 10.14: Total Value and Cost of Capital (Traditional Approach)
In Example 10.7, it is clear that the optimal debt equity must less than 2.67 since at
this ratio, the value of the firm is Rs 2,75,000, while at a debt-equity ratio of 1.08 it is Rs
2,88,235. The traditional Approach suggests that:
Other things being equal, the market value of a companys securities will rise as the
amount of leverage (L) in its financial structure is increased from zero to some point
determined by the capital markets evaluation of the level of business uncertainty involved.
Beyond this point and up to a second point, changes in leverage have very little effect, that
is, within this range of leverage the total market value of the company is unchanged as
leverage changes. Beyond this range of acceptable leverage, the total market value of
other things will decline with further increase in L.
The effect of increase in leverage from zero, on cost of capital and valuation of the
firm, can be thought to involve three distinct phase.
10.2 INCREASED VALUATION AND DECREASED OVERALL COST OF
CAPITAL
During the first phase, increasing leverage increases the total valuation of the firm and
lowers the overall cost of capital. As the proportion of debt in the capital structure increases,
the cost of equity (K
e
) begins to rise as a reflection of the increased financial risk. But it
Less interest (f)

e
)

Total Market value of equity (S) = NI/K
e
Total Market value of debt

Overall cost of capital, K
o
= EBIT/V
Debt-equity ratio (B/S) (Rs 2,00,000/ Rs 75,000)
Rs. 40,000
25,000
---------------
15,000
0.20
---------------
75,000
2,00,000
---------------
2,75,000
0.145
2.67
DBA 1764
NOTES
does not rise fast enough to off set the advantage of using the cheaper source of debt
capital. Likewise, for most of the range of this phase, the cost of debt (K
i
.) either remains
constant or rises to a very small extent because the proportion of debt by the lender is
considered to be within safe limits. Therefore, they are prepared to lend to the firm at
almost the same rate of interest. Since debt is typically a cheaper source of capital than
equity, the combined effect is that the overall cost of capital begins to fall with the increasing
use of debt. Example 10.7 has shown that an increase in leverage (B/S) from 0.53 to 1.08
has had the effect of increasing the total market value from Rs 2,87,500 to Rs 2,88,235
and decreasing the overall capitalisation rate from 13.9 to 13.8 per cent.
10.3 CONSTANT VALUATION AND CONSTANT OVERALL COST OF
CAPITAL
After a certain degree of leverage is reached, further moderate increases in leverage
have little or no effect on total market value. During the middle range, the changes brought
in equity-capitalisation rate and debt-capitalisation rate balance each other. As a result, the
values of (V) and (k
0
) remain almost constant.
10.4 DECREASED VALUATION AND INCREASED OVERALL COST OF
CAPITAL
Beyond a certain critical point, further increases in debt proportions are not considered
desirable. They increase financial risks so much that both k
e
and K
i
start rising rapidly
causing (k
Q
) to rise and (V) to fall. In Example 10.7, the effect of an increase in B/S ratio
from 1.08 to 2.67 is to increase (k
o
) from 13.8 to 14.5 per cent and to decrease (V) from
Rs 2,88,235 to Rs 2,75,000.
Table 10.15 Leverage, Capitalisation Rates and Valuation
B ki(%) EBIT L NI
(EBIT)
K0
(%)
Number
of
shares
Amount of
shares
(book
value)
S
(Ni
+k
e
)
Market
value
per
share
V K
0
L
1
L
2

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
0
100
200
300
400
500
600
700
800
4.0
4.0
4.0
4.2
4.5
5.0
5.5
7.0
8.5
Rs.100
100
100
100
100
100
100
100
100
Rs.Nil
4.0
8.0
12.6
18.0
25.0
33.0
49.0
68.0
Rs.100
960
92
87.4
82
75
67
51
32
100
96
92
87.4
82
75
67
51
32
10.0
10.0
10.3
10.8
11.5
12.3
13.1
14.0
15.0
10.0
10.0
10.3
10.8
11.5
12.3
13.1
14.0
15.0
100
90
80
70
60
50
40
30
20
1,000
960
893
810
711
611
512
364
213
1,000
10.67
10.16
11.57
11.85
12.22
12.80
12.13
10.65
1,000
1,060
1,093
1,111
1,111
1,111
1,111
1,064
1,013
10.2
9.4
9.1
9.0
9.0
9.0
9.0
9.4
9.9
0
0.10
0.22
0.33
0.56
0.82
1.17
1.92
3.76
0
0.09
0.18
0.27
0.36
0.45
0.54
0.65
0.79

NOTES
Tables 10.15 reveal that with an increase in leverage (B/V) from zero to 0.27, the
market value of the firm increases (from Rs 1,000 to Rs 1,111) and the overall cost of
capital declines from 10 to 9 per cent (Phase I). With further increases in leverage from
0.27 up to 0.54, there is no change either in (V) or in (k
0
); both the values remain constant,
that is, Rs 1,111 and 9 per cent respectively (Phase 2). During Phase 3, with an increase in
the ratio beyond 0.54 up to 0.79, there is a decrease in market value of the firm (from Rs
1,111 to Rs 1,013) and an increase in (k
Q
) (from 9 to 9.4 per cent), suggesting that the
optimal leverage lies within the range of 0.27 to 0.54 debt-equity ratio.
The traditional view on leverage is commonly referred to as one of U shaped
cost of capital curve. In such a situation, the degree of leverage is optimum at a point at
which the rising marginal cost of borrowing is equal to the average overall cost of capital.
For this purpose, marginal cost of a unit of debt capital consists of two parts: (i) the
increase in total interest payable on debt; (ii) the amount of extra net earnings required to
restore the value of equity component to what it would have been under the pre-existing
capitalisation rate before the debt is increased.
Thus, in Table 10.15, the marginal cost of borrowing the seventh to Rs 100 units of
funds is Rs 19 or 19 per cent. It is determined as follows:
Since the marginal cost of debt is 19 per cent, while the over all cost of capital is 9 per
cent, the use of more debt at this stage is imprudent. In other words, a mix of debt of
Rs.600 with equity capital of Rs 400 provides the optimum combination of debt and
equity and optimum capital structure.
Thus, according to the traditional approach, the cost of capital of a firm as also its
valuation is dependent upon the capital structure of the firm and there is an optimum capital
structure in which the firms k
0
is minimum and its (V) the maximum.
Summary
To summarise, there are sharp differences of opinion in academic literature on the
theoretical relationship between capital structure, cost of capital and valuation.
(i) increase in total interest payable (i) Rs.16
Rs.49 when B is Rs.700) Rs.33 (when B is 600)
Plus (ii) increase in net income required for share holders
(When the value of a share is Rs.12,13 the required earnings are Rs.51.
Therefore to maintain the value of share at Rs.12.80, the earnings are

Rs. 43 i.e.
(
Rs.12.13
Rs.12.80
x Rs.51; thus, the increased earnings required is Rs.3)
Rs.16

3

DBA 1764
NOTES
The NI Approach at one extreme argues that leverage always affects the (k
0
) and the
(V) of a firm. There is an optimum capital structure at which the value of the firm is the
highest and the cost of capital is the lowest.
The NOI Approach, in contrast, is at the other extreme of the spectrum. According
to this Approach, capital structure is totally irrelevant.
Modigliani and Miller concur with NOI and provide behavioural support to its basic
proposition. However, the basic premises of the MM Approach are of doubtful validity.
As a result, the arbitrage process is impeded. To the extent the arbitrage process is imperfect,
it may be inferred that the capital structure matters. It implies with a judicious mixture of
debt and equity, the (V) and (k
0
) can be altered. The NOI Approach takes an extreme
position. Modigliani and Miller also agree that with corporate taxes debt has a definite
advantage as it is tax-deductible and leverage will lower the overall cost of capital. The
MM position implies, like the NI Approach, that cost of capital will decline continually
with the degree of leverage.
The Traditional Approach strikes a balance between these extremes. A firm can increase
its (V) and reduce its (k
0
,) up to a point, but beyond that point, the use of further debt will
lead to arise in the weighted average cost of capital. At that point the capital structure is
optimum.
Although the empirical testing has been only suggestive with respect to the true
relationship between leverage and cost of capital, the Traditional Approach provides a
fairly close approximation of the position. The optimum capital structure would, of course,
vary from case to case. In other words, an appropriate capital structure will depend upon
the circumstances of each case. The factors which have a bearing on the determination of
an appropriate capital structure are, therefore, outlined in the next chapter.
Review Questions
1) Explain the assumptions and implications of the NI approach and the NOI
approach. Illustrate your answer with hypothetical examples.
2) Describe the Traditional view on the optimum capital structure. Compare and
contrast this view with NOI approach and NI approach.
3) Explain the position of M-M on the issue of an optimum capital structure, ignoring
the corporate income tax. Use an illustration to show how home-made leverage
by an individual investor can replicate the same risk and return as provided by the
levered firm.
4) Assuming the existence of the corporate income taxes, describe M-Ms position
on the issue of an optimum capital structure.
5) M-M thesis is based on unrealistic assumptions. Evaluate the reality of the
assumptions made by M-M.
6) How does the cost of the equity behave with leverage under the traditional view
and the M-M position?
NOTES
CHAPTER 11
DETERMINANTS OF OPTIMUM CAPITAL STRUCTURE
Some companies do not plan their capital structures; it develops as a result of the
financial decisions taken by the financial manager without any formal policy and planning.
Financing decisions are reactive and they evolve in response to the operating decisions.
These companies may prosper in the short-run, but ultimately they may face considerable
difficulties in raising funds to finance their activities. With unplanned capital structure, these
companies may also fail to economise the use of their funds.
Consequently, it is being increasingly realised that a company should plan its capital
structure to maximise the use of the funds and to be able to adapt more easily to the
changing conditions.
Theoretically, the financial manager should plan an optimum capital structure for
his company. The optimum capital structure is one that maximises the market value of the
firm. What we have discussed in the last chapter has been theoretical. In practice, the
determination of an optimum capital structure is a formidable task, and one has to go
beyond the theory. There are significant variations among industries and among companies
within an industry in terms of capital structure. Since a number of factors influence the
capital structure decision of a company, the judgment of the person making the capital
structure decision plays a crucial part. Two similar companies may have different capital
structures if the decision-makers differ in their judgment of the significance of various factors.
A totally theoretical model perhaps cannot adequately handle all those factors, which affect
the capital structure decision in practice. These factors are highly psychological, complex
and qualitative and do not always follow accepted theory, since capital markets are not
perfect and the decision has to be taken under imperfect knowledge and risk.
The board of directors or the chief financial officer (CFO) of a company should
develop an appropriate or target capital structure, which is most advantageous to the
company. This can be done only when all those factors, which are relevant to the companys
capital structure decision, are properly analysed and balanced. The capital structure should
be planned generally keeping in view the interests of the equity shareholders and the financial
requirements of a company. The equity shareholders, being the owners of the company
and the providers of risk capital (equity), would be concerned about the ways of financing
a companys operations. However, the interests of other groups, such as employees,
customers, creditors, society and government, should also be given reasonable
consideration. When the company lays down its objective in terms of the shareholder
wealth maximisation (SWM), it is generally compatible with the interests of other groups.
Thus, while developing an appropriate capital structure for its company, the financial manager
should inter alia aim at maximising the long-term market price per share. Theoretically,
there may be a precise point or range within which the market value per share is maximum.
DBA 1764
NOTES
In practice, for most companies within an industry there may be a range of an appropriate
capital structure within which there would not be great differences in the market value per
share. One way to get an idea of this range is to observe the capital structure patterns of
companies vis--vis their market prices of shares. It may be found empirically that there
are not significant differences in the share values within a given range. The management of
a company may fix its capital structure near the top of this range in order to make maximum
use of favourable leverage, subject to other requirements such as flexibility, solvency, control
and norms set by the financial institutions, the Security Exchange Board of India (SEBI)
and stock exchanges.
11.1 ELEMENTS OF CAPITAL STRUCTURE
A company formulating its long-term financial policy should, first of all, analyse its
current financial structure. The following are the important elements of the companys
financial structure that need proper scrutiny and analysis
.
11.1.1 Capital Mix
Firms have to decide about the mix of debt and equity capital. Debt capital can be
mobilised from a variety of sources. How heavily does the company depend on debt?
What is the mix of debt instruments? Given the companys risks, is the reliance on the level
and instruments of debt reasonable? Does the firms debt policy allow it flexibility to undertake
strategic investments in adverse financial conditions? The firms and analysts use debt ratios,
debt-service coverage ratios, and the funds flow statement to analyse the capital mix.
11.1.2 Maturity and Priority
The maturity of securities used in the capital mix may differ. Equity is the most permanent
capital. Within debt, commercial paper has the shortest maturity and public debt longest.
Similarly, the priorities of securities also differ. Capitalised debt like lease or hire purchase
finance is quite safe from the lenders point of view and the value of assets backing the
debt provides the protection to the lender. Collateralised or secured debts are relatively
safe and have priority over unsecured debt in the event of insolvency. Do maturities of the
firms assets and liabilities match? If not, what trade-off is the firm making? A firm may
obtain a risk-neutral position by matching the maturity of assets and liabilities; that is, it may
use current liabilities to finance current assets and short-medium and long-term debt for
financing the fixed assets in that order of maturities. In practice, firms do not perfectly
match the sources and uses of funds. They may show preference for retained earnings.
Within debt, they may use long-term funds to finance current assets and assets with shorter
life. Some firms are more aggressive, and they use short-term funds to finance long-term
assets.
NOTES
11.1.3 Terms and Conditions
Firms have choices with regard to the basis of interest payments. They may obtain
loans either at fixed or floating rates of interest. In case of equity, the firm may like to return
income either in the form of large dividends or large capital gains. What is the firms preference
with regard to the basis of payments of interest and dividend? How do the firms interest
and dividend payments match with its earnings and operating cash flows? The firms choice
of the basis of payments indicates the managements assessment about the future interest
rates and the firms earnings. Does the firm have protection against interest rates fluctuations?
The financial manager can protect the firm against interest rates fluctuations through the
interest rates derivatives.

