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Capital Investment (Meaning & Definition)

The act of placing capital into a project or business with the intent of making a profit on the initial placing of capital. An investment may involve the extension of a loan or line of credit, which entitles one to repayment with interest, or it may involve buying an ownership stake in a business, with the hope that the business will become profitable. Investing may also involve buying a particular asset with the intent to resell it later for a higher price. Many types of investing exist, and each is subject to greater or lesser regulation in the jurisdiction in which it takes place. Legally, investing requires the existence and protection of individual property rights. Investing wisely requires a combination of astuteness, knowledge of the market, and timing. The term Capital Investment has two usages in business. Firstly, Capital Investment refers to money used by a business to purchase fixed assets, such as land, machinery, or buildings. Secondly , Capital Investment refers to money invested in a business with the understanding that the money will be used to purchase fixed assets, rather than used to cover the business' day-today operating expenses.

Importance of capital Investment

The following motives will clearly explain why capital investment is very important for a firm:

1. Expansion: Capital investment is directed towards expansion of the level of operations. It is done through acquisition of fixed assets by purchasing property and plant facilities, which in turn ensure a proper investment and balancing in investment.

2. Replacement: After maturity period when firm's growth slows down, it is required to replace or renew some outdated or worn-out assets, i.e. machinery, equipment, vehicles, etc. Thus a firm can return into its full-fledged production and generate desired benefits.

3. Renewal: As an alternative to replacement, renewal may involve rebuilding, overhauling or retrofitting an existing asset. It certainly increases the productions and profits of a firm.

4. Other importance: There are certain other importance of capital investment , which include -

a) Plan for securing funds

b) Retain a competitive position in the market

c) Sales and cash forecast

d) Sales guarantee

e) Comparative study of alternative projects and launching new products

Types of Investment : Following are the types of Capital Investment 1. Physical 2. Monetary assets 3. Intangible 4. Strategic Investment 5. Tactical Investment 6. Mandatory Investment 7. Replacement 8. Expansion 9. Diversification 10. R & D Investment 11. Miscellaneous

Analyzing different types of capital investment projects and investing in the most profitable projects is what gives life and growth to a company. Unless a company conducts the necessary research and development to develop new products, to improve existing products or services, and to discover ways to operate more efficiently, that company and the economy in which it operates will stagnate.

Companies of any size, and entrepreneurs starting a new business, do and should have a Research and Development Department. That department, along with usually a committee

composed of finance, marketing, technology, and other executives are charged with coming up with ideas to improve the company and the products and services offered by the company.

Research and development is not free to a company. It is a cost/benefit operation. Well-managed firms go to great lengths to develop good capital budgeting proposals that provide value to the firm and the economy at large.

There are numerous types of capital budgeting projects as discussed below:

1. New Projects: New products or new markets A new capital investment project is important for the growth and expansion of a company. It is also important for the economy at large as it means research and development. This type of project is one that is either for expansion into a new product line or into a new product market, often called the target market.

A new product or a new target market could, conceivably, change the nature of the business. It should be approved by higher-ups in the business organization. A new project, either a new product or a new target market, requires a detailed financial analysis and the approval of possibly even the firm's Board of Director's.

An example of a new product would be a new medical device that is conceived, researched and developed by a company specializing in medical devices. Perhaps this medical device would tap into a target market that the company had not yet been able to reach.

2. Expansion of existing products or markets

The expansion of existing products or target markets means an expansion of the business. If a company undertakes this kind of capital budgeting product, they are effectively acknowledging a surge in growth of demand. A detailed financial analysis is required, but not as detailed as that required for the expansion of the company into new products or new target markets.

3. Replacement project necessary to continue operations as usual An example of a replacement project necessary to continue operations as usual would be, in a manufacturing plant, replacing a worn out piece of equipment with a new piece of the same equipment designed to do the same job. This is a simple capital budgeting project to evaluate. It would be possible to use one of these simpler capital budgeting methods to evaluate this project and abide by the decision of the capital budgeting method.

The cash flows from a replacement project necessary to continue operations as usual are fairly easy to estimate, at least compared to other types of projects, because the business owner is replacing the same type of equipment and is, therefore, somewhat familiar with it.

4. Replacement project necessary to reduce business costs During the Great Recession, many companies have been looking at this type of capital project. Sometimes, businesses need to replace some projects with others in order to reduce costs. An example would be replacing a piece of obsolete equipment with a more modern piece of equipment that is easier to have serviced. This type of capital budgeting project would require a detailed financial analysis with cash flows estimated from each piece of equipment in order to determine which generates the most in cash flows and, thus, saves money.

Difficulties in capital investment

The capital investment decisions suffer from a many constraints generally. The sum of capital which an organization collects is restricted and thus it gets the restraint on the firms choice down to an extent, over several project investments. When the firms debt is raised, the firms debt-equity ratio too is increased and thus it gets hard for a business to be able to increase more debts.

Making strategic capital investment decisions which are consistent could also be problematic because a lot of people prefer using capital investment appraisal techniques which increases the chances of having their favorites projects accepted. In a lot of cases, capital investment decisions are reached subjectively and financial techniques are put in to use to rationalize, once the capital investment decision has been made.

Most of the investment projects which are strategic have problems which are ill-structured, calling for an approach which might never have been ever put to use before, thus, complexity, novelty, irreversibility and ambiguity characterize these capital investment decision projects. Its important that we recognize thus and put the strategies in place to deal with such issues and problems because if you make one wrong capital investment decision, then it can impact a businesss value negatively thereby making creditors and investors not really willing or keen to fund the business any time in future.

The capital investment decision of project ranking plays a crucial role in capital investment decisions. Depending upon the kind of project a firm has at a particular point of time, the

companies prioritize the various projects. Project ranking is dependent on the fact as to how much would a particular project return as well as which project has the ability to provide the business, a maximum value. There are a lot of measures which give an estimate of the firms return over several investment projects. To be able to determine a specific projects value, the three most common used methods are - payback method, net present value method, and the IRR methods. These are the different kind of methods which are put to use while taking capital investment decisions.

