FINANCIAL MANAGEMENT – PPT NOTES

1. Scope of Financial Management

2. Objective of Financial Management

• Maximise Profit: Every business is there to make profit and maximising that is a goal.
However, it lacks clarity:
 absolute profit or % on investment?
 What about risk associated with profit maximisation? How is it managed?
 Time patterns of profit, Some realise profit in initial years, some realised it in latter
years of business
• Maximise Shareholder’s Wealth: Often investments are brought from various sources and
the value created through the business becomes shareholders wealth after meeting
obligations of other fund providers
Wealth = Present Value of all profits/ benefits – present value of all cost
Maximisation of wealth involves following financial decisions/management:
• Investment Decisions: Business need to invest in right ventures to create profit/ wealth – All
investment decisions shall be taken to maximise profit and in consequence value
maximisation for shareholders
• Financing Decisions: The source of finance comes with a cost or return expectations – all
financing decision shall be taken to minimise the cost of fund so that business is able to
generate adequate profit to meet expectations of providers of fund / shareholders
• Working Capital Management: Current assets and current liabilities are significant
components of short-term financial needs of business and its management can reduce/
optimise fund requirements
• Risk management reduces uncertainty of business and reasonably maintain cashflows to
business
• Business performance management optimises business operation and cashflow

1
3. Roshanlal & Maniklal Bakery – Caselet
Maniklal Gupta family is in the business of making sweets and confectionaries in Bhubaneswar for
three generations. They have 10 shops across the city and a sound customer base. Maniklal could see
the rising demand for cakes and pastries eating into their business. Maniklal and his son Roshan
decided to start a bakery. They decided to take advantage of their goodwill to make a Retail bakery
unit. Roshan will operate the bakery business named Roshanlal & Maniklal Backery and supply them
to existing family sweet shops.
Roshan worked on the bakery project and decided to setup the bakery business as detailed below;
Nature of Bakery: It will be a retail bakery unit. The products will  Retail Bakery Business
be sold through existing sweet shops of family business  10 retail counters
Products: It will produce all three varieties; Cakes, Cookies and  Cakes, Cookies and Bread
Bread. 90% will be standardised products adjusted to local  90% standardised
demand and 10% customised products catering to occasions like;  10% customised
birthday, anniversary, celebrations, parties etc.
Bakery Unit: They bakery require nearly 3000 sqft shed for setting  Area of Shed: 3000 sqft
up a medium size bakery. Of which, 500 sqft will be required for  Rent per month: Rs. 1 lakh
setting-up the baking oven. 500 sqft will be required for raw-  Investment in shed partition
material storage and 500 sqft for Finished goods store. 1000 sqft and storage area: Rs.5 lakh
of working area for setting up the machinery and finishing tables.  Investment in various
200 sqft of office space and 200 sqft of resting area for the registration and licenses: Rs.2
workers. 100 sqft will be for utility and cleaning areas. A shed will lakh
be taken on rent and layout different units within that. The rent of
a 3000 sqft shed will be approximately Rs.1,00,000 per month.
Setting up the space with partitions, racks & refrigerators for
storage and electricity connection will cost Rs.5 lakh. Food licence,
GST registration, Municipal licence etc. will cost another Rs.2 lakh.
Plant and Equipment: A rotary baking oven will cost Rs.30 lakh.  Rotary Baking oven: Rs.30
Transportation and Installation of machines will be another Rs.3 Lakh
lakh. Other equipment like mixing machine, moulds, slicers, and  Other Equipment: Rs.20 Lakh
working tables will be another Rs.20 lakhs.
Office & workers resting areas: Furnishing the place with  Furniture and Fixtures for
furniture, light, fan, ACs, computer etc. would require an Office and worker rest rooms:
investment of Rs.3 lakh Rs.3 lakh
Manpower: Roshan will be in-charge of Bakery. 1 Bakery  Own Staff: Bakery Supervisor,
Supervisor, 1 Store Keeper, 1 Accountant, 1 Technicians for Store Keeper, Accountant,
operation & maintenance of machines and 1 Sales supervisor to O&M Technician and Sales
deliver goods and collect payments will be direct employees. Supervisor.
The production activity will be managed by a team of baking chefs  Service Outsourcing: Bakery
and workers, who will be paid for each unit/ pound of production. operation, Distribution and
Distribution activities will be outsourced to third party vendors. Cleaning activities
Cleaning activity of unity will be outsourced to expert cleaners.
Operating Cost: Pre-mix raw materials will be purchased for  Raw-material & overhead:50%
production and will cost 30% of sales price. Fuel, Electricity,  Retail margin: 30%
manpower and transportation will be 20%. Retail margin 30%. Loss  Loss on unsold stock:5%
due to date expired stock 5%.
Project Financing: Out of the total investment, 1/3rd will be  1/3rd Own capital
invested by Roshan and rest will be term loan from Bank, which  2/3rd Term loan
will be repaid in 5 years with 10% interest.