There are other important terms and conditions that the firm
should consider. Most loan agreements include what the firm can do and what it cant do.
They may also state the schemes of payments, pre-payments, renegotiations etc. What are
the lending criteria used by the suppliers of capital? How do negative and positive conditions
affect the operations of the firm? Do they constraint and compromise the firms operating
strategy? Do they limit or enhance the firms competitive position? Is the company level to
comply with the terms and conditions in good time and bad time?
11.1.4 Currency
Firms in a number of countries have the choice of raising funds from the overseas
markets. Overseas financial markets provide opportunities to raise large amounts of funds.
Accessing capital internationally also helps company to globalise its operations fast. Because
international financial markets may not be perfect and may not be fully integrated, firms
may be able to issue capital overseas at lower costs than in the domestic markets. The
exchange rates fluctuations can create risk for the firm in servicing it foreign debt and
equity. The financial manager will have to ensure a system of risk hedging. Does the firm
borrow from the overseas markets? At what terms and conditions? How has firm benefited
- operationally and or financially in raising funds overseas? Is there a consistency between
the firms foreign currency obligations and operating inflows?
11.1.5 Financial innovations
Firms may raise capital either through the issues of simple securities or through the
issues innovative securities. Financial innovations are intended to make the security issue
attractive to investors and reduce cost of capital. For example, a company may issue
convertible debentures at a lower interest rate rather than non-convertible debentures at a
relatively higher interest rate. A further innovation could be that the company may offer
higher simple interest rate on debentures and offer to convert interest amount into equity.
The company will be able to conserve cash outflows. A firm can issue varieties of option-
linked securities; it can also issue tailor-made securities to large suppliers of capital. The
financial manager will have to continuously design innovative securities to be able to reduce
the cost. An innovation introduced once does not attract investors any more. What is the
DBA 1764
NOTES
firms history in terms of issuing innovative securities? What were the motivations in issuing
innovative securities and did the company achieve intended benefits?
11.1.6 Financial market segments
There are several segments of financial markets from where the firm can tap capital.
For example, a firm can tap the private or the public debt market for raising long-term
debt. The firm can raise short-term debt either from banks or by issuing commercial papers
or certificate deposits in the money market. The firm also has the alternative of raising
short-term funds by public deposits. What segments of financial markets have the firm
tapped for raising funds and why? How did the firm tap and approach these segments?
11.2 FRAMEWORK FOR CAPITAL STRUCTURE: THE FRICT ANALYSIS
A financial structure may be evaluated from various perspectives. From the owners
point of view return, risk and value are important considerations. From the strategic point
of view, flexibility is an important concern. Issues of control, flexibility and feasibility assume
great significance. A sound capital structure will be achieved by balancing all these
considerations:
- Flexibility The capital structure should be determined within the debt capacity of
the company, and this capacity should not be exceeded. The debt capacity of a
company depends on its ability to generate future cash flows. It should have enough
cash to pay creditors fixed charges and principal sum and leave some excess
cash to meet future contingency. The capital structure should be flexible. It should
be possible for a company to adapt its capital structure with a minimum cost and
delay if warranted by a changed situation. It should also be possible for the company
to provide funds whenever needed to finance its profitable activities.
- Risk The risk depends on the variability in the firms operations. It may be caused
by the macroeconomic factors and industry and firm specific factors. The excessive
use of debt magnifies the variability of shareholders earnings, and threatens the
solvency of the company.
- Income The capital structure of the company should be most advantageous to the
owners (shareholders) of the firm. It should create value; subject to other
considerations, it should generate maximum returns to the shareholders with
minimum additional cost.
- Control The capital structure should involve minimum risk of loss of control of the
company. The owners of closely held companies are particularly concerned about
dilution of control.
- Timing The capital structure should be feasible to implement given the current
and future conditions of the capital market. The sequencing of sources of financing
is important. The current decision influences the future options of raising capital.
NOTES
The FRICT (flexibility, risk, income, control and timing) analysis provides the general
framework for evaluating a firms capital structure. The particular characteristics of a
company may reflect some additional specific features. Further, the emphasis given to
each of these features will differ from company to company. For example, a company may
give more importance to flexibility than control, while another company may be more
concerned about solvency than any other requirement. Furthermore, the relative importance
of these requirements may change with shifting conditions. The companys capital structure
should, therefore, be easily adaptable.
11.3 APPROACHES TO ESTABLISH TARGET CAPITAL STRUCTURE
The capital structure will be planned initially when a company is incorporated. The
initial capital structure should be designed very carefully. The management of the company
should set a target capital structure and the subsequent financing decisions should be
made with a view to achieve the target capital structure. The financial manager has also to
deal with an existing capital structure. The company needs funds to finance its activities
continuously. Every time when funds have to be procured, the financial manager weighs
the pros and cons of various sources of finance and selects the most advantageous sources
keeping in view the target capital structure. Thus, the capital structure decision is a continuous
one and has to be taken whenever a firm needs additional finances. The following are the
three most common approaches to decide about a firms capital structure:
- EBIT-EPS approach for analysing the impact of debt on shareholders return and
risk.
- Valuation approach for determining the impact of debt on the shareholders value.
- Cash flow approach for analysing the firms ability to service debt and avoid
financial distress.
11.3.1 EBIT-EPS Analysis
The EBIT-EPS analysis is an important tool to analyse the impact of alternative financial
plans on the shareholders income and its variability. The firm should consider the possible
fluctuations in EBIT and examine their impact on EPS (or ROE) under different financial
plans. If the probability of the rate of return on the firms assets falling below the cost of
debt is low, the firm can employ high debt to increase EPS. Other things remaining the
same, this may also have a favourable effect on the market value the firms share. On the
other hand, if the probability of the rate of return on the firms assets falling below the cost
of debt is very high, the firm should refrain from employing too much debt capital. Thus,
the greater the level of EBIT and lower the probability of downward fluctuations, the more
beneficial it is to employ debt. However, it should be realised that the EBIT-EPS analysis
is a first step in deciding about a firms capital structure. It suffers from certain limitations
and does not provide unambiguous - guide in determining the level of debt in practice.
DBA 1764
NOTES
EPS is one of the most widely used measures of a companys performance in practice.
Hence, in choosing between debt and equity, sometimes too much attention is paid on
EPS, which, however, has serious limitations as a financing-decision criterion. The major
shortcomings of the EPS as a financing-decision criterion are:
- It is based on arbitrary accounting assumptions and does not reflect the economic
profits.
- It does not consider the time value of money.
- It ignores the variability about the expected value of EPS, and hence, ignores risk.
The belief that investors would be just concerned with the expected EPS is not well
founded. Investors in valuing the shares of the company consider both expected value and
risk (variability).
11.3.1.1 EPS variability and financial risk
We know that the EPS variability, resulting from the use of leverage, causes financial
risk. The extreme variability in earnings can threaten the firms solvency. A firm can avoid
financial risk altogether if it does not employ any debt. But then the shareholders will be
deprived of the benefit of the expected increases in EPS. Therefore, a company may
employ debt to take advantage of the increase in earnings provided shareholders do not
perceive the financial risk exceeding the benefit of increased EPS. As we have discussed
earlier in this chapter, as a firm increases the use of debt, the expected EPS may continue
to increase, but the value of the company may fall because of the greater exposure of
shareholders to financial risk in the form of financial distress. Shareholders expect higher
compensation for taking the additional financial risk.
The EPS criterion does not consider the long-term perspectives of financing decisions.
It fails to deal with the risk-return trade-off. A long-term view of the effects of financing
decisions will lead one to a criterion of wealth maximisation rather than EPS maximisation.
The EPS criterion is an important performance measure but not a decision criterion.
Given its limitations, should the EPS criterion be ignored in making financing decisions?
Remember that it is an important index of the firms performance and that investors rely
heavily on it for their investment decisions. Investors also do not have information on the
projected earnings and cash flows and they base their evaluation on historical data. In
choosing between alternative financial plans, management should start with the evaluation
of the impact of each alternative on near-term EPS. But the best interests of shareholders
should guide managements ultimate decision making. Therefore, a long-term view of the
effect of the alternative financial plans on the value of the shares should be taken. If
management opts for a financial plan, which will maximise value in the long run but has an
adverse impact on near-term EPS, the reasons must be communicated to investors. A
careful communication to market will be helpful in reducing the misunderstanding between
management and investors.
NOTES
11.3.1.2 Operating conditions and business risk
The level and variability of EPS depends is the growth and stability of sales. EPS
will fluctuate with fluctuations in sales. The magnitude of the EPS variability with sales will
depend on the degrees of operating and financial leverages employed by the company. A
firm with stable sales and favourable cost and price structure and well-focused operating
strategy will have stable earnings and cash flows and thus, it can employ a high degree of
financial leverage; it will not face difficulty in meeting the fixed charges commitments of
debt. The likely fluctuations in sales increase the business risk. A small change in sales can
lead to a dramatic change in the earnings of a company when its fixed costs are high. The
fixed interest charges shift the break-even point upward. Hence, shareholders perceive a
high degree of financial risk if companies with high operating leverage employ high amount
of debt. A company will get into a debt trap if operating conditions become unfavourable
and if it lacks a well articulated, focused strategy (see Exhibit 11.1 for an example of a
company in a debt trap).
Sales of the consumer goods industries show wide fluctuations; therefore, they do not
employ a large amount of debt. On the other hand, the sales of public utilities are quite
stable and predictable. Public utilities, therefore, employ a large amount of debt to finance
their assets. The expected growth in sales also affects the degree of leverage. The greater
the expectation of growth, the greater the amount of external financing needed since it may
not be possible for the firm to cope up with growth through internally generated funds. A
number of managers consider debt to be cheaper and easy to raise. The growth firms,
therefore, may usually employ a high degree of leverage. Companies with declining sales
should not employ debt, as they would find difficulty in meeting their fixed obligations.
Non-payment of fixed charges can force a company into liquidation. It may be noted that
sales growth and stability is just one factor in the leverage decision; many other factors
would dictate the final decision. There are instances of a large number of high growth firms
employing no or small amount of debt.
EXHIBIT 11.1: DEBT TRAP: CASE OF HINDUSTAN SHIPYARD
- The fluctuating raw materials and component prices cause ups and downs in the
revenues and profits of a ship-building company. With the right operating strategy
and appropriate prudent financing, a company can manage to sail safely. Hindustan
Shipyard Limited (HSL), however, found it quite difficult to come out of the troubled
waters due to huge borrowings. In 1990, it had total outstanding debt of Rs 554
crore: working capital loan Rs 138 crore, development loan for modernisation Rs
69 crore, and outstanding interest on these loans Rs 160 crore; cash credit Rs 62
crore, outstanding interest on cash credit Rs 65 crore and penal interest Rs 60
crore. How did this happen?
- HSLs trouble began when, between 1981 and 1982, Japanese and South Korean
shipbuilders started offering heavily subsidised rates against the rates fixed by
DBA 1764
NOTES
the Indian government, based on international parity price. In effect, building ships
turned out to be unviable for the yard. Further, HSLs overtime wages bill soared
up, being a highly overstaffed company. It had 11,000 workers in 1990. A lack of
strategy paved way for unchecked downfall. Orders continued declining, and
became almost nil by 1988 and 1989. To tide over this, company borrowed funds,
and since operating performance did not improve, the company fell deeper and
deeper into debt trap.
- HSL was technically insolvent. The capital restructuring plans helped to put the
company back on its feet.
11.3.2 Valuation Approach
We have discussed that shareholders assume a high degree of risk than debt-holders.
Hence debt is a cheaper source of funds than equity. But debt causes financial risk, which
increases the cost of equity. Higher debt increases the costs of financial distress and the
agency costs also increase. The tax deducibility of interest charges, however, adds value
to shareholders. Thus, there is a trade-off between the tax benefits and the costs of financial
distress and agency problems. The firm should employ debt to the point where the marginal
benefits and costs are equal. This will be the point of maximum value of the firm and
minimum weighted average cost of capital.
The difficulty with the valuation framework is that managers find it difficult to put into
practice. It is not possible for them to quantify the effect of debt on the value of the firm.
Also, the operations of the financial markets are so complicated that it is not easy for the
financial managers to understand them. But the analysis of the impact of debt on the value
is crucial and it must be carried out. A financial manager should think and act like investors.
He or she must determine the contribution of alternative financial policies in creating value
for shareholders. The most desirable capital structure is the one that creates the maximum
value.
11.3.3 Cash Flow Analysis
One practical method of assessing the firms ability to carry debt without getting into
serious financial distress is to carry out a comprehensive cash flow analysis over a long
period of time. A sound capital structure is expected to be conservative. Conservatism
does not mean employing no debt or small amount of debt. Conservatism is related to the
firms ability to-generate cash to meet the fixed charges created by the use of debt in the
capital structure under adverse conditions. Hence, in practice, the question of the optimum
debt-equity mix boils down to the firms ability to service debt without any threat of insolvency
and operating inflexibility. A firm is considered prudently financed if it is able to service its
fixed charges under any reasonably predictable adverse conditions.
The fixed charges of a company include payment of interest and principal, and they
depend on both the amount of loan, interest rates and the terms of payment. The amount of
NOTES
fixed charges may be high if the company employs a large amount of debt with short-term
maturity. Whenever a company thinks of raising additional debt, it should analyse its expected
future cash flows to meet the fixed charges. It is mandatory to pay interest and repay the
principal amount of debt. If a company is not able to generate enough cash to meet its fixed
obligation, it may face financial distress leading to insolvency. The companies expecting
larger and stable cash inflows in the future can employ a large amount of debt in their
capital structure. It is quite risky to employ high amount of debt by those companies whose
cash inflows are unstable and unpredictable. It is possible for a high growth, profitable
company to suffer from cash shortage if its liquidity (working capital) management is poor.
We have examples of Indian companies like BHEL and NTPC, whose debtors are very
sticky and they continuously face liquidity problem in spite of being profitable and high
growth companies. Servicing debt proves burdensome for these companies.
11.3.3.1 Debt-servicing coverage ratio
One-important ratio, which should be examined at the time of planning the capital
structure, is the ratio of expected net operating cash flows to fixed charges or the debt-
servicing coverage ratio. This ratio indicates the number of times the fixed financial obligations
are covered by the net operating cash flows generated by the company. The greater is the
expected coverage ratio, the greater is the amount of debt a company could use. However,
a company with a small coverage can also employ high amount of debt if there are not
significant yearly variations in its operating cash flows and if there is a low probability of
these cash flows being considerably less to meet fixed charges in a given period. Thus, it is
not the average cash flows but the yearly cash flows, which are important to determine the