Phases of Capital Budgeting Capital budgeting is a very complex process which can be divided into five phases: Planning-The planning phase of a firms capital budgeting process is concerned with verbalization of its wide investment strategy and the creation and preliminary screening of project proposals. The investment strategies of the firm describe the wide areas or types of investments the firm plants to undertake. These give the framework which shapes, guides, and define the identification of individual project opportunities. Once a project proposal is recognized, it needs to be examined. To start with, a preliminary project analysis is done. An introduction to the full blown possibility study, this exercise is meant to judge (i) whether the project is prima-facie worthwhile to assess a possibility study and (ii)what aspect of the project are grave to its visibility and thus warrant an in depth investigation. Analysis-If the preliminary screening proposes that the project is prima facie meaningful, a detailed analysis of the marketing, technical, financial, economic, and ecological aspects is undertaken. The questions and issues aroused in a detailed analysis are described in the following section. The center of this phase of capital budgeting is on gathering, preparing and resizing relevant information about various project proposals which are being considered for

inclusion in the capital budget. Based on the information developed in this analysis, the flow of costs and benefits with the project can be defined. Selection-Selection follows, and usually overlaps, analysis. It addresses that -Whether the project worthwhile? A broad range of appraisal criteria have been suggested to evaluate the worth while ness of a project. They are usually divided into two broad categories, viz, non- discounting standard and discounting standard. The main non-discounting standard is the payback time and the accounting rate of return and the benefit cost ratio. To apply the various appraisals standard cut-off principles have to be specified. These are fundamentally a function of the blend of financing and the intensity of project risk. While the former can be defined with comparative simplicity, the latter strictly tests the capability of the project evaluator. Certainly, in spite of a wide range of tools and techniques for risk analysis (sensitivity analysis, Monte simulation, decision tree analysis, portfolio theory, capital asset pricing model, and the like), risk analysis remains the most inflexible part of the project valuation exercise. Implementation-The implementation phase for business project that involves setting up of industrial facilities that consists of several stages such as 1. Projectand engineering designs 2. Negotiations and contracting 3.Construction 4.Training, and 5.Plant commissioning Translating an investment suggestion into a material is a complex, time- consuming, and risk burdened task. Delays in implementation that are common, can lead to considerable cost overruns. For speedy implementation at a rational cost, the below are helpful. 1. Adequate Formulation of Projects. A major reason for the delay is not enough for formulation of projects. In other words, if necessary homework in terms of preliminary studies and complete and detailed formulation of

the project is not done, many surprises and shocks are likely to spring on the way. Thus the need for sufficient formulation of the project cannot be greater. 2. Use of the Principle of Responsibility Accounting. Conveying specific responsibilities to project managers for implementation of the project within the defined time-frame and cost limits is supportive in quick execution and cost control. 3. Use of Network Techniques. For project planning and control two basic techniques are available 4. PERT (Programmed Evaluation Review Technique) and CPM (Critical Path Method). With the help of these methods, monitoring becomes easier. Review-Once the project is made to order the review phase has to be set in motion. Performance review should be done from time to time to evaluate actual performance with probable performance. A feedback device can be useful in several ways. (i) It throws light on how realistic were the suppositions underlying the project; (ii) It provides a documented record of experience that is extremely valuable in future decision making; (iii) It proposes corrective action to be taken in the light of actual presentation; (iv) It helps in finding judgmental biases; (v) It encourages a desired warning among project sponsors.

Decision Making Levels in Capital Budgeting

For planning and control process, three levels of decision making have been identified:
1. 2. 3.

Operating capital budgeting Administrative capital budgeting Strategic capital budgeting

Capital budgeting decisions could be categorized into these three decision levels.

Operating capital budgeting- This may include routine minor expenditures, such as expenditure on office equipment. The lower or the middle level management can easily handle the operating capital budgeting decisions.


Administrative capital budgeting- This involves medium-size investments such as expenditure on expansion of existing line of business. Administrative capital budgeting decisions are semi-structured in nature, and they may also involve some options, such as option to delay. Generally, the senior management is assigned the responsibility of handling these decisions.


Strategic capital budgeting - This involves large investments such as acquisition of a new business or expansion in a new line of business. Strategic investments are unique and unstructured and involve simple or complex options, and they cast a significant influence on the direction and value of the business. Top management, therefore, generally handles such investments.

Facets of Project Analysis Analysis of sponsoring firms and project companies illustrates how financing structures affect managerial investment decisions and subsequent cash flows. The project analysis mainly coversmarket analysis, technical analysis, financial analysis and economic and ecological analysis.

These are detailed below:


Market Analysis - Market analysis is concerned primarily with two questions of aggregate demand andmarket share for the business in future. To answer the above questions, appropriate forecasting methods and following information is required:

Present Supply position and forecast Production possibilities and constraints Other competing projects in the state Consumption trends in the past and the present consumption level Import and export Structure of competition Costs structure Elasticity of demand Consumer behavior, intentions, motivations Distribution channels and marketing policies in use Administrative, technical and legal constraints


Technical Analysis -Technical and engineering analysis seeks to determine whether the prerequisite for thesuccessful commissioning of the project have been considered and reasonably good choices have been made with respect to location, size, process etc. The criteria being

Status of preliminary tests and studies for the project Availability of fuel, water, and other in outs Scale of operation and technology- is it suitable? Provision and requirement if affluent treatment Project schedules- is it realistic?


Financial Analysis - Financial analysis seeks to ascertain whether the proposed project will be financiallyviable and give satisfactory returns to the investor. It also shows that the project is ableto meet the burden servicing debt. The main aspects that have been looked into whileconducting financial appraisal are:


Investment outlay and capital cost of project; Means of financing including interest rates and repayment schedules Cost of capital Projected profitability Cash flows of the project Projected financial position Level of risk in the project Economic and Ecological Analysis - Economic analysis, also referred to as social cost benefit analysis, is concerned with judging a project from the larger social point of view. Environment is another issue, which needs special attention, particularly for large projects such as power projects. Themajor issues are:

Direct economic benefits and costs of the project measured i n t e r m s o f efficiency. Impact of the project on the level of savings and investment in the society

Contribution of the project towards the fulfillment of certain merit like self sufficiency, employment and social order Environmental impact

Objectives of Capital Budgeting

1. 2.

Establish cost guidelines and benchmarks to assist analysts in budget development. Clarify our understanding of funding constraints and conditions to make it easier to correctly align project types with funding sources.


By taking a more comprehensive approach to the budget development and implementation cycle, eliminate low-value tasks and help all participants focus on the most important issues.


Improve tools for the budget processes to reduce the burden of administrative tasks and increase time available for analysis and decision-making.

5. 6.

Ensure better connections between the operating and capital budgets. Improve the allotment and monitoring processes to reduce time spent on non-value added tasks.

7. 8.

Improve the guidance available for everyone involved in the capital budget process. Make better use of information about facility needs and conditions for budget development and monitoring.


Streamline the budget bill process.