2
Projected sales of Bakery: Daily sales of the Bakery unit is  Daily Sales Rs. 1 lakh
expected to be Rs.1 lakh
3.1Investment plans
Financing the Project Investment Requirements – Rs.60 Lakh
Capital cost of project – Rs.60 Lakh  Initial Investment in various registration
• Own investment 1/3rd : Rs.20 Lakh and obtaining licenses: Rs.2 lakh
• Term loan from Bank 2/3rd : Rs.40 Lakh @  Factory Shed: Investment in shed partition
10% and storage area: Rs.5 lakh
 Machinery & Equipment
― Rotary oven: Rs.30 Lakh
― Other Equipment: Rs.20 Lakh
 Furniture and Fixtures for Office and
workers rest rooms: Rs.3 lakh

Expenses Revenue
• Raw-material 30%: Rs.365 lakh x 30% • Rs.1 lakh per day: Annual Rs.365 lakh
• Other expenses 20%: Rs.365 lakh x 20%
• Retail Margin 30%: Rs.365 lakh x 30%
• Loss of date expired stock 5%: Rs.365 lakh x
5%
• Profit 15%: Rs.365 lakh x 15%

3
4
Time Value of Money

5
6
7
8
9
10
11
Risk and Return
Reference reading: Chapter-8, Risk & Return and Chapter-9, Portfolio Theory and Asset Pricing
Model

12
13
14
15
16
17
Discounted Cashflow and Valuation of Assets
Valuation Concepts
• Book Value:
Book value of an Asset is Historical value of asset less accumulated depreciation
Book value of firm’s equity is Book value of its assets lees book value of its labilities
• Market Value:
IFRS requires assets to be reported in fair value, not historical cost, a market reference value
In case of listed share, the market value is determined through stock exchange declared share price
• Intrinsic value
Market price is expected to follow the intrinsic value of an asset
In case of Equity, the discounted price of stream of cashflow it generates will be intrinsic value of
equity
In an efficient market the market price of equity shall hover around the intrinsic value

Bond Valuation – Types of Debentures

From the Point of view of Security
• Secured Debentures: A charge is created on the assets of the company, may be fixed or floating
• Unsecured Debentures: Do not have a specific charge on the assets
From the Point of view of Tenure
• Redeemable Debentures: Which are payable on the expiry of the specific period
• Irredeemable Debentures: Also called Perpetual Debentures, repayable on the winding-up or on
the expiry of a long period
From the view Point of Registration
• Registered Debentures: particulars of holding of the debenture holders are entered in a register
kept by the company
• Bearer Debentures: company does not keep any record of the debenture holders. Interest on
debentures is paid to a person who produces the interest coupon attached to such debentures.
From the Point of view of Convertibility
• Convertible Debentures: convertible into equity shares or in any other security either at the option
of the company or the debenture holders. It can be fully convertible or partly convertible.
• Non-Convertible Debentures: cannot be converted into shares or in any other securities. Most
debentures fall in this category.
From Coupon Rate Point of view
• Specific Coupon Rate Debentures: issued with a specified rate of interest, can be fixed or floating
tagged to the bank rate.
• Zero Coupon Rate Debentures: do not carry a specific rate of interest. Such debentures are issued
at substantial discount

18
19
Bond Price-Yield Relationship

Coupon rate > Required yield: Price > Par (Premium bond)

Coupon rate = Required yield: Price = Par

Coupon rate < Required yield: Price < Par (Discount bond)

20
21
Cost of Capital

Factors Affecting Weighted Average Cost of Capital

Factors outside firms control
• Interest Rate: Investor add premium considering risk of the project on the risk free interest
rate to set his return expectations while investing in a project
• Business Risk refers to firms ability to generate sufficient revenue to cover its operational
expenses. The investors will probably raise the cost of funds so as to be compensated for the
business risk perceived.
• Financial Risk: refers to the firm’s ability to manage financial leverage and service the debts.
Higher the proportion of fixed cost securities in the overall capital structure, greater would be
the financial risk. The investor adds financial risk premium over and above the business risk
premium.

