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Attribution Non-Commercial (BY-NC)

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This is an assignment in my college.

Attribution Non-Commercial (BY-NC)

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FinanciaI management study materiaI

(ReIerence: Einancial management by S.N.Maheshwari, Einancial

management by I.M. Pandey , Einancial management by Prassana

Chandra & Anna university study material)

Unit - I

FOUNDATON8 OF FNANCE

Einancial management: An Overview Time value oI money introduction

to the concept oI risk and return oI a single asset and oI a portIolio,

valuation oI bounds and shares option valuation

O81LC1IvLS AND IUNC1IONS OI IINANCIAL MANACLMLN1

Maximization oI the wealth oI equity share holders appears to be

the most appropriate goal Ior Iinancial decision making. Apart Irom the

main goal other alternatives have been suggested (ie) maximization oI

proIit, maximization oI earnings per share, maximization oI return on

equity.

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MLANINC OI IINANCIAL MANACLMLN1 According to soloman

'Einancial Management is concerned economic resource namely capital

Iunds.

Einancial management is mainly concerned with the proper

management oI Iunds. The Iinancial manager must see that the Iunds are

procured in a manner that the risk cost and control considerations are

property balanced in a given situation and there is optimum utilization oI

Iunds

O81LC1IvLS OI IINANCIAL MANACLMLN1

Basic objectives

The basic objectives oI Iinancial management are the maintenance

oI liquid assets and maximization oI the proIitability oI the Iirm.

Maintenance of Liquid assets Maintenance oI liquid assets means that

the Iirm has adequate cash in hand to meet 15 obligations at all times

Maximization of profitability A business Iirm is a proIit seeking

organization. Hence proIit maximization is also well considered to be an

important objective oI Iinancial management.

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Wealth maximization The objective is also consistent with the objective

oI maximizing the economic welIare oI the shareholders oI a company

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Other objectives

Ensuring a Iair return to shareholders

Building up reserves Ior growth and expansion

Ensuring maximum operational eIIiciency by eIIicient and

eIIective utilization oI Iinances

Ensuring Iinancial discipline in the organization

Organization of the financial function

Organization oI the Iinancial Iunction diIIers Irom company to

company depending on their respective needs and the Iinancial

philosophy. The titles used to designate the key Iinance oIIicial are also

diIIerent (viz) vice president (Iinancial) chieI executive (Iinancial)

General manager (Iinancial) etc. however in most companies the vice

president (Iinancial) has under him two oIIicers carrying out the two

important Iunctions the accounting and the Iinance Iunctions. The Iormer

is designated as controller and the later as Treasurer.

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Importance of Financial Management

Sound Iinancial management is essential in both proIit & non proIit

organization. The Iinancial management helps in monitoring Iixed assets

& in working capital.

Einancial Management also helps in cocerntaining how the

company would perIorm in Iuture. It helps in indicating whether the Iirm

will generate enough whether the Iirm will generate enough Iunds to meet

it various obligations like repayment oI the various instatements due to

loans, redemption oI other liabilities etc.

1ime value of money

What are all the time factors?

When interest an Iunds raised will have to be paid

When return an investment will be received

Whether it will be received on a consistent basis or otherwise etc

Jarious valuation concepts

Compound value concept

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Annuity concept

Present value

All these concepts are basically boned on this Iact that the money

has a time value (ie) a rupee today is much more valuable than a rupee

tomorrow.

1ime value of money

Money has a time value because oI the Iollowing reasons

1. Individuals generally preIer current consumption

2. An investor can proIitable employ a rupee received today to give

him a higher value to be received tomorrow or aIter a certain

period

3. In an inIlationary economy a rupee received today has more

purchasing power than money to be received in Iuture

Various techniques used Ior ascertaining the time value oI money

Jaluation concept

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There is a preIerence oI having money at present than at a Iuture

point oI time this means that a person will have to pay in Iuture more Ior

a rupee received today. A person may accept less Ior a rupee to be

received in Iuture.

The above statement radiates to two diIIerent concepts

1. Compound value concept

2. Present value concept

Compound value concept

In case oI this concept the interest earned on the initial principal

becomes a part oI principal at the end oI compounding period.

Eor eg. Rs. 100 is invested 10 com. In erest Ior two years the

return Ior Iirst year will be Rs. 10& Ior second year interest will be

received on Rs. 110 (ie) (10010)

Compound value concept is divided into

a) Compounding of interest over "A" years

The returns Irom an investment are generally spread over a number

a year A p(1i)

n

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b) Multiple compounding periods

Interest can be compounded even more than once in a year

A p(1i/m)

mn

In case oI semiannual complaining interest is paid twice a year bat

at halI the annual rate.

C. Future value of series of cash flows

The transactions in real liIe are not limited to one. An investor

investing money in instatements may wish to know the value oI savings

aIter in years.