Limitations of Capital Budgeting 1. It has long term implementations which can't be used in short term and it is used as operations of the business. A wrong decision in the early stages can affect the long-term survival of the company. The operating cost gets increased when the investment of fixed assets is more than required. 2. Inadequate investment makes it difficult for the company to increase it budget and the capital. 3. Capital budgeting involves large number of funds so the decision has to be taken carefully.

4. Decisions in capital budgeting are not modifiable as it is hard to locate the market for capital goods. 5. The estimation can be in respect of cash outflow and the revenues/saving and costs attached which are with projects.

Capital Structure Meaning:- Capital structure presents the mix between different sources of finance basically long term sources of finance, eg. Equity, preference, debentures, bonds, retained earnings etc. The term capitalization is used for the total long term sources of finance. E. capital structure of the company consists of Rs. 100000.00 in equity, Rs. 100000.00 in preference shares, and Rs. 50000.00 in retained earnings. Capital Structure and Financial Structure:The term capital structure is different from financial structure. Financial structure refers to the ways the firms assets are financed. In other words it includes both long term as well as short term sources of funds. But capital structure is permanent financing of company represented primarily by long term debt and shareholders funds excluding short term credits. Pattern of capital structure:Basically there are 4 patterns of capital structure:1. 2. 3. 4. With equity shares only With both equity and preference shares only With equity and debentures With equity shares, preference shares and debentures.

The choice of an appropriate capital structure depends upon the number of factors such as nature of company, business, earning of the company, condition of money market, attitude of investor etc. Debt is the liability on business hence interest has to be paid irrespective of companies profit while equity consist of shareholders or owners funds on which payment of dividends depends upon the availability of profits.

A high proportion of debt content in capital structure increases the risk and may lead to financing insolvency. However raising funds through debt is considered as cheaper source of finance rather raising the funds through equity and preference shares. Reason for the same is interest on debentures is considered as an expense and deductable for tax purpose. Optimum Capital Structure:A firm try to maintain the optimum capital structure with a view to maintain financial stability, the optimum capital structure is maintained when the market value per equity share is maximum, in the value of the firm in stock exchange. Optimum structure is defined as that mix of debt and equity which will maximize the market value of the company. Considerations:Following are the considerations will greatly helps the finance manager in achieving his goals of optimum structure. 1. He should take advantage of favorable financial leverage. In the other words if Return on investment is higher than the fixed cost of funds, he may prefer raising funds having fixed cost to increase the return on equity. 2. He should take advantage of leverage offered by the corporate taxes. 3. He should avoid a perceived high risk capital structure because if the equity shareholders perceive an excessive amount on debt then the price of the equity will go down and depress the market price of the equity shares.

Capital Structure theories:Basically there are four theories of capital structure:1. 2. 3. 4. Net income approach Net operating income approach Modigilani-Millor approach Traditional Approach

Capital structure theories deal with the fact whether capital structure decisions are relevant to the valuation of firm or not. Assumptions:1. The firm employees only 2 types of capital

(a) (b) 2. 3. 4. 5. 6. 7. 8.

Debentures Equity There are no corporate taxes, this assumption has been removed later. The firm pays 100% of its earning as dividends. Firms total assets does not change, that is investment decisions are assumed to be constant. Firms total financing remains constant, the firm can change its capital structure either by redeeming the debentures by issue of shares or by raising more debentures. EBIT remains constant Business risk remains constant Firm has perpetual life.

NI Approach:Suggested by Durand David, According to him, capital structure decision is relevant to the valuation of the firm. In the other word change in capital structure causes a change in overall cost of capital as well as value of the firm. According to this approach higher debt content in the capital structure will result in decline in the overall cost of capital or WACC. This will cause increase in the market value of the firm and consequently increase in the value of equity shareholders. Assuptions:1. No taxes 2. Cost of Debt is less than the cost of equity rate 3. Use of debt does not change the risk perception of the investor. Value of the firm on the basis of NI approach can be ascertained as follows:V=S+B V= Value of the firm S= Market value of Equity shares B= Market value of the Debt So the market value of the equity is => S= NI/Ke Ke= equity capitalization rate

Net operating Income Approach:This approach is also suggested by Durand David, just opposite of NI approach. According to this approach the market value of the firm is not at all affected by the capital structure changes. Market value of the firm is ascertained by capitalizing net operating income at overall cost of capital which is considered as constant. The market value of equity is ascertained by deducting the market value of debt from the market value of the firm. Assumptions:1. Overall cost of capital remains constant. 2. Market capitalizes the value of the firm as a whole and therefore, the split between debt and equity is not relevant. 3. No corporate taxes 4. Use of debt increases the risk of equity shareholders. Value of the firm:=> V=EBIT/Ko S=V-B

Validity of NOI Appraoch can be verified by the calculations of the overall cost of capital Ko=Kd(B/V)+Ke(S/V) Ko= overall cost of capital Kd= cost of debentures/Debenture capitalization rate B= Total Debt S= Total Equity shares V= Value of the firm Ke= Equity capitalization rate

According to the NOI approach, the market price per share remains unaffected in account of change in debt equity mix.

MM Approach It is similar to NOI approach, according to this approach the value of the firm is independent of its capital structure. But NOI approach and MM approach is different from each other because NOI is purely definitional or conceptual based, it does not provide any operational justification for irrelevance of capital structure. But MM approach provides behavioral/ Operational justification. MM approach maintains that WACC does not change with the change in the debt equity mix or capital structure of the firm. It also gives operational justification of the same. Basic propositions:1. The overall cost of capital and the value of the firm are independent of the capital structure, hence Ko and V remains constant. 2. Ke= Equity capitalization rate + Premium for the financial risk. 3. The cut off rate for the investment is completely independent of the way in which an investment is completely independent of the way in which an investement is financed. Assumption:1. Perfect capital market 2. All firms are classified into homogeneous risk class. All firms with the same class will have the same degree of business risk. 3. All investors have same expectations of firms NOI. 4. Dividend payout ration is 100%, in the other word there is no retained earnings. 5. No Corporate taxes. MM approach provides behavioral justification which is the process of arbitration:Arbitration process:- it refers to the act of buying an asset/ Security in one market having lower price and selling it to another market having higher price. The consequence of such action is that the market price of securities of the two firms will become similar in all respects. The use of debt by investor for arbitrage is called home made or personal leverage. This can be understand with the help of example. Illustration:- Two firms A & B, are identical in all respect except that the firm A has 10% of Rs. 50000 debentures. Both firms have same earnings before intt and taxes amounted to Rs.

