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Capital

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Department of MBA

Salem 10

Subject: Financial Management

Topic: capital budgeting and its nature

Unit: 02

Hour: 01

CAPITAL BUDGETING

Dictionary

Meaning:

Budget:

DEFINITION:

Financial

Capital Budgeting is long term planning for making and financing proposed capital

plan

outlay.

- Charles T Hongreen

Capital Budgeting consists in planning for development of available capital for the

purpose of maximizing the long-term profitability of the firm

Key Words:

-R. M. Lynch

MEANING:

Capital Budgeting:

Capital budgeting is the process of evaluating and selecting long term

investments that are consistent with the goal of shareholders wealth maximization.

of capital or commitment of funds to long-term assets that would yield benefits in

the future.

Capital Budgeting decision relates to the choice of the new asset out of the

alternatives available or the reallocation of capital when an existing asset fails to

justify the funds committed

Capital

budgeting is

the process

of evaluating

and selecting

long term

investments

Teaching

Aid:

CB

Capital Expenditure:

Capital expenditure is an outlay of funds that is expected to produce benefits

over a period of time exceeding one year. These benefits may be either in the form of

increased revenues or reduced costs. Capital expenditure management includes

disposition, modification and replacement of fixed assets.

CAPITAL BUDGETING PROCESS OR STEPS INVOLVED IN CAPITAL

BUDGETING:

1. Idea Generation:

Generating the proposals for investment is the first process of capital budgeting.

For an ongoing business concern, investment proposals of various types may

originate at different levels within a firm.

The investment proposal may fall into one of the following categories:

Proposals to add new product to the product line, and

Proposal to expand production capacity in existing product lines.

Proposals to reduce the costs of the output of the existing products without altering

the scale of operation.

25

Books

Referred:

Financial

managemen

t I.M.

Pandey

2. Project Evaluation:

Project evaluation involves two steps:

Estimation of benefits and costs

Selection of an appropriate criterion to judge the desirability of the project.

The benefits and costs of the project are measured in terms of cash flows.

The estimation of the cash inflows and cash outflows mainly depends on future

uncertainties.

The risk associated with each project must be carefully analyzed from the aspects

like marketing, technical, financial and economic.

3. Project selection:

No standard administrative procedure can be laid down for approving the

investment proposal.

The screening and selection procedures are different from firm to firm.

In a real life situation all capital budgeting decisions are made by top management.

However the projects can scientifically be screened by middle level management in

consulting with the head of the finance department.

4. Financing the selected project:

After the selection of the project, the next step is financing. Financing

arrangements have to be made.

There are two broad sources available such as equity and debt. While deciding the

capital structure, the decision maker has to keep in mind some factors, which

influence capital structure.

The factors are flexibility, risk, income, control and tax benefit.

5. Execution or implementation:

Planning is paper work and implementation is physically implementing the selected

project.

Implementation of an industrial project involves the stages like engineering

designs, negotiations and contracting, construction, training and plant

commissioning.

Translating an investment proposal from paper work to concrete work is complex,

time consuming and a risky task.

6. Review of the project:

Once the project is converted from paper work into concrete work, then there is a

need to review the project.

Performance review should be done periodically, in which phase the actual

performance is compared with the pre-determined performance

26

TYPES OF CAPITAL INVESTMENT DECISIONS

TYPES

BASED ON NATURES

DECISION

1. Mutually Exclusive

Decision

2. Accept Reject

Decision

3. Capital Rationing

Decision

BASED ON FIRMS

EXISTENCE

Revenue

Expansion

Decision

Cost Reduction

Decision

1. Expansion

decision

1. Replacement

Decision

2. Diversification

2. Modernization

Decision

Decision

1. Mutually Exclusive Decisions:

Decisions are said to be mutually exclusive if two (or) more alternative proposals

are such that the acceptance of one proposal will exclude acceptance of the other

alternative proposals. For example, a company is intending to buy a new machine. There

are three competing brands, each with a different initial investment and operating costs. All

these machines compared and select the best among the alternatives. The mutually

exclusive project decisions are not independent.

2. Accept-Reject Decisions:

These are opposite to mutually exclusive decisions. The Accept-Reject

decisions occur when proposals are independent and do not complete with each other. The

firm may accept (or) reject a proposal on the basis of a minimum return on the required

investment. All proposals that give a return higher than a certain desired rate are accepted

and the rest are rejected.

3. Capital Rationing Decision:

In a situation the firm has unlimited funds, all independent investment proposals yielding

return greater than some pre-determined level are accepted. However, this situation does

27

not prevail in most of the business firms in actual practice. They have a fixed capital

budget. A large number of investment proposal compete for these limited funds. The firm

must therefore ration them. The firm allocates funds to projects in a manner that it

maximises long run returns. Capital rationing employs ranking of the acceptable

investment projects. The projects can be ranked on the basis of pre-determined criterion

such as the rate of return.

1. Cost Reduction Decisions:

These Decisions focus on reduction of operating cost and improving efficiency.

They can be sub classified into:

a. Replacement Decisions: To Replace an existing asset with a new and improved one

which version to choose etc.,

b. Modernization Decisions:To install new machinery in the place of an old one, which

has become technologically outdated

2. Revenue Technologically Outdated:

These Decisions focus on improving sales, product lines, improved versions of

products, etc., These are sub classified into:

a. Expansion Decision: To add capacity to existing product lines to meet increased

demand, to improve production facilities and to increase market share or existing products.

b. Diversification Decision: To diversify and enter into new product lines, venture into

new markets, to reduce business risk by dealing in different products and operating in

different markets.

Possible Questions & University Questions:

1. What is capital budgeting or define capital budgeting?

2. What is capital expenditure?

3. Explain the nature of capital budgeting decision.

4. Explain capital budgeting process or steps involved in capital budgeting.

Department of MBA

Salem 10

Subject: Financial Management

Topic: Identifying relevant cash flows

Unit: 02

Hour: 02

Capital budgeting is concerned with investment decisions which yield return over a period

of time in future. The foremost requirement for evaluation of any capital investment

28

(i)

(ii)

Cash flows.

Dictionary

The basic difference between them primarily due to the inclusion of certain non- Meaning:

cash expenses in the profit and loss account. Example: depreciation. Therefore, the

accounting profit is to be adjusted for non-cash expenditure to determine the actual cash

inflow. The cash flow approach of measuring future benefits of a project is superior to the

accounting approach as cash flows are theoretically better measures of the net economic

benefits of cost associated with a proposed project.

Elements of Cash flow Stream

To evaluate a project, one must determine the relevant cash flows, which art the

incremental after-tax cash flows associated with the project. The cash flow stream of a Key Words:

conventional project - a project which involves cash outflows followed by cash inflowscomprises three basic components:

Teaching

Aid:

1. Initial Investment: The initial investment is the after-tax cash outlay on capital

CB

expenditure and net working capital when the project is set-up. In general, the

initial cash outflow for a project is determined. As seen, the cost of the asset is

subject to adjustments to reflect the totality of cash flows associated with its

acquisition. These cash flows include installation costs, changes in net working

capital, sale proceeds from the disposition of any assets replaced, and tax

Books

adjustments.

Referred

2. Operating Cash Inflows: They are after tax cash inflows resulting from the

operations of the projects during its economic life. After making the initial cash

outflow that is necessary to being implementing a project, the firm hopes to benefit

from the future cash inflows generated by the projects. Generally, these future cash

flows can be determined by following the step-by-step procedure outline.