2. Present value or discounting concept

The present value concept is exact opposite oI the complaining

technique concept while in case oI present value concept, they estimate

the preset worth oI a Iuture payment / installment or series oI payments

adjusted Ior the time value oI money. The interest can be earned on the

money is termed as 'discounting rate.

Present value can be divided into

1. Present value after :n` years

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n

i) (1

A

pv

With this Iormula the amount can be directly calculate any deposit

or would be willing to accept at present, with a time preIerence rate or

discount rate oI X

2. Present value of a series cash flow

In a business situation it is very natural that returns received by a

Iirm are spread over a number oI years series oI returns the present value

oI each expected inIlows will be calculated

) 1 (

.........

) 1 ( ) 1 ( i) (1

A

p

3

3

2

2

1

1

In the above case there was a mixed stream oI cash inIlows. An

individual or depositor may receive only constant returns over a number

oI years. To Iind out the present value oI annuity either by Iind the

present value oI each cash Ilow or use the annuity table.

4. Present value of a perceptual Annuity

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A person may like to Iind out the present value oI his investment in

case he is going to get a constant return year aIter year. An annuity oI this

kind which goes on Iorever is called perpetuity

5. Capm-Capital asset pricing model Relationship between Risk and

Return

Securities are risky because their returns are variable

The most commonly used measure oI risk or variability is standard

deviation

The risk oI a security can be split into two parts unique risk &

market risk

Unique risk stems Irom speciIic Iactors whereas market risk

emanates Irom economy wide Iactors

PortIolio diversiIication washes away unique risk but not market

risk. Hence the risk oI a Iully diversiIied partygoer is it market risk.

The contribution oI a security to the risk oI a Iully diversiIied

portIolio is measured by it beta which reIlects it sensitivity to the

general market movement.

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Methods of Risk Management

1. Avoidance oI risk

2. Prevention oI risk

3. Retention oI risk

4. TransIer oI risk

5. Insurance

Sources of risk

1. Interest rate risk - (reduction in interest rate)

2. Market risk - (It will aIIect equity shareholders)

3. InIlation risk - (Share value will come down)

4. Business risk - (innovation oI new product by

competitors)

5. Einancial risk - (proportion between Dept& equity)

6. Liquidity risk

Concept of risk and return of a single asset & of a portfolio

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Risk

Risk may be deIined as 'the chance oI Iuture loss that can be

Ioreseen.

In other words in case oI risk an estimate can be made about the

degree oI happening oI the loss. This is usually done by assigning

probabilities to the risk on the basis oI part data & the probable trend.

Return

The return represents the beneIits derived by a business Irom its

operations

Measurement of return

1. ProIit approach

2. Income

a. Exiling beIore interest & Tax (EBIT)

b. Exiling beIore Tax (EBT)

c. Earning aIter tax (EAT)

3. Cash Ilow approach

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4. Rations approach

Return of a single Asset

The rate oI return on an asset Ior a given period (usually a period oI

one year) is deIined as Iollows

Rate oI return Annual incent Ending price Beginning price

Beginning price

Return on single asset

Purchase oI shares oI the company at the beginning oI a

yrmktprice oI the Rs.225. The par value oI each sh is rs. 10, then total

investment

22510022.500

Rupee return

During the yr iI the co pd dividend 25 then dividend per share

would be (25)

100

25

Rs.10 2.50

Dividend (Dividend rate par value) No

Dividend Dividend per sh No. oI shs

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Dividend 2.50100250

Percentage return

Percentage returns are Irequently calculated on per share basis. The

return has 2 components the divined income and the capital gain

Rate oI returns Divided yield gain yield

Unrealized capital gain or loss

II an investor holds a share & does not sell it at the end oI period

the diIIerence between the beginning & ending share prices is the

unrealized capital gain (or loss).

Risk & Return of a portfolio

A portIolio is a bundle or a combination oI individual assets or

securities. The portIolio theory provides a normative approach to

investors to make decisions to invest their wealth in assets or securities

under risk. It is based on the assumption that investors are risk averse.

This implies that investors hold well diversiIied portIolios instead

oI investing their entire wealth in a single or a Iew assets one important

conclusion oI portIolio theory is that iI the investor hold a well diversiIied

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portIolio oI assets then their concern should be the expected rat oI return

& risk oI the portIolio rather than individual assets & the contribution oI

individual asset to the portIolio risk.

The second assumption oI the portIolio theory is that the returns oI

assets are normally distributed. This means that the mean (the expected

value) & variance (or std deviation) analysis is the Ioundation oI portIolio

decisions. PortIolio theory is considered as a Irame work Ior valuing risky

assets. The Iramework is reIerred to as the

1. Capital asset pricing Model (APM)

2. Arbitrage pricing theory (APT) an alternative model Ior valuing

risky assets

Portfolio return: 2 asset case

The return oI a portIolio is equal to the weighted average oI the

returns oI individual assets in the portIolio with weights being equal to

the proportion oI investment value in each asset.