10000.00 and equity capitalization rate for firm A is 16% and for B is 12.5%, Calculate the total market value of each firm and explain the process of arbitrage. Solution:EBIT (-)intt Firm A 10000 5000 Firm B 10000 -

Earning for equity Ke Amount of equity shares(i) (Earnings/Ke) Mkt value of Debt(ii)

5000 16% 31250

10000 12.5% 80000


Value of the firm(i)+(ii)



Overall cost of capital EBIT/V

10000/81250 12.3%

10000/80000 12.5%

There is investor Mr. X who is having 10% share holdings in firm A I Mr. X position in firm A (a) Investment in equity=10%31250 =3125 (b) Dividend income:- 500 II Mr. X Position with Firm B (a) Investment in equity = 8000 (b) Dividend income = 1000

In order to make similar amount of risk, Mr X borrows Rs. 5000 with intt rate of 10% to equalize the impact of levered firm, so intt paid will be Rs.500.00

III Mr. X position with Firm B with overall investment in shares (a) Total investment (3125+5000)= 8125 (b) Total income (10000/80000)*8125 = 1016 Intt paid on loan= Income (-) 500

= Rs. 516.00

Hence Mr. X is now in better position, and this situation will continue till the market will be in equilibrium.

MM Hypothesis with Corporate Taxes If the corporate taxes are introduced, the value of the firm will increase and cost of capital will decline. This is tax deduction on intt payment because of which effective cost of borrowing is less than the contractual rate of intt. Vl= Vu + Bt Vl= Value levered firm Vu=Value of unlevered firm B= Amount of debt debt t = tax rate The optimum capital structure is not one which has maximum amount of debt. But one which has desired amount of debt. Vu= S Vu is market value of unlevered firm will be equal to the market value of its share. S= Market Value of equity Vu=(1-t)EBT/Ke

In case of unlevered firm there is no debt so EBIT means EBT, no intt on debt content.

Traditional approach:It is midway between NI and NOI approach, according to NI approach, the cost of capital and total value of the firm is dependent on capital structure, and according to NOI approach cost of capital and value of the firm is independent on capital structure. It particularly contains the features of both the approaches as given below:1) Traditional approach is similar to NI approach to the extent it accepts the capital structure or leverage of the firm affects the cost of capital and its valuation. However it does not subscribe to NI approach that the value of the firm will necessarily increase with the degree of leverage. 2) It subscribe to NOI approach that beyond a certain degree of leverage, the overall cost of capital increase resulting in decrease in total value of the firm, however it differs from NOI approach in the sense that the cost of capital will not remain constant for all degree of leverage.

The essence of the traditional approach lies in the fact that a firm through judicious use of debt equity mix can increase its total value and reduction in cost of capital. Debt is considered as cheaper source of finance as compared to shares because of tax advantage. However beyond a point raising of funds though debt may become financial risk and would result in higher equity capitalization rate. Up to a point, the content of debt in the capital structure will favorable affect the value of firm but beyond a point, the use of debt adversely affect the value of the firm.

Factors determining capital structure:-

1. Trading on equity:- if the rate of return(ROI) on total capital employed is more than the rate of intt on debentures or rate of dividend on preference shares, it is said that company is trading on equity. If the company is trading on equity then the funds can be raised by using the mix of debentures, preference shares and equity so that the company may be in position to pay higher rate of return on equity funds.


(a) only possible when company have trading on equity (b) Trading on equity is beneficial only when company have stability in their earnings. (c) Every rupee extra borrowing increases the risk and hence the rate of intt expected by the lenders goes on increasing. Thus, borrowing become costlier source of finance which ultimately result in increasing the cost and reducing the amount of profit. 2. Retaining Control:- As we know that preference shareholders and debenture holders have not much say in management of the company, if promoters that is equity shareholders need extra source of funds and they do not want to lose their grip over the affairs of the company they will prefer preference shares or debentures over the equity. 3. Nature of enterprise:- Business enterprise which have stability in their earnings or enjoy monopoly regarding their product may go for preference/debentures since they will have adequate profits to meet the cost of fixed dividend/ intt. Eg. Public utility concerns.

4. Legal requirements:- promoters of the company have also to keep in view the legal requirements while deciding capital structure. 5. Purpose of Financing:- if the funds are required for some directly productive purpose like for purchase of new machinery company can afford to raise the funds by issue of debentures on the other hands, if the funds are required for non productive purpose then the company should raise the funds by issue of equity shares.

6. Period of finance:- in case, funds are required for 8-10 years , company should go for debentures because in case the funds are issued by shares, their repayment after 8-10 years will be subject to certain legal restrictions/compliance. 7. Market sentiments:- there are the periods in which market where people want have absolute safety. It will be appropriate to raise funds through debenture. On the other hand when people may be intt in earning high speculative income, it will be appropriate to raise the funds by issue of equity shares.

8. Size of company:- Company with small size have to rely considerably upon the owners fund for financing . 9. Govt. Policies:- Change in lending policy of financial institution may completely change the financial pattern of the company. Policies made by SEBI, can afford the capital structure decisions. Besides this, the monetary and fiscal policies of the government also affect the capital structure decisions.

Capital structure practice in India:-

Several research and theories have been conducted regarding the choice of capital structure. These studies revealed the following:-

Capital structure and cost of capital:- Traditional view, that the cost of capital is affected by the debt and equity mix, still hold good. The study conducted by Sama and Roa and Pandey confirmed this viewpoint. Chakrabortys study also revealed the same facts. According to this study the average cost of capital for all consumer goods industry was highest while lowest for intermediary goods industry. This was primarily because of low debt content in total capital structure in case of former category of industry as compared to the latter.

Choice between Debt and equity:- the earlier studies conducted by Bhatt and Pandey revealed that corporate managers generally prefer borrowings to owned funds because of advantage of lower cost and no dilution of existing management control over the company, but recent study conducted by Babu and Jain, it has been found that the firms in India are now showing almost an

equal perforce for debt and equity in designing their capital structure. In the study conducted by RBI on the basis of sample of about 1950 non govt companies covering the period from 1984-88 to 1997-98, it was disclosed that the relevant share of internal sources tended to decline, while the external sources tended to move up in the total capital structure of the company. Among the external sources, corporates reliance or debt financing has been much more than equity financing. Thus the study conducted by RBI confirms the result of the study consutted by Babu and Jain.

Share valuation:- According to the study conducted by Prasanna Chandra, a significant relationship existed between the share price and the variables like return, risk, growth, leverage etc. Thus the leverage or the debt equity mix in the capital structure is also one of the important factor affecting the value of a share of the firm.

