FINC002

FINANCIAL MANAGEMENT
VISION

Imparting continuum of management education through distance mode to learners across the globe.

MISSION
Be an academic community leveraging technology as a bridge to innovation and life-long learning.
To continuously evolve management competencies for enhanced employability and entrepreneurship.
To serve society through excellence and leadership in management education, research and consultancy.
EXPERT COMMITTEE
Prof. (Dr.) S. R. Musanna Prof. (Dr.) S. S. Yadav
IMT CDL, Ghaziabad DMS, IIT Delhi

Prof. (Dr.) Ravindra Kumar Prof. (Dr.) Madhu Vij (Retd.)

IMTCDL, Ghaziabad FMS, Delhi

Prof.(Dr.) Subhajit Bhattacharya Mr. Ritesh Chandra

IMT, Ghaziabad Yes Bank, Delhi

Prof. (Dr.) A. H. Kalro (Retd.) Prof. (Dr.) Asif Zameer

IIM, Kozhikode IMT CDL, Ghaziabad

Prof. (Dr.) P. K. Jain

IIT, Delhi

Prof. (Dr.) B. B. Chakraborti (Retd.)

IIM, Kolkata

SLM PREPARATION TEAM

Dr. Priti Sharma Dr. Meena Bhatia
IMTCDL, Ghaziabad BIMTECH, Noida

Dr. Ruchi Arora Dr. Geetika Batra

NDIM, Delhi Finance Trainer

COURSE COORDINATOR EXPERT REVIEW

Dr. Priti Sharma Dr. Vinod Kumar
IMTCDL, Ghaziabad JIMS, Rohini Delhi

PUBLISHER & PRINTER

Cover Concept by: Ms. Ramneek Majithia, Communication Design and Product Management Consultant
PUBLISHER & PRINTER
Published by: Institute of Management Technology, Centre for Distance Learning, Ghaziabad
Publisher Address: A-16, Site 3, UPSIDC Industrial Area, Meerut Road, Ghaziabad
Printed by: M/s. Vikas Computer & Printers - E-33, Sector A 5/6 Tronica City UPSIDC Ind. Area Loni,
Ghaziabad- 201102
Edition First (2021), Re-Print (January 2025)
© Institute of Management Technology, Centre for Distance Learning, Ghaziabad
ISBN: 978-81-951960-5-0
All rights reserved. No part of this work may be reproduced in any form, by mimeography or any other means, without
permission in writing from The Institute of Management Technology Centre for Distance Learning.
Further information on the Institute o f Management Technology Centre for Distance Learning may b e obtained
from the Institute Head Office at Ghaziabad or www.imtcdl.ac.in
ACKNOWLEDGEMENT

We acknowledge, with gratitude, the assistance taken, in preparing the study

material of the present course, from the texts, websites, and a/v sources cited at
different places within the Units. We, thankfully, also acknowledge the
assistance taken by us from the content generated by individual authors,
publishing houses, educational institutes, research agencies, consultancies,
government bodies and public sources of commercial organizations etc. (cited
within the Units). Special thanks to our PGDM-Executive student Ms. Ramneek
Majithia for helping us in cover concept & design.
 FINC002
Financial
Management

INDEX

UNIT 1

An Overview of Financial Management 1

UNIT 2
Time Value of Money 20
UNIT 3
Risk and Return 47
UNIT 4
Valuation of Securities 65
UNIT 5
Basics of Capital Budgeting 83
UNIT 6
Cash Flows in Capital Budgeting 108
UNIT 7
Cost of Capital 128
UNIT 8
Capital Structure 154
UNIT 9
Leverage 180
UNIT 10
Dividend Policy and Shareholders Value Creation 207
UNIT 11
Working Capital Management 231
UNIT 12
Inventory Management & Financing of Working Capital 254
 Course Overview

Financial Management focuses on optimizing financial resources and applying management

principles to an enterprise's financial aspects. Its primary objectives include minimizing
financing costs, ensuring sufficient funds, and effectively planning, organizing, and controlling
financial activities like procurement and utilization of funds. Finance is a critical resource for
any business, demanding prudent management due to its limited nature. This course provides
a foundational understanding of financial management, covering its scope, significance, and
key financial decisions across 12 comprehensive units.
The course begins with Unit 1, introducing the fundamentals of Financial Management, its
scope, and the critical decisions finance managers make. Unit 2 explores the Time Value of
Money, emphasizing its importance in comparing investments and addressing concepts like
loans, savings, and annuities. Unit 3 discusses Risk and Return, focusing on expected returns,
risk measurement, and factors influencing investment decisions.
Units 4 and 5 delve into Valuation of Securities and the Basics of Capital Budgeting, explaining
valuation methods for stocks and bonds and decision-making for long-term capital
investments. Unit 6 expands on Cashflows in Capital Budgeting, addressing the complexities
of forecasting project-specific cash flows.
Units 7 and 8 cover the Cost of Capital and Capital Structure, discussing the calculation and
significance of funding costs and designing an optimal mix of financing sources. Unit 9
introduces Leverage, examining its types and impact on earnings and return magnification.
Units 10 and 11 focus on Dividend Policy and Working Capital Management, explaining
dividend decisions, shareholder value creation, and the operating cycle of cash and working
capital. Finally, Unit 12 addresses Inventory Management and Working Capital Financing,
covering concepts like Economic Order Quantity (EOQ), Just-in-Time (JIT), and financing
strategies.
We hope this structured course aids in developing a practical understanding of Financial
Management.
 Course Outcomes

After completing the course, you would be able to:

• CO1: Apply the fundamental concepts of financial management for decision making.

• CO2: Evaluate alternative long-term investment opportunities for an entity.

• CO3: Assess the impact of leverage on firm’s profitability and design the optimum capital structure.

• CO4: Schematize for efficient management of working capital of a firm.

Mapping of Course Outcomes with Course Units:

CO1 CO2 CO3 CO4

Unit 1 *

Unit 2 *

Unit 3 *

Unit 4 * *

Unit 5 * *

Unit 6 * *

Unit 7 * * *

Unit 8 * * *

Unit 9 * *

Unit 10 * * *

Unit 11 * *

Unit 12 * *
 FINC002
Financial Management

UNIT 1 NOTES

AN OVERVIEW OF
FINANCIAL MANAGEMENT

STRUCTURE
1.0 Objectives
1.1 Introduction
1.2 Legal forms of the Business organizations
1.3 Finance and Other Disciplines
1.4 Objective of Financial Management
1.5 Financial Management Decisions
1.6 Role of a Finance Manager
1.7 Agency Theory
1.8 Let Us Sum Up
1.9 Key Words
1.10 References And Suggested Additional Readings
1.11 Self-Assessment Questions
1.12 Check Your Progress-Possible Answers
1.13 Answers to Self-Assessment Questions

1.0 OBJECTIVES
On completion of this unit, you should be able to:
• Understand the meaning of Financial Management
• Understand legal forms of business
• Understand relationship between Finance & other disciplines
• Understand the scope and purpose of Financial Management
• Classify major decisions taken by the Finance Manager
• Explain the agency problem

1.1 INTRODUCTION
Organizations do the majority of the world's work. Resources are brought together-
equipment, building, inventory, people, information technology, and many more, to run 1
UNIT 1
An Overview of
Financial Management

NOTES organizations. Organization ensure that they use these resources productively to recover
more than what they have paid for. Financial management incorporates all of the firm's
decisions that have financial implications. Are you aware of any decision of an organization
that does not have any financial implication? Isn't that difficult to find? There is always a
financial aspect to the majority of the decisions taken up by an organization.
As per Brealey & Myers, Success is usually judged by value: Shareholders are made better off
by any decision that increases their stake in the firm... The secret of success in Financial
Management is to increase value.”

