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1. Introduction 1.”Financial management is more than procurement of funds. ” What do you think are the responsibilities of a finance manager? RTP Discuss the functions of a Finance Manager/ chief financial officer. Decisions involving management of funds come under the purview of the Finance Manager. This includes1. Fund requirement estimation: a) The Finance Manager has to carefully estimate the Firm’s requirements of funds. b) The purpose of funds (investment in Fixed assets or working capital) and timing of funds (ie when it is required) should be determined, using techniques like budgetary control and long range planning. c) This calls for forecasting all physical activities of the firm and translating them into monetary terms. 2. Capital structure/ financing decisions:

a)

The Finance Manager has to determine the proper mix/ combination of procuring funds. Funds can be procured from various sources for short term and long term purposes.

b) Decisions regarding Capital Structure (called Financing Decisions) should be taken to provide proper balance

between – (i) Long term and Short term funds and also (ii) Long Funds and Own Funds. c) Long term funds are required to a) Finance fixed assets and long term investments and b) provide for permanent needs of working capital. Short term funds are required for working capital purposes.

3.

Cash Management Decisions: a)The Finance Manager has to ensure that all sections/ branches/ factories/ departments and units of the Firm have adequate funds (cash), to facilitate smooth flow of business operations. b) He should also ensure that there is no excessive cash (idle funds) in any division at any point of time. c) For this purpose, cash management and cash disbursement/ transfer policies should be laid down.

4. Capital budgeting/ Investment Decisions: a) Funds procured should be invested/ utilized effectively. The Finance Manager should prescribe the asset management policies, for Fixed Assets and Current Assets. b) Long Term Funds should be invested – (i) in Fixed Assets/ Projects after capital Budgeting and (ii) in Permanent Working Capital after estimating the requirements carefully. 5. Financial Analysis/ Performance evaluation: a) Financial Analysis help in assessing how effectively the funds have been utilized and in identifying methods of improvement. So, the Finance Manager has to evaluate financial performance of various units of the Firm.

b) There are various tools of Financial Analysis like Budgetary Control, Ratio Analysis, Cash Flow and Fund Flow Analysis, Common Size Statement Analysis, IntraFirm comparison etc.

6.

Dividend Decisions: a) The finance Manager should assist the top management in deciding the dividend-payout and retention ratio ie – (i) what amount of dividend should be paid to shareholders and (ii) what amount should be retained in the business itself.

b)

Dividend decisions depend upon factors like – (i) trend of earnings (ii) requirement of funds for future growth, (iii) cash flow situation, (iv) trend of share prices, and (v) tax liability of Firm/ Shareholders.

7. Financial Negotiations / Liaison with Lenders: The Finance Manager is required to interact and carry out negotiations with financial institutions, banks, and public depositors. Negotiations especially with outside financiers require specialized skills.

8. Market Impact Analysis: a) The Finance Manager has to monitor the Stock Exchange quotations and behavior of share prices. This involves analysis of major trends in the stock market and judging their impact on the share price of the Firm.

b)

Value Maximization Objective is achieved through this analysis and action.

Payables etc. Debtors. OBJECTIVES AND FUNCTIONS FINANCE MANAGER Profit and Wealth PROCUREMENT OF FUNDS Maximisation UTILISATION OF FUNDS (i.g.OVERVIEW OF FINANCIAL MANAGEMENT – ASPECTS. Sources of Funds) (i.e. Current Assets e.g. Stock. Creditors.e. Cash Capital structure Investment Decisions/ Decisions / Financing Capital Budgeting Decisions Working Capital Management Decisions . Application of Funds) Objectives: To Maximize Cost Objectives: To maximize Returns Long Term Sources Short Term Sources Long Term Investments Short Term Investments Own Funds Loan Funds Current Liabilities Fixed Assets and Projects (Equity) (Debt) e.

2. Linkage: a) A new project (investment) needs finance. Investment Decisions are based on the Financing Decisions. the inter – relationship between the three types of decisions should be analyzed jointly. b) The Financing Decision is influenced by. Hence. c) So. should be selected. in order to maximize the Shareholders’ Wealth. in the following way – a) Investment Decisions: . The returns should be high enough as to distribute reasonable dividends and also retain adequate resources for the Company’s growth prospects. M 01 1. which require funds. . 2. and influences the Dividend decision. Financing and Dividend decisions is “maximization of Shareholders’ Wealth”. – Investment. Decision – Making: The 3 decision can be linked to maximize Shareholders’ wealth. Also. a company may have to expand / develop its operations. Objective: The underlying objective of all the three decisions viz. Financing and Dividend Decisions. RTP.Projects which give reasonable returns (higher than cost) in order to add to the surplus of the Shareholders’. since retained earnings used in internal financing means reduction in dividends paid to Shareholders. Explain the inter – relationship between Investment. 3. The Finance Manager has to consider the joint impact of these three decisions on the market price of the company’s Shares.Investment in Long Term Projects should be made after Capital Budgeting and uncertainty analysis. b) Financing Decisions: .

which can be used for dividend distribution as well as internal financing of new projects / growth plans.Proper balancing between long – term and short – term funds as well as own funds and loan funds will help the Firm to minimize its overall cost of capital and increase its wealth / value.Low cost of funds will mean higher profit margins. rather than declaration of dividend. .. Investment Decisions (ie investing funds for maximizing returns) Ie Distribution of Profits Business Operations resulting in Surplus ie Profit = Returns Less Cost Dividend decision Financing Decisions (ie Business procuring funds from various sources at minimum cost) Retention in Minimum Cost ie Internal Fund generation .The optimum dividend pay – ratio ensures that shareholders’ wealth is optimized.Where the funds at the disposal of the Company earn a higher return than if distributed to shareholders’ wealth maximization can be achieved by retaining the funds. c) Dividend Decisions: . .

decision should be taken after a careful review of all available information. Quantification of future events involves application of statistical and probabilistic techniques. or b) Evaluation of expenditure decisions. 2. the greater is the risk / uncertainty associated with cash flows. d) Period of uncertainty: Effect of decision is known only in the future and not immediately. What is Capital Budgeting? Why is it such an important exercise? RTP 1. or c) Forecast of likely or expected returns from a new investment project and to determine whether returns are adequate. Hence. and hence is effected by uncertainty. e) Complexity: Decisions are based on forecasting of future events and inflows. b) Irreversibility: Decisions are irreversible in nature and commitment of resources should be made on proper evaluation. . Importance: a) Substantial Initial Cost: Initial Investment is substantial. f) Surplus: Funds are obtained by a Firm at a certain cost (ie WACC). Long term Projects.3. Careful judgment and application of mind is necessary. Hence commitment of resources should be made properly. Capital Budgeting Process: a) Decision making with regard to investment in fixed assets (capital projects). Cash outflows occur immediately. which involve current outlays / outflows but are likely to produce benefits over a longer period of time. Even internally generated funds have an implicit cost. c) Risk: The longer the time period of returns. while operating inflows / returns arise over a future period – of – time.

RTP Capital Investment Decisions are part of the Capital Budgeting process. and 3) how the total amount of capital expenditure should be financed. Evaluation -Determine the inflows and outflows relating to various proposals.Hence. there is a need to obtain a surplus over and above the cost of funds. The Capital Budgeting Process consists of the following stages: Stage Planning Procedure -Identify the various available investment opportunities -Determine the ability of the management to exploit / utilize the opportunities. -Reject opportunities which do not have much merit. -Use appropriate technique (like NPV. 4. and prepare Proposals in respect of investment opportunities which have reasonable value for the Firm. MIRR. Write short notes on the Capital Budgeting Process. PI etc) to evaluate the proposals. IRR. 2) the total amount of capital expenditure which the firm should undertake. which is concerned with determining – 1) which specific projects a Firm should accept. . Selection -Weigh the risk – return trade – off relating to various investment proposals -Compare WACC or Cost of Capital with the Return(ROCE) from various proposals.