Determination of Optimum capital structure:-

It is already stated that at optimum capital structure, the value of equity share is maximum while the average cost of capital is minimum. The value of equity share mainly depends upon earning per share, so as long as ROI is more than the cost of borrowing, each rupee of extra borrowing pushes up the earning per share in turn pushes up the market value of the share. However each extra rupee borrowing increases the risk, therefore in spite of increasing EPS, Market Value of equity may fall because investors taking it as more risky investment.

Increase in the risk may increase the value of the companys equity shares, because of investors speculations in future profits. It will be impossible to precisely measure the fall in the market value of equity on account of high profit risk cause due to high debt content. Market factors are psychological, complex and do not follow accepted theoretical principals.

Thus it is not possible to find out the exact debt equity mix where the capital structure is optimum. However the range of capital structure can be determined. It simply means, if the company maintains capital structure with in this range, the value of the equity will not decline due to more risk. In order to maintain maximum tax advantage on intt payable the company may maintain debt equity ratio near the range keeping in view other factors like profitability, solvency, control etc.

Hence capital structure may arrived may not be optimum but it is preferable to use term Appropriate or sound capital structure.

Diversification Diversification strategies are used to expand firms' operations by adding markets, products, services, or stages of production to the existing business. The purpose of diversification is to allow the company to enter lines of business that are different from current operations. When the new venture is strategically related to the existing lines of business, it is called concentric diversification. Conglomerate diversification occurs when there is no common thread of strategic fit or relationship between the new and old lines of business; the new and old businesses are unrelated. DIVERSIFICATION IN THE CONTEXT OF GROWTH STRATEGIES Diversification is a form of growth strategy. Growth strategies involve a significant increase in performance objectives (usually sales or market share) beyond past levels of performance. Many organizations pursue one or more types of growth strategies. One of the primary reasons is the view held by many investors and executives that "bigger is better." Growth in sales is often used as a measure of performance. Even if profits remain stable or decline, an increase in sales satisfies many people. The assumption is often made that if sales increase, profits will eventually follow. Rewards for managers are usually greater when a firm is pursuing a growth strategy. Managers are often paid a commission based on sales. The higher the sales level, the larger the compensation received. Recognition and power also accrue to managers of growing companies. They are more frequently invited to speak to professional groups and are more often interviewed and written about by the press than are managers of companies with greater rates of return but slower rates of growth. Thus, growth companies also become better known and may be better able, to attract quality managers. Growth may also improve the effectiveness of the organization. Larger companies have a number of advantages over smaller firms operating in more limited markets. 1. Large size or large market share can lead to economies of scale. Marketing or production synergies may result from more efficient use of sales calls, reduced travel time, reduced changeover time, and longer production runs. 2. Learning and experience curve effects may produce lower costs as the firm gains experience in producing and distributing its product or service. Experience and large size may also lead to improved layout, gains in labor efficiency, redesign of products or





production processes, or larger and more qualified staff departments (e.g., marketing research or research and development). Lower average unit costs may result from a firm's ability to spread administrative expenses and other overhead costs over a larger unit volume. The more capital intensive a business is, the more important its ability to spread costs across a large volume becomes. Improved linkages with other stages of production can also result from large size. Better links with suppliers may be attained through large orders, which may produce lower costs (quantity discounts), improved delivery, or custom-made products that would be unaffordable for smaller operations. Links with distribution channels may lower costs by better location of warehouses, more efficient advertising, and shipping efficiencies. The size of the organization relative to its customers or suppliers influences its bargaining power and its ability to influence price and services provided. Sharing of information between units of a large firm allows knowledge gained in one business unit to be applied to problems being experienced in another unit. Especially for companies relying heavily on technology, the reduction of R&D costs and the time needed to develop new technology may give larger firms an advantage over smaller, more specialized firms. The more similar the activities are among units, the easier the transfer of information becomes. Taking advantage of geographic differences is possible for large firms. Especially for multinational firms, differences in wage rates, taxes, energy costs, shipping and freight charges, and trade restrictions influence the costs of business. A large firm can sometimes lower its cost of business by placing multiple plants in locations providing the lowest cost. Smaller firms with only one location must operate within the strengths and weaknesses of its single location.

CONCENTRIC DIVERSIFICATION Concentric diversification occurs when a firm adds related products or markets. The goal of such diversification is to achieve strategic fit. Strategic fit allows an organization to achieve synergy. In essence, synergy is the ability of two or more parts of an organization to achieve greater total effectiveness together than would be experienced if the efforts of the independent parts were summed. Synergy may be achieved by combining firms with complementary marketing, financial, operating, or management efforts. Breweries have been able to achieve marketing synergy through national advertising and distribution. By combining a number of regional breweries into a national network, beer producers have been able to produce and sell more beer than had independent regional breweries. Financial synergy may be obtained by combining a firm with strong financial resources but limited growth opportunities with a company having great market potential but weak financial resources. For example, debt-ridden companies may seek to acquire firms that are relatively debt-free to increase the lever-aged firm's borrowing capacity. Similarly, firms sometimes attempt to stabilize earnings by diversifying into businesses with different seasonal or cyclical sales patterns. Strategic fit in operations could result in synergy by the combination of operating units to improve overall efficiency. Combining two units so that duplicate equipment or research and

development are eliminated would improve overall efficiency. Quantity discounts through combined ordering would be another possible way to achieve operating synergy. Yet another way to improve efficiency is to diversify into an area that can use by-products from existing operations. For example, breweries have been able to convert grain, a by-product of the fermentation process, into feed for livestock. Management synergy can be achieved when management experience and expertise is applied to different situations. Perhaps a manager's experience in working with unions in one company could be applied to labor management problems in another company. Caution must be exercised, however, in assuming that management experience is universally transferable. Situations that appear similar may require significantly different management strategies. Personality clashes and other situational differences may make management synergy difficult to achieve. Although managerial skills and experience can be transferred, individual managers may not be able to make the transfer effectively. CONGLOMERATE DIVERSIFICATION Conglomerate diversification occurs when a firm diversifies into areas that are unrelated to its current line of business. Synergy may result through the application of management expertise or financial resources, but the primary purpose of conglomerate diversification is improved profitability of the acquiring firm. Little, if any, concern is given to achieving marketing or production synergy with conglomerate diversification. One of the most common reasons for pursuing a conglomerate growth strategy is that opportunities in a firm's current line of business are limited. Finding an attractive investment opportunity requires the firm to consider alternatives in other types of business. Philip Morris's acquisition of Miller Brewing was a conglomerate move. Products, markets, and production technologies of the brewery were quite different from those required to produce cigarettes. Firms may also pursue a conglomerate diversification strategy as a means of increasing the firm's growth rate. As discussed earlier, growth in sales may make the company more attractive to investors. Growth may also increase the power and prestige of the firm's executives. Conglomerate growth may be effective if the new area has growth opportunities greater than those available in the existing line of business. Probably the biggest disadvantage of a conglomerate diversification strategy is the increase in administrative problems associated with operating unrelated businesses. Managers from different divisions may have different backgrounds and may be unable to work together effectively. Competition between strategic business units for resources may entail shifting resources away from one division to another. Such a move may create rivalry and administrative problems between the units. Caution must also be exercised in entering businesses with seemingly promising opportunities, especially if the management team lacks experience or skill in the new line of business. Without some knowledge of the new industry, a firm may be unable to accurately evaluate the industry's potential. Even if the new business is initially successful, problems will eventually occur.

