SECTION: A

Q.no: 1

Capital budgeting is the process of making investment decisions in long term assets. It is the

process of deciding whether or not to invest in a particular project as all the investment

possibilities may not be rewarding. 

Thus, the manager has to choose a project that gives a rate of return more than the cost financing

such a project. That is why he has to value a project in terms of cost and benefit. 

Following are the categories of projects that can be examined using capital budgeting

process:

 The decision to buy new machinery

 Expansion of business in other geographical areas

 Replacement of an obsolete equipment

 New product or market development etc.

Principles of Capital budgeting:

1. Decisions are based on cash flow not accounting income: The capital budgeting
decisions are based on the cash flow forecasts instead of relying on the accounting
income. These are the incremental cash flows, that is, the additional cash flow that will
occur if the project is undertaken compared to if the project is not undertaken.
2. Timing of cash flow: Another important aspect of the analysis is to estimate the timing
of cash flow as accurately as possible. As the capital budgeting analysis uses the concept
 of time value of money, the time at which the cash flow occurs significantly impacts the
present value of the project. The earlier the cash flow occurs the more valuable it is.
3. Opportunity cost should be considered: The project analysis should include
opportunity costs. Opportunity cost is the cash flow that the company loses because of
undertaking the new project.
4. Cash flow should be adjusted for taxes: After-tax cash flow should be used for capital
budgeting analysis.
5. Financing Costs should be ignored: Financing costs should not be included in the cash
flow. Analysts will take the after-tax operating cash flows and will discount them using
the required rate of return to arrive at the net present value. The financing costs are
already reflected in the required rate of return and the cash flow should not be adjusted
for the same, irrespective of whether the project is financed using equity, debt or a
combination of both.

Process of Capital Budgeting

 Identification, Screening and Selection of investment proposals: Various projects from

different departments of a firm are taken up and evaluated to conform with organization`s

investment needs and projects which positively impact the future cash flows of the firm

are selected.

 Capital Budget Proposal: After the screening and evaluation of projects, the chosen

projects are subjected to capital budgeting tools to determine the future cash flows and

their potential to achieve organizational objectives. Data is collected from various

departments and requests of various department heads are also entertained while

finalizing the projects and preparing a capital expenditure budget.

 Approval and Authorization of capital expenditure budget: Some additional research and

analysis may be conducted before the selected projects are approved and authorized. The
 adequate funds are allocated to each projects and teams are appointed for implementation

of the projects.

 Project Tracking: It involves monitoring of the work in progress and expenditure related

to projects and communicating the performance to the Top Management. It aims to

identify any problems associated with implementation of the project and take corrective

actions to ensure smooth execution of projects.

 Post-Completion Audit and Performance Review: Projects may be subjected to an audit

after a few years of its completion or during its implementation to assess whether it will

be profitable to continue or not. All projects are not subjected to such audits but are

reviewed to determine deviations in expected and actual performance.

Q.no: 3

Difference between Internal rate of return and net present value

NPV IRR

The total of all the present values of cash IRR is described as a rate at which the sum

flows (both positive and negative) of a project of discounted cash inflows equates

is known as Net Present Value or NPV. discounted cash outflows.

It represents the surplus from the project It represents the point of no profit no loss

(Breakeven point)

It makes decision making easy. It does not help in decision making

The variation in the cash outflow timing will The variation in the cash outflow timing

not affect NPV will show negative or multiple IRR

Example: If a company has to determine its Example:  If a company has to estimate its

investment securities, access new ventures, profitability IRR is to be calculated

value a business or find ways to effect a cost

reduction, NPV is to be calculated.

