SAS PART II PAPER VII SECTION – I: FINANCIAL MANAGEMENT INDEX

1. FINANCE

Sl. No. 1. 2. 3. 4.

TOPICS Financial Management - An overview, an understanding of basic terms / concept in Finance. Concept of Time Value of Money. Capital Expenditure Decisions. Project Appraisal and Control Techniques

FINANCIAL MANAGEMENT -AN OVERVIEW
INTRODUCTION Finance may be defined as the art and science of managing money. The major areas of finance are: (1) financial services and (2) managerial finance/corporate finance/financial management. While financial services is concerned with the design and delivery of advice and financial products to individuals, businesses and governments within the areas of banking and related institutions, personal financial planning, investments, real estate, insurance and so on, financial management is concerned with the duties of the financial managers in the business firm. Financial managers actively manage the financial affairs of any type of business, namely, financial and non-financial, private and public, large and small, profit-seeking and not-for-profit. They perform such varied tasks as budgeting, financial forecasting, cash management, credit administration, investment analysis, funds management and so on. In recent years, the changing regulatory and economic environments coupled with the globalisation of business activities have increased, the complexity as well as the importance of the financial managers' duties. As a result, the financial management function has become more demanding and complex. This Chapter provides an overview of financial management function. It is organised into seven Sections: . Relationship of finance and related disciplines . Scope of financial management . Goal /objectives ,of financial management . Agency problem . Organisation of the finance function . Emerging role of finance managers in India . An overview FINANCE –FINANCE AND RELATED DISCIPLINE Financial management, as an integral part of overall management, is not a totally independent area. It draws heavily on related disciplines and fields of study, such as economics, "accounting, marketing, production and quantitative methods. Although these disciplines are interrelated, there are key differences among them. In this Section, we discuss these relationships. Finance and Economics The relevance of economics. to financial management can be described in the light of the two broad areas of economics: macroeconomics and microeconomics. Macroeconomics is concerned with the overall institutional environment in which the firm operates. It looks at the economy as a whole. Macroeconomics is concerned with the institutional structure of the banking system, money and capital markets, financial intermediaries, monetary, credit and fiscal policies and economic policies dealing with, and controlling level of, activity within an economy. Since business firms operate in the macroeconomic environment, it is important for financial managers to understand the broad economic environment. Specifically, they should (1) recognise and understand how monetary policy affects the cost and the availability of funds; (2) be versed in fiscal policy and its effects on the economy; (3) be ware of the various financial institutions/financing

outlets; (4) understand the consequences of various levels of economic activity and changes in economic policy for their decision environment and so on. Microeconomics deals with the economic decisions of individuals and organisations. It concerns itself with the determination of optimal operating strategies. In other words, the theories of microeconomics provide for effective operations of business firms. They are concerned with defining actions that will permit the firms to achieve success. The concepts and theories of microeconomics relevant to financial management are, for instance, those involving (1) supply and demand relationships and profit maximisation strategies, (2) issues related to the mix of productive factors, 'optimal' sales level and product pricing strategies, (3) measurement of utility preference, risk and the determination of value, and (4) the rationale of depreciating assets. In addition, the primary principle that applies in financial management is marginal analysis; it suggests that financial decisions should be made on the basis of comparison of marginal revenue and marginal cost. Such decisions will lead to an increase in profits of the firm. It is, therefore, important that financial managers must be familiar with basic microeconomics. To illustrate, the financial manager of a department store is contemplating to replace one of its online computers with a new, more sophisticated one that would both speed up processing time and handle a large volume of transactions. The new computer would require a cash outlay of Rs 8,00,000 and the old computer could be sold to net Rs 2,80,000. The total benefits from the new computer and the old computer would be Rs 10,00,000 and Rs 3,50,000 respectively. Applying marginal analysis, we get: Benefits with new computer Rs 10,00,000 Less: Benefits with old computer Marginal benefits (a) Cost of new computer 3,50,000 Marginal Benefits (a) Rs 6,50,000 Cost of new computer Rs 8,00,000 Less: Proceeds from sale of old computer Marginal cost (b) Net benefits [(a) (b)] Rs 2,80,000 Marginal cost (b) Rs 5,20,000 Net benefits (a) –(b) 1,30,0000 As the store would get a net benefit of Rs 1,30,000, the old computer should be replaced by the new one. Thus, a knowledge of economics is necessary for a financial manager to understand both the financial environment and the decision theories which underline contemporary financial management. He should be familiar with these two areas of economics. Macroeconomics provides the financial manager with an insight into policies by which economic activity is controlled. Operating within that institutional framework, the financial manager draws on microeconomic theories of the operation of firms and profit maximisation. A basic knowledge of economics is, therefore, necessary to understand both the environment and the decision. techniques of financial management. Finance and Accounting The relationship between finance and accounting, conceptually speaking, has two dimensions: CO they are closely related to the extent that accounting is an important input in financial decision

making; and (ii) there. are key differences in viewpoints between them. . Accounting function is a necessary input into the finance function. That is, accounting is a subfunction of finance. Accounting generates information/data relating to operations/activities of the firm. The end-product of accounting constitutes financial statements such as the balance sheet, the income statement (profit and loss account) and the statement of changes in financial position/ sources and uses of funds statement/cash flow statement. The information contained in these statements and reports assists financial managers in assessing the past performance and future directions of the firm and in meeting legal obligations, such as payment of taxes and so on. Thus, accounting and finance are functionally closely related. Moreover, the finance (treasurer) and accounting (controller) activities are typically within the control of the vicepresident/director (finance)/Chief financial officer (CFO) as shown in Fig. 1.2. These functions are closely related and generally overlap; indeed, financial management and accounting are often not easily distinguishable. In small firms the controller often carries out the finance function and in large firms many accountants are intimately involved in various finance activities. But there are two key differences between finance and accounting. The first difference relates to the treatment of funds, while the second relates to decision making. Treatment of Funds The viewpoint of accounting relating to the funds of the firm is different from that of finance. The measurement of funds (income and expenses) in accounting is based on the accrual principle/system. For instance, revenue is recognised at the point of sale and not when collected. Similarly, expenses are recognised when they are incurred rather than when actually paid. The accrual-based accounting data do not reflect fully the financial circumstances of the firm. A firm may be quite profitable in the accounting sense in that it has earned profit (sales less expenses) but it may not be able to meet current obligations owing to shortage of liquidity. due to uncollectable receivables, for instance. Such a firm will not survive regardless of its levels of profits. ,The viewpoint of finance relating to the treatment of funds is based on cashflows. The revenues are recognised only when actually received in cash (Le. cash inflow) and expenses are recognised on actual payment (Le. cash outflow). This is so because the financial manager is concerned with maintaining solvency of the firm by providing the cashflows necessary to satisfy its obligations and acquiring and financing the assets needed to achieve the goals of the firm. Thus, cashflow-based returns help financial managers avoid insolvency and achieve the desired financial goals. To illustrate, total sales of a trader during the year amounted to Rs 10,00,000 while the cost of sales was Rs 8,00,000. At the end of the year, it has yet to collect Rs 8,00,000 from the customers. The accounting view and the financial view of the firms performance during the year are given below. Accounting View View (Income Statement) Sales Rs 2,00,000 Less: Cost Rs 8,00,000 ___________ Net Profit outflow Rs 6,00,000 Financial Rs 10,00,000 Rs 8,00,000 (Cash Flow Statement) Cash inflow Less cash outflow

_____________ Rs 2,00,000 Net cash

Finance and Other Related Disciplines Apart from economics and accounting. in a sense. present and future operations of the firm. For instance. Decision Making Finance and accounting also differ in respect of their purposes. Production . controlling and decision making. Investment analysis 2. Regardless of its profits. the firm is quite profitable in accounting sense. the tools of analysis developed in the quantitative methods area are helpful in analysing complex financial management problems. Macroeconomics 2~ Working capital management: 3. It does not mean that accountants never make decisions or financial managers never collect data.Obviously. Analysis of risks and returns Other Relates Discipline Decision 1. finally. financial managers should consider the impact of new product development and promotion plans made in marketing area since their plans will require capital outlays and have an impact on the projected cash flows. finance begins where accounting ends. production and quantitative methods are.1. Determination of capital structure 5. only indirectly related to day-today decision making by financial managers and are supportive in nature while economics and accounting are the primary disciplines on which the financial manager draws substantially. it is a financial failure in. Sources and cost of funds 4. ' 6. Thus. The relationship between financial management and supportive disciplines is depicted in Fig 1. The purpose of accounting is collection and presentation of financial data. terms of actual cash flows resulting from uncollected receivables. production and quantitative methods. And. Financial Primary Discipline 1. Dividend policy. finance also draws-for its day-to-day decisions-on supportive disciplines such as marketing. Marketing 2. the firm would not survive due to inadequate cash inflows to meet its obligations. Accounting Support Area Support 1. The marketing. It provides consistently developed and easily interpreted data on the past. changes in the production process may necessitate capital expenditures which the financial managers must evaluate and finance. Micro economics 3. Similarly. But the primary focus of the functions of accountants is on collection and presentation of data while the financial manager's major responsibility relates to financial planning. The financial manager uses such data for financial decision making. thus.