debt capacity of a company. Fixed financial obligations must be met when due, not on an
average or in most years, but always. This requires a full cash flow analysis showing the
impact of different capital structures under different economic conditions.
11.3.3.2 Debt capacity
The technique of cash flow analysis is helpful in determining a firms debt capacity.
Debt capacity is the amount, which a firm can service easily even under adverse conditions;
it is the amount that the firm should employ. There may be lenders who are prepared to
lend to the firm at higher interest rates. But the firm should borrow only if it can service
debt without any problem. A firm can avoid the risk of financial distress if it can maintain its
ability to meet contractual obligation of interest and principal payments. Debt capacity,
therefore, should be thought in terms of the operating cash flows servicing debt rather than
debt ratios. A high debt ratio is not necessarily bad. If a firm can service high amount of
debt without much financial risk, it will increase shareholders wealth. On the other hand, a
low debt ratio can prove to be burdensome for a firm, which has liquidity problem. A firm
faces financial distress (or even insolvency) when it has cash flow problem. It is dangerous
to finance a capital-intensive project out of borrowings, which has built in uncertainty
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NOTES
about the earnings and cash flows. National Aluminium Company is an example of a wrong
initial choice of capital structure, which was inconsistent with its operating conditions (see
Exhibit 11.2).
Some companies define their target capital structure or debt capacity in terms of the
debt rating they desire. They choose the debt-equity ratio consistent with the debt rating.
They work out the financial consequences of this choice and adjust their operations and
other sources of finance ensuring the feasibility of the chosen capital structure.
11.3.3.3 Components of cash flows
The cash flows should be analysed over a long period of time, which can cover the
various adverse phases, for determining the firms debt policy. The cash flow analysis
involves preparing proforma cash flow statements showing the firms financial conditions
under adverse conditions such as a recession. The expected cash flows can be categorised
into three groups:
- Operating cash flows
- Non-operating cash flows
- Financial flows
EXHIBIT 11.2: DEBT BURDEN UNDER CASH CRUNCH SITUATION CASE
OF NALCO
National Aluminium Company (NALCO), started in 1981, is the largest integrated
aluminium complex in Asia of total investment of Rs 2,408 crore, borrowings from a
consortium of European banks financed to the extent of $ 830 million or Rs. 1,119 crore
(46.5 percent). The loan was repayable by 1995. Aluminium is an electricity-intensive
business; each tonne of aluminium needs over 15,000 kw of electricity. Since its
commissioning inl988, Nalco has exported substantial portion of its production since the
domestic demand has been very low than what the company had projected at its inception.
The falling international prices in last few years have eroded the companys profitability.
The net profit of Rs 172 crore in 1989 dropped to Rs 14 crore in 1991-92. The Rs 1,119
crore Eurodollar loan has appreciated to Rs 2,667 crore inspite of having repaid Rs 644
crore. Due to profitability and liquidity problem and hit by the depreciating rupee and the
liberalised exchange mechanism, the company is forced to reschedule repayments of its
debt by the year 2003 instead of 1995. Nalcos debt-equity ratio has increased from 1:1
to 2.7:1.
- The reasons for Nalcos plight are its decision to go for the production of aluminium
which consumes heavy electricity in addition to alumina. The problem of power
shortage led to the setting up of power plant, which is proving very costly to the
company. The overcapacities of aluminium production worldwide and highly
NOTES
competitive prices have added to Nalcos woes. Nalco is trying to get out of its
problems by attempting to diversify into value-added products.
- Nalcos fate can change if the domestic demand for aluminium picks up and
international prices rise. The mounting debt of the company poses a question:
Should you use heavy dose of debt (since it is available from certain sources) to
finance investments in a business like aluminium which has worldwide overcapacity,
fluctuating international prices and expensive and short supply of electricity in the
country in which it is set up? Debt would accentuate the financial crises when a
company has built-in operating uncertainties.
Operating cash flows relate to the operations of the firm and can be determined from the
projected profit and loss statements. The behaviour of sales volume, output price and
input price over the period of analysis should be examined and predicted
Non-operating cash flows generally include capital expenditures and working capital
changes. During a recessionary period, the firm may have to specially spend on advertising
etc. for the promotion of the product. Such expenditures should be included in the non-
operating cash flows. Certain types of capital expenditures cannot be avoided even during
most adverse conditions. They are necessary to maintain the minimum operating efficiency
of the firms resources. Such irreducible, minimum capital expenditures should be clearly
identified.
Financial flows include interest, dividends, lease rentals, repayment of debt etc. They are
further divided into: contractual obligations and policy obligations. Contractual obligations
include those financial obligations, like interest, lease rentals and principal payments that
are matters of contract, and should not be defaulted.
Policy obligations consist of those financial obligations, like dividends, that are at the
discretion of the board of directors. Policy obligations are also called discretionary
obligations.
The cash flow analysis may indicate that a decline in sales, resulting in profit decline or
losses, may not necessarily cause cash inadequacy. This may be so because cash may be
realised from permanent inventory and receivable. Also, some of the permanent current
liabilities may decline with fall in sales and profits. On the other hand, when sales and
profits are growing, the firm may face cash inadequacy, as large amount of cash is needed
to finance growing inventory and receivable. If the profits decline due to increase in expenses
or falling output prices, instead of the decline in the number of units sold, the firm may face
cash inadequacy because its funds in inventory and receivable will not be released. The
point to be emphasised is that a firm should carry out cash flow analysis to get a clear
picture of its ability to service debt obligations even under the adverse conditions, and
thus, decide about the proper amount of debt. The firm must examine the impact of
alternative debt policies on the firms cash flow ability. The firm should then choose the
debt policy, which it can implement.
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NOTES
11.3.3.4 Utility of cash flow analysis
Is cash flow analysis superior to EBIT-EPS analysis? How does it incorporate the
insights of the finance theory? The cash flow analysis has the following advantages
- It focuses on the liquidity and solvency of the firm over a long period of time,
even encompassing adverse circumstances. Thus, it evaluates the firms ability to
meet fixed obligations.
- It is more comprehensive and goes beyond the analysis of profit and loss statement
and also considers changes in the balance sheet items.
- It identifies discretionary cash flows. The firm can thus prepare an action plan to
face adverse situations.
- It provides a list of potential financial flows, which can be utilised under emergency
It is a long-term dynamic analysis and does not remain confined to a single period
analysis.
The most significant advantage of the cash flow analysis is that it provides a practical
way of incorporating the insights of the finance theory. As per the theory, debt financing has
tax advantage. But it also involves risk of financial distress. Therefore, the optimum amount
of debt depends on the trade-off between tax advantage of debt and risk of financial
distress. Financial distress occurs when the firm is not in a position to meet its contractual
obligations. The cash flow analysis indicates when the firm will find it difficult to service its
debt. Therefore, it is useful in providing good insights to determine the debt capacity,
which helps to maximise the market value of me firm.
11.3.3.5 Cash flow analysis versus debt-equity ratio
The cash flow analysis might reveal that a higher debt-equity ratio is not risky if the
company has the ability of generating substantial cash inflows in the future to meet its fixed
financial obligations. Financial risk in this sense is indicated by the companys cash-flow
ability, not by the debt-equity ratio. To quote Van Horne the analysis of debt-to-equity
ratios alone can be deceiving, and analysis of the magnitude and stability of cash-flows
relative to fixed charges is extremely important in determining the appropriate capital structure
for the firm. To the extent that creditors and investors analyse a firms cash-flow ability to
service debt, and managements risk preferences correspond to those of investors, capital
structure decisions made in this basis should tend to maximise share price. The cash-flow
analysis does have its limitations. It is difficult to predict all possible factors, which may
influence the firms cash flows. Therefore, it is not a foolproof technique to determine the
firms debt policy.
NOTES
11.4 PRACTICAL CONSIDERATIONS IN DETERMINING CAPITAL
STRUCTURE
The determination of capital structure in practice involves additional considerations in
addition to the concerns about EPS, value and cash flow. A firm may have enough debt
servicing ability but it may not have assets to offer as collateral. Attitudes of firms with
regard to financing decisions may also be quite often influenced by their desire of not losing
control, maintaining operating flexibility and have convenient timing and cheaper means of
raising funds. Some of the most important considerations are discussed below.
11.4.1 Assets
The forms of assets held by a company are important determinants of its capital
structure. Tangible fixed assets serve as collateral to debt. In the event of financial distress,
the lenders can access these assets and liquidate them to realise funds lent by them.
Companies with higher tangible fixed assets will have less expected costs of financial distress
and hence, higher debt ratios. On the other hand, those companies, whose primary assets
are intangible assets, will not have much to offer by way of collateral and will have higher
costs of financial distress. Companies have intangible assets in the form of human capital,
relations with stakeholders, brands, reputation etc., and their values start eroding as the
firm faces financial difficulties and its financial risk increases.
11.4.2 Growth Opportunities
The nature of growth opportunities has an important influence on a firms financial
leverage. Firms with high market-to-book value ratios have high growth opportunities. A
substantial part of the value for these companies comes from organisational or intangible
assets. These firms have a lot of investment opportunities. There is also higher threat of
bankruptcy and high costs of financial distress associated with high growth firms once they
start facing financial problems. These firms employ lower debt ratios to avoid the problem
of under-investment and costs of financial distress. But bankruptcy is not the only time
when debt-financed high-growth firms let go of the valuable investment opportunities. When
faced with the possibility of interest default, managers tend to be risk averse and either put
off major capital projects or cut down on R&D expenses or both. Therefore, firms with
growth opportunities will probably find debt financing quite expensive in terms of high
interest to be paid due to lack of good collateral and investment opportunities to be lost.
High growth firms would prefer to take debts with lower maturities to keep interest rates
down and to retain the financial flexibility since their performance can change unexpectedly
any time. They would also prefer unsecured debt to have operating flexibility.
Mature firms with low market-to-book value ratio and limited growth opportunities
face the risk of managers spending free cash flow either in unprofitable maturing business
or diversifying into risky businesses. Both these decisions are undesirable. This behaviour
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NOTES
of managers can be controlled by high leverage that makes them more careful in utilising
surplus cash. Mature firms have tangible assets and stable profits. They have low costs of
financial distress. Hence these firms would raise debt with longer maturities as the interest
rates will not be high for them and they have a lesser need of financial flexibility since their
fortunes are not expected to shift suddenly. They can avail high interest tax shields by
having high leverage ratios.
11.4.3 Debt- and Non-debt Tax Shields
We know that debt, due to interest deductibility, reduces the tax liability and increases
the firms after-tax free cash flows. In the absence of personal taxes, the interest tax shields
increase the value of the firm. Generally, investors pay taxes on interest income but not on
equity income. Hence, personal taxes reduce the tax advantage of debt over equity. The
tax advantage of debt implies that firms will employ more debt to reduce tax liabilities and
increase value. In practice, this is not always true as is evidenced from many empirical
studies. Firms also have non-debt tax shields available to them. For example, firms can use
depreciation, carry forward losses etc. to shield taxes. This implies that those firms that
have larger non-debt tax shields would employ low debt, as they may not have sufficient
taxable profit available to have the benefit of interest deductibility. However, there is a link
between the non-debt tax shields and the debt tax shields since companies with higher
depreciation would tend to have higher fixed assets, which serve as collateral against debt.
11.4.4 Financial Flexibility and Operating Strategy
A cash flow analysis might indicate that a firm could carry high level of debt without
much threat of insolvency. But in practice, the firm may still make conservative use of debt
since the future is uncertain and it is difficult to be able to consider all possible scenarios of
adversity. It is, therefore, prudent to maintain financial flexibility that enables the firm to
adjust to any change in the future events or forecasting error.
As discussed earlier, financial flexibility is a serious consideration in setting up the
capital structure policy. Financial flexibility means a companys ability to adapt its capital
structure to the needs of the changing conditions. The company should be able to raise
funds, without undue delay and cost, whenever needed, to finance the profitable investments.
It should also be in a position to redeem its debt whenever warranted by the future
conditions. The financial plan of the company should be flexible enough to change the
composition of the capital structure as warranted by the companys operating strategy
and needs. It should also be able to substitute one form of financing for another to economise
the use of funds. Flexibility depends on loan covenants, option to early retirement of loans
and the financial slack, viz., excess resources at the command of the firm.
NOTES
11.4.5 Loan Covenants
Restrictive covenants are commonly included in the long-term loan agreements and
debentures. These restrictions curtail the companys freedom in dealing with the financial
matters and put it in an inflexible position. Covenants in loan agreements may include
restrictions to distribute cash dividends, to incur capital expenditure, to raise additional
external finances or to maintain working capital at a particular level. The types of covenants
restricting the firms investment, financing and dividend policies vary depending on the
source of debt. While private debt contains both affirmative and negative covenants, public
debt has a lot of negative covenants and commercial paper does not entail much restrictions.
Loan covenants may look quite reasonable from the lenders point of view as they are
meant to protect their interests, but they reduce the flexibility of the borrowing company to
operate freely and it may become burdensome if conditions change. Growth firms prefer
to take private rather than public debt since it is much easier to renegotiate terms in time of
crisis with few private lenders than several debenture-holders. Generally, a company while
issuing debentures or accepting other forms of debt should ensure to have minimum of
restrictive clauses that circumscribe its financial actions in the future in debt agreements.
This is a tough task for the financial manager. A highly levered firm is subject to many
constraints under debt covenants that restrict its choice of decisions, policies and
programmes. Violation of covenants can have serious adverse consequences. The firms
ability to respond quickly to changing conditions also reduces. The operating inflexibility
could prove to be very costly for the firms that are operating in unstable environment.
These companies are likely to have low debt ratios and maintain high financial flexibility to
remain competitive and not allow compromising their competitive posture. Thus, financial
flexibility is essential to maintain the operating flexibility and face unanticipated contingencies.
11.4.6 Financial Slack
The financial flexibility of a firm depends on the financial slack it maintains. The financial
slack includes unused debt capacity, excess liquid assets, unutilised lines of credit and
access to various untapped sources of funds. The financial flexibility depends a lot on the
companys debt capacity and unused debt capacity. The higher is the debt capacity of a
firm and the higher is the unused debt capacity; the higher will be the degree of flexibility
enjoyed by the firm. If a company borrows to the limit of its debt capacity, it will not be in
a position to borrow additional funds to finance unforeseen and unpredictable demands
except at restrictive and unfavourable terms. Therefore, a company should not borrow to
the limit of its capacity, but keep available some unused capacity to raise funds in the future
to meet some sudden demand for finances.
11.4.7 Early repayment
A considerable degree of flexibility will be introduced if a company has the discretion
of early repaying its debt. This will enable management to retire or replace cheaper source
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NOTES
of finance for the expensive one whenever warranted by the circumstances. When a company