Difference Between the concept of compounding and discounting:

 Compounding Discounting

It can be defined as a process of This can be defined as a process of

calculating the future value of a present calculating the present value of a future

investment cash flow

It is calculated with the compound It is calculated with the discount rate

interest rate

It formula is It is calculated with the following formula

A = P (1+ r/n)nt Dn = 1/(1+r)n

For Example: If a company has to For example: If a company is to determine how

determine the amount of earnings to be much should be invested in a certain project to

gained by making an investment make maximum returns in the future,

compounding is to be done discounting is to done

Q.no: 4

The capital structure is said to be optimum, when the company has selected such a

combination of equity and debt, so that the company's wealth is maximum. At this, capital

structure, the cost of capital is minimum and market price per share is maximum. But, it is

difficult to measure a fall in the market value of an equity share on account of increase in risk
due to high debt content in the capital structure. In reality, however, instead of optimum, an

appropriate capital structure is more realistic.

For a company to have an optimum capital structure are as below:

1. Maximum Earning: The most profitable capital structure is one that tends to minimize

financing cost and maximize of earnings per equity share.

2. Flexibility: The capitals structure should be such that the company is able to raise funds

whenever needed.

3. Safety: Debt content in capital structure should not exceed the limit which the company

can bear.

4. Solvency: Capital structure should be such that the business does not run the risk of

insolvency.

5. Maximum Control: Capital structure should be devised in such a manner that it involves

minimum risk of loss of control over the company.

6. Minimum cost of capital: The Company has to be in a point where the weighted average

cost of capital is minimum. Optimum debt- equity proportion establishes balance between

owned capital and debt capital. The firm should be cautious about the financial risk

associated with the maximum utilization of debt.

7. Commensurate to legal requirements: The Company should have all the necessary

legal requirements to have an optimum capital structure. If the company is dealing in

projects which is not legal or does not have all the documents required it cannot be

considered optimum.
 8. Simplicity: A complicated capital structure may not be understood by all; on the contrary

it may raise suspicions and create confusion. A capital structure must be as simple as

possible.

Q.no: 5

The different types of ratios to be considered for ratio analysis are as follows:

Activity Ratio: Activity ratio is a type of financial metric that indicates how efficiently a

company is leveraging the assets on its balance sheet, to generate revenues and cash. Activity

ratios help in evaluating a business’s operating efficiency by analyzing fixed assets, inventories,

and accounts receivables. It not just expresses a business’s financial health but also indicates the

utilization of the balance sheet components. Activity ratio helps to measure the following ratios

of a company:

1. Inventory turnover Ratio: Measures how efficiently a company is able to manage its

inventory

2. Days of inventory on hand: Measures the number of days it takes to sell inventory

balance.

3. Receivable turnover ratio: Measures how efficiently a company is able to manage its

credit sales and convert its account receivables into cash.

4. Payable turnover ratio: Measures how quickly a company is paying off its accounts

payable to creditors.

5. No. of days payable: Measures the number of days it takes to pay off creditors.

6. Working capital turnover: Measures how efficiently a company is using its working

capital to support a given level of sales.

 7. Fixed assets turnover: Measures how efficiently a company is using its fixed assets.

8. Days of sales outstanding: Represents the average number of days it takes credit sales to

be converted into cash or how long it takes a company to collect its account receivables

Liquidity Ratio: Liquidity ratios are an important class of financial metrics used to determine a

debtor's ability to pay off current debt obligations without raising external capital. Types of

liquidity ratios are as follows:

1. Current Ratio: Measures the capability of a business to meet its short-term obligations

that are due within a year.

2. Quick Ratio: Measures the ability of a business to pay its short-term liabilities by having

assets that are readily convertible into cash

3. Cash Ratio: Measures a company’s capacity to pay off short-term debt obligations with

its cash and cash equivalents.

Profitability Ratio: Profitability ratios are a class of financial metrics that are used to assess a

business's ability to generate earnings relative to its revenue, operating costs, balance sheet

assets, or shareholders' equity over time, using data from a specific point in time. Profitability

ratio helps to measure the following ratios of a company:

1. Gross Profit Margin: Shows how much a business is earning, taking into account the

needed costs to produce its goods and services.

