SAS PART II PAPER VII SECTION I: FINANCIAL MANAGEMENT INDEX

1. FINANCE

Sl. No. 1. ". '. ).

TOPICS Financial Management - An overview, an understanding of basic terms conce!t in Finance. #once!t of $ime %alue of Mone&. #a!ital E(!enditure Decisions. *ro+ect A!!raisal and #ontrol $ec,ni-ues

FINANCIAL MANAGEMENT -AN OVERVIEW

INTRODUCTION Finance ma& be defined as t,e art and science of managing mone&. $,e ma+or areas of finance are. /10 financial services and /"0 managerial finance cor!orate finance financial management. 1,ile financial services is concerned wit, t,e design and deliver& of advice and financial !roducts to individuals, businesses and governments wit,in t,e areas of ban2ing and related institutions, !ersonal financial !lanning, investments, real estate, insurance and so on, financial management is concerned wit, t,e duties of t,e financial managers in t,e business firm. Financial managers activel& manage t,e financial affairs of an& t&!e of business, namel&, financial and non-financial, !rivate and !ublic, large and small, !rofit-see2ing and not-for-!rofit. $,e& !erform suc, varied tas2s as budgeting, financial forecasting, cas, management, credit administration, investment anal&sis, funds management and so on. In recent &ears, t,e c,anging regulator& and economic environments cou!led wit, t,e globalisation of business activities ,ave increased, t,e com!le(it& as well as t,e im!ortance of t,e financial managers3 duties. As a result, t,e financial management function ,as become more demanding and com!le(. $,is #,a!ter !rovides an overview of financial management function. It is organised into seven 4ections. . 5elations,i! of finance and related disci!lines . 4co!e of financial management . 6oal ob+ectives ,of financial management . Agenc& !roblem . 7rganisation of t,e finance function . Emerging role of finance managers in India . An overview FINAN#E 8FINAN#E AND 5E9A$ED DI4#I*9INE Financial management, as an integral !art of overall management, is not a totall& inde!endent area. It draws ,eavil& on related disci!lines and fields of stud&, suc, as economics, :accounting, mar2eting, !roduction and -uantitative met,ods. Alt,oug, t,ese disci!lines are interrelated, t,ere are 2e& differences among t,em. In t,is 4ection, we discuss t,ese relations,i!s. Finance and Economics $,e relevance of economics. to financial management can be described in t,e lig,t of t,e two broad areas of economics. macroeconomics and microeconomics. Macroeconomics is concerned wit, t,e overall institutional environment in w,ic, t,e firm o!erates. It loo2s at t,e econom& as a w,ole. Macroeconomics is concerned wit, t,e institutional structure of t,e ban2ing s&stem, mone& and ca!ital mar2ets, financial intermediaries, monetar&, credit and fiscal !olicies and economic !olicies dealing wit,, and controlling level of, activit& wit,in an econom&. 4ince business firms o!erate in t,e macroeconomic environment, it is im!ortant for financial managers to understand t,e broad economic environment. 4!ecificall&, t,e& s,ould /10 recognise and understand ,ow monetar& !olic& affects t,e cost and t,e availabilit& of funds; /"0 be versed in fiscal !olic& and its effects on t,e econom&; /'0 be ware of t,e various financial institutions financing

outlets; /)0 understand t,e conse-uences of various levels of economic activit& and c,anges in economic !olic& for t,eir decision environment and so on. Microeconomics deals wit, t,e economic decisions of individuals and organisations. It concerns itself wit, t,e determination of o!timal o!erating strategies. In ot,er words, t,e t,eories of microeconomics !rovide for effective o!erations of business firms. $,e& are concerned wit, defining actions t,at will !ermit t,e firms to ac,ieve success. $,e conce!ts and t,eories of microeconomics relevant to financial management are, for instance, t,ose involving /10 su!!l& and demand relations,i!s and !rofit ma(imisation strategies, /"0 issues related to t,e mi( of !roductive factors, 3o!timal3 sales level and !roduct !ricing strategies, /'0 measurement of utilit& !reference, ris2 and t,e determination of value, and /)0 t,e rationale of de!reciating assets. In addition, t,e !rimar& !rinci!le t,at a!!lies in financial management is marginal anal&sis; it suggests t,at financial decisions s,ould be made on t,e basis of com!arison of marginal revenue and marginal cost. 4uc, decisions will lead to an increase in !rofits of t,e firm. It is, t,erefore, im!ortant t,at financial managers must be familiar wit, basic microeconomics. $o illustrate, t,e financial manager of a de!artment store is contem!lating to re!lace one of its online com!uters wit, a new, more so!,isticated one t,at would bot, s!eed u! !rocessing time and ,andle a large volume of transactions. $,e new com!uter would re-uire a cas, outla& of 5s <,==,=== and t,e old com!uter could be sold to net 5s ",<=,===. $,e total benefits from t,e new com!uter and t,e old com!uter would be 5s 1=,==,=== and 5s ',>=,=== res!ectivel&. A!!l&ing marginal anal&sis, we get. ?enefits wit, new com!uter 5s 1=,==,=== Less: ?enefits wit, old com!uter Marginal benefits /a0 #ost of new com!uter ',>=,=== Marginal ?enefits /a0 5s @,>=,=== #ost of new com!uter 5s <,==,=== Less: *roceeds from sale of old com!uter Marginal cost /b0 Net benefits A/a0 /b0B 5s ",<=,=== Marginal cost /b0 5s >,"=,=== Net benefits /a0 8/b0 1,'=,==== As t,e store would get a net benefit of 5s 1,'=,===, t,e old com!uter s,ould be re!laced b& t,e new one. $,us, a 2nowledge of economics is necessar& for a financial manager to understand bot, t,e financial environment and t,e decision t,eories w,ic, underline contem!orar& financial management. Ce s,ould be familiar wit, t,ese two areas of economics. Macroeconomics !rovides t,e financial manager wit, an insig,t into !olicies b& w,ic, economic activit& is controlled. 7!erating wit,in t,at institutional framewor2, t,e financial manager draws on microeconomic t,eories of t,e o!eration of firms and !rofit ma(imisation. A basic 2nowledge of economics is, t,erefore, necessar& to understand bot, t,e environment and t,e decision. tec,ni-ues of financial management. Finance an Acco!n"in# $,e relations,i! between finance and accounting, conce!tuall& s!ea2ing, ,as two dimensions. #7 t,e& are closel& related to t,e e(tent t,at accounting is an im!ortant in!ut in financial decision

ma2ing; and /ii0 t,ere. are 2e& differences in view!oints between t,em. . Accounting function is a necessar& in!ut into t,e finance function. $,at is, accounting is a subfunction of finance. Accounting generates information data relating to o!erations activities of t,e firm. $,e end-!roduct of accounting constitutes financial statements suc, as t,e balance s,eet, t,e income statement /!rofit and loss account0 and t,e statement of c,anges in financial !osition sources and uses of funds statement cas, flow statement. $,e information contained in t,ese statements and re!orts assists financial managers in assessing t,e !ast !erformance and future directions of t,e firm and in meeting legal obligations, suc, as !a&ment of ta(es and so on. $,us, accounting and finance are functionall& closel& related. Moreover, t,e finance /treasurer0 and accounting /controller0 activities are t&!icall& wit,in t,e control of t,e vice!resident director /finance0 #,ief financial officer /#F70 as s,own in Fig. 1.". $,ese functions are closel& related and generall& overla!; indeed, financial management and accounting are often not easil& distinguis,able. In small firms t,e controller often carries out t,e finance function and in large firms man& accountants are intimatel& involved in various finance activities. ?ut t,ere are two 2e& differences between finance and accounting. $,e first difference relates to t,e treatment of funds, w,ile t,e second relates to decision ma2ing. T$ea"%en" o& F!n ' $,e view!oint of accounting relating to t,e funds of t,e firm is different from t,at of finance. $,e measurement of funds /income and e(!enses0 in accounting is based on t,e accrual !rinci!le s&stem. For instance, revenue is recognised at t,e !oint of sale and not w,en collected. 4imilarl&, e(!enses are recognised w,en t,e& are incurred rat,er t,an w,en actuall& !aid. $,e accrual-based accounting data do not reflect full& t,e financial circumstances of t,e firm. A firm ma& be -uite !rofitable in t,e accounting sense in t,at it ,as earned !rofit /sales less e(!enses0 but it ma& not be able to meet current obligations owing to s,ortage of li-uidit&. due to uncollectable receivables, for instance. 4uc, a firm will not survive regardless of its levels of !rofits. ,$,e view!oint of finance relating to t,e treatment of funds is based on cas,flows. $,e revenues are recognised onl& w,en actuall& received in cas, /9e. cas, inflow0 and e(!enses are recognised on actual !a&ment /9e. cas, outflow0. $,is is so because t,e financial manager is concerned wit, maintaining solvenc& of t,e firm b& !roviding t,e cas,flows necessar& to satisf& its obligations and ac-uiring and financing t,e assets needed to ac,ieve t,e goals of t,e firm. $,us, cas,flow-based returns ,el! financial managers avoid insolvenc& and ac,ieve t,e desired financial goals. $o illustrate, total sales of a trader during t,e &ear amounted to 5s 1=,==,=== w,ile t,e cost of sales was 5s <,==,===. At t,e end of t,e &ear, it ,as &et to collect 5s <,==,=== from t,e customers. $,e accounting view and t,e financial view of t,e firms !erformance during t,e &ear are given below. Accounting %iew %iew /Income 4tatement0 4ales 5s ",==,=== 9ess. #ost 5s <,==,=== DDDDDDDDDDD Net *rofit outflow 5s @,==,=== Financial 5s 1=,==,=== 5s <,==,=== /#as, Flow 4tatement0 #as, inflow 9ess cas, outflow

DDDDDDDDDDDDD 5s ",==,=== Net cas,

7bviousl&, t,e firm is -uite !rofitable in accounting sense, it is a financial failure in, terms of actual cas, flows resulting from uncollected receivables. 5egardless of its !rofits, t,e firm would not survive due to inade-uate cas, inflows to meet its obligations. Deci'ion Ma(in# Finance and accounting also differ in res!ect of t,eir !ur!oses. $,e !ur!ose of accounting is collection and !resentation of financial data. It !rovides consistentl& develo!ed and easil& inter!reted data on t,e !ast, !resent and future o!erations of t,e firm. $,e financial manager uses suc, data for financial decision ma2ing. It does not mean t,at accountants never ma2e decisions or financial managers never collect data. ?ut t,e !rimar& focus of t,e functions of accountants is on collection and !resentation of data w,ile t,e financial manager3s ma+or res!onsibilit& relates to financial !lanning, controlling and decision ma2ing. $,us, in a sense, finance begins w,ere accounting ends. Finance an O")e$ Rela"e Di'ci*line' A!art from economics and accounting, finance also draws-for its da&-to-da& decisions-on su!!ortive disci!lines suc, as mar2eting, !roduction and -uantitative met,ods. For instance, financial managers s,ould consider t,e im!act of new !roduct develo!ment and !romotion !lans made in mar2eting area since t,eir !lans will re-uire ca!ital outla&s and ,ave an im!act on t,e !ro+ected cas, flows. 4imilarl&, c,anges in t,e !roduction !rocess ma& necessitate ca!ital e(!enditures w,ic, t,e financial managers must evaluate and finance. And, finall&, t,e tools of anal&sis develo!ed in t,e -uantitative met,ods area are ,el!ful in anal&sing com!le( financial management !roblems. $,e mar2eting, !roduction and -uantitative met,ods are, t,us, onl& indirectl& related to da&-toda& decision ma2ing b& financial managers and are su!!ortive in nature w,ile economics and accounting are t,e !rimar& disci!lines on w,ic, t,e financial manager draws substantiall&. $,e relations,i! between financial management and su!!ortive disci!lines is de!icted in Fig 1.1.

Financial *rimar& Disci!line 1. Investment anal&sis ". Macroeconomics "E 1or2ing ca!ital management. '. Micro economics '. 4ources and cost of funds ). Determination of ca!ital structure >. Dividend !olic&. 3 @. Anal&sis of ris2s and returns 7t,er 5elates Disci!line

Decision 1. Accounting 4u!!ort

Area

4u!!ort 1. Mar2eting ". *roduction

'. Fuantatative met,od 5esulting in 4,are,olders 1ealt, Ma(imisation

4#7*E 7F FINAN#IA9 MANA6EMEN$ $,e a!!roac, to t,e sco!e and functions of financial management is divided, for !ur!oses of e(!osition, into two broad categories. /a0 $,e $raditional A!!roac,, and /b0 $,e Modem A!!roac,. T$a i"ional A**$oac) $,e "$a i"ional a**$oac) to t,e sco!e of financial management refers to its sub+ect-matter, in academic literature in t,e initial stages of its evolution, as a se!arate branc, of academic 4tud&. $,e term 3cor!oration finance3 was used to describe w,at is now 2nown in t,e academic world as 3financial management3. As t,e name suggests, t,e concern of cor!oration finance was wit, t,e financing of cor!orate enter!rises. In ot,er words, t,e sco!e of t,e finance function was treated b& t,e traditional a!!roac, in t,e narrow sense of !rocurement of funds b& cor!orate enter!rise to meet t,eir financing needs. $,e term 3!rocurement3 was used in a broad sense so as to include t,e w,ole gamut of raising funds e(ternall&. $,us defined, t,e field of stud& dealing wit, finance was treated as encom!assing t,ree interrelated as!ects of raising and administering resources from outside. /i0 t,e institutional arrangement in t,e form of financial institutions w,ic, com!rise t,e organisation of t,e ca!ital mar2et; /ii0 t,e financial instruments t,roug, w,ic, funds are raised from t,e ca!ital mar2ets and t,e related as!ects of !ractices and t,e !rocedural as!ects of ca!ital mar2ets; and /iii0 t,e legal and accounting relations,i!s between a firm and its sources of funds. $,e coverage of cor!oration finance was, t,erefore, conceived to describe t,e ra!idl& evolving com!le( of ca!ital mar2et institutions, instruments and !ractices. A related as!ect was t,at firms re-uire funds at certain e!isodic events suc, as merger, li-uidation, reorganisation and so on. A detailed descri!tion of t,ese ma+or events constituted t,e second element of t,e sco!e of t,is field of academic stud&. $,at t,ese were t,e broad features of t,e sub+ect-matter of cor!oration finance is elo-uentl& reflected in t,e academic writings around t,e !eriod during w,ic, t,e traditional a!!roac, dominated academic t,in2ing. 1 $,us, t,e issues to w,ic, literature on finance addressed itself was ,ow resources could best be raised from t,e combination of t,e available sources. $,e traditional a!!roac, to t,e sco!e of t,e finance function evolved during t,e 1G"=s and 1G'=s and dominated academic t,in2ing during3 t,E forties and t,roug, t,e earl& ftfties. It ,as now been discarded as it suffers from serious limitations. $,e wea2nesses of t,e traditional a!!roac, fall into two broad categories. /i0 t,ose relating to t,e treatment of various to!ics and t,e em!,asis attac,ed to t,em; and /ii0 t,ose relating to t,e basic conce!tual and anal&tical framewor2 of t,e definitions and sco!e of t,e finance function. $,e first argument against t,e traditional a!!roac, was based on its em!,asis on issues relating to t,e !rocurement of funds b& cor!orate enter!rises. $,is a!!roac, was c,allenged during t,e !eriod w,en t,e a!!roac, dominated t,e scene itself." Furt,er, t,e traditional treatment of finance was criticised' because t,e finance function was e-uated wit, t,e issues involved in raising and administering funds, t,e t,eme was woven around t,e view!oint of t,e su!!liers