has excess cash and does not have profitable investment opportunities, it becomes desirable
to retire debt. Similarly, a company can take advantage of declining rates of interest if it has
a right to repay debt at its option. Suppose that funds are available at 12 per cent rate of
interest presently. The company has outstanding debt at 16 per cent rate o f interest. It can
save in terms of interest cost if it can retire the old debt and replace it by the new debt.
11.4.8 Limits of financial flexibility
Financial flexibility is useful, but the firm must understand its limit. It can help a profitable
firm to seize opportunities, and it can provide temporary help in adverse situation, but it
cannot save a firm, which is basically unhealthy. No doubt that financial flexibility is desirable,
but the firm should have basic financial strength. Also, it is achieved at a cost. A company
trying to obtain loans on easy terms will have to pay interest at a higher rate. Also, to obtain
the right of refunding, it may have to compensate lenders by paying a higher interest or may
have to allow them to participate in the equity. Therefore, the company should compare
the benefits and costs of attaining the desired degree of flexibility and balance them properly.
11.4.9 Sustainability and Feasibility
The financing policy of a firm should be sustainable and feasible in the long run. Most
firms want to maintain the sustainability of their financing policy over a long period of time.
The sustainable growth model helps to analyse the sustainability and the feasibility of the
long-term financial plans in achieving growth. This model is based on the assumption that
the firm uses the internal financing and debt, consistent with the target debt-equity ratio and
payout ratio and does not issue shares during the planning horizon. Given the firms financing
and payout policies and operating efficiency, this model implies that its assets and sales will
grow in tandem with growth in equity (internal). Thus, the sustainable growth depends on
return on equity (ROE) and retention ratio:
Sustainable growth = ROE x (1 - payout) (1)
ROE depends on assets turnover, net margin, and financial leverage:
ROE = asset turnover x net margin x leverage
ROE = assets/sales x net profit/sales x assets/equity (2)
Alternatively, ROE depends on the firms before-tax return on capital employed
(ROCE), the financial leverage premium and the tax rate:
ROE = [ROCE + (ROCE - K
d
) D/E] (1 - T) (3)
The sustainable growth model indicates the growth rate that the firm should target.
Any other growth rate will not be consistent with the financial policies set by the management.
NOTES
If the firm intends to achieve a different growth rate than that implied by the sustainable
growth model, it will have to change its financial policy, either the debt-equity ratio, or the
payout ratio or both. In fact, the model also indicates the trade-offs between the financing
and operating policies. Instead of changing its financial policies for achieving higher growth,
the firm can examine its operating policies vis--vis price, cost, assets utilisation etc. The
firm must realise that growth does not ensure value creation. If the firm does not account
for the investment duration and the cost of capital, growth may destroy value. The firm
should also examine the impact of alternative financial policy on the value of the firm.
11.4.10 Control
In designing the capital structure, sometimes the existing management is governed by
its desire to continue control over the company. This is particularly so in the case of the
firms promoted by entrepreneurs. The existing management team not only wants control
and ownership but also to manage the company, without any outside interference.
11.4.11 Widely held companies
The ordinary shareholders elect the directors of the company. If the company issues
new shares, there is risk of dilution of control. The company can issue rights shares to
avoid dilution of ownership. But the existing shareholders may not be willing to fully subscribe
to the issue. Dilution is not a very important consideration in the case of widely held
companies. Most shareholders are not interested in taking active part in a companys
management. Nor do they have time and money to attend the meetings. They are interested
in dividends and capital gains. If they are not satisfied, they will sell their shares. Thus, the
best way to ensure control and to have the confidence of the shareholders is to manage the
company most efficiently and compensate shareholders in the form of dividends and capital
gains. The risk of loss of control can be reduced by distribution of shares widely and in
small lots.
11.4.12 Closely held companies
The consideration of maintaining control may be significant in case of closely held and
small companies. A shareholder or a group of shareholders can purchase all or most of the
new shares of a small or closely held company and control it. Even if the owner-managers
hold the majority shares, their freedom to manage the company will be curtailed when they
go for initial public offerings (IPOs). Fear of sharing control and being interfered by others
often delays the decision of the closely held small companies to go public. To avoid the risk
of loss of control, small companies may slow their rate of growth or issue preference
shares or raise debt capital. If the closely held companies can ensure a wide distribution of
shares, they need not worry about the loss of control so much.
The holders of debt do not have voting rights. Therefore, it is suggested that a company
should use debt to avoid the loss of control. However, when a company uses large amount
DBA 1764
NOTES
of debt, a lot of restrictions are put by the debt-holders, specifically the financial institutions
in India, since they are the major providers of loan capital to the companies. These
restrictions curtail the freedom of the management to run the business. A very excessive
amount of debt can also cause serious liquidity problem and ultimately render the company
sick, which means a complete loss of control.
11.4.13 Marketability and Timing
Marketability means the readiness of investors to purchase a security in a given period
of time and to demand reasonable return. Marketability does not influence the initial capital
structure, but it is an important consideration to decide about the appropriate timing of
security issues. The capital markets are changing continuously. At one time, the market
favours debenture issues, and, at another time, it may readily accept share issues. Due to
the changing market sentiments, the company has to decide whether to raise funds with an
equity issue or a debt issue. The alternative methods of financing should, therefore, be
evaluated in the light of general market conditions and the internal conditions of the company.
11.4.14 Capital market conditions
If the capital market is depressed, a company will not issue equity shares, but it may
issue debt and wait to issue equity shares till the share market revives. During boom period
in the share market, it may be advantageous for the company to issue shares at high premium.
This will help to keep its debt capacity unutilised. The internal conditions of a company
may also dictate the marketability of securities. For example, a highly levered company
may find it difficult to raise additional debt. Similarly, when restrictive covenants in existing
debt-agreements preclude payment of dividends on equity shares, convertible debt may
be the only source to raise additional funds. A small company may find difficulty in issuing
any security in the market merely because of its small size. The heavy indebtedness, low
payout, small size, low profitability, high degree of competition etc. cause low rating of the
company, which would make it difficult for the company to raise external finance at favourable
terms.
11.4.15 Issue Costs
Issue or flotation costs are incurred when the funds are externally raised. Generally,
the cost of floating a debt is less than the cost of floating an equity issue. This may encourage
companies to use debt than issue equity shares. Retained earnings do not involve flotation
costs. The source of debt also influences the issue costs with fixed costs being much higher
for issue of commercial paper and public debt (debenture) than the private debt. This also
means that economies of scale are high for the debt instruments having high fixed costs.
Hence these instruments should be used when large amounts of funds are needed. Issue
costs as a percentage of funds raised will decline with larger amount of funds. Large firms
require large amounts of funds, and they may plan large issues of securities to economise
NOTES
on the issue costs. These firms are more likely than others to resort to commercial paper or
public debt for raising capital. A large issue of securities can, however, curtail a companys
financial flexibility. The company should raise only that much of funds, which it can employ
profitably. Many other more important factors have to be considered when deciding about
the methods of financing and the size of a security issue.
11.4.16 Capacity of Raising Funds
The size of a company may influence its capital and availability of funds from different
sources. A small company finds great difficulties in raising long-term loans. If it is able to
obtain some long-term loan, it will be available at a higher rate of interest and inconvenient
terms. The highly restrictive covenants in loan agreements in case of small companies
make their capital structures very inflexible and management cannot run business freely
without interference. Small companies, therefore, depend on share capital and retained
earnings for their long-term funds requirements. It is quite difficult for small companies to
raise share capital in the capital markets. Also, the capital base of most small companies is
so small that they can not be listed on the stock exchanges. For those small companies,
which are able to approach the capital markets, the cost of issuing shares is generally more
than the large ones. Further, resorting frequently to ordinary share issues to raise long-term
funds carries a greater risk of the possible loss of control for a small company. The shares
of small companies are not widely scattered and the dissident group of shareholders can
be easily organised to get control of the company. The small companies, therefore,
sometimes limit the growth of their business to what can easily be financed by retaining the
earnings.
A large company has relative flexibility in designing its capital structure. It can obtain
loans on easy terms and sell ordinary shares, preference shares and debentures to the
public. Because of the large size of issues, its cost of distributing a security is less than that
for a small company. A large issue of ordinary shares can be widely distributed and thus,
making the loss of control difficult. The size of the firm has an influence on the amount and
the cost of funds, but it does not necessarily determine the pattern of financing. In practice,
the debt-equity ratios of the firms do not have a definite relationship with their size.
EXHIBIT 11.3 DO MANAGERS PREFER BORROWING?
- A number of companies in practice prefer to borrow for the following reasons:
- Tax deducibility of interest
- Higher return to shareholders due to gearing
- Complicated procedure for raising equity capital
- No dilution of ownership and control
- Equity results in a permanent commitment than debt.
DBA 1764
NOTES
- There are, however, managers whose choice of financing depends on internal and
external factors. The internal factors include: purpose of financing, company earning
capacity, existing capital structure, cash flow ability, investment plans etc. The
external factors are: capital and money market conditions, debt-equity stipulations
followed by financiers, restrictions imposed etc. A company, for example, feels:
- There can be no specific preference towards borrowings as a source of finance.
The companys financial requirement will vary from time to time depending on
factors such as its existing capital structure, investment plans vis--vis expansion,
modernisation and replacement as also its margin money requirement for incremental
working capital. In addition, the cost of share issue, existing money market and
banking conditions and the impact of statutory regulations would influence the mix
of finance required by a company.
- In practice, it may not be possible for a company to borrow whenever it wants.
Lenders may analyse a number of characteristics of the borrower before they
decide to lend. What factors do borrowers think are considered by lenders?
Borrowing firms managers perceive the following factors in order of importance
being considered by lenders: (i) profitability, (ii) quality of management, (iii) security,
(iv) liquidity, (v) existing debt-equity ratio, (vi) sales growth, (yii) net worth, (viii)
reserve position, and (ix) fluctuations in profits.
11.4.17 MANAGERS ATTITUDE TOWARDS DEBT
We know now the factors, which are theoretically important in determining the capital
structure policy of a company. They are interest tax shield (adjusted for personal taxes)
and costs of financial distress. We also know the additional factors in practice such as
sales growth and stability, cash flow, market conditions, transaction costs etc. which may
have influence on the choice of capital structure. How do managers really view the question
of borrowing? There seems to be a mixed feeling. Some would prefer borrowing while
others would like to decide after considering a variety of factors. They also feel that they
can borrow only when lenders are prepared to lend. They think that lenders evaluate a
number of factors before deciding to lend, and these factors go beyond the theoretical
considerations of risk, return and value.
Review Questions
1) Briefly explain the factors that influence the planning of the capital structure in
practice.
2) Explain the features and limitations of three approaches of determining a firms
capital structure: a) EBIT-EPS approach, b) Valuation approach, and c) Cash
flow approach.
3) How do the considerations of control and size affect the capital structure decision
of the firm.
NOTES
CHAPTER 12
INTERNATIONAL CAPITAL STRUCTURE
In the two previous sections, we examined various motivations for using particular
types of financing. However, while knowledge of the costs and benefits of each individual
source of funds is helpful, it is not sufficient to establish an optimal global financial plan.
This plan requires consideration not only of the component costs of capital, but also of
how the use of one source affects the cost and availability of other sources. A firm that uses
too much debt might find the cost of equity (and new-debt) financing prohibitive. The
capital structure problem for the multinational enterprise, therefore, is to determine the mix
of debt and equity for the parent entity and for all consolidated and unconsolidated
subsidiaries that maximizes shareholder wealth.
The focus is on the consolidated, worldwide financial structure because suppliers of
capital to a multinational firm are assumed to associate the risk of default with the MNCs
worldwide debt ratio. This association stems from the view that bankruptcy or other forms
of financial distress in an overseas subsidiary can seriously impair the parent companys
ability to operate domestically. Any deviations from the MNCs target capital structure will
cause adjustments in the mix of debt and equity used to finance future investments.
Another factor that may be relevant in establishing a worldwide debt ratio is the
empirical evidence that earnings variability appears to be a decreasing function of foreign-
source earnings. Because the risk of bankruptcy for a firm is dependent on its total earnings
variability, th earnings diversification provided by its foreign operations may enable the
multinational - firm to leverage itself more highly than can a purely domestic corporation,
without increasing its default risk.
12.1 FOREIGN SUBSIDIARY CAPITAL STRUCTURE
Once a decision has been made regarding the appropriate mix of debt and equity for
the entire corporation, questions about individual operations can be raised. How should
MNCs arrange the capital structures of their foreign affiliates? And what factors are relevant
in making this decision? Specifically, the problem is whether foreign subsidiary capital
structures should
Conform to the capital structure of the parent company
Reflect the capitalization norms in each foreign county
Vary to take advantage of opportunities to minimize the MNCs cost of capital
Disregarding public and government relations and legal requirements for the moment,
the parent company could finance its foreign affiliates by raising funds in its own country
and investing these funds as equity. The overseas operations would then have a zero debt
ratio (debt/total assets). Alternatively, the parent could hold only one dollar of share capital
DBA 1764
NOTES
in each affiliate and require all to borrow on their own, with or without guarantees; in this
case, affiliate debt ratios would approach 100%. Or the parent can itself borrow and
relend the monies as intra-corporate advances. Here again, the affiliates debt ratios would
be close to 100%, In all these cases, the total amount of borrowing and the debt/equity
mix of the consolidated corporation are identical. Thus, the question of an optimal capital
structure for a foreign affiliate is completely distinct from the corporations overall debt /
equity ratio.
Moreover, any accounting rendition of a separate capital structure for the subsidiary
is wholly illusory unless the parent is willing to allow its affiliate to default on its debt. As
long as the rest of the MNC group has a legal or moral obligation or sound business
reasons for preventing the affiliate from defaulting, the individual unit has no independent
capital structure Rather, its true debt/equity ratio is equal to that of the consolidated group.
Exhibits 12.1 and 12.2 show the stated and the true debt-to-equity ratios for a subsidiary
and its parent for four separate cases. In cases I, II, and III, the parent borrows $100 to
invest in a foreign subsidiary, in varying portions of debt and equity. In case IV, the subsidiary
borrows the $100 directly, from the bank. Depending on what the parent calls its investment,
the subsidiarys debt-to-equity ratio can vary from zero to infinity. Despite this variation,
the consolidated balance sheet shows a debt-to-equity ratio following the foreign investment
of 4:7 regardless of how the investment is financed and what it is called.
Exhibit 12.5 shows that the financing mechanism does affect the pattern of returns,
whether they are called dividends or interest and principal payments. It also determines the
initial recipient of the cash flows. Are the cash flows from the foreign unit paid directly to
the outside investor (The bank) or are they first paid to the parent, which then turns around
and repays the bank?
EXHIBIT 12.1 SUBSIDIARY CAPITAL STRUCTURE