The expected rate oI return on a portIolio (portIolio return) is the

weighted average oI the expected rates oI return on assets in the portIolio

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The expected rate oI portIolio

Weight oI security expected rate return on security weight

oI security Y x expected return on security y.

Portfolio risk - two assets case

The risk oI individual assets two assets is measured by their

variance or std deviation. The portIolio return is the weighted average oI

returns on individual assents. The portIolio variance or std deviation

depends on the co-movement oI 2 assets.

Calculation of covariance (Measure the co-movement)

1. Determine the expected return on assets

2. Determine the divination oI possible return

3. Determine the sum oI the product oI each deviation oI returns oI

2 assets.

Jaluation of bonds & shares

Securities like shares & bonds are called Iinancial assets.

How to value bonds & shares

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Book value:

Assets are recorded B.V may include intangible assets at

acquisition cost minus amortized value.

B.V per share is determined as net worth divided by the no oI

shares outstanding Book value reIlects historical cost rather than value

(value is what an assets is worth today)

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Replacement value

R.V. is the amount that a company would be required to spend iI it

were to replace it existing assets in the current condition. It is diIIicult to

Iind cost oI assets currently being used by the company.

Liquidation value

L.V. is the amt that a company could realize oI it sold its assets

aIter having terminated it business liquidation value is generally a

minimum value which a company might accept iI it sold its business.

Going concern value

G.C.V. is the amt that a company could relies iI it sold it business

as an operating business G.C.V. would always since it reIlects the Iuture

value oI assets & value oI intangibles.

Market value

M.V. oI an asset or security is the current price at which the asset

or the security is being sold or bought in the market MV the share is

expected to be higher than the book value per share Ior proIitable.

Bonds values yields

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Bonds maybe classiIied into 3 categories

1. Bonds with maturity

2. Pure discount bounds

3. Perpetual bonds

1. Bonds with maturity

The government & Companies mostly issue bonds that speciIy the

interest rate (coupon) & the maturity period. The present value oI a bond

is the discounted value oI it cash Ilows that is the annual interest

payments plus bond`s termite or maturity value. The discount rate oI the

interest rate that investors could earn on bonds with similar could earn on

bonds with similar.

a) Jalue of Bonds with maturity

YTM is the Maxell oI a bond`s rate oI return that considers bath

the interest income & any capital gain or loss. YTM is bonds internal rate

oI return

b) Current yield

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Current yield is the annual interest divided by the bounds current

value Ior (eg.) the annual interest is Rs. 60 on the current investment

883.40.

The current rate oI return or the current yield is 60/883.4068 . II

the bond`s current price were less than is maturity value its overall rate iI

return would be less than the current yield.

c) Yield to call

A no oI companies bonds with back or call provision. Thus a bond

be redeemed or called beIore maturity.

d) Bond values & semiannual interest payment

It is a practice oI many companies in India to pay interest on bonds

semi annually (eg) 10 yr bond oI Rs. 1000 w hen an annual rate oI

interest oI 12. The interest is paid halI yearly.

2. Pure Discount Bonds

It does not carry an explicit rate oI interest. It provides Ior the

payment oI lump sum amount at a Iuture date in exchange Ior the current

price oI the bond. The diIIerence between the Iace value oI the bond its

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purchase price gives the return or YTM to the investor pure discount

bonds are called deep descant bonds or zero interest bonds or zero coupon

bonds.

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3. Perceptual Bonds

PB has an indeIinite liIe thereIore it has no maturity value PB or

debentures are mainly Iound in practice. In case oI perpetual bonds as

there is no maturity or terminal value the value oI the bonds would

simply be the discounted value oI the inIinite stream oI interest Ilows.

How to determine the value of the bonds

Bond vale & changes (i) interest rate

The value oI the bond declines as the mkt interest rate (distaste)

increases the easiness bonds cash Ilows (interest & principal repayment)

are discounted at higher interest rates.

Bond maturity & interest rate risk

Value oI the bard depends upon the market interest rate. As interest

rate changes the value oI the bond also var. there is an inverse

relationship between the value oI a bond & the interest rate. The bond

value world decline when the interest rate vises & vice versa

Interest rates have the tendency oI rising or Ialling in practice. Thus

the investors oI bonds are exposed to the interest rate risk.

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Bond durations & interest rate sensitivity

Bond prices are sensitive to change in the interest rates & they are

inversely related to the interest relates. The bonds duration is measured as

the weighted average oI times to each cash Ilow interest payment or

repayment oI principal. The intensity oI the price sensitivity depends on a

bonds maturity & the coupon rate oI interest. Longer the maturity oI bond

the higher will be its sensitivity in the interest rate changes.