22
 • Market Risk Premium refers to the premium on normal market return expected by investor
due to risk perception of a particular stock
• Tax Rates: Corporate Tax has a direct impact on the post-tax cost of Debt used in WACC
and Capital Gain Tax has an indirect impact on the cost of equity used in WACC
Factors within firm’s control
• Investment policy: if the firm invest in asset with similar risk level of existing assets, the
Cost of capital will remain same, else the marginal cost of capital will vary in accordance
with the risk level of new investments
• Capital Structure Policy: Capital structure is designed and WACC is calculated on the
same. As post tax cost of Debt is lower than cost of equity, the capital structure impacts the
WACC, which can be changed by firm
• Dividend Policy: Dividend policy, how much to distribute as dividend and how much to
retain will impact the earning received by investors and consequential cost of equity.
• Liquidity of securities: Higher the liquidity available with an investment, lower would be the
premium demanded by the investor. If the investment is not easily marketable, then the
investors may add a premium and consequently demand a higher rate of return.

Cost of Debt
Debt Instruments
• Bank Loan is raised to meet the long term invest requirement of the project
• Debentures is a medium to long-term debt instrument used by large companies to borrow
money, at a fixed rate of interest.
• Commercial Papers was introduced in India in 1990 with a view to enabling highly rated
corporate borrowers to diversify their sources of short-term borrowings and also provide an
additional financial instrument to investors
Cost of Debt (Historical cost)
• Bank loan comes with fixed rate of interest and that remains the cost of the loan to the firm.
This is not traded in financial market.

23
 • Debenture is issued by the firm at a fixed rate of Interest, called coupon rate. For example;
Debenture of face value of Rs.1,000 each issued for 4 years with a coupon rate of 10%. That
means the debenture will earn 10% per year till maturity, i.e., 4 years. Annual Interest is
compounded, i.e., reinvested at the same rate.
• Commercial Papers are issued at a discount and redeemed at its face value on maturity. The
amount of discount is the intrinsic cost of the Commercial paper a firm pays upon maturity

Cost of Debenture
It is imperative to know the Yield to Maturity (earning % of bond from current Market Price to
Maturity Value) to determine current cost of debt for the firm OR to advice an investor on adjusted
interest rate of bond
Cost of Debenture =
Annual Interest Payment + (Face Value – Current Market Price) / no of years left to maturity
---------------------------------------------------------------------------------------------------------------------------
0.6 x Current Market Value + 0.4 x Face Value

Illustration
Consider the debenture of Multiplex Limited
Face Value Rs.1,000
Coupon Rate 12%
Remaining period to maturity 4 years - (this might have been issued in a prior year)
Current Market Price Rs.1040 - This is rate at which it is trading in the market/
stock exchange

24
Yield to Maturity of Debenture = 1000x12% + (1,000 – 1,040)/ 4 = 120 – 10 = 110 = 10.74%
0.6 x 1,040 + 0.4 x 1,000 24 + 400 1024
Hence, if the firm will raise debt today, it may do so at 10.74%, so the current cost of debt will
be 10.74%
Yield to Maturity Computation in Excel

Investment is Cash outflow (-ve) and all future receipts are cash inflow (+ve)

Cost of Preference Share

• Preference share carries a fixed rate of Dividend and these are redeemable after some years
• The obligation to pay dividend depends on the profit of the firm
• If preference share is cumulative preference share, unpaid dividend are cumulated and paid
• Preference share dividend are dividend and not tax deductible unlike Interest, hence cost of
preference share is simply equal to its yield
Illustration
Consider the preference stock of Multiplex Limited with following information
Face value of Preference share Rs.100
Dividend rate of Preference share 11%
Maturity period 5 years – this might have been issued earlier
Market price Rs.95

The yield of preference share (same formula as that of Debenture) =

Annual Dividend + (Face Value – Current Market Price) / no of years left to maturity =
0.6 x Current Market Value + 0.4 x Face Value