-Establish the infrastructure (assets. -After the project is over. Performance Reports. obtain the necessary funds for the project. etc) to monitor the implementation of the project. BASED ON FIRM’s EXISTENCE: 1. and implement the project. according to the stipulated time – frame. Review 5. Execution -After deciding on the project to be implemented. review the project – a) to explain its success or failure. and b) to generate ideas for new proposals to be undertaken in future.-Choose that project which will maximize the Shareholders’ wealth. . Cost Reduction Decisions: These decisions focus on reduction of operating cost and improving efficiency. b) Modernization Decisions: To install new machinery in the place of an old one which has become technologically outdated. What are the various types of Capital Investment Decisions? A. etc). etc. equipments. Internal Audit / Inspection Reports. They can be sub – classified into – a) Replacement Decision: To replace an existing asset with a new and improved one – which version to choose. acquire the resources. Control -Obtain feedback reports (Capital Expenditure Progress Reports.

to reduce business risk by dealing in different products and operating in different markets. The accept – reject decisions occur when proposals are independent and do not compete with each other. Accept – Reject Decisions: These are opposite to mutually exclusive decisions. and vice – versa. b) Diversification Decisions: To diversify and enter into new product lines. The firm may accept or reject a proposal on the basis of a minimum return on the required investment. Contingent Decisions: These are dependent proposals. product lines. to improve production facilities and to increased market share of existing products.2. Mutually Exclusive Decision: 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. a firm may be considering proposal to buy either a low cost economy model asset or a high cost super model asset. For example if a company accepts a proposal to set up a factory in a remote area it may have to invest in . improved versions of products etc. For example. If the economy is purchased. All proposals that give a return higher than a certain desired rate are accepted and the rest are rejected. The investments in one proposal require investment in one or more other proposals. it means that the super model needs not be purchased. B. Revenue Expansion Decisions: These decisions focus on improving sales. BASED ON NATURE OF DECISION: 1. 2. venture into new markets. 3. These are sub – classified into – a) Expansion Decisions: To add capacity to existing product lines to meet increased demand.

It is determined based on – a) technological obsolescence. Generally. net of salvage value of old assets if any. 5. b) physical deterioration. So the Present Value of future Cash Inflows will be computed by discounting the same at the appropriate discount rate. Generally CFAT = PAT (Profit After Tax) + Depreciation and other amortizations. there may be terminal inflows like – a) Recovery of Working Capital investment in the project. 4. Cash Flow after Taxes (CFAT): This refers to the Cash Inflows generated by the projects at various points of time. What are the basic financial factors used in Project Evaluation? The following basic financial factors are used in project evaluation techniques 1. 2. Time value of Money: The value of money differs at different point of time.infrastructure also. Initial Investment: This equals the cash outflow at the initial stage. b) Salvage value of fixed assets etc. and c) fall in market demand for the product. A project which does not earn at least the cut – off rate should not be accepted. houses for employees etc. the rate used for . 6. eg building of roads. 3. Project Life: The time period during which the project generates positive Cash Flow After Taxes is called Project Life. 6. Initial Investment = Cost of New Assets purchased + Investment in working Capital Less Sale value of old assets. Terminal Inflows: At the end of the project. if any. Discount Rate: It represents the cut – off rate for capital investment evaluation.

Initial Investment estimation: Generally. etc). 2. the need for maintaining higher Sundry Debtors. Since future flows are forecasted. an element of uncertainty or probability exists in these cash flows. Estimation of Additional Working Capital Requirements: a) Every Capital Project involves additional Working Capital to finance the increase in the level of activity (i. against certain Capital Goods. and d) ancillary equipments or utilities. b) Possibility of foreign exchange rate fluctuations. Cash and Bank Balances.e. b) removal and disposal of old equipment. e) Possibility of delay in the execution of the project and overruns due to delay beyond expected time. Stock-in-Hand. How are Project Cash Flows estimated? Project Cash Flows refer to the Costs (Cash Outflows) and Benefits (cash Inflows) associated with the Project. So. in case of Imported Capital Goods. d) Scrap Value or Net Realizable Value of old assets and equipment. The following points are to be considered in the estimation of future Cash Flows of a project 1. c) preparing the site and erection of equipments. Initial Investment includes the cost of the following – a) new equipment.discounting is the Weighted Average Cost of Capital of the enterprise. Other Factors to be considered in initial investment estimation – a) Impact of possible inflation on the value of Capital Goods. c) Subsidy of Special Capital Incentives if any. the additional Working Capital required to . 7.

At the expiry of the useful life of the project the working capital will be released and can. additional amount of working capital may be required every year. Repairs and Maintenance. the requirement should be shown in term of Cash Outflows. c) In case of inflation. c) Extent of Competition. Power and Fuel.facilitate expansion or diversification should be estimated carefully by the Finance Manager. Administrative Expenses. b) In expenses estimation. 5. 4. d) Effect of Advertisement and promotional expenditure. even though there is no increase in the activity levels. Sales promotion Expenses. etc are estimated individually. b) Effect of Price Change on Demand. therefore. distinction should be drawn between – i) Fixed Cost. e) Capacity of plant and the budgeted level of utilization. Estimation of production and Sales: The possible production and sales are based on the following – a) Nature of the market. which remains the same at various activity levels and ii) Variable Cost. Estimation of Cash Expenses: a) Major items of Cash Expenses like Raw Materials. The Gross Sale Revenue is estimated as Sale Quantity X Selling Price per unit. be treated as Cash Inflow. which varies at different levels of output. Estimation of Cash Inflows: The Cash Inflows for every year is determined in the following manner – . b) As the new capital project starts operating. 3. Labor.

a) Project Earnings = EBIT X (100% . b) Example: Firm may finance its expansion plan by withdrawing money from its bank deposits. 2) Differential Cost: It is the change in costs due to change in the level of activity or pattern or method of production. 1) Marginal Cost: Marginal Cost is the total variable cost.e. the loss of interests on the bank deposit is the opportunity cost for carrying out the expansion plan.Tax Rate) Interest Expenses (100% . Then. A) Relevant Costs: These are costs which are relevant and useful for decision-making process. Prime cost plus Variable Overheads. What are the principles involved in the estimation of Project Cash Flows? On the basis of relevance to decision-making. if a person quits his job and enters into . the difference is called Decremental costs. It is assumed that variable cost varies directly with production whereas fixed cost remains fixed irrespective of volume of production. Marginal Cost is a relevant cost for decision making as this cost will be incurred in future for additional units of production. 3) Opportunity cost: a) This refers to the value of sacrifice made or benefit of opportunity foregone in accepting an alternative course of action. Costs are classified into A) Relevant and B) Irrelevant Costs. Where the change results in increase in cost it is called Incremental cost whereas if costs are reduced due to decrease of output. i. Similarly.Tax Rate) (OR) EAT + b) Cash Inflows after Taxes (CAFT) = Project Earnings + Depreciation 8.

making and analytical purposes. opportunity cost is not recorded in formal accounts and is computed only for decision. 5) Replacement Cost: It is the cost at which there could be purchased of an asset or material identical to that which is being replaced or revalued. Such costs are relevant for decision – making. as these will occur in near future. Where alternative capital investment projects are being evaluated. It is that portion of total cost which involves cash outflow. examples of output are the products.business. it is necessary to consider the imputed interest on capital before a decision is arrived at. which are essential for the accomplishment of a managerial objective. etc. 6) Imputed Costs: These are notional costs appearing in the cost accounts only e. . interest on capital for which no interest has been paid. as to which is the most profitable project. It is the cost of replacement at current market price and is relevant for decision – making. 8) Engineered Costs: These are costs that result specifically from a clear cause and effect relationship between inputs and outputs. these are costs. Examples of inputs are Direct Material Costs. However. c) Opportunity Cost is a relevant cost where alternatives are available. 4) Out – of – pocket Costs: These are costs which entail current or near future outlays of cash for the decision at hand as opposed to costs which do not require any cash outlay like depreciation. notional rent charges. These can be avoided if a particular course of action is not chosen. 7) Discretionary Costs: These are “escapable” or “avoidable” costs. The relationship is usually directly and personally observable. In other words.g. the salary forgone from employment constitutes opportunity cost.

However. escalation and overrun aspects. commercial and social viabilities.B) Irrelevant Costs: These are costs which are not relevant or useful for decision – making. Explain the main features in the preparation of project report distinguishing between viability. which are avoidable costs. 2. 3. if Fixed Cost are specific. they are irrelevant for managerial decision – making. Definition: Project Report or Feasibility Report is a return account of various activities to be undertaken by a firm and their technical. Committed Cost: A cost which has been already committed by the management is not relevant for decision – making.Purpose: Project report states as to what business is intended to be undertaken by the entrepreneur and whether it would be technically possible. commercially profitable and socially desirable to do such a business. 10. It is not relevant for decision – making and is caused by complete abandonment as against temporary shut – down. 2. financially viable. Although such fixed costs are absorbed in cost of production at a normal rate. feasibility.Features of a Project Report: a) Technical Feasibility: This includes analysis about the technical requirements of the industry in relation to the project in . RTP 1. 1. 3. financial. they become relevant. This should be contrasted with discretionary costs. Sunk Cost: it is a cost which has already been incurred or sunk in the past. Absorbed Fixed Cost: Fixed Costs do not change due to increase or decrease in activity.

assessment of fixed and variable costs.Social viability becomes necessary for performing the social responsibilities of the firm. -Financial Viability includes estimation of capital requirements and its costs. selection of machinery and plant etc.Business entity depend heavily on specialized Financial Institutions. arrangement of credit. etc. 11. the social benefits of the project must be analyzed well. Financial and Commercial Viability: -Economic Viability is concerned with a thorough analysis of present and future market prospects for the proposed product and involves the study of possible competitors in the market and the firm’s relative cost advantages and disadvantages in relation to them. at the time of preparing the project report. forecasting of sales revenue. adoption of appropriate technology. .hand and involves an examination of issues like suitability of plant location. financially and commercially viable. Therefore. for procuring finance. A project must. finding out the break-even points. therefore. What are the contents of a project report? . be economically. c) Social Viability: . measurement of profit. Government or its agencies would extend assistance to a business unit only if the proposed project is socially desirable. -Commercial Viability includes the estimation of the selling problems and profitability of the project. computation of operating costs. cash flow estimates. b) Economic. funded or approved by Government.