3. Terminal Cash Inflow: The terminal cash inflow is the after tax cash flow

resulting from the liquidation of the project at the end of its economic life. Finally,

turned attention to determine the project incremental cash flow in its final, or

terminal, year of existence. The apply the same step-by-step procedure for this

periods cash flow as we did to those in all the interim periods. These potential

project wind-up cash flows are:

The salvage value

Taxes

Any project termination related change in working capital

29

1. Identify Incremental Cash flows:

Incremental cash flows are the changes in cash flows that are attributable to

the decision to invest in a given project. Cash flows not attributable to a new project are

irrelevant to the investment decision-making process. When a firm decides whether to

replace an old machine with a new, more efficient one, the relevant cash flows consist of

those generated by the new machine less those that would have been retained by keeping

the old machine.

The decision should hinge on the differences in cash flows between the two

machines. Favourable incremental net cash flows resulting from making the decision will

provide the relevant data needed to make the decision. Although the principle of

incremental analysis is a simple idea, applying it in practice is often difficult.

2. Focus on After-Tax Flows:

The only cash flows relevant to capital budgeting are those generated by a

project and still remaining after paying taxes. This is true for all phases of a project's life.

Considering a project's untaxed revenues overstates its benefit because the firm cannot

invest all these funds in other projects or pay them out to shareholders. Some more

common tax provisions influencing cash flows involve depreciation expense as well as

gains and losses from the sale of existing fixed assets.

3. Postpone Considering Financing Costs:

A common mistake in estimating cash flows involves the treatment of interest

expense and other financial cash flows attributable to financing the project. Financing

costs are payments that the company makes to the parties supplying capital to finance the

project. These costs may include interest paid to lenders or dividends paid to shareholders.

As a general principle, capital budgeting analyses require separating investment (capital

budgeting) and financing decisions, i.e., analysts should evaluate a capital budgeting

project independently of the source of funds used to finance' the project.

4. Net Operating Working Capital:

Adopting a project may require a change in a firm's Net Operating Working

Capital (NOWC), which is the change in all current assets that do not pay interest less the

change in all current liabilities that do not charge interest. For example, a project that

entails producing and selling a new product will probably require the firm to increase its

inventories and to hold more cash to conduct additional transactions

5. Sunk Costs: A sunk cost is an outlay incurred before making an investment

decision and represents a historical cost. Past expenditures on a project should not

influence the decision whether to undertake, continue, or end a project because

they are not incremental cash flows. Instead, decision-makers should base their

decision on future costs and benefits. Sunk costs are irrelevant because the decision

to adopt or reject the proposed project will not result in any change in the project's

cash flows related to these costs, the firm has already incurred the sunk cost with or

without the project. Because these sunk costs are irrevocable and have no bearing

30

on a new project, they are not incremental cash flows. Thus, sunk costs are not part

of the evaluation process.

6. Opportunity Costs:

Estimating project cash flows requires considering both direct outlays and opportunity

costs. An opportunity cost is the most valuable alternative use of a resource or an asset

that the firm gives up by accepting a project. By using the asset or resource in the

proposed project, the firm forgoes the opportunity to employ the asset in its alternative

use. The cash flows that the firm forgoes represent an opportunity cost to the proposed

project. Opportunity cost can be difficult to estimate, but they are important to

recognize when estimating the relevant cash flows for analyzing a project.

7. Allocated Overhead:

For internal reporting purposes, accountants often allocate existing overhead, such as

general and administrative expenses, to each unit or division that undertakes a project,

However, if the firm's current overhead will remain unchanged by accepting a project,

the firm should exclude this allocated overhead from the project's cash flows in the

capital budgeting analysis. Here, overhead is an existing (fixed) cost, not an

incremental cost. Managers should recognize only an increase in overhead that will

result from accepting the project, such as hiring a new accountant, as part of a project's

cash flows.

8. Side Effects: Adopting and implementing new projects may have important side

effects because they affect the cash flows of other products or divisions. Project

planners should consider these potential side effects, or externalities, in the capital

budgeting analysis for the project. Side effects are complements if they enhance the

cash flows of existing assets and substitutes if the effect is negative.

BIASES IN CASH FLOW ESTIMATION.

As cash flows have to be forecasted far into the future, errors in estimation are bound to

occur. Yet, given the critical importance of cash flow forecasts in project evaluation,

adequate care should be taken to guard against certain biases which may lead to overstatement or under-statement of true project profitability.

1) Overstatement of Profitability: Knowledgeable observers of capital budgeting

believe that profitability is often over-stated because the initial investment is underestimated and the operating cash inflows are exaggerated. The principal reasons for

such optimistic bias appear to be as follows:

i.

proj.ect sponsors may intentionally over-estimate the benefits and under-estimate

the costs. Given the uncertainties characterizing the future, project sponsors enjoy

some latitude in twisting the figures the way they want.

ii.

generally leads overoptimistic estimates. Experience often induces conservatism

that checks over-optimistic tendencies. Inexperience, on the other hand, may lead

to wishful thinking.

iii.

too involved and lose their sense of proportion. The lack of objectivity In this case

31

is neither intentional nor due to inexperience. It may simply be the effect of 'masspsychology' as each person's favorable opinion may be reinforced and magnified

by others in the group. Referred to as "risky shift" or "group polarization effect" in

social psychology, this phenomenon is widely supported by empirical studies.

iv.

maybe externally determined or internally imposed. An awareness of such

constraint induces project sponsors to exaggerate the benefits of projects proposed

by them. After all every sponsor is keen that his proposal finds a place in the

limited capital budget when there is competition among various claimants.

over-statement of project cash flows and profitability. There can be an opposite kind of

bias relating to the terminal benefit which may depress a project's true profitability. To

understand this bias let us look at how the terminal cash flow is estimated in practice.

Typically it is defined as:

Net salvage value of fixed assets + Net recovery of working capital margin.

Generally, the net salvage value of fixed assets is put equal to five per cent of the

original cost and the net recovery of working capital margin is set equal to its original

book value (under the assumption that current assets do not depreciate).

The above approach almost invariably leads to under-estimation of the terminal benefit of

the project, due to the following reasons:

i.

Salvage Values are Under-Estimated: To put the net salvage value of fixed assets

equal to just five per cent (which may more or less correspond to the book value

after 8 to 10 years) of the original cost is to ignore the fact that in real life situations

fixed assets, ever after 8 to 10 years of use, generally command a substantial

market value.

ii.

Intangible Benefits are ignored: The terminal benefits from a project cannot be

equated with just the salvage values of tangible. assets left in the project; Apart

from investment in tangible assets for which salvage values can be estimated more

easily (taking into account the factors mentioned above) major projects -are

designed to establish a market position, perfect research and engineering capability,

develop a distribution network, and build brand loyalty. To assume that these

benefits are worthless beyond an arbitrarily chosen time horizon is to overlook

important business realities. These benefits should not be ignored just because it is

difficult to quantify them.

iii Value of Future Options is Over looked: More often than not, a project has a

strategic pay-off in the form of new investment opportunities that may possibly open-up if

the project is undertaken.

Possible Questions & University Questions:

1. Identify the relevant cash flow stream.

2. What are the guidelines to estimate the project cash flow?

32

Department of MBA

Salem 10

Subject: Financial Management

Topic: Methods and Techniques

Unit: 02

Hour: 3

EVALUATION OF INVESTMENT:

Three steps are involved in the evaluation of an investment.

Estimation of the required rate of returns.

Application of a decision rule for making the choice.

1.

2.

3.

4.

5.

Ranking of projects in order of their desirability.

Choosing among several alternatives.

A criterion which is applicable to any conceivable project.

Recognizing the fact that bigger benefits are preferable to smaller ones and early

benefits are preferable to later one.