1.2 LEGAL FORMS OF THE BUSINESS ORGANIZATIONS

Will you like to work for a sole proprietor, partnership firm or company? Ask this question
from your friends too. In case you want to be an entrepreneur, would you like to be a founder
of a company like Tata Consultancy Services (TCS) Ltd. or M/S Pankant software solutions?
Business can be formed in many ways, keeping in view the legal and commercial angle. There
are four common forms of organizing business.

1.2.1 SOLE PROPRIETORSHIP

As the name implies, there will be a single owner in a sole proprietorship. There is no
distinction between the owner and the business. Business is the owner's property, and it will
exist as long as the owner exists. She brings in the Money, takes the risk and keeps all the
profit she earns. If the business does not do well, she is liable to pay all the debts. For this
deficiency, personal assets will also be used. This unlimited liability is the major weakness of
this form of organization. Another limitation that this form of organization is the limited life
of the organization, as the organization's life is attached to the owner's life. It also suffers
from limited access to capital and talent. Both talent and capital are limited to what an owner
can bring to the table.
The significant advantages of this structure are, it is simple to form, easy to operate, and
decision making is faster than other forms of businesses.
Now let us consider the following situations
Situation 1: Mr Rahul started a pickle business with an investment of Rs 30,000. After two
months, the business has Rs10,000 in cash and 20,000 in unpaid bills. He has savings of
Rs12,000 and no personal debts.
What happens next?
Rahul is short of Rs 10,000 for paying his business bills. He will have to bring in Rs 10,000 from
his savings (personal) to pay the bills in full. Once he makes the payment, he is solvent, and
the business will continue. As we are concerned with the current position, the initial
investment is irrelevant.

CHECK YOUR PROGRESS-I

Case 1: Ms Chandni started her venture with an investment of Rs 50,000. After six months,
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Financial Management

her business has Rs 35,000 in cash and 50,000 unpaid bills. She has Rs 5,000 as personal cash NOTES
and no personal debts.
How much cash, if any, should Chandni bring in?

1.2.2 PARTNERSHIP
Do you know that you and your friend/sibling can start a firm? Usually, partnerships are
formed by people who know and trust each other. It is similar to a proprietorship with two or
more owners who have combined their funds and skills. Unless the partners have agreed
otherwise, the partners will share the profits and losses equally. In case the skill and wealth
contribution differs amongst partners, it will be better to have a partnership deed, which
indicates the profit-sharing ratio.
Each partner has unlimited liability for all the firm's debts and obligations and is also
responsible for the liabilities in the firm of fellow partner/s. The Indian partnership act
regulates partnership businesses, though the regulation is minimal. Registration with the
government is also not compulsory.
The advantage of partnership over sole proprietorship is that it allows many people to pool in
funds and talent to form a large enterprise. In specific industries, partnerships are more
dominant, such as accounting, law, consulting, medicine, and architects' practices.
Now let us consider the following situations
Situation 2: Ankur and Shradha starteda consulting firm with an initial contribution of
Rs 20,000 each. After 2 years, the firm has Rs 55,700 in cash and Rs 75,000 of outstanding
bills. Ankur and Shradha have personal savings of Rs10,000 each and have no personal debts.
What happens next?
The firm is short of Rs 19,300 for paying its bills. Both partners must bring in Rs 9,650 each in
order to pay the bills in full. By adding personal savings, they will stay solvent, and the firm
and the business will continue.
The partners from their personal assets should fund the deficit in the business. In case the
personal assets of a Partner fall short, he will be declared insolvent. The other partners must
fund the business in such a case. The main point is in the law's eyes, the partners and the
businesses are the same.
I am sure you can identify the drawbacks of a partnership firm

CHECK YOUR PROGRESS-II

Case 1: Suhani and Ragini started a boutique with an initial contribution of Rs 25,000 each.
After two years, the firm has Rs 35,000 in cash and outstanding bills worth Rs 50,000 Suhani
has savings of Rs 17,000 and Ragini has savings of Rs 3,000. They do not have any personal
debt.
How much cash, if any, should Suhani and Ragini bring in?

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NOTES 1.2.3 CORPORATE

A corporate/company is a distinct legal entity; it has a name and enjoys many legal powers as
enjoyed by a natural person. Of all the forms of organization, the corporate form is the most
important. It is dominant in terms of aggregate sales and profits. It can acquire and sell
property, can enter into contracts, can borrow and lend, and can sue and be sued. It cannot
vote, though, for legal purposes; it is a citizen of its state. It is governed by the Companies Act
2013.
Starting a corporation is more demanding and complicated than starting a sole
proprietorship and partnership, as there are many legal formalities and processes.
To put it simply, a company has three groups of distinct interests
• The Shareholders: They are the ones who have contributed capital for the
business, and therefore, control the company's direction and policy
• The Directors: Directors (Board) are elected by shareholders. As per the Ministry
of Corporate Affairs, the Board of Directors must measure and reward based on
its performance while keeping a strategic oversight over business operations.
They must also ensure compliance with the legal framework, integrity of financial
accounting and reporting systems and credibility in the stakeholders' eyes
through proper and timely disclosures.
• The Top Management: The top Management manages the corporation's
operations, keeping in mind the interest of the shareholders.
Companies can be further segregated into a private limited company and a public limited
company. A private limited company cannot raise Money from the public and has a
minimum of 2 and a maximum of 200 shareholders. They have "private limited" as part of
their name. Pepsi Co, a public limited company in the USA, is a private limited company in
India. The name of the Company is Pepsico India Holdings Private Limited. It was
incorporated in 1994.
A public limited company must have at least seven shareholders, and there is no upper limit
for the number of shareholders. These companies are listed on stock exchange/s. They are
listed on Bombay Stock Exchange (BSE) and/or National Stock Exchange (NSE) in India. The
shares of these companies are available to the public for investment and trading. They have
"limited" as part of their name, which is generally written in short form as ltd. The word
limited means that the shareholders’ liability is limited to the amount contributed for
business; beyond this amount, they are not liable for any of the company's debts.
Situation 3: Lipika and Meghali started a company with an initial contribution in terms of the
share capital of Rs 25,000 each. After two years, the company has Rs 35,000 in cash and
outstanding bills worth Rs 50,000 Lipika and Meghali have personal savings of Rs 15,000 and
do not have any personal debt.
What happens next?
The business is short of Rs 15,000 for meeting its liabilities. Both Lipika and Meghali
contributed their agreed share capital. Their liability is limited to this amount only; they need
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not have to bring any more cash. They will stay solvent. The business will be liquidated, and NOTES
the liability will be recovered by selling the assets of the company.
Note that the shareholders have no legal obligation to bring in more Money if the company's
assets fall short of its liabilities. In such a case, the shortage will go unpaid. The company will
be liquidated; the shareholders will continue to be solvent. Here the key point is that the
shareholder and the company are two different persons, and that is how the law treats them.

CHECK YOUR PROGRESS-III

Case 1: Epic Private ltd. was started by Saloni and Rahul with an agreed share capital of Rs
50,000 each. They contributed Rs 40,000 each. The business has Rs 1,25,000 in cash and due
and unpaid bills worth Rs 1,50,000. Saloni has savings of Rs 40,000; Rahul has savings of Rs
2,500. They do not have any personal debt.
How much cash, if any, should Saloni and Rahul bring in?

1.2.4 LIMITED LIABILITY PARTNERSHIP (LLP)

This form of business is not as old as other forms of businesses described above. It has
features of partnership firm and a company. It must have at least two partners' and there is
no upper limit. An LLP was created by the LLP Act, 2008 and the notification of the LLP Rules,
2009. It should be mandatorily registered with Registrar of Companies. Just like any other
company, it is an ongoing concern which is a separate legal entity. In this form, apart from
individuals, corporate bodies can also be partners. Partners have limited liability in LLPs
except in the case of fraud. Every partner of an LLP is an agent of the LLP but is generally not
bound by anything done by the other partners. One or more partners can be designated as
managing or executive partners for compliance with legal requirements. It is particularly
suitable for professional services firm.
Situation 4: Orange LLP was started by Meenakshi and Karan, and they invested Rs 5,00,000
each as capital. The business has Rs 12,00,000 in cash and due and unpaid bills worth
Rs 25,00,000.
How much cash, if any, should Meenakshi and Karan bring in?
The business is short of Rs 13,00,000 for meeting its liabilities. Both Meenakshi and Karan
contributed their agreed share capital. Their liability is limited to this amount only; they need
not have to bring any more cash.