Raw materials. Production Processa) Broad description of different production processes and their relative economies. specification and quality of raw materials required and their sources of availability. If power to be generated – total cost of investment. 2. boiler feed. 5. choice of fuel and the cost for fuel available to factory. Industry Information – a) Information about industry and its status in the economy. indicating licensed.Availability of skilled labor and other grades of labor to meet the project’s requirements. Government policies and export potential. sources of water available and making it usable for the factory and to townships. b) Availability of technical know-how within and outside the country.A project report consists of the following – 1. present production and demand pattern. etc. cooling etc. Resources/ Utilitiesa) Location of plant. installed capacity. b) Broad market trend of the product and by-products within and outside the states/ country for 5 years. specification of power and choice between purchased power and generated power. 4. . its advantage and justifications. c)Power – total power requirements for the factory. d)Fuel – its requirement for steam raising or processing source. b)Water – requirements of water for process. 3. Man Power. and price at which it will be available for factory.

contingencies. investment in the effluent treatment and disposal. organizational chart. Cost of Project. Cost of Production. promoter’s contribution. commissioning expences. approvals from authorities like pollution control board etc.project broad pattern for 5years vis-à-vis design capacity. working capital margin requirements.Implementation and construction programme in the form of CPM/PERT and flow charts indicating critical paths and schedules. Profitability – a) Profitability for 5years after commission of the project should be worked out. promoter’s experience and background. delegation of power. cost of spares. price trend of raw materials and finished goods. plant and machinery.e) Effluents – type and quality of effluents. their treatment and disposal. 9. b) Cash flow statement and pay-back period for the project. key personnel. buildings. 11. preliminary expenses. 6. and responsibility structure.Organisation and management – description of corporate management. Implementation Programme. 7. utilities. break-even point. 8.details of capital structure or financing mix broad pattern. 10. selling price etc.Lists the objective in various spheres of business and evaluates the objectives in the right perspective. effect of variation of cost of raw materials. What are the advantages of a project report? The advantages of a project report are1. Pattern of Finance. 12.Expenditure on Land. loan components etc. .

13. production scheduled and targets as laid down in the project report. 3.management background. 5. What are the steps taken in project appraisal by the financial institutions? Do these steps differ in inflationary and deflationary conditions? RTP 1. Purpose: appraisal exercises are aimed at determining the viability of a project. -traits as entrepreneurs. Steps in appraisal: major steps undertaken by financial institutions under project appraisal are a) Promoter’s Capacity: Promoters capacity and competence is examined with reference to their. equipment. and sometimes reshape the project so as to upgrade its viability.2. . for arriving at a financing decision. 4. Provides a framework of the presentation of the information regarding business required by government for granting licenses etc. Identifies constraints on resources viz manpower. Helps in procuring finance from various financial institutions and banks which ask for such detailed information before giving any assistance. The successful implementation of a project depends upon the projected profitability and cash flows. Meaning: project appraisal is a process whereby a lending financial institution makes an independent and objective assessment of the various aspects of an investment proposal. Facilities planning of business by setting guideline for future action. financial and technological etc well in advance to take remedial measures in due course of time. 2. 3.

and the market share expected to be captured. projected growth in the market demand. Reference to the size of the market. -past performance etc Different considerations are applied in the case of new entrepreneurs. b) Project report: project report must be complete in all aspects so that its appraisal becomes easy and relevant. economic. quality and cost of services. It involves evaluation of project cost in the light of period of Economic Viability Financial vaibility . financial. labour.contained study with necessary feasibility report. market surveys etc. housing transportation etc. the project report should be a self.-business or industrial experience. Management. power. availability. fuel. For this purpose. supplies of raw materials. land. It is done on the basis of market analysis of the product or service with particular. commercial. c) Viability Test: viability test of a project is to be carried out by examining the project from different aspects viz. technical. social and other related aspects as discussed below Technical feasibility It involves consideration of technical aspects like location and size of the project.

construction work, provision for cost escalation, timing of raising funds, projected cost of production and profitability, and cash flow projections, to ensure the potentiality of the project to meet the current and long term obligations. Management capability It is an examination of the track record of promoter’s, their background and capabilities, and competence of the management team. Social relevance of a project like conformity with national policies and plant priorities are also important factors to be considered in project appraisal.

Social relevance

4. Appraisal in inflationary and deflationary situations: project appraisal during inflationary and deflationary conditions does not differ materially from that of an appraisal during normal conditions, except that the financial, economic and commercial aspects require to be taken care ofInflationary Situations a) Project cost, prices of raw materials and labor cost will go up. Hence there would be a decline in the profitability, as the prices of end products are controlled by the government or Deflationary situations a) During a recessionary period, the stocks of finished goods tend to accumulate resulting in the blocking up of working capital, and thereby contributing to the sickness of

market. b) Market may not be prepared to pay a higher price during an inflationary period. Such a situation impairs the financial viability of the project.

the project. b) It is important to take into consideration the economic conditions while appraising a project.

14. Write a brief note on project appraisal under inflationary conditions. N03 1. Cost escalation: It is required to make provisions for cost escalation on all heads of cost, keeping in view the rate of inflation of during likely period of delay in project implementation. 2. Cost of funds: The various sources of finance should be carefully scrutinized with reference to probable revision in the rate of interest by the lenders and the revision which could be effected in the interest bearing securities to be issued. All these factors will push up the cost of funds for the firm. 3. Adjustment in projections: Adjustments should be made in profitability and cash flow projections to take care of the inflationary pressures affecting future projections. 4. Re-evaluation of financial viability: a) The financial viability of the project should be examined at the revised rates and should be assessed with reference to economic justifications of the project.

b) The appropriate measure for this aspect is the economic rate of return for the project, which will equate the present value of capital expenditures to net cash flows over the life of the project. c) The rate of return should be acceptable which also accommodates the rate of inflation per annum. 5. Choice of Project: In an inflationary situation, projects having early pay back periods should be preferred because projects with long payback period are more risky. 6. Approaches: a) Adjustment of Cash flows: Projected Cash flows should be adjusted to an inflation index, recognizing selling price increases and cost increases annually; or b) Adjustment of Cut-off rate: “Acceptance Rate” (Cut-off) should be adjusted for inflations, retaining cash flow projections at current price levels. Note: Adjustment in both the cash flows and the cut – off rate should not be done.

2. PROJECT EVALUATION TECHNIQUES 15. List some technique of evaluating a project’s financial viability. The following are some techniques of Project Evaluation – 1. Simple Payback Period 2. Discounted Payback Period 3. Payback Reciprocal 4. Accounting or Average Rate of Return (ARR)

Meaning: a) Payback period represents the time period required for complete recovery of the initial investment in the project. Profitability Index (PI) or Desirability Factor or Benefit – Cost Ratio. 7. since initial investment is recouped faster. Internal Rate of return (IRR) and Modified Internal Rate of Return (MIRR) 16. Example: Suppose a project with an initial investment of Rs 100 lakhs.5. In this case. b) The lower the payback period. What do you understand by Payback Period? How is it determined? 1. c) Compute payback period as under- . after writing off depreciation of Rs 5 lakhs per annum. the payback period is computed as under – a) CFAT per annum = PAT + Depreciation = Rs 20 + Rs 5 = Rs 25 lakhs b) Hence Payback Period = Initial Investment/ CFAT per annum = 100/25=4years. the better it is. Net Present Value (NPV) or Discounted Cash Flow (DCF) 6. yields profit of Rs 20lakhs. It is the period within which the total cash inflows from the project equals the cost of investment in the project. Procedure for computation of Simple Payback Period: a) Determine the initial investment (Cash Outflow) of the Project. 2. b) Determine the CFAT (Cash Inflows ) from the project for various years. 3.