Executives from the conglomerate will have to become involved in the operations of the new enterprise at some point. Without adequate experience or skills (Management Synergy) the new business may become a poor performer. Without some form of strategic fit, the combined performance of the individual units will probably not exceed the performance of the units operating independently. In fact, combined performance may deteriorate because of controls placed on the individual units by the parent conglomerate. Decision-making may become slower due to longer review periods and complicated reporting systems. DIVERSIFICATION: GROW OR BUY? Diversification efforts may be either internal or external. Internal diversification occurs when a firm enters a different, but usually related, line of business by developing the new line of business itself. Internal diversification frequently involves expanding a firm's product or market base. External diversification may achieve the same result; however, the company enters a new area of business by purchasing another company or business unit. Mergers and acquisitions are common forms of external diversification. INTERNAL DIVERSIFICATION. One form of internal diversification is to market existing products in new markets. A firm may elect to broaden its geographic base to include new customers, either within its home country or in international markets. A business could also pursue an internal diversification strategy by finding new users for its current product. For example, Arm & Hammer marketed its baking soda as a refrigerator deodorizer. Finally, firms may attempt to change markets by increasing or decreasing the price of products to make them appeal to consumers of different income levels. Another form of internal diversification is to market new products in existing markets. Generally this strategy involves using existing channels of distribution to market new products. Retailers often change product lines to include new items that appear to have good market potential. Johnson & Johnson added a line of baby toys to its existing line of items for infants. Packagedfood firms have added salt-free or low-calorie options to existing product lines. It is also possible to have conglomerate growth through internal diversification. This strategy would entail marketing new and unrelated products to new markets. This strategy is the least used among the internal diversification strategies, as it is the most risky. It requires the company to enter a new market where it is not established. The firm is also developing and introducing a new product. Research and development costs, as well as advertising costs, will likely be higher than if existing products were marketed. In effect, the investment and the probability of failure are much greater when both the product and market are new. EXTERNAL DIVERSIFICATION. External diversification occurs when a firm looks outside of its current operations and buys access to new products or markets. Mergers are one common form of external diversification.

Mergers occur when two or more firms combine operations to form one corporation, perhaps with a new name. These firms are usually of similar size. One goal of a merger is to achieve management synergy by creating a stronger management team. This can be achieved in a merger by combining the management teams from the merged firms. Acquisitions, a second form of external growth, occur when the purchased corporation loses its identity. The acquiring company absorbs it. The acquired company and its assets may be absorbed into an existing business unit or remain intact as an independent subsidiary within the parent company. Acquisitions usually occur when a larger firm purchases a smaller company. Acquisitions are called friendly if the firm being purchased is receptive to the acquisition. (Mergers are usually "friendly.") Unfriendly mergers or hostile takeovers occur when the management of the firm targeted for acquisition resists being purchased. DIVERSIFICATION: VERTICAL OR HORIZONTAL? Diversification strategies can also be classified by the direction of the diversification. Vertical integration occurs when firms undertake operations at different stages of production. Involvement in the different stages of production can be developed inside the company (internal diversification) or by acquiring another firm (external diversification). Horizontal integration or diversification involves the firm moving into operations at the same stage of production. Vertical integration is usually related to existing operations and would be considered concentric diversification. Horizontal integration can be either a concentric or a conglomerate form of diversification. VERTICAL INTEGRATION. The steps that a product goes through in being transformed from raw materials to a finished product in the possession of the customer constitute the various stages of production. When a firm diversifies closer to the sources of raw materials in the stages of production, it is following a backward vertical integration strategy. Avon's primary line of business has been the selling of cosmetics door-to-door. Avon pursued a backward form of vertical integration by entering into the production of some of its cosmetics. Forward diversification occurs when firms move closer to the consumer in terms of the production stages. Levi Strauss & Co., traditionally a manufacturer of clothing, has diversified forward by opening retail stores to market its textile products rather than producing them and selling them to another firm to retail. Backward integration allows the diversifying firm to exercise more control over the quality of the supplies being purchased. Backward integration also may be undertaken to provide a more dependable source of needed raw materials. Forward integration allows a manufacturing company to assure itself of an outlet for its products. Forward integration also allows a firm more control over how its products are sold and serviced. Furthermore, a company may be better able to differentiate its products from those of its competitors by forward integration. By opening its own retail outlets, a firm is often better able to control and train the personnel selling and servicing its equipment.

Since servicing is an important part of many products, having an excellent service department may provide an integrated firm a competitive advantage over firms that are strictly manufacturers. Some firms employ vertical integration strategies to eliminate the "profits of the middleman." Firms are sometimes able to efficiently execute the tasks being performed by the middleman (wholesalers, retailers) and receive additional profits. However, middlemen receive their income by being competent at providing a service. Unless a firm is equally efficient in providing that service, the firm will have a smaller profit margin than the middleman. If a firm is too inefficient, customers may refuse to work with the firm, resulting in lost sales. Vertical integration strategies have one major disadvantage. A vertically integrated firm places "all of its eggs in one basket." If demand for the product falls, essential supplies are not available, or a substitute product displaces the product in the marketplace, the earnings of the entire organization may suffer. HORIZONTAL DIVERSIFICATION. Horizontal integration occurs when a firm enters a new business (either related or unrelated) at the same stage of production as its current operations. For example, Avon's move to market jewelry through its door-to-door sales force involved marketing new products through existing channels of distribution. An alternative form of horizontal integration that Avon has also undertaken is selling its products by mail order (e.g., clothing, plastic products) and through retail stores (e.g., Tiffany's). In both cases, Avon is still at the retail stage of the production process. DIVERSIFICATION STRATEGY AND MANAGEMENT TEAMS As documented in a study by Marlin, Lamont, and Geiger, ensuring a firm's diversification strategy is well matched to the strengths of its top management team members factored into the success of that strategy. For example, the success of a merger may depend not only on how integrated the joining firms become, but also on how well suited top executives are to manage that effort. The study also suggests that different diversification strategies (concentric vs. conglomerate) require different skills on the part of a company's top managers, and that the factors should be taken into consideration before firms are joined. There are many reasons for pursuing a diversification strategy, but most pertain to management's desire for the organization to grow. Companies must decide whether they want to diversify by going into related or unrelated businesses. They must then decide whether they want to expand by developing the new business or by buying an ongoing business. Finally, management must decide at what stage in the production process they wish to diversify. 2. DIVERSIFICATION DEBATE To diversify or not to diversify? For corporations in pursuit of a sound acquisitions strategy, this is indeed the eternal question. Traditional wisdom holds that diversification offers protection