1.3 FINANCE AND OTHER RELATED DISCIPLINES

When we speak about financial management as a subject we need to give importance to the
fact that it isn't totally an independent area. It's interrelated and dependent to various fields
of study such as Accounting, Economics, Marketing, production and Quantitative methods.
However, there are some integral differences among them too. Let's understand them in
detail.

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An Overview of
Financial Management

NOTES 1.3.1 FINANCE AND ACCOUNTING

Do you think that Finance and Accounting are the same? Or are there any differences
between the two? Or they are significantly related to each other? Do they interdepend and
overlap? They are different disciplines yet interrelated.
Let us understand what accounting does? Accounting provides information to people within
the organization and people outside the organization regarding the organization's resources.
It processes the transactions and generates the output in terms of financial statements,
namely- Balance Sheet, Statement of Profit and loss, Statement of Changes in Equity and
Cash Flow Statement. Accounting involves bookkeeping, which deals with recording and
maintaining all financial transactions made by a business. Accounting primarily deals with
the past and present of an organization.
The financial statements help the financial manager assess the performance, position and
liquidity of an organization over a period of time. S/he needs to be aware of an organization's
past performance and its position as on date to make decisions. Finance as a discipline is
related to the future aspects. It would include the preparation of forecasted financial
statements and all those calculations that would enable the business to make decisions
pertaining to future business's operations. Accountants are primarily responsible for
creating financial statements after processing and recording them. At the same time, finance
professionals are responsible for analysing them and making decisions based on these
statements that should increase these statements' value. The finance manager deals with
the decision that should result in improving the position of an organization.
Thus Accounting and finance are closely related. But there lie specific differences
Table 1.1: Difference between Accounting and Finance
Basis of difference Accounting Finance

Basic responsibilities Statutory compliance Strategy formulation for value creation

and tax liabilities

Focus Accuracy, reliability Insights, analysis, judgement and

decision making

Financial Statements Responsible for Responsible for analyzing them, and

preparing them taking decisions which increases the
position of the organization

View-Point/ Approach Backward looking Forward looking

Business Purpose Communicating the Figuring out how to add value

financial position

Thought Process Rules based Analysis based

Basis of processing Accrual basis Cash basis and considers time value
information of Money
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Financial Management

NOTES
In accounting, the accrual method is used while preparing the Statement of Profit and loss.
The revenues reported includes both cash revenue and credit sales. Also, for expenses, it will
consider all expenses of the period, whether paid or not. So the reported profit will not
necessarily be cash inflows.
Let us understand this with an example:
Situation 5 : A small scale technology company has a cash revenue of Rs 5,70,000 for March.
It also provided IT services this month worth Rs 3,00,000, and clients will make payment in
June. The expenses for March are Rs 500,000, of which the outstanding bills are Rs 50,000.

Treatment in Accounting Treatment in Finance

Particulars Rs Particulars Rs

Cash Sales 5,70,000 Cash Sales 5,70,000

Credit Sales 3,00,000

Total revenue 8,70,000 Total inflows 5,70,000

Cash expenses 4,50,000 Cash expenses 4,50,000

Credit expenses 50,000

Total expenses 5,00,000 Total outflows 4,50,000

Profit 3,70,000 Net Cash inflow 1,20,000

Accounting treatment does not properly reflect the cash situations of the firm. For instance,
the firm could be profitable (as per the reported profits) but might not be able to meet its
short-term obligations due to the shortage of cash (liquidity), which might be due to
uncollectable receivables etc. It is also possible that the firm is reporting profits but has
negative cash flows. From the financial point of view, the treatment of funds is based on cash
flows. Revenue is identified when cash is received; and expenses are identified on actual
payments (cash outflow).
The cash flows thus help the financial manager maintain the firm's solvency and accordingly
satisfy the obligations, acquisition and financing of assets as needed to achieve the firm's
goals. The actual inflows and outflows of cash help the financial manager to achieve desired
financial goals and avoid insolvency.

1.3.2 FINANCE AND ECONOMICS

Economics is considered to be the mother of all social sciences. Economics can be
categorized into two areas- Micro economics and Macroeconomics. Finance as a discipline is
linked with both Macro as well as Micro Economics.
Macroeconomics deals with the economy as a whole. It is concerned with the overall
institutional environment in which the firm functions. Macroeconomics studies the 7
UNIT 1
An Overview of
Financial Management

NOTES institutional structure of the Banking system, Money and capital markets, monetary, credit,
fiscal and economic policies and financial intermediaries. This is where the financial
manager will raise funds for the organization, impacting the cost of raising funds. It is one of
the most critical areas with which a finance manager deals.
Thus, financial managers should be aware of the economic environment. Particularly they
should-
a) Be cognisant of several financial intermediaries and institutions
b) Be well-informed about the fiscal policy and monetary policy of the country and
its impact on the industry and economy.
c) Be conscious of Global Business Environment and integrated financial markets.
d) Identify and understand the broad economic environment
On the other hand, Micro economics is concerned with the economic decisions of
organizations and individuals. It provides effective operations for business firms by
performing optimal operating strategies.
Here the financial manager needs to understand-
a) The problems are concerned with a combination of optimum sales levels, product
pricing strategies and productive factors.
b) Demand and Supply interrelations and profit maximization strategies.
c) Ascertaining value, risk and utility preference.
d) The rationale of depreciating Assets
The principle of incremental/marginal analysis is applied in financial management
suggesting that financial decisions need to be made on comparing incremental/marginal
revenue and incremental/marginal cost. These decisions are essential to increase the profits
of the firm.
Situation 6 : The Financial Manager of a manufacturing organization is planning to replace its
existing machinery, with a more advanced new machinery. The old machine can be sold for
Rs 4,00,000, and it has 3 years remaining life. The new machinery cost Rs 7,00,000, with 3
years' life. The operating cost per unit is Rs 30 and Rs 20 with the old machine and new
machine, respectively. The output of both machines is Rs 20,000 units per annum. Let us
understand this by marginal/incremental analysis. Rs Rs

a Cost of new machinery 7,00,000

b Proceeds from Sale of old machinery 4,00,000
c Incremental cost (a-b) 3,00,000
d Operating costs with the old machinery 18,00,000
e Operating costs with the new machinery 12,00,000
f Incremental Benefits (d-e) 6,00,000
g Net benefits (f-c) 3,00,000
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NOTES
The old machinery needs to be replaced as the incremental benefits are more than the
incremental costs.
Financial managers should be, therefore, familiar with both the areas of Economics for a
better understanding of both, the financial environment and decision theories

1.3.3 FINANCE AND OTHER RELATED DISCIPLINES

Other functional Areas- Human resources management (HRM), production, Marketing,
Information Technology and quantitative methods are related to the area of financial
management.
The Financial managers should deliberate on how the new promotional campaign will result
in cash flows and the outlay needed for this project.
The revisions in the production method/s may result in incremental capital expenditures
(Capex), which will be evaluated by the financial managers in terms of additional cash flows
that it will generate in the future.
One of the critical resources of an organization is its human resources. It generates the
results and also involves costs. HR recruits, trains, motivates and develop people to work for
organizational goals. The HR managers in the current business setting are carrying out
certain duties that were traditionally thought to be financial duties. In fact, the CFOs are also
doing certain duties pertaining to HR area. The HR managers must follow the cost-benefit
approach while taking any HR decisions like recruiting employees, undertaking a training and
development programme. They are expected to know how the HR policies that they frame
impacts the performance and position of the organization. Therefore, they need to be good
with data crunching as many of their decisions are dependent on data analysis and the
financial projections.
Fig.1.1: Finance and other Related Disciplines