100x11% + (100 – 95)/5 = (11+1) / (57 + 40) = 12 / 97 = 12.37 %

0.6 x 95 + 0.4 x 100

Cost of preference share is 12.37 %

25
Cost of Equity Share
• Equity shares issued to shareholders in the inception of the company (initial shareholders are
promoters)
• Further equity finance is obtained in following ways;
 Issue of additional equity shares (Fresh issue)
 Retention of earning (The amount of PAT retained by company after payment of
Dividend)
• When firm retain the earnings, the PAT is retained to that extent it is not given out as dividend.
As a consequence, the shareholders loose an opportunity of investing that, if would have received
as dividend
• Hence, when the firm retains the earning or issues fresh equity, the cost is same. Following
approaches are followed to determine Cost of Equity;
 Capital Asset Pricing Model (CAPM) approach – we will study this approach
 Bond Yield Plus Risk Premium Approach
 Dividend Growth Model Approach (Gordons’s Model)
 Earning Price Ratio Approach

Cost of Equity Share - Capital Asset Pricing Model (CAPM)

• Risk free return is government bonds guaranteed by government – the return is low but investor is
guaranteed for both interest and return of principal amount of investment
• BSE Sensex or NIFTY index consists of fixed number of stocks and return over the years on
those stock is an example of market return on a portfolio of investment in shares – The risk
premium of market is amount of return above the risk free rate
• For each company there is a risk factor called “Beta” (β), used to arrive at the return expected by
investor, β indicates the sensitivity of the cost of equity to the variation in market returns
 If β is more than 1, the investor will expect return above the market portfolio returns
 If β is equal to 1, the investor will expect return equal to the market portfolio returns
 If β is less than 1, the investor will expect return below the market portfolio return
Now to calculate cost of equity or Required Rate of Return on Equity (RE)
RE = Rf + βE ((E(RM) - Rf ) = Risk free rate (Rf) + Beta of the equity (βE) of the
Company x [Expected return on Market portfolio E(RM) –Risk free rate (Rf )]
Illustration – Compute cost of Equity from the following information using CAPM method
• Risk free rate Rf is 6.5% (Government of India Bond with 1 year residual maturity period yields 6.326%)
• Expected return on Market portfolio E(RM) is 16.5% (Av of 15 year av return on BSE Sensex (1979-2020)
6-27%)
• Beta of Equity βE for 3 Securities are (1) 0.5 (2) 1.0 (3) 1.5
Cost of equity or Required Rate of Return on Equity = RE = Rf + βE ((E(RM) - Rf ) =
Risk free rate (Rf) + Beta of the equity (βE) of the Company (Expected return on Market portfolio
(E(RM) –Risk free rate (Rf ))
(1) Security-1: For βE 0.5 RE = 6.5 + 0.5 (16.5 – 6.5) = 6.5 + 0.5 (10) = 6.5 + 5 = 11.5%
(2) Security- 2: For βE 1.0 RE = 6.5 + 1.0 (16.5 – 6.5) = 6.5 + 1.0 (10) = 6.5 + 10 = 16.5%
(3) Security- 3:For βE 1.5 RE = 6.5 + 1.5 (16.5 – 6.5) = 6.5 + 1.5 (10) = 6.5 + 15 = 21.5%
βE < 1, risk factor is low and investor is happy to invest in the equity at a rate lower than market portfolio
returns
βE = 1, risk factor is same as market portfolio returns and investor expects same return as that of the market
βE > 1, risk factor is high and investor expects a rate of return higher than market portfolio returns to invest in
shares

26
Capital Budgeting
Roshanlal & Maniklal Bakery – Case study
Maniklal Gupta family is in the business of making sweets and confectionary in Bhubaneswar for
three generations. They have 10 shops across the city and a sound customer base. Maniklal could
see the rising demand for cakes and pastries eating into their business. Maniklal and his son Roshan
decided to take advantage of their goodwill to make a Retail bakery unit. Roshan will operate the
bakery business named Roshanlal & Maniklal Bakery and supply them to existing family sweet shops.
This will not only supplement the loss of sweets sale, but bring more revenue leading to higher
profits for the business.