The weaknesses of the traditional approach fall into two broad categories: (i) those relating to the treatment of various topics and the emphasis attached to them. and (ii) those relating to the basic conceptual and analytical framework of the definitions and scope of the finance function. the theme was woven around the viewpoint of the suppliers . (ii) the financial instruments through which funds are raised from the capital markets and the related aspects of practices and the procedural aspects of capital markets. Quantatative method Resulting in Shareholders Wealth Maximisation SCOPE OF FINANCIAL MANAGEMENT The approach to the scope and functions of financial management is divided.3.2 Further. into two broad categories: (a) The Traditional Approach. the field of study dealing with finance was treated as encompassing three interrelated aspects of raising and administering resources from outside: (i) the institutional arrangement in the form of financial institutions which comprise the organisation of the capital market. and (b) The Modem Approach. That these were the broad features of the subject-matter of corporation finance is eloquently reflected in the academic writings around the period during which the traditional approach dominated academic thinking. therefore. This approach was challenged during the period when the approach dominated the scene itself. In other words. liquidation. 1 Thus. for purposes of exposition. It has now been discarded as it suffers from serious limitations. and (iii) the legal and accounting relationships between a firm and its sources of funds. the issues to which literature on finance addressed itself was how resources could best be raised from the combination of the available sources. A detailed description of these major events constituted the second element of the scope of this field of academic study. The first argument against the traditional approach was based on its emphasis on issues relating to the procurement of funds by corporate enterprises. the scope of the finance function was treated by the traditional approach in the narrow sense of procurement of funds by corporate enterprise to meet their financing needs. Traditional Approach The traditional approach to the scope of financial management refers to its subject-matter. The term 'procurement' was used in a broad sense so as to include the whole gamut of raising funds externally. Thus defined. The coverage of corporation finance was. reorganisation and so on. A related aspect was that firms require funds at certain episodic events such as merger. in academic literature in the initial stages of its evolution. as a separate branch of academic Study. the traditional treatment of finance was criticised3 because the finance function was equated with the issues involved in raising and administering funds. conceived to describe the rapidly evolving complex of capital market institutions. As the name suggests. instruments and practices. The traditional approach to the scope of the finance function evolved during the 1920s and 1930s and dominated academic thinking during' th~ forties and through the early ftfties. The term 'corporation finance' was used to describe what is now known in the academic world as 'financial management'. the concern of corporation finance was with the financing of corporate enterprises.

These issues were reflected in the following fundamental questions which a finance manager should address. according to the new approach. The conceptual and analytical shortcoming of this approach arose from the fact that it confirmed financial management to issues involved in procurement of external funds. as non-corporate organisations lay outside its scope. To that extent the scope of financial management was confirmed only to a segment of the industrial enterprises. the outsider-looking-in approach. consolidation. merger. and how fast should it grow? (ii) In what form should it hold assets? and (Hi) what should be the composition of its liabilities? The three questions posed above cover between them the major' financial problems of a firm. it did not consider the important dimension of allocation of capital. the principal contents of the modem approach to financial management can be said to be: (0 how large should an enterprise be. Defined in a broad sense. investment bankers and so on. The limitations of the traditional approach were not entirely based on treatment or emphasis of different aspects. Finally. Should an enterprise commit capital funds to certain purposes? Do the expected returns meet financial standards of performance? How should these standards be set and what is the cost of capital funds to the enterprises? How does the cost vary with the mixture of financing methods used? In the absence of the coverage of these crucial aspects. Modem Approach The modern approach views the term financial management in a broad sense and provides a conceptual and analytical framework for financial decision making. in other words. incorporation. It implies that no consideration was given to viewpoint of those who had to take internal financial decisions. financing and dividend decisions. Yet another basis on which the traditional approach was challenged was that the treatment was built too closely around episodic events.of funds such as investors. the day-to-day financial problems of a normal company did not receive much attention. insider-looking-out) was completely ignored. As a logical corollary. such as promotion. the traditional approach implied a very narrow scope for financial management. its weaknesses were more fundamental. is concerned with the solution of three major problems relating to the financial operations of a firm. The traditional treatment was. Financial management was' confirmed to a description of these infrequent happenings in the life of an enterprise. apart from the issues involved in acquiring external funds. the traditional treatment was found to have a lacuna to the extent that the focus was on long-term financing. The conceptual framework of the traditional treatment ignored what Solomon aptly described as the central issues of financial management. In other words. reorganisation and so on. The limitation was that internal decision making (ie. the finance function covers both acquisition of funds as well as their allocations. The second ground of criticism of the traditional treatment was that the focus was on financing problems of corporate enterprise. that. Thus. According to it. it is viewed as an integral part of overall management. Its natural implication was that the issues involved in working capital management were not in the purview of the finance function. is the outsiders. financial management in modern sense of a firm can be broken down into three major decisions as . the main concern of financial management is the efficient and wise allocation of funds to various uses. The main contents of this approach are: What is the total volume of funds an enterprise should commit? What specific assets should an enterprise acquire? How should the funds required be financed? Alternatively. The new approach is an analytical way of viewing the financial problems of a firm. corresponding to the three questions of investment. Thus. In other words. The modem approach provides a solution to these shortcomings. the financial management.

a major element in the capital budgeting exercise. There is a conflict between profitability and liquidity. profitability is adversely affected.functions of finance: (D The investment decision. The long-term assets can be either new or old/existing ones. the evaluation of the worth of a long-term project implies a certain norm or standard against which the benefits are to be judged. (ii) the business risk complexion of the firm. be evaluated in relation to the risk associated with it. In addition. Whether an asset will be accepted or not will depend upon the relative benefits and returns associated with it. and (iii) the dividend policy decision. It is an important and integral part of financial management as short-term survival is a prerequisite for long-term success. Investment Decision The investment decision relates to the selection of assets in which funds will be invested by a firm. (ii) short-term or current assets. Since the benefits from the investment proposals extend into the future. If a firm does not have adequate working capital. This implies a discussion of the methods of appraising investment proposals. The second element of the capital budgeting decision is the analysis of risk and uncertainty. An element of risk in the sense of uncertainty of future' benefits is. In brief. If the current assets are too large.. their accrual is uncertain. (ii) the financing decision. and (Hi) the concept and measurement of the cost of capital. involved in the exercise. The returns from capital budgeting decisions should. that is. Working Capital Management Working capital management is concerned with the management of current assets. The first of these involving the first category of assets is popularly known in financial literature as capital budgeting. therefore. The aspect of financial decision making with reference to current assets or short-term assets is popularly termed as working capital management. minimum rate of return and so on. One aspect of working capital management is the trade-off between profitability and risk (liquidity). The key strategies and considerations in ensuring a trade-off between profitability and liquidity is one major dimension of working capital management. This standard is broadly expressed in terms of the cost of capital. The concept and measurement of the cost of capital is. Capital Budgeting Capital budgeting is probably the most crucial financial decision of a firm. hurdle rate. It relates to the selection of an asset or investment proposal or course of action whose benefits are likely to be available in future over the lifetime of the project. They have to be estimated under various assumptions of the physical volume of sale and the level of prices. The requisite norm is known by different names such as cut-off rate. it does not invest sufficient funds in current assets. invite the risk of bankruptcy. usually within a year. defined as those assets which in the normal course of business are convertible into cash without diminution in value. thus. it may become illiquid and consequently may not have the ability to meet its current obligations and. The measurement of the worth of the investment proposals is. therefore. the main elements of capital budgeting decisions are: (I) the long-term assets and their composition. The assets which can be acquired fall into two broad groups: (I) long-term assets which yield a return over a period of time in future. thus. required rate. The first aspect of the capital budgeting decision relates to the choice of the new asset out of the alternatives available or the reallocation of capital when an existing asset fails to justify the funds committed. Finally. another major aspect of capital budgeting decision. the individual current assets should be efficiently managed so that neither . thus.

It had rightly been discarded in the ac:ldemic literature. The dividend decision should be analysed in' relation to the financing decision of a firm. what proportion of net profits should be paid out to the shareholders. The decision as to which course should be followed depends largely on a significant element in the dividend decision. The modem approach to the scope of financial management has broadened its scope which involves the solution of three major decisions. given the facts of a particular case. they should be related to the objectives of financial management. Two alternatives are available in dealing with the profits of a firm: (0 they can be distributed to the shareholders in the form of dividends or (i0 they can be retained in the business itself. The investment decision is broadly concerned with the asset-mix or the composition of the assets of a firm. The financing decision of a firm relates to the choice of the proportion of these sources to finance the investment requirements. one dimension of the financing decision whether there is an optimum capital structure and in what proportion should funds be raised to maximise the return to the shareholders? The second aspect of the financing decision is the determination of to an appropriate capital structure. receivables and inventory. Performing Financial Analysis and Planning The concern of financial analysis . the dividendpayout ratio. that is. In other words. . Thus. There are two aspects of the financing decision. Financing Decision the second major decision involved in financial management is the financing decision. and (2) the capital structure decision. the management of working capital has two basic ingredients: (1) an overview of working capital management as a whole. The use of debt implies a higher return to the shareholders as also the financial risk. A proper balance between debt and equity to ensure a trade-off between risk and return to the shareholders is necessary. namely. Thus. The concern of the financing decision is with the financing-mix or capital structure or leverage. investment. To conclude. and (2) efficient management of the individual current assets such as cash. A capital structure with a reasonable proportion of debt and equity capital is called the optimum capital structure. The second major aspect of the. fmancing and dividend. Thus. Dividend Policy Decision The third major decision area of financial management is the decision relating to the dividend policy. the theory of capital structure which shows the theoretical relationship between the employment of debt and the return to the shareholders. First. (i0 making investment decisions and (HO making financing decisions. These are interrelated and should be jointly taken so that financial decision making is optimal. The term capital structure refers to the proportion of debt (fixedinterest sources of financing) and equity capital (variable-dividend securities/source of funds). The conceptual framework for optimum financial decisions is the objective of financial management. the financing decision covers two interrelated aspects: (1) the capital structure theory. dividend decision is the factors determining dividend policy of a firm in practice. to ensure an optimum decision in respect of these three areas.inadequate nor unnecessary funds are locked up. Key Activities of the Financial Manager The primary activities of a financial manager are: (i) performing financial analysis and planning. the traditional approach to the functions of financial management had a very narrow perception and was devoid of an integrated conceptual and analytical framework. The fmal decision will depend upon the preference of the shareholders and investment opportunities available within the firm.