Dictionary

Meaning:

Reciprocal:

Give and take

Equal

Mutual

Joint

Shared

Key Words:

Among the various methods, the following are commonly used by many business

concerns:

Pay-back

period may be

Traditional (or) non time value method (or) non discounted.

defined as the

Pay-back period

period of time.

Improvement of Traditional Approach to Pay-back period method

i.e. the number

Post Pay-back Profitability method

of years

Discounted Pay-back period

required for

Reciprocal Pay-back period method

cash inflow to

get back the

Average / Accounting Rate of Return.

original cost of

Discounted cash flow methods/time adjusted methods/present value method.

the project

Net present value

Profitability index.

Internal rate of return

Teaching Aid:

CB

I. Traditional Method:

1) Payback method:

The payback period refers to the length of time which will be required for the sum

of annual net cash benefits to equal the initial investment.

Books

Referred with

33

Pay-back period may be defined as the period of time. i.e. the number of years page number:

required for cash inflow to get back the original cost of the project. According to this

method, every capital expenditure pays itself back over a number of years. This method is Financial

management

also known as pay off period, break even period (or) Recoupment period.

M.Y. Khan and

Computation of the pay-back period:

P.K. Jain

(a) When annual inflows are equal:

When the cash inflows being generated by a proposal are equal per time period i.e.,

the cash inflow are in the form are annual, the pay-back period can be computed by

dividing the cash outflows by the amount of annuity.

Initial Investment

Payback period = --------------------------Annual cash inflow

Annual cash inflow is the net income from the project (or) assets after tax but

before depreciation.

(b) When annual inflows are unequal:

In case the cash inflows from the proposal are not in annuity form then the

cumulative cash flows are used to compute the payback period.

In such a case, payback period is computed by the process of cumulating

cash inflows till the time when cumulative cash inflows becomes equal to the original

investment outlay. In the formula form:

Payback period = E + B/C

E No. of years immediately proceeding the year of recovery.

B Balance of amount of Investment to be recovered.

C Savings (Cash inflow) during the year of final recovery.

If the Actual pay-back period is less than the standard pay-back period, the project

would be accepted, if not, it would be rejected.

When mutually exclusive projects are under consideration, they may be ranked

according to the length of the payback period. Thus, the project having the shortest

pay-back may be assigned rank one, following in that order so that the project with the

longer pay-back would be the lowest.

1. When the cost of the project is small.

34

2.

3.

4.

5.

When the project goes for immediate production.

When the promoter thinks that competition may damage the prospects of the concern.

When the promoter considers that the industry may face technological competition and

problem of obsolescence.

6. When the project lacks long term stability.

Merits:

Selection or rejection of the project can be made easily

The result obtained under this method is more reliable.

It is the best method for evaluating high-risk projects

Demerits:

It does not recognize the importance of time value of money.

It does not consider the profitability of economic life of the project.

It does not recognize the pattern of cash flows and its timing.

Pay-back period concept does not reflect all the relevant dimensions of profitability.

1A) Pay-back profitability Method or Post Pay-back Profitability Method:

Under this method, the cash inflow generated from a project during the economic

life is taken into account whereas in pay-back period the cash inflows were considered

only to the extent of recovering the original investment. But in the practical situation, after

the pay-back period, a project or a machine is still capable of generating cash inflows.

Therefore, to evaluate the project the entire amount of earnings or cash inflows must be

considered.

Computations of post pay-back profitability:

Total cash inflow generated during the economic life of a project

xxxxx

xxxxx

xxxxx

Merits:

Less time consuming

It is easy to follow and even a non-finance executive can also understand the concept.

It takes into account the earnings of the project of entire life.

Demerits:

It doesnt consider the impact of time value of money.

35

It ignores depreciation.

This method is also designed to overcome the limitations of the pay-back period

method. When savings are not leveled, it is better to calculate the pay-back period by

taking into consideration the present value of cash inflows. Discounted pay-back method

helps to measure the present value of all cash inflows and outflows at an appropriate

discount rate.

The time period at which the cumulated present value of cash inflows equals the

present value of cash outflows is known as discounted pay-back period. This method takes

into account both the interest factor as well as the return after pay-back period.

1C) Reciprocal pay-back period method

This method helps to measure the expected rate of return of income generate by a

project. Pay-back reciprocal is exactly equal to the unadjusted rate of return. Unadjusted

rate means a rate which has not been adjusted by taking into account the time value of

money. It is useful where the flows are relatively consistent and the life of the asset is at

least double the payback period. If the pay-back period is same as the life of the asset, the

reciprocal would be one. This can be calculated by the following formula:

Reciprocal Pay-back period = ---------------------------------- x 100

Total Investment

Possible Questions & University Questions:

1. Explain the traditional method of evaluating investment decision.

2. Explain pay-back period method in appraising capital budget.

Department of MBA

Salem 10

Subject: Financial Management

Topic: Accounting rate of return

Unit: 02

Hour: 04

Accounting / Average Rate of Return means the average annual yield on the

project. In this method, profits after taxes are used for evaluation.

Dictionary

Meaning:

It may be defined as the annualized net income earned on the average funds

invested in a project. In other words, the annual returns of a project are expressed as a

Yield:

percentage of the net Investment in the project.

Return

36

Give in

Calculation of ARR

In case the expected profits (after tax) generated by a project are equal for all the year

then the annual profit itself is the average profit.

If the project is expected to generate unequal profits over different years, then the

ARR may be calculated by finding out the average annual profit and then comparing

it with the average investment of the project as follows:

Average Annual Profit (after tax)

ARR = -------------------------------------------- x 100

Average Investment in the project

Average Investment:

The average investment refers to the average annual quantum of funds that remains

invested or blocked in the proposal over its economic life. The average investment of a

proposal is affected by the method of depreciation, salvage value and the additional working

capital required by the proposal. The following two approaches are available t calculate the

average investment.

Key Words:

Average Rate

of Return

means the

average

annual yield

on the

project.

In this case, the original cost of investment and the installation expenses, if any, is

taken as the amount invested in the project.

(ii) Average annual book value after depreciation as average investment:

Teaching

Aid:

CB

For the firms which are adopting method of depreciation other than the

straight line method:

Find out the opening book values and the closing book values of the project

for all the years of its economic life.

Find out the average book values for all the years by taking the simple

arithmetic mean of the opening and closing book values.

Find out the average of all the yearly averages. This average will be the

average investment of the proposal.

For the firms which are adopting straight line method the following short cut

methods can be used:

Scrap value.

Average Investment = [(Original Investment + Installation expenses Scrap value)/2] +

Scrap value + Additional Working capital.

Merits:

It is based on book figures which are easily available.

The benefits over the entire life of the project are considered.

37

Books

Referred

Financial

management

I.M. Pandey

Demerits:

It does not take into consideration, the time value of money.

The method ignores fluctuation in the profit from year to year.

It considers only the Rate of Return and not the length of project lives.

1. Explain the Average rate of return in detail.

Department of MBA

Salem 10

Subject: Financial Management

Topic: DCF Techniques, Net Present Value

Unit: 02

Hour: 05

Dictionary

Meaning:

Working

anticipation of future returns. Hence, the timing of expected future cash flow is important

capital:

in the investment decision. For example, investors play a higher value on recent returns

than on future ones. Hence, the technique that discounts the future value into them present

Day to day

values at a specified time value (discount rate) is called as DCF technique.

Requirement

(Current

Asset

Current

Discounting is reducing the values of future cash flows to make it directly comparable Liabilities)

to the values at present.

The rate at which the future cash flows are reduced to their present value is termed as

discount rate.

Key Words:

The Economic life of a project is used as the discounting period. However, the length

of discounting period depends on factors such as the life of equipment with the largest NPV =

Discounted

life span, technological change, availability of Raw materials, market stability, etc.