I. 100% Parent Financed II. 100% Parent Financed

$100 D = $50 $ 100 D = $
10e
E = 50 D/E = Infinity
D/E = 1:1

II 100% Parent Financed II. IV. 100% Parent
Financed

$100 D = $0 $ 100 D = $
100
E = 100 E = 0
D/E = 1:1 D/E = Infinity

NOTES
EXHIBIT 12.2 : CONSOLIDATED PARENT BALANCE SHEET
The Point of this exercise is to show that unlike the case for the corporation as a
whole an affiliates degree of leverage does not determine its financial risk. Therefore, the
first two options-having affiliate financial structures conform to parent or local norms are
unrelated to share holder wealth maximization.
The irrelevance of subsidiary financial structures seems to be recognized by
multinationals. In a 1979 survey by Business International of eight U.S. based MNCs,
most of the firms expressed little concern with the debt/ equity mixes of their foreign affiliates.
Before Foreign Investment

$100 D = $50 D = $ 300
E = 700
D/E = 3:7
After Foreign Investment

Cases, I, II and III Parent Cases IV
Parent Financed with 100% Subsidiary Financed with
Bank 100% Bank Debt

Domestic $1,000 D = $400 Domestic S 1000 D = $ 400
100 E = 700 Foreign 100 E = 700
D/E = 4:7 D/E =4 : 7

DBA 1764
NOTES
EXHIBIT 12.3: Subsidiary Capital Structure Depends on What its Funds are Called.
(Admittedly, for most of the firms interviewed, the debt ratios of affiliates had not
significantly raised the MNCs consolidated indebtedness.) Their primary focus was on
the worldwide, rather than individual, capital structure. The third option of varying affiliate
financial structures to take advantage of local financing opportunities appears to be the
appropriate choice. Thus, within the constraints set by foreign statutory or minimum equity
requirements, the need to appear to be a responsible and, good guest, and the requirements
of a worldwide financial structure, a multinational corporation should finance its affiliates to
minimize its incremental average cost of capital.
A subsidiary with a capital structure similar to its parent may forgo profitable
opportunities to lower its cost of funds. For example, rigid adherence to a fixed debt/
equity ratio may not allow a subsidiary to take advantage of government-subsidized debt
or low-cost loans from international agencies. Furthermore, it may be worthwhile to raise
funds locally if the country is politically risky. In the event the affiliate is expropriated, for
instance, it would default on all loans from local financial institutions. Similarly, borrowing
funds locally will decrease the companys vulnerability to exchange controls. Local currency
(LC) profits can be used to service its LC debt. On the other hand, forcing a subsidiary to
borrow funds locally to meet parent norms may be quite expensive in a country with a
high-cost, capital market or if the subsidiary is in a tax-loss-carry forward position. In the
latter case, since the subsidiary cant realize the tax benefits of the interest write-off, the
parent should make an equity injection financed by borrowed funds. In this way, the interest
deduction need not be sacrificed.
Leverage and the Tax Reform Act of 1986. The choice of where to borrow to finance
foreign operations has become more complicated with passage of the Tax Reform Act of