It clarifies the concept of profit or surplus. there is no profit on any project unless the payback period is over. . Surplus arises only if the initial investment is fully recovered. since they can be rotated more number of times. When funds are limited. . 3. ADVANTAGES: 1. Hence. projects having shorter payback periods should be selected. 17.In case of uniform CFAT CFAT for various years per annum In case of Differential Payback period = Initial Investment cumulative CFAT at the end CFAT per annum -compute of every year . 2.Determine the year in which cumulative CFAT exceeds Initial Investment. Bring out the advantages and disadvantages of the Simple payback method. This method is simple to understand and easy to operate.Payback period = Time at which cumulative CFAT = Initial Investment (Calculated on time proportion basis) d) Accept if payback period is less than maximum or benchmark period. A. else reject the project.

LIMITATIONS: 1. Cash flows occurring at all points of time are treated equally. the point at which the costs are fully recovered but profits are yet to commence. It does not consider the post – payback cash flows. This method becomes an inadequate measure of evaluating two projects where the cash inflows are uneven. 5. This method focuses on projects which generates Cash inflows in earlier years. 7. Other projects with moderately higher but uniform CFAT may be rejected because of longer payback. it is not good measure to evaluate where the comparison is between two projects. This is a very useful evaluation tool in case of liquidity crunch and high cost of capital. Thus payback period tries to eliminate or minimize risk factor. 6. This goes against the basic principle of financial analysis which stipulates . 3. This method promotes liquidity by stressing on projects with earlier cash inflows. This method is suitable in the case of industries where the risk of technological obsolescence is very high and hence only those projects which have a shorter payback period should be financed.e. There may be projects with heavy initial inflows and very less inflows in later years. returns from the project after its payback period. risk and uncertainty also increases. Hence. As time period of cash flows increases. one involving a long gestation period and the other yielding quick results but only for a short period. The payback period can be compared to a break-even point. It stresses on capital recovery rather than profitability. thereby eliminating projects bringing cash inflows in later years. i.4. 2. 4. B. This method ignores the time value of money.

Determine the year in which cumulative DCFAT exceeds initial investment. What do you mean by payback reciprocal? How is it used for project evaluation? . Outline the manner of computation of discounted payback period.(Initial Investment) Determine the cash inflow after taxes (CFAT) for each year. else reject the project.off rate). Compute discounted payback period as the time at which cumulative DCFAT = Initial Investment. DCFAT = CFAT of each year X PV factor for that year. 7 19. This is calculated on “time proportion basis”. Accept if discounted payback period less than maximum/ benchmark period. 4 5 6 Determine the cumulative DCFAT at the end of every year. It is computed as under – Step 1 2 3 Procedures Determine the total cash outflow of the project. 18. Determine the PV factor for each year and compute discounted CFAT (DCFAT) for each year. When the payback period is computed after discounting the cash flows by a pre determined rate (cut.compounding or discounting of cash flows when they arise at different points of time. it is called as the ‘Discounted Payback Period’.

Utility: The payback reciprocal is considered to be an approximation of the internal rate of return. Determine the Profits After Tax (PAT) for each year.1. PAT = CFAT less depreciation. Its payback reciprocal will be Rs 10lakhs/ Rs 50lakhs = 20%. 1. Meaning: Accounting or Average Rate of Return means the average annual yield on the project. Procedure for computation of ARR: St ep 1. CFAT p. Profit after taxes (instead of CFAT) is used for evaluation. 2 3 4 5 Procedure Determine net investment of the project. 20.) Initial Investment 2.a. Determine the total PAT for N years. if – a) The life of the project is at least twice the payback period and b) The project generates equal amount of the annual cash inflows. Example: A project with an initial investment of Rs 50 lakhs and life of 10 years. generates CFAT of Rs 10 lakhs per annum. where N = Project life. In this method. 3.e. Meaning: It is the reciprocal of payback period. Write a brief note on Accounting or Average Rate of Return Method (ARR). 2. It is expressed in percentage and computed as under – Payback reciprocal = Average annual cash inflows (i. Compute average PAT per annum = total PAT of all years/ N years ARR = Average PAT per annum / Net Investment = sept 4 / . Net investment = Initial Investment less Salvage Value.

c) It ignores time value of money. Explain the net present value method (NPV) discounted cash flow technique (DCF). Advantages: a) simple to understand b) easy to operate and compute c) Income throughout the project life is considered. which is important in capital budgeting decisions.Sept 1 3.2.4……n Initial Investment pertains to Time 0 and is hence not discounted. 4. 21. The patterns of fluctuations in profits are ignored. FV = Future Cash inflows arising at points of time 1. Limitations: a) It does not considers cash inflows (CFAT). Meaning: The Net present value of an investment proposal is defined as the sum of the present values of all future cash inflows less the sum of the present values of all cash outflows associated with the proposal. NPV= FV1/(1+K)1 + FV2/(1+K)2 + FV3/(1+K)3 + FV4/(1+K)4 + ……+ FVn/(1+K)n Less initial Invt0 Note: K = Cut –off rate. b) It takes the rough average of profits of future years. NPV is calculated as under – NVP = Discounted Cash Inflows Less Discounted Cash Outflows. which is important in project evaluation rather than PAT.3. Thus. . 1.

Cash outflows: Generally. 6. Reject the project. Project generates cash flows at a rate just equal to the coat of capital. 3. This constitutes an indifference point. Surplus over and above the cut – off rate is obtained. Procedure Determine the total cash outflow of the project and the time periods in which they occur. NPV<0 4. else reject. 4. Procedure for computation of NPV: Ste p 1. it may be accepted or rejected. cash outflows consists of – a) initial investment which occurs at time “0” and b) special . Compute the total discounted cash outflow = outflow X PV factor Determine the total cash inflows of the project and the time periods in which they arise. The project does not provide returns even equivalent to the cut – off rate. Decision making or Acceptance rule: If NVP> 0 NPV=0 Decision Accept the project. 2. 3. 5.2. Hence. Compute the total discounted cash inflows = Inflow X PV factor Compute NVP = Discounted Cash inflows less discounted Cash outflows (Step 4 less step 2) Accept project if NPV is positive.

tax savings on loss due to sale of old asset.8264 and so on. 22. the relevant discount factor can be computed as 1/(1+k)n. 5. annuity tables may be used.9091 Similarly. Tax paid on Capital Gain made by sale of old asset. should be carefully considered. PV factor at the end of two years = 1/(1. Discounting cash inflows and outflows: Each item of cash inflow and cash outflow is discounted to ascertain its present value. specific cash inflows like salvage value of new assets and recovery of working capital at the end of the project. In case of uniform cash inflows p. where k = cost of capital and n = year in which the inflow or outflow takes place. Use of discounting rate: of using the PV factor tables. Cash inflows: cash inflows = CFAT. Note: The NPV method will give valid results only if money can be immediately reinvested at a rate of return equal to the firm’s cost of capital. Also. PV factor at the end of two years = 1/ (1. The general assumption is that all cash inflows occur at the end of each year. What are the merits and demerits of the NPV method? A. The present value tables are used to calculate the present value of various cash flows.a.ADVANTAGES: . For this purpose. eg Working Capital outflow which arises in the year of commercial production. 7. 6..payments and outflows. if any.10)1 = 0.10)2 = 0. the discounting rate is generally taken as the cost of capital since the project must earn at least what is paid out on the funds blocked in the project. Hence.

4. causing inconsistency in decision – making. while evaluating mutually exclusive projects. 23. It involves complex calculations in discounting and present value computations. each project can be evaluated independent of others o its own merit. 4.1. B. 3. Unlike payback period. NPV constitutes addition to the wealth of shareholders and thus focuses on the basic objective of financial management. LIMITATIONS: 1. it satisfies the basic criterion for project evaluation. 3. It involves forecasting cash flows and application of discount rate. Thus accuracy of NPV depends on accurate estimation of these two factors which may be quite difficult in practice. Hence. What is desirability factor? How is it determined? RTP Write a brief note on profitability index. PI [or] desirability factor [or] benefit cost ratio = Present value of operational cash inflows . different projects can be compared on NPV basis. 1. NPV and project ranking may differ at different rates. all cash flows (Including post-payback returns) are considered. Since all cash flows are converted into present value (current rupees). Thus. It considers the time value of money. size of different proposals etc. 2. It ignores the difference in initial outflows. 2. Definition: Benefit – cost ratio / profitability index or desirability factor is the ratio of present value of operating cash inflows to the present value of net investment cost.