Source: Adapted from (Damodaran, 2001)

CHECK YOUR PROGRESS-IV

Q.1 Financial management is related to
a) Marketing
b) Micro-economics
c) Human Resources Management
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NOTES d) Accounting
e) All of the above
Q.2 Financial management uses accrual basis approach for arriving at future benefits
a) True
b) False

1.4 OBJECTIVE OF FINANCIAL MANAGEMENT

What do you think is the objective of an organization? Commonly, people believe that an
organization's objective is to make profits.
Can you identify what is wrong with profit maximization as an objective?
Do we all understand the term profit in the same way?
Let us have a look at the Income Statement
Particulars

Revenue from Operations

(Less) Cost of Goods Sold (COGS) (All direct expenses)
Gross Profit
(Less) Selling & Distribution Expenses
(Less) Administrative Expenses
(Less) General Expenses
Earnings before interest, taxes, depreciation and amortization (EBITDA)
(Less) Depreciation and Amortization
Earnings before interest and taxes (EBIT)
(Less) Interest Expenses
Earnings Before tax (EBT)
(Less) Tax Expense
Earnings/profit after tax (EAT/PAT) or Net Income
Can you identify how many variants of profits are reflected in the table above? There are five.
One needs to be sure which variant of profit one is talking about. So the first major issue with
the term profit is, it lacks clarity because of its multiple meanings. Another issue with this
objective is the time frame it addresses. Profit maximization is to increase the capability of
earning profits in the short run to make the company survive and grow in the existing
competitive market. The short term orientation can prove to be damaging in the long term. A
company may be able to increase the current year's profits by cutting back on the training
and development of employees. This expenditure may have added long-term value.
Shareholders will not welcome higher short-term profits if long-term profits are damaged.
Bearing in mind the inadequacies of profit maximization as an objective, wealth/value
maximization is considered the primary objective of Financial Management.

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What do we understand by the term wealth? NOTES

To understand this, you must understand the concept of valuation. How should we judge the
value of an organization? What is the value of Tata Motors as on 31st March 2021?
The quickest way to find the value is to look at its stock price. The close price was Rs 301.85.
An investor who bought shares of Tata Motors, wants the company to generate value so that
the stock price goes up in the long term. By doing so, the wealth of the investor goes up. That
is the primary objective of an investor, apart from earning dividends. Wealth maximization is
the ability of a company to increase the market value of its common stock over time.
Many people objected to wealth maximization as an objective. Why should the design of the
objective be to meet only the shareholders? How about other stakeholders? Namely,
customers, suppliers, creditors and employees? The theoretical and empirical arguments
support that managers must focus on shareholder wealth maximization. Equity
shareholders are also called the residual claimants, which means they are paid once the
claims of all other stakeholder are taken care of. Firms will have to satisfy customers,
employees, creditors and suppliers before maximising the shareholders' returns.
Principle of Financial Management
How should a company ensure that the value of the firm goes up?
It does so by taking financial decisions so that the present value of the future benefits is
maximised. You must have noticed the term 'future', which is pointing at the long term
orientation.
How is the present value of future benefits calculated?
What are the future benefits?
Remember our discussion about the difference between accounting and finance? Finance as
a discipline focuses on cash flows.
Can we measure the future cash flows?
Yes, we can. Using historical financial statements, analysing and applying judgement, we can
calculate future cash flows with some confidence. You will be taught this in the forthcoming
units.
Here the main principle is that;
The present value of future cash inflows > The present value of cash outflows
The difference between the two is the Net Present Value, which should be positive.
Let us understand this with an example.
Situation 7 : Will you buy a machine worth Rs 5,00,000, if it has life of five years and it gives
you cash inflows as follows?

0 1 2 3 4 5
(5,00,000) 80,000 85,000 1,10,000 1,15,000 1,25,000

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NOTES Will it be correct to add all inflows and subtract outflows to calculate the overall benefits
from this investment decision?
If you add all the inflows, you will get Rs 5,15,000. Will you buy this machine?
If you have said, Yes, your answer is wrong.
The value of rupees across five years is not the same. The value of Rs 100 that you have today
is of more value than Rs 100 that you will receive after a year. It is called the time value of
Money. Unit two is dedicated to this concept. For now, you must understand this with a
simple example. If 10% is the current rate of interest, wouldn't your Rs 100 that you have
today will become Rs 110 (100+10%*100)? Yes! We just calculate the value of Rs 100 after a
year. The other way of saying the same thing is
Rs 100 today = Rs 110 after a year (when the rate of interest is 10%)
If we divide 110 with 1.1 (1+10%*1) we will get Rs 100. We just calculated the present value
of Rs 110.
Let's look at situation 7 again.

Time Cash flows PV factor PV of cash flows

(a) (b) (c ) = 1/(1+r)n d) = (b)*© )

0 -5,00,000 1 -5,00,000.00

1 80,000 0.909 72727.273

2 85,000 0.826 70247.934

3 1,10,000 0.751 82644.628

4 1,15,000 0.683 78546.547

5 1,25,000 0.621 77615.165

Net Present Value=

-1,18,218.453

By applying the time value of Money, you realised that the decision you would have taken
without applying this concept would have been wrong. The 10% rate that we have used here
is also called the hurdle rate. Isn't it common sense that an organization must earn more than
the hurdle rate (cost of capital/ cost of raising Money).
The financial manager must make the decisions keeping in mind that the Net Present Value is
positive. It will increase the value of the organization. Wealth maximization recognises the
time value of Money by discounting the expected cash flows of different years at a specific
discount rate (cost of capital).
We will learn these concepts in detail in upcoming units.

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1.5 FINANCIAL MANAGEMENT DECISIONS NOTES

You must have seen a balance sheet that is based on a simple accounting equation which is
Assets= liabilities + capital. Assets are the application of funds, and Liabilities and Capital are
the sources of funds. In the Financial Accounting course, you must have learnt how to
prepare financial statements. One of the most crucial Statement was the balance sheet. The
financial management decisions will be taken so that the balance sheet's value goes up.
Balance Sheet

ASSETS EQUITY AND LIABILITIES

Non-Current Assets (A) Equity (C)
Comprises of Long lived assets, Comprises of contributed Capital
which are generating cash and other equity (accumulated
flows profit)-Residual Claim on cash flows
-Significant Role in Management
=Perpetual Lives
Current Assets (B) Non-Current liabilities (D)
Short lived assets used for Long term debt, Fixed Claim on
working capital needs cash flows, -Little or No role in
management
-Fixed Maturity
-Tax Deductible
Current Liabilities(E)
Short term Liabilities

1.5.1 INVESTMENT DECISIONS

These decisions deal with the Non-Current Assets or the long-lived assets of the business.
These are also called Capital budgeting decisions. It involves selecting an asset or a course of
action whose benefits shall be available in the future for over the lifetime of a project. Here
again, we are guided by the financial management principle given in section 1.4., that is, the
future benefit generated by an asset should be more than the cost involved in buying it. The
relative benefits and returns of an asset decides whether the assets will be accepted or not.
Thus, the major element in the capital budgeting decision is measuring the worth of the
investment proposals.
Firms have scarce resources, and that must be allocated amongst various competing uses.
The returns from a proposed investment/asset are compared to a minimum acceptable
hurdle rate to accept or reject a project. The hurdle rate is the minimum rate of return below
which no investment proposal would be accepted. In financial management, we measure
(estimate) the return on a proposed investment and compare it to the minimum acceptable
hurdle rate to decide whether or not the project is acceptable. The hurdle rate is a function of
the project's riskiness; the project is riskier, higher the hurdle rate. There is a broad argument
that the correct hurdle rate is the opportunity cost of capital. The opportunity cost of capital
13
UNIT 1
An Overview of
Financial Management

NOTES is the rate of return that an investor could earn by investing in financial assets of equivalent
risk. It is also called cut-off rate, Required rate, or minimum rate. These norms are expressed
in terms of the cost of the capital. We will understand the concept and calculations of cost of
capital in the unit dedicated to this topic.
The limited resources available to organizations must be allocated between various
competing uses. Thus, it becomes essential that the return generated by an investment or an
asset is compared with a minimum acceptable rate to take a decision regarding its
acceptance. Companies decide the minimum rate of return in advance, below which they
don’t accept any investment. This minimum rate is based on project's riskiness; the
minimum rate has direct relation with risk, i.e., higher the risk, higher will be the hurdle rate.
Generally speaking, the correct hurdle rate is the opportunity cost of capital. The
opportunity cost of capital is the rate of return that an investor could earn by investing in
financial assets of equivalent risk. It is also called cut-off rate, Required rate, or minimum
rate. We will understand the concept and calculations of cost of capital in the unit dedicated
to this topic.