Option valuation

Options may reIer to choice or alternative or privilege or

opportunity Ior preIerence or right. Option is a claim without any

liability. An option is a contract that gives the holder a right without any

obligations to buy or sell an asset to any agreed price on or beIore a

speciIied period oI time.

The option to buy an asset is known as a call option & the option to

sell an asset is known as a put option. The price at which option can be

exercised is called an exercise price or a strike price.

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Factors determining option value

The option holder will exercise his option only when it is

beneIicial. The call option will be beneIicial to is buyer when the exercise

price is less than the price oI the share (the underlying asset) when the

call option is art oI the money (i.e.) the exercise price to more that the

price oI the undying asset) the minimum value oI the (all option at

expiration will be zero). The value oI the option depends on the Iollowing

Iactors.

1. Exercise price & the share

2. Volatility oI return on share

3. Time to explication

At the expiration date the holders will know the share price & he will

exercise his option iI the exercise price is lower than the sh. Price. The

excess oI the sh.price over the exercise price is the value oI the option at

the expiration oI the option at expiration oI the option. II the sh.price is

more that the exercise price a call option is said to be the money.

Suppose you hold a 2 month option on the share or Bright ways

company. The exercise price ot Rs. 100 & the current market price is Rs.

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100. The option will be worthless iI the share price remains Rs. 100 at

maturity.

Interest rate

The holder oI a call option pays exercise. Price not when he buys

the option rather later can when he exercise is option. Thus the present

value oI the exercise price will depend on the interest rate.

Option expiration

The present value oI the exercise price also depends on the time to

expiration oI the option. (The present value oI the exercise price will be

less time to expiration is longer & consequently the value oI option will

be higher).

Risk Return Relationship possibility of something and happening

Risk

Risk may be deIined as the chance oI Iuture loss that can be

Ioreseen. In other words in case oI risk an estimate can be made about the

degree oI happening oI the loss. This is usually done by assigning

probabilities to the risk on the basis oI past data and the probable trends.

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Certainty

Uncertainty may be deIined as the unIoreseen change Ior Iuture

loss or damages. In case oI uncertainty since the Iirm cannot anticipate

the Iuture loss and hence it cannot directly in deal with it in its planning

process and is possible in the case oI risk.

Return

The return represents the beneIits derived by a business Irom its

operations.

Measurement of return

1. ProIit approach

2. Income approach

a. Earning beIore interest & Tax (EBIT)

b. Earning beIore tax (EBT)

c. Earning aIter tax (EAT)

3. Cash Ilow approach

4. Ratios approach

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Relationship between Risk & Return

The rate oI return required to a great extent depends upon the risk

involved higher the risk. Greater is the return expected by the Iirm. The

rate oI return required by the business consists oI 3 components.

1. Return at Zero Risk

This reIers to the expected rate oI return where a project involves

no risk whether business or Iinancial

2. Premium for Business Risk

The term business risk reIers to the variability in operating proIit

(EBIT) due to changes in sales. In case oI a projects having more than the

normal or average risk the Iirm will expect a higher rate oI return than the

normal rate.

3. Premium of financial Risk

The term Iinancial risk reIers to the risk on account oI pattern oI

capital structure. (debt equity mix). A Iirm having higher debt content in

its capital structure expects a higher rate oI return as compared to a Iirm

which has comparatively debt content.

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This is become in the Iencer case the Iirm requires higher operating

proIit to cover periodic interest payments and repayment oI principal at

the time oI maturity as compared to the latter.

The above 3 components may be put in the Iorm oI Iollowing

equation

Rate oI return r

0

bI

r0 return as zero risk

b premium Ior business risk

I premium Ior Iinancial risk

Criteria for evaluating proposals to minimize risk

1. Select the least risky proposal

2. Apply hurdle rates The Iirm may decide the minimum acceptable

return below which is not going to accept the proposal.

3. Avoid propose is with Iluctuating risk

4. Adopt weighted Average approach on the basis oI risk & return oI

the project.

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``````````````````````````````````````````````

UNIT- 2

INVESTMENT DECISIONS

Capital budgeting

Principles & techniques Nature oI capital budgeting, identiIying relevant

cash Ilows, evaluation techniques, payback, Accounting rate oI return,

Net present value, Internal Rate oI return, proIitability index, Comparison

oI DCE techniques. Project selection under capital rationing inIlation &

capital budgeting concept & measurement oI cost oI capital, speciIic

costs and overall cost oI capital.

Capital budgeting

Capitalbudget is budget Ior capital projects the exercise involves

ascertaining cash inIlows & outIlows matching & evaluation with

outIlows appropriately &evaluation oI the desirability oI the project

under consideration

Capital budget is the planned expenditure on capital investments Ior

projects .It is a long term plan Ior proposed capital outlays & the means

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oI Iinancing capital budget help the mgmt to avoid over investment &

under investment the investment oI huge amount oI expenditure

includes.