Both NPV and PI use the same factors i.e. b) It is a better project evaluation technique than Net Present Value and helps in ranking projects where Net Present Value is positive. it may be accepted or rejected. c) It focuses on maximum return per rupee of investment and hence is useful in case of investment in divisible project. PI will always be greater than 1. 5. in the computation. The project does not provide returns even equivalent to the cut – off rate. whereas PI = A / B. Reject the project. NPV = A – B.Present value of net investment 2. PI < 1 Note: when NPV > 0. for every rupee invested in the project. since the greater is the return for every rupee of investment in the project. Surplus ever and above the cut – off rate is obtained. 3. 4. the better it is . Disadvantage: . Hence. This constitutes an indifference point. discounted cash inflows (A) and discounted cash outflows (B). Significance: Profitability index represents amount obtained at the end of the project life. when availability of funds is restricted. Advantage: a) This method considers the time value of money. Decision making or acceptance rule: If PI>1 PI = 1 Decision Accept the project. Project generates cash flows at a rate just equal to the cost of capital. The higher the PI.

IRR refers to that discount rate K.e. the total NPV in such case being more than the one with a project with highest profitability index. the net present value is equal to zero and the discount rate which satisfies this condition is determined. profitability index alone cannot be used as a measure for choosing. b) 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. possibility of accepting several small projects which together may have NPV then the single project is excluded. NPV = 0 and PI = 1 The discount rate . cost of capital is assumed to be known in the determination of net present value. M96 1. i. Interpretation: Internal rate of return can be interpret in two ways – a) IRR represents the rate of return on the unrecovered investment balanced in the project. Meaning: Internal rate of return (IRR) is the rate at which the sum total of discount cash inflows equals the discount cash outflows. such that FV1/(1+K)1 + FV2/(1+K)2 + FV3/(1+K)3 + FV4/(1+K)4 + ……+ FVn/ (1+K)n Less initial Invt0 = 0 (Zero) At IRR. . 24. c) In case of more than one proposals. The internal rate of return of a project is the discount rate which makes net present value of the project equals to zero. Write short notes on Internal Rate of Return.a) In case a single large project with high profitability index is selected. 2. while in the IRR calculation. which are mutually exclusive. with different investment patterns or values.

Hence. Procedure for computation of IRR: Step 1 2 Procedure Determine the total cash outflow of the project and the time periods in which they occur. 4. . Project generates cash flows at a rate just equal to the cost of capital. since it may not always be possible for an enterprise to reinvest intermediate cash flows at a rate equal to the IRR.b) IRR is the rate of return earn on the initial investment made in the project. The project does not provide returns even equivalent to the cut – off rate. Of these. it may be accepted or rejected. Decision making or acceptance rule : If IRR > K0 IRR = K0 IRR < K0 Decision Accept the project. This constitutes an indifference point. Surplus over and above the cut –off rate is obtained. 3. the first view seems to be more realistic. Determine the total cash inflows of the project and the time periods in which they arise. Reject the project.

3 4 Compute the NPV at an arbitrary discount rate. Advantages: a) time value of money is taken into account. 5 6 5. All projects having IRR above the cost of capital will be automatically accepted. d) It helps in achieving the basic objective of maximization of shareholders wealth. compute the discount rate at which NPV is zero. Compute the change in NPV over the two selected discount rates. Multiple IRR’s may result. b) all cash inflows of the project. . 6. In case NPV is negative at 10%. Disadvantages: a) IRR is only an approximation and cannot be computed exactly always. C) It may conflict with NPV in cash inflow / outflow patterns are different in alternative proposals. arising at different points of time are considered. leading to difficulty in interpretation. b) It is tedious to compute in case of multiple cash outflows . The second discount Rate is chosen in such a way that one of the NPV’s is negative and the other is positive. choose a lower rate. c) decisions are immediately taken by comparing IRR with the cost of capital. NPV is positive at 10% choose a higher discount rate so as to get a negative NPV. On proportionate basis. say 10% Choose another discount rate and compute NPV. Suppose.

the initial investment. .e.e. How should the comparison of two mutually exclusive projects be prepared be treated when they are of unequal investment size? Compare between two projects can be done based on NPV method only if initial investment and project lives are the same.d) The presumption that all the future cash inflows of a proposal are reinvested at a rate equal to the IRR may not be practically valid. This is taken as the “inflow” from the project. where reinvestment factor = (1+ K)n where n = number of years balance remaining in the project. Compute MIRR. to be compared with the “outflow” i. 25. the interpolation techniques applicable to IRR may be used. Compute total of terminal values as computed under step 2. Write short notes on the modified internet rate of return (MIRR) Modified internal rate of return is computed as under – Step 1 2 Procedure Determine the total cash outflows and inflows of the project and the time periods in which they occur. discount rate such that PV of terminal value = initial investment. Compute terminal value of all cash flows other than the initial investment. 3 4 26. Note: for computing MIRR. i. terminal value of a cash flow = Amount of Cash flow X Re-investment Factor. For this purpose.

. in case of cost comparison.e. the salvage value at the end of the 3rd year should be considered in the evaluation process.. during which period machine A will be replaced 5 times and machine B will be replaced 3 times. 3.Equivalent annual flows method: a) Cash flows are converted into an equivalent annual annuity called EAB i. Cash flows are extended to this period and computations made. In the above example. LCM method: a) Evaluate the alternatives over an interval equal to the lowest common multiple of the lives of the alternatives under consideration..Where project lives are different. the decisions can be obtained by any of the following methods – 1. Terminal value: Estimate the terminal value for the alternatives at the end of a certain period i. b) The amounts are then compared and decisions drawn i. if the product can be produced only for 3years. product life... equal years. The final results would then be on equal platform i. discussed above.e. proposal A has 3 years and proposal B has 5 years. Lowest common multiple period = 15 years. Equivalent annual benefit (in case of net inflow) or EAC i. proposal with the lower equivalent annual flow will be selected. equivalent annual cost (in case of net outflow) i..e. c) This is similar to the equivalent annual benefits / cost method. . Total discounted cash flows / Total discount factor for the period. and hence would be comparable.e. and in case of benefit comparison. b) Example.e.e. 2. proposal with the higher annual flow will be selected.

However. 7 28. Resource constraint: There may be situations where a firm has a number of projects that yield a positive NPV.. Such a situation is considered as a resource constraint situation.e. Explain how investment decisions are taken in a capital rationing situation. the objective of the firm is to maximize the wealth of shareholders with the available funds. the most important resource in investment decisions. i. Explain the annual equivalent annual flows methods used in project – life disparity situations. Capital rationing: In case of restricted availability of funds. 2. Such investment planning . Step 1 2 3 4 5 6 Procedure Compute the initial investment of each alternative Determine the project lives of each alternative Determine the annuity factor relating to the project life of each alternative Compute equivalent annual investment (EAI) = initial investment / relevant annuity factor Compute CFAT per annum or cash outflows per annum. funds is not fully available to undertake all the projects. Compute equivalent annual benefit (EAB) = CFAT per annum Less EAI OR Compute equivalent annual Costs (EAC) = Cash outflows per annum + Cash outflows per annum + EAI Select project with maximum EAB or minimum EAC. as the case may be.27. of each alternative. 1.

• Compute NPV of each combination. may be market constraint on the amount of funds available for investment during a period. • Select combination with maximum NPV Divisible Partial investment is possible and proportionate NPV can be obtained. due to external factor is called Hard Capital Rationing. in the following situations. There are two possible situations of capital rationing(a) Generally. This inability to obtain funds from the market.e. the project will lapse. during a given period of time. • Determine the combination of project to utilize amount available. Step involved in decision-making 4. Other Factors: In the above procedure. firms fix up maximum amount that can be invested in capital projects. additional mathematical techniques are adopted to resolve the Capital Rationing problem- . i. NPV Maximization: Whenever Capital Rationing exists. The following principles may be applied in selecting the appropriate investment proposals/combinationsNature of Project Meaning Indivisible Investment should be made in full. • Compute PI of various projects and rank them based on PI • Projects are selected based on maximum Profitability Index. (b) There 3. This budget ceiling imposed internally is called as Soft Capital Rationing. However. say a year. if investment is not made immediately. partial or proportionate investment is not possible. it is assumed that the investment funds are restricted for one period only. the Firm should allocate the limited funds available in such a way that maximizes the NPV of the Firm.is called capital rationing.