1.5.2 FINANCING DECISIONS

The Financing decisions focus on the proportion of debt and equity (C & D of the Balance
Sheet given above). The financing decision is concerned with the financing mix or capital
structure. Capital structure refers to the proportion of debt and equity capital. The choices of
proportion of these sources to finance the investment requirement is the main aim of the
decision. This decision will have major bearing on the hurdle rate (cost of capital).
The benefit of borrowing more is the tax advantage that accrues from the fact that interest is
tax-deductible. The downside is that there is a fixed cost that the company incurs. If it is
unable to meet these obligations, lenders may take control of the company. The firm has to
decide the reasonable proportion between debt and equity; this is called optimum capital
structure. We will delve into details of this concept in unit pertaining to capital structure.

1.5.3 DIVIDEND DECISIONS

The Dividend policy decision must be analysed concerning the financing decision of the firm.
There are two options available to a firm while dealing with its profits-
a. It can be distributed among the shareholders of the firm in the form of dividends
b. Alternatively, it can be retained with the business.
If firms cannot find investments that earn a minimum required rate of return, the firm should
return cash that the business generates to its owners.
The significant element to be followed for a dividend decision is the dividend payout ratio.
This ratio explains what proportion of profits needs to be paid out to the shareholders. The
final decision solely depends on the investment opportunities available within the firm and
the shareholders. A complete unit is dedicated to discuss the dividend decision to be taken
by finance mangers.

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1.5.4 WORKING CAPITAL MANAGEMENT DECISIONS NOTES

The working capital management decisions are also called liquidity decisions. These
decisions deal with the management of short term assets (current assets) and short term
liabilities (current liabilities). The short term survival of the firm is a prerequisite for its long
term success. Here the major decision is the tradeoff between profitability and risk
(liquidity).
If a firm doesn't invest enough funds in current assets it may become illiquid and may not
have the ability to meet its current obligations and therefore invite the risk of bankruptcy.
Also, if current assets are too large, profitability is adversely affected. To ensure a tradeoff
between profitability and liquidity Working capital management decision plays an important
role. The individual current assets should be efficiently managed so that no unnecessary or
inadequate funds are locked up.
Thus, working capital management has two elements- Previewing Working capital
management as a whole, and Efficient Management of current assets such as cash,
receivables, and inventory. In the upcoming units we will discuss the working capital
management in detail.

1.6 ROLE OF A FINANCE MANAGER

Now that you have understood the major financial management decisions, you will quickly
understand the role of the financial manager. The key responsibilities of a financial manager
include financial planning, investing (capital budgeting: long-lived assets; working capital:
short term assets), and financing (capital structure). The financial manager will be guided by
the main goal of the firm that is maximising the value of the firm.

CHECK YOUR PROGRESS-V

Q.1 Which of the following is not a financial management decision?
a) Investment decisions
b) Financing decisions
c) Dividend decisions
d) Working capital management decisions
e) Recruitment for a new project
Q.2 Financial manager of the firm is guided by the following goal of the firm
a) Cost reduction
b) Profit maximization
c) Value maximization
d) Cost management
e) None of the above

15
UNIT 1
An Overview of
Financial Management

NOTES 1.7 AGENCY THEORY

The finance manager must work in the stockholders' best interests by making decisions that
increase the value of the stock. In a larger organization where ownership is spread over many
stockholders, Board of Directors are appointed to take the strategic decisions on behalf of
Shareholders. The Board of Directors appoints the chief executive and other professionals
are hired by the firm to manage the business. In large organizations, management effectively
controls the organization. Now, the question arises, will they act in the best interest of the
stockholders? Or management may pursue its own goals at the expense of stockholders?
The relationship between stockholders and management is called an agency relationship.
Agency relationship exists whenever a principal (stockholders in this case) hires the agent
(Management) to represent his/her interest. There is a possibility of conflict between agent
and principal; such a conflict is called agency problem.
In the recent past, there have been corporate frauds like Enron, IL&FS financial services,
DHFL where the agents have inappropriately used the authority vested in them by the
principal.
Now the question arises, how to resolve or eliminate the agency problems?
Let us look at various ways of circumventing this problem
1.7.1 EXECUTIVE/MANAGERIAL COMPENSATION
Management will have an incentive to increase the share value if their compensation is
affected by the organization's value. A large number of organizations, therefore, give stock
options to top management. The more the value of the stocks will be, the more attractive will
be this scheme. Having this kind of incentives encourages more employees and
management to act in the business's best interest. Infosys granted a total of 37,88,260 stock
incentive units to specific key managerial personnel (KMP) and eligible employees under its
2015 Incentive Compensation Plan" and "Expanded Stock Ownership Program 2019.
Similarly, many other Indian companies follow this practice.

1.7.2 SECURITY MARKET PARTICIPANTS BEHAVIOUR

The Large institutional investors, namely, financial institutions, mutual funds, pensions
funds, hold a large chunk of companies' shares, and actively participate in its management.
By doing so, they ensure that management works in the best interest of the shareholders.
They use their voting rights. They also regularly communicate and exert pressure on
management to maximise the organization's value or face replacement.

1.7.3 HOSTILE TAKEOVERS

Another way that management can be replaced is by a takeover. Corporate that are not
adequately managed become attractive target for acquisition as compared with the
adequately managed companies. It happens as the acquiring firm believes that the target
firm is undervalued due to poor management. It puts pressure on corporate to perform and
act in the stockholders' interest.

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1.8 LET US SUM UP NOTES

This is an introductory unit of Financial Management. As a Masters student in Business Ad-
ministration, you must understand the functioning of the organizations and role that
Financial Management plays in it. When you look around yourself you will find that there are
organizations of different kind, nature and size.
There are four primary legal forms of business organizations. A single-owner runs sole
proprietorship. It is simple to form, easy to operate and decision making is faster, but the
owner has unlimited liability. The partnership is similar to proprietorship with two or more
owners who have combined their funds and skills. Each partner has unlimited liability for all
the debts and obligations of the firm. The corporate form of an organization is dominant in
terms of aggregate sales and profits. It is superior to other forms in raising Money,
transferring ownership interests, and limited liability. Limited liability partnership is a hybrid
between a corporate and a partnership.
Finance as a discipline is also related to many other disciplines; it is closely related to
accounting and economics. The finance manager uses the information and data produced by
an accountant. Though both finance and accounting are dealing with Money, the approach
of these two areas is different. Finance uses a cash flow approach, as compared with the
accrual approach used by accounting. Finance is closely related to economics, and finance
manager is expected to understand the institutional environment in which the firm operates
and be updated about the various government policies that impact the firm. Micro
economics helps in designing various profit maximization strategies, and a finance manager
provides these strategies based on the theory of the firm.
The goal of financial management is to make decisions that increase the value of the stock or,
more generally, helps in wealth maximization. The decisions are primarily, Investment
decisions; Financing decisions; Dividend decisions, and Working capital management
decisions. The financial manager will be making these decisions and will be guided by the
primary goal of the firm that is maximising the value of the firm.
An agency problem results when managers as agents of owners place personal goals ahead
of corporate goals. Managerial compensation, security market participants' behaviour and
the threat of hostile takeover tend to act to minimise agency problems.