of funds suc, as investors, investment ban2ers and so on, t,at, is t,e outsiders. It im!lies t,at no consideration was given to view!oint of t,ose w,o ,ad to ta2e internal financial decisions. $,e traditional treatment was, in ot,er words, t,e outsider-loo2ing-in a!!roac,. $,e limitation was t,at internal decision ma2ing /ie. insider-loo2ing-out0 was com!letel& ignored. $,e second ground of criticism of t,e traditional treatment was t,at t,e focus was on financing !roblems of cor!orate enter!rise. $o t,at e(tent t,e sco!e of financial management was confirmed onl& to a segment of t,e industrial enter!rises, as non-cor!orate organisations la& outside its sco!e. Het anot,er basis on w,ic, t,e traditional a!!roac, was c,allenged was t,at t,e treatment was built too closel& around e!isodic events, suc, as !romotion, incor!oration, merger, consolidation, reorganisation and so on. Financial management was3 confirmed to a descri!tion of t,ese infre-uent ,a!!enings in t,e life of an enter!rise. As a logical corollar&, t,e da&-to-da& financial !roblems of a normal com!an& did not receive muc, attention. Finally, t,e traditional treatment was found to ,ave a lacuna to t,e e(tent t,at t,e focus was on long-term financing. Its natural im!lication was t,at t,e issues involved in wor2ing ca!ital management were not in t,e !urview of t,e finance function. $,e limitations of t,e traditional a!!roac, were not entirel& based on treatment or em!,asis of different as!ects. In ot,er words, its wea2nesses were more fundamental. $,e conce!tual and anal&tical s,ortcoming of t,is a!!roac, arose from t,e fact t,at it confirmed financial management to issues involved in !rocurement of e(ternal funds, it did not consider t,e im!ortant dimension of allocation of ca!ital. $,e conce!tual framewor2 of t,e traditional treatment ignored w,at 4olomon a!tl& described as t,e central issues of financial management. $,ese issues were reflected in t,e following fundamental -uestions w,ic, a finance manager s,ould address. 4,ould an enter!rise commit ca!ital funds to certain !ur!osesI Do t,e e(!ected returns meet financial standards of !erformanceI Cow s,ould t,ese standards be set and w,at is t,e cost of ca!ital funds to t,e enter!risesI Cow does t,e cost var& wit, t,e mi(ture of financing met,ods usedI In t,e absence of t,e coverage of t,ese crucial as!ects, t,e traditional a!!roac, im!lied a ver& narrow sco!e for financial management. $,e modem a!!roac, !rovides a solution to t,ese s,ortcomings. Mo e% A**$oac) $,e modern a!!roac, views t,e term financial management in a broad sense and !rovides a conce!tual and anal&tical framewor2 for financial decision ma2ing. According to it, t,e finance function covers bot, ac-uisition of funds as well as t,eir allocations. $,us, a!art from t,e issues involved in ac-uiring e(ternal funds, t,e main concern of financial management is t,e efficient and wise allocation of funds to various uses. Defined in a broad sense, it is viewed as an integral !art of overall management. $,e new a!!roac, is an anal&tical wa& of viewing t,e financial !roblems of a firm. $,e main contents of t,is a!!roac, are. 1,at is t,e total volume of funds an enter!rise s,ould commitI 1,at s!ecific assets s,ould an enter!rise ac-uireI Cow s,ould t,e funds re-uired be financedI Alternativel&, t,e !rinci!al contents of t,e modem a!!roac, to financial management can be said to be. /= ,ow large s,ould an enter!rise be, and ,ow fast s,ould it growI /ii0 In w,at form s,ould it ,old assetsI and /Ci0 w,at s,ould be t,e com!osition of its liabilitiesI $,e t,ree -uestions !osed above cover between t,em t,e ma+or3 financial !roblems of a firm. In ot,er words, t,e financial management, according to t,e new a!!roac,, is concerned wit, t,e solution of t,ree ma+or !roblems relating to t,e financial o!erations of a firm, corres!onding to t,e t,ree -uestions of investment, financing and dividend decisions. $,us, financial management in modern sense of a firm can be bro2en down into t,ree ma+or decisions as

functions of finance. /D $,e investment decision, /ii0 t,e financing decision, and /iii0 t,e dividend !olic& decision. In+e'"%en" Deci'ion $,e investment decision relates to t,e selection of assets in w,ic, funds will be invested b& a firm. $,e assets w,ic, can be ac-uired fall into two broad grou!s. /I0 long-term assets w,ic, &ield a return over a !eriod of time in future, /ii0 s,ort-term or current assets, defined as t,ose assets w,ic, in t,e normal course of business are convertible into cas, wit,out diminution in value, usuall& wit,in a &ear. $,e first of t,ese involving t,e first categor& of assets is !o!ularl& 2nown in financial literature as ca*i"al ,! #e"in#. $,e as!ect of financial decision ma2ing wit, reference to current assets or s,ort-term assets is !o!ularl& termed as -o$(in# ca*i"al %ana#e%en". Capital Budgeting #a!ital budgeting is !robabl& t,e most crucial financial decision of a firm. It relates to t,e selection of an asset or investment !ro!osal or course of action w,ose benefits are li2el& to be available in future over t,e lifetime of t,e !ro+ect. $,e long-term assets can be eit,er new or old e(isting ones. $,e first as!ect of t,e ca!ital budgeting decision relates to t,e c,oice of t,e new asset out of t,e alternatives available or t,e reallocation of ca!ital w,en an e(isting asset fails to +ustif& t,e funds committed. 1,et,er an asset will be acce!ted or not will de!end u!on t,e relative benefits and returns associated wit, it. $,e measurement of t,e wort, of t,e investment !ro!osals is, t,erefore, a ma+or element in t,e ca!ital budgeting e(ercise. $,is im!lies a discussion of t,e met,ods of a!!raising investment !ro!osals. $,e second element of t,e ca!ital budgeting decision is t,e anal&sis of ris2 and uncertaint&. 4ince t,e benefits from t,e investment !ro!osals e(tend into t,e future, t,eir accrual is uncertain. $,e& ,ave to be estimated under various assum!tions of t,e !,&sical volume of sale and t,e level of !rices. An element of ris2 in t,e sense of uncertaint& of future3 benefits is, t,us, involved in t,e e(ercise. $,e returns from ca!ital budgeting decisions s,ould, t,erefore, be evaluated in relation to t,e ris2 associated wit, it. Finally, t,e evaluation of t,e wort, of a long-term !ro+ect im!lies a certain norm or standard against w,ic, t,e benefits are to be +udged. $,e re-uisite norm is 2nown b& different names suc, a' c!"-o&& $a"e. )!$ le $a"e. $e/!i$e $a"e. %ini%!% $a"e o& $e"!$n and so on. $,is standard is broadl& e(!ressed in terms of t,e cost of ca!ital. $,e conce!t and measurement of t,e cost of ca!ital is, t,us, anot,er ma+or as!ect of ca!ital budgeting decision. In brief, t,e main elements of ca!ital budgeting decisions are. /I0 t,e long-term assets and t,eir com!osition, /ii0 t,e business ris2 com!le(ion of t,e firm, and /Ci0 t,e conce!t and measurement of t,e cost of ca!ital. Working Capital Management 1or2ing ca!ital management is concerned wit, t,e management of current assets. It is an im!ortant and integral !art of financial management as s,ort-term survival is a !rere-uisite for long-term success. 7ne as!ect of wor2ing ca!ital management is t,e trade-off between !rofitabilit& and ris2 /li-uidit&0. $,ere is a conflict between !rofitabilit& and li-uidit&. If a firm does not ,ave ade-uate wor2ing ca!ital, t,at is, it does not invest sufficient funds in current assets, it ma& become illi-uid and conse-uentl& ma& not ,ave t,e abilit& to meet its current obligations and, t,us, invite t,e ris2 of ban2ru!tc&.. If t,e current assets are too large, !rofitabilit& is adversel& affected. $,e 2e& strategies and considerations in ensuring a trade-off between !rofitabilit& and li-uidit& is one ma+or dimension of wor2ing ca!ital management. In addition, t,e individual current assets s,ould be efficientl& managed so t,at neit,er

inade-uate nor unnecessar& funds are loc2ed u!. $,us, t,e management of wor2ing ca!ital ,as two basic ingredients. /10 an overview of wor2ing ca!ital management as a w,ole, and /"0 efficient management of t,e individual current assets suc, as cas,, receivables and inventor&. Financin# Deci'ion t,e second ma+or decision involved in financial management is t,e financing decision. $,e investment decision is broadl& concerned wit, t,e asset-mi( or t,e com!osition of t,e assets of a firm. $,e concern of t,e financing decision is wit, t,e financing-mi( or ca!ital structure or leverage. $,e term ca*i"al '"$!c"!$e refers to t,e !ro!ortion of debt /fi(edinterest sources of financing0 and e-uit& ca!ital /variable-dividend securities source of funds0. $,e financing decision of a firm relates to t,e c,oice of t,e !ro!ortion of t,ese sources to finance t,e investment re-uirements. $,ere are two as!ects of t,e financing decision. First, t,e t,eor& of ca!ital structure w,ic, s,ows t,e t,eoretical relations,i! between t,e em!lo&ment of debt and t,e return to t,e s,are,olders. $,e use of debt im!lies a ,ig,er return to t,e s,are,olders as also t,e financial ris2. A !ro!er balance between debt and e-uit& to ensure a trade-off between ris2 and return to t,e s,are,olders is necessar&. A ca!ital structure wit, a reasonable !ro!ortion of debt and e-uit& ca!ital is called t,e o*"i%!% ca*i"al structure. $,us, one dimension of t,e financing decision w,et,er t,ere is an o!timum ca!ital structure and in w,at !ro!ortion s,ould funds be raised to ma(imise t,e return to t,e s,are,oldersI $,e second as!ect of t,e financing decision is t,e determination of to an a!!ro!riate ca!ital structure, given t,e facts of a !articular case. $,us, t,e financing decision covers two interrelated as!ects. /10 t,e ca!ital structure t,eor&, and /"0 t,e ca!ital structure decision. Di+i en Polic0 Deci'ion $,e t,ird ma+or decision area of financial management is t,e decision relating to t,e dividend !olic&. $,e dividend decision s,ould be anal&sed in3 relation to t,e financing decision of a firm. $wo alternatives are available in dealing wit, t,e !rofits of a firm. /= t,e& can be distributed to t,e s,are,olders in t,e form of dividends or /i= t,e& can be retained in t,e business itself. $,e decision as to w,ic, course s,ould be followed de!ends largel& on a significant element in t,e dividend decision, t,e i+i en *a0o!" ratio, t,at is, w,at !ro!ortion of net !rofits s,ould be !aid out to t,e s,are,olders. $,e fmal decision will de!end u!on t,e !reference of t,e s,are,olders and investment o!!ortunities available wit,in t,e firm. $,e second ma+or as!ect of t,e. dividend decision is t,e factors determining dividend !olic& of a firm in !ractice. . $o conclude, t,e traditional a!!roac, to t,e functions of financial management ,ad a ver& narrow !erce!tion and was devoid of an integrated conce!tual and anal&tical framewor2. It ,ad rig,tl& been discarded in t,e ac.ldemic literature. $,e modem a!!roac, to t,e sco!e of financial management ,as broadened its sco!e w,ic, involves t,e solution of t,ree ma+or decisions, namel&, investment, fmancing and dividend. $,ese are interrelated and s,ould be +ointl& ta2en so t,at financial decision ma2ing is o!timal. $,e conce!tual framewor2 for o!timum financial decisions is t,e ob+ective of financial management. In ot,er words, to ensure an o!timum decision in res!ect of t,ese t,ree areas, t,e& s,ould be related to t,e ob+ectives of financial management. 1e0 Ac"i+i"ie' o& ")e Financial Mana#e$ $,e !rimar& activities of a financial manager are. /i0 !erforming financial anal&sis and !lanning, /i= ma2ing investment decisions and /C7 ma2ing financing decisions. Pe$&o$%in# Financial Anal0'i' and Plannin# The concern of financial analysis

and planning is with (a) transforming financial data into a form that can be used to monitor financial condition, (b) evaluating the need for increased (reduced) productive capacity and (c) determining the additional/reduced financing required. Although this activity relies heavily on accrual-based financial statements, its underlying ob ective is to assess cash flows and develop plans to ensure adequate cash flows to support achievement of the firm!s goals Ma(in# In+e'"%en" Deci'ion' Investment decisions determine bot, t,e mi( and t,e t&!e of assets ,eld b& a firm. $,e mi( refers to t,e amount of current assets and fi(ed assets. #onsistent wit, t,e mi(, t,e financial manager must determine and maintain certain o!timal levels of eac, t&!e of current assets. Ce s,ould "11so decide t,e best fi(ed assets to ac-uire and w,en e(isting fi(ed assets need to be modified re!laced li-uidated. $,e success of a firm in ac,ieving its goals de!ends on t,ese decisions. Ma(in# Financin# Deci'ion' Financing decisions involve two ma+or areas. first, t,e most a!!ro!riate mi( of s,ort-term and long-term financing; second, t,e best individual s,ort-term or long-term sources of financing at a given !oint of time. Man& of t,ese decisions are dictated b& necessit&, but some re-uire an inde!t, anal&sis of t,e available financing alternatives, t,eir costs and t,eir longterm im!lications O23ECTIVES OF FINANCIAL MANAGEMENT $o ma2e wise decisions a clear understanding of t,e ob+ectives w,ic, are soug,t to be ac,ieved is necessar&. $,e ob+ective !rovide a framewor2 for o!timum financial decision ma2ing. In ot,er words, t,e& are concerned wit, designing a met,od of o!erating t,e internal investment and financing of a firm. $,e term 3ob+ective3 is used in t,e sense of a goal or decision criterion for t,e t,ree decisions involved in financial management. It im!lies t,at w,at is relevant is not t,e overall ob+ective or goal of a business but a o!erationall& useful criterion b& w,ic, to +udge a s!ecific set of mutuall& interrelated business decisions, namel&, investment, financing and dividend !olic&. Moreover, it !rovides a n7ffi3lative framewor2. $,at is, t,e focus in financial literature is on w,at a firm s,ould tr& to ac,ieve and on !olicies t,at s,ould bE followed if certain goals are to be ac,ieved. $,e im!lication is t,at t,ese are not necessaril& followed b& firms in actual !ractice. $,e& are rat,er em!lo&ed to serve as a basis for t,eoretical anal&sis and do not reflect contem!orar& em!irical industr& !ractices. $,us, t,e term is used in a rat,er narrow sense of w,at a finn should anempt to ac,ieve wit, its investment, fmancing and dividend !olic& decisions. Firms in !ractice state t,eir vision, mission and values in broad terms and are also concerned about tec,nolog&, leaders,i!, !roductivit&, mar2et standing, image, !rofitabilit&, financial resources, em!lo&ees satisfaction and so on. 1e discuss in t,is 4ection t,e alternative a!!roac,es in financial literature, $,ere are two widel&-discussed a!!roac,es. /= *rofit /total0 Earning *er 4,are /E*40 ma(imisation a!!roac,, and /i= 1ealt, ma(imisation a!!roac,.