Roshan worked on the bakery project and decided to setup the bakery business as detailed below;

Nature of Bakery: It will be a retail bakery unit. The products  Retail Bakery Business
will be sold through existing sweet shops of family business  10 retail counters
Products: It will produce all three varieties; Cakes, Cookies and  Cakes, Cookies and Bread
Bread. 90% will be standardised products adjusted to local  90% standardised
demand and 10% customised products catering to occasions  10% customised
like; birthday, anniversary, celebrations, parties etc.
Bakery Unit: They bakery require nearly 3000 sqft shed for  Area of Shed: 3000 sqft
setting up a medium size bakery. Of which, 500 sqft will be  Rent per month: Rs. 1 lakh
required for setting-up the baking oven. 500 sqft will be  Investment in shed
required for raw-material storage and 500 sqft for Finished partition and storage area:
goods store. 1000 sqft of working area for setting up the Rs.5 lakh
machinery and finishing tables. 200 sqft of office space and 200  Investment in various
sqft of resting area for the workers. 100 sqft will be for utility registration and Licenses:
and cleaning areas. A shed will be taken on rent and layout Rs.2 lakh
different units within that. The rent of a 3000 sqft shed will be
approximately Rs.1,00,000 per month. Setting up the space
with partitions, racks & refrigerators for storage and electricity
connection will cost Rs.5 lakh. Food licence, GST registration,
Municipal licence etc. will cost another Rs.2 lakh.
Plant and Equipment: A rotary baking oven will cost Rs.30 lakh.  Rotary Baking oven: Rs.30
Transportation and Installation of machines will be another Rs.3 Lakh
lakh. Other equipment like mixing machine, moulds, slicers, and  Other Equipment: Rs.20
working tables will be another Rs.20 lakhs. Lakh
Office & workers resting areas: Furnishing the place with  Furniture and Fixtures for
furniture, light, fan, ACs, computer etc. would require an Office and worker rest
investment of Rs.3 lakh rooms: Rs.3 lakh
Manpower: Roshan will be in-charge of Bakery. 1 Bakery  Own Staff: Bakery
Supervisor, 1 Store Keeper, 1 Accountant, 1 Technicians for Supervisor, Store Keeper,
operation & maintenance of machines and 1 Sales supervisor to Accountant, O&M
deliver goods and collect payments will be direct employees. Technician and Sales
The production activity will be managed by a team of baking Supervisor.
chefs and workers, who will be paid for each unit/ pound of  Service Outsourcing:
production. Distribution activities will be outsourced to third Bakery operation,

27
party vendors. Cleaning activity of unity will be outsourced to Distribution and Cleaning
expert cleaners. activities

Operating Cost: Pre-mix raw materials and other ingredients  Raw-material:

will be purchased for production and will cost Rs.120 per pound Rs.120/pound of cake &
of cake & pastries and Rs.40 per KG of Bread. Fuel per month Pastries, Rs.40 per KG of
for the oven will be Rs.90,000, Electricity expenses per month Bread
will be 30,000. Salary of permanent employees will be 150,000  Fuel: Rs,90,000,
per month. Transportation will be 2% Sales Price. Retail margin Electricity:30,000
18%. Loss due to date expired stock 3%.  Salary: Rs.150,000,
Bakery operation (Chef and assistants) will take Rs.50 per Transport:2%
pound of Cake & pastries and Rs.15 per kg of Bread as  Retail margin: 18%
conversion cost  Loss on unsold stock:3%
Cleaning of mould and bakery will be Rs.50,000 per month  Conversion cost Rs.50/
Projected sales: Daily sales 200 pound cake & pastries @Rs.300 pound of cake & pastry and
and 1,000 loaf of bread (400 gm) @ Rs.40 Rs.15/kg of bread
 Cleaning cost Rs.50,000 per
month
 Daily Sales: Cakes 200
pound @Rs.300, 1,000 loaf
(400gm) @ Rs.40
Working Capital:  Raw-material: Rs.120 per
• Pre-mix raw materials Rs.120 per pound of cake & pastries pound of cake and Rs.40
and Rs.40 per KG of Bread to produce 200 pound cake & per KG of bread
pastries and 1,000 loaf of bread (400 gm) – Keep 7 days  Fuel: Rs,90,000/Mth-15
stock. Supplier takes weekly payment days stock
• Fuel for the oven will be Rs.90,000 per month – Keeps 15  Electricity:30,000 paid
days stock. Supplier supplies every 15 days and gives 15 monthly
days credit  Salary: Rs.150,000 Paid
• Electricity expenses per month will be 30,000 – Monthly monthly
payment  Transport:2% of sale paid
• Salary of permanent employees will be 150,000 per month monthly
• Transportation will be 2% Sales Price, paid monthly  Conversion cost: Rs.50/
• (Chef and assistants) will take Rs.50 per pound of Cake & pound of cake and Rs.15 /
pastries and Rs.15 per kg of Bread as conversion cost – Paid KG of bread – paid
fortnightly fortnightly
• Cleaning of mould and bakery Rs.50,000 per month – paid  Cleaning cost: Rs.50,000
monthly per month, paid monthly
• Sales price realisation: Buyers pay in 7 days  Debtor: 7 days sales