2. Operating Margin: Looks at earnings as a percentage of sales before interest expense and

income taxes are deduced.

3. Pretax Margin: Measures the operating efficiency of a company before deducting taxes.
Net profit Margin: Provides the final picture of how profitable a company is after all expenses,

including interest and taxes, have been taken into account.

ROA: Measures how efficient a company's management is in generating earnings from their

economic resources or assets on their balance sheet.

ROE: Measures how effectively management is using a company’s assets to create profits.

Return on common equity: Measures how well management is generating a return, given the

current amount of equity on hand.

Solvency Ratio: The solvency ratio is a key metric used to measure an enterprise’s ability to

meet its debt obligations and is used often by prospective business lenders. The solvency ratio

indicates whether a company’s cash flow is sufficient to meet its short-and long-term liabilities.

The lower a company's solvency ratio, the greater the probability that it will default on its debt

obligations.

1. Debt to asset ratio: Indicates the percentage of assets that are being financed with debt.

The higher the ratio, the greater the degree of leverage and financial risk.

2. Debt to capital ratio: Measures the proportion of debt a company uses to finance its

operations as compared with its capital.

3. Debt to equity ratio: Shows the percentage of company financing that comes from

creditors and investors. A higher debt to equity ratio indicates that more creditor

financing (bank loans) is used than investor financing (shareholders).

4. Financial leverage Ratio: Indicates the ability of a company to repay principal amount of

its debts, pay interest on its borrowings, and to meet its other financial obligations
Valuation Ratio: A valuation ratio is any one of several calculations that determines whether a

particular security is cheap or expensive when compared to a certain measure, such as profits or

enterprise value. In other words, valuation ratio helps an investor to determine the cost of an

investment with respect to the value or benefits of owning that investments. Some of valuation

ratios are as follows:

1. P/E ratio: Relates a company's share price to its earnings per share.

2. EPS: Indicates how much money a company makes for each share of its stock and is a

widely used metric for corporate profits.

3. Price to book value per share: Measures the market's valuation of a company relative to

its book value

4. Price to cash flow ratio: Compares a company's market value to its operating cash flow or

its stock price per share to operating cash flow per share

5. Operating cash flow per share: Measures how well current liabilities are covered by cash

flows from operations.

6. PEG ratio: Determines a stock's value while also factoring in the company's expected

earnings growth, and is thought to provide a more complete picture than the more

standard P/E ratio.

Q.no: 2

Equity financing is the process of raising capital through the sale of shares. Companies raise

money because they might have a short-term need to pay bills or they might have a long-

term goal and require funds to invest in their growth. Equity financing places no additional

financial burden on the company, however, the downside is quite large. Equity is the most risky

source of capital amongst Debt and Preference shares because for the following reasons:

1. Loss of Ownership: If a business raises too much equity capital, it risks losing control of

the company. Equity investors are typically entitled to vote on certain company matters.

If you sell a large equity stake to one investor or a group of investors, they might try to

influence the company in a way with which you don’t agree. For example, if a small

business sells 60% stake in the company to an investor, the investor might try to take

over the company if they are unsatisfied with the performance.

2. Missing Growth Opportunities: Depending on the agreement between a business and its

investors, the business might be required to periodically distribute a portion of its profits

to shareholders in the form of dividends. A small business in a growth phase typically

wants to reinvest all of its profits into its business. If a company distributes too much of

its profits to investors, it risks missing out on growth opportunities. For example, if a

small business generates Rs. 40,000 in quarterly profit, but distributes Rs.20, 000 to

investors, your growth potential might be limited.

3. Voting Rights: In large, publicly held companies, shareholders exert their greatest control

through electing the company’s directors. However, in small, privately held companies,

officers and directors often own large blocks of shares. The voting period affects the
company because if a large number shareholders vote for something opposite than which

the company management had initially decided, then the plan not go likewise.
SECTION: B