(e) Hence.2 Lakhs Rs.10 Lakhs Rs. NPV and PI method give the same Accept or Reject decision. if one project is to be selected out of two mutually exclusive projects. whereas PI=A/B. for a given project. PI will be less than 1. (c) Both NPV and PI use the same factors i.5 Lakhs Rs. Acceptance-Rejection Decision: (a) Both NPV&PI techniques recognize the time value of money.3 Lakhs 2.5 Lakhs Rs. Do the Profitability Index (PI) and Net Present Value (NPV) criterion of investment proposals lead to the same acceptance-rejection and ranking decisions? In what situations will they give conflicting result? 1. NPV=A-B. 29. Also when NPV<0.(a) Cost of investment projects spread over several periods.e. the NPV and PI method may give conflicting ranking criteria. PI will always be greater than 1. An example is given belowProject Discounted Cash Inflows Less: Discounted Cash Outflows Net Present Value Profitability P Rs. (b)Projects providing relatively higher cash flows in earlier years. (d) When NPV>0. Ranking criteria: However. Discounted Cash Inflow (A) and Discounted Cash Outflows (B). which can be used for incre3asing the fund availability for other projects in those early years.5 Lakhs 2. (b) The discount rate used in NPV and PI methods are the same.50 .00 Q Rs. 2. in the computation.

. (b) Project Life Disparity-I. M 01 1. by setting NPV = 0. b) NPV considers Cost of capital as constant. This is because NPV gives the ranking in terms of absolute value of rupees. the NPV method must prevail. However. Under IRR. i. in the following situations(a) Initial Investment Disparity. Decision-making: Generally the NPV method should be preferred since NPV indicates the economic contribution or surplus of the project in absolute terms.i. 3. Causes for Conflict: Higher the NPV. in capital rationing situation.Project P has a better ranking based on NPV while Project Q will be preferred if PI were to be used for decision –making. PI is a better evaluation technique. whereas PI gives ranking for every rupee of investment. 30. NPV and IRR may give conflicting result in the evaluation of different projects. for deciding between mutually exclusive projects. 2. as given from the following points – a) NPV represents the surplus from the project but IRR represents the point of no surplus – no deficit. (c) Outflow Patterns-i. rather than as Initial Investment (Time 0) only. Decisions are based on NPV. higher will be the IRR. In case of NPV and IRR. Thus. the discount rate is determined by reverse working. A project with heavy initial CFAT than compared to later years will have higher IRR and vice versa. due to the comparative of NPV. (d) Cash Flow Disparity-when there is a huge difference between initial CFAT and later years’ CFAT. in terms of ratio. Superiority of NPV: In Case of conflicting decisions based on NPV and IRR. Different in Project Lives. which method is superior in project evaluation? M 02. Different Project Sizes. between NPV and PI methods. there is a conflict in Ranking.e. However.e.e.e. when Cash Outflows arise at different point of time during the Project Life.

IRR is greatly affected by the volatility / variance in cash flows patterns. Reinvestment at the cut – off rate. e) IRR presumes that intermediate cash inflows will be reinvested at the rate (IRR). 2. is more realistic than reinvestment at IRR. b) The purpose of SCBA to supplement and strengthen the existing techniques of financial analysis. IRR by itself does not aid decision – making. NPV does not pose such interpretation problems. Explain the concept of “social cost – benefit analysis”. For example. projects with positive NPV are accepted. the return on investment factor is considered dominant. However. . Meaning: a) In evaluation of investment proposals. f) There may be projects with negative IRR / Multiple IRR etc. the social impact of investment proposals should also be considered. 31. The later presumption viz. d) NPV method considers the timing difference in cash flows at the appropriate discount rate. a project with IRR = 18% will be accepted if Ko < 18%. This leads to difficulty in interpretation. Need for social cost benefit analysis (SCBA): a) Market prices used to measure costs and benefits in project analysis.e. since scarce resources are employed. whereas in the case of NPV method. intermediate cash inflows are presumed to be reinvested at the cut – off rate..c) NPV aids decision – making by itself i. Is it relevant for private enterprises also? RTP 1. do not represent social values due to imperfections in market. However. if cash outflows arise at different points of time. the project will be rejected if Ko = 21% (say > 18%). Such analysis is called Social Cost Benefit Analysis (SCBA).

it will ensure that it is not ignoring its own long – term interest. Ascertain alternative solutions / projects to the problem Estimate and analyst the social costs and benefits. c) Taxes and subsidies are monetary costs and gains. Thus merit wants are important appraisal criterion for SCBA. or creating infrastructure like electricity generation are more important than projects for manufacture of liquor and cigarettes. 3. Procedure: Social Cost Benefit Analysis involves the following steps: Step 1 2 3 4 5 Procedure Determine the problem to be considered. e) Projects manufacturing life necessities like medicines.b) Monetary Cost Benefit Analysis fails to consider the external effects of a project. b) If the private sector includes social cost benefit analysis in its project evaluation techniques. 4. Decide on the optimal solution. but these are only transfer payments from social point of view and therefore irrelevant. since in the long – run only projects that are socially beneficial and acceptable. which may be positive like development of infrastructure or negative like pollution and imbalance in environment. Relevance of Social Cost Benefit Analysis for Private Enterprises: a) Social cost benefit analysis is important for private corporation also which have a moral responsibility to undertake socially desirable projects. Appraise the estimated social costs and benefits. will survive. d) SCBA is essential for measuring the redistribution effect of benefits of a project as benefits going to poorer section are more important than one going to sections which are economically better off. .

and will result in incorrect decisions. IFCI. Financial decisions: a) This involves identifying the source from which the finance manager should raise the quantum of funds required by a company. etc even insist on social cost benefit analysis of a private sector project before sanctioning any loan. Investment Decision: a) Investment decisions will be biased. expectations of equity shareholders will rise. d) Private enterprise cannot afford to lose sight of social aspects of a project. he must take into consideration the inflation factor. Issues to be addressed while considering inflation in various aspects of financial management are as follows – 1..c) Methodology of social cost benefit analysis can be adopted either from the guidelines issued by the United Nations Industrial Development Organization (UNIDO) or the Organization of economic corporation and development (OECD). 3. Risk Analysis Inflation affects various aspects of financial management. This is because cash flows of an investment project occur over a long period of time. . 2. b) Debenture holder and preference shareholders are interested in fixed income while equity shareholders are interested in higher profits to earn high dividend. if the impact of inflation is not correctly factored in the analysis. since under inflationary conditions. Financial institutions e. IDBI. c) While estimating the revenue and costs. b) Non – consideration or inappropriate consideration will give rise to wrong profitability values.g. The finance manager is required to estimate the amount of profits he is going to earn in future.

Working Capital Decisions: a) Impact of inflation should be considered while estimating the requirements of working capital.3.Dividend payout policy: a) While taking dividend decisions. even after the payment of dividend. What is Sensitivity Analysis? RTP. Objectives: Sensitivity Analysis seeks to provide the decision maker with information concerning – . 33. each variable is fixed except one. 4. where technological changes industries. 2. more profits may have to be retained than what has been retained by way of depreciation. It is a study which determines how changes or errors in the values of parameters affect the output of a model. which is changed to see the effect on NPV or IRR. the depreciation provided on the basis of historical costs of assets would not provide adequate funds for replacement of fixed assets at the expiry of their useful lives. b) In any inflationary situation. more funds will be blocked in inventories and receivables. b) Even though working capital management is over a shorter period. inflation rate may vary wildly even in short periods of time. Due to the increasing input prices and manufacturing costs. where technological changes will render the existing infrastructure redundant at a rapid pace. b) In this analysis. c) Therefore. the finance manager has to consider the inflation factor. This is more relevant in case of those industries. Meaning : a) Sensitivity analysis shows the measure of sensitivity of a decision due to changes in the values of one or more parameters. and ensure that the capital of the company remains intact. N02 1.

Criticisms: a) Assumptions of Unrelated Variables – Not valid : Sensitivity analysis assumes variables to be completely unrelated to each other. The extent of change in NPV / IRR / PI reflects the extent of inverse of extent of sensitivity.. Summarize the conclusions based on findings obtained in Step 4. and find the NPV. . Determine the extent of change in NPV / IRR / PI. it may have an impact on other variables as well.e. i. when one variables changes. without adjusting the cost per unit. and b) The potential for reversal in the preferences as for economic investment alternatives. 3. extent of sensitivity. Internal Rate of Return and Profitability Index. Example: Generally. Steps in Sensitivity analysis: Step 1 Description of procedure Conduct a base case analysis based on expectations for the future cash flows and ascertain Net Present Value.a) The behavior of the measure of economic effectiveness due to errors in estimating various values of the parameters. IRR or PI after the change. 2 3 4 5 4. If quantity of goods sold is reduced by 30% in sensitivity analysis. it would be inappropriate. Identity key assumptions (variables) made in the base analysis. It is only when the combined effect of changes in the set of inter – related variables is considered. which is generally not the case. Change one assumption at a time. a proper conclusion can be arrived at. due to change in variables. since the scale of activity will have a bearing on cost / price per unit.