they are concerned with designing a method of operating the internal investment and financing of a firm. its underlying objective is to assess cash flows and develop plans to ensure adequate cash flows to support achievement of the firm's goals Making Investment Decisions Investment decisions determine both the mix and the type of assets held by a firm. We discuss in this Section the alternative approaches in financial literature. The mix refers to the amount of current assets and fixed assets. investment. The objective provide a framework for optimum financial decision making. There are two widely-discussed approaches: (0 Profit (total)/Earning Per Share (EPS) maximisation approach. the best individual short-term or long-term sources of financing at a given point of time. That is. Although this activity relies heavily on accrual-based financial statements. but some require an indepth analysis of the available financing alternatives. Any financial action which creates wealth or which has a net present worth above zero is a desirable one and should be undertaken. If two or more desirable courses of action are mutUally exclusive (Le. financing and dividend policy. (b) evaluating the need for increased (reduced) productive capacity and (c) determining the additional/reduced financing required. then the decision should be to do . and (i0 Wealth maximisation approach. discounted (or captialised) at a rate which reflects their certainty or uncertainty. Any financial action which does not meet this test should be rejected. The term 'objective' is used in the sense of a goal or decision criterion for the three decisions involved in financial management. the focus in financial literature is on what a firm should try to achieve and on policies that should b~ followed if certain goals are to be achieved. fmancing and dividend policy decisions. the most appropriate mix of short-term and long-term financing. Wealth or net present worth is the difference between gross present worth and the amount of capital investment required to achieve the benefits being discussed. The gross present worth of a course of action is equal to the capitalised value of the flow of futUre expected benefit. Making Financing Decisions Financing decisions involve two major areas: first. They are rather employed to serve as a basis for theoretical analysis and do not reflect contemporary empirical industry practices. Consistent with the mix. productivity. Firms in practice state their vision. the term is used in a rather narrow sense of what a finn should anempt to achieve with its investment. The implication is that these are not necessarily followed by firms in actual practice. image. their costs and their longterm implications OBJECTIVES OF FINANCIAL MANAGEMENT To make wise decisions a clear understanding of the objectives which are sought to be achieved is necessary.and planning is with (a) transforming financial data into a form that can be used to monitor financial condition. profitability. mission and values in broad terms and are also concerned about technology. employees satisfaction and so on. Moreover. if only one can be undertaken). Thus. namely. The success of a firm in achieving its goals depends on these decisions. market standing. leadership. Many of these decisions are dictated by necessity. second. He should 211so decide the best fixed assets to acquire and when existing fixed assets need to be modified/replaced/liquidated. In other words. It implies that what is relevant is not the overall objective or goal of a business but a operationally useful criterion by which to judge a specific set of mutually interrelated business decisions. the financial manager must determine and maintain certain optimal levels of each type of current assets. financial resources. it provides a nOffi'lative framework.

Moreover. It provides the yardstick by which economic performance can be judged. focus on the second type of limitations to profit maximisation as an objective of financial management. therefore. the profit maximisation criterion implies that the investment. In other words. it refers to the amount and share of national income which is paid to the owners of business. projects and decisions which are profitable and reject those which are not. Ambiguity One practical difficulty with profit maximisation criterion for financial decision making is that the term profit is a vague and ambiguous concept. argued that profitability maximisation should serve as the basic criterion for financial" management decisions. which of these variants of profit should a firm try to maximise? Obviously. Consider Table 1. capital. Used in this sense. a loose expression like profit cannot form the basis of operational criterion for financial management. In specific operational terms. financing and dividend policy decisions of a firm should be oriented to the maximisation of profits/EPS. The profit maximisation criterion has. The term 'profit' can be used in two senses. as resources tend to be directed to uses which in terms of profitability are the most desirable. It is an operational concept and signifies economic efficiency. profitability refers to a situation where output exceeds input. it leads to efficient allocation of resources. irrespective of when they were received. . The individual search for maximum profitability provides the famous 'invisible hand' by which total economic welfare is maximised. The rationale behind profitability maximisation. namely. therefore. It is. It is amenable to different interpretations by different people. Finally. timing of benefits. As a variant. To illustrate. that is. actions that increase profits (total)/EPS should be undertaken and those that decrease profits/EPS are to be avoided. it ensures maximum social welfare. as a guide to financial decision making. If profit maximisation is taken to be the objective. those who supply equity capital. It has no precise connotation.1. however. and quality of benefits. as a guide to financial decision making. is simple. it may return on total capital employed or total assets or shareholders' equity and so on. there is a general agreement that profit maximisation is used in the second sense. select assets. The reasons for the opposition in academic literature fall into two broad groups: (1) those that are based on misapprehensions about the workability and fairness of the private enterprise itself. is that it ignores the differences in the time pattern of the benefits received over the working life of the asset. In the current financial literature. As a owner-oriented concept.Profit/EPS Maximisation Decision Criterion According to this approach. profitability maximisation would imply that a firm should be guided in financial decision making by one test. the value created by the use of resources is more than the total of the input resources. Timing of Benefits A more important technical objection to profit maximisation. it may be before-tax or after-tax. it is described as profitability. refers to an explicit operational guide for the internal investment and financing of a firm and not the overall goal of business operations. profit may be short-term or long-term. it may be total profit or rate of profit. and (2) those that arise out of the difficulty of applying this criterion in actual situations. that is. the question arises. Financial management is concerned with the efficient use of an important economic resource (jnput) . been questioned and criticised on several grounds. It would be recalled that the term objective. We. as applied to financial management.7 The main tecbnical flaws of this criterion are ambiguity. Profit is a test of economic efficiency. as applicable to financial management.

A and B. As a rule. It can be safely assumed that the investors are risk-averters. both the alternatives would be ranked equally. the more certain the expected return. If the profit maximisation is the decision criterion. that is. the lower is the quality of the benefits. The problem of uncertainty renders profit maximisation unsuitable as an operational criterion for financial management as it considers only the size of benefits and gives no weight to the degree of uncertainty of the future benefits. This is not true in actual practice as benefits in early years should be valued more highly than equivalent benefits in later years.Time-Pattern of Benefits (Profits) Time Alternate A(Rs in lakh)__________Alternate B(Rs in lakh) Period I 50 -Period II 100 100 Period III 50 100 ________________________________________________________________ ___________________ Total 200 200 It can be seen from Table 1. while alternative A provides higher returns in earlier years. But the returns from both the alternatives differ in one important respect. This is primarily because a basic dictum of financial planning is the earlier the better as benefits received sooner are more valuable than benefits received later. The profit maximisation criterion does not consider the distinction between returns received in different time periods and treats all benefits irrespective of the timing. They can.1 that the total profits associated with the alternatives. as equally valuable. the two alternative courses of action are not strictly identical. The assumption of equal value is inconsistent with the real world situation. the more uncertain/fluctuating is the expected benefits. therefore. the higher is the quality of the benefits.2. Uncertainty About Expected Benefits (Profits) crore) __________________________________________ State of Economy Benefits Recession (Period I) Normal (Period II) 9 Profit(Rs Alternate A 0 10 . This is illustrated in Table 1. is that it ignores the quality aspect of benefits associated with a financial course of action. be reasonably expected to have a preference for a return which is more certain in the sense that it has smaller variance over the years. As a result. An uncertain and fluctuating return implies risk to the investors. they want to avoid or at least minimise risk. This is referred to as time value of money. The reason for the superiority of benefits now over benefits later lies in the fact that the former can be reinvested to earn a return. are identical. Conversely. the returns from alternative B are larger in later years. Quality of Benefits Probably the most important technical limitation of profit maximisation as an operational objective. The term quality here refers to the degree of certainty with which benefits can be expected.

it also incorporates the time value of money. At the same time. The profit maximisation criterion fails to reveal this. Wealth Maximisation Decision Criterion This is also known as value maximisation or net present worth maximisation. (ij) be based on the 'bigger the better' principle. Measuring benefits in terms of cash flows avoids the ambiguity associated with accounting profits. A significant element in computing the value of a financial course of action is the precise estimation of the benefits associated with it. and (iv) recognise the time value of money. secondly. In current academic literature value maximisation is almost universally accepted as an appropriate operational decision criterion for financial management decisions as it removes the technical limitations which characterise the earlier profit maximisation criterion. namely. exactness. The value of an asset should be viewed in terms of the benefits it can produce. The wealth maximisation criterion is based on the concept of cash flows generated by the decision rather than accounting profit which is the basis of the measurement of benefits in the case of the profit maximisation criterion. The alternative to profit maxirnisation.2 that the total returns associated with the two alternatives are identical in a normal situation but the range of variations is very wide in case of alternative B. risk. and time value of money. to incorporate risk and.10 Boom (Period III) 20 Total 30 11 30 It is clear from Table 1. alternative A is beuer in terms of risk and uncertainty. It is not only vague and ambiguous but it also ignores two important dimensions of financial analysis. wealth maximisation is one such measure. ordinary shareholders. (iij) consider both quantity and quality dimensions of benefits. The capitaIisation (discount) rate that is employed is. that is. that is. quality of benefits and the time value of money. It follows from the above that an appropriate operational decision criterion for financial management should (j) be precise and exact. The value of a stream of cash flows with value maximisation criterion is calculated by discounting its element back to the present at a capitalisation rate that reflects both time and risk. This is the first operational feature of the net present worth maximisation criterion The second important feature of the wealth maximisation criterion is that it considers both the quantity and quality dimensions of benefits. To conclude. financing and dividend decisions of a firm. the rate that . while it is narrow in respect of alternative A. Its operational features satisfy all the three requirements of a suitable operational objective of financial course of action. the profit maximisation criterion is inappropriate and unsuitable as an operational objective of investment. the earnings associated with alternative B are more uncertain (risky) as they fluctuate widely depending on the state of the economy. the term value is used in terms of worth to the owners. The value of a course of action must be viewed in terms of its worth to those providing the resources necessary for its undertaking. namely. To put It differently. firstly. The worth of a course of action can similarly be judged in terms of the value of the benefits it produces less the cost of undertaking it. therefore. The operational implication of the uncertainty and timing dimensions of the benefits emanating from a financial decision is that adjustments should be made in the cash-flow pattern. Cash flow is a precise concept with a definite connotation. Obviously. to make an allowance for differences in the timing of benefits. In applying the value maximisation criterion.