Expansion oI existing business

Staring new projects

Replacement projects

Modernization& diversiIication oI projects

Research&n development projects

Capital bud is the process oI deciding whether or not to commit

resources to a capital project whose beneIits would be spread over

general time period.

According to Lynch

'Capital bud consists in planning, development oI available capital

Ior the purpose oI maximizing the long term proIitability oI the concern

Accordingto Horn gren

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'Capital bud is long term planning Ior making and Iinancing proposed

capital outlays

SIGNIFICANCE OF CAPITAL BUDGETING

1. DEALS WITH RIGHT KIND OF EVALUATION

A project may be scientiIically evaluated so that no under

Iavor or disIavor is shown. A good project must not be rejected & a bad

project must not be selected.

2. INVOLVES CAPITAL RATIONING

The available Iunds must be allocated to competing project in the order

oI project potentials usually the indivisibility oI project poses the

problem oI capital rationing because required Iunds and available Iunds

may not be the same.

3. CLEAR SYSTEM OF FORECASING

The building blocks oI capital budgeting exercise are mostly estimates oI

prices and variable cost per unit output quantity oI output that can be

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sold the tax rate the cost oI capital the useIul liIe oI the project etc over a

period oI years.

4. CAPITAL BUDGETING - A SIGNIFICANT TASK

Capital investment proposals involve i)longer gestation period

development oI an idea (ii) huge capital outlay (iii) technological

considerations needing technological Iorecasting (iv) measuring oI

dealing with project risks. All these make capital budgeting a signiIicant

task.

ADVANTAGES OF CAPITAL BUDGETING

1.It is helpIul Ior taking proper decisions

1. It inIluences the Iirms growth in the long run.

2. It indicates proper timings Ior purchase oI Iixed assets.

3. It avoids over investment or under investment in Iixedassets.

4. It provides a sound policy Ior depreciation & replacement oI Iixed

assets.

5. It serves as a means oI controlling expenditure.

LIMITATIONS OF CAPITAL BUDGETING

1. It is a very diIIicult task.

33

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2. None oI the various methods oI capital appraisal available is Iree

Irom drawbacks.

3. They are irreversible or reversible at substantial loss.

APPRAISAL OF CAPITAL PRO1ECTS.

Appraisal means examinations & evaluation. The cost oI capital projects

include the initial investment at the inception oI the project Initial

investment made in Land, building, machinery, plant, equipment,

Iurniture, Iixtures etc. Investment in these Iixed assets is one time.

Eurther a onetime investment in working capital is needed in the

beginning, which is Iully salvaged at the end oI the liIe oI the project &

tax.

The net cash earning are computed as Iollows

Cash earning ((P-V)(Q-E-D-I)(I-T)D)

P Price per unit

V VariableCost

Q Quantity produced & sold

E Total Iixed expensed exclusive oI depn

D stand Ior depn on Iixed assets

I Interest on borrowed capital

34

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T Tax rate.

BeneIits are estimated the same may be compared with costs oI the

capital projects to Iind out whether costs exceed beneIits or beneIits

exceed costs This process oI estimation oI cost & beneIits &

comparison oI the same is called. CapitalAppraisal.

CAPITAL BUDGETTING TECHNIQUES. OR METHODS USED

FOR CAPITAL PRO1ECT APPRAISAL

TWO METHODs

1. Traditional or non discounted cash Ilow or non time value

techniques.

2. Modern, discounted cash Ilow techniques Time value techniques.

TRADITIONAL METHOD

1. Pay back, pay oII or recoupment period method

2. Post pay back proIitability method

3. Accounting rate oI return, Average rate oI return or investment

method

Modern/discounted cash flow method:

1. Discounted pay back

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2. Net present value

3. ProIitability index or cost beneIit ratio method

4. Internal rate oI return.

A. Payback period (PBP) method

Payback period reIers to the number oI years one has to wait to setback

the capital invested in Iixed assets in the beginning. It is a traditional &

simple method oI evaluating the projects .It does not take the eIIect oI

time value oI money.

II the annual cash inIlows are uniIorm the Iormula will be

Payback period

The selection oI the project to based on the earning capacity oI a project

Here the Iin mgr`s aim is to know how soon the original investments are

recovered he has to compare. It the payback period is more than the cut

oII rate (rate oI interest Ior capital) the proposal are rejected iI the

payback period to less than the cut oII rate such proposals are selected

Ior investment.

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Pay back profitability method or post payback profitability method

To remove the drawbacks oI payback period Post pay back proIitability

method was developed under this method the cash inIlow generated

Irom a project during the economic liIe is taken into account where as in

pay back. Period the cash inIlows were considered only to the extent oI

recovering the original investment.