Equity

Subsidiary
Debt

Parent
Interest and
Principal
Dividends
Interest
and
principal
Loan
Interest
And principal
Bank

Loan
NOTES
1986 because the distribution of debt between U.S. parents and their foreign subsidiaries
affects the use of foreign tax credits. Tax Reform Act has put many U.S,-based MNCs in
a position of excess foreign tax credits. One way to use up these FTCs is to push expenses
overseasand thus lower overseas profitsby increasing the leverage of foreign
subsidiaries. In the aforementioned example, the U.S. parent may have one of its taxpaying
foreign units borrow funds and use them to pay a dividend to the parent. The parent can
then turn around and invest these funds as equity in the non-tax paying subsidiary, In this
way, the worldwide corporation can reduce its taxes without being subject to the constraints
imposed by the Tax Reform Act.
Leasing and the Tax Reform Act of 1986. As an alternative to increasing the debt of
foreign subsidiaries, U.S. multinationals could expand their use of leasing in the United
States. Although leasing an asset is economically equivalent to using borrowed funds to
purchase the asset, the international tax consequences differ. Prior to 1986, U.S.
multinationals counted virtually all their interest expense as a fully deductible U.S. expense.
Under the new law, firms must allocate interest expense on general borrowings to match
the location of their assets, even if all the interest is paid in the United States. This allocation
has the effect of reducing the amount of interest expense that can be written off against
U.S. income. Rental expense, on the other hand, can be allocated to the location of the
leased property. Lease payments on equipment located in the United States, therefore,
can be fully deducted.
At the same time, leasing equipment to be used in the United States, instead of
borrowing to finance it, increases reported foreign income (since there is less interest expense
to allocate against foreign income). The effect of leasing, therefore, is to increase the
allowable foreign tax credit to offset U.S. taxes owed on foreign source income, thereby
providing another tax advantage of leasing for firms that Owe U.S. tax on their foreign
source income.
Cost Minimizing Approach to Global Capital Structure: The cost-minimizing approach
to determining foreign affiliate capital structures would be to allow subsidiaries with access
to low-cost capital markets to exceed the parent company capitalization norm, while
subsidiaries in higher-capital-cost nations would have lower target debt ratios. These costs
must be figured on an after-tax basis, taking into account the companys worldwide tax
position.
A counterargument is that a subsidiarys financial structure should conform to local
norms. Then because German and Japanese firms are more highly leveraged than, say,
companies in the United States and France, the Japanese and German subsidiaries of a
U.S. firm should have much higher debt/equity ratios than the U.S. parent or a French
subsidiary. The problem with this argument, though, is that it ignores the strong linkage
between U.S-based multinationals and the U.S. capital market. Because most of their
DBA 1764
NOTES
stock is owned and traded in the United States, it follows that the firms target debt/equity
ratios are dependent on U.S. shareholders risk perceptions. Similar arguments hold for
multinationals not based in the United States. Furthermore, the level of foreign debt/equity
ratios is usually determined by institutional factors that have no bearing on foreign-based
multinationals, For example. Japanese and German banks own much of the equity as well
as the debt issues of local corporations. Combining the functions of stockholder and lender
may reduce the perceived risk of default on loans to captive corporations and increase the
desirability of substantial leverage. These institutional considerations would not apply to a
wholly owned subsidiary. However, a joint venture with a corporation tied to the local
banking system may enable an MNC to lower its local cost of capital by leveraging itself
without a proportional increase in risk - to a degree that would be impossible otherwise.
The basic hypothesis proposed in this section is that a subsidiarys capital structure is
relevant only insofar as it affects the parents consolidated worldwide debt ratio. Nonetheless,
some companies have a general policy of every tub on its own bottom. Foreign units are
expected to be financially independent following the parents initial investment. The rationale
for this policy is to avoid giving management a crutch. By forcing foreign affiliates to
stand on their own feet, affiliate managers will presumably be working harder to improve
local operations, thereby generating the internal cash flow that will help replace parent
financing. Moreover, the local financial institutions will have a greater incentive to monitor
the local subsidiarys performance because they can no longer look to the parent company
to bail them out if their loans go sour. But companies that expect their subsidiaries to
borrow locally had better be prepared to provide enough initial equity capital or subordinated
loans. In addition, local suppliers and customers are likely to shy away from a new subsidiary
operating on a shoestring if that subsidiary is not receiving financial backing from its parent.
The foreign subsidiary may have to show its balance sheet to local trade creditors,
distributors, and other stakeholders. Having a balance sheet that shows more equity
demonstrates that the unit has greater staying power.
It also takes more staff time to manage a highly leveraged subsidiary in counties like
Brazil and Mexico where government controls and high inflation make local funds scarce.
One treasury manager complained. We spend 75%8O% of managements time trying
to figure out how to finance the company. Running around chasing our tails instead of
attending to our basic businessgetting production costs lower, sales up, and making the
product better.
12.2 PARENT COMPANY GUARANTEES AND CONSOLIDATION
Multinational firms are sometimes reluctant to guarantee explicitly the debt of their
subsidiaries, even when a more advantageous interest rate can be negotiated for several
reasons.
NOTES
1. Some companies argue that their affiliates should be able to stand alone. In the
case of a joint venture when the other partner is unable or unwilling to provide a
valuable counter guarantee, a penalty rate of interest may be accepted to avoid
over-financing other shareholders. A cost is incurred to maintain a principle and
avoid a dangerous precedent.
2. The protection against expropriation provided by an affiliates borrowing may be
lost if the parent guarantees those debts.
3. Many firms believe lenders should be reasonable, requesting a guarantee when the
affiliate is operating at a loss or with a debt-heavy capital structure and lending
without one when the borrower itself is creditworthy.
4. Providing explicit support for one operation can lead to lenders demands in other
cases.
5. Many firms assume that non-guaranteed debt would not be included in the parent
companys worldwide debt ratio, whereas guaranteed debt as a contingent liability
would affect the parents debt-raising capacity.
The issue of whether or not to issue guarantees may be more important in theory than
in fact. It is likely that a parent company would keep lenders whole if a subsidiary defaulted,
even if it had no legal obligation to do so. in a 1985 survey by Business International, most
treasurers said that they would always assume the debt of a failed overseas subsidiary
even if the parent had not guaranteed it. This attitude reflects pragmatic business reasons,
not benevolence or a sense of morality. A multinational firm relies on financial institutions in
many countries. In a real sense, it could rarely, if ever, function without them. Any action,
such as allowing an affiliate to become bankrupt, that jeopardizes these relations has an
extremely high cost. Multinational firms also may distinguish between international and
local banks. The former could be kept whole and the latter directed to their own government
for repayment if an affiliate were expropriated and were unable to pay its debts.
If an explicit guarantee will reduce a subsidiarys borrowing costs, it will usually be in
the parents best interest to give this support, provided there is an actual commitment to
satisfy the subsidiarys obligations. It is likely that the market has already incorporated this
practical commitment in its estimate of the parents worldwide debt capacity. An overseas
creditor, on the other hand, may not be as certain regarding the firms intentions. The fact
that the parent doesnt guarantee its subsidiaries debt may then convey some information
(i.e., commitment to subsidiary debt is not that strong).
In at least two cases, Raytheon in Sicily (1968) and Freeport Sulphur in Cuba (1960),
firms did allow their foreign affiliates to go bankrupt. However, the publicity surrounding
these events makes it clear how unusual they were. Moreover, a parent that once walks
away from the debt of an affiliate will be unable to again borrow overseas unless it either
guarantees its affiliates debts or pays a higher interest rate to compensate lenders for the
possibility of default.
DBA 1764
NOTES
The U.S. Internal Revenue Service argues that by guaranteeing foreign affiliates debts,
a U.S. corporation is providing a valuable service for which it should be compensated.
The IRS, therefore, imputes income to the guarantor and levies a tax. This additional tax
cost should be incorporated in the determination of whether the parent should guarantee a
foreign subsidiarys borrowing.
Another factor may also influence corporate policy regarding parent guarantees. When
a firm provides an affiliate with a loan guarantee, you lose the bank as your partner in
controls. Since it will be repaid regardless of the affiliates profitability, the bank will have
less incentive to monitor the affiliates activities. On the other hand, in the absence of a
guarantee, the local bank will probably insist on inserting various restrictive covenants in its
loan agreement with the subsidiary. The parent can prevent these restrictive covenants and
the resulting loss in operational and financial flexibility by supplying loan guarantees. The
relative magnitudes of these two costs will help determine whether the parent guarantees
its affiliates debts.
Related to the issue of parent-guaranteed debt is the belief among some firms that do
not consolidate their foreign affiliates that unconsolidated (and non-guaranteed) overseas
debt need not affect the MNCs debt ratio. But unless investors and analysts can be fooled
permanently, unconsolidated overseas leveraging will not allow a firm to lower its cost of
capital below the cost of capital for an identical firm that consolidates its foreign affiliates.
Any overseas debt offering that is large enough to materially affect an MNCs degree of
leverage would quickly come to the attention of financial analysts.
Some evidence of this form of market efficiency was provided by bond raters at
Moodys and at Standard and Poors. Individuals from both agencies said that they would
closely examine situations where non-guaranteed debt issued by unconsolidated foreign
affiliates would noticeably affect a firms worldwide debt: equity ratio. In addition, parent-
company-guaranteed debt is included in bond rater analyses of a firms contingent liabilities,
whether this debt is consolidated or not. Thus, it appears that the growing financial
sophistication of MNCs has been paralleled by increased sophistication among rating
agencies and investors.
12.3 JOINT VENTURES
Because many MNCs participate in joint ventures, either by choice or necessity,
establishing an appropriate financing mix for this form of investment is an important
consideration. The previous assumption that affiliate debt is equivalent to parent debt in
terms of its impact on perceived default risk may no longer be valid. In countries such as
Japan and Germany, increased leverage will not necessarily lead to increased financial
risks, due to the close relationship between the local banks and corporations. Thus, debt
raised by a joint venture in Japan, for example, may not be equivalent to parent-raised
debt in terms of its impact on default risk. The assessment of the effects of leverage in a
NOTES
joint venture requires a qualitative analysis of the partners ties with the local financial
community, particularly with the local banks.
Unless the joint venture can be isolated from its partners operations, there are likely
to be some significant conflicts associated with this form of ownership. Transfer pricing,
setting royalty and licensing fees, and allocating production and markets among plants are
just some of the areas in which each owner has an incentive to engage in activities that will
harm its partners. These conflicts explain why bringing in outside equity investors is generally
such an unstable form of external financing.
Because of their lack of complete control over a joint ventures decisions and its
profits, most MNCs will, at most, guarantee joint venture loans in proportion to their share
of ownership. But where the MNC is substantially stronger financially than its partner, the
MNC may wind up implicitly guaranteeing its weaker partners share of any joint-venture
borrowings, as well as its own. In this case, it makes sense to push for as large an equity
base as possible; the weaker partners share of the borrowings is then supported by its
larger equity investment,
ILLUSTRATION NESTLE
Nestle, the $17 billion Swiss foods conglomerate, is about as multinational as a
company can be. About 98% of its sales take place overseas, and-the groups diversified
operations span 150 countries. Nestles numerous (and generally wholly owned) subsidiaries
are operationally decentralized. However, finances are centralized in Vevey, Switzerland.
Staffed by just 12 people, the finance department makes all subsidiary funding decisions,
manages the resulting currency exposures, determines subsidiary dividend amounts, sets
the worldwide debt/equity structure, and evaluates subsidiary performance.
Nestles centralized finance function plays the pivotal role in the firms intricate web of
subsidiary-to-headquarters profit remittances and headquarters-to-subsidiary investment
flows. Profits and excess cash are collected by the treasury department in Vevey and then
channeled back to overseas subsidiaries in the form of equity and debt investments. Nestle
considers this approach to be the best possible investment for the groups wealth.
When a subsidiary is first established, its fixed assetswhich form about half of the
total investmentare financed by the Nestle group, generally with equity. Later on, the
group may supply long-term debt as needed to support operations. The local subsidiary
manager handles all the marketing and production decisions, but decisions regarding long-
term debt and equity funding are managed solely by Vevey headquarters.
The other half of the investmentworking capitalis then acquired locally, usually
via bank credit or commercial paper. However, Nestle varies this general approach to suit
each country. In certain countriesthose that permit free transfers of fundsNestle finances
part of the working capital from Vevey instead of using local bank credits.
DBA 1764
NOTES
Central control over affiliate capital structures is facilitated by the policy of forcing
local managers to dividend out almost 100% of their profits to Switzerland. The particular
capital structure chosen for an affiliate depends on various considerations, including taxes,
political risk, and currency risk.
To ensure that it borrows at the lowest possible cost, Nestle takes considerable care
to structure its capital base to keep a top credit rating. The desire for a low-risk capital
structure is also consistent with Nestles business strategy. According to Senior Vice
President, Finance, Daniel Regolatti, Our basic strategy is that we are an industrial company.
We have a lot of risks in a lot of countries, so we should not add high financial risks.
Summary and conclusion
This chapter has attempted to provide a framework for multinational firms to use in
arranging their global financing. The primary emphasis is on taking advantage of distortions
resulting from Government intervention in financial markets or from differential national tax
law, either of which may cause difference to exit in the risk-adjust after- tax costs of
different sources and types funds. Secondarily, this framework includes the possibility of
reducing various operating risks resulting from political or economic factors. Last, it seeks
to determine appropriate parent, of affiliate, and worldwide capital structures- taking into
account the unique attributes of being a multinational corporation.
Review Questions
1) What are the advantages of having highly levered foreign subsidiaries?
2) How has the Tax Reforms Act of 1986 affected the capital structure choice for
foreign subsidiaries?
3) What financing problems might be associated with joint ventures?
4) Reference
5) Shapiro C.Allen, Multinational Financial Management, Prentice Hall, Fourth
Edition.
6) Eugene.F.Brigham, Michael C.Ehrhardt, Financial Management Theory and
Practice, Thomson South Weatern, Tenth Edition.
NOTES
UNIT V
FINANCIAL DISTRESS
CHAPTER 13
FINANCIAL DISTRESS
Financial distress is defined as a condition where obligations are not met or are met
with difficulty. It is a situation where a firms operating cash flows are not sufficient to
satisfy current obligations and the firm is forced to take corrective action. Financial distress
may lead a firm to default on a contract, and it may involve financial restructuring between
the firm, its creditors, and its equity investors. The three terms default, bankruptcy and
financial distress can be distinguished as follows
- Default
Failure to meet an interest payment, or
Violation of debt agreement
- Bankruptcy
Formal procedure for working out default
Does not automatically follow from default.
- Financial Distress
Includes default and bankruptcy, but also
Threat of default or bankruptcy and its effect on the company
Defined to capture the costs and benefits of using large amounts of debt finance
A major disadvantage for a firm taking on higher levels of debt is that it increases the
risk of financial distress, and ultimately liquidation. This may have detrimental effect on
both the equity and debt holders.
13.1 TYPES OF BUSINESS FAILURE
A firm may fail because its returns are negative or low. A firm that consistently
reports operating losses will probably experience a decline in market value. If the firm fails
to earn a return that is greater than its cost of capital, it can be viewed as having failed.
DBA 1764
NOTES
Negative or low returns, unless remedied, are likely to result eventually in one of the following
more serious types of failure.
A second type of failure, technical insolvency, occurs when a firm is unable to pay
its liabilities as they come due. When a firm is technically insolvent, its assets are still
greater than its liabilities, but it is confronted with a liquidity crisis. If some of its assets
can be converted into cash within a reasonable period, the company may be able to escape
complete failure. If not, the result is the third and most serious type of failure, bankruptcy.
Bankruptcy occurs when a firms liabilities exceed the fair market value of its assets. A
bankrupt firm has a negative stockholders equity. This means that the claims of creditors
cannot be satisfied unless the firms assets can be liquidated for more than their book
value. Although bankruptcy is an obvious form of failure, the courts treat technical
insolvency and bankruptcy in the same way. They are both considered to indicate the
financial failure of the firm.
13.2 MAJOR CAUSES OF BUSINESS FAILURE
The primary cause of business failure is mismanagement, which accounts for more
than 50 percent of all cases. Numerous specific managerial faults can cause the firm to fail.
Overexpansion, poor financial actions, an ineffective sales force, and high production costs
can all singly or in combination cause failure. For example, poor financial actions include
bad capital budgeting decisions (based on unrealistic sales and cost forecasts, failure to
identify all relevant cash flows, or failure to assess risk properly), poor financial evaluation
of the firms strategic plans prior to making financial commitments, inadequate or nonexistent
cash flow planning, and failure to control receivables and inventories. Because all major
corporate decisions are eventually measured in terms of money value, the financial manager
may play a key role in avoiding or causing a business failure. It is his or her duty to monitor
the firms financial pulse.
Economic activity especially economic downturns can contribute to the failure
of a firm. If the economy goes into a recession, sale may decrease abruptly, leaving the
firm with high fixed costs and insufficient revenues to cover them. In addition, rapid rises
in interest rates just prior to a recession can further contribute to cash flow problems and
make it more difficult for the firm to obtain and maintain needed financing. During the early
1990s, a number of major business failures such as those of Olympia and York (real
estate) America, West Airlines, and Southmark Corporation (convenience stores) resulted
from over expansion and the recessionary economy.
A final cause of business failure is corporate maturity. Firms, like individuals, do not
have infinite lives. Like a product, a firm goes through the stages of birth, growth, maturity,
and eventual decline. The firms management should attempt to prolong the growth stage
through research, new products, and mergers. Once the firm has matured and has begun
NOTES
to decline, it should seek to be acquired by another firm or liquidate before it fails. Effective
management planning should help the firm to postpone decline and ultimate failure.
A recent Dun & Bradstreet compilation assigned percentage values to business failure
causes, as shown in Table 13-1. Economic factors include industry weakness and poor
location. Financial factors include too much debt and insufficient capital. The importance
of the different factors varies over time, depending on such things as the state of the economy
and the level of interest rates. Also, most business failures occur because of number of
factors combine to make the business unsustainable. Further, case studies show that financial
difficulties are usually the result of a series of errors, misjudgments, and interrelated weakness
that can be attributed directly or indirectly to management. As you might guess, signs of
potential financial distress are generally evident in a ratio analysis long before the firm
actually fails, and researchers use ratio analysis to predict the probability that a given firm
will go bankrupt.
13.1 CAUSES OF BUSINESS FAILURE
13.3 THE BUSINESS FAILURE RECORD
How widespread is business failure in the United States? In Table 13-2, we see that
a fairly large number of businesses fail each year, although the failures in any one year are
not a large percentage of the total business population. It is interesting to note that the
failure rate per 10,000 business population fluctuates with the state of the economy, the
average liability per failure has tended to increase over time, at least into the early 1990s.
This is due primarily to inflation, but it also reflects the fact that some very large firms have
failed in recent years.
Although bankruptcy is more frequent among smaller firms, it is clear from Table 13-
3 that large firms are not immune. However, some firms might be too big or too important
to be allowed to fail. The mergers or governmental intervention are often used as an
alternative to outright failure and liquidation. The decision to give federal aid to Chrysler
(now a part of Daimler Chrysler AG) in the 1980s is an excellent illustration. Also, in
recent years federal regulators have arranged the absorption of many problem financial
Causes of Failure Percentage of Total
Economic Factors
Financial Factors
Neglect, Disaster and Fraud
Other Factors
37.1%
47.3%
14.0%
1.6%
100.0%
DBA 1764
NOTES
institutions by financially sound institutions. In addition, several U.S. government agencies,
principally the Defense Department, were able to bail out Lockheed when it otherwise
would have failed, and the shortgun marriage of Douglas Aircraft and Mc Donnel was
designed to prevent Douglass failure. Another example of intervention is that of Merrill
Lynch taking over the brokerage firm Goodbody & company, which would otherwise
have gone bankrupt and would have frozen the accounts of its 225,000 customers while a
bankruptcy settlement was being worked out. Good bodys failure would have panicked
investors across the country, so New York Stock Exchange member firms put up $30
million as an inducement to get Merrill Lynch to keep Goodbody from folding. Similar
instances in other industries could also be cited.
Why do government and industry seek to avoid failure among larger firms? There are
many reasons. In the case of banks, the main reason is to prevent an erosion of confidence
and a consequent run on the banks. With Lockheed and Douglas, the Defense Department
wanted not only to maintain viable suppliers but also to avoid disrupting local communities.
With Chrysler, the government wanted to preserve jobs as well as a competitor in the U.S.
auto industry. Even when the public interest is not at stake, the fact that bankruptcy is a
very expensive process gives private industry strong incentives to avoid outright bankruptcy.
The costs and complexities of a formal Bankruptcy are discussed in subsequent sections
of this chapter, after we examine some less formal and less expensive procedures.
13.2 HISTORICAL FAILURE RATE OF U.S. BUSINESSES
Years Average number
of Failures per
year
Average failures rate
per 10,000 business
Average Liability
per failure
1950-1959 11,119 42 $41,082
1960-1969 13,110 52 92,271
1970-1979 9,311 36 296,497
1980 11,742 42 394,744
1985 57,253 115 645,160
1990 60,747 74 923,996
1991 88,140 107 1,098,539
1992 97,069 110 971,653
1993 86,133 109 554,438
1994 71,558 86 404,955
1995 71,128 86 524,175
1996 71,931 80 411,071
1997 83,384 88 448,970