Meaning: Decision tree analysis is the technique of solving /evaluating a decision making problem by the mapping all feasible alternatives action. the cash flow of the proposal is adjusted so as to reflect the risk element. as based on the chance estimated by the Firm. the smaller is the certain equivalent value for receipts. . and likely to be inconsistent from one investment to another.(b) Arbitrary: while using sensitivity analysis the financial analyst uses different valves of the uncertain variables purely on adhoc basis. The greater the risk of expected cash flow . Features: Expected cash flow (a) The certainty equivalent approach adjust future cash flows than the discount rate (b) Expected cash flow is converted to equivalent riskless amount. Assignment of the weights/ probabilities: Probabilities are the assign for future uncertain event. by adjusting estimate cash flow and employs risk free to discount the adjusted cash flows.e. This is superior to the risk adjusted discount approach as it can measure risk more accurately. Measurement of Risk 35 “Decision Tree Analysis is Helpful in Managerial Decision. 2. point of first alternative. Meaning: certainty equivalent approach recognize risk in capital budgeting analysis. Explain the Certainty Equivalent Approach to Capital Budgeting. (b) The approach explicitly recognizes risk but the procedure for reducing the forecast of the cash flow is implicit. and longer the certainty equivalent value for payment (a) The certainty equivalent approach. assigning respective weight and evaluating the net effect of the different at the starting point i. 2. 34. M02 1. Assigning value in such an arbitrary fashion is unscientific. for each alternative at each stage.” Explain RTP 1.

chance events and other data indicating there in the projected cash flow. (b) Assumptions: (c) . by the analysis of result at each decision point by backward computation. the approach clearly set the implicit assumption and calculation for all concerned with a project to see. Benefits: (a) Elimination unprofitable investments: Working backward from the future to the present help in the eliminating unprofitable branches or potentially unsafe decision and uncertain optimum decision point. represented by the circle: A decision which may result in two or more outcome 4. which is much easier to understand. Easier to understand and interpret: Decision tree approach enables a decision maker to visualize assumption and alternative in a graphic form. 5. i. than plain fact and figures. and elimination of the alternatives branches in the basic of the dominance.3. question and revise. Step: (a) Identification and definition of the investment proposal.e assignment of probability and estimation of the cash flow. probabilities and expected payoffs. (f) Evaluation of the project at the starting point. (d) Drawing the branch of the tree showing the decision point. (b) Identification of the decision alternatives (c) Identification / estimation of possible outcome for each decision. Components: Each decision tree has the two components or type of nodes – (a) Decision point. (e) Determination of the optimal decision (decision which result the maximum net expected profit) at various decision point. represent by the square boxes : Point where more than one decision can be taken (b) Chance point.

e the deviation of cash flow from the mean cash flow) 2. Decision: the project which have lower efficient of variation( variation per unit ) will be preferred . How would the standard deviation of the present value distribution help in Capital Budgeting Decision ? 1. Meaning : Standard deviation is a statistical measure of dispersion.6.e the mean. Write a short note on Hiller’s model to risk analysis. Standard deviation as a measured of Uncertainty: Uncertainty or the risk associated with the capital expenditure proposal is shown by the standard deviation of the expected cash flow. Inference :lower the standard deviation ( i. while coefficient of variation give the extend of deviation with reference to the central value (b)It can be used to identify which of the project least. in tream of cash flow (c) If it is assumed that probability distribution is approximately normal. 4. 36. if project sized are heterogeneous (different ). Standard deviation give deviation in value. Limitation/ shortcoming (a) Decision tree analysis is applicable only to those projects with clearly delineated stages. Not all the project can be clearly delineated for the proposed of Decision Tree Analysis (b) It can be applied only for project with sufficient information available in respect of probabilities for the outcomes. : Evaluation done in respect of two or more project giving the similar cash flow : 2. . Applicability 3. 1. Purpose (a) It help to measure extent of the variation. 37. it will be easy to calculate the probability of a cash budgeting generating the NPV less than or more than the specified amount. which measure the deviation from a central number i.

2. The yearly standard deviations are discounted. 2. Scenario: The two scenarios under which the Standard Deviation of a project is computed are-(a) Case 1. much more objective by factoring both risk uncertainty and time value of the money. generally three conditions are considered to exist in all the years. 1. (c) Hiller’s model the finance manger in taking up the capital budgeting decision. . Standard Deviation is computed on a daily basis over the life of the project. (b) Case 2-Cash Flows are independent. (b) In the case of two project.and if the standard deviation of the cash flow from the two project differ . The square root of the aggregate sum is the project standard deviation. one with the lower standard deviation should be chosen. more than three cash sets of cash flows may also be considered] 38.Cash Flows are perfectly correlated. 2. Utility : (a) The approach will recognized the uncertainty involve with the future project as it consider a range of cash flow for a given period. 3. Present value of standard deviations are squared and then aggregated. 4. Method of computation: Case 1. The yearly standard deviations over the life of the project are discounted to find the present value of standard deviation. in Hillier’s model. accept that in some scenario analysis.Cash Flows are perfectly correlated 1.3. Flows are 1. 3. giving the same or almost same mean cash flow . The discounted standard deviations are aggregated. 3. Meaning: Project Standard Deviation is the Present Value of Standard Deviation over the life of the project. to ascertain the present value of yearly standard deviations. The resultant sum is the standard Case 2-Cash independent. Write a brief note on Standard Deviation as a measure of Risk Analysis. [Notes: This is the same as scenario analysis.

Expected NPV: Expected NPV is the same if the Cash Flows are perfectly correlated as well as when the Cash Flows are independent. funds invested in a project involve Opportunity Cost. Write short notes on the Discount Rate or Cut-off Rate in Capital Budgeting decisions. Opportunity Cost: Funds available with a company for investment purposes are procured at a certain cost (WACC). it cannot be invested elsewhere to earn a return. it should earn a return in excess of 6%. or (d) Cutoff Rate. investment in risk-free securities or in other projects. The Opportunity Cost of the investment is known alternatively as-(a) Minimum Required Rate of Return. 2. If the yield from the project is less than 6% and the Company has no other project that can yield this return. These funds also have alternative uses. e. 3. If a Firm invests in a Project with zero-risk. or (b) Cost of Capital. If cash is invested in a project.g.present value of standard deviation in year 2. Then the formula applicable to find out the Project Standard Deviation is √(PV yEAR1)2 + (PVyear2)2 + ……+(PV year n)2 Where (PV yEAR1)2 – present value of standard deviation in year 1. or (c) Discount Rate . or (e) Interest rate. Example: Suppose. only if they yield a return in excess of the Opportunity Cost of investment. . 4. Hence. 1. Surplus making Projects: A firm should therefore invest in Capital Projects. the amount available should be distributed to Shareholders as dividends.deviation of the project. (PVyear2)2 . 4 . (PV year n)2 – present value in standard deviation in the final year. Interest on Government Bonds is 6%. 39.

financing policy. this is the minimum rate of return that is expected of any other investment alternatives. Hence. It comprises of the following• Firm’s Normal Risk: This is an adjustment for the Firm’s normal risk. nature of its constitution etc. 5. Risk premium model: An appropriate discount rate (RD) for a given project is a function of the following factors(a) Risk Free Rate of Return [RN]: If a project with a risk is going to yield a return lower than the Risk Free Rate of Return.The Shareholders can themselves invest the amounts so received and earn 6% return (from Government Bonds). 4. whose target customers are all abroad. Interest Rate on Government Bonds (Risk-Free Rate) cannot be used as Cut-Off Rate for decision-making purposes. the financing alternative (debt-equity mix) is not considered. this project will carry a higher risk than other existing projects. Constant WACC: As per the Net Operating Income and Modigliani & Miller approach to Cost of Capital. Hence. the cash flows will be affected by Exchange Rate fluctuations. Risk Aspect and WACC: Every project undertaken by a firm entails some risk. 40. Overall Cost of Capital or Discount Rate is considered constant for the Firm. Risk premium is the additional return that is expected for any risky investment. Example: For a new project. Hence. Therefore. while evaluating an investment proposal. where this exchange rate fluctuation is not a factor. • . the overall cost of capital of a Firm is constant irrespective of the level of debt-equity mix. 1. Explain the components of an appropriate discount rate. This may arise due to its capital structure. (b) Risk premium [RP]: extra return would mean extra risk. Project’s Risk: This is an adjustment for the differential risk for a particular project. the Firm would be well off by investing its funds in the risk here security. management risk.