Accounting Rate of Return method/Average rate of return

ARR is the Capital investment proposals are judged on the basis oI their

relative proIitability accounting Concepts, over the entire economic liIe

oI the projects& then the averageyield is calculated. Such a rate is

termed as ARR. It may be calculated according to any one oI the

methods.

i) x100

ii) x100

The term average annual net earnings is the average oI earnings (aIter

depn&tax) over the whole oI the economic liIe oI the project.

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The amt oI average investment can be calculated according to any oI the

Iollowing methods.

a)

b)

c)

d)

Accept/ Reject Criteria

Normally business enterprises Iix a minimum rate Any project expected

to give a return below this rate will be rejected.

In case oI several projects where a choice has to be made the diIIerent

projects may be ranked in the ascend/descending order oI their rate oI

return. Projects below the minimum rate will be rejected & Project

giving higher rate will be selected.

Merits

1. It is simple & Common sense Oriented

38

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2. ProIits oI all years are taken in to account.

Demerits

1. Time Value oI money is not considered

2. Risk involved in the project is not considered.

3. Annual average proIits might be the same Ior diIIerent project.

4. ARR has several variants & it lacks uniIormity

MODERN METHOD (DISCOUNTED CASH FLOW

METHOD)

Discounted cash flow method or Time adjusted Techniques.

The DCE techniques are an improvement on the payback period method.

It takes both the interest Iactor as well as the return aIter payback

period. This method involves 3 stages.

i)Calculations oI cash Ilows (i.e) inIlows & outIlows (preIerably aIter

tax) over the Iull liIe oI the asset.

ii) Discounting the cash Ilows so calculated by a discount Iactor.

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iii) Aggregating oI discounted cash inIlows & comparing the total with

the discounted cash outIlows.

DCET thus recognizes that Re 1 oI today (the cash outIlow) is worth

more than Re 1 received at a Iuture date (Cash inIlow)

DCE methods Ior evaluating capital investment proposal are divided into

1 NPV method

Best method under discount cash Ilow. It considered cash inIlows & cash

outIlows associated with each project. The PV oI these cash inIlow are

compared with cash outIlows then calculated at the rate oI return

acceptable to the management. This rate oI return is considered as the

cut oII rate & is generally acc determined on the basis oI cast oI capital

suitably adjusted to allow Ior the risk element involved in the project

cash out Ilow represent the investment. The working capital is taken as

a cash outIlow in the year the project starts commercial production

proIit aIter tax but beIore depreciation represents cash inIlow.The NPV

is the diII between the total present value oI Iuture cash inIlow & the

total present value oI Iuture cash outIlows.

40

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The equation Ior calculation NPV in cash oI conventional cash Ilows

can be

In case oI non conventional cash inIlows the equation is

R Cash inIlows at diII time periods

K cost oI capital or cut oII rate

Z cash outIlows at diIIerent time periods.

Accept / Reject criteria

In case the NPV is positive (P.V oI cash inIlows is more than PV oI cash

outIlows) The project should be accepted However iI the NPV is

negative (PV oI cash inIlow is less than the present value oI cash

outIlows) the accept/reject criterion can be put as Iollows

NPV~ Zero accept the proposal

41

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NPV Zero reject proposal

PV~ C accept proposal

PV C the proposal

PV- Present value oI cash inIlow &

C- Present value oI cash out Ilow (or) outlays.

b) Excess Present value Index/ BeneIit cost ratio

This is a reIinement oI the net present value method. Instead oI working

cut the NPV a PV index is Iound out oI PV oI cash inIlows & the total

oI the PV oI Iuture cash outIlows.

Excess PV index or beneIits cost (B/C) ratio

Excess PV index provides ready comparison between investment

proposals oI diIIerent magnitudes. Eor eg project A requiring an

investment Rs.1,00,00 shows excess PV oI Rs.20,000 while another

project B requiring loan investment oI Rs 10,000 shows an excess on pv

42

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oI Rs 5000. It absolute Iigs oI NPV are compared project mayA seem to

be proIitable.

However iI excess PV index method is Iollowed project B would

prove to be proIitable.

C) Internal Rate of Return

IRR is that rate at which the sum oI discount cash inIlows equals

the sum oI discount cash inIlows equals the sum oI discount cash

outIlows In other worth it is the rate which discounts the cash Ilow to

Zero. It can be stated in the Iorm oI a ratio as Iollows.

Thus in case oI this method the discount rate is not known but the cash

outIlows & cash inIlows are known Ior eg iI a sum oI Rs 800 invested

in a project becomes Rs.100at the end oI a yr the rate oI return comes to

25 cal as Iollows.

43

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I Cash outIlow )

R Cash inIlow

R Rate oI return yielded by the Investment or (IRR)

Or 800r800 1,000

Or 800r 200

Or r25

In case oI return is over a number oI years the calculation would take

the Iollowing pattern in case oI conventional cash Ilow

Where

I cash outlay (outIlow) at diIIerent time period.