NOTES
13.3 SOME RECENT LARGE BANKRUPTCIES (BILLIONS OF DOLLARS)
13.4 CONSEQUENCES OF FINANCIAL DISTRESS
- The risk of incurring the costs of financial distress has a negative effect on a firms
value which offsets the value of tax relief of increasing debt levels.
- These costs become considerable with very high gearing. Even if a firm manages
to avoid liquidation its relationships with suppliers, customers, employees and
creditors may be seriously damaged.
- Suppliers providing goods and services on credit are likely to reduce the generosity
of their terms, or even stop supplying altogether, if they believe that there is an
increased chance of the firm not being in existence in a few months time.
- Customers may develop close relationships with their suppliers, and plan their
own production on the assumption of a continuance of that relationship. If there is
any doubt about the longevity of a firm it will not be able to secure high-quality
contracts. In the consumer markets customers often need assurance that firms are
sufficiently stable to deliver on promises.
In a financial distress situation, employees may become demotivated as they sense
increased job insecurity and few prospects for advancement. The best staff will start to
move to posts in safer companies.
Company Business Assets Date
Integrated health Services Health Care $5.4 February 2, 2000
Montgomery Ward Holding Retail Department
Stores
4.9 July 7, 1997
Loewen Group International Funeral Services 4.7 June 1, 1999
Safety Kleen Chemical Waste 4.4 June 9, 2000
Dow Croning corporation Silicon 4.1 May 15, 1995
Iridium LLC / Capital
corporation
Wireless
communications
3.7 August 13, 1999
CHS Electronics Computer products 3.6 April 4, 2000
Mariner Post Acut Health Care 3.0 January 18,2000
Harnischfeger Industries, Inc Surface Mining
Equipment
2.9 June 7, 1999
ICO Global communications Wireless
Communications
2.6 August 29, 1999

DBA 1764
NOTES
Bankers and other lenders will tend to look upon a request for further finance from a
financially distressed company with a prejudiced eye taking a safety-first approach
and this can continue for many years after the crisis has passed.
Management find that much of their time is spent fire fighting dealing with day-to-
day liquidity problems and focusing on short-term cash flow rather than long-term
shareholder wealth.
The indirect costs associated with financial distress can be much more significant than
the more obvious direct costs such as paying for lawyers, accountants and for refinancing
programs. Some of these indirect and direct costs are shown in the table below:
13.5 SOME INDICATORS OF FINANCIAL DISTRESS
As the risk of financial distress rises with the gearing ratio, shareholders (and lenders)
demand an increasing return in compensation.
The important issue is at what point does the probability of financial distress so increase
the cost of equity and debt that it outweighs the benefit of the tax relief on debt?
Financial Analysis may be used to view some of the indicators of the financial distress.
Important ratios to be considered include:
NOTES
- Liquidity ratios
- Debt management ratios
- Asset utilization ratios
13.6 BANKRUPTCY PREDICTION MODELS
Interest in insolvency prediction has long been confined to academics, with most of
the published material restricted to business and accounting journals specializing in esoteric
and complicated subjects. A possible reason why insolvency prediction models have not
gained greater use in the business community is because it has been difficult to calculate the
results. With the wide spread use of personal computers and the internet, the utilization of
an insolvency prediction model is now practical and available to all. Now may be the time
when prediction models come into their own.
Four software programs are reviewed here using five different prediction models. All
of the models reviewed here, but one, were developed using the statistical technique, step-
wise multiple discriminate analysis. This statistical technique gives weights to financial ratios
used to best differentiate or discriminate between failed and successful companies. For
example, 22 financial ratios were tested in developing the Altman Model (1968). 66
companies were used - 33 failed and 33 successful. The first result was a formula with 22
functions. The function that contributed the least to discriminating between the failed and
successful companies was dropped and the statistical software was run again. This was
repeated over and over each time dropping the ratio which least contributed to discriminating
between the failed and successful companies. In the case of the Altman model, five functions
remained.
The software we have reviewed here are easy to operate and give quick read outs.
We have not evaluated the models compared with each other because it is impossible to
say, in this kind of review, that one model is better or more accurate than another. One of
the great problems in developing and testing prediction models is that it is very difficult to
gather data on matched sets of failed and successful companies.
Some Words of Caution! All developers of prediction models warn that the technique
should be considered as just another tool of the analyst and that it is not intended to
replace experienced and informed personal evaluation. Perhaps the best use of any of
these models is as a filter to identify companies requiring further review or to establish a
trend for a company over a number of years. If, for example, the trend for a company over
a number of years is downward then that company has problems that if caught in time,
could be corrected to allow the company to survive.
13.6.1 Altman Model (U.S. - 1968)
Edward I. Altman (1968) is the dean of insolvency predictors. He was the first person
to successfully use step-wise multiple discriminate analysis to develop a prediction model
DBA 1764
NOTES
with a high degree of accuracy. Using the sample of 66 companies, 33 failed and 33
successful, Altmans model achieved an accuracy rate of 95.0%. Altmans model takes the
following form -:
Z = 1.2A + 1.4B + 3.3C + 0.6D + .999E
Z < 2.675; then the firm is classified as failed
WHERE A = Working Capital/Total Assets
B = Retained Earnings/Total Assets
C = Earnings before Interest and Taxes/Total Assets
D = Market Value of Equity/Book Value of Total Debt
E = Sales/Total Assets
13.6.2 Springate (Canadian - 1978)
This model was developed in 1978 at S.F.U. by Gordon L.V. Springate, following
procedures developed by Altman in the U.S. Springate used step-wise multiple discriminate
analysis to select four out of 19 popular financial ratios that best distinguished between
sound business and those that actually failed. The Springate model takes the following
form -:
Z = 1.03A + 3.07B + 0.66C + 0.4D
Z < 0.862; then the firm is classified as failed
WHERE A = Working Capital/Total Assets
B = Net Profit before Interest and Taxes/Total Assets
C = Net Profit before Taxes/Current Liabilities
D = Sales/Total Assets
This model achieved an accuracy rate of 92.5% using the 40 companies tested by
Springate. Botheras (1979) tested the Springate Model on 50 companies with an average
asset size of $2.5 million and found an 88.0% accuracy rate. Sands (1980) tested the
Springate Model on 24 companies with an average asset size of $63.4 million and found
an accuracy rate of 83.3%.
13.6.3 Fulmer Model (U.S. - 1984)
Fulmer (1984) used step-wise multiple discriminate analysis to evaluate 40 financial
ratios applied to a sample of 60 companies -30 failed and 30 successful. The average
asset size of these firms was $455,000.
NOTES
The model takes the following form -:
H = 5.528 (V1) + 0.212 (V2) + 0.073 (V3)
+ 1.270 (V4) - 0.120 (V5) + 2.335 (V6)
+ 0.575 (V7) + 1.083 (V8) + 0.894 (V9)
- 6.075
H < 0; then the firm is classified as failed
WHERE V1 = Retained Earning/Total Assets
V2 = Sales/Total Assets
V3 = EBT/Equity
V4 = Cash Flow/Total Debt
V5 = Debt/Total Assets
V6 = Current Liabilities/Total Assets
V7 = Log Tangible Total Assets
V8 = Working Capital/Total Debt
V9 = Log EBIT/Interest
Fulmer reported a 98% accuracy rate in classifying the test companies one year prior
to failure and an 81% accuracy rate more than one year prior to bankruptcy.
13.6.4 Blasztk System (Canadian 1984)
This is the only business failure prediction method outlined here that was not developed
using multiple discriminate analysis. This system was developed by William Blasztk in 1984.
The essence of the system is that the financial ratios for the company to be evaluated are
calculated, weighted and then compared with ratios for average companies in that same
industry as given by Dunn & Bradstreet. One of this methods strengths is that it does
compare the company being evaluated with companies in the same industry.
13.6.5 CA - Score (Canadian 1987)
This model is recommended by the Ordre des compatables agrees des Quebec
(Quebec CAs) and according to its developer is used by over 1,000 CAs in Quebec.
This model was developed under the direction of Jean Legault of the University of
Quebec at Montreal, using step-wise multiple discriminate analysis. Thirty financial ratios
were analyzed in a sample of 173 Quebec manufacturing businesses having annual sales
ranging between $1-20 million.
DBA 1764
NOTES
The model takes the following form -:
CA-Score = 4.5913 (*shareholders investments(1)/total assets(1))
+ 4.5080 (earnings before taxes and extraordinary items + financial
expenses(1)/total assets(1))
+ 0.3936 (sales(2)/total assets(2))
2.7616
CA-Score < - 0.3; then the firm is classified as failed
1) Figures from previous period
2) Figures from two previous periods
* Shareholders investments is calculated by adding to shareholders equity the net debt
owing to directors.
This model, as reported in Bilanas (1987), has an average reliability rate of 83% and
is restricted to evaluating manufacturing companies.
13.7 ISSUES FACING A FIRM IN FINANCIAL DISTRESS
Financial distress begins when a firm is unable to meet scheduled payments or when
cash flow projections indicate that it will soon be unable to do so. As the situation develops,
these central issues arise:
1. Is the firms inability to meet scheduled debt payments a temporary cash flow
problem, or is it a permanent problem caused by asset values having fallen below
debt obligations?
2. If the problem is a temporary one, then an agreement with creditors that gives the
firm time to recover and to satisfy everyone may be worked out. However, if
basic long-run asset values have truly declined, then economic losses have occurred.
In this event, who should bear losses, and who should get whatever value remains?
3. Is the company worth more dead than alive? That is, would the business be
more valuable if it were maintained and continued in operation or if it were liquidated
and sold off in pieces?
4. Should the firm file for protection under chapter 11 of the Bankruptcy Act, or
should it try to use informal procedure? (Both reorganization and liquidation can
be accomplished either informally or under the direction of a bankruptcy court)
5. Who should control the firm while it is being liquidated or rehabilitated? Should the
existing management be left in charge, or should a trustee be placed in charge of
operations?
NOTES
In the remainder of the chapter, we discuss these questions.
13.8 WHAT HAPPENS IN FINANCIAL DISTRESS?
- Financial distress does not usually result in the firms death.
- Firms deal with distress by
O Selling major assets.
O Merging with another firm.
O Reducing capital spending and research and development.
O Issuing new securities.
O Negotiating with banks and other creditors.
O Exchanging debt for equity.
O Filing for bankruptcy.
13.9 RESPONSES TO FINANCIAL DISTRESS
- Think of the two sides of the balance sheet.
- Asset Restructuring:
Selling major assets.
Merging with another firm.
Reducing capital spending and R&D spending.
- Financial Restructuring:
Issuing new securities.
Negotiating with banks and other creditors.
Exchanging debt for equity.
Filing for bankruptcy.