Adjustment for Risk: Relationship Appropriate Discount Rate Risk of Project=Risk of the other Average Cost of Capital Investment of the Firm Risk of Project>Risk of the other Investment of the Firm Higher than average cost of capital .e. should be a factor of the following(a) Real Rate of Return [RR]: This is the discount rate that should be applied in respect of cash flows in a static economy. the relationship is expressed as follows1 + RD = (1 + RR) X (1+I) 41. Mathematically. the relationship is expressed as follows1+ RD = (1+RF) X (1 + RN) X (1 + RP) Where. Inflation Adjusted Rate: Appropriate discount rate for evaluating the projects cash flows. 2.(c)Formula: Theoretically. Meaning: Risk Adjusted Discount Rate is the normal discount rate adjusted upwards or downwards for the element of risk to reflect Project Risk. the appropriate discount rate is the sum of the Risk Free Rate and the Risk Free Premium.e. (1+RF) X (1 + RN) constitute the average cost of capital of the Firm. there is no inflation/deflation or cash flows are not affected by inflation. Explain the Risk Adjusted Discount Rate Method. 1. (b) Inflation [I]: Real Rate should be adjusted for inflation.e. 2. Mathematically. increased by the inflation rate to ascertain the appropriate discount rate. (c) Formula: Theoretically. which are expressed in nominal terms ( i. i. the appropriate discount rate is the sum of the Real Discount Rate and Inflation Rate. i. the actual estimated cash flow in money terms).

since the cash flows are Risk Adjusted Discount rate method Risk adjusted discount method adjusts discount (WACC) for risk. (c) Discount the cash flow at the RADR and identity the NPV.What are the differences between Certainty Equivalent Method and Risk Adjusted Discount Rate Method? Certainly equivalent Method Certainty equivalent method adjusts the cash flows of a project for risk. it is estimated on an adhoc basis. else Project is rejected. Certainty equivalent method is superior. (b) This method assumes that risk increase with time at a constant rate. (d) If the NPV is positive. rate rate Risk adjusted discount rate method does not consider the risk . Generally.Risk of Project<Risk of the other Investment of the Firm Lesser than average cost of capital 3. the Project may be accepted. which may not be valid. 42. 5. Project Evaluation: (a) Identity cash flows. Formula: Risk Adjusted Discount Rate={(1+ Cost of Capital)X(1+ Premium for Risk)]-1 4. Limitations: (a) It is difficult to estimate risk premium associated with a project consistently. (b) Compute the risk adjusted discount rate [RADR].

1. based on macro-economics. growth operating margin . 43. based on the NPV under on 2 3 4 . Financial breakeven Analysis: (a) This is a takeoff from accounting breakeven Analysis.etc) will take on under its scenario are estimated NPV and IRR under its scenario are estimated A decision is made on the project . (b) Financial breakeven takes into consideration of opportunity cost of funds. Steps: The steps in a Scenario Analysis areStep 1 Description of Procedure The biggest source of uncertainty for the future success of the project is selected as the factor around which scenarios will be built The value each of the variable in the investment analysis ( revenue . Financial breakeven analysis seeks to estimate the annual cash flow needed to make the NPV zero. Write short notes on Scenario Analysis. and considers time value of money. (i. industry and firmspecific factors. Accounting Breakeven Analysis: Accounting breakeven analysis seeks to estimate the revenues that will be needed in order for a project or Company to break even. 2. 2. Meaning: Scenario Analysis is an analysis of the NPV or IRR of a project under a series of specific scenarios. Aggregate of Cash Inflows=Investment Cost) in accounting terms. 44.e. It is usually a higher hurdle than the accounting breakeven. 1. Write short notes on breakeven analysis.adjusted for risk over time under this method. over time.

e mean NPV 3. all the input are set at the most optimistic level (b) In the worst case analysis. . there may give rise to a huge number of scenario for analysis (c) There is no clear road map to indicate how the decision –maker will used result of the scenario analysis. 2. Meaning of the stimulation: (a) Stimulation is the quantitative procedure will describe a process by developing of that process and then conduction a series of organize trial and error experiment to predict the behavior of the process.the scenario rather than just the base case i. 4. M88 1. input are all measure at the most pietistic level. Explain the Hert’s Model to Risk Analysis . Basis: Capital investment investment decision and financial decision are complex. Best case and worst case analysis these are variant of the scenario analysis. and therefore can’t be express by a mathematical models unsolvable mathematical model are build to run them on trial data to stimulate the behavior of the system Flexibility: Stimulation is the flexible tool of operational research .used for capital budgeting decision 3. (a) In a best case analysis . for computer NPV and IRR 45. Limitation: (a) There are no clearly delineated scenario in many cases (b) If there many important variable to consider. Write short on stimulation at the tool of risk analysis in capital budgeting decision M87.

mean . Run the stimulation Analyze the system of the stimulation and. c) Variability should be found out and a normal distribution may be derived d) After deriving the distributions of all the input variables i.4. Step in Stimulation: Step 1 2 3 4 5 6 7 8 Description Define the problem or system intended to be stimulated.e. e) Several trial runs can be done to cover most of the possible stimulation for analysis. ie increase the chances that any interference that may be drawn about the real situation from running the stimulation will be valid 5. b) Mean is calculated for each variable for the available data. Capital budgeting a) Distribution is defined for each variable. Formulate the model intended to be used Test the model and compare its behavior with the behavior of the actual problem environment. if desired. change the solution that is being evaluated Return the stimulation to test new solution Validate the stimulation. standard deviation and shape of distributions for each variable. Identify and collect the data needed to test the model. . stimulation experiment will be performed by considering different levels of these factors. based on either past data or on estimate for the future.

stimulation avoids the cost of real world experimentations when the best solution is found. than a complex mathematical model. . test it and make improvements thereto. Thus. It does not require simplifications and assumptions to the extent required in analytical solution Testing of alternatives: It provides the way for the decisions maker to select and alternative. enhance easier to understand and explain . organizational an environmental changes on the operation of a system can be studied and if necessary alteration in the model of the system can be made. Model experimentation: Stimulation can serve as a pre service test to try out new policies and decision rule for operating a system before running the risk of experimenting on the real system. Allow time factors: Stimulation allows the manager to incorporate time into an analysis. Suitability: Stimulation suitable even in cases • Of large complex problem where analytical results are not available • Where mathematical convenient distributions are not applicable to the problem. In a computer stimulation of business operation. stimulation helps to anticipate bottle neck and other problems that may arise in the behavior of the system. Alteration of model: The effect of certain informational. the manager can compress the result of several years or periods into a few mins of running time. as a result of which analytical analysis is not possible • Where the actual environment is difficult to observe b) c) d) e) f) g) Anticipation of bottle neck: When new elements are introduced into a system.6. Benefits [N96] a) Simplicity: It is a description of the behavior of some system or process .

. When there is a situation without a random component. Meaning : Options is right to do an activity. Method – Not a solution – Simulation generates only a way to evaluate solutions. Circumstances: a) The concept of options in capital budgeting arises in scenarios of uncertainty in cash flows.7. b) c) d) e) f) 46. It may take even years to develop a usable corporate planning model. the variability or otherwise of a project will be known only after a certain point in time. It does not provide solution techniques. whereby. Absence of randomness: All situations cannot be evaluated using simulation. Since capital budgeting involves huge capital outlay and generally the decision is not reversible. Only situations involving uncertainty can be measured. Applicability – all situations cannot converted into a simulation model. Shortcomings : [N02] a) Lack of precession: Stimulation is not précised. Only at that time a clearer picture may also result in losing an opportunity. Options in capital budgeting refers to those rights or choices purchased. 2. Different results – Different irritations may provide different solutions and may cause confusion to the evaluator. which does not carry any obligations to do the same. 1. negative effect of uncertainty can cripple an organization. all simulated experiments would produce the same answer. the firm can choose whether or not exercise the options depending upon the outcomes till that point. It is not an optimization process and does not yield and answer but merely provides a set of the system’s response to different operating conditions Time and cost: A good stimulation model may be very expensive. Write a brief note on options in capital budgeting. b) Generally.

also known as an investment timing option. b) Option to abandon: if a project has abandonment value. For some projects there is the option to wait. computation: Value of option = NPV with option less NPV without option Note: generally. Examples: a) Options to expand: an important option is to expand production if conditions turn favorable and to contract production if conditions turn bad. thereby obtaining new information. . c) Option to postpone: the option to postpone.e. This represents a put option (i. the price of the option would be available. and the requirement would be to ascertain the project worth by considering the value of option as an alternative cash flow. 4. right to sell). selling off the project on “as is where is” basis.3. The former is sometimes called a growth options. Example: A flat promoter may dispose of his unfinished building to an industrial house or another flat promoter. instead of proceeding further to sell it as individual units. and the later may actually involve the shutdown of production.

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