The market rate of interest is normally considered for discounting. But the cost of Cash Inflows

capital computed based on the overall capital structure of the company or on the basis less discounted

Cash Outflows.

of financial pattern would be an appropriate discount rate.

What is discounting?

The Net Present Value of an Investment proposal is defined as the sum of the Teaching

38

present value of all future cash inflows less the sum of the present values of all cash Aid:

outflows associated with the proposal.

CB

NPV = Discounted Cash Inflows less discounted Cash Outflows.

Cash Outflow consist of :

1. Initial Investment and

2. Special payment and outflows. E.g., working capital outflow which arises in the year

of commercial production. Tax paid on Capital Gain made by sale of old assets, if any.

Cash Inflows = Profit after tax + Depreciation

Also, specific cash inflows like salvage value of new Assets and recovery

of working capital at the end of the project, tax savings on loss due to sale of old asset, Books

should be carefully considered. The general assumptions are that all cash inflows occur at Referred

the end of each year.

Financial

Management

Discounting rate:

I.M. Pandey

Instead of using the PV factor tables, the relevant discount factor can be computed

as 1/ (1+K).

Where,

K Cost of Capital.

n year in which the inflow (or) outflow takes place.

Hence, PV factor at 10% after one year 1/1.10 = 0.9091

Similarly, PV factor at the end of 2 years 1(1.10) = 0.8264 and so on.

Merits:

It considers the time value of money. Hence it satisfies the basic criterion for project

evaluation.

Unlike payback period, all cash flows are considered.

NPV constitutes addition to the wealth of shareholders and thus focus on the basic

objectives of financial management.

Since all cash flows are converted into present value (current rupees), different projects

can be compared on NPV basis. Thus, each project, can be evaluated independent of

others on its own merits.

Demerits:

It involves forecasting cash flow and application of discount rate. Thus accuracy of

NPV depends on accurate estimation of these two factors which may be quite difficult

in practice.

NPV and ranking of project may differ at different proposals, etc., while evaluating

mutually exclusive projects.

1. Explain the DCF techniques and Net present value.

39

Department of MBA

Salem 10

Subject: Financial Management

Topic: Profitability Index and IRR

Unit: 02

Hour: 06

Where different investment proposals each involving different initial investments

and cash inflows are to be compared, the technique of Profitability Index (PI) is used.

Total of Discounted Cash Outflows

Key Words:

Projects with

PI > 1 are

accepted and

PI < 1 are

rejected.

PI represents the amount obtained at the end of the project life, for every rupee

invested in the project at the initial state. Hence, Projects with PI > 1 are accepted and PI

< 1 are rejected.

Teaching

Aid:

CB

Merits:

It is a better project evaluation technique than NPV and helps in ranking projects

where NPV is positive.

It focuses on maximum return per rupee of investment and hence is useful in case of Books

Referred

investment in divisible projects, when funds are not fully available.

Demerits:

Once a single large project with high NPV is selected, possibility of accepting several

small projects which together may have higher NPV than the single project is

excluded.

Situations may arise where a project with a lower profitability index selected may

generate cash flows in such a way that another project can be taken up one or two

years later, the total NPV in such case being more than the one with a project with

highest profitability Index.

Internal Rate of Return is the rate at which the sum total of discounted cash inflows

40

Financial

Management

I.M. Pandey

equals the discounted cash outflows. The Internal rate of return of a project is the discount

rate which makes net present value of the project equal to zero.

Acceptance Rule:

If IRR > Cut Off rate i.e., Cost of Capital, then accept the project.

If IRR = Cut Off rate i.e., Cost of Capital, then the firm is indifferent, either accept (or)

reject the project.

If IRR < Cut Off rate i.e., Cost of Capital, then reject the project.

Merits:

All cash inflows of the project arising at different points of time are considered.

Decisions are immediately taken by comparing IRR with the cost of capital.

It helps in achieving the basic objective of maximization of shareholders wealth.

Demerits:

Multiple IRRs may result, leading to difficulty in interpretation.

Method of Calculation:

1. When Cash inflows/savings are even for all the year:

The factor to be located in the relevant annuity table II is calculated by using the following

simple equation.

F = I/C

When, F Factors to be located

I Original Investment

C Cash inflows per year.

The factor, thus calculated is located in table II (or) the line representing the no. of

years corresponding to the estimated useful life of the assets and the relevant percentage of

the discount which represents the rate of return.

In this process, cash inflows are to be discounted by a number of trial rates. Total

of such present values should be compared with the cost of investment.

If the calculated total present value of cash inflow is lower than the cost of

investment, then the further interpolation is carried on at lower rate.

On the other hand, a higher rate should be attempted if the present value of Inflows

is higher than the cost of investment.

This process continues till the present value of cash inflows and the cost of

41

investment are equal (or) nearly equal. However, the exact rate may be interpolated

with the help of the following formula.

Positive NPV

IRR = Lower Rate + ---------------------------------------------- x Difference in Rate

Difference in calculated present value

If the Internal Rate of Return is more than the required rate, the project is

profitable, otherwise it should be rejected.

1. Explain the Profitability Index and Internal Rate of Return.

Department of MBA

Salem 10

Subject: Financial Management

Topic: Project selection under capital rationing

Unit: 02

Hour: 07

42

NPV Vs IRR:

The IRR approach solves for a rate unique to each project, while the NPV

approach solves for the trade off cash inflows and outflows using a general required rate of

return.

On the basis of the above discussion of NPV and IRR, a comparison between

the two may be attempted as follows:

1. IRR gives percentage return while the NPV gives absolute return.

2. For IRR, the availability of required rate of return is not a pre-requisite while for

NPV it is must.

b. Superiority of NPV over IRR:

1. NPV shows expected increase in the wealth of the shareholders.

2. NPV gives clear cut accept-reject decision rule, while the IRR may give multiple

results also.

3. The NPV of different projects are additive while IRR cannot be added.

4. NPV gives better ranking as compared to the IRR

CAPITAL RATIONING

When necessary funds are available; the management can take up all profitable

projects.

When funds are insufficient, the firm has to choose some more profitable projects and

reject some less profitable investment proposals.

Thus, because of lack of funds, the firm is able to invest in all profitable projects the

extent to which the funds are sufficient. Moreover, the executives with the required

managerial skills to fruitfully utilize the funds may also be a constraint. This situation is

described as a capital rationing.

Capital rationing refers to a situation where the firm is constrained for external or

internal reasons to secure the necessary funds to invest in all profitable investment proposals.

The situation of capital rationing may arise due to both:

1. External factors; or

2. Internal constrains imposed by the management

43

1. External factors

External factors mainly refer to the situation in capital market. Fluctuations in capital

market may force a firm to have capital rationing of its investment proposals. Such

fluctuations arise due to deficiencies in market information, due to a difference between the

interest rates of borrowing and lending, due to rigidities that affect the free flow of capital

between firms. Because of such situations in capital market, the firm is unable to obtain

necessary capital to finance all its profitable investment proposals.

2. Internal factors

Internal factors refer to investment restrictions imposed by the firm itself. Various

types of restrictions can be imposed by the management. By adopting a conservative policy,

it may decide not to obtain additional capital by incurring a debt to finance its investment

proposals. It may also impose the maximum limits up to which investment can be made by

its middle level management. By stipulating a minimum rate of return to be higher than the

cost of capital, the management may resort to capital rationing.