Project Financing: Out of the total investment, 1/3rd will be  1/3rd Own capital
invested by the Family and rest will be Term loan from Bank,  2/3rd Term loan
which will be repaid in 5 years with 10% interest. Working  Working Capital from Own
capital will be financed from Family’s own source of fund. fund
The expected return on the investments is 10%.

28
1. Estimation of Investment Requirement
 Initial Investment: Rs.2 lakh
(GST registration, Municipal Trade License, Food License)
 Factory Shed Partition: Investment in shed partition and storage area: Rs.5 lakh
 Machinery & Equipment
• Rotary oven: Rs.30 Lakh
― Transport & Installation cost Rs.3 lakh Rs.33 Lakh
• Other Equipment: Rs.20 Lakh Rs.53 lakh
 Furniture and Fixtures for Office and workers rest rooms: Rs. 3 lakh
Total Investment Requirement in the assets of the bakery Rs.63 lakh

2. Estimation of Working Capital Requirement

3. Source of Fund
Total Investment Requirement of the Bakery Project Rs.63 lakh

Source of Fund: Owner’s Equity Borrowings

Owners’ equity 1/3rd of the Investment requirement (Rs.63 lakh x 1/3) Rs.21 lakh

Term loan from Bank 2/3rd of the investment (Rs.63 lakh x 2/3) Rs.42 lakh
@10% interest to be repaid in 5 years

Working capital Rs.1.70 lakh .

Total Fund Rs.22.70 lakh Rs.42 lakh

29
4. Estimation of Operating Profit (PBIT)
Investment decision will be taken based on the financial viability of the project, i.e., ability to earn
expected return on the investments made by various investors in the project. For that we must
compute cashflow of the project and analyse the same. Thus we are computing operating profit.

4.1 Estimation of Operating Income

Income from Sale of Cakes & Bread

Assumption: The Bakery will operate 360 days in a year

A retail Margin of 18% will be given to the retail shops for selling the Cakes & Pastries and Bread

4.2 Estimation of Raw Material cost

Raw Material - Pre-mix Flour

4.3 Estimation of Bakery operation cost

Bakery operation cost paid to Chef and his assistants

30
4.4 Estimation of Depreciation and Amortisation

Assumptions:
• Life of Oven will be 20 years with 10% residual value
• Life of Equipment, Partition and Furniture will be 10 years with 5% residual value
• Initial investments in GST registration and other permissions will be amortised in 5 years in equal
instalments
4.5 Estimation of Interest Payment and Loan Repayment

Condition of Loan and Interest payment:

• Interest on Term loan of Rs.42 lakh paid @ 10% per annum
• Loan is to be paid in 5 years in equal instalments

4.6 Estimated Operating profit & loss for five years

Estimation is done for the entire life of the project, however it is given for five years in the reports

31
Cashflow Estimation

5 Estimation of Cash flow of the project

Assumption: Tax rate is assumed to be 25%

Computation
• Tax on Profit: computed multiplying profit by 25%, tax is paid to government
• Profit After Tax = Profit from operation of the bakery – Tax on profit
• Profit After Tax (PAT) is available to the firm for its utilisation, however to determine the cash-
inflow, Depreciation being a non-cash expenses, is added back to PAT to arrive at cash inflow
from operation

32
6 Investment Decision Making-Computation of NPV, IRR and Payback
period

Discounted cash-flow indicates the value of each year’s cash-flow as it’s value would be at the
beginning of Year-0
NPV ₹ 12,53,864 IRR 18.10%
Payback Period (slightly more than 4 years) : (-) 64,70,000 + 21,08,625 + 20,87,625 + 20,66,625 =
(-)2,07,125 4 years net cashflow is Rs.2 lakh less, hence it will take little more than 4 years for payback
Discounted Payback Period (5 Years):(-)58,81,818 + 17,42,665 + 15,68,464 + 14,11,533 + 12,70,172 = 1,11,016