. W can be expressed symbolically by a short-cut method as in Eq. A1 A2. the net present value maximisation is superior to the profit maximisation as an operational objective. the net present worth can be calculated as shown below: . The gross present worth of a course of action is equal to the capitalised value of the flow of futUre expected benefit. If two or more desirable courses of action are mutually exclusive (Le. As a measure of quality (risk) and timing.(M + 1+ 1) (1. . For the above reasons. Such actions should be undertaken. Thus. As a decision criterion. In the words of Ezra Solomon. An action that has a discounted value-reflecting both time and risk-that exceeds its cost can be said to create value. Alternatively. 15 per cent is written as 0. An represents the stream of cash flows expected to occur . The operational objective of financial management is the maximisation of W in Eq.4). before maintenance charges.C (1. Net present value (worth) or wealth is W = (1+K) A1 -----------(1+K) 2 A2 + ----------(1+K) 3 A3 +…+ -------------- (1. it involves a comparison of value to cost.. In the case of mutually exclusive alternatives. say. Any financial action which creates wealth or which has a net present worth above zero is a desirable one and should be undertaken.reflects the time and risk preferences of the owners or suppliers of capital. taxes and interest and other prior charges like preference dividend M = Average annual reinvestment required to maintain G at the projected level T= Expected annual outflow on account of taxes and other prior charges. Any financial action which does not meet this test should be rejected. Conversely. when only one has to be chosen the alternative with the greatest net present value should be selected.3) Where G = Average future flow of gross annual earnings expected from the course of action.2) Where E = Size of future benefits available to the suppliers of the input capital K = The capitalisation (discount) rate reflecting the quality (certainty/uncertainty)and timing of benefits attached to E (iii) E = G . it is expressed in decimal notation. while a very risky stream may carry a 15 per cent discount rate.4) where ~.1). Wealth or net present worth is the difference between gross present worth and the amount of capital investment required to achieve the benefits being discussed. then the decision should be to do that which creates most wealth or shows the greatest amount of net present worth. (1. Using Ezra Solomon's symbols and methods.15. discounted (or captialised) at a rate which reflects their certainty or uncertainty. with less value than cost. if only one can be undertaken). (i) w= v.1) Where W = Net present worth V = Gross present worth C = Investment (equity capital) required to acquire the asset or to purchase the course of action (ii) V = FJ K (1. (1. a stream of cash flows that is quite certain might be associated with a rate of 5 per cent. A discount rate of. actions. reduce wealth and should be rejected. A large capitalisation rate is the result of higher risk and longer time period.

The merits of EVA are: (a) its relative simplicity and (b) its strong link with the wealth rnaximisation of the owners. With a positive EVA. moreover. and therefore. it has been replaced by the wealth maxirnisation decision criterion because of the shortcomings of the former as an operational criterion. particularly with respect to the investment decision. K is the appropriate discount rate to measure risk and timing. It is important to note that value maxirnisation is simply extension of profit rnaxirnisation to a world that is uncertain and multiperiod in nature. However. profit maximisation cannot be applied in real world situations. Where the time period is short and degree of uncertainty is not great.Rs 38 crore). Therefore. Its modified form is the value rnaximisation criterion. The wealth of the owners is reflected in the market value of shares. suppliers.from a course of action over a period of time. two important issues are related to the value/share pricernaximisation. value maxirnisation and profit rnaximisation amount to essentially the same thing. It prima facie exhibits a strong link to share prices. in effect. customers. Profit EPS maxirnisation was initially the generally accepted theoretical criterion for making efficient economic decisions. a precise and unambiguous concept. that is. In other words. creditors and owners and others who . assuming an after-tax profit of Rs 40 crore and associated costs of financing the investments of Rs 38 crore. be seen that in the value maximisation decision criterion. however. there is a broader focus in financial management to include the interest of the stakeholders as well as the shareholders. and (ill) it is ambiguous in its computation. a repackaged and well-marketed application of the NPV technique of investment decision. involve numerous accounting and financial issues. It can. thus. the time value of money and handling of the risk as measured by the uncertainty of the expected benefits is an integral part of the exercise. So wealth maximisation implies the rnaxirnisation of the market price of shares. . as (j) It does not take account of uncertainty of risk. and C is the initial outlay to acquire that asset or pursue the course of action. positive EVA is associated with increase in prices of shares and vice versa. But EVA is certainly a useful tool for operationalising the owners' value rnaximisation goal. economic value added and focus on stakeholders Economic Value Added (EVA) It is a popular measure currently being used by several firrns to determine whether an existing/proposed investment positively contributes to the owners'/shareholders' wealth. The EVA is equal to after-tax operating profits of a firm less the cost of funds used to finance investments. In current financial literature. Focus on Stakeholders The shareholders wealth rnaximisation as the primary goal notwithstanding. the investment would add value and increase the wealth of the owners and should be accepted. EVA is. In brief. The stakeholders include employees. To illustrate. It is. (ij) it ignores the time value of money. the EVA = Rs 2 crore (Rs 40 crore . A positive EVA would increase owners' value/wealth.substitute for value/wealth/net present value rnaximisation as a decision criterion. The computation of the after-tax operating profits attributable to the investment under consideration as well as the cost of funds used to finance it would. Owing to these technical limitations. an appropriate and operationally feasible decision criterion for financial management decisions. It would also be noted that the focus of financial management is on the value to the owners or suppliers of equity capital. However. which should guide the financial course of action. what is relevant is not the overall goal of a firm but a decision criterion. maxirnisation of the market price of shares is the operational . namely. using profit as an economic concept and defining profit rnaximisation as a criterion for economic efficiency. only investments with positive EVA would be desirable from the viewpoint of maximizing shareholders' wealth.

The implication of the focus on stakeholders is that a firm should avoid actions detrimental to them through the transfer of their wealth to the firm arid. ICICI. There was preponderance of loan capital in their financial structure and shareholders equity played a rather marginal role. To cater to the requirements of these institutional investors. the goal of shareholders' wealth maximisation has emerged almost at the centre-stage. dominated by group companies with close links with the promoter groups. exemption on dividends in recent years has provided an incentive to corporates to enhance share prices and. the family-owned corporate are also undergoing major transformation. foreign institutional investors and so on dominate the structure of the Indian capital market. (ii) growing importance of institutional investors. With the foreign exposure. thus. however. conflict and litigation. damage their wealth. In the post-90 liberalisation era. alter the shareholders' wealth maximisation goal. that corporate India paid scant attention to shareholders' wealth maximisation with few exceptions such as Reliance Industries Ltd. institutional investors such as mutual funds. they also appreciate the importance of shareholders' wealth. In brief. Their funding primarily was through institutional borrowings from public development finance institutions like IFCI. ____________________________ . Thirdly. the corporate industrial sector in India was . It was no wonder. Thus. therefore. thus. insurance organisations. as a result of the institutionalisation of savings. the abolition of wealth tax on equity shares and other financial assets coupled with tax. It tends to limit the firm's actions to preserve the wealth of the stakeholders. IDBI! and so on. The goal should be preserve the well-being of the stakeholders and not to maximise it. its other stakeholders. shareholder orientation is unmistakably visible in the corporate India. a firm can better achieve its goal of shareholders' wealth maximisation with the cooperation of. focus on shareholders' wealth. With the gradual decline in the significance of the development/public term/term lending institutions over the years and their disappearance from the Indian financial scene recently (as a result of their conversion/proposed conversion into banks) and the consequent emergence of the capital market as the main source of corporate financing. The main contributory factors have been (0 greater dependence on capital market. Secondly. shareholders' wealth maximisation is emerging as the prime goal of corporate financial management.have a direct link to the firm. The scions of most business families are acquiring higher professional education in India and abroad. The stakeholders view is considered part of its "social responsibility" and is expected to provide maximum long term benefit to the shareholders by maintaining positive stakeholders relationship which would minimize stakeholder turnover. Shareholder Orientation in India Traditionally. Finally. rather than conflict with. corporates are pursuing more shareholder friendly policies as reflected in their efforts to focus on shareholders' wealth maximisation. (iii) tax concessions/ incentives to shareholders and (iv) foreign exposure. The focus on the stakeholders does not.

We can use this concept in buying a house.1 INTRODUCTION The principles of present value also underlie most of what we do in Corporate Finance by evaluating projects and valuation of company shares and a great deal of personal finance and investment.0 OBJECTIVES The objective is to understand the concept that money has a time value. 1. simple to calculate and can be applied in a wide range of situations in corporate finance.it on real life examples. It is an intuitive and simple concept. The following figure shows a cash flow of Rs 100 at the end of five years.2 DESCRIPTION Dealing with Cash Flows at different points of time can be made easier using a time line that shows both the value and timing of cash flows.education cheaper and all the common essentials becoming dearer year after year? In the following pages you will understand the concept and learn to apply . How often have we heard our elders say that a kilo of rice was so cheap or that a house was so cheap and had they invested wisely it might have been better? How often are clothes cheaper. In this chapter we shall examine the following questions: · What do we mean by time value of money? · What is the basis for present value? What factors affect the timing of cash flows and how does this affect the time value? 1. . Present value is a concept which shows that money has a time value. That money has time value stems from the concept that the value of money gets eroded by the concept of inflation. This can be grasped without the use of models and mathematics. The notion that a rupee today is preferable to the same rupee in the future is intuitive enough for most people to grasp.CONCEPT OF TIME VALUE OF MONEY PRESENT VALUE 1. picking a project or more complex situations like valuing a buyout of a company share. The simplest tools in finance are often the most powerful. saving for a child's education. The principal of present value provides the backing for this and enables us to calculate exactly how much a rupee some time in the future is worth today.

etc.refers to the cash flow that occurs at the end of period 1. It depends how you look at it.In the figure above '0' time on the time line depicts now. Finally the discount rate which is 10 per cent in this example is specified in each period of the time line and may be different for each period. Positive and negatives cash flows: Cash flows can neither be negative or positive.Beginning of Each Period the beginning of each year instead of the end of each year. Please note that the beginning of year 2 is the end of year 1. Thus a cash flow or rupees received by you today has the same value today. The portion of the time line between 0 and 1 and 2 and 3. Had the cash flows been at 0 1 yr Rs 100 2 yrs Rs 100 3 yrs Rs 100 4 yrs Rs 100 5 yrs Rs 100 10% 10% 10% 10% Fig 1 (a) A Time Line for Cash Flows. at the present moment or today. The cash flow that occurs in a point in time -1.1(b) A Time Line for cash Flows. refers to period 1 and period 3 which in this example is the first year and third year. Notations Notation PV FV Cf A r g n Meaning Present Value Future Value Cash flow at the end of period t Annuity-Constant Cash Flows over several periods Discount Rate Expected growth rate in cash flows Number of periods over which cash flows are received or paid . Now a distinction should be made between a period in time and a point in time. Thus it need not be adjusted for time value. the time line would be as redrawn above.Cash inflows are called Positive Cash Flows and Csh outflows are called Negative Cash flows.End of Each Period 0 Rs 100 1 yr Rs 100 2 yrs Rs 100 3 yrs Rs 100 4 yrs Rs 100 10% 5 yrs 10% 10% 10% 10% 10% Fig 1.