Under the situation of capital rationing, the firm is not in a position to accept all profitable

investment proposals. By comparing the profitable investment proposals, the firm has to

select the relatively more profitable proposals and to reject the others. The said selection Key Words:

Ranking

process involves the following two steps:

projects on

1. Ranking projects on the basis of profitability measured by the most suitable the basis of

capital evaluation method.

profitability

2. Selection projects in the descending order of profitability until the funds are measured.

exhausted, i.e., the project with the highest rank has to be selected first and then

the project with next highest rank and so on. This process can be continued till all Teaching

the funds available for investment become exhausted.

Aid:

CB

While ranking the projects, the profitable criterion can be measured by adopting NPV,

IRR or Profitability Index Methods. The preference can be given to the IRR method, as it is Books

easy to understand.

Referred

Financial

Management:

I.M.Pandey

Possible Questions & University Questions:

1. Explain about capital rationing?

2. Compare and contrast NPV with IRR.

44

Department of MBA

Salem 10

Subject: Financial Management

Topic: Inflation and capital budgeting

Unit: 02

Hour: 08

Estimating the cash flows is the first step which requires the estimation of cost and

Dictionary

benefits of different proposals being considered for decision-making. Usually, two Meaning:

alternatives are suggested for measuring the 'Cost and benefits of a proposal' i.e. the

accounting profits and the cash flows.

Inflation:

In reality, estimating the cash flows is most important as well as difficult task. It is because Price rise

Price

of uncertainty and accounting ambiguity.

Increases

Accounting profit is the resultant figure on the basis of several accounting concepts and

policies. Adequate care should be taken while adjusting the accounting data, otherwise

errors would arise in estimating cash flows. The term cash flow is used to describe the cash

oriented measures of return, generated by a proposal. Though it may not be possible to Key Words:

obtain exact cash-effect measurement, it is possible to generate useful approximations

discount rate

based on available accounting data. The costs are denoted as cash outflows whereas the means the

benefits are denoted as cash inflows.

minimum

requisite rate

Effects of Inflation on Cash Flows

of return on

funds

Often there is a tendency to assume erroneously that, when, both net revenues

committed to

and the project cost rise proportionately, the inflation would not have much impact. These the project

lines of arguments seem to be convincing and it is correct for two reasons. First, the rate

used for discounting cash flows is generally expressed in nominal terms. It would be

inappropriate and inconsistent to use a nominal rate to discount cash flows which are not

adjusted for the impact of inflation. Second, selling prices and costs show different degrees

of responsiveness to inflation.

Teaching

Aid:

The discount rate has become one of the central concepts of finance. Some of CB

its manifestations include familiar concepts such as opportunity cost, capital cost,

borrowing rate, lending rate and the rate of return on stocks or bonds. It is greatly

influenced in computing NPV. The selection of proper rate is critical which helps for

making correct decision. In order to compute net present value, it is necessary to discount Books

future benefits and costs. This discounting reflects the time value of money. Benefits and Referred

costs are worth more if they are experienced sooner. The higher the discount rate, the

Inflation and Discount Rate

45

For typical investments, with costs concentrated in early periods and benefits

following in later periods, raising the discount rate tends to reduce the net present value.

Financial

Management:

I.M.Pandey

Thus, discount rate means the minimum requisite rate of return on funds

committed to the project. The primary Purpose of measuring the cost of capital is its use as

a financial standard for evaluating investment projects.

Implications of Expected Rate of Inflation on the Capital Budgeting

1) The Company should raise the output price above the expected rate of inflation.

Unless it has lower Net Present Value which may lead to forego the proposals and

vice versa.

2) If the company is unable to raise the output price, it can make some internal

adjustments through careful management of working capital.

3) With respect of discount rate, the adjustment should be made through capital

structure.

Possible Questions & University Questions:

1. What is inflation and its implications?

VSA SCHOOL OF MANAGEMENT

Department of MBA

Salem 10

Subject: Financial Management

Topic: Cost of capital

Unit: 02

Hour: 7

Generally, most of the companies are financed by way of debt, bonds and equity.

An investors investment in long-term funds such as shares, debentures, public deposits,

etc. of a company are on the basis of expecting good rate or return. It is important because

acceptance or rejection of an investment decision depends on the cost of capital of a firm.

Thus, to the company, the cost of capital is the minimum rate of return that the company

must earn on its investments to satisfy the expectations of its investors.

Meaning:

Dictionary

Meaning:

Bond:

Debt

instrument

The term cost of capital refers to the rate of return on investment projects necessary

to leave unchallenged the market price of a firms stocks. It is the rate of return required by

Key Words:

those who supply the capital. The cost of capital is a weighted average of the cost of each

type of capital.

cost of

capital refers

In simple words, cost of capital refers to minimum rate of return a firm must earn to minimum

on its investment so that the market value of the companys equity shares does not fall. rate of return

This is consonance with the overall firms objective of wealth maximization.

a firm must

earn on its

Definition:

investment

46

The cost of capital is the minimum required rate of earnings or the cut-off rate for

the allocation of capital to investments of projects. It is the rate of return on a project that

will leave unchanged the market price of the stock

- James C. Van Horne

Teaching

Aid:

CB

Cost of capital may be defined as the rate of return the firm requires from its

investment in order to increase the value of the firm in the market place.

Books

Referred

Financial

The risk-free interest rate, If, is the interest rate on the risk free and default-free securities. Management:

For example, the securities issued by the Government of India are taken as risk-free and I.M.Pandey

default-free in respect of payment of periodic interest as well as principal repayment on

maturity.

2. Business risk: The business risk is related to the response of the firms Earnings

Before Interest and Taxes, EBIT, to change in sales revenue. Every project has its

effect on the business risk of the firm. If a firm accepts a proposal which is more

risky than average present risk, the investor will probably raise the cost of funds so

as to be compensated for the increased risk.

3. Financial risk: The particular composition and mixing of different sources of

finance, known as the financial plan or the capital structure, can affect the return

available to the investors. The financial risk is often defined as the likelihood that

the firm would not be able to meet its fixed financial charges. Higher the

proportion of fixed cost securities in the overall capital structure, greater would be

the financial risk. The investors in such a case require to be compensated for this

increased risk.

4. Other Considerations: The investors may also like to add a premium with

reference to other factors. One such factor may be the liquidity or marketability of

the investment. Higher the liquidity available with an investment, lower would be

the premium demanded by the investors.

1. What is cost of capital?

2. What are the various factors affecting cost of capital?

47

Department of MBA

Salem 10

Subject: Financial Management

Topic: concept and Types of cost of capital

Unit: 02

Hour: 08

TYPES OF COST

Dictionary

Meaning:

Explicit Cost: The Explicit cost of any source of finance may be defined as the

discount rate that equates the present value of the funds received by the firm net of Dividend:

underwriting costs, with the present value of the expected cash outflows. These outflows

may be interested payment, repayment of principal (or) dividend. This may be calculated Bonus

Share

by computing value according to the following equation.

Surplus

Implicit Cost: The Implicit Cost may be defined as the rate of return associated Payment

with the best investment opportunity for the firm and its shareholders that will be forgone Extra

if the project presently under consideration by the firm were accepted.

2. Future and Historical Cost:

Future Cost refers to the expected cost of funds to finance the project, while

historical cost is the cost, which has already been incurred for financing a particular

project. In financial decision making, the relevant costs are future costs and not the

historical costs. However, historical costs are useful in projecting the future costs and

providing an appraisal of the past performance when compared with standard (or) Teaching

predetermined cost.