The gross present worth of a course of action is equal to the capitalised value of the flow of fut"re e#pected benefit, discounted (or captialised) at a rate which reflects their certainty or uncertainty. $ealth or net present worth is the difference between gross present worth and the amount of capital investment required to achieve the benefits being discussed. Any financial action which creates wealth or which has a net present worth above %ero is a desirable one and should be underta&en. Any financial action which does not meet this test should be re ected. 'f two or more desirable courses of action are mut"ally e#clusive ((e. if only one can be underta&en), then the decision should be to do

P$o&i"4EPS Ma5i%i'a"ion Deci'ion C$i"e$ion According to t,is a!!roac,, actions t,at increase !rofits /total0 E*4 s,ould be underta2en and t,ose t,at decrease !rofits E*4 are to be avoided, In s!ecific o!erational terms, as a!!licable to financial management, t,e !rofit ma(imisation criterion im!lies t,at t,e investment, financing and dividend !olic& decisions of a firm s,ould be oriented to t,e ma(imisation of !rofits E*4. $,e term 3!rofit3 can be used in two senses. As a owner-oriented concept, it refers to t,e amount and share of national income w,ic, is paid to the owners of business, t,at is, t,ose w,o su!!l& e-uit& ca!ital. As a variant, it is described as profitability. 't is an operational concept and signifies economic efficiency. 'n other words, profitability refers to a situation where output e#ceeds input, that is, the value created by the use of resources is more than the total of the input resources. "sed in this sense, profitability ma#imisation would imply that a firm should be guided in financial decision ma&ing by one test) select assets, pro ects and decisions which are profitable and re ect those which are not. 'n the current financial literature, there is a general agreement that profit ma#imisation is used in the second sense. $,e rationale be,ind !rofitabilit& ma(imisation, as a guide to financial decision ma2ing, is sim!le. *rofit is a test of economic efficienc&. It !rovides t,e &ardstic2 b& w,ic, economic !erformance can be +udged. Moreover, it leads to efficient allocation of resources, as resources tend to be directed to uses w,ic, in terms of !rofitabilit& are t,e most desirable. Finall&, it ensures ma(imum social welfare. $,e individual searc, for ma(imum !rofitabilit& !rovides t,e famous 3invisible ,and3 b& w,ic, total economic welfare is ma(imised. Financial management is concerned wit, t,e efficient use of an im!ortant economic resource /+n!ut0 , namel&, ca!ital. It is, t,erefore, argued t,at !rofitabilit& ma(imisation s,ould serve as t,e basic criterion for financial: management decisions. $,e !rofit ma(imisation criterion ,as, ,owever, been -uestioned and criticised on several grounds. $,e reasons for t,e o!!osition in academic literature fall into two broad grou!s. /10 t,ose t,at are based on misa!!re,ensions about t,e wor2abilit& and fairness of t,e !rivate enter!rise itself, and /"0 t,ose t,at arise out of t,e difficult& of a!!l&ing t,is criterion in actual situations. It would be recalled t,at t,e term ob+ective, as a!!lied to financial management, refers to an e(!licit o!erational guide for t,e internal investment and financing of a firm and not t,e overall goal of business o!erations. 1e, t,erefore, focus on t,e second t&!e of limitations to !rofit ma(imisation as an ob+ective of financial management.J $,e main tecbnical flaws of t,is criterion are a%,i#!i"0. "i%in# o& ,ene&i"'. an /!ali"0 o& ,ene&i"'. A%,i#!i"0 7ne !ractical difficult& wit, !rofit ma(imisation criterion for financial decision ma2ing is t,at t,e term !rofit is a vague and ambiguous conce!t. It ,as no !recise connotation. It is amenable to different inter!retations b& different !eo!le. $o illustrate, !rofit ma& be s,ort-term or long-term; it ma& be total !rofit or rate of !rofit; it ma& be before-ta( or after-ta(; it ma& return on total ca!ital em!lo&ed or total assets or s,are,olders3 e-uit& and so on. If !rofit ma(imisation is ta2en to be t,e ob+ective, t,e -uestion arises, w,ic, of t,ese variants of !rofit s,ould a firm tr& to ma(imiseI 7bviousl&, a loose e(!ression li2e !rofit cannot form t,e basis of o!erational criterion for financial management. Ti%in# o& 2ene&i"' A more im!ortant tec,nical ob+ection to !rofit ma(imisation, as a guide to financial decision ma2ing, is t,at it ignores t,e differences in t,e time !attern of t,e benefits received over t,e wor2ing life of t,e asset, irres!ective of w,en t,e& were received. #onsider $able 1.1.

$ime-*attern of ?enefits /*rofits0 Time Alternate A(Rs in lakh !!!!!!!!!!Alternate "(Rs in lakh *eriod I >= -*eriod II 1== 1== *eriod III >= 1== DDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDD DDDDDDDDDDDDDDDDDDD $otal "== "== It can be seen from $able 1.1 t,at t,e total !rofits associated wit, t,e alternatives, A and ?, are identical. If t,e !rofit ma(imisation is t,e decision criterion, bot, t,e alternatives would be ran2ed e-uall&. ?ut t,e returns from bot, t,e alternatives differ in one im!ortant res!ect, w,ile alternative A !rovides ,ig,er returns in earlier &ears, t,e returns from alternative ? are larger in later &ears. As a result, t,e two alternative courses of action are not strictl& identical. $,is is !rimaril& because a basic dictum of financial !lanning is t,e earlier t,e better as benefits received sooner are more valuable t,an benefits received later. $,e reason for t,e su!eriorit& of benefits now over benefits later lies in t,e fact t,at t,e former can be reinvested to earn a return. $,is is referred to as time value of mone&. $,e !rofit ma(imisation criterion does not consider t,e distinction between returns received in different time !eriods and treats all benefits irres!ective of t,e timing, as e-uall& valuable. $,is is not true in actual !ractice as benefits in earl& &ears s,ould be valued more ,ig,l& t,an e-uivalent benefits in later &ears. $,e assum!tion of e-ual value is inconsistent wit, t,e real world situation. 6!ali"0 o& 2ene&i"' *robabl& t,e most im!ortant tec,nical limitation of !rofit ma(imisation as an o!erational ob+ective, is t,at it ignores t,e /!ali"0 as!ect of benefits associated wit, a financial course of action. $,e term -ualit& ,ere refers to t,e degree of certaint& wit, w,ic, benefits can be e(!ected. As a rule, t,e more certain t,e e(!ected return, t,e ,ig,er is t,e -ualit& of t,e benefits. #onversel&, t,e more uncertain fluctuating is t,e e(!ected benefits, t,e lower is t,e -ualit& of t,e benefits. An uncertain and fluctuating return im!lies $i'( to t,e investors. It can be safel& assumed t,at t,e investors are $i'(-a+e$"e$'. t,at is, t,e& want to avoid or at least minimise ris2. $,e& can, t,erefore, be reasonabl& e(!ected to ,ave a !reference for a return w,ic, is more certain in t,e sense t,at it ,as smaller variance over t,e &ears. $,e !roblem of uncertaint& renders !rofit ma(imisation unsuitable as an o!erational criterion for financial management as it considers onl& t,e siKe of benefits and gives no weig,t to t,e degree of uncertaint& of t,e future benefits. $,is is illustrated in $able 1.". Lncertaint& About E(!ected ?enefits /*rofits0 crore0 DDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDD 4tate of Econom& ?enefits 5ecession /*eriod I0 Normal /*eriod II0 G *rofit/5s

Alternate A = 1=

1= ?oom /*eriod III0 "= $otal '=

11 '=

It is clear from $able 1." t,at t,e total returns associated wit, t,e two alternatives are identical in a normal situation but t,e range of variations is ver& wide in case of alternative ?, w,ile it is narrow in res!ect of alternative A. $o !ut It differentl&, t,e earnings associated wit, alternative ? are more uncertain /ris2&0 as t,e& fluctuate widel& de!ending on t,e state of t,e econom&. 7bviousl&, alternative A is beuer in terms of ris2 and uncertaint&. $,e !rofit ma(imisation criterion fails to reveal t,is. $o conclude, t,e !rofit ma(imisation criterion is ina!!ro!riate and unsuitable as an o!erational ob+ective of investment, financing and dividend decisions of a firm. It is not onl& vague and ambiguous but it also ignores two im!ortant dimensions of financial anal&sis, namel&, ris2, and time value of mone&. It follows from t,e above t,at an a!!ro!riate o!erational decision criterion for financial management s,ould /+0 be !recise and e(act, /i+0 be based on t,e 3bigger t,e better3 !rinci!le, /ii+0 consider bot, -uantit& and -ualit& dimensions of benefits, and /iv0 recognise t,e time value of mone&. $,e alternative to !rofit ma(irnisation, t,at is, wealt, ma(imisation is one suc, measure. Weal") Ma5i%i'a"ion Deci'ion C$i"e$ion $,is is also 2nown as value ma(imisation or net !resent wort, ma(imisation. In current academic literature value ma(imisation is almost universall& acce!ted as an a!!ro!riate o!erational decision criterion for financial management decisions as it removes t,e tec,nical limitations w,ic, c,aracterise t,e earlier !rofit ma(imisation criterion. Its o!erational features satisf& all t,e t,ree re-uirements of a suitable o!erational ob+ective of financial course of action, namel&, e(actness, -ualit& of benefits and t,e time value of mone&. $,e value of an asset s,ould be viewed in terms of t,e benefits it can !roduce. $,e wort, of a course of action can similarl& be +udged in terms of t,e value of t,e benefits it !roduces less t,e cost of underta2ing it. A significant element in com!uting t,e value of a financial course of action is t,e !recise estimation of t,e benefits associated wit, it. $,e wealt, ma(imisation criterion is based on t,e conce!t of cas, flows generated b& t,e decision rat,er t,an accounting !rofit w,ic, is t,e basis of t,e measurement of benefits in t,e case of t,e !rofit ma(imisation criterion. #as, flow is a !recise conce!t wit, a definite connotation. Measuring benefits in terms of cas, flows avoids t,e ambiguit& associated wit, accounting !rofits. $,is is t,e first o!erational feature of t,e net !resent wort, ma(imisation criterion $,e second im!ortant feature of t,e wealt, ma(imisation criterion is t,at it considers bot, t,e -uantit& and -ualit& dimensions of benefits. At t,e same time, it also incor!orates t,e time value of mone&. $,e o!erational im!lication of t,e uncertaint& and timing dimensions of t,e benefits emanating from a financial decision is t,at ad+ustments s,ould be made in t,e cas,-flow !attern, firstl&, to incor!orate ris2 and, secondl&, to ma2e an allowance for differences in t,e timing of benefits. $,e value of a stream of cas, flows wit, value ma(imisation criterion is calculated b& discounting its element bac2 to t,e !resent at a ca!italisation rate t,at reflects bot, time and ris2. $,e value of a course of action must be viewed in terms of its wort, to t,ose !roviding t,e resources necessar& for its underta2ing. In a!!l&ing t,e value ma(imisation criterion, t,e term +al!e is used in terms of wort, to t,e owners, t,at is, ordinar& s,are,olders. $,e ca*i"aIi'a"ion 7 i'co!n"8 $a"e t,at is em!lo&ed is, t,erefore, t,e rate t,at