People would have to be offered more in the future to give up present consumption.3 COMMON SENSE APPROACH TO PRESENT VALUE A cash flow in the future is worthless than a. the degree of this preference varies across individuals. consumption to give up current consumption.3. Thus there is always a trade off which is always reflected by the high-real . Due to inflation the value of money/currency depreciates or erodes over a period of time. and the magnitude of these factors is reflected in the discount rate. This means there is a risk associated with receiving the cash flow in future and this reduces the. similar cash flow today ● ● ● ● because: People prefer present consumption to future consumption. It incorporates 1. A higher discount rate will lead to a lower present value for future cash flows. The uncertainty in the future cash flows (higher risk ___ higher discount rate). value associated with the cash flow. Due to the uncertainty of receiving the cash flow in the future the value of the cash flow in the future reduces further. This trade off between present consumption (Co) and future consumption (C1) can be explained as follows. Expected inflation (higher inflation _ higher discount rate). This happens due to inflation. What is Discount Rate? The discount rate is a rate at which present and future cash flows are traded off. 1. If the preference for current consumption is strong then we have to offer more in terms of future. The process by which future cash flows are adjusted to reflect these factors is called discounting. A may choose to consume the whole amount. B may consume more money by borrowing and C may consume less and save and lend the remaining portion. The preference for currrent consumption ( greater preference 2. In the real world people can get the same amount of money in each period and they can either consume it or save it or lend it. The greater the inflation the greater is the erosion in the value of the rupee today and in the future.4 TRADE OFF IN REAL CONSUMPTION OVER TIME Although individuals prefer present consumption to future consumption. The greater the risk the greater the erosion in value. 3.

Growing Perpetuities 1. Cash flows at different points to time cannot be compared and aggregated unless they are all brought to the same point in time before we can compare or aggregate them. 1. Simple cash flows A simple cash flow is a single cash flow in a specified future time period. Many an old couple enjoy their retirement because they have intuitively used the concept of time value of money properly and when their earning capacity goes down they can enjoy the fruits of their savings ans investment decisions. Conversely. .cash flows in the present can be compounded to arrive at an expected future cash flow. or wealth saved will always be lent out as because it can earn a return for the saver. The story of the grasshopper and the ant reflects this. There are five types of cash flows: 1. The grasshopper may make merry and use all of his money whereas the ant may save to enjoy during winter.rate of return or discount rate.5 THE CALCULATION OF PRESENT VALUE The process of discounting future cash flows converts them into cash flows in present value terms. If the preference for current consumption is weak then a person can settle for a lower real rate of return or discount rate. Simple cash flows 2. Conversely the process of compounding converts present cash flows into future cash flows. The assumption here is that any money. Perpetuities and 5. Discounting: is the process by which a cash flow which is expected to occur in the future is brought to its present value. Annuities 3. On a time line CF t = Cash Flow at Time t 0 t This cash flow can be discounted back to the present discount rate that reflects the uncertainty of the cash flow. Growing Annuities 4.

00. The rate of return r is the reward that investors demand for accepting a delayed payment. To calculate discount factor and compound factors we have tables to aid us in complex calculations.000 a year from now must be less than Rs 1.000 after a year. Thus the building investment is a better option as you get a higher rate of return.00. you would have to invest Rs 5. That is easy as the interest rate is 9 per cent.Compounding: is the process by which a cash flow today is converted into its expected future value. To calculate present value.000 in a year if you sold it. It is usually expressed as a reciprocal of 1 plus a rate of return. How much would you have. That is not the only way you can earn money as you have various investment options. to invest in PPF to receive Rs 5. These are given as an appendix to the chapter below.59. However you must bear in mind that the real estate investment has a higher risk in terms of variability of return. one year hence then Present Value (PV) = Discount factor x C1 Or In the example earlier Present Value (PV) = __CF1__ (1 + r) Thus the discount factor is the value received today of Rs 1 received in the future.09.00. which is Rs 458715. If the discount factor is more than 1 a rupee today would be worthless than a rupee tomorrow. we discount the expected payoff by the rate of return offered by equivalent investment alternatives in the capital or financial! markets. Calculating Present Value The present value of Rs 1.000 today and your real estate advisor has estimated that the cost would go upto Rs 5.00.00.00. If C1 denotes the expected payoff at period 1.000 today. You are considering investing in a house or property worth Rs 4.000/1. You can invest in Public Provident Fund with an interest rate of 9 per cent. Thus the present value of the delayed payoff can be found out by multiplying the payoff with the discount factor which is less than 1. Thus risk is related to return whereas the PPF option has a lower risk and lower return. This rate of return is often referred to as the discount . Discount factor = 1 (1 + r) Similarly you have a compounding factor.

59 In other words your investment in the property is worth more than it costs .00. Net Present Value is found by subtracting the required investment NPV= PV .000 by 1.00.Required Investment = Rs 4. In our example Co is . Public Provident Fund is certainly less risky as it .59 today but you committed Rs 4.59. however we make the unrealistic assumption of assigning the same level of risk and only taking decisions based on the comparative returns of alternative means of adjustments.00.rate. It is called opportunity cost because it is the return forgone by investing in the project rather than investing in securities. Present value was obtained by dividing Rs 5. The real estate advisor or property advisor cannot be sure about the return in the market.58. The formula for calculating NPV can be written as NPV= C 0 C1 +_____ 1+r Remember that Co the cash flow at time 0 (that is today). If the future value of this property is risky our calculation is wrong.000 = Rs 458715. Net Present Value Let us suppose that your property is worth Rs 458715.09 3.000 initial outgo to purchase the property.000.00.59 1.715.00.715. hurdle rate or opportunity cost of capital.000 = Rs 58.Rs 4.it makes a net contribution to value. PV = Discount factor x C1 = _1____x C1 1+r = 5. In our example the opportunity cost was 9 per cent.59 .Rs 4. Co is an investment and therefore a cash outflow.09. So your NET PRESENT VALUE is Rs 58715. Relation of Risk to Present Value In many of our calculations we feel it is enough to compare the present values and aggregates. In other words. will usually be a negative number.

The general formula for converting nominal cash flows at a future period ‘t' to real cash flows is Real Cash Flow = (Nominal cash flow)/(1 + inflation rate). the concepts of present value and the opportunity cost of capital still make sense for risky investments.5 million Mexican pesos a year from now will have to reduce this expected cash flow to arrive at the present value.the promisee might not be around to receive payment . an investor who expects to make 10. Thus.for instance. This leads to greater budget and trade deficits.11. and expected inflation affect the present value of all cash flows not all cash flows are equally predictable. How does a low saving rate affect discount rates? Effect of Inflation on Discount Rate: The effect of inflation on present value is evident because it reduces the purchasing power of future cash flows. Only after the present values are calculated using these two different discount rates is the best investment avenue or project decided. This adjustment reduces the value of future cash flows.09 but the discount rate for the building property may be 11 per cent or 0. You will learn more about expected payoffs when you do Capital Budgeting Later. It is still proper to discount the payoff by the rate of return offered by an equivalent investment. but these real cash flows.neither pessimistic nor optimistic. For now it will be enough if you think of an expected payoff and the expected rates of returns on other investments. the real cash flow will be only 0. Most investors avoid risk when they can do so without sacrificing return.(might have died) or some other contingency or . Effect of Risk on Discount Rate: Although both the preference for current consumption. You will learn more about expected payoffs when you do Capital Budgeting Later. Thus if you were asking someone else to invest in this property along with you they may not agree to give you the present value amount but something less than that. Thus.e. the trade offs between current and future consumption) and any uncertainty associated with the cash flows to arrive at the present value. A promised cash might not be delivered for a number of reasons: the promisor (lnterest and investment not received as company winds up) might default on the payment. Thus we do not use the same discount factor while comparing alternative investment avenues. will have to be reduced further to reflect real returns (i.is akin to Government security. an investor who expects 1 million Italian Lire a year from now will have to reduce this expected cash flow to 1 reflect the expected inflation rate in Mexico. For now it will be enough if you think of an expected payoff as a realistic forecast.8 million Italian lire. If that inflation rate is 25 per cent. However. Thus we invoke another financial principal that a safe rupee is worth more than a risky one. But we have to think of Expected payoffs and the expected rates of returns on other investments. The discount rate for PPF may be 9 per cent OR 0. Concept check: India has a low savings rate as compared to Japan.

To calculate how much it is worth.000) = 0.000 =(70. · Net present value rule. · Rate of return rule. Our building venture is worth undertaking because its rate of return exceeds its cost of capital. Example You have decided to invest in a construction of an office building as it is worth more than it costs. If the office building is as risky as investing in stock market securities where the expected return is 14 per cent then the return forgone is 14 per cent. The greater the uncertainty associated with a cash flow in the future.00. if present values are estimated correctly the user should be indifferent between the future cash flow and the present value of the cash flow.30. Accept investments that offer rates of return in excess of their opportunity costs of capital 1. The rate of return is simply the profit as a proportion of the initial outlay. once cash flows are converted into present value rupees.30.30. The project's future value is equal to its future income discounted at the rate of return offered by these securities.WHY IT IS IMPORTANT Discounting a cash flow converts it into present value rupees and enables the user to do several things.it has positive net present value. they can be aggregated and compared. We can say this another way. the higher the discount rate used to calculate the present value of this cash flow will be and the present value of that cash flow will consequently be lower.163 about 16 per cent The cost of capital is once again the return foregone by not investing in securities. .000-4. Return = Profit/Investment =(5. Second. First.000) /(4.would have to pay to achieve the same pay off by investing directly in securities. Accept investments that have positive net present values. Since the 16 per cent return on the office building exceeds the 14 per cent opportunity cost. Hence we have two equivalent decision rules for capital investment.6 DISCOUNTING A SIMPLE CASH FLOW .some happening may intervene to prevent the promised payment or to reduce it. you should go ahead with the project.000)/4.