Aid:

CB

3. Specific Cost and Combined Cost:

Specific Cost: The Cost of each component of capital (i.e., equity shares,

preference shares, debentures, loans, etc.) is known as specific Cost of Capital. In order to

determine the average cost of capital of the firm it becomes necessary first to consider the Books

Referred

cost of specific methods of financing.

with page

Combined Cost: The composite / combined cost of capital is inclusive of all cost number:

of capital from all sources i.e., equity shares, preference shares, debentures and other

loans. In capital investment decisions, the composite cost of capital will be used as a basis Financial

Management:

for accepting (or) rejecting the proposal even though the company may finance one

I.M.Pandey

proposal from one source of financing while another proposal from another source of

financing.

4. Average Cost and Marginal Cost:

Average Cost: The Average Cost of Capital is the weighted average of the costs of

each component of funds employed by the firm. The weights are in proportion of the share

48

Marginal Cost: Marginal Cost of Capital, on the other hand, is the weighted

average cost of new funds raised by the firm for capital budgeting and financing decision,

the marginal cost of capital is the most important factor to be considered.

1. What are the various types of costs?

VSA SCHOOL OF MANAGEMENT

Department of MBA

Salem 10

Subject: Financial Management

Topic: Methods of computing cost of capital

Unit: 02

Hour: 09

The cost of each component of capital will have to be separately assessed. A firm

may be in a position to use debt-financing at a lower rate of interest. But this is possible

only up to a certain point, at which the overall cost of capital, is reduced.

Computation of overall cost of capital of a firm involves:

A. Computation of cost of specific source of finance, and

B. Computation of weighted average cost of capital.

A. Computation of Specific source of Finance

Computation of each specific source of finance, viz, debt, preference share capital,

equity share capital and retained earnings is discussed as below:

1. Cost Debt Capital:

The cost of debt is the rate of interest payable on debt.

(i) Cost of Irredeemable debt

Before tax = Kdb = Interest (I) / Net proceeds (NP)

After tax = Kda = [Interest (1-tax rate)] / Net proceeds (NP)

(ii) Cost of Redeemable debt

Usually, the debt is issued to be redeemed after a certain period during the

life time of a firm. Such a debt issue is known as Redeemable debt. The cost of

49

(a) Before tax = Interest + (RV-Net proceeds) / N

(RV + Net Proceeds)/2

(b) After tax = Interest (1-tax rate) + (RV-Net proceeds) / N

(RV + Net Proceeds)/2

N = Life of the redeemable debt.

Preference capital carries a fixed rate of dividend though this dividend is

payable at the discretion of the board of directors, companies intend to pay the stated

preference dividend regularly and preference shareholders expect to receive preference

dividend regularly. The cost of preference capital which is irredeemable is the value of K p

in the following expression.

Kp = Preference Dividend / Net Proceeds of issue

Sometimes Redeemable Preference Shares are issued which can be redeemed or

cancelled on maturity date. The cost of redeemable preference share capital can be

calculated as:

Kp = Preference Dividend + (RV Net proceeds) / N

(RV+ Net Proceeds) / 2

N = Life of the redeemable preference shares.

Cost of equity capital (K e) represents the expectations of equity shareholders from

a company. Based on investors behavior and expectations, the cost of equity capital can

be determined by any of the following approaches.

According to this method, the cost of equity capital is the discount rate that

equates the present value of expected future dividends per share with the net proceeds (or

current market price) of a share. Formula,

50

Ke = D / NP

Where, Ke = Cost of Equity Capital

D = Expected dividend per share

NP = Net proceeds per share

Drawbacks

1.

2.

3.

4.

Ignores the growth in the capital value of the shares.

Ignores the earnings on retained earnings.

It may not be adequate to deal with the problem of determining the cost of

equity share capital

5. It neglects the fact that stock market price rise may be due to retained earnings

also.

(b) Calculation of cost of existing equity shares

According to this approach, the determination of cost existing equity shares

is based on the market price of the companys shares. The cost of existing equity

shares is calculated with the help of the following formula:

Ke = D / MP

Where, Ke = Cost of Equity Capital

D = Expected dividend per share

MP = Market Price per share

The basic assumptions underlying this method are that the investors give prime

importance to dividends and risk in the firm remains unchanged.

2. Dividend Yield plus Growth in dividend method:

When the dividends of the firm are expected to grow at a constant rate and the

dividend pay-out ratio is constant this method may be used to compute the cost of equity

capital. According to this method the cost of equity capital is based on the dividends and

the growth rate.

Ke = (D / NP) + g

Where, g = Rate of growth in dividends

In case cost of existing equity share capital is to be calculated, the NP should be

changed with MP (market price per share) in the above formula.

Ke = (D / MP) + g

Assumptions

51

1.

2.

3.

4.

The growth rate will be constant over a period of time.

Future earnings will grow at a constant rate.

The market price is influenced only by variations in earnings.

According to this method, the cost of equity capital is the discount rate that

equates the present value of expected future earnings per share with the net proceeds (or

current market price) of a share.

Formula,

Ke = Earnings per share

Net proceeds

Where, the cost of existing capital is to be calculated

Ke =

4. Realised Yield approach:

According to this approach investor is presumed to be interested in present

dividends and future earnings, which are reflections of past track record. This method

takes into account the actual average rate of return realized in the past, may be applied to

compute the cost of equity share capital. To calculate the average rate of return realized,

dividends received in the past alongwith the gain realized at the time of sale of shares

should be considered. The cost of equity capital is said to be the realized rate of return by

shareholders.

Assumptions:

1. The company should remain fundamentally the same irregardless of risk.

2. The shareholders are required to bear the risk for expecting the same rate of

return

3. The shareholders reinvestment opportunity rate must be equal to the realized

yield

4. Cost of Retained Earnings

The cost of retained earnings may be considered as the rate of return which the

existing shareholders can obtain by investing the after-tax dividends in alternative

opportunity of equal qualities. It is, thus, the opportunity cost of dividends foregone by

shareholders. Cost of retained earnings can be computed with the help of following

52

formula:

Kr = (D / NP) + G

Where, G = Rate of growth in dividends

Shareholders cannot obtain the entire amount of retained profits by way of

dividends. Some adjustment has to be made for tax. Moreover, if the shareholders wish to

invest their after-tax dividend income in alternative securities, they may have to incur

some costs of purchasing the securities, such as brokerage. To make adjustment in the cost

of retained earnings for tax and costs of purchasing new securities, the following formula

may be adopted:

Kr = [(D / NP) + G] x (1-tax rate) x (1-brokerage cost)

1. What are the various methods of measuring cost of capital?

Department of MBA

Salem 10

Subject: Financial Management

Topic: Weighted average cost of capital

Unit: 02

Hour: 10

Weighted average cost of capital is the average cost of the costs of

various sources of financing. Weighted average cost of capital is also known as composite

cost of capital, overall cost of capital or average cost of capital. Once the specific cost of

individual sources of finance is determined, we can compute the weighted average cost of

capital by putting weights to the specific costs of capital in proportion of the various

sources of funds to the total. The WACC may be described as follows:

WACC = Ke.We + Kd.Wd + Kp.Wp

Dictionary

Meaning:

Marginal:

Minor

Subsidiary

Secondary

Key Words:

Ke = Cost of equity capital

53

In WACC,

there must be

a system of

assigning

Kp = Cost of preference shares

We = Proportion of equity capital in capital structure

weights to

different

specific cost

of capital.

Wp = Proportion of preference capital in capital structure

Teaching

In order to calculate the WACC, there must be a system of assigning weights to Aid:

CB

different specific cost of capital. The following considerations are worth noting while

assigning weights to specific cost of capital to find out the WACC.

Historical, Marginal and Target weights:

Books

Referred

Historical or existing weights are the weights based on the actual or existing

proportions of different sources in the overall capital structure. Such weighting system is

based on the actual proportions at the time when the WACC is being calculated. The

weighting system is the proportions in which the funds already been raised by the firm.