reflects t,e time and ris2 !references of t,e owners or su!!liers of ca!ital. As a measure of -ualit& /ris20 and timing, it is e(!ressed in decimal notation. A discount rate of, sa&, 1> !er cent is written as =.1>. A large ca!italisation rate is t,e result of ,ig,er ris2 and longer time !eriod. $,us, a stream of cas, flows t,at is -uite certain mig,t be associated wit, a rate of > !er cent, w,ile a ver& ris2& stream ma& carr& a 1> !er cent discount rate. For t,e above reasons, t,e net !resent value ma(imisation is su!erior to t,e !rofit ma(imisation as an o!erational ob+ective. As a decision criterion, it involves a com!arison of value to cost. An action t,at ,as a discounted value-reflecting bot, time and ris2-t,at e(ceeds its cost can be said to create value. 4uc, actions s,ould be underta2en. #onversel&, actions, wit, less value t,an cost, reduce wealt, and s,ould be re+ected. In t,e case of mutuall& e(clusive alternatives, w,en onl& one ,as to be c,osen t,e alternative wit, t,e greatest net !resent value s,ould be selected. In t,e words of EKra 4olomon, $,e gross !resent wort, of a course of action is e-ual to t,e ca!italised value of t,e flow of futLre e(!ected benefit, discounted /or ca!tialised0 at a rate w,ic, reflects t,eir certaint& or uncertaint&. 1ealt, or net !resent wort, is t,e difference between gross !resent wort, and t,e amount of ca!ital investment re-uired to ac,ieve t,e benefits being discussed. An& financial action w,ic, creates wealt, or w,ic, ,as a net !resent wort, above Kero is a desirable one and s,ould be underta2en. An& financial action w,ic, does not meet t,is test s,ould be re+ected. If two or more desirable courses of action are mutuall& e(clusive /9e. if onl& one can be underta2en0, t,en t,e decision s,ould be to do t,at w,ic, creates most wealt, or s,ows t,e greatest amount of net !resent wort,. Lsing EKra 4olomon3s s&mbols and met,ods, t,e net !resent wort, can be calculated as s,own below. . (i w# v- # /1.10 1,ere $ M Net !resent wort, % M 6ross !resent wort, # M Investment /e-uit& ca!ital0 re-uired to ac-uire t,e asset or to !urc,ase t,e course of action /ii0 % M F& ' (()* 1,ere + M 4iKe of future benefits available to t,e su!!liers of t,e in!ut ca!ital ' M $,e ca!italisation /discount0 rate reflecting t,e -ualit& /certaint& uncertaint&0and timing of benefits attac,ed to + /iii0 + M , - (- N (. 10 /1.'0 1,ere , M Average future flow of gross annual earnings e(!ected from t,e course of action, before maintenance c,arges, ta(es and interest and ot,er !rior c,arges li2e !reference dividend - M Average annual reinvestment re-uired to maintain 6 at t,e !ro+ected level T# E(!ected annual outflow on account of ta(es and ot,er !rior c,arges. $,e o!erational ob+ective of financial management is t,e ma(imisation of $ in E-. /1.10. Alternativel&, $ can be e(!ressed s&mbolicall& b& a s,ort-cut met,od as in E-. /1.)0. Net !resent value /wort,0 or wealt, is 1 M /1NP0 A1 -----------/1NP0 " A" N ----------/1NP0 ' A' NON --------------

/1.)0

w,ere E, A1 A", ... An re!resents t,e stream of cas, flows e(!ected to occur

from a course of action over a !eriod of time; ' is t,e a!!ro!riate discount rate to measure ris2 and timing; and # is t,e initial outla& to ac-uire t,at asset or !ursue t,e course of action. It can, t,us, be seen t,at in t,e value ma(imisation decision criterion, t,e time value of mone& and ,andling of t,e ris2 as measured b& t,e uncertaint& of t,e e(!ected benefits is an integral !art of t,e e(ercise. It is, moreover, a !recise and unambiguous conce!t, and t,erefore, an a!!ro!riate and o!erationall& feasible decision criterion for financial management decisions. It would also be noted t,at t,e focus of financial management is on t,e value to t,e owners or su!!liers of e-uit& ca!ital. $,e wealt, of t,e owners is reflected in t,e mar2et value of s,ares. 4o wealt, ma(imisation im!lies t,e rna(irnisation of t,e mar2et !rice of s,ares. In ot,er words, ma(irnisation of t,e mar2et !rice of s,ares is t,e o!erational ;substitute for value wealt, net !resent value rna(imisation as a decision criterion. In brief, w,at is relevant is not t,e overall goal of a firm but a decision criterion, w,ic, s,ould guide t,e financial course of action. *rofit E*4 ma(irnisation was initiall& t,e generall& acce!ted t,eoretical criterion for ma2ing efficient economic decisions, using !rofit as an economic conce!t and defining !rofit rna(imisation as a criterion for economic efficienc&. In current financial literature, it ,as been re!laced b& t,e wealt, ma(irnisation decision criterion because of t,e s,ortcomings of t,e former as an o!erational criterion, as /+0 It does not ta2e account of uncertaint& of ris2, /i+0 it ignores t,e time value of mone&, and /ill0 it is ambiguous in its com!utation. 7wing to t,ese tec,nical limitations, !rofit ma(imisation cannot be a!!lied in real world situations. Its modified form is t,e value rna(imisation criterion. It is im!ortant to note t,at value ma(irnisation is sim!l& e(tension of !rofit rna(irnisation to a world t,at is uncertain and multi!eriod in nature. 1,ere t,e time !eriod is s,ort and degree of uncertaint& is not great, value ma(irnisation and !rofit rna(imisation amount to essentiall& t,e same t,ing. Cowever, two im!ortant issues are related to t,e value s,are !ricerna(imisation, namel&, economic value added and focus on sta2e,olders Econo%ic Val!e A e 7EVA8 It is a !o!ular measure currentl& being used b& several firrns to determine w,et,er an e(isting !ro!osed investment !ositivel& contributes to t,e owners3 s,are,olders3 wealt,. $,e E%A is e-ual to after-ta( o!erating !rofits of a firm less t,e cost of funds used to finance investments. A !ositive E%A would increase owners3 value wealt,. $,erefore, onl& investments wit, !ositive E%A would be desirable from t,e view!oint of ma(imiKing s,are,olders3 wealt,. $o illustrate, assuming an after-ta( !rofit of 5s )= crore and associated costs of financing t,e investments of 5s '< crore, t,e E%A M 5s " crore /5s )= crore - 5s '< crore0. 1it, a !ositive E%A, t,e investment would add value and increase t,e wealt, of t,e owners and s,ould be acce!ted. $,e com!utation of t,e after-ta( o!erating !rofits attributable to t,e investment under consideration as well as t,e cost of funds used to finance it would, ,owever, involve numerous accounting and financial issues. $,e merits of E%A are. /a0 its relative sim!licit& and /b0 its strong lin2 wit, t,e wealt, rna(imisation of t,e owners. It prima facie e(,ibits a strong lin2 to s,are !rices, t,at is, !ositive E%A is associated wit, increase in !rices of s,ares and vice versa) Cowever, E%A is, in effect, a re!ac2aged and well-mar2eted a!!lication of t,e N*% tec,ni-ue of investment decision. ?ut E%A is certainl& a useful tool for o!erationalising t,e owners3 value rna(imisation goal, !articularl& wit, res!ect to t,e investment decision. . Foc!' on S"a(e)ol e$' $,e s,are,olders wealt, rna(imisation as t,e !rimar& goal notwit,standing, t,ere is a broader focus in financial management to include t,e interest of t,e sta2e,olders as well as t,e s,are,olders. $,e sta2e,olders include em!lo&ees; customers, su!!liers, creditors and owners and ot,ers w,o

,ave a direct lin2 to t,e firm. $,e im!lication of t,e focus on sta2e,olders is t,at a firm s,ould avoid actions detrimental to t,em t,roug, t,e transfer of t,eir wealt, to t,e firm arid, t,us, damage t,eir wealt,. $,e goal s,ould be !reserve t,e well-being of t,e sta2e,olders and not to ma(imise it. $,e focus on t,e sta2e,olders does not, ,owever, alter t,e s,are,olders3 wealt, ma(imisation goal. It tends to limit t,e firm3s actions to !reserve t,e wealt, of t,e sta2e,olders. $,e sta2e,olders view is considered !art of its :social res!onsibilit&: and is e(!ected to !rovide ma(imum long term benefit to t,e s,are,olders b& maintaining !ositive sta2e,olders relations,i! w,ic, would minimiKe sta2e,older turnover, conflict and litigation. In brief, a firm can better ac,ieve its goal of s,are,olders3 wealt, ma(imisation wit, t,e coo!eration of, rat,er t,an conflict wit,, its ot,er sta2e,olders. S)a$e)ol e$ O$ien"a"ion in In ia $raditionall&, t,e cor!orate industrial sector in India was . dominated b& grou! com!anies wit, close lin2s wit, t,e !romoter grou!s. $,eir funding !rimaril& was t,roug, institutional borrowings from !ublic develo!ment finance institutions li2e IF#I, I#I#I, ID?IQ and so on. $,ere was !re!onderance of loan ca!ital in t,eir financial structure and s,are,olders e-uit& !la&ed a rat,er marginal role. It was no wonder, t,erefore, t,at cor!orate India !aid scant attention to s,are,olders3 wealt, ma(imisation wit, few e(ce!tions suc, as 5eliance Industries 9td. In t,e !ost-G= liberalisation era, t,e goal of s,are,olders3 wealt, ma(imisation ,as emerged almost at t,e centre-stage. $,e main contributor& factors ,ave been /= greater de!endence on ca!ital mar2et, /ii0 growing im!ortance of institutional investors, /iii0 ta( concessions incentives to s,are,olders and /iv0 foreign e(!osure. 1it, t,e gradual decline in t,e significance of t,e develo!ment !ublic term term lending institutions over t,e &ears and t,eir disa!!earance from t,e Indian financial scene recentl& /as a result of t,eir conversion !ro!osed conversion into ban2s0 and t,e conse-uent emergence of t,e ca!ital mar2et as t,e main source of cor!orate financing, s,are,olders3 wealt, ma(imisation is emerging as t,e !rime goal of cor!orate financial management. 4econdl&, as a result of t,e institutionalisation of savings, institutional investors suc, as mutual funds, insurance organisations, foreign institutional investors and so on dominate t,e structure of t,e Indian ca!ital mar2et. $o cater to t,e re-uirements of t,ese institutional investors, cor!orates are !ursuing more s,are,older friendl& !olicies as reflected in t,eir efforts to focus on s,are,olders3 wealt, ma(imisation. $,irdl&, t,e abolition of wealt, ta( on e-uit& s,ares and ot,er financial assets cou!led wit, ta(. e(em!tion on dividends in recent &ears ,as !rovided an incentive to cor!orates to en,ance s,are !rices and, t,us, focus on s,are,olders3 wealt,. Finall&, t,e famil&-owned cor!orate are also undergoing ma+or transformation. $,e scions of most business families are ac-uiring ,ig,er !rofessional education in India and abroad. 1it, t,e foreign e(!osure, t,e& also a!!reciate t,e im!ortance of s,are,olders3 wealt,. $,us, s,are,older orientation is unmista2abl& visible in t,e cor!orate India. DDDDDDDDDDDDDDDDDDDDDDDDDDDD

CONCEPT OF TIME VALUE OF MONE9 PRESENT VALUE

1.: O23ECTIVES $,e ob+ective is to understand t,e conce!t t,at mone& ,as a time value. $,e notion t,at a ru!ee toda& is !referable to t,e same ru!ee in t,e future is intuitive enoug, for most !eo!le to gras!. $,is can be gras!ed wit,out t,e use of models and mat,ematics. $,e !rinci!al of !resent value !rovides t,e bac2ing for t,is and enables us to calculate e(actl& ,ow muc, a ru!ee some time in t,e future is wort, toda&. In t,is c,a!ter we s,all e(amine t,e following -uestions. R 1,at do we mean b& time value of mone&I R 1,at is t,e basis for !resent valueI 1,at factors affect t,e timing of cas, flows and ,ow does t,is affect t,e time valueI 1.1 INTRODUCTION $,e !rinci!les of !resent value also underlie most of w,at we do in #or!orate Finance b& evaluating !ro+ects and valuation of com!an& s,ares and a great deal of !ersonal finance and investment. $,e sim!lest tools in finance are often t,e most !owerful. *resent value is a conce!t w,ic, s,ows t,at mone& ,as a time value. It is an intuitive and sim!le conce!t, sim!le to calculate and can be a!!lied in a wide range of situations in cor!orate finance. 1e can use t,is conce!t in bu&ing a ,ouse, saving for a c,ild3s education, !ic2ing a !ro+ect or more com!le( situations li2e valuing a bu&out of a com!an& s,are. $,at mone& ,as time value stems from t,e conce!t t,at t,e value of mone& gets eroded b& t,e conce!t of inflation. Cow often ,ave we ,eard our elders sa& t,at a 2ilo of rice was so c,ea! or t,at a ,ouse was so c,ea! and ,ad t,e& invested wisel& it mig,t ,ave been betterI Cow often are clot,es c,ea!er,education c,ea!er and all t,e common essentials becoming dearer &ear after &earI In t,e following !ages &ou will understand t,e conce!t and learn to a!!l& .it on real life e(am!les. 1.; DESCRIPTION

Dealing wit, #as, Flows at different !oints of time can be made easier using a time line t,at s,ows bot, t,e value and timing of cas, flows. $,e following figure s,ows a cas, flow of 5s 1== at t,e end of five &ears.

In t,e figure above 3=3 time on the time line de!icts now, at t,e !resent moment or toda&. $,us a cas, flow or ru!ees received b& &ou toda& ,as t,e same value toda&. $,us it need not be ad+usted for time value. Now a distinction s,ould be made between a !eriod in time and a !oint in time. $,e !ortion of t,e time line between = and 1 and " and ', etc. refers to !eriod 1 and !eriod ' w,ic, in t,is e(am!le is t,e first &ear and t,ird &ear. $,e cas, flow t,at occurs in a !oint in time -1- refers to t,e cas, flow t,at occurs at t,e end of !eriod 1. Finall& t,e discount rate w,ic, is 1= !er cent in t,is e(am!le is s!ecified in eac, !eriod of t,e time line and ma& be different for eac, !eriod. Cad t,e cas, flows been at * + yr ,s +** - yrs ,s +** . yrs ,s +** / yrs ,s +** 0 yrs ,s +**

+*1 +*1 +*1 +*1 Fig 1 /a0 A $ime 9ine for #as, Flows- End of Eac, *eriod * ,s +** + yr ,s +** - yrs ,s +** . yrs ,s +** / yrs ,s +**

+*1

0 yrs

+*1 +*1 +*1 +*1 +*1 Fig 1.1/b0 A $ime 9ine for cas, Flows- ?eginning of Eac, *eriod t,e beginning of eac, &ear instead of t,e end of eac, &ear, t,e time line would be as redrawn above. *lease note t,at t,e beginning of &ear " is t,e end of &ear 1. It de!ends ,ow &ou loo2 at it. *ositive and negatives cas, flows. #as, flows can neit,er be negative or !ositive.#as, inflows are called *ositive #as, Flows and #s, outflows are called Negative #as, flows. Notations Notation *% F% #f A r g n Meaning *resent %alue Future %alue #as, flow at t,e end of !eriod t Annuit&-#onstant #as, Flows over several !eriods Discount 5ate E(!ected growt, rate in cas, flows Number of !eriods over w,ic, cas, flows are received or !aid

<.<

COMMON SENSE APPROAC= TO PRESENT VALUE

A cas, flow in t,e future is wort,less t,an a. similar cas, flow toda&

because. *eo!le !refer !resent consum!tion to future consum!tion. *eo!le would ,ave to be offered more in t,e future to give u! !resent consum!tion. Due to inflation t,e value of mone& currenc& de!reciates or erodes over a !eriod of time. $,is ,a!!ens due to inflation. $,e greater t,e inflation t,e greater is t,e erosion in t,e value of t,e ru!ee toda& and in t,e future. Due to t,e uncertaint& of receiving t,e cas, flow in t,e future t,e value of t,e cas, flow in t,e future reduces furt,er. $,is means t,ere is a ris2 associated wit, receiving t,e cas, flow in future and t,is reduces t,e, value associated wit, t,e cas, flow. $,e greater t,e ris2 t,e greater t,e erosion in value.