Computation of NPV and IRR for the entire life of the project (Project life assumed to be 20 years)

Investment Decision
• Rs.63 lakh investment is required to setup the bakery and Rs.1.7 lakh working capital required to
operate the same. Of the total investments
 Rs.42 Lakh will be Term loan from bank @10% interest to be repaid in 5 years
 Remaining Rs.21 lakh for investment and Rs.1.7 lakh working capital will be Owner’s equity
• The Bakery will earn more than Rs.20 lakh Operating Profit (PBIT) every year
• Operating Cash-flow after paying Taxes will be nearly Rs.17 lakh and will keep growing in successive
years
• Roshanlal will be able to repay the loan (Rs.840,000 every year) for five years out of Operating
Cashflow
• The Payback period of the project is little more than 4 years and Discounted Payback period is 5
years. That means the Bakery will earn enough to payback all its investments in 5 years.
• Assuming bakery’s investments will be for 20 years, the NPV will be nearly Rs.98 lakhs, which means,
after meeting the Expected Return of 10%, there will be a surplus earning of Rs.98 lakh in present
value
• IRR indicates projects actual return, which is 31.66% for 20 years project period. Which means the
average expected return of this bakery project is 31.66%, much higher than expected return
We shall decide the INVEST IN THE BAKERY project and FINANCE the same as proposed aboveIn view of
the above, Roshanlal and Maniklal shall decide to invest in the bakery.

33
Cash Flow of the Project – Choosing right principle

Cash Flow for Replacement Project

Based on the estimated cash flow, the project is evaluated computing NPV, IRR, Payback period etc.

Biases in Cash Flow Estimation

• Over statement of Profitability
 Intentional
 Lack of Experience
 Myopic Euphoria – too involved and loose their sense or group polarisation by
accepting someone’s view
 Capital rationing – people exaggerate the project to get allocation
• Understatement of Profitability
 Salvage Value Underestimated
 Intangible benefits are ignored – Goodwill, Brand building, Market share increased
• Value of Future option overlooked (Strategic Advantages)
 Now getting into Scooter manufacturing can give advantage to be leader in two-
wheeler market

34
 Risk Analysis in Capital Budgeting
Sensitivity Analysis
• In uncertain future, things may go wrong impacting different parameters of revenue or cost,
which will affect the viability of the project
• What If analysis for important parameters impacting cash flow, gives an understanding about
how sensitive those parameters to any variation – This is called Sensitivity Analysis.
• Let’s consider the case of Raw material Prices going up by 10% in the Roshanlal Bakery case
study, how the cashflow will change

Analysis of 20 years cashflow, the entire project life, shows +ve NPV and IRR is more than 10%, the
expected return. Hence the project is feasible.
Cashflow is highly sensitive to variation in raw material price and makes huge impact on Surplus
cashflow (NPV) and IRR

35
Simple Illustration on Sensitivity Analysis
Bishnu to start a AC sales & service business
• The Initial investment is expected to be Rs.40 lakh
• Av. AC sales at Rs.50,000 / unit
• AC sales target per year - 200 nos.
• The serving revenue is around 20% of sales
• Cost of the AC is 80% of sales value
• Marketing cost of AC averages to 10% of sales price
• Fixed operating expenses Rs.10 lakh
• Analyse the sensitivity of project cash flow to variation in sales – say 20% upward and
downward
• Discounting Rate of cash flow 10%
Revenue estimation
• Sale of AC Rs.50,000 x 200 nos = Rs.100 lakh
• Revenue from Servicing Rs.100 lakh sale x 20% = Rs.20 lakh
Expenses estimation
• Cost of the AC 80% of sale: Rs.100 lakh x 80% = Rs.80 lakh
• Marketing cost 10% sale price: Rs.100 lakh x 10% = Rs.10 lakh
• Fixed operating cost Rs.10 lakh

Cash-flow is highly sensitive to variance in sales. The firm shall evaluate market and other risk
impacting sales
Scenario Analysis
• In Sensitivity analysis, typically one variable is varied at a time
• In scenario analysis, several variables are varied simultaneously, normally three scenarios
are considered
 Normal – All parameters are assumed at their normal values
 Optimistic – All parameters are assumed at their optimistic values
 Pessimistic – All Parameters are assumed their pessimistic value

36
Illustration

• Geeta Corporation planning to invest in a new stream of business of Manufacturing Water

bottles. The firm has estimated following factors of new business with their respective
values. The sales forecast and cost of manufacturing the products can vary.