(b) Marginal weights:

The marginal weights refer to the proportions in which the firm wants to raise

funds from different sources. In other words the proportions in which additional funds

required to finance the investment proposals will be raised are known as marginal weights.

So, in case of marginal weights, the firm in fact, calculates the actual WACC of the

incremental funds.

(c) Target Weights:

The target weights refer to the proportion in which the firm plans to raise the funds

from various sources in the long run. In the target weights system, the firm in the first

instance decides about the shape of the optimal capital structure and proportion of different

sources in this optimal capital structure.

Book value versus Market Value Weights:

(a) Book Value Weights:

The weights are said to be book value weights if the proportions of different

sources are ascertained on the basis of the face values i.e., the accounting values. The

book value weights can be easily calculated by taking the relevant information from the

capital structure as given in the balance sheet of the firm.

(b) Market Value Weights:

The weights may also be calculated on the basis of the market values of different

sources i.e., the proportion of each source at its market value. In order to calculate the

market value weights, the firm has to find out the current market price of the securities in

54

Financial

management

Sudharsan

Reddy

each categories. The advantages of using the market value weights are:

The market value weights are consistent with the concept of maintaining

market value in the definition of the overall cost of capital.

The market value weights provide current estimate of the investors

required rate of return.

The market value weights yields goods estimates of the cost of capital that

would be incurred if the firm requires additional funds from the market.

However, the market values weights suffer from some limitations as follows:

Not only that the market values of all types of securities issued have to be

obtained but also that the market value of equity share is to be segregated

into capital and retained earnings.

The market values are subject to change from time to time and so the

concept of optimal capital structure in terms of market values does not

remain relevant any longer.

1. How to calculate weighted average cost of capital?

VSA SCHOOL OF MANAGEMENT

Department of MBA

Salem 10

Subject: Financial Management

Topic: Problems

Unit: 02

Hour: 11

55

A non-discount method of capital budgeting does not explicitly consider the time value of

money. In other words, each dollar earned in the future is assumed to have the same value

as each dollar that was invested many years earlier. The payback method and Accounting

rate of return are some of the techniques used in capital budgeting that does not consider

the time value of money.

Payback period method

The number of years required to recover the initial outlay of the investment is called

payback period. It is the investment with short term payback period is preferred

Payback period = initial investment / Annual or net cash inflow

Payback period problems:

1. The project requires 100000 and yields annual cash inflow of 20000 for 8 years.

Calculate payback period.

2. The project requires an initial investment of 20000 and the annual cash inflows of 5

years are 6000, 8000, 5000, 12000, 4000 respectively. Calculate payback period.

3. Ram limited company purchases of new machine which will carry out some

operations performed by labor X and Y are alternative models. Calculate the

payback period and recommend which model you would prefer.

Particulars

Project X

Project Y

Cost of machine

150000

250000

Estimated life

5 years

6 years

6000

8000

10000

15000

Additional

cost

of 19000

maintenance

Estimated savings in direct 150

wages per employee

Total no. of employees

600

27000

Taxation

50%

200

600

50%

Project

C0

C1

C2

C3

C4

A

B

C

D

1000

1000

300

300

600

200

100

0

200

200

100

0

200

600

100

300

1000

1000

600

600

56

Users accounting information are revealed by financial statements to measure profitability

of an investment the accounting rate of return is the ratio of average after tax profit divided

by the average investment. Average investment is the half of the original investment.

ARR = Average annual profits / Net investment project * 100

Average return on Average investment method = Average annual profit after

depreciation and tax / Average investment * 100

Average investment = total investment / 2

1. A project requires an investment of Rs.500000 and as a scrap value of Rs.20000

after 5 years. It is expected to yield profits after depreciation and taxes during the 5

years amounting to Rs.40000, 60000, 70000, 50000, and 20000. Calculate the

average rate of return on investment and average rate on average investment.

2. Calculate the average rate of return for project A & B from the following

information

Particulars

Project A

Project B

Investment

20000

30000

Estimated life

4 years

5 years

Year

2000

3000

1500

3000

1500

2000

1000

1000

1000

TOTAL

6000

10000

It is an evaluation of the future net cash flows generated by capital project by discounting

them to the present day value. The discounting technique converts cash inflow and outflow

for different years into the respective values at the same point of time allows for time value

of money.

Net present value (NPV)

The objective of the firm is to create wealth by using existing and future resources to

produce goods and service. To create wealth, inflows must exceed the present value of all

57

anticipated cash outflows. The net present value is obtained by discounting all cash

outflows and inflows attributable to a capital investment project by choosen percentage.

The method discounts the net cash flow from the investment by the minimum required rate

of return and deducts the initial investment to give the yield from the funds invested.

Steps to calculate:

1. Determine the discount rate

2. Compute the present value of total investment outlay at the determined rate.

3. Calculate the NPV of each project by subtracting the present value of cash inflows

from the present value of cash outflows for each project

4. If NPV is positive (or) zero that proposal may be accepted otherwise it should be

rejected. Suppose two or more proposal are having positive return the project

which has highest NPV to be selected

NPV Problems:

1. A firm invests in project X Rs.2500 now and expected to generate yearend cash

flow of Rs.900, 800, 700, 600 and 500 in years of 1 through 5. The opportunity

cost of the capital may be assumed to be 10%.

2. The following two projects A and B required an investment of Rs.200000 each.

The income returns after taxes for these projects are as follows:

Year

80000

20000

80000

40000

40000

40000

20000

40000

60000

60000

VSA SCHOOL OF MANAGEMENT

Department of MBA

Salem 10

Subject: Financial Management

Topic: Problems

Unit: 02

Hour: 12

58

1. Calculate the NPV for a small size project requiring an initial investment of

Rs.20000 and which provides net cash inflows of Rs.6000 each year for 6 years.

Assume the cost of funds to be 8% per annum and that there is no scrap value. (The

present value of an annuity for 6 years and 8% is 4.623)

2. From the following information calculate NPV of two projects and suggest which

of two things should be invested. Assume the decision rate 10%

Particulars

Project X

Project Y

Initial investment

20000

30000

Estimated life

5 years

5 years

Scrap value

1000

2000

Year

Cash flow Y 20000

10000

10000

10000

5000

3000

3000

2000

2000

It is a modern technique of capital budgeting that takes into account the time value of

money. It is also known as time adjusted rate of return or yield method. In the NPV

method, the net present value is determine by discounting the future cash flows of a project

at a pre-determined rate called cut-off rate, but under the IRR method the cash flow of a

project are discounted at a suitable rate of trial and error method, which equates the NPV

calculated to the amount of investment. Under this method the discount rate is determined

internally.

The rate of discount at which present value of cash inflow is equal to present value of cash

outflow

Internal Rate of Return (IRR) problems:

1. Calculate IRR, consider the cash flow of a project.

Year

Cash flow

100000

30000

30000

40000

45000

2. A project cost Rs.16000 and its expected to generate cash inflows of Rs.8000,

7000, and 6000 at the end of each year for next 3 years. Calculate IRR.

3. A firms cost of capital is 2.5% is considering two mutually exclusive project X&

Y

Year

59

70000

70000

10000

50000

20000

40000

30000

20000

45000

10000

60000

10000

Profitability Index / benefit cost ratio Problems:

Profitability Index = present value of annual cash flows/ Initial investment

Net profitability Index = NPV/ Initial investment

The ratio of the present value of cash flow to the initial outlay is profitability index or

benefit cost ratio.

Acceptance rule:

(i)

(ii)

(iii)

Reject if P.I < 1

Project may be accepted if P.I = 1

1. The initial outlay of a project is 50000 and it generates cash inflows of 20000,

15000, 25000, and 10000 in 4 years using present value index method appraise

profitability of the proposed investment, assuming 10% rate of discount.