$,e !rocess b& w,ic, future cas, flows are ad+usted to reflect t,ese factors is called discounting, and t,e magnitude of t,ese factors is reflected in t,e discount rate)

What is Discount Ra"e>

$,e discount rate is a rate at w,ic, !resent and future cas, flows are traded off.

It incor!orates

1. $,e !reference for currrent consum!tion / greater !reference ". E(!ected inflation /,ig,er inflation D ,ig,er discount rate0. '. $,e uncertaint& in t,e future cas, flows /,ig,er ris2 DDD ,ig,er discount

rate0.
A ,ig,er discount rate will lead to a lower !resent value for future cas, flows. 1.?

TRADE OFF IN REAL CONSUMPTION OVER TIME

Alt,oug, individuals !refer !resent consum!tion to future consum!tion, t,e degree of t,is !reference varies across individuals. $,is trade off between !resent consum!tion /#o0 and future consum!tion /#10 can be e(!lained as follows. In t,e real world !eo!le can get t,e same amount of mone& in eac, !eriod and t,e& can eit,er consume it or save it or lend it. A ma& c,oose to consume t,e w,ole amount, ? ma& consume more mone& b& borrowing and # ma& consume less and save and lend t,e remaining !ortion. If t,e !reference for current consum!tion is strong t,en we ,ave to offer more in terms of future. consum!tion to give u! current consum!tion. $,us t,ere is alwa&s a trade off w,ic, is alwa&s reflected b& t,e hi/h-real

rate of return or discount rate. If t,e !reference for current consum!tion is wea2 t,en a !erson can settle for a lower real rate of return or discount rate. $,e assum!tion ,ere is t,at an& money) or wealt, saved will alwa&s be lent out as because it can earn a return for t,e saver. $,e stor& of t,e grass,o!!er and t,e ant reflects t,is. $,e grass,o!!er ma& ma2e merr& and use all of ,is mone& w,ereas t,e ant ma& save to en+o& during winter. Man& an old cou!le en+o& t,eir retirement because t,e& ,ave intuitivel& used t,e conce!t of time value of mone& !ro!erl& and w,en t,eir earning ca!acit& goes down t,e& can en+o& t,e fruits of t,eir savings ans investment decisions. 1.@ T=E CALCULATION OF PRESENT VALUE

$,e !rocess of discounting future cas, flows converts t,em into cas, flows in !resent value terms. #onversel& t,e !rocess of com!ounding converts !resent cas, flows into future cas, flows. #as, flows at different !oints to time cannot be com!ared and aggregated unless t,e& are all broug,t to t,e same !oint in time before we can com!are or aggregate t,em. $,ere are five t&!es of cas, flows. 1. 4im!le cas, flows ". Annuities '. 6rowing Annuities ). *er!etuities and >. 6rowing *er!etuities

1. Si%*le ca') &lo-' A sim!le cas, flow is a single cas, flow in a s!ecified future time !eriod. 7n a time line #F t M #as, Flow at $ime t

$,is cas, flow can be discounted bac2 to t,e !resent discount rate t,at reflects t,e uncertaint& of t,e cas, flow. #onversel&,cas, flows in t,e !resent can be com!ounded to arrive at an e(!ected future cas, flow. Discounting. is t,e !rocess b& w,ic, a cas, flow w,ic, is e(!ected to occur in t,e future is broug,t to its !resent value.

#om!ounding. is t,e !rocess b& w,ic, a cas, flow toda& is converted into its e(!ected future value.

Calc!la"in# P$e'en" Val!e

$,e !resent value of 5s 1,==,=== a &ear from now must be less t,an 5s 1,==,=== toda&. $,us t,e !resent value of t,e dela&ed !a&off can be found out b& multi!l&ing t,e !a&off wit, t,e discount factor w,ic, is less t,an 1. If t,e discount factor is more t,an 1 a ru!ee toda& would be wort,less t,an a ru!ee tomorrow. If #1 denotes t,e e(!ected !a&off at !eriod 1, one &ear ,ence t,en *resent %alue /*%0 M Discount factor ( #1 O$ In t,e e(am!le earlier *resent %alue /*%0 M DD#F1DD /1 N r0 $,us t,e discount factor is t,e value received toda& of 5s 1 received in t,e future. It is usuall& e(!ressed as a reci!rocal of 1 !lus a rate of return. Discount factor M 1 /1 N r0 4imilarl& &ou ,ave a com!ounding factor. $o calculate discount factor and com!ound factors we ,ave tables to aid us in com!le( calculations. $,ese are given as an a!!endi( to t,e c,a!ter below. $,e rate of return r is t,e reward t,at investors demand for acce!ting a dela&ed !a&ment. Hou are considering investing in a ,ouse or !ro!ert& wort, 5s /,**,*** toda& and &our real estate advisor ,as estimated t,at t,e cost would go u!to 5s >,==,=== in a &ear if &ou sold it. $,at is not t,e onl& wa& &ou can earn mone& as &ou ,ave various investment o!tions. Hou can invest in *ublic *rovident Fund wit, an interest rate of G !er cent. Cow muc, would &ou ,ave; to invest in **F to receive 5s >,==,=== after a &ear. $,at is eas& as t,e interest rate is G !er cent, &ou would ,ave to invest 5s >,==,=== 1.=G, w,ic, is 5s )><J1>.>G. $,us t,e building investment is a better o!tion as &ou get a ,ig,er rate of return. Cowever &ou must bear in mind t,at t,e real estate investment ,as a ,ig,er ris2 in terms of variabilit& of return. $,us ris2 is related to return w,ereas t,e **F o!tion ,as a lower ris2 and lower return. $o calculate !resent value, we discount t,e e(!ected !a&off b& t,e rate of return offered b& e-uivalent investment alternatives in t,e ca!ital or financialQ mar2ets. $,is rate of return is often referred to as t,e discount

rate, ,urdle rate or o!!ortunit& cost of ca!ital. It is called o!!ortunit& cost because it is t,e return forgone b& investing in t,e !ro+ect rat,er t,an investing in securities. In our e(am!le t,e o!!ortunit& cost was G !er cent. *resent value was obtained b& dividing 5s >,==,=== b& 1.=G. *% M Discount factor ( #1 M D1DDDD( #1 1Nr

M >,==,=== M 5s )><J1>.>G 1.=G

<. Ne" P$e'en" Val!e

9et us su!!ose t,at &our !ro!ert& is wort, 5s )><J1>.>G toda& but &ou committed 5s ),==,=== initial outgo to !urc,ase t,e !ro!ert&. 4o &our NE$ *5E4EN$ %A9LE is 5s ><J1>.>G. Net *resent %alue is found b& subtracting t,e re-uired investment N*%M *% - 5e-uired Investment M 5s ),><,J1>.>G - 5s ),==,=== M 5s ><,J1>.>G In ot,er words &our investment in t,e !ro!ert& is wort, more t,an it costs - it ma2es a net contribution to value. $,e formula for calculating N*% can be written as

N*%M # =

#1 NDDDDD 1Nr

5emember t,at #o t,e cas, flow at time = /t,at is toda&0, will usuall& be a negative number. In ot,er words, #o is an investment and t,erefore a cas, outflow. In our e(am!le #o is - 5s ),==,===.

5elation of 5is2 to *resent %alue

In man& of our calculations we feel it is enoug, to com!are t,e !resent values and aggregates, ,owever we ma2e t,e unrealistic assum!tion of assigning t,e same level of ris2 and onl& ta2ing decisions based on t,e com!arative returns of alternative means of ad+ustments. $,e real estate advisor or !ro!ert& advisor cannot be sure about t,e return in t,e mar2et. If t,e future value of t,is !ro!ert& is ris2& our calculation is wrong. *ublic *rovident Fund is certainl& less ris2& as it

is a2in to 6overnment securit&. $,us if &ou were as2ing someone else to invest in t,is !ro!ert& along wit, &ou t,e& ma& not agree to give &ou t,e !resent value amount but somet,ing less t,an t,at. $,us we invo2e anot,er financial !rinci!al t,at a safe ru!ee is wort, more t,an a ris2& one. $,us we do not use t,e same discount factor w,ile com!aring alternative investment avenues. $,e discount rate for **F ma& be G !er cent 75 =.=G but t,e discount rate for t,e building !ro!ert& ma& be 11 !er cent or =.11. 7nl& after t,e !resent values are calculated using t,ese two different discount rates is t,e best investment avenue or !ro+ect decided. Most investors avoid ris2 w,en t,e& can do so wit,out sacrificing return. Cowever, t,e conce!ts of !resent value and t,e o!!ortunit& cost of ca!ital still ma2e sense for ris2& investments. It is still !ro!er to discount t,e !a&off b& t,e rate of return offered b& an e-uivalent investment. ?ut we ,ave to t,in2 of E(!ected !a&offs and t,e e(!ected rates of returns on ot,er investments. Hou will learn more about e(!ected !a&offs w,en &ou do #a!ital ?udgeting 9ater. For now it will be enoug, if &ou t,in2 of an e(!ected !a&off and t,e e(!ected rates of returns on ot,er investments. Hou will learn more about e(!ected !a&offs w,en &ou do #a!ital ?udgeting 9ater. For now it will be enoug, if &ou t,in2 of an e(!ected !a&off as a realistic forecast,neit,er !essimistic nor

o!timistic.
0oncept check: India ,as a low savings rate as com!ared to Sa!an. $,is leads to greater budget and trade deficits. Cow does a low saving rate affect discount ratesI +ffect of 1nflation on 2iscount Rate: $,e effect of inflation on !resent value is evident because it reduces t,e !urc,asing !ower of future cas, flows. $,is ad+ustment reduces t,e value of future cas, flows, but t,ese real cas, flows, will ,ave to be reduced furt,er to reflect real returns /i.e. t,e trade offs between current and future consum!tion0 and an& uncertaint& associated wit, t,e cas, flows to arrive at t,e !resent value. $,us, an investor w,o e(!ects to ma2e 1=.> million Me(ican !esos a &ear from now will ,ave to reduce t,is e(!ected cas, flow to arrive at t,e !resent value. $,us, an investor w,o e(!ects 1 million Italian 9ire a &ear from now will ,ave to reduce t,is e(!ected cas, flow to 1 reflect t,e e(!ected inflation rate in Me(ico. If t,at inflation rate is "> !er cent,for instance, t,e real cas, flow will be onl& =.< million Italian lire. $,e general formula for converting nominal cas, flows at a future !eriod Tt3 to real cas, flows is 5eal #as, Flow M /Nominal cas, flow0 /1 N inflation rate0. +ffect of Risk on 2iscount Rate: Alt,oug, bot, t,e !reference for current consum!tion, and e(!ected inflation affect t,e !resent value of all cas, flows not all cas, flows are e-uall& !redictable. A !romised cas, mig,t not be delivered for a number of reasons. t,e !romisor /lnterest and investment not received as com!an& winds u!0 mig,t default on t,e !a&ment- t,e !romisee mig,t not be around to receive !a&ment - /mig,t ,ave died0 or some ot,er contingenc& or

some ,a!!ening ma& intervene to !revent t,e !romised !a&ment or to reduce it. $,e greater t,e uncertaint& associated wit, a cas, flow in t,e future, t,e ,ig,er t,e discount rate used to calculate t,e !resent value of t,is cas, flow will be and t,e !resent value of t,at cas, flow will conse-uentl& be lower.

E5a%*le
Hou ,ave decided to invest in a construction of an office building as it is wort, more t,an it costs- it ,as !ositive net !resent value. $o calculate ,ow muc, it is wort,- would ,ave to !a& to ac,ieve t,e same !a& off b& investing directl& in securities. $,e !ro+ect3s future value is e-ual to its future income discounted at t,e rate of return offered b& t,ese securities. 1e can sa& t,is anot,er wa&. 7ur building venture is wort, underta2ing because its rate of return e(ceeds its cost of ca!ital. $,e rate of return is sim!l& t,e !rofit as a !ro!ortion of t,e initial outla&. 5eturn M *rofit Investment M/>,==,===-),'=,===0 ),'=,=== M/J=,===0 /),'=,===0 M =.1@' about 1@ !er cent $,e cost of ca!ital is once again t,e return foregone b& not investing in securities. If t,e office building is as ris2& as investing in stoc2 mar2et securities w,ere t,e e(!ected return is 1) !er cent t,en t,e return forgone is 1) !er cent. 4ince t,e 1@ !er cent return on t,e office building e(ceeds t,e 1) !er cent o!!ortunit& cost, &ou s,ould go a,ead wit, t,e !ro+ect. Cence we ,ave two e-uivalent decision rules for ca!ital investment. 3 4et present value rule) Acce!t investments t,at ,ave !ositive net !resent values. 3 Rate of return rule) Acce!t investments t,at offer rates of return in e(cess of t,eir o!!ortunit& costs of ca!ital

1.A DISCOUNTING A SIMPLE CAS= FLOW - W=9 IT IS IMPORTANT

Discounting a cas, flow converts it into !resent value ru!ees and enables t,e user to do several t,ings. First, once cas, flows are converted into !resent value ru!ees, t,e& can be aggregated and com!ared. 4econd, if !resent values are estimated correctl& t,e user s,ould be indifferent between t,e future cas, flow and t,e !resent value of t,e cas, flow.