against the vagaries of the business cycle. But throughout the mergers-and-acquisitions boom of the 1990s, the business cycle seemed to have disappeared and a relentless focus on core competencies was all the rage. Diversify if you must, the markets urged, but only if you can demonstrate synergies between businesses as you do so. Few companies mastered this feat as well as The Walt Disney Co., whose move into television broadcasting made it the very model of a synergistic conglomerate. Of course, such companies used to be called vertically integrated, and everyone who has forgotten the risks inherent in such structures could learn a lesson from Disney's recent troubles in the capital markets. These days, diversification is back in favor. But as with "synergies," the advantages of diversifying aren't always what they seem, especially in the wake of September 11. To be sure, Disney managed to raise $1 billion in two- and three-year notes the first day the markets reopened after the attacks. But roughly $200 million of the debt was initially left in the hands of Goldman Sachs, which underwrote all but 3 percent of the deal. Not surprisingly, some three weeks later, Disney enlisted the help of nine underwriters besides Goldman to raise another $830 million in yen-denominated medium-term notes, and in mid-October used six banks for $275 million in 30-year bonds aimed at individuals. The more underwriters an issuer needs, of course, the more it pays in fees. And Disney's capital requirements remain considerable: It must finance the acquisition of Fox Family Worldwide, a cable TV operation, for $5.2 billion in cash and assumed debt. Yet even before the terrorist attacks, Disney's two most important business segments, theme parks and television advertising, were suffering. And while the prospects of both have since shown some improvement, Disney's difficulties have nonetheless led to its first credit downgrades since 1996, when it borrowed heavily to finance the acquisition of Capital Cities/ABC. "Most investors thought Disney was well diversified," notes Glenn Eckert, a senior analyst for Moody's Investors Service. But he says the attacks, along with the economic downturn, have revealed how closely correlated the travel and entertainment businesses can be. Yet anyone who took Disney's own discussions of its strategy seriously shouldn't have been surprised, as success was predicated on each of its business segments, in effect, feeding the others. CFO Thomas Staggs recently told Bloomberg News Service that the company was comfortable with its balance sheet and liquidity

Portfolio Planning Models Portfolio planning tools have been developed to guide the process of strategic planning and resource allocation . Three such tools are : BCG Matrix The General Electric Stoplight matrix & The Mckinsey matrix

BCG MATRIX Developed by Boston Consulting Group , the BCG matrix classifies the various businesses in a firm portfolio on the basis of relative market share and relative market growth rate . The BCG matrix consists of four cells with market share on horizontal axis and market growth rate on the vertical axis .

The BCG matrix classifies businesses in four categories as described below : Stars : Business which enjoy a high market share and high growth rate are referred to as stars. Though they earn high profits , they require additional commitment of funds because of the need to make further investment for expanding their production and sales .As growth declines and additional investment need diminish stars become cash cows . Question Marks : Business with high growth potential but low present market share are called question marks . Additional resources are required to improve their market share

and potentially convert them into stars . There is no guarantee that this would happen - tat is why they are called question marks . Cash Cows : Business which enjoy relatively high market share but low growth are called cash cows . They generate substantial profits and cash flows but their investment requirement are modest . The cash surplus provided them are available for use elsewhere in the business. Dogs : Business with low market share and limited growth potential are referred to as dogs . Since the prospects for such products are bleak , it is advisable to phase them out rather continue with them. From the above description it is broadly clear that cash cows generate funds and dogs if divested release funds . On the other hand , stars and question mark require further commitment of funds . GENERAL ELECTRIC STOPLIGT MATRIX The General Electric company is highly admired for the sophistication , maturity and quality of its planning system . It uses 3*3 matrix called the General Electric's Stoplight Matrix to guide the allocation of resources . This matrix calls for evaluating the business of a firm in two key issues : Business strength Industry Attractiveness

The commitment of resources to various business is guided by how they are related in terms of above two dimensions . MCKINSEY MATRIX Mckinsey Matrix very much similar to General Electric Matrix , the Mckinsey Matrix has two dimensins viz ., competitive position and industry attractiveness . The criteria or factors used for judging industry attractiveness and competitive position along with suggested weighs for them.

Sources of Long-term Finance A business requires funds to purchase fixed assets like land and building,plant and machinery, furniture etc. These assets may be regarded as the foundation of a business. The capital required for these assets is called fixed capital. A part of the working capital is also of a permanent nature. Funds required for this part of the working capital and for fixed capital is called long term finance. Purpose of long term finance: Long term finance is required for the following purposes:

1. To Finance fixed assets : Business requires fixed assets like machines, Building, furniture etc. Finance required to buy these assets is for a long period, because such assets can be used for a long period and are not for resale. 2. To finance the permanent part of working capital: Business is a continuing activity. It must have a certain amount of working capital which would be needed again and again. This part of working capital is of a fixed or permanent nature. This requirement is also met from long term funds. 3. To finance growth and expansion of business: Expansion of business requires investment of a huge amount of capital permanently or for a long period. Factors determining long-term financial requirements : The amount required to meet the long term capital needs of a company depend upon many factors. These are : (a) Nature of Business: The nature and character of a business determines the amount of fixed capital. A manufacturing company requires land, building, machines etc. So it has to invest a large amount of capital for a long period. But a trading concern dealing in, say, washing machines will require a smaller amount of long term fund because it does not have to buy building or machines. (b) Nature of goods produced: If a business is engaged in manufacturing small and simple articles it will require a smaller amount of fixed capital as compared to one manufacturing heavy machines or heavy consumer items like cars, refrigerators etc. which will require more fixed capital. (c) Technology used: In heavy industries like steel the fixed capital investment is larger than in the case of a business producing plastic jars using simple technology or producing goods using labour intensive technique. The main sources of long term finance are as follows: 1. Shares: These are issued to the general public. These may be of two types: (i) Equity and (ii) Preference. The holders of shares are the owners of the business. 2. Debentures: These are also issued to the general public. The holders of debentures are the creditors of the company. 3. Public Deposits : General public also like to deposit their savings with a popular and well established company which can pay interest periodically and pay-back the deposit when due.