40 321. Ibbotson and Sinquefield's Study As the length of the holding period is extended.WHY IT IS IMPORTANT Current cash flows can be moved into the future by compounding the cash flow at the appropriate discount rate. Assuming that these returns continue into the future.Asset Classes Holding Period 1 5 10 Stocks 112. Thus present value is a decreasing function of the discount rate. is the process by which cash flows are converted from present value to future value rupees. The future value of a simple cash flow is Future Value of a Simple Cash Flow = CFo (1+ r)' where CF o = Cash Flow Now . the future value of investing in stocks.6 per cent.2 percent. the table below provides the future value of dollar 100 invested n each category at the end off a number of holding periods .86 T.60 119. 5 years.7COMPOUNDING A CASH FLOW .4 per cent. The differences in future value from investing at these different rates of return are small for short compounding periods( such as one year) but become larger as the compounding period is extended.Other things remaining equal.4 per cent Treasury Bonds made 5. 1. Future Value of Investments .43 . is more than 12 times larger than the future value of investing in Treasury bonds at an average return of 5.6 per cent. with a 40 year time horizon. small differences in discount rates can lead to large differences in future value.34 142. Ibbotson and Sinquefield found that stocks on the average made 12. the present value of a cash flow will decrease as the discount rate increases and continue to decrease the further into the future the cash flow occurs. 30 years and 40 years. at an average return of 12.1 year. Bonds 105.40 179.02 T.85 166. 20 years. and Treasury Bills made 3. the compounding effect increases with both the discount rate and the compounding period.r = Discount Rate Again. 10 years. For instance.20 128. Bills 103. In a study of returns on stocks and bonds between 1926 and 1992.2 per cent and more than 25 times the future value of investing in Treasury Bills at an average return of 3. Compounding.

In some cases however the interest may be computed more frequently. the Cash flows were assumed to be discounted and compounded annually .18 10731.30 275.52 Concept Check Most pension funds allow individuals to decide where their pension funds will be invested.93 411. The effective interest rate can be computed as follows. a cash flow growing at 6 per cent will. In the examples above.92 3334.59 759. the present and future values may be very different from those computed on annual basis. Effective Interest Rate= (1+Stated Annual Interest Rate) n ---------------------------------------------------1 N Where N=number of compounding periods (2=semi annual.stocks (equity).68 202. the stated interest rate on an annual basis can deviate significantly from the effective or true interest rate. The Frequency of Discounting and Compounding The frequency of compounding affects both the future and present values of cash flows. etc. In these cases. bonds (debt) or money market accounts.20 30 40 1035. Where would you choose to invest your pension fund? Do you think your allocation should change as you get older ? Why? The Rule of 72.that is.12 =monthly) . double in value in approximately 12 years. taking into account the compounding effects of more frequent interest payments. interest payments and income were computed at the end of each year. while a cash flow growing at 9 percent will double in value in approximately 8 years. such as on a monthly or semi annual basis.62 457. based on the balance at the beginning of each year. the rule of 72 provides an approximate answer to the question "How quickly will this amount double in value?" by dividing 72 by the discount on interest rate used in the analysis.86 288. Effective Interest Rate This is the true rate of interest.A shortcut to estimating the Compounding effect In a pinch. Thus.

10/2)2 -1 10.10/365)365 Daily 10 365 10. Effect of Compounding Frequency on Effective Interest Rates Frequency Annual Semi-Annual Monthly Rate(% ) 10 10 10 T 1 2 12 Formula . and the present value of future cash flows decreases.10 Effective Annual Rate(%) 10 (1 +.0) = 10. a 10 per cent annual interest rate. Annuity An annuity is a constant cash flow occurring at regular intervals of time.5156 1 Continuous 10 continuous e. Thus the interest rate quoted to you may be too low and actually quite deceptive.1. the effective rate increases.25 per cent As compounding becomes continuous.25 (1 +.052 . To get the effective Annual rate you should use the formula above and see what the actual effective interest rate is.1025 . if there is semi annual compounding works out to an effective interest rate of Effective Interest Rate = (1. For example the home loans which various companies offer you require monthly repayments and may have monthly compounding.1 1 O5171 As you can see.47. as compounding becomes more frequent. the effective interest rate can be computed as follows: Effective Interest Rate = (exp )r .1) =(1.10112)12 . (1 +.1 where exp = exponential function r = stated annual interest rate The Table below provides the effective rates as a function of the compoundin! g frequency.For Instance.1 10. Annuities .10 .

if the opportunity cost is 12% then calculate your decision? PV of Rs 90.429. You have choice of buying the car cash down for Rs 400. a formula can be used in the calculation. n)=A ( (1+r)n ) ( r ) where A = Annuity r = Discount Rate n = Number of years Accordingly the notation used internationally for the present value of an. Present Value of an end-of-the period annuity The present value of an annuity can be calculated by taking each cash flow and discounting it back to the present and then adding up the present values. Alternatively.000 ( (1.000 a year for five years for the same car. Defining A to be the annuity time. n).75 . or at the.12) = 3.000 or paying Rs 90. r..-------) ( 5) = 90. the time line for an annuity may be drawn as follows: A A A A 0 4 1 2 3 An annuity can occur at the end of each period.24.1 ) PV of an Annuity =PV(A. In the case of annuities that occur at the end of each period. annuity is PV(A. What would you rather do. as in this time line. Suppose you start a rent-a-car business and want to buy an automobile.000 each year for the next 5 years 1 ( 1 . beginning of each period.An annuity is a constant cash flow that occurs at regular intervals at fixed period of time. r. this formula can be written as (1.

. Concept Check Often you have a choice of buying an asset like a car. Nowadays spreadsheets like excel are used to calculate the values of different annuities or using advanced programme calculators which all insurance company agents use. Alternatively above you could have discounted each instalment separately land added up the present values for all five and arrived at the same figure. etc. When the present values of your instalment payments exceed the cash down price it is better to pay cash down and acquire the asset. plane.12) Obviously 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. The present values of your instalments versus cash down will always be higher but if you do not have the money right now or you can get a higher return by using this loan then it is worthwhile taking the loan. Is it appropriate to compare the present value of just your lease payments to your purchase price? Why or why not? Future Value of End-of-the-Period Annuities n some cases.n)= A{ (1+r)n . an individual may plan to set aside a fixed annuity each period for a number of periods and will want to know how much he or she will have at the end of the period. Thus you will also have to look 'into your inflows by hiring out the carls in your rent-a-car business. computer. r . The future value of an end-of-the-period annuity can be calculated as follows FV of an annuity = FV(A. r .( 0.1} r Thus the standard notation widely practiced for Future Value of an annuity is FV( A. time and rate of interest/discount factor you can calculate the present value of different annuities and take financial decisions both personal and commercial. n) Concept Check Knowing the future value formula can you calculate the future value of Rs 5000 tax exempted PPF you deposit every year for twenty years? Or for forty yean Assume you start at age 25 years. Thus using the formulas programmed in the spreadsheet and changing the variables like amount.

Thus any company will have to set aside a fixed amount each year till the date of redeeming of bonds/ debentures to avoid defaulting on repayment to bondholders or debenture holders. Companies that borrow money using balloon repayment loans like bonds or debentures often set aside money in sinking funds during the life of the loan to ensure they have enough at maturity to pay the principal on the loan or the face value of the bonds.A (FV.with a discount rate of 10%.If it is taxed obviously you have a lower return.which means you are given the future value and are looking for the annuity . Sinking Fund: A sinking fund is a fund to which firms make annual contributions in order to have enough funds to meet a large financial liability in future. Juggling the above formula if you know the future value of what you have repay and you want to set aside a fixed sum even year so that you can repay the sum you can calculate the annuity. Rs 100 100 Rs 100 Rs 100 Rs 0 4 10% 1 10% 2 10% 3 10% . The size of the sinking fund will vary with the change in interest rate. n) can be calculated as follow Annuity given the future value= A (FV. Both the present and future values are affected if the cash flow occurs at the beginning of each period instead of the end. and the-entire principal is paid at the end of the loan's life. r. n) = FV{__r__} ( 1+r)n -1 Balloon Repayment Loan: A balloon Repayment loan refers to a Ioan on which only interest is paid for the life of the Ioan. Concept Check Do Insurance Companies and Pension Funds provide for sinking funds? When insurance is only a contingent/uncertain liability why do these companies also provide for sinking funds? Effect of Annuities at the Beginning of Each Year The annuities we talked about till now are end of the period cash flows. Thus Annuity given future value . To illustrate this effect. r. consider an annuity of Rs 100 at the end of each year for the next four years.

The future value of a beginning-of-a-period annuity typically can be estimated by allowing for one additional period of compounding for each cash flow: PV of Period Annuities at beginning = A (1+r) (1+r) n-1 of each of next n years _________ r This future value will be higher than the future value of an equivalent annuity at the end of each period.10 In general. and the remaining cash flows take the form of an end-of-the-period annuity over three years. Thus if you invest your annuity at the beginning of each year instead of the end of each year. ] .0 Rs 100 1 Rs 100 2 Rs 100 Fig 1. your future value will be higher.4 3 Rs 100 4 Rs 100 Because the first of these annuities occurs right now.1___ 3 of each of next four year 1.period annuity over an year can be written as follows PV of Period Annuities at beginning = A + A [1-__1_ of each of next n years (1+r) n-1 _________ r This present value will be higher than the present value of an equivalen to annuity at the end of each period. The present value of this annuity can be written as follows: PV of Rs 100 at beginning = 100 + 100[1.a. the present value of a beginning – of.10__ 0.

the preseni value is equal to the nominal sums of the annuities over the period. Perpetuity A perpetuity is a constant cash flow paid (or received) at regular time intervals forever. In that case. The Process of Discounting a Growing Annuity The present value of a growing annuity can be estimated by using the following formula: PV of a Growing Annuity = A(1+g) { 1 _ (1 + g)" } (1+r)" r–9 The present value of a growing annuity can be estimated in all cases but one if the growth rate is equal to the discount rate. and g is the expected growth rate.Growing Annuities A growing annuity is a cash flow that grows at a constant rate for a specified period of time. without the growth effect. If A is the current cash flow.. the growth rate in each period ha~ to be the same as the growth rate in the prior period. the time line for a growing annuity is as follows: A(1+ g)1 g)4 A(1+ g) 2 A(1+ g)3 A(1+ I 0 1 2 3 4 Note that to qualify as a growing annuity. . PV of a Growing Annuity for n years (when r = g) = nA It is important to note that the expanded formulation works even when th~ growth rate is greater than the discount rate.