2. The initial outlay of a project is 100000 and it can generate cash inflow of 40000,

30000, 50000, and 20000 in year 1 through 4. Assume a 10% rate of discount.

Department of MBA

Salem 10

Subject: Financial Management

Topic: Problems

Unit: 02

Hour: 13

60

1. A company considering an investment proposal to install a new milling control at a cost

of Rs.50000. the facility has a life expectancy of 5 years without any salvage value. The

firm uses SLM of depreciation and the same is used for tax purposes. The tax rate is

assumed to be 35%. The estimated cash flows before depreciation and tax(CFBT) from the

investment proposal are as follows:

Year

CFBT

10000

10692

12769

13462

20385

COMPUTE:

i)

ii)

iii)

iv)

Payback period

Average rate of return

NPV at 10% discount rate

Profitability index at 10% discount rate

2. Determine the optimal project mix on the basis of the assumption that the project are

divisible

Project

Required

initial NPV at the appropriate cost of

investment

capital

A

100000

20000

B

300000

35000

C

50000

16000

D

200000

25000

E

100000

30000

Total fund available is Rs.300000. determine the optimal contribution of projects

assuming that the projects are divisible.

INFLATION AND CAPITAL BUDGETING

Inflation is defined as increase in the average price of goods and services. The accepted

measure of general inflation is the retail price index which is based on the assumed

expenditure patents of an average family. It is a monetary alignment in an economy and it

can be defined as the changes in purchasing power in a currency from period to period

relative to some basket of goods and services.

INFLATION PROBLEM:

3. A machine cost Rs.10000 and its expected to yield the following net cash returns

(estimated current price)

Year

Rs.

5000

8000

6000

We expect inflation to be at the rate of 5% per annum. The cost of capital is 15.5% per

61

annum.

Department of MBA

Salem 10

Subject: Financial Management

Topic: Problems

Unit: 02

Hour: 14

1. X ltd issues of Rs.50,000, 8% debentures at par. The tax rate applicable to the company is 50%.

Compute the cost of debt capital

2. Y ltd issues of Rs.50,000, 8% debentures at premium of 10%, The tax rate applicable to the

company is 60%. Compute Kdb?

3. A ltd issues of Rs.50,000, 8% debentures at a discount of 5%, The tax rate applicable to the

company is 50%. Compute the cost of debt?

4. X ltd issues of Rs.1,00,000, 9% debentures at premium of 10%, the cost of floatation are 2%. The

tax rate applicable to the company is 60%. Compute cost of debt?

5. A company issues of Rs.100000 at 10% redeemable debentures at a discount of 5%. The cost of

floatation amount to Rs.30000. The debentures are redeemable after 5 years. Calculate before tax

and after tax cost of debt assuming a tax rate of 50%?

6. X ltd issues 12% debentures of face value of Rs.100 each and realises Rs.95 per debenture. The

debentures are redeemable after 10 years at a premium of 10%.

7. The company issues Rs.10000 at 10% preference shares of Rs.100 each. Cost of issue is Rs.2 per

share. Calculate of cost of preference share capital if these shares are

i)

At par

ii)

At premium of 10%/

iii)

At a discount of 5%

8. Y ltd issues preference shares of face value of Rs.100 each carrying 14%/ dividend and he

realises Rs.92 per share. The shares repayable after 12 years.

9. A company issues of Rs.10000 at 10% preference share of Rs.100 each redeemable after 10 years,

at a premium of 5%, cost of issue is 2 per share. Calculate cost of preference share capital.

10. A company issues 1000 at 7% preference share of Rs.100 at a premium of 10%, redeemable after 5

years. Compute cost of preference share capital.

Department of MBA

Salem 10

Subject: Financial Management

Topic: Problems

Unit: 02

Hour: 15

62

COST OF CAPITAL

The objective of business firm is to maximize the wealth of shareholders. The management

should invest in projects which give a return in excess of cost of funds invested in the

projects of the business. The cost of capital is the minimum rate of return expected by its

investors. The cost of capital is the rate of return, the company has to pay various suppliers

of funds in the company. A decision to invest in a particular project depends upon the cost

of capital which is the minimum rate of return expected by investors. Generally higher the

risk involve in a firm, higher the cost of capital

Concept of cost of capital

1. Cost of capital is not a cost

2. It is the minimum rate of return

Cost of equity share capital

1. A company plans to issue 1000 new shares of Rs.100 each, the floatation cost are

expected to be 5 % of the share price the company pays a dividend of Rs.10 per

share initially and growth dividend is expected to be 5 %. Compute the cost of new

issue of equity shares. If the market price of an equity share is Rs.150. calculate the

cost of existing equity share capital.

DIVIDEND YIELD METHOD

Dividend per share is expected current market price. The present value of all expected

future dividends per share with the net proceeds of sale (or) the current market price of

a share this method is based on assumptions that the market value of shares is directly

related to the future dividends on the share.

Another assumption is that the future dividend per share is expected to be constant and

the company is expected to earn at least yield to keep the shareholders constant

Present value

Market value

Future dividend

Shareholders will normally expect dividend to increase year after year. In this method an

allowance for future growth in dividend is added to the current dividend yield

Problems

1. A firm is considering an expenditure of Rs.60, 00,000 for expanding its operations

the relevant information is as follows. Number of existing equity share 10, 00, 000

market value of existing share Rs.60, net earnings Rs.90, 00, 000. Compute the

cost of existing equity share capital and the cost of new equity capital. Assuming

63

that new shares will be issued at a price of Rs.52 per share and the cost of new

issue will be 2 per share.

2. Right starts ltd has its equity share of Rs.10 each quoted in market price of Rs.56.

a constant expected annual growth rate of 6% and dividend of Rs. 3.60 per share

has been paid for current year. Calculate the cost of capital

3. The shares of apple ltd selling at Rs.24 per share the firm had paid dividend at 1.30

per share last year. The estimated growth of company is 5% per year. Determine

the cost of equity of the company.

COST OF RETAINED EARNINGS

Maintain as reserve from the capital for expansion, diversification, uncertainties, and

branches.

The retained earnings is one of the major sources of finance available for the

established companies to finance in expansion and diversification programs. These

funds are also taken into account while calculating cost of equity. Retained earnings

are not distributed to the shareholders. A company can use the funds within the

company for further profitable investment opportunities

1. The cost of equity capital is 24%. The personal taxation of individual shareholders

is 35%. Calculate the cost of retained earnings.

WEIGHTED AVERAGE COST OF CAPITAL/ OVERALL COST OF CAPITAL

1. As the average cost of companies finance (equity, debentures, bank loan) weighted

according to the proportions each element bears to the total of capital. Weighting is

usually based on market valuation current yields and cost after tax.

2. Guna cements ltd has the following capital structure.

Particulars

Market

Book value

Cost of tax (%)

value

Equity share capital 80

120

18

Preference

share 30

20

15

capital

Fully

secured 40

40

14

debentures

Calculate the companies weighted average cost of capital.

INDIFFERENCE POINT

1. Calculate the level of EBIT at which the indifference point following financial

alternatives

Ordinary share capital is 10, 00, 000 (or)

15% debentures of Rs.5, 00, 000 and ordinary share capital of Rs. 5, 00, 000, tax

rate 50% earning price Rs.10 per share

2. Ordinary share capital of Rs.10, 00, 000 (or)

64

13% preference share capital of Rs.5,00,000 and ordinary share capital of Rs.5, 00,

000, ordinary share price Rs.10 per share

UNIT 2 (COMPLETED)

65

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