1.9 KEY WORDS

Investment Decisions: Is concerned with how a firm's funds are invested in its assets
Financing Decisions: Is concerned with how a firm will raise short term and long term finance
through debt and equity
Dividend Decisions: This is concerned with how much profits needs to distributed as
dividends to equity shareholders.
Working Capital Management Decisions: This is concerned with the capital needed to run
the organization on a day-to-day basis.
Wealth Maximization: This is the objective of financial management, which means
increasing the wealth of shareholders by maximising the value of stocks that they own. 17
UNIT 1
An Overview of
Financial Management

NOTES Agency Theory: Management must work in the interest of the stockholders.

1.10 REFERENCES AND SUGGESTED ADDITIONAL READINGS

Chandra, P. (n.d.). Financial Management. Theory and Practice. Second Reprint 2011. Tata
McGraw-Hill Publishing Limited. New Delhi. McGraw-Hill Offices. Indian ….
Corporate Finance-Theory and Practice Aswath Damodaran—Google Scholar. (n.d.).
Retrieved April 7, 2021, from
https://scholar.google.com/scholar?hl=en&as_sdt=0%2C5&q=Corporate+Finance-
Theory+and+Practice+Aswath+Damodaran&btnG=
Khan, M.Y., & Jain, P.K. (2007). Financial Management, Text, Problems and Cases. Tata. Mc
Graw-Hill Publishing Company Limited.
Richard, P., & Bill, N. (2006). Corporate Finance and Investment-Decisions & Strategies.
Pearson Education Limited.
Ross, S. A., Westerfield, R., & Jordan, B. D. (2008). Fundamentals of Corporate Fi-nance. Tata
McGraw-Hill Education.
Van Horne, J. C., & Wachowicz, J. M. (2005). Fundamentals of Financial: Manage-ment
Prinsip-Prinsip Manajemen Keuangan. Penerjemah: Dewi Fitriasari Dan Deny Arnos Kwary.
Penerbit Salemba Empat: Jakarta.

1.11 SELF-ASSESSMENT QUESTIONS

In the following multiple-choice questions select the correct answers.
Q.1 What is the most likely objective of capital budgeting?
a) Capital Optimization
b) Wealth Maximization
c) Profit Maximization
Q.2 Financial manager of the firm is guided by which Principle?
a) Cash inflows should be more than cash outflows
b) Present value of Cash inflows should be more than cash outflows
c) Present value of Cash inflows should be more than the present value of cash
outflows
d) Profit should be more than the hurdle rate
Q.3 Financial managers create firm value by:
a) Declaring more dividends
b) Making Capex decisions which result in higher cash inflows in excess of their cost
c) by doing window dressing
d) by lowering the product’s price to increase the market share
Q.4 Which of the following is correct about Financial management?
a) It deals with preparation of financial statements
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Financial Management

b) It is rules based NOTES

c) It is backward looking
d) It considers time value of money
e) All of the above
Essay Questions
Q.1 Identify the differences between Profit maximization and Value maximization? Which
of the two is the objective of Financial Management?
Q.2 Elaborate on how is accounting and finance are interrelated
Q.3 What are the major decisions taken by a financial manager? Write with examples.

1.12 CHECK YOUR PROGRESS – POSSIBLE ANSWERS

CHECK YOUR PROGRESS – I
Case 1: Chandni is short of Rs 15,000 for paying her business bills. She will have to bring in
Rs 15,000 from her savings (personal); she only has Rs 5000 in her savings. She will
have to arrange the remaining Rs 10,000 from her friends or family to pay the bills in
full. If he does not make the payment, she will turn insolvent, and the business will
discontinue.
CHECK YOUR PROGRESS-II
Case 1: The firm is short of Rs 15,000 for paying its bills. Both partners must bring in Rs 7,500
each in order to pay the bills in full. Ragini has Rs 3,000, and Suhani must bring in Rs 12,000.
Suhani can take the extra Money contributed by her later from Ragini. This way, they will stay
solvent, and the firm and the business will continue.
CHECK YOUR PROGRESS-III
Case 1: The business is short of Rs 25,000 for meeting its liabilities. Both Saloni and Rahul
contributed their agreed share capital. Their liability is limited to this amount only; they need
not have brought any more cash. They will stay solvent. The business will be liquidated, and
the liability will be recovered by selling the business.
CHECK YOUR PROGRESS-IV
Q.1 e
Q.2 b
CHECK YOUR PROGRESS-V
Q.1 e
Q.2 c

1.13 ANSWERS TO SELF-ASSESSMENT QUESTIONS

Q.1 b
Q.2 c
Q.3 b
Q.4 d 19
NOTES UNIT 2

TIME VALUE OF MONEY

STRUCTURE
2.0 Objectives
2.1 Introduction
2.2 Cash Flow
2.3 Future Value
2.4 Present Value
2.5 Nominal and Effective Rate of Interest
2.6 Concept of Continuous Compounding
2.7 Capital Recovery and Loan Amortization
2.8 Concept of Sinking Fund
2.9 Let Us Sum Up
2.10 Key Words
2.11 References And Suggested additional Readings
2.12 Self-Assessment Questions
2.13 Check Your Progress-Possible Answers
2.14 Answers to Self-Assessment Questions

2.0 OBJECTIVES
On completion of this unit, you should be able to:
• Draw the relationship between time & money
• Understand the concept of cash flow
• Differentiate between lumpsum and Annuity
• Differentiate between ordinary annuity and annuity due
• Calculate the future value of cash flows
• Calculate the present value of cash flows
• Understand the capital recovery and sinking fund concepts

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2.1 INTRODUCTION NOTES

Time Value of Money (TVM) is an important concept in financial management. It can be used
to compare investment alternatives and to solve problems involving loans, mortgages,
leases, savings, and annuities. In order to have complete understanding of Financial
Management, it is important to gain sound understanding of Time value of Money concept.
It defines the relationship of money with time. In this unit we will discuss that how value of
money changes with time and the factors which affects the time value of money.
Many financial decisions like purchase of machinery, procurement of raw materials, paying
for day-to-day operations involves cash outflows and related inflows in different time
periods. For Example: If machinery is purchased, huge amount of cash outflow will take place
today and will generate cash inflows in subsequent future periods. Cash flows occurring at
different time period are not comparable. So rationally cash outflows and cash inflows
should be compared at the same point of time. Cash flows become logically comparable
when they are adjusted for time and risk. If the firm takes decision without considering the
time and risk involved in the cash flows then the decision would not be appropriate and it will
not fulfil the objective of maximising shareholder’s wealth.
Now the question is Why value of money does not remain same over different periods of
time?
In real life, it has been found that the value of money declines with the passage of time.
Individuals would have preference for possession of a given amount of money now, rather
than the same amount of money at some future time period. There are many reasons
attributable to it:
a. Inflation- The value of money declines with time which is generally denoted as
Inflation. It refers to the percentage increase in the prices which in turn declines
the purchasing power of money. For example: If you can buy 1 kg of wheat at Rs
40/, if there is inflation then the same quantity of wheat i.e 1 kg cannot be bought
with Rs 40/-nin future. You have to pay higher amount to buy same quantity
during inflationary times.
b. Present Consumption is preferable- Individuals prefer present consumption
over future consumption that may be because of many reasons like uncertainty of
future due to death, illness etc.. There is a saying that “A Bird in hand is worth two
in the Bush”.
c. Rate of interest or investment Opportunities- A rational person would always
choose money today as he can invest this money in order to earn more money in
future. For Ex. Rs 500/- given today would be preferable to Rs. 500/- given after
one year. A rational individual will invest 500/- to earn more in future.
Few Important Concepts:
a. Importance of Timeline
Timeline is the graphical representation of cash flows; outflow or inflows
depicted in a line over different period. Every period would be depicted by a tick.
For ex. In the Fig-1, “0” denotes today, 1 denotes one period from today, 2 21
UNIT 2
Time Value of Money