7t,er t,ings remaining e-ual, t,e !resent value of a cas, flow will decrease as t,e discount rate increases and continue to decrease t,e furt,er into t,e future t,e cas, flow occurs. $,us !resent value is a decreasing function of t,e discount rate.

1.BCOMPOUNDING A CAS= FLOW - W=9 IT IS IMPORTANT

#urrent cas, flows can be moved into t,e future b& com!ounding t,e cas, flow at t,e a!!ro!riate discount rate. $,e future value of a sim!le cas, flow is Future %alue of a 4im!le #as, Flow M #Fo /1N r03 w,ere #F o M #as, Flow Now ,r M Discount 5ate Again, t,e com!ounding effect increases wit, bot, t,e discount rate and t,e com!ounding !eriod. 0ompoundin/) is t,e !rocess b& w,ic, cas, flows are converted from !resent value to future value ru!ees. I,,o"'on an Sin/!e&iel C' S"! 0 As t,e lengt, of t,e ,olding !eriod is e(tended, small differences in discount rates can lead to large differences in future value. In a stud& of returns on stoc2s and bonds between 1G"@ and 1GG", Ibbotson and 4in-uefield found t,at stoc2s on t,e average made 1".) !er cent $reasur& ?onds made >." !ercent, and $reasur& ?ills made '.@ !er cent. Assuming t,at t,ese returns continue into t,e future, t,e table below !rovides t,e future value of dollar 1== invested n eac, categor& at t,e end off a number of ,olding !eriods - 1 &ear, > &ears, 1= &ears, "= &ears, '= &ears and )= &ears. $,e differences in future value from investing at t,ese different rates of return are small for s,ort com!ounding !eriods/ suc, as one &ear0 but become larger as t,e com!ounding !eriod is e(tended. For instance, wit, a )= &ear time ,oriKon, t,e future value of investing in stoc2s, at an average return of 1".) !er cent, is more t,an 1" times larger t,an t,e future value of investing in $reasur& bonds at an average return of >." !er cent and more t,an "> times t,e future value of investing in $reasur& ?ills at an average return of '.@ !er cent.

F!"!$e Val!e o& In+e'"%en"' - A''e" Cla''e' Colding *eriod 1 > 1= 4toc2s 11".)= 1JG.)= '"1.<@ $. ?onds 1=>."= 1"<.<> 1@@.=" $. ?ills 1='.@= 11G.') 1)".)'

"=
'=
)=

1='>.G"
''').1<
1=J'1.'=

"J>.@"
)>J.>G
J>G.@<

"=".<@
"<<.G'
)11.>"

Concept Check Most !ension funds allow individuals to decide w,ere t,eir !ension funds will be invested- stoc2s /e-uit&0, bonds /debt0 or mone& mar2et accounts, etc. 1,ere would &ou c,oose to invest &our !ension fundI Do &ou t,in2 &our allocation s,ould c,ange as &ou get older I 1,&I The Rule of 2-- A shortcut to estimating the Compounding effect In a !inc,, t,e rule of J" !rovides an a!!ro(imate answer to t,e -uestion :Cow -uic2l& will t,is amount double in valueI: b& dividing J" b& t,e discount on interest rate used in t,e anal&sis. $,us, a cas, flow growing at @ !er cent will, double in value in a!!ro(imatel& 1" &ears, w,ile a cas, flow growing at G !ercent will double in value in a!!ro(imatel& < &ears.

E&&ec"i+e In"e$e'" Ra"e

$,is is t,e true rate of interest, ta2ing into account t,e com!ounding effects of more fre-uent interest !a&ments.

The Fre5uency of 2iscountin/ and 0ompoundin/

$,e fre-uenc& of com!ounding affects bot, t,e future and !resent values of cas, flows. In t,e e(am!les above, t,e #as, flows were assumed to be discounted and com!ounded annuall& - t,at is, interest !a&ments and income were com!uted at t,e end of eac, &ear, based on t,e balance at t,e beginning of eac, &ear. In some cases ,owever t,e interest ma& be com!uted more fre-uentl&, suc, as on a mont,l& or semi annual basis. In t,ese cases, t,e !resent and future values ma& be ver& different from t,ose com!uted on annual basis; t,e stated interest rate on an annual basis can deviate significantl& from t,e effective or true interest rate. $,e effective interest rate can be com!uted as follows. Effective Interest 5ateM /1N4tated Annual Interest 5ate0 n ---------------------------------------------------1 N 1,ere NMnumber of com!ounding !eriods /"Msemi annual;1" Mmont,l&0

For Instance, a 1= !er cent annual interest rate, if t,ere is semi annual com!ounding wor2s out to an effective interest rate of Effective Interest 5ate 3 (+.*0- - +) 3(+.+*-0 - +.*) 3 +*.-0 per cent As com!ounding becomes continuous, t,e effective interest rate can be com!uted as follows. Effective Interest 5ate M /e(! 0r - 1 w,ere e(! M e(!onential function r M stated annual interest rate $,e $able below !rovides t,e effective rates as a function of t,e com!oundinQ g fre-uenc&.

Effect of #om!ounding Fre-uenc& on Effective Interest 5ates

4requency
Annual 4emi-Annual Mont,l& 5ate/U 0 1= 1= 1= $ 1 " 1" Formula .1= Effective Annual 5ate/U0 1=

/1 N.1= "0" -1 1=."> /1 .)(6((* (* - 1 1=.)J, /1 .)(6789: 89: Dail& 1= '@> 1=.>1>@ 1 #ontinuous 1= continuous e,1= - 1 1 7>1J1 As &ou can see, as com!ounding becomes more fre-uent, t,e effective rate increases, and t,e !resent value of future cas, flows decreases. For e(am!le t,e ,ome loans w,ic, various com!anies offer &ou re-uire mont,l& re!a&ments and ma& ,ave mont,l& com!ounding. $,us t,e interest rate -uoted to &ou ma& be too low and actuall& -uite dece!tive. $o get t,e effective Annual rate &ou s,ould use t,e formula above and see w,at t,e actual effective interest rate is.

Ann!i"0
An annuit& is a constant cas, flow occurring at regular intervals of time.

Ann!i"ie'

An annuit& is a constant cas, flow t,at occurs at regular intervals at fi(ed !eriod of time. Defining A to be t,e annuit& time, t,e time line for an annuit& ma& be drawn as follows. A A A A

= )

"

'

An annuit& can occur at t,e end of eac, !eriod, as in t,is time line, or at t,e,; beginning of eac, !eriod.

;resent %alue of an end-of-the period annuity

$,e !resent value of an annuit& can be calculated b& ta2ing eac, cas, flow and discounting it bac2 to t,e !resent and t,en adding u! t,e !resent values. Alternativel&, a formula can be used in t,e calculation. In t,e case of annuities t,at occur at t,e end of eac, !eriod, t,is formula can be written as /1- 1 0 *% of an Annuit& M*%/A, r, n0MA / /1Nr0n 0 ( r w,ere A M Annuit& r M Discount 5ate n M Number of &ears Accordingl& t,e notation used internationall& for t,e !resent value of an. annuit& is *%/A, r, n0. 4u!!ose &ou start a rent-a-car business and want to bu& an automobile. Hou ,ave c,oice of bu&ing t,e car cas, down for 5s )==,=== or !a&ing 5s G=,=== a &ear for five &ears for t,e same car. 1,at would &ou rat,er do, if t,e o!!ortunit& cost is 1"U t,en calculate &our decisionI *% of 5s G=,=== eac, &ear for t,e ne(t > &ears 1

/ 1 - -------0 / >0

M G=,===

/ /1.1"0

M ',"),)"G.J>

=.1"0

<bviously it is better to take the auto loan rather than pay cash down and naturally no auto loan company or bank will come up with such a scheme) $,e !resent values of &our instalments versus cas, down will alwa&s be ,ig,er but if &ou do not ,ave t,e mone& rig,t now or &ou can get a ,ig,er return b& using t,is loan t,en it is wort,w,ile ta2ing t,e loan. $,us &ou will also ,ave to loo2 3into &our inflows b& ,iring out t,e carls in &our rent-a-car business. 1,en t,e !resent values of &our instalment !a&ments e(ceed t,e cas, down !rice it is better to !a& cas, down and ac-uire t,e asset. Alternativel& above &ou could ,ave discounted eac, instalment se!aratel& land added u! t,e !resent values for all five and arrived at t,e same figure. Nowada&s s!reads,eets li2e e(cel are used to calculate t,e values of different annuities or using advanced !rogramme calculators w,ic, all insurance com!an& agents use. $,us using t,e formulas !rogrammed in t,e s!reads,eet and c,anging t,e variables li2e amount, time and rate of interest discount factor &ou can calculate t,e !resent value of different annuities and ta2e financial decisions bot, !ersonal and commercial.

Conce*" C)ec(
7ften &ou ,ave a c,oice of bu&ing an asset li2e a car, com!uter, !lane, etc. Is it a!!ro!riate to com!are t,e !resent value of +ust &our lease !a&ments to &our !urc,ase !riceI 1,& or w,& notI Future %alue of +nd-of-the-;eriod Annuities
n some cases, an individual ma& !lan to set aside a fi(ed annuit& eac, !eriod for a number of !eriods and will want to 2now ,ow muc, ,e or s,e will ,ave at t,e end of t,e !eriod. $,e future value of an end-of-t,e-!eriod annuit& can be calculated as follows F% of an annuit& M F%/A, r ,n0M AV /1Nr0n - 1W r Thus t,e standard notation widel& !racticed for Future %alue of an annuit& is F%/ A, r , n0 Conce*" C)ec( Pnowing t,e future value formula can &ou calculate t,e future value of 5s >=== ta( e(em!ted **F &ou de!osit ever& &ear for twent& &earsI 7r for fort& &ean Assume &ou start at age "> &ears.

If it is ta(ed obviousl& &ou ,ave a lower return. Suggling t,e above formula if &ou 2now t,e future value of w,at &ou ,ave re!a& and &ou want to set aside a fi(ed sum even &ear so t,at &ou can re!a& t,e sum &ou can calculate t,e annuit&. $,us Annuit& given future value - w,ic, means &ou are given t,e future value and are loo2ing for t,e annuit& - A /F%, r, n0 can be calculated as follow Annuit& given t,e future valueM A /F%, r, n0 M F%VDDrDDW / 1Nr0n -1 "alloon Repayment Loan: A balloon 5e!a&ment loan refers to a Ioan on w,ic, onl& interest is !aid for t,e life of t,e Ioan, and t,e-entire !rinci!al is !aid at t,e end of t,e loan3s life. #om!anies t,at borrow mone& using balloon re!a&ment loans li2e bonds or debentures often set aside mone& in sin2ing funds during t,e life of t,e loan to ensure t,e& ,ave enoug, at maturit& to !a& t,e !rinci!al on t,e loan or t,e face value of t,e bonds. $,us an& com!an& will ,ave to set aside a fi(ed amount eac, &ear till t,e date of redeeming of bonds debentures to avoid defaulting on re!a&ment to bond,olders or debenture ,olders. $,e siKe of t,e sin2ing fund will var& wit, t,e c,ange in interest rate. Sinking Fund: A sin2ing fund is a fund to w,ic, firms ma2e annual contributions in order to ,ave enoug, funds to meet a large financial liabilit& in future.

Conce*" C)ec(
Do Insurance #om!anies and *ension Funds !rovide for sin2ing fundsI 1,en insurance is onl& a contingent uncertain liabilit& w,& do t,ese com!anies also !rovide for sin2ing fundsI E&&ec" o& Ann!i"ie' a" ")e 2e#innin# o& Eac) 9ea$ $,e annuities we tal2ed about till now are end of t,e !eriod cas, flows. ?ot, t,e !resent and future values are affected if t,e cas, flow occurs at t,e beginning of eac, !eriod instead of t,e end. $o illustrate t,is effect, consider an annuit& of 5s 1== at t,e end of eac, &ear for t,e ne(t four &ears,wit, a discount rate of 1=U. 5s 1== 1== 5s 1== 5s 1== 5s

= )

1=U

1=U

"

1=U

'

1=U

= 5s 1==

1 5s 1==

" 5s 1== Fig 1.)

' 5s 1==

) 5s 1==

?ecause t,e first of t,ese annuities occurs rig,t now, and t,e remaining cas, flows ta2e t,e form of an end-of-t,e-!eriod annuit& over t,ree &ears. $,e !resent value of t,is annuit& can be written as follows. *% of 5s 1== at beginning M 1== N 1==A1- 1DDD ' of eac, of ne(t four &ear 1.1=DD =.1=

In general, t,e !resent value of a beginning 8 of- a- !eriod annuit& over an &ear can be written as follows *% of *eriod Annuities at beginning M A N A A1-DD1D of eac, of ne(t n &ears /1Nr0 n-1 DDDDDDDDD r $,is !resent value will be ,ig,er t,an t,e !resent value of an e-uivalen to annuit& at t,e end of eac, !eriod. $,e future value of a beginning-of-a-!eriod annuit& t&!icall& can be estimated b& allowing for one additional !eriod of com!ounding for eac, cas, flow. *% of *eriod Annuities at beginning M A /1Nr0 /1Nr0 n-1 of eac, of ne(t n &ears DDDDDDDDD r $,is future value will be ,ig,er t,an t,e future value of an e-uivalent annuit& at t,e end of eac, !eriod. $,us if &ou invest &our annuit& at t,e beginning of eac, &ear instead of t,e end of eac, &ear, &our future value will be ,ig,er. B

6rowing Annuities
A growing annuit& is a cas, flow t,at grows at a constant rate for a s!ecified !eriod of time. If A is t,e current cas, flow, and g is t,e e(!ected growt, rate,; t,e time line for a growing annuit& is as follows. A/1N g01 g0) A/1N g0 " A/1N g0' A/1N I

Note t,at to -ualif& as a growing annuit&, t,e growt, rate in eac, !eriod ,aE to be t,e same as t,e growt, rate in t,e !rior !eriod.

The ;rocess of 2iscountin/ a ,rowin/ Annuity $,e !resent value of a growing annuit& can be estimated b& using t,e following
formula: ;% of a ,rowin/ Annuity # A((./ = ( ! (( . / > ? /1Nr0: r@A $,e !resent value of a growing annuit& can be estimated in all cases but one if t,e growt, rate is e-ual to t,e discount rate. In t,at case, t,e !reseni value is e-ual to t,e nominal sums of t,e annuities over t,e !eriod, wit,out t,e growt, effect. *% of a 6rowing Annuit& for n &ears /w,en r M g0 M nA It is im!ortant to note t,at t,e e(!anded formulation wor2s even w,en t,E /rowth rate is /reater than the discount rate)

*er!etuit&
A !er!etuit& is a constant cas, flow !aid /or received0 at regular time intervals forever.