R Cash inIlow at diII time period

44

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r rate oI return yielded by the investment or (IRR)

Since I & R are known Iactors r is the only Iactors to be calculated

However calculations will becomes very diIIicult over a long period iI

worked out according to the above equations. Tabular values are

thereIore used.IRR is calculated according to the methods on the basis

oI Tabular values as Iollows.

1) Where cash inIlows are uniIorm

In the cone oI these projects which result in uniIorm cash inIlows

IRR can be calculated by locating the in annuity Table II TheIactor to

calculated as Iollows

E Iactor to be located

I original investment

C Cash inIlow year.

When cash inIlows are not uniIorm the IRR is calculated by

making trial calculation in an attempt to compute the correct interest

rate which equates the PV oI cash inIlows with the pr oI cash outIlows.

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Decision Tree approach

DTA is a versatile tool used Ior decision making under conditions

oI risk the Ieatures oI this approach are

1) It takes into account the result oI all expected outcomes

2) It is suitable where decisions are to be made to sequential a part

that is iI this has happened already what will happen next & what

decision has to Iollow.

3) Every possible outcome to weighted using joint probability model

& expected outcome worked out.

4) A tree Iorm pictorial presentation oI all possible outcomes is

presented here & hence the term decision tree is used.

Capital Rationing

Capital rationing arise at any time there is budget ceiling constraint

on the amount oI Iunds that can be invested during a speciIic period

such constraints are prevalent in a no oI Iirms. Particularly in those that

have a policy oI Iinancing all capital expenditure internally.

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C.R. reIers to a situation where the Iirm is constrained Ior external

or selI imposed reasons to obtain necessary Iunds to invest in all

proIitable investment projects under CR the mgmt has to determine the

proIitable opportunities`& then to rank them according to their relative

probabilities.Capital rationing means distribution oI capital in Iavor oI

more acceptable proposal

Reason for capital rationing

Cap rationing may be due to external Iactors & interest constraints

imposed by management. External occurs because oI the imperIections

may caused by.

1. DeIiciencies in market inIormation.

2. A diIIerence between the interest rate at which the Iirm can obtain

capital in the market & the interest rate it could earn by lending its own

capital to others in the market.

3. Hamper the Iree how oI capital between Iirms Internals cap rat due

to selI imposed restrictions by the mgmt oI the Iirm such restrictions

are

a. Decision not to obtain additional debt capital

b. Ceiling on the amts to be invested by divisional mgrs.

47

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c. Condition that the rate oI return should be higher than the cost oI

capital

Selection of project under capital Rationing

There are 2 ways oI selecting the project.

1. IRR or ProIitability index will be taken as a base Ior selecting a

project according to priority. The ProIitability will indicate whether it is

Ieasible to invest on a project or not.

2. The project can also be selected Ior investment on the basis oI

proIitability within the estimated amount while selecting the project

wealth maximization concept is considered This means the Iirms can go

on thinking oI investing in projects which yield proIit & also increase

the image oI the Iirm in capital market& in terms oI maintaining

solvency & liquidity While estimating the Iuture earnings. NPV oI

Iuture earnings will be taken into a/c.

Measurement of specific cost

This is the combined cost oI the speciIic costs

associated with speciIic sources oI Iinancing the cost oI the diII sources

48

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oI Iinancing represents the components oI combined cost the

computation oI the cost oI capital involves 2 steps.

i. The computation oI the diIIerent elements oI the cost in terms oI the cost

oI the diIIerent sources oI Iinance( speciIic costs) (ii) the calculation oI

the overall cost by combining the speciIic costs into made upon various

source speciIic costs into composite cost.

The Iirst step in the measurement oI the cost oI capital oI the Iirmis the

calculation oI the cost oI individual sources oI raising Iunds Irom the

viewpoint oI cap budget decision the long term sources oI Iunds are

relevant as they constitute the major sources oI Iinancing oI Iixed asset.

In calculating the cost oI capital thereIore the Iocus is on long term Iunds

In other words the speciIic costs have to be calculated Ior.

i)Long term debt (including debentures)

ii) PreIerence shares

iii) Equity capital &

iv) Retained earnings

1.Cost of debt

49

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The cost oI Iunds raised through debt in the Iorm oI debentures or

loan Irom Iinancial institutions can be determined.

We need data regarding.

i)Net cash proceeds (inIlows) (the issue price oI debs/amt oI

loan minus all Iloatation costs)

ii) Net cash outIlow in term oI the amt oI periodic

interest payment & repayment oI principal in installments or

in lump sum on maturity.