NOTES denotes two periods from today and so on. Period can be year, month, or quarter.
Fig. 2.1: Time Line

Fig. 1

In a yearly timeline there will be n number of annual periods and i will be the
annual interest rate. If this annual timeline is converted to semi-annual timeline,
then there will be 2n semi-annual periods and rate of interest will be halved to
i/2for each semi-annual period. We can say that frequency of each semi-annual
period is 2 in a year. This can be generalized that if the annual timeline is
converted to frequency of m periods in a year, then there will be m×n periods and
i÷m will be the rate applicable to each period. For example, if a bond with
maturity of 5 years, pays 8% interest per annum at semi-annual frequency. Here,
number of periods n=5, frequency m=2and coupon rate i=8%. For the semi-
annual timeline, number of periods will be 2x5i.e. 10 semi-annual periods, rate of
interest will be 8/2 i.e. 4% for each semi-annual period.
b. Compounding
Compounding is the process in which present value of money is converted into
future value. Let’s understand with the help of an example: If you have 1000/-
today and you decide to invest it for future. Suppose the rate of interest is 10% p.a
then after one year, you would get Rs 1,100/.Now suppose you keep that money
for two years, you would earn interest on that earlier interest which is Rs 100/-.
Now your amount would grow to Rs (1100*10/100)+1100=1,210/-. This process
of getting interest on interest is known as compounding. It has been said in
Finance world that “Compounding is the eighth wonder of the world” and the
most important tool in the world. This will make money work for you even if you
are sleeping. You may get exponential growth if you start investing at early age.
c. Discounting
Discounting on the other hand is the process in which future value of money gets
converted in to present value. We use term “rate of discount” instead of “rate of
interest” when we calculate present value from future value. Let’s take same
example as above, if you want to accumulate Rs 1100/- after one year, how much
would you have to save today if rate of discount is 10% p.a. Amount would be
1100/1.10=1000/-

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Financial Management

Fig. 2.2: Compounding and d Discounting NOTES

Fig. 2.3: Type of Cash Flows

2.2 TYPES OF CASH FLOWS

2.2.1 LUMP SUM CASH FLOWS
Lumpsum cash flow means that the amount is either deposited or withdrawn at one go.
There are no instalments involved. For example, we deposited 10,000 in a bank account or
we withdraw 10,000 from ATM.

2.2.2 STREAM OF CASH FLOWS

A UNEVEN CASH FLOWS
Series of unequal cash flows that are not fixed are uneven cash flows. For
example, You withdraw some random account every month from bank account
say Rs 100, Rs 200, Rs 300, and so on.
B EVEN CASH FLOWS (ANNUITY)
A series of equal cash flows at equidistant periods (intervals) of time is called an
annuity. For Example, Paying Equated monthly instalments (EMI), Paying
Insurance premium, Paying Rent, and so on are all known as annuities.

23
UNIT 2
Time Value of Money

NOTES ANNUITY CAN BE OF VARIOUS TYPES:

1. Ordinary Annuity
2. Annuity Due
3. Perpetuity
There are other types of annuities as well but our readings are restricted to above three.
Ordinary Annuity
Ordinary Annuity refers to the series of equal cash flows occurring at regular interval at the
end of the period. Period can be annually, semi-annually, quarterly or monthly. Example, Mr.
Sharma is depositing Rs 500 at the end of every year for 10 years. Another example: Mr. X has
purchased an annuity plan from which he is getting Rs 3000 at the end of every month.
Annuity Due
Annuity Due refers to the series of equal payments made or received at regular interval at the
beginning of the period. Period can be annually, semi-annually, quarterly or monthly. Ex . Mr.
Sharma is depositing Rs 500 in the beginning of every year for 10 years. Ex. Mr. X paying rent
every month in the beginning and so on.
Fig. 2.4: Difference between Ordinary Annuity and Annuity Due

i The major difference between ordinary annuity and annuity due is that payments are
made at the beginning of the period in case of annuity due and at the end of the period
in case of ordinary annuity.
ii Future value of annuity due is always higher than the future value of ordinary annuity
because each cash flow is compounded for one additional period. It is recommended
to invest in the beginning of the period in order to maximise the return.
In order to simplify the concept, let’s take an example of Public Provident fund.
Interest of PPF account is calculated on minimum balance between 5th of that month
and end of month. So, if you deposit an amount on or before 5th of that month then
you would get interest on previous month’s balance as well as current month’s balance
On the contrary, if you deposit after 5th of that month then interest would be
calculated on previous month’s balance. One period may look small but when
compounding takes place on a large sum then the difference would be quite

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noticeable. NOTES
FV of Annuity Due= FV of Ordinary Annuity*(1+r)
iii Similarly, present value of annuity due is higher than the present value of ordinary
annuity. It is due to the fact that annuity due payments are received earlier and
therefore discounted less for one period. The first cash flow is being received at the
beginning of 1st period i.e. t=0, therefore, it will not be discounted at all.
PV of Annuity Due= PV of Ordinary Annuity*(1+r)
In the following sections, we will learn the calculation of Future value of money if the
Present Cash Flows are known. We will also cover the analysis of Present value of
money if Future cash flows are given. The assessment of Future and Present value of
Money is extremely important in order to assess many real-life situations. For
example, calculation of EMI for a loan, worth of expected future sum of money to be
received from a life insurance policy, stream of cash flows to be invested to accumulate
a specified sum of money for future period etc., all require the understanding of the
future and present value.
PERPETUITY - perpetuity refers to series of equal cash flows at regular interval for an
infinite period

2.3 FUTURE VALUE (FV)

2.3.1 FUTURE VALUE OF MONEY (LUMP SUM)
To Calculate future value of money at a specified interest rate, we use two methods of
applying interest. namely,
a. Simple interest
b. Compound Interest
In real life compound interest is widely used method of calculating future value. Let us
understand meaning and application of both the methods:
Simple Interest: Simple interest is calculated on the original principal. Accumulated interest
from prior periods is not used in calculations of interest for the following periods.
Simple Interest = Principal interest rate *time /100
Example 1: Harsh borrowed Rs 100000 for 5 years at 10% p.a. simple interest. How much
interest he will have to pay after 5 years?
Simple interest = 100000*10*5/100 = 50000
Compound Interest: Compound interest is paid on the original principal and on the
accumulated past interest
FV = PV (1 + r)n
where, FV = Future Value
PV = Present value
r= interest rate
n= number of periods 25
UNIT 2
Time Value of Money

NOTES Example 2: Uday invested Rs 40000 in a scheme that gives interest 12% p.a. compounding
annually. Calculate the maturity amount after 10 years?
Accumulated amount or Future Value = 40000*(1.12)10 = Rs. 1,24,233.93
Apart from using above formulae, we can calculate future value using future value factor
tables. Factor tables are given at the end of the book. Factor value represents the value of
Re 1.
Future value interest factor (FVIF), is the value of Re 1 after time ‘n’ invested at rate ‘r’, for
example If Re 1 is invested today at the rate of 10% for 5 years, and it would turn out to be:
FVIF (r%, n) = (1+r)ⁿ
= (1.12)⁵
FVIF (12%,5) = 1.7623
Here Re 1 is principal invested and 1.7623 is the interest earned in 7 years @ 12% p.a.
Similarly, we can calculate the value of Re 1 invested for any time ‘n’, at any rate ‘r’. The value
of FVIF For any time ‘n’, at any rate ‘r’ can be directly taken from ‘Future Value of Rs 1’ Table.
Example 3: Anil invested Rs 50000 in bank FD at 10% p.a. compounding quarterly for 3 years
for arranging college fees of his son. Calculate the amount received after 3 years r = 10% p.a.
compounding quarterly = 10%/4 per quarter= 2.5% per quarter n = 3 years = 3*4 = 12
quarters
Now put the values in formulae
FV = PV (1 + r)ⁿ
Amount received = 50000* (1.025)¹²
= 67244
By using the above formulae we can calculate the PV, r, and n.
The above problem can be solved in Microsoft Excel using Finance Functions
In order to calculate Future Value, use FV function in excel
Example 3 (Contd.)