$,us a lifetime !ension can be considered as !er!etuall& or rentals received from e(!loitation of land w,ic, is !assed on from generation to generation. $,e !resent value of a !er!etuit& can be written as *% of *er!etuit& M A r A #onsole ?ond is a bond t,at ,as no maturit& and !a&s a fi(ed cou!on /rate of interest0. Assume t,at &ou ,ave a @ !er cent cou!on console bond. $,e original face value M 5s 1===. $,e current value of t,is bond if t,e interest rate is G !er cent is as follows. #urrent value of #onsole ?ond M 5s 96(6)6A M 5s @@J $,e value of a #onsole bond will be e-ual to its face value onl& if t,e cou!on rate is e-ual to t,e interest rate. In t,is case 5s 1===, 9e. 9676)69

,rowin/ ;erpetuties
A growing !er!etuit& is a cas, flow t,at is e(!ected to grow at a constant rate. forever. $,e !resent value of a growing !er!etuit& can be-written as *% of 6rowing *er!etuit& M #DDD /r - g0

A growing !er!etuit& is a constant cas, flow, growing at a constant rate, and !aid at regular time intervals forever. Althou/h a /rowin/ annuity and a /rowin/ perpetuity share several features, the fact that a /rowin/ perpetuity lasts forever puts constraints on the /rowth rate) 1t has to be less than the discount rate for the formula to work)

Recommended Readin/s Financial -ana/ement "y 'han B &ain

CAPITAL EDPENDITURE DECISIONS

O23ECTIVES
$,is c,a!ter !rovides a broad overview of t,e field of !ro+ect a!!raisal and ca!ital budgeting. It is divided into five sections as follows. R #a!ital e(!enditures. im!ortance and difficulties R *,ases of ca!ital budgeting R 9evels of decision-ma2ing R Facets of !ro+ect anal&sis R Feasibilit& stud&. a sc,ematic diagram E 7b+ectives of ca!ital budgeting

#A*I$A9 EX*ENDI$L5E DE#I4I7N4 Ca*i"al E5*en i"!$e': I%*o$"ance an Di&&ic!l"ie'

I%*o$"ance
#a!ital e(!enditure decisions often re!resent t,e most im!ortant decisions ta2en b& a firm. $,eir im!ortance stems from t,ree inter-related reasons. Lon/-term effects: $,e conse-uences of ca!ital e(!enditure decisions e(tend far into t,e future. $,e sco!e of current manufacturing activities of a firm is governed largel& b& ca!ital e(!enditures in t,e !ast. (i&ewise current ca!ital e(!enditure decisions !rovide t,e framewor2 for future activities. #a!ital investment decisions ,ave an enormous bearing on t,e basic c,aracter of a firm. 1rreversibility: $,e mar2et for used ca!ital e-ui!ment in general is iIlorganised. Furt,er, for some t&!es of ca!ital e-ui!ments,custom made to meet s!ecific re-uirement, t,e mar2et ma& virtuall& be non-e(istent. 7nce suc, an e-ui!ment is ac-uired, reversal of decision ma& mean scra!!ing t,e ca!ital e-ui!ment. $,us, a wrong ca!ital investment decision, often cannot be reversed wit,out incurring a substantial loss Cubstantial outlays: #a!ital e(!enditures usuall& involve substantial outla&s. An integrated steel !lant, for e(am!le, involves an outla& of several t,ousand millions. #a!ital costs tend to increase wit, advanced.

Di&&ic!l"ie'
1,ile ca!ital e(!enditure decisions are e(tremel& im!ortant, t,e& also post difficulties w,ic, stem from t,ree !rinci!al sources. .

-easurement problems: Identif&ing and measuring t,e costs and benefits of a ca!ital e(!enditure !ro!osal tends to be difficult. $,is is more so w,en a ca!ital e(!enditure ,as a bearing on some ot,er activities of t,e firm /li2e cutting into t,e sales of some e(isting !roduct0 or ,as some intangible conse-uences /li2e im!roving t,e morale of wor2ers0.

Dncertainty: A ca!ital e(!enditure decision involves costs and benefits t,at e(tend far into future. It is im!ossible to !redict e(actl& w,at will ,a!!en in future. Cence, t,ere is usuall& a great deal of uncertaint& c,aracterising t,e costs and benefits of a ca!ital e(!enditure decision. Temporal spread: $,e costs and benefits associated wit, a ca!ital e(!enditure decision are s!read out over a long !eriod of time, usuall& 1=-"= &ears for industrial !ro+ects and "=->= &ears for infrastructural !ro+ects. 4uc, a tem!oral s!read creates some !roblems in estimating discount rates and establis,ing e-uivalences.

P=ASES OF CAPITAL 2UDGETING

#a!ital budgeting is a com!le( !rocess w,ic, ma& be divided into five broad !,ases. !lanning, anal&sis, selection, im!lementation, and review. E(,ibit 11.1!ortra&s t,e relations,i! among t,ese !,ases. $,e solid arrows reflect t,e main se-uence. !lanning !recedes anal&sis; anal&sis !recedes selection; and so on. $,e das,ed arrows indicate t,at t,e !,ases of ca!ital budgeting are not related in a sim!le, se-uential manner. Instead, t,ere are several feedbac2 loops reflecting t,e iterative nature of t,e !rocess.

Plannin#
$,e !lanning !,ase of a firm3s ca!ital budgeting !rocess is concerned wit, t,e articulation of its broad investment strateg& and t,e generation and !reliminar& screening of !ro+ect !ro!osals. $,e investment strateg& of t,e firm delineates t,e broad areas or t&!es of investments t,e firm !lans to underta2e. $,is !rovides t,e framewor2 w,ic, s,a!es, guides, and circumscribes t,e identification of individual !ro+ect o!!ortunities.

5#hibit ++.+ 6apital 7udgeting 8rocess

7nce a !ro+ect !ro!osal is identified, it needs to be e(amined. $o begin wit,, a !reliminar& !ro+ect anal&sis is done. A !relude to t,e full blown feasibilit& stud&, t,is e(ercise is meant to assess /i0 w,et,er t,e !ro+ect is !rima facie wort,w,ile to +ustif& a feasibilit& stud& and /ii0 1,at as!ects of t,e !ro+ect are critical to its viabilit& and ,ence warrant an in-de!t, investigation.

Anal0'i'
If t,e !reliminar& screening suggests t,at t,e !ro+ect is !rima facie wort,w,ile, detailed anal&sis of t,e mar2eting, tec,nical, financial, economic, and ecological as!ects is underta2en. $,e -uestions and issues raised in suc, a detailed anal&sis are described in t,e following section. $,e focus of t,is phase of ca!ital e(!enditure decisions is on gat,ering, !re!aring, and summarising relevant information about various !ro+ect !ro!osals w,ic, are being considered for inclusion in t,e ca!ital budget. ?ased on t,e information develo!ed in t,is anal&sis, t,e stream of costs and benefits associated wit, t,e !ro+ect can be defined.

Selec"ion
4election follows, and often overla!s, anal&sis. It addresses t,e -uestion-Is t,e !ro+ect wort,w,ileI A wide range of a!!raisal criteria ,ave been suggested to +udge t,e wort,w,ileness of a !ro+ect. $,e& are divided into two broad categories, viK., non-discounting criteria and discounting criteria. $,e principal non-discounting criteria are t,e !a&bac2 !eriod and t,e accounting rate of return. $,e 2e& discounting criteria are t,e net !resent value, t,e internal rate of return, and t,e benefit cost ratio. $,e selection rules associated wit, t,ese criteria are as follows. DDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDD D #riterion Acce!t 5e+ect

*a&bac2 !eriod/*?*0 *?*X target !eriod Accounting rate of return/A550 A55Ytarget rate rate Net !resent value/N*%0 Internal rate of return/I550 ?enefit cost ratio/?#50 N*%Y=

*?*Y $arget !eriod A55X$arget N*%X=

I55Ycost of ca!ital I55X cost of ca!ital ?#5Y1 ?#5X1

DDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDDD D $o a!!l& t,e various a!!raisal criteria suitable cut-off values /,urdle rate target

rate, and cost of ca!ital0 ,ave to be s!ecified. $,ese essentiall& a

function of

t,e mi( of financing and t,e level of !ro+ect ris2. 1,ile t,e former can be defined wit, relative ease, t,e latter trul& tests t,e abilit& of t,e !ro+ect evaluator. Indeed des!ite a wide range of tools and tec,ni-ues for ris2 anal&sis /sensitivit& anal&sis, scenario anal&sis, Monte #arlo simulation, decision tree anal&sis !ortfolio t,eor&, ca!ital asset !ricing model, and so on0, ris2 anal&sis remains t,e most intractable !art of t,e !ro+ect evaluation eEercise)

I%*le%en"a"ion
$,e im!lementation !,ase for an industrial !ro+ect, w,ic, involves setting of manufacturing facilities, consists of several stages. /i0 !ro+ect and engineering designs, /ii0 negotiations and contracting, /iii0 construction, /iv0 training, and /v0 !lant commissioning. 1,at is done in t,ese stages is briefly described below !

!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!! ! 4tages
*ro+ect and engineering designs

#oncerned wit, 4ite !robing and !ros!ecting, !re!aration of blue!rint and !lant designs , !lant engineering, selection of s!ecific mac,ineries and e-ui!ment. Negotiating and drawing u! of legal contracts wit, res!ect to !ro+ect financing, ac-uisition of tec,nolog&, construction of building and civil wor2s, !rovision of

Negotiations and contracting

utilities, su!!l& of mac,iner& and e-ui!ment, mar2eting arrangements, etc.

#onstruction

4ite !re!aration, construction of buildings and civil wor2s, erection and installation of mac,iner& and e-ui!ment. $raining of engineers, tec,nicians, and wor2ers. /$,is can !roceed simultaneousl& along wit, t,e construction wor20 4tart u! of t,e !lant. /$,is is a brief but commissioning is tec,nicall& crucial stage in t,e !ro+ect develo!ment c&cle.0

$raining

Plant commissioning

$ranslating an investment !ro!osal into a concrete !ro+ect is a com!le( timeconsuming, and ris2-fraug,t tas2. Dela&s in im!lementation,w,ic, is common, can lead to substantial cost overruns. For e(!editious im!lementation at a reasonable cost, t,e following are ,el!ful.

() Ade5uate formulation of proFects: A ma+or reason for dela& is inade-uate

formulation of !ro+ects. *ut differentl&, if necessar& ,omewor2 in terms of !reliminar& studies and com!re,ensive and detailed formulation of t,e !ro+ect is not done, man& sur!rises and s,oc2s are li2el& to 4!ring on t,e wa&. Cence, the need for adequate formulation of the !ro+ect cannot be overem!,asised.

*) Dse of the principle of responsibility accountin/ : Assigning s!ecific

res!onsibilities to !ro+ect managers for com!leting t,e !ro+ect wit,in t,e defined time frame and cost limits is ,el!ful in e(!editious e(ecution and cost control. '. Dse of network techni5ues: For !ro+ect !lanning and control two basic tec,ni-ues are available - *E5$ /*rogramme Evaluation 5eview $ec,ni-ue0 and #*M /#ritical *at, Met,od0. $,ese tec,ni-ues ,ave, of late, merged and are being referred to b& a common terminolog&, t,at is networ2 tec,ni-ues. 1it, t,e ,el! of t,ese tec,ni-ues, monitoring becomes easier.

Re+ie7nce t,e !ro+ect is commissioned t,e review !,ase ,as to be set in motion. *erformance review s,ould be done !eriodicall& to com!are actual !erformance wit, !ro+ected !erformance. A feedbac2 device is useful in several wa&s. /i0 It

t,rows lig,t on ,ow realistic were t,e assum!tions underl&ing t,e !ro+ect; /ii0 It !rovides a documented log of e(!erience t,at is ,ig,l& valuable in future decision-ma2ing; /iii0 It suggests corrective action to be ta2en in t,e lig,t of actual !erformance; /iv0 It ,el!s in uncovering +udgemental biases; /v0 It induces a desired caution among !ro+ect s!onsors.

9E%E94 7F DE#I4I7N-MAPIN6
7!erating 4trategic decisions 1,ere is t,e decision ta2en management Cow structured is t,e decision 1,at is t,e level of resource resource commitment Minor resource commitment Moderate resource Ma+or commitment Medium term commitment 9ong-term 9ower level management 5outine decisions Middle level management 4emi-structured Lnstructured decision $o! level Administrative

1,at is t,e time ,oriKon 4,ort-term

$,e t,ree levels /o!erating, administrative, and strategic0 of decision ma2ing can be readil& a!!lied to ca!ital e(!enditure budgeting decision. E(am!les are given below. 7!erating ca!ital budgeting decision Administrative ca!ital budgeting decision 4trategic ca!ital budgeting decision . Minor office e-ui!ment . ?alancing e-ui!ment . Diversification !ro+ect

1,ile t,e met,ods and techniques covered in t,is boo2 are a!!licable to all levels of ca!ital budgeting decision. 7ur discussion will mainl& be oriented towards administrative and strategic budgeting decisions.

$,e im!ortant facets of !ro+ect anal&sis are9 R Mar2et anal&sis R $ec,nical anal&sis

P$oFec" A**$ai'al an Con"$ol "ec)ni/!e' PROFITA2ILIT9 STUD9-VARIOUS FACTS OF PRO3ECT ANAL9SIS

R Financial anal&sis R Economic anal&sis E Ecological anal&sis

Ma$(e" Anal0'i'
Mar2et anal&sis is concern wit, !rimaril& two -uestions. R 1,at would be t,e aggregate demand of t,e !ro!osed !roduct service in future R 1,at would be t,e mar2et s,are of t,e !ro+ect under a!!raisalI

$o answer t,e above -uestion, t,e variet&

mar2et anal&st re-uires a wide

of information and a!!ro!riate forecasting met,ods. $,e 2inds of information re-uired are.