It is a very old source of finance in India. When modern banks were not there, people used to deposit their savings with business concerns of good repute. Even today it is a very popular and convenient method of raising medium term finance. The period for which business undertakings accept public deposits ranges between six months to three years. 4. Retained earnings: The company may not distribute the whole of its profits among its shareholders. It may retain a part of the profits and utilize it as capital. 5. Term loans from banks: Many industrial development banks, cooperative banks and commercial banks grant medium term loans for a period of three to five years. The merits of long-term borrowing from banks are as follows: 1. It is a flexible source of finance as loans can be repaid when the need is met. 2. Finance is available for a definite period, hence it is not a permanent burden. 3. Banks keep the financial operations of their clients secret. 4. Less time and cost is involved as compared to issue of shares, debentures etc. 6. Loan from financial institutions: There are many specialised financial institutions established by the Central and State governments which give long term loans at reasonable rate of interest. Some of these institutions are: Industrial Finance Corporation of India ( IFCI), Industrial Development Bank of India (IDBI), Industrial Credit and Investment Corporation of India (ICICI), Unit Trust of India ( UTI ), State Finance Corporations etc

'Venture Capital' Money provided by investors to startup firms and small businesses with perceived long-term growth potential. This is a very important source of funding for startups that do not have access to capital markets. It typically entails high risk for the investor, but it has the potential for aboveaverage returns. Venture capital can also include managerial and technical expertise. Most venture capital comes from a group of wealthy investors, investment banks and other financial institutions that pool such investments or partnerships. This form of raising capital is popular among new companies or ventures with limited operating history, which cannot raise funds by issuing debt. The downside for entrepreneurs is that venture capitalists usually get a say in company decisions, in addition to a portion of the equity.

The venture capital recognises different stages of financing, namely:

Early stage financing - This is the first stage financing when the firm is undertaking production and need additional funds for selling its products. It involves seed/ initial

finance for supporting a concept or idea of an entrepreneur. The capital is provided for product development, R&D and initial marketing.

Expansion financing - This is the second stage financing for working capital and expansion of a business. It involves development financing so as to facilitate the public issue. Acquisition/ buyout financing - This later stage involves:i. Acquisition financing in order to acquire another firm for further growth

ii. iii.

Management buyout financing so as to enable the operating groups/ investors for acquiring an existing product line or business and Turnaround financing in order to revitalise and revive the sick enterprises.

In India, the venture capital funds (VCFs) can be categorised into the following groups:

Those promoted by the Central Government controlled development finance institutions, for example:

ICICI Venture Funds Ltd. IFCI Venture Capital Funds Limited (IVCF) SIDBI Venture Capital Limited (SVCL)

Those promoted by State Government controlled development finance institutions, for example:

Gujarat Venture Finance Limited (GVFL) Kerala Venture Capital Fund Pvt Ltd. Punjab Infotech Venture Fund Hyderabad Information Technology Venture Enterprises Limited (HITVEL)

Those promoted by public banks, for example:

Canbank Venture Capital Fund SBI Capital Markets Limited

Those promoted by private sector companies, for example:

IL&FS Trust Company Limited Infinity Venture India Fund

Those established as an overseas venture capital fund, for example:-

Walden International Investment Group SEAF India Investment & Growth Fund BTS India Private Equity Fund Limited

All these venture capital funds are governed by the Securities and Exchange Board of India (SEBI) . SEBI is the nodal agency for registration and regulation of both domestic and overseas venture capital funds. Accordingly, it has made the following regulations, namely, Securities and Exchange Board of India (Venture Capital Funds) Regulations 1996 and Securities and Exchange Board of India (Foreign Venture Capital Investors) Regulations 2000. These regulations provide broad guidelines and procedures for establishment of venture capital funds both within India and outside it; their management structure and set up; as well as size and investment criteria's of the funds. Profit-and-Loss Projection Projection of your sales and expenses is the first step toward creating a cash flow budget that your business can rely on. This profit and loss (P&L) projection is not intended to be a detailed financial statement. It is intended to act as a guide to help you forecast your company's sales and expenses. The categories on the projection work sheet are arbitrary and should be changed to reflect your company's operations. After you've completed this projection, you may wish to create a more detailed P&L projection that reflects your business's sales and expenses on a monthly or quarterly basis. How to use this projection: Here are four steps to creating a P&L projection using this tool: 1. Forecast sales: During the course of the next year, what are the lowest sales figures you could expect? What are the highest? Break down your sales assumptions by product (or service) lines, starting with the worst-case scenario. The product/service lines are placeholders where you can insert products or services that reflect your business's operations. The goal here is to get a handle on the worst possible situation. Then project sales under the best possible conditions, with all of your sales efforts succeeding and customers flocking to your door. Once you've forecasted sales, record a forecast for the cost of goods sold. Use the categories you've assigned to the sales forecast here, as well.

2. Forecast expenses: Identify all of the expenses that you'll incur to generate revenue under both the low and high sales projections you've made. Unless your company is a start-up, you should review past operating statement and business records to derive this information. Costs that, whatever your sales level, are present and remain fairly constant should be entered as fixed expenses. They may include such expenses as rent/mortgage payments,

certain taxes, leased equipment payments, and basic telephone and utilities expenses. Expenses that increase and decrease with production are considered variable expenses. They may include cost of goods sold, cost of sales, advertising, labor, and variable utilities. Fixed expenses will most likely remain the same for best- and worst-case situations. When projecting variable expenses, many expenses will remain a constant percentage of sales, but some will not. Payroll and payroll taxes may fluctuate as new hires are brought on to keep up with demand. Or advertising expenses may increase if you try to take over more market share. If you're confused whether an expense is fixed or variable, try considering it a fixed expense; that will force you to create a conservative forecast. 3. Compare and review "best" and "worst": Now that you've recorded both scenarios, create a "most likely" scenario by comparing the two. With this method, you will produce a more realistic forecast upon which you can make decisions. 4. Look at your profit level: Now total your scenarios to discover your profit before depreciation. You will have three potential profit figures: one low, one high, and one that is most likely. Next, calculate the depreciation of your fixed assets. (Depreciation involves the amortization of the cost of fixed assets over time. Check with your accountant for more details.) Now discover your net profit before income taxes. Subtract "depreciation" from "profit before depreciation and income taxes" to arrive at your net profit before income taxes.