06 Growing Perpetuties A growing perpetuity is a cash flow that is expected to grow at a constant rate. Current value of Console Bond = Rs 6010.09 = Rs 667 The value of a Console bond will be equal to its face value only if the coupon rate is equal to the interest rate.g) A growing perpetuity is a constant cash flow. It has to be less than the discount rate for the formula to work. The present value of a growing perpetuity can be-written as PV of Growing Perpetuity = C___ (r . In this case Rs 1000. Although a growing annuity and a growing perpetuity share several features. 60/0.Thus a lifetime pension can be considered as perpetually or rentals received from exploitation of land which is passed on from generation to generation. The original face value = Rs 1000. Recommended Readings Financial Management By Khan & Jain . Le. the fact that a growing perpetuity lasts forever puts constraints on the growth rate. The present value of a perpetuity can be written as PV of Perpetuity = A r A Console Bond is a bond that has no maturity and pays a fixed coupon (rate of interest). forever. and paid at regular time intervals forever. Assume that you have a 6 per cent coupon console bond. growing at a constant rate. The current value of this bond if the interest rate is 9 per cent is as follows.

It is divided into five sections as follows: · Capital expenditures: importance and difficulties · Phases of capital budgeting · Levels of decision-making · Facets of project analysis · Feasibility study: a schematic diagram · Objectives of capital budgeting CAPITAL EXPENDITURE DECISIONS Capital Expenditures: Importance and Difficulties .CAPITAL EXPENDITURE DECISIONS OBJECTIVES This chapter provides a broad overview of the field of project appraisal and capital budgeting.

custom made to meet specific requirement. ● Measurement problems: Identifying and measuring the costs and benefits of a capital expenditure proposal tends to be difficult. ● PHASES OF CAPITAL BUDGETING . This is more so when a capital expenditure has a bearing on some other activities of the firm (like cutting into the sales of some existing product) or has some intangible consequences (like improving the morale of workers). often cannot be reversed without incurring a substantial loss ● Substantial outlays: Capital expenditures usually involve substantial outlays. Difficulties While capital expenditure decisions are extremely important. usually 10-20 years for industrial projects and 20-50 years for infrastructural projects. for example. Capital investment decisions have an enormous bearing on the basic character of a firm. the market may virtually be non-existent. The scope of current manufacturing activities of a firm is governed largely by capital expenditures in the past. for some types of capital equipments. Irreversibility: The market for used capital equipment in general is iIlorganised. Further. It is impossible to predict exactly what will happen in future. Such a temporal spread creates some problems in estimating discount rates and establishing equivalences. Thus.Importance Capital expenditure decisions often represent the most important decisions taken by a firm. Temporal spread: The costs and benefits associated with a capital expenditure decision are spread out over a long period of time. Once such an equipment is acquired. Their importance stems from three inter-related reasons: Long-term effects: The consequences of capital expenditure decisions extend far into the future. there is usually a great deal of uncertainty characterising the costs and benefits of a capital expenditure decision. they also post difficulties which stem from three principal sources: . Hence. reversal of decision may mean scrapping the capital equipment. An integrated steel plant. involves an outlay of several thousand millions. Capital costs tend to increase with advanced. Likewise current capital expenditure decisions provide the framework for future activities. a wrong capital investment decision. ● Uncertainty: A capital expenditure decision involves costs and benefits that extend far into future.

Planning The planning phase of a firm's capital budgeting process is concerned with the articulation of its broad investment strategy and the generation and preliminary screening of project proposals. The solid arrows reflect the main sequence: planning precedes analysis. This provides the framework which shapes.1portrays the relationship among these phases. there are several feedback loops reflecting the iterative nature of the process. analysis precedes selection. sequential manner. implementation. The investment strategy of the firm delineates the broad areas or types of investments the firm plans to undertake. and review. and so on. selection. and circumscribes the identification of individual project opportunities. guides.1 Capital Budgeting Process . The dashed arrows indicate that the phases of capital budgeting are not related in a simple.Capital budgeting is a complex process which may be divided into five broad phases: planning. Exhibit 11. analysis. Exhibit 11. Instead.

financial. Selection Selection follows. The selection rules associated with these criteria are as follows: ________________________________________________________________ _ Criterion Accept Reject . economic. It addresses the question-Is the project worthwhile? A wide range of appraisal criteria have been suggested to judge the worthwhileness of a project. and ecological aspects is undertaken. and often overlaps. analysis. Analysis If the preliminary screening suggests that the project is prima facie worthwhile. and the benefit cost ratio. preparing. The key discounting criteria are the net present value. technical. To begin with.. it needs to be examined.Once a project proposal is identified. and summarising relevant information about various project proposals which are being considered for inclusion in the capital budget. They are divided into two broad categories. The questions and issues raised in such a detailed analysis are described in the following section. this exercise is meant to assess (i) whether the project is prima facie worthwhile to justify a feasibility study and (ii) What aspects of the project are critical to its viability and hence warrant an in-depth investigation. A prelude to the full blown feasibility study. Based on the information developed in this analysis. a preliminary project analysis is done. the stream of costs and benefits associated with the project can be defined. The principal non-discounting criteria are the payback period and the accounting rate of return. the internal rate of return. non-discounting criteria and discounting criteria. detailed analysis of the marketing. The focus of this phase of capital expenditure decisions is on gathering. viz.

capital asset pricing model. Monte Carlo simulation. While the former can be defined with relative ease. Indeed despite a wide range of tools and techniques for risk analysis (sensitivity analysis. the latter truly tests the ability of the project evaluator. What is done in these stages is briefly described below _ _______________________________________________________________ _ Stages Project and engineering designs Concerned with Site probing and prospecting. preparation of blueprint and plant designs . provision of Negotiations and contracting . (iii) construction. and so on). which involves setting of manufacturing facilities. (ii) negotiations and contracting. consists of several stages: (i) project and engineering designs.Payback period(PBP) PBP< target period Accounting rate of return(ARR) ARR>target rate rate Net present value(NPV) Internal rate of return(IRR) Benefit cost ratio(BCR) NPV>0 PBP> Target period ARR<Target NPV<0 IRR>cost of capital IRR< cost of capital BCR>1 BCR<1 ________________________________________________________________ _ To apply the various appraisal criteria suitable cut-off values (hurdle rate target rate. risk analysis remains the most intractable part of the project evaluation exercise. decision tree analysis portfolio theory. These essentially a function of the mix of financing and the level of project risk. construction of building and civil works. selection of specific machineries and equipment. scenario analysis. and cost of capital) have to be specified. and (v) plant commissioning. Negotiating and drawing up of legal contracts with respect to project financing. acquisition of technology. (iv) training. plant engineering. Implementation The implementation phase for an industrial project.

erection and installation of machinery and equipment.which is common. and workers. many surprises and shocks are likely to Spring on the way. A feedback device is useful in several ways: (i) It . (This is a brief but commissioning is technically crucial stage in the project development cycle. etc. Review Once the project is commissioned the review phase has to be set in motion. These techniques have. Construction Site preparation. For expeditious implementation at a reasonable cost. Adequate formulation of projects: A major reason for delay is inadequate formulation of projects. Delays in implementation. 2. supply of machinery and equipment. 3. monitoring becomes easier.) Training Plant commissioning Translating an investment proposal into a concrete project is a complex timeconsuming. that is network techniques. Put differently. Performance review should be done periodically to compare actual performance with projected performance. Use of network techniques: For project planning and control two basic techniques are available . construction of buildings and civil works. Training of engineers. merged and are being referred to by a common terminology. can lead to substantial cost overruns. if necessary homework in terms of preliminary studies and comprehensive and detailed formulation of the project is not done. marketing arrangements.utilities. Hence. technicians. 1. the need for adequate formulation of the project cannot be overemphasised. (This can proceed simultaneously along with the construction work) Start up of the plant. of late. and risk-fraught task.PERT (Programme Evaluation Review Technique) and CPM (Critical Path Method). the following are helpful. Use of the principle of responsibility accounting : Assigning specific responsibilities to project managers for completing the project within the defined time frame and cost limits is helpful in expeditious execution and cost control. With the help of these techniques.