2) Cost oI preIerence shares

The computation oI the cost oI preIerence shares is diIIicult as

compared to the cost or debt .It is true that a Iixed dividend rate is

stipulated on preIerence share holders have some right compared

toOrdinary shares holders.

i)PreIerence shareholders prior right to receive dividend over equity

holders.

ii) PreIerence Shares are cumulative

Two types oI preI. shares

i)Irredeemable

30

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ii) Redeemable

3.Cost ofEquity capital

The cost oI equity capital is relatively the highest among all the

sources The investors purchase the shares in the expectation oI a certain

rate oI return the equity shares involve the highest degree oI risk as they

also expect higher return & thereIore higher cost is associated with them.

iv) Cost of retained earnings

. That retained earning does not involve any Iormal arrangement to

become a source oI Iunds. In other words there is no obligation on a Iirm

to pay a return on retained earnings. Retained earnings may appear to

carry no cost; on the contrary they do involve cost like any other sources.

Overall cost of capital

Over all composite cost oI capital deIined as weighted average oI

the cost oI each speciIic type oI Iund. The overall proportions oI various.

Sources oI sit Iunds in the capital structure oI a Iirm are diIIerent. The

overall cost oI capital show take into a/c the relative proportions oI diII

sources & hence the weighted avg.

31

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The computation oI overall cost oI capital involves the Iollowing

1. Assigning weights to speciIics cost

2. Multiplying the cost oI each oI the sources by the

appropriate weights

3. Dividing the total weighted cost by the total weights

This is Iollowed by the mechanics oI computation

Computation oI overall cost oI capital symbolically.

Assignment of weights

The aspects relevant to the selection oI appropriate weights are

i)Historical weights vs Marginal weights

ii) Historical weights can be book value weights (or) (b)

mkt value weight

a) Marginal weights

The use oI m-weights involves weighting the speciIics costs by the

proportion oI each type oI Iund to the total Iunds to be raised. The

marginal weight represents the percentage share oI diIIerent

Iinancing sources the Iirm intents to raise/employ. The basis

32

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oIassigning relative weight is thereIore new/add/incremental issue

oI Iunds & hence marginal weights.

In using marginal weights we are concerned with the actual amount

oI each type oI Iinancing used in raising additional Iunds to Iinance

new projects by the company. Another merit oI marginal weight is

that their use reIlects the Iacts that the Iirm does not have a great

deal oI control over the amount oI Iinance obtained thro retained

earnings or other sources which are inIluenced by several Iactors

such as temper oI the mkt, investors preIerence & soon.

B, Historical weights

The alternative to the use oI marginal weights is to use historical.

Weights. The relative proportions oI various sources to the existing

capital structure are used to assign weights.The basis oI weights

system is the Iunds already employed by the Iirm.

C,Book value & mkt value weights

In- use oI mkt value weight Ior calculations the cost oI capital is

more appearing than the use oI book value weights because.

33

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1. Market values oI securities closely approximate the actual

amt to be relieved Irom their sale while selling the security.

2. The cost oI the speciIic sources oI Iinance .

CAPITAL ASSET. PRICING MODEL APPROACH

(CAPM)

Another technique used to estimate the cost oI equity is the

(CAPM approach)

CAPM explains the behavior oI security prices &

provides a mechanism whereby investors could assess the

impact oI proposed security investment on their overall

portIolio risk& return It describes the risk return trade oII Ior

securities. The basis assumption oI CAPM are related to (a) the

eIIiciency oI the security markets & (b) Investor preIerences.

The risk to which security investment is exposed to Ialls into 2

groups

(i) DiversiIiable (unsystematic)

(ii) Non diversiIiable (systematic)

Diversifiable

34

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The Iirst represents that portion oI the total risk oI an investment

that can be eliminated /minimized through diversiIication the risk vary

Irom Iirm to Iirm the sources oI such risk include mgmt capabilities&

decisions, strikes, unique government regulation, availability oI raw

materials, competition, level oI operating etc.

Non diversifiable risk

An unsystematic risk can be eliminated by an investor through

diversiIication.

Project selection under inflations

Normally cash Ilows oI an investment project occur over a long

period oI time a Iirm should usually concerned about the impact oI

inIlation on the projects proIitability The capital budgeting results will be

based iI the impact oI inIlation is not correctly Iactored in the analysis.

Due to inIlation prices oI certain products may be controlled by

govt(eg) drugs & pharmaceutical some cost may wages may at a

higher rate than Iuel power or even raw material. The WORKING capital

oI an investment project during inIlation

33

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The salvage value oI projects may also aIIected by inIlation during

rising price Iirm may able to sell an onset at the end oI its useIul liIe.

The rate oI inIlation is taken into account with the help oI Iollowing

points.

NOMINAL VS REAL RATES OE RETURN

Eg. Jose deposits Rs.100 SBI -1yr 10 interest receives RS-110

10 - Nominal rate oI return

100- real rate oI return

,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,,

36

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