Reorganize
and emerge
Merge with
another firm
Liquidation
83%
10%
7%
Financial
distress
Financial
restructuring
No financial
restructuring
49%
51%
Legal bankruptcy
Chapter 11
Private
workout
47%
53%
DBA 1764
NOTES
13.10 VOLUNTARY SETTLEMENT TO SUSTAIN THE FIRM
Normally, the rationale for sustaining a firm is that it is reasonable to believe that the
firms recovery is feasible. By sustaining the firm, the creditor can continue to receive
business from it. A number of strategies are commonly used. An extension is an arrangement
whereby the firms creditors receive payment in full, although not immediately. Normally,
when creditors grant an extension, they require the firm to make cash payments for purchases
until all past debts have been paid. A second arrangement, called composition, is a pro
rata cash settlement of creditor claims. Instead of receiving full payment of their claims,
creditors receive only a partial payment. A uniform percentage of each dollar owed is paid
in satisfaction of each creditors claim. A third arrangement is creditor control. In this
case, the creditor committee may decide that the only circumstance in which maintaining
the firm is feasible, if the operating management is replaced. The Committee may then
take control of the firm and operate it until all claims have been settled. Sometimes, a plan
involving some combination of extension, composition, and creditor control will result. An
example of this would be a settlement whereby the debtor agrees to pay a total of 75 cents
on the dollar in three annual installments of 25 cents on the dollar, and the creditors agree
to sell additional merchandise to the firm on 30 day terms if the existing management is
replaced by new management that is acceptable to them.
13.10.1 Voluntary Settlement Resulting in Liquidation
After the situation of the firm has been investigated by the creditor committee, the
only acceptable course of action may be liquidation of the firm. Liquidation can be carried
out in two ways privately or through the legal procedures provided by bankruptcy law.
If the debtor firm is willing to accept liquidation, legal procedures may not be required.
Generally, the avoidance of litigation enables the creditors to obtain quicker and higher
settlements. However, all the creditors must agree to a private liquidation for it to be
feasible.
The objective of the voluntary liquidation process is to recover as much per dollar
owed as possible. Under voluntary liquidation, common stockholders (the firms true
owners) cannot receive any funds until the claims of all other parties have been satisfied. A
common procedure is to have a meeting of the creditors at which they make an assignment
by passing the power to liquidate the firms assets to an adjustment bureau, a trade
association, or a third party, which is designated the assignee. The assignees job is to
liquidate the assets, obtaining the best price possible. The assignee is sometimes referred
to as the trustee, because it is entrusted with the title to the companys assets and the
responsibility to liquidate them efficiently. Once the trustee has liquidated the assets, it
distributes the recovered funds to the creditors and owners (if any funds remain for the
owners). The final action in a private liquidation is for the creditors to sign a release
attesting to the satisfactory settlement of their claims.
NOTES
13.11 INFORMAL REORGANIZATION
In the case of an economically sound company whose financial difficulties appear to
be temporary, creditors are generally willing to work with the company to help it recover
and reestablish itself on a sound financial basis. Such voluntary plans, commonly called
workouts, usually require a restructuring of the firms debt, because current cash flows are
insufficient to service the existing debt. Restructuring typically involves extension and / or
composition. In an extension, creditors postpone the dates of required interest or principal
payments, or both. In a composition, creditors voluntarily reduce their fixed claims on the
debtor by accepting a lower principal amount, by reducing the interest rate on the debt, by
taking equity for debt, or by some combination of these changes.
A debt restructuring begins with a meeting between the failing firms managers and
creditors. The creditors appoint a committee consisting of four or five of the largest creditors,
plus one or two of the smaller ones. This meeting is often arranged and conducted by an
adjustment bureau associated with and run by a local credit managers association. The
first step is to draw up a list of creditors, with amounts of debt owed. There are typically
different classes of debt, ranging from first mortgage holders to unsecured creditors.
Next, the company develops information showing the value of the firm under different
scenarios. Typically, one scenario is going out of business, selling off the assets, and then
distributing the proceeds to the various creditors in accordance with the priority of their
claims, with any surplus going to the common stockholders. The company may hire an
appraiser to get an appraisal for the value of the firms property to use as basis for this
scenario. Other scenarios include continued operations, frequently with some improvements
in capital equipment, marketing, and perhaps some management changes.
This information is then shared with the firms bankers and other creditors. Frequently,
it can be demonstrated that the firms debts exceed its liquidating value, and it can also be
shown that legal fees and other costs associated with a formal liquidation under federal
bankruptcy procedures would materially lower the net proceeds available to creditors.
Further, it generally takes at least a year, and often several years, to resolve matters in a
formal proceeding, so the present value of the eventual proceeds will be lower still. This
information, when presented in a credible manner, often convinces creditors that they would
be better off accepting something less than the full amount of their claims rather than holding
out for the full face amount. If management and the major creditors agree that the problems
can probably be resolved, then a more formal plan is drafted and presented to all the
creditors, along with the reasons creditors should be willing to compromise on their claims.
In developing the reorganization plan, creditors prefer an extension because it promises
eventual payment in full. In some cases, creditors may agree not only to postpone the date
of payment but also to subordinate existing claims to vendors who are willing to extend
new credit during the extension, perhaps in exchange for a pledge of collateral. Because of
DBA 1764
NOTES
the sacrifices involved, the creditors must have faith that the debtor firm will be able to
solve its problems.
In a composition, creditors agree to reduce their claims. Typically, creditors receive
cash and / or new securities that have a combined market value that is less than the amounts
owned them. The cash and securities, which might have a value of only 10 percent of the
original claim, are taken as full settlement of the original debt. Bargaining will take place
between the debtor and the creditors over the savings that result from avoiding the costs of
legal bankruptcy: administrative costs, legal fees, investigative costs, and so on. In addition
to escaping such costs, the debtor gains in that the stigma of bankruptcy may be avoided.
As a result, the debtor may be induced to part with most of the savings from avoiding
formal bankruptcy.
Often, the bargaining process will result in a restructuring that involves both extension
and composition. For example, the settlement may provide for a cash payment of 25
percent of the debt immediately, plus a new note promising six future installments of 10
percent each, for a total payment of 85 percent.
Voluntary settlements are both informal and simple, and also relatively inexpensive
because legal and administrative expenses are held to a minimum. Thus, voluntary
procedures generally result in the largest return to creditors. Although creditors do not
obtain immediate payment and may even have to accept less than is owned them, they
generally recover more money, and sooner, than if the firm were to file for bankruptcy.
In recent years, one factor that has motivated some creditors, especially banks and
insurance companies, to agree to voluntary restructurings is the fact that restructurings can
sometimes help creditors avoid showing a loss. Thus, a bank that is in trouble with its
regulators over weak capital ratios may agree to extend further loans that are used to pay
the interest on earlier loans in order to keep the bank from having to write down the value
of its earlier loans. The particular type of restructuring depends on (1) the willingness of the
regulators to go along with the process, and (2) whether the bank is likely to recover more
in the end by restructuring the debt than by forcing the borrower into bankruptcy
immediately.
We should point out that informal voluntary settlements are not reserved for small
firms. International Harvester (now Navistar International) avoided formal bankruptcy
proceedings by getting its creditors to agree to restructure more than $3.5 billion of debt.
Likewise, Chryslers creditors accepted both an extension and a composition to help it
through its bad years. The biggest problem with informal reorganizations is getting all the
parties to agree to the voluntary plan. This problem, called the holdout problem, is discussed
in a later section.
NOTES
13.12 INFORMAL LIQUIDATION
When it is obvious that a firm is more valuable dead than alive, informal procedures
can also be used to liquidate the firm. Assignment is an informal procedure for liquidating a
firm, and it usually yields creditors a larger amount than they would get in formal bankruptcy
liquidation. However, assignments are feasible only if the firm is small and its affairs are not
too complex. An assignment calls for title to the debtors assets to be transferred to a third
party, known as an assignee or trustee. The assignee is instructed to liquidate the assets
through a private sale or public auction and then to distribute the proceeds among the
creditors on a pro rata basis. The assignment does not automatically discharge the debtors
obligations. However, the debtor may have the assignee write on the check to each creditor
the requisite legal language to make endorsement of the check acknowledgement of full
settlement of the claim.
Assignment has some advantages over liquidation in federal bankruptcy courts in
terms of time, legal formality, and expense. The assignee has more flexibility in disposing of
property than does a federal bankruptcy trustee, so action can be taken sooner, before
inventory becomes obsolete or machinery rusts. Also, because the assignee is often familiar
with the debtors business, better results may be achieved. However, an assignment does
not automatically result in a full and legal discharge of all the debtors liabilities, nor does it
protect the creditors against fraud. Both of these problems can be reduced by formal
liquidation in bankruptcy, which we discuss in a later section.
13.13 REORGANIZATION IN BANKRUPTCY
It might appear that most reorganizations should be handled informally because informal
reorganizations are faster and less costly than formal bankruptcy. However, two problems
often arise to stymie informal reorganization and thus force debtors into Chapter 11
bankruptcy the common pool problem and the holdout problem.
To illustrate these problems, consider a firm that is having financial difficulties. It is
worth $9 million as a going concern (this is the present value of its expected future free
cash flows) but only $7 million if it is liquidated. The firms debt totals $10 million at face
value ten creditors with equal priority each have a $1 million claim. Now suppose the
firms liquidity deteriorates to the point where it defaults on one of its loans. The holder of
that loan has the contractual right to accelerate the claim, which means the creditor can
foreclose on the loan and demand payment of the entire balance. Further, since most debt
agreements have cross default provisions, defaulting on one loan effectively places all
loans in default.
The firms market value is less than the $10 million face value of debt, regardless of
whether it remains in business or liquidates. Therefore, it would be impossible to pay off
all of the creditors in full. However, the creditors in total would be better off if the firm is
DBA 1764
NOTES
not shut down, because they can recover $9 million if the firm remains in business but only
$7 million if it is liquidated. The problem here, which is called the common pool problem,
is that, in the absence of protection under the bankruptcy Act, individual creditors would
have an incentive to foreclose on the firm even though it is worth more as an ongoing
concern.
An individual creditor would have the incentive to foreclose because it could then
force the firm to liquidate a portion of its assets to pay off that particular creditors $I
million claim in full. The payment to that creditor would probably require the liquidation of
vital assets, which might cause a shutdown of the firm and thus lead to liquidation. Therefore,
the value of the remaining creditors claims would decline. Of course, all the creditors
would recognize the gains to be had from this strategy, so they would storm the debtor
with foreclosure notices. Even those creditors who understand the merits of keeping the
firm alive would be forced to foreclose, because the foreclosures of the other creditors
would reduce the payoff to those who do not. In our hypothetical example, if seven creditors
foreclosed and forced liquidation, they would be paid in full, and the remaining three creditors
would receive nothing.
With many creditors, as soon as a firm defaults on one loan, there is the potential for
a disruptive flood of foreclosures that would make the creditors collectively worse off. In
our example, the creditors would lose $9 - $7 = $2 million in value if a flood of foreclosures
were to force the firm to liquidate. If the firm had only one creditor, say, a single bank loan,
the common pool problem would not exist. If a bank has loaned the company $10 million,
it would not force liquidation to get $7 million when it could keep the firm alive and eventually
realize $9 million.
Chapter 11 of the Bankruptcy Act provides a solution to the common pool problem
through its automatic stay provision. An automatic stay, which is forced on all creditors in
a bankruptcy, limits the ability of creditors of foreclose to collect their individual claims.
However, the creditors can collectively foreclose on the debtor and force liquidation.
While bankruptcy gives the firm a chance to work out its problems without the threat
of creditor foreclosure, management does not have a completely free reign over the firms
assets. First, bankruptcy law requires the debtor firm to request permission from the court
to take many actions, and the law also gives creditors the right to petition the bankruptcy
court to block almost any action the firm might take while in bankruptcy. Second, fraudulent
conveyance statutes, which are part of debtor-creditor law, protect creditors from unjustified
transfers of property by a firm in financial distress.
To illustrate fraudulent conveyance, suppose a holding company is contemplating
bankruptcy protection for one of its subsidiaries. The holding company might be tempted
to sell some or all of the subsidiarys assets to itself (the parent company) for less than the
true market value of its assets and the amount paid and the loss would be borne primarily
NOTES
by the subsidiarys creditors. Such a transaction would be voided by the courts as a
fraudulent conveyance. Note also that transactions that favour one creditor at the expense
of another can be voided under the same law. For example, a transaction in which an asset
is sold and the proceeds are used to pay one creditor in full at the expense of other
creditors could be voided. Thus, fraudulent conveyance laws also protect creditors from
each other.
The second problem that the bankruptcy law mitigates is the holdout problem. To
illustrate this problem, consider again our example with ten creditors owed $1 million each
but with assets worth only $9 million. The goal of the firm is to avoid Liquidation by
remedying the default. In an informal workout, this would require a reorganization plan
that is agreed to by each of the ten creditors. Suppose the firm offers each creditor new
debt with a face value of $850,000 in exchange for the old $1,000,000 face value debt. If
each of the creditors accepted the offer, the firm could be successfully reorganized. The
reorganization would leave the equity holders with some value the market value of the
equity would be $9,000,000 10($850,000) = $500,000. Further, the creditors would
have claims worth $8.5 million, much more than the $7 million value of their claims in
liquidation.
Although such an exchange offer seems to benefit all parties, it might not be accepted
by the creditors. Heres why: Suppose seven of the ten creditors tender their bonds; thus
seven creditors each now have claims with a face value of $850,000 each, or $5,950,000
in total, while the three creditors that did not tender their bonds each still have a claim with
a face value of $1 million. The total face value of the debt at this pointy is $8,950,000
which is less than the $9 million value of the firm. In this situation, the three holdout
creditors would receive the full face value of their debt. However, this probably would not
happen, because (1) all of the creditors would be sophisticated enough to realize this could
happen, and (2) each creditor would want to be one of the three holdouts that gets paid in
full. Thus, it is likely that none of the creditors would accept the offer. Thus, the holdout
problem makes it difficult to restructure the firms debts. Again, if the firm had a single
creditor, there would be no holdout problem.
The holdout problem is mitigated in bankruptcy proceedings by the bankruptcy courts
ability to lump creditors into classes. Each class is considered to have accepted a
reorganization plan if two-thirds of the amount of debt and one-half the number of claimants
vote for the plan, and the plan will be approved by the court if it is deemed to be fair and
equitable to the dissenting parties. This procedure, in which the court mandates a
reorganization plan in spite of dissent, is called a cram down, because the court crams the
plan down the throats of the dissenters. The ability of the court to force acceptance of a
reorganization plan greatly reduces the incentive for creditors to hold out. Thus, in our
example, if the reorganization plan offered each creditor a new claim worth $850,000 in
face value, along with information that each creditor would probably receive only &700,000
under the liquidation alternative, it would have a good chance of success.
DBA 1764
NOTES
It is easier for a firm with few creditors to informally reorganize than it is for a firm with
many creditors. A study examined 169 publicly traded firms that experienced severe
financial distress from 1978 to 1987. About half of the firms reorganized without filing for
bankruptcy, while the other half were forced to reorganize in bankruptcy. The firms that
reorganized without filing for bankruptcy owed most of their debt to a few banks, and they
had fewer creditors. Generally, bank debt can be reorganized outside of bankruptcy, but
a publicly traded bond issue held by thousands of individual bondholders makes
reorganization difficult.
Filing for bankruptcy under Chapter 11 has several other features that help the bankrupt
firm:
1. Interest and principal payments, including interest on delayed payments, may be
delayed without penalty until a reorganization plan is approved, and the plan itself
may call for even further delays. This permits cash generated from operations to
be used to sustain operations rather than be paid to creditors.
2. The firm is permitted to issue debtor-in-possession (DIP0 financing). DIP financing
enhances the ability of the firm to borrow funds for short-term liquidity purposes,
because such as loans are, under the law, senior to all previous unsecured debt.
3. The debtor firms managers are given the exclusive right for 120 days after filing
for bankruptcy protection to submit a reorganization plan, plus another 60 days to
obtain agreement on the plan from the affected parties. The court may also extend
these dates. After managements first right to submit a plan has expired, any party
to the proceedings may propose its own reorganization plan.
Under the early bankruptcy laws, most formal reorganization plans were guided by
the absolute priority doctrine. This doctrine holds that creditors should be compensated
for their claims in a rigid hierarchical order, and that senior claims must be paid in full
before junior claims can receive even a dime. If there was any chance that a delay would
lead to losses by senior creditors, then the firm would be shut down and liquidated. However,
an alternative position, the relative priority doctrine, holds that more flexibility should be
allowed in reorganization, and that a balanced consideration should be given to all claimants.
The current law represents a movement away from absolute priority toward relative priority.
The primary role of the bankruptcy court in reorganization is to determine the fairness
and the feasibility of the proposed plan of reorganization. The basis doctrine of fairness
states that claims must be recognized in the order of their legal and contractual priority.
Feasibility means that there is a reasonable chance that the reorganized company will be
viable. Carrying out the concepts of fairness and feasibility in reorganization involves the
following steps:
NOTES
1. Future sales must be estimated.
2. Operating conditions must be analyzed so that future earnings and cash flows can
be predicted.
3. The appropriate capitalization rate must be determined.
4. This capitalization rate must then be applied to the estimated cash flows to obtain
an estimate of the companys value.
5. An appropriate capital structure for the company after it emerges from Chapter 11
must be determined.
6. The reorganized firms securities must be allocated to the various claimants in a fair
and equitable manner.
The primary test of feasibility in reorganization is whether the fixed charges after
reorganization will be adequately covered by earnings. Adequate coverage generally requires
an improvement in earnings, a reduction of fixed charges, or both. Among the actions that
must generally be taken are the following:
1. Debt maturities are usually lengthened, interest rates may be lowered, and some
debt is usually converted into equity.
2. When the quality of management has been substandard, a new team must be given
control of the company.
3. If inventories have become obsolete or depleted, they must be replaced.
4. Sometimes the plant and equipment must be modernized before the firm can operate
and compete successfully.
5. Reorganization may also require an improvement in production, marketing,
advertising, and other functions.
6. It is sometimes necessary to develop new products or markets to enable the firm
to move from areas where economic trends are poor into areas with more potential
for growth.
These actions usually require at least some new money, so most reorganization plans
include new investors who are willing to put up new capital.
It might appear that stockholders have very little to say in a bankruptcy situation
where the firms assets are worth less than the face value of its debt. Under the absolute
priority rule, stockholders in such a situation should get nothing of value under a reorganization
plan. In fact, however, stockholders may be able to extract some of the firms value. This
occurs because (1) stockholders generally continue to control the firm during the bankruptcy
proceedings, (2) stockholders have the first right to file a reorganization plan, and (3) for
the creditors, developing a plan taking it through the courts would be expensive and time
consuming, Given this situation, creditors may support a plan under which they are not
paid off in full and where the old stockholders will control the reorganized company just
because the creditors want to get the problem behind them and to get some money in the
near future.
DBA 1764
NOTES
13.14 PREPACKAGED BANKRUPTCIES
In recent years, a new type of reorganization that combines the advantages of both
the informal workout and formal chapter 11 reorganization has become popular. This new
hybrid is called a prepackaged bankruptcy, or pre-pack.
In an informal workout, debtor negotiates a restructuring with its creditors. Even
though complex workouts typically involve corporate officers, lenders, lawyers, and
investment bankers, workouts are still less expensive and less damaging to reputations
than are chapter 11 reorganizations. In a prepackaged bankruptcy, the debtor firm gets all,
or most of, the creditors to agree to the reorganization plan prior to filing for bankruptcy.
Then, a reorganization plan is filed along with, or shortly after, the bankruptcy petition. If
enough creditors have signed on before the filing, a cram down can be used to bring
reluctant creditors along.
A logical question arises: Why would a firm that can arrange an informal reorganization
want to file for bankruptcy? The three primary advantages of a prepackaged bankruptcy
are (1) reduction of the holdout problem, (2) preserving creditors claims, and (3) taxes.
Perhaps the biggest benefit of a prepackaged bankruptcy is the reduction of the holdout
problem-a bankruptcy filing permits a cream down that would otherwise be impossible.
By eliminating holdouts, bankruptcy forces all creditors in each class to participate on a
pro rata basis, which preserves the relative value of all claimants. Also, filing for formal
bankruptcy can at times have positive tax implications. First, in an informal reorganization
in which the debt holders trade debt for equity, if the original equity holders end up with
less than 50 percent ownership, the company loses its accumulated tax losses. If formal
bankruptcy, the firm may get to keep its loss carry forwards. Second, in a workout, when
debt worth, say, $1,000, is exchanged for debt worth, say, $500, the reduction in debt of
$500 is considered to be taxable income to the corporation. However, if this same situation
occurs in a chapter 11 reorganization, the difference is not treated as taxable income.
13.15 REORGANIZATION TIME AND EXPENSE
The time, expense, and headaches involved in reorganization are almost beyond
comprehension. Even in $2 to $3 million bankruptcies, many people and groups are involved:
lawyers representing the company, the U.S. Bankruptcy Trustee, each class of secured
creditor, the general creditors as a group, tax authorities, and the stockholders if they are
upset with management. There are time limits within which things are supposed to be
done, but the process generally takes at least a year and probably much longer. The company
must be given time to file its plan, and creditor groups must be given time to study and seek
clarifications to it and then file counter plans to which the company must respond. Also,
different creditor classes often disagree among themselves as to how much each class
should receive, and hearings must be held to resolve such conflicts.
NOTES
Management may want to remain in business, while some well-secured creditors may
want the company liquidated as quickly as possible. Often, some partys plan will involve
selling the business to another concern. Obviously, it can take months to seek out and
negotiate with potential merger candidates.
The typical bankruptcy case takes about two years from the time the company files
for protection under chapter 11 until the final reorganization plan is approved or rejected.
While all of this is going on, the companys business suffers. Sales certainly wont be
helped, key employees may leave, and the remaining employees will be worrying about
their jobs rather than concentrating on their work. Further, management will be spending
much of its time on the bankruptcy rather than running the business, and it wont be able to
take any significant action without court approval, which requires filing a formal petition
with the court and giving all parties involved a chance to respond.
Even if its operations do not suffer, the companys assets will surely be reduced by its
own legal fees and the required court and trustee costs. Good bankruptcy lawyers charge
from $200 to $400 per hour, depending on the location, so those costs are not trivial. The
creditors will also be incurring legal costs. Indeed, the sound of all of those meters ticking
at $200 or so an hour in a slow-moving hearing can be deafening.
Note that creditors also lose the time value of their money. A creditor with a $100,000
claim and a 10 percent opportunity cost who ends up getting $50,000 after two years
would have been better off settling for $41,500 initially. When the creditors legal fees,
executive time, and general aggravation are taken into account, it might make sense to
settle for $20,000 or $25,000.
Both the troubled company and its creditors know the drawbacks of formal bankruptcy
or their lawyers will inform them. Armed with knowledge of how bankruptcy works,
management may be in a strong position to persuade creditors to accept a workout which
on the surface appears to be unfair and unreasonable. Or, if a Chapter 11 case has already
begun, creditors may at some point agree to settle just to stop the bleeding.
One final point should be made before closing this section. In most reorganization
plans, creditors with claims of less than $1,000 are paid off in full. Paying off these nuisance
claims does not cost much money, and it saves time and gets votes to support the plan.
13.16 LIQUIDATION IN BANKRUPTCY
If a company too far gone to be recognized, then it must be liquidated. Liquidation
should occur when the business is worth more dead than alive, or when the possibility of
resorting it to financial health is remote and the creditors are exposed to a high risk of
greater loss if operations are continued. Earlier we discussed assignment, which is an
informal liquidation procedure. Now we consider liquidation in bankruptcy, which is carried
out under the jurisdiction of a federal bankruptcy court.
DBA 1764
NOTES
Chapter 7 of the federal Bankruptcy reform Act deals with liquidation. It (10s
provides safeguards against fraud by the debtor, (2) provides for an equitable distribution
of the debtors assets among the creditors (3) allows insolvent debtors to discharge all
their obligations and thus be able to start new business unhampered by the burdens of
prior debt. However, formal Liquidations is time consuming and costly, and it extinguishes
the business.
The distribution of assets in liquidation under chapter 7 is governed by the following
priority of claims:
1. Past due property taxes.
2. Secured creditors, who are entitled to the proceeds of the sale of specific property
pledged for a lien or a mortgage. If the proceeds from the sale of the pledged
property do not fully satisfy a secured creditors claim the remaining balance is
treated as a general creditor claim ( see Item 10 below) 12
3. Legal fees and other expenses to administer and operate the bankrupt firm. These
costs include legal fees incurred in trying to reorganize.
4. Expenses incurred after an involuntary case has begun but before a trustee is
appointed.
5. Wages due workers if earned within three months prior to the filing of the petition
in bankruptcy. The amount of wages is limited to $2,000 per employee.
6. Claims for unpaid contributions to employee pension plans that should have been
paid within six months prior to filing. These claims, plus wages in Item 5, may not
exceed the $2,000 per- wage-earner limit.
7. Unsecured claims for customer deposits. These claims are limited to a maximum
of $900 per individual.
8. Taxes due to federal, state, country and other government agencies.
9. Unfunded pension plan liabilities. These liabilities have a claim above that of the
general creditors for an amount up to 30 percent of the common and preferred
equity, and any remaining unfunded pension claims rank with the general creditors.
10. General, or unsecured, creditors. Holders of trade credit, unsecured loans,
the unsatisfied portion of secured loans, and debenture bonds are classified as
general creditors. Holders of subordinated debt also fall into this category, but
they must turn over required amounts to the senior debt.
11. Preferred stockholders. These stockholders can receive an amount up to the
par value of their stock.
12. Common stockholders. These stockholders receive any remaining funds.
NOTES
13.17 OTHER MOTIVATIONS FOR BANKRUPTCY
Normally, bankruptcy proceedings do not commence until a company has become
so financially weak that it cannot meet its current obligations. However, bankruptcy law
also permits a company to file for bankruptcy if its financial forecasts indicate that a
continuation of current conditions would lead to insolvency. This provision was used by
Continental Airlines in 1993 to break its union contract and hence lower its labour costs.
Continental demonstrated to a bankruptcy court that operations under the then current
union contract would lead to insolvency in a matter of months. The company then filed a
reorganization plan that included major changes in all its contracts, including its union contract.
Continental then reorganized as a nonunion carrier, and that reorganization turned the
company from a money loser into a money maker. Congress changed the law after the
Continental affair to make it more difficult for companies to use bankruptcy to break union
contracts, but this case did set the precedent for using bankruptcy to help head off financial
problems as well as to help solve existing ones.
Bankruptcy law has also been used to hasten settlements in major product liability
suits. The Manville asbestos and A.H. Robins Dalkon Shield cases are examples. In both
situations, the companies were being bombarded by thousands of lawsuits, and the very
existence of such huge contingent liabilities made normal operations impossible. Further,
in both cases it was relatively easy to prove (1) that if the plaintiffs won, the companies
would be unable to be the full amount of the claims, (2) that a larger amount of funds would
be available to the claimants if the companies continued to operate rather than liquidate,
(3) that continued operations were possible only if the suits were brought to a conclusion,
and (4) that a timely resolution of all the suits was impossible because of their vast number
and variety. The bankruptcy statutes were used to consolidate all the suits and to reach
settlement under which the plaintiffs obtained more money than they otherwise would have
received, and the companies were able to stay in business. The stockholders did poorly
under these plans, because most of the companies future cash flows were assigned to the
plaintiffs, but even so, the stockholders probably fared better than they would have if the
suits had been concluded through the jury system.
DBA 1764
NOTES
Review Questions
1) What are the three types of business failure? What is the difference between
technical insolvency and bankruptcy? What are the major causes of business failure?
2) Define an extension and composition, and explain how they might be combined to
form a voluntary settlement plan to sustain the firm. How is a voluntary settlement
resulting in liquidation?
3) What is the concern of Chapter 11 of the Bankruptcy Reform Act of 1978? How
is the debtor in possession(DIP) involved in i) the valuation of the firm, ii) the
recapitalization of the firm, and iii) the exchange of obligations using the priority
rule?
4) What is the concern of Chapter 7 of the Bankruptcy Reforms Act of 1978? Under
which conditions is a firm liquidated in bankruptcy? Describe the procedures
involved in liquidating the bankrupt firm.
5) What five major issues must be addressed when a firm faces financial distress?
6) What are the advantages of liquidation by assignment versus formal bankruptcy
liquidation?
7) Describe briefly the priority of claims in a formal liquidation.

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