New business details

Initial Investment Rs.500,000
Cost of Capital 10%
Water bottles expected to be
manufactured & sold annually 50,000 nos.
Sales Price per bottle Rs.50
Variable cost per bottle Rs.30
Fixed cost of business per year Rs.200,000
Depreciation Rs.100,000
Tax Rate 30%
Life of the project 5 years
Salvage value of investments Nil

• The Firm wants to analyse the variation in this business in different scenario. Two scenarios
have been visualised in the table given below;

WE WILL USE THIS ILLUSTRATION FOR BOTH, COMPUTATION OS SENSITIVITY ANALYSIS OF

INDIVIDUAL PARAMETERS AND FINALLY THE SCENARIO ANALYSIS OF ALL THREE PARAMETERS
PUT TOGETHER.

37
With 10% variation in sales price, the IRR came down to 78% from 115% (Normal value), making
an impact of 37%. The cashflow is highly sensitive to variation in sales price of bottle.

With 10% variation in Variable cost per bottle, the IRR came down to 93% from 115% (Normal
value), making an impact of 22%. The cashflow is comparatively less sensitive to variation in
Variable cost than sales price per bottle.

38
With 10% variation in No of Bottles produced and sold, the IRR came down to 101% from 115%
(Normal value), making an impact of 14%. The cashflow is least sensitive to variation in no of
bottles produced in comparison to Variable cost and sales price per bottle.

WE WILL SEE THE IMPACT OF SIMULTANEOUS VARIATION OS ALL THE THREE PARAMETERS –
CALLED SCENARIO ANALYSIS

In scenario analysis, we observed that, in pessimistic scenario, the IRR will come down to 45%
from 115%, making an impact of 70%. Similarly, in optimistic scenario, the IRR will rise to 193%
creating great opportunity to make very high gain.

However, the scenarios analysis shows, in pessimistic scenario also, the project will earn 45%,
which more than 4 times of the expected return of 10%. This business is robust enough to
sustain in bad times also.

39
 Capital Structure Decision and Firm Value
Enterprises of Rajaji & Sudama – Caselet
• Rajaji and Sudama were good friends from childhood. Rajaji’s father was a landlord and
Sudama is son of a peasant. Both were very good friends and studied together. After their
education, they decided to start a cardboard manufacturing business. They got into a long-
term supply contract with Amazon to sell their produce, which they have to supply half at
Bikaner and other Half at Mysore.
• Considering the distance between above to places, they decided to form two separate
companies, Rajaji Enterprises Pvt Ltd. at Bikaner and Sudama Enterprises Pvt Ltd at Mysore.
They will fund their own enterprises and run the business independently. They requested their
respective fathers to fund the equity capital, which they agreed only in the condition that, they
should give 50% of their earnings as Dividend.
• Rajaji’s father gave Rs.30 lakh as equity capital for Rajaji Enterprises. Sudama also needed
Rs.30 lakh for his investment, but could manage Rs.10 lakh from his father towards equity
investment. Rajaji’s father agreed to give him Rs.20 lakh loan at 10% rate interest per annum.
• They began their respective business with same investment and has same revenue and
expenditure. The extracts from their3 years financial statements are given below;

Rajaji’s father is wondering now, how Sudama can give such huge amount in dividend which is
increasing on a faster rate year after year, though both the friends invested same amount in business,
having same revenue and expenses.

40
ROI – ROE Analysis
• Return on Investment (ROI): PBIT / Total Investment
• Return on Equity (ROE): PAT / Equity

Leverage Analysis

41
42
Break-even PBIT Level or Indifference point

Financial Leverage of Rajaji and Sudama

Rajaji %Change in PBIT = [(31-13)/ 13 ] x 100 =138%, % Change in PBT = [(31-13)/ 13 ] x 100 = 138% No leverage
Sudama %Change in PBIT = [(31-13)/ 13 ] x 100 = 138% % Change in PBT = [(29 -11)/ 11 ] x 100 = 163%
Financial Leverage : 163% / 138% = 1.19 times

43
Valuation of the firms of Rajaji and Sudama

Cost of Capital of Rajaji and Sudama

44