(v) It induces a desired caution among project sponsors. The important facets of project analysis are: · Market analysis · Technical analysis Project Appraisal and Control techniques PROFITABILITY STUDY-VARIOUS FACTS OF PROJECT ANALYSIS . (ii) It provides a documented log of experience that is highly valuable in future decision-making. Our discussion will mainly be oriented towards administrative and strategic budgeting decisions.throws light on how realistic were the assumptions underlying the project. Examples are given below: Operating capital budgeting decision Administrative capital budgeting decision Strategic capital budgeting decision : Minor office equipment : Balancing equipment : Diversification project While the methods and techniques covered in this book are applicable to all levels of capital budgeting decision. LEVELS OF DECISION-MAKING Operating Strategic decisions Where is the decision taken management How structured is the decision What is the level of resource resource commitment Minor resource commitment Moderate resource Major commitment Medium term commitment Long-term Lower level management Routine decisions Middle level management Semi-structured Unstructured decision Top level Administrative What is the time horizon Short-term The three levels (operating. (iv) It helps in uncovering judgemental biases. and strategic) of decision making can be readily applied to capital expenditure budgeting decision. administrative. (iii) It suggests corrective action to be taken in the light of actual performance.

attitudes. technical and legal constraints ● ● Technical Analysis Analysis of the technical and engineering aspects of a project needs to be done continually when a project is formulated. the variety market analyst requires a wide of information and appropriate forecasting methods. innovations. Technical analysis seeks to determine whether the prerequisites for the successful commissioning of the Project have .· Financial analysis · Economic analysis · Ecological analysis Market Analysis Market analysis is concern with primarily two questions: · What would be the aggregate demand of the proposed product/service in future · What would be the market share of the project under appraisal? To answer the above question. motivations. references and requirements Distribution channels and marketing policies in useful Administrative. The kinds of information required are: ● ● ● ● ● ● ● ● Consumption trends in the past and the present consumption Past and present supply position Production possibilities and constraints Import and exports Structure of competition Cost structure Elasticity of demand Consumer behaviour.

been considered and reasonably good choices have been made with respect to location. power. etc. size. is concerned . also referred to as social cost benefit analysis. The important questions raised in technical analysis are: for? · Whether the availability of raw materials. The aspects which have to be looked into while conducting financial appraisal are: · Investment outlay and cost of project · Means of financing · Cost of capital · Projected profitability · Break-even point · Cash flows of the project · Investment worthwhileness judged in terms of various criteria of merit · Projected financial position · Level of risk · Whether the preliminary tests and studies have been done or provided Economic Analysis Economic analysis. and other inputs has been established? · Whether the selected scale of operation is optimal? · Whether the production process chosen is suitable? · Whether the equipment and machines chosen are appropriate? · Whether the auxiliary equipments and supplementary engineering works have been provided for ? · Whether provision has been made for the treatment of effluents? · Whether the proposed layout of the site. process. buildings. and plant is sound? · Whether work schedules have been realistically drawn up? · Whether the technology proposed to be employed is appropriate from the social point of view? Financial Analysis Financial analysis seeks to ascertain whether the proposed project will be financially viable in the sense of being able to meet the burden of servicing debt and whether the proposed project will satisfy the return expectations of those who provide the capital.

The key questions r~sed in ecological analysis are: . What is the cost of restoration measures required to ensure that the damage to the environment is contained within acceptable limits? Exhibit 11. and leather processing-).with judging a project from the larger social point of view. In such an evaluation the focus is on the social costs and benefits of a project which may often be different from its monetary costs and benefits. and social order? ● What Ecological Analysis In recent years. What is the likely damage caused by the project to the environment? . Ecological analysis should be done particularly for major projects which have significant ecological implications like power plants and irrigation schemes. and environmental-polluting industries (like bulk drugs. The questions sought to be answered in social cost benefits analysis are: are the direct economic benefits and costs of the project measured in terms of shadow (efficiency) prices and not in terms of market prices? ● What would be the impact of the project on the distribution of income in the society? ● What would be the impact of the project on the level of savings and investment in the society? ● What would be the contribution of the project towards the fulfillment of certain merit wants like self-sufficiency. environmental concerns have assumed a great deal of significance-and rightly so. chemicals.2 summarises the key issues considered indifferent types of analysis: Exhibit 11.2 Key Issues in Project Analysis Market Analysis Technical Analysis Financial Analysis Economics Analysis Ecological Analysis ________Potential Market Market Share _________Technical Viability Sensible Choices ___________Risk Return ___________Benefits and Cost in shadow Prices Other Impact _________ Environmental Damage Restoration Measures . employment.

in general. Alternatives Are there other goals. efforts to maximise equity share prices would result in an efficient allocation of resources. The feasibility study is concerned with the first three phases of capital budgeting.. and ecological analysis. besides the goal of maximum shareholder wealth . being fully owned. the goal of financial management for such firms should be to maximise the market value of equity shares. it behoves on corporate managements to promote the welfare of equity shareholders. in determining the present value of the stream of equity returns. Hence. and selection (evaluation) and involves market. The bases for allocation of savings in the economy are expected return and risk. financial. Hence. What about a public sector firm the equity stock of which. rests on the premise that the goal of financial management (which subsumes investment decision-making) should be to maximise the present wealth of the firm's equity shareholders. is not traded on the stock market? In such a case. analysis. Of course. the wealth of the equity shareholders is reflected in the market value of the equity shares. viz.Feasibility Study: A Schematic Diagram We have looked at the five broad phases of capital budgeting and examined the key facets of project analysis. the goal of financial management should be to maximise the present value of the stream of equity returns. Another justification may be provided for the goal of shareholder wealth maximisation. planning. Since equity share prices are based on expected return and risk. Equity shareholders provide the venture (risk) capital required to start a business firm and appoint the management of the firm indirectly through the board of directors. A similar observation may be made with respect to other companies whose equity shares are either not traded or very poorly traded. economic. Objectives of Capital Budgeting Financial theory. an appropriate discount rate has to be applied. technical. The pursuit of the welfare of equity shareholders is justified on the grounds that it contributes to an efficient allocation of capital in the economy. For a firm whose equity shares are actively traded on the stock market. by the government.

Firms may pursue or ought to pursue several other goals. be in consonance with the goal of shareholder wealth maximisation. further customer satisfaction. a dominant market position.n suggested: maximisation of profit. maximisation of earnings per share. For a rapid growth rate. Even efforts toward solving societal problems may further the interest of shareholders in the .000. of course. In view of the shortcomings of the alternatives discussed above. Business firms seek to achieve a high rate of growth. support education and research. · It glosses over the factor of risk. They. Though the strict validity of this goal rests on certain rigid assumptions about capital markets. There is no guide for comparing profit now with profit in future or for comparing profit streams of different durations. The goals of maximisation of earnings per share and maximisation of retum on equity do not suffer from the first limitation mentioned above. for example.000 and an investment project which has a variable profit outcome with an expected value of Rs 50. it can be reasonably defined as a guide for financial decision making under fairly plausible assumptions. and solve other societal problems. project which generates a certain profit of Rs 50. maximisation of the wealth of equity shareholders (as reflected in the market price of equity) appears to be the most appropriate goal for financial decision-making. attain product and technological leadership. may. however suffer from the other limitations and hence are not suitable. discriminate between an investment.expressing the shareholders viewpoint? Several alternatives have bee. · It leaves considerations of timing and duration undefined. It Should be expressed on a per share basis or related to investment. It suffers from several limitations: · Profit in absolute terms is not a proper guide to decision-making. promote employee welfare. It cannot. Other Concerns of the Business Do firms really act or should solely act to further shareholders welfare? This does not seem to be the issue here. improve community life. maximisation of return on equity (defined as equity earnings/net worth). enjoy a substantial market share. Some of these goals. and a higher customer satisfaction may lead to increasing returns for equity shareholders. Maximisation of profit is not as inclusive a goal as maximisation of shareholders wealth.

long run by improving the image of the firm and strengthening its relationship with the environment. return. Since cost is the inverse of return. lower the market value. higher the market value. Likewise. higher the risk.4 Decision. What aspects are relevant from the financial angle? From the financial point of view the relevant dimension are return and risk. risk and market value of equity? Higher the return. Exhibit 11. In financial . The aspects along which such a proposal is examined are cost and risk. It should be appreciated that the maximisation of the wealth of equity shareholders constitutes the principal guarantee for efficient allocation of resources in the economy and hence is to be regarded as the normative goal from the financial point of view. ceteris paribus. an alternative which has a lower return tends to have a lower risk. Return. The trade-off has to be understood. an alternative which has a higher return tends to have higher risk too. ceteris paribus. risk. When these other goals seem to conflict with the goal of maximising the wealth of equity shareholders. here too the basic dimensions are return and risk. risk and return go hand in hand. In general. Take another decision situation in which the firm is considering a financing proposal. Exhibit 11. and market value are related. it is helpful to know the cost of pursuing these goals. This means that in a decision situation.Risk and market value Return Investment Decision Market Value of the Firm Financing Decision Risk It may be emphasized that typically. Basic Considerations: Risk and Return Suppose a firm is evaluating an investment proposal.4 shows the schematic diagram of how decisions. What is the relationship between return. we find that these are the two basic dimensions of financial analysis.

Capital budget: The schedule of investment project selected to be undertaken over some interval of time. Let Us Sum Up ● Essentially a capital project represents a scheme for investing resources that can be analysed and appraised reasonably independently. Business firms may pursue other goals. The method ignores the time value of money and cash flows. and ecological analysis. and temporal spread. When these other goals conflict with the goal of maximising the wealth of equity shareholders. Internal rate of return method: A selection method using the compounding rate of return on the cash flow of a project. selection. ● Financial theory. The method evaluates differential cash flow between proposals. ● While capital expenditure decisions are extremely important. ● The important facets of project analysis are: market analysis. . administrative. technical analysis. they pose difficulties which stem from three principal sources: measurement problems. uncertainty. rests on the premise that the goal of financial management should be to maximise the present wealth of the firm's equity shareholders. Net present value: A selection method using the difference between the present value of the cash inflows of the project and the investment outlay. ● Capital budgeting is a complex process which may be divided into five broad phases: planning.analysis. irreversibility. implementation. and review. ● Capital expenditure decisions often represent the most important decisions taken by a firm. ● The basic characteristic of a capital project is that it typically involves a current outlay (or current and future outlays) of funds in the expectation of a stream of benefits extending far into future. Their importance stems from three interrelated reasons: long-term effects. ● One can look at capital budgeting decisions at three levels: operating. and substantial outlays. Keywords Accounting rate of return method: A selection criterion using average net income and investment outlay to compute a rate of return for a project. in general. the trade-off has to be understood. economic analysis. the trade-off between risk and return needs to be carefully analysed. financial analysis. analysis. and strategic.

Recommended reading: Financial Management by Khan and Jain Financial Management by I M Panday ● ● . This method ignores the time value of money and cash flows beyond the pay back period.Payback method: A selection method in which a firm sets a maximum pay. back period during which cash inflow must be sufficient to recover the initial outlay.

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