#onsum!tion trends in t,e !ast and t,e !resent consum!tion *ast and !resent su!!l& !osition *roduction !ossibilities and constraints Im!ort and e(!orts 4tructure of com!etition #ost structure Elasticit& of demand #onsumer be,aviour, innovations, motivations, attitudes, references and re-uirements Distribution c,annels and mar2eting !olicies in useful Administrative, tec,nical and legal constraints

Tec)nical Anal0'i'
Anal&sis of t,e tec,nical and engineering aspects of a !ro+ect needs to be done continuall& w,en a !ro+ect is formulated. $ec,nical anal&sis see2s to determine w,et,er t,e !rere-uisites for t,e successful commissioning of t,e Project ,ave

been considered and reasonabl& good c,oices ,ave been made wit, res!ect to

location, siKe, !rocess, etc. $,e im!ortant -uestions raised in tec,nical anal&sis are. forI R 1,et,er t,e availabilit& of raw materials, !ower, and ot,er in!uts ,as been establis,edI R 1,et,er t,e selected scale of o!eration is o!timalI R 1,et,er t,e !roduction !rocess c,osen is suitableI R 1,et,er t,e e-ui!ment and mac,ines c,osen are a!!ro!riateI R 1,et,er t,e au(iliar& e-ui!ments and su!!lementar& engineering wor2s ,ave been !rovided for I R 1,et,er !rovision ,as been made for t,e treatment of effluentsI R 1,et,er t,e !ro!osed la&out of t,e site, buildings, and !lant is soundI R 1,et,er wor2 sc,edules ,ave been realisticall& drawn u!I R 1,et,er t,e tec,nolog& !ro!osed to be em!lo&ed is a!!ro!riate from t,e social !oint of viewI Financial Anal0'i'
Financial anal&sis see2s to ascertain w,et,er t,e !ro!osed !ro+ect will be financiall& viable in t,e sense of being able to meet t,e burden of servicing debt and w,et,er t,e !ro!osed !ro+ect will satisf& t,e return e(!ectations of t,ose w,o !rovide t,e ca!ital. $,e as!ects w,ic, ,ave to be loo2ed into while conducting financial a!!raisal are. R Investment outla& and cost of !ro+ect R Means of financing R #ost of ca!ital R *ro+ected !rofitabilit& R ?rea2-even !oint R #as, flows of t,e !ro+ect R Investment wort,w,ileness +udged in terms of various criteria of merit R *ro+ected financial !osition R 9evel of ris2

R 1,et,er t,e !reliminar& tests and studies ,ave been done or !rovided

Economic Anal0'i'
Economic anal&sis, also referred to as social cost benefit anal&sis, is concerned

wit, +udging a !ro+ect from t,e larger social !oint of view. In suc, an evaluation t,e focus is on t,e social costs and benefits of a !ro+ect w,ic, ma& often be different from its monetar& costs and benefits. $,e -uestions soug,t to be answered in social cost benefits anal&sis are.

1,at are t,e direct economic benefits and costs of t,e !ro+ect measured in terms of s,adow /efficienc&0 !rices and not in terms of mar2et !ricesI 1,at would be t,e im!act of t,e !ro+ect on t,e distribution of income in t,e societ&I 1,at would be t,e im!act of t,e !ro+ect on t,e level of savings and investment in t,e societ&I 1,at would be t,e contribution of t,e !ro+ect towards t,e fulfillment of certain merit wants li2e self-sufficienc&, em!lo&ment, and social orderI

Ecolo#ical Anal0'i'
In recent &ears, environmental concerns ,ave assumed a great deal of significance-and rig,tl& so. Ecological anal&sis s,ould be done !articularl& for ma+or !ro+ects w,ic, ,ave significant ecological im!lications li2e !ower !lants and irrigation sc,emes, and environmental-!olluting industries /li2e bul2 drugs, c,emicals, and leat,er !rocessing-0. $,e 2e& -uestions rEsed in ecological anal&sis are. . 1,at is t,e li2el& damage caused b& t,e !ro+ect to t,e environmentI . 1,at is t,e cost of restoration measures re-uired to ensure t,at t,e damage to t,e environment is contained wit,in acce!table limitsI E(,ibit 11." summarises t,e 2e& issues considered indifferent t&!es of anal&sis. E5)i,i" 11.; Pe& Issues in *ro+ect Anal&sis
Mar2et Anal&sis $ec,nical Anal&sis Financial Anal&sis Economics Anal&sis Ecological Anal&sis DDDDDDDD*otential Mar2et Mar2et 4,are DDDDDDDDD$ec,nical %iabilit& 4ensible #,oices DDDDDDDDDDD5is2 5eturn DDDDDDDDDDD?enefits and #ost in s,adow *rices 7t,er Im!act DDDDDDDDD Environmental Damage 5estoration Measures

Feasibility S"! 0: A Sc)e%a"ic Dia#$a% 1e ,ave loo2ed at t,e five broad !,ases of ca!ital budgeting and e(amined t,e 2e& facets of !ro+ect anal&sis. $,e feasibilit& stud& is concerned wit, t,e first t,ree !,ases of ca!ital budgeting, viK., !lanning, anal&sis, and selection /evaluation0 and involves mar2et, tec,nical, financial, economic, and ecological anal&sis. O,Fec"i+e' o& Ca*i"al 2! #e"in#

Financial t,eor&, in general, rests on t,e !remise t,at t,e goal of financial management /w,ic, subsumes investment decision-ma2ing0 s,ould be to ma(imise t,e !resent wealt, of t,e firm3s e-uit& s,are,olders. For a firm w,ose e-uit& s,ares are activel& traded on t,e stoc2 mar2et, t,e wealt, of t,e e-uit& s,are,olders is reflected in t,e mar2et value of t,e e-uit& s,ares. Cence, t,e goal of financial management for suc, firms s,ould be to ma(imise t,e mar2et value of e-uit& s,ares. $,e !ursuit of t,e welfare of e-uit& s,are,olders is +ustified on t,e grounds t,at it contributes to an efficient allocation of ca!ital in t,e econom&. $,e bases for allocation of savings in t,e econom& are e(!ected return and ris2. 4ince e-uit& s,are !rices are based on e(!ected return and ris2, efforts to ma(imise e-uit& s,are !rices would result in an efficient allocation of resources. Anot,er +ustification ma& be !rovided for t,e goal of s,are,older wealt, ma(imisation. E-uit& s,are,olders !rovide t,e venture /ris20 ca!ital re-uired to start a business firm and a!!oint t,e management of t,e firm indirectl& t,roug, t,e board of directors. Cence, it be,oves on cor!orate managements to !romote t,e welfare of e-uit& s,are,olders. 1,at about a !ublic sector firm t,e e-uit& stoc2 of w,ic,, being full& owned, b& t,e government, is not traded on t,e stoc2 mar2etI In suc, a case, t,e goal of financial management s,ould be to ma(imise t,e !resent value of t,e stream of e-uit& returns. 7f course, in determining t,e !resent value of t,e stream of e-uit& returns, an a!!ro!riate discount rate ,as to be a!!lied. A similar observation ma& be made wit, res!ect to ot,er com!anies w,ose e-uit& s,ares are eit,er not traded or ver& !oorl& traded. Al"e$na"i+e' Are t,ere ot,er goals, besides t,e goal of ma(imum s,are,older wealth

e(!ressing t,e s,are,olders view!ointI 4everal alternatives ,ave bee,n suggested. ma(imisation of !rofit, ma(imisation of earnings !er s,are,

ma(imisation of return on e-uit& /defined as e-uit& earnings net wort,0.

Ma(imisation of !rofit is not as inclusive a goal as ma(imisation of s,are,olders wealt,. It suffers from several limitations.

R *rofit in absolute terms is not a !ro!er guide to decision-ma2ing. It

Should

be e(!ressed on a !er s,are basis or related to investment.

R It leaves considerations of timing and duration undefined. $,ere is no guide for com!aring !rofit now wit, !rofit in future or for com!aring !rofit streams of different durations. R It glosses over t,e factor of ris2. It cannot, for e(am!le, discriminate between an investment. !ro+ect w,ic, generates a certain !rofit of 5s >=,=== and an investment !ro+ect w,ic, ,as a variable !rofit outcome wit, an e(!ected value of 5s >=,===.

$,e goals of ma(imisation of earnings !er s,are and ma(imisation of retum on e-uit& do not suffer from t,e first limitation mentioned above. $,e&, ,owever suffer from t,e ot,er limitations and ,ence are not suitable. In view of t,e s,ortcomings of t,e alternatives discussed above, ma(imisation of t,e wealt, of e-uit& s,are,olders /as reflected in t,e mar2et !rice of e-uit&0 a!!ears to be t,e most a!!ro!riate goal for financial decision-ma2ing. $,oug, t,e strict validit& of t,is goal rests on certain rigid assum!tions about capital mar2ets, it can be reasonabl& defined as a guide for financial decision ma2ing under fairl& !lausible assum!tions.

O")e$ Conce$n' o& ")e 2!'ine''

Do firms reall& act or s,ould solel& act to furt,er s,are,olders welfareI This does not seem to be t,e issue ,ere. Firms ma& !ursue or oug,t to pursue several ot,er goals. ?usiness firms see2 to ac,ieve a ,ig, rate of growth, en+o& a substantial mar2et s,are, attain !roduct and tec,nological leaders,i!, !romote em!lo&ee welfare, furt,er customer satisfaction, su!!ort education and researc,, im!rove communit& life, and solve ot,er societal !roblems. Some of t,ese goals, ma&, of course, be in consonance wit, t,e goal of s,are,older wealt, ma(imisation. For a ra!id growt, rate, a dominant mar2et !osition, and a ,ig,er customer satisfaction ma& lead to increasing returns for e-uit& s,are,olders. Even efforts toward solving societal !roblems ma& furt,er t,e interest of s,are,olders in t,e

long run b& im!roving t,e image of t,e firm and strengt,ening its relations,i! wit, t,e environment. 1,en t,ese ot,er goals seem to conflict wit, t,e goal of ma(imising t,e wealt, of e-uit& s,are,olders, it is ,el!ful to 2now t,e cost of !ursuing t,ese goals. $,e trade-off ,as to be understood. It s,ould be a!!reciated t,at t,e ma(imisation of t,e wealth of e-uit& s,are,olders constitutes t,e !rinci!al guarantee for efficient allocation of resources in t,e econom& and ,ence is to be regarded as t,e normative goal from t,e financial !oint of view. 2a'ic Con'i e$a"ion': Ri'( an Re"!$n 4u!!ose a firm is evaluating an investment !ro!osal. 1,at as!ects are relevant from t,e financial angleI From t,e financial !oint of view t,e relevant dimension are return and ris2. $a2e anot,er decision situation in w,ic, t,e firm is considering a financing !ro!osal. $,e as!ects along w,ic, suc, a !ro!osal is e(amined are cost and ris2. 4ince cost is t,e inverse of return, ,ere too t,e basic dimensions are return and ris2. In general, we find t,at t,ese are t,e two basic dimensions of financial anal&sis. 1,at is t,e relations,i! between return, ris2 and mar2et value of e-uit&I Cig,er t,e return, ceteris !aribus, ,ig,er t,e mar2et value; ,ig,er t,e ris2, ceteris !aribus, lower t,e mar2et value. E(,ibit 11.) s,ows t,e sc,ematic diagram of ,ow decisions, return, ris2, and mar2et value are related. E(,ibit 11.) Decision, 5eturn,5is2 and mar2et value ,eturn 'nvestment :ecision

;ar&et <alue of the 4irm

4inancing :ecision

,is&

It ma& be em!,asiKed t,at t&!icall&, ris2 and return go ,and in ,and. $,is means t,at in a decision situation, an alternative w,ic, ,as a ,ig,er return tends to ,ave ,ig,er ris2 too. 9i2ewise, an alternative w,ic, ,as a lower return tends to ,ave a lower ris2. In financial

anal&sis, t,e trade-off between ris2 and return needs to be carefull& anal&sed. 9et Ls 4um L! Essentiall& a ca!ital !ro+ect re!resents a sc,eme for investing resources t,at can be anal&sed and a!!raised reasonabl& inde!endentl&. $,e basic c,aracteristic of a ca!ital !ro+ect is t,at it t&!icall& involves a current outla& /or current and future outla&s0 of funds in t,e e(!ectation of a stream of benefits e(tending far into future. #a!ital e(!enditure decisions often re!resent t,e most im!ortant decisions ta2en b& a firm. $,eir im!ortance stems from t,ree interrelated reasons. long-term effects, irreversibilit&, and substantial outla&s.

1,ile ca!ital e(!enditure decisions are e(tremel& im!ortant, t,e& !ose

difficulties w,ic, stem from t,ree !rinci!al sources. measurement !roblems, uncertaint&, and tem!oral s!read.

#a!ital budgeting is a com!le( !rocess w,ic, ma& be divided into five broad

!,ases. !lanning, anal&sis, selection, im!lementation, and review. 7ne can loo2 at ca!ital budgeting decisions at t,ree levels. o!erating, administrative, and strategic. $,e im!ortant facets of !ro+ect anal&sis are. mar2et anal&sis, tec,nical anal&sis, financial anal&sis, economic anal&sis, and ecological anal&sis. Financial t,eor&, in general, rests on t,e !remise t,at t,e goal of financial management s,ould be to ma(imise t,e !resent wealt, of t,e firm3s e-uit& s,are,olders. ?usiness firms ma& !ursue ot,er goals. 1,en t,ese ot,er goals conflict wit, t,e goal of ma(imising t,e wealt, of e-uit& s,are,olders, t,e trade-off ,as to be understood. 1e0-o$ ' Accountin/ rate of return method: A selection criterion using average net income and investment outla& to com!ute a rate of return for a !ro+ect. $,e met,od ignores t,e time value of mone& and cas, flows. 0apital bud/et: $,e sc,edule of investment !ro+ect selected to be underta2en over some interval of time. 1nternal rate of return method: A selection met,od using t,e com!ounding rate of return on t,e cas, flow of a !ro+ect. 4et present value: A selection met,od using t,e difference between t,e !resent value of t,e cas, inflows of t,e !ro+ect and t,e investment outla&. $,e met,od evaluates differential cas, flow between !ro!osals.

;ayback method: A selection met,od in w,ic, a firm sets a ma(imum !a&. bac2 !eriod during w,ic, cas, inflow must be sufficient to recover t,e initial outla&. $,is met,od ignores t,e time value of mone& and cas, flows be&ond t,e !a& bac2 !eriod. 5ecommended reading. Financial Management b& P,an and Sain Financial Management b& I M *anda&