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Abbreviations used in excel NOTES

Present Value (PV)
Future Value (FV)
Annuity (PMT)
Rate (Rate)
Number of Period (NPER)
Type (0-end of the period) & (1-beginning of the period)
Example-3 (Contd.)

PRESENT VALUE 50000

NPER 3
RATE 10%
PMT NA
FUTURE VALUE ₹ 67,244.44
TYPE 0
FREQUENCY 4

Please Note: Present value can be taken as negative as it indicates cash outflow and when
there is lump sum cash flow then “Type” can be taken as 0 or 1, output will remain same.

2.3.2 FUTURE VALUE OF ORDINARY ANNUITY

Ordinary Annuity refers to the series of equal payments made at regular interval at the end of
the period. Period can be annually, semi-annually, quarterly or monthly. For Example- Mr.
Sharma is depositing Rs 500 in a mutual fund scheme through systematic investment plan at
the end of every year for 10 years. Another Example is Mr. X has purchased an annuity plan
from an insurance company which he is getting Rs 3000 at the end of every month.
Calculation of Accumulated Value of Ordinary Annuity
Future value of Ordinary annuity gives us the accumulated amount of annuity which are paid
or received at the end of the period.
Example 4: Mahima deposits Rs1000 at the end of every year for 3 years in a bank at 10% p.a.
What will be the total value of this series of deposits at the end of 3 years?
Using Formula
The future value of an annuity is given by the following formula:

((1+r)ⁿ-1) (1+0.1)³-1
Future value of ordinary annuity (Sn) = A x r = 1000 x 0.1 = 3310

Here A = amount of annuity

27
UNIT 2
Time Value of Money

NOTES Using Factor Tables:

Future value of Annuity= Annuity X FVIFA (r%,n)

Future value of Annuity= Annuity X FVIFA (r%,n)

Future value interest factor of an annuity (FVIFA), is the value of Rs 1 invested at the END
of every period for ‘n’ number of periods at rate ‘r’ per period, for example If Re 1 is
invested at the end of every year for 10 years at the rate of 15% pa., it would turn out to
be:

(1+r)ⁿ-1
FVIFA(r%,n) =
r
(1+0.15)¹⁰-1
=
0.15
FVIFA (15%,10) = 4.0456
FVIFA can be directly taken from Table- Future Value of Annuity of Rs 1. Refer table -2
(Future Value Interest Factors for One Rupee Compounded at r Percent for n Periods),
n=10, Period= 15%, FVIFA (15%,10)=4.0456

Example 5: How much will be accumulated after 5 years if 1000/- is invested every year for
five years at the end of the period, rate of interest is 12% p.a.

Future value of Annuity= Annuity x (1+r)ⁿ-1

r
FVIFA (r%,n) = 1000 x (1+0.12)⁵-1
0.12

= 1000 x 6.3528 = 6352.80

[Alternatively, refer factor table- Future Value Interest Factors for One Rupee Compounded
at r Percent for n Periods]

Future value of Annuity= 1000 x FVIFA ₁₂%,₅

= 1000 x 6.3528

=6352.80
Example 6: If you deposit 10,000 every quarter in a mutual fund scheme, how much would
you get after 3 years? Rate of return is 12% p.a
In this case, 10,000 is deposited every quarter which means in one year 4 deposits are made

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NOTES
((1+r)ⁿ-1)
Future value of Annuity= Annuity x
r

r=rate= 12%/4 =3%

n = 3*4=12
((1+0.03)¹²-1)
Future value of Annuity= 10,000 x
0.03
Example 7: How much will be accumulated after 5 years if 1000/- is invested every year for
five years at the end of the period, rate of interest is 12% p.a.

We can solve the above problem in excel using FV Function

PRESENT VALUE ₹ 0.00

NPER 5
RATE 12%
PMT 1000
FUTURE VALUE ₹ 6,352.85 (solve)
TYPE 0
FREQUENCY 1

2.3.3 FUTURE VALUE OF ANNUITY DUE

Calculation of Accumulated Value of Annuity Due
Annuity Due is the series of equal payments made at equal intervals in the beginning of the
period.
Future value of Annuity Due gives us the accumulated amount at the end of the stipulated
period if the cash flows are paid or received in the beginning of the period.
Example 7a: How much will be accumulated after 4 years if 5000/- is invested every year for
29
UNIT 2
Time Value of Money
five years in the beginning of the period, rate of interest is 6% p.a.

NOTES

Using Formulae:

FV= A* FVIFA (r%,n) × (1+r)

((1+r)ⁿ-1)
Where FVIFA (r%,n)= r

n=4 r=6%

A= 5000
((1+0.64)⁴-1)
FV=5000 × 0.64 × (1+.06)=23,185.46

Alternatively, we can use factor table also

FV= 5000 × FVIFA (6%,4) × (1+.06)

FVIFA (6%,4)= 4.3746 (Refer Table- 2 Future value of Annuity factor)

FV=5000×4.3746*(1+.06)=23,185.46

Using Excel to solve the above problem:

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NOTES

We have taken Type as 1 instead of “0” as it is annuity due.

CHECK YOUR PROGRESS-I

Q.1 How much will be accumulated after 3 years if 5000/- is invested every quarter for
three years in the beginning of the period, rate of interest is 20% p.a.

2.3.4 FUTURE VALUE : UNEVEN CASH FLOW

As discussed above, uneven cash flows are those which are not same every period i.e
irregular.
In order to calculate future value of uneven cash flows, we need to calculate future value of
each cash flow separately and then sum them.
Let us take example to understand:
You are depositing cash flows for next 3 years at the end of the period in a bank account
which are as follows:

Year Amount
1 10000
2 20000
3 40000

Now, you want to know how much is being accumulated after 3 years if rate of interest is
10% p.a.

Year Amount FVIF Total

1 10000 10000× (1.10)² 12,100
2 20000 20000× (1.10)¹ 22,000
3 40000 40000× (1.10)⁰ 40,000
Total 74,100

Explanation : Money deposited at the end of year I will be compounded for next 2 years. Sum
deposited at the end of year 2 will be compounded for next 1 year and sum deposited at the
end of year 3 will remain as it is. 31
UNIT 2
Time Value of Money

NOTES At the end of 3rd year, you will accumulate 74,100 if rate of interest is 10% p.a.

2.4 PRESENT VALUE (PV)

2.4.1 PRESENT VALUE OF LUMP SUM AMOUNT

Present value is the value received today against the amount due in future or it is the worth
of money to be received in future today In order to calculate the present value we need the
amount due (future value) and discount rate which can be found out by using PVIF (r%,n)
from factor table.

Alternatively, we can use factor table

PV = FV X PVIF (r%,n)
Where,
PV = Present Value
FV = Future Value
PVIF (r%,n) = Present Value of Interest Factor at the rate ‘r’ for time ‘n’
PVIF (r%, n)
Present value interest factor, is the value of Rs 1 due after time ‘n’ discounted at rate ‘r’, for
example, what would be the value of Rs 1000 now, falling due after 8 years if discounted at
the rate of 12%
We can solve using formulae:

We will look at the Table-Present Value Interest Factors for One Rupee Discounted at r
Percent for n Periods: PVIF r, n = 1 / (1 + r)ⁿ given at the end of the book
PV = FV x PVIF (12%,8 yrs)
PV=1000 x .4039=403.9
The above problem can be solved in Microsoft Excel using Finance Functions
In order to calculate Present Value, use PV function in excel

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NOTES

PRESENT VALUE ₹ -403.88 (solve)

NPER 8
RATE 12%
PMT Not applicable
FUTURE VALUE ₹ 1,000.00
TYPE 0
FREQUENCY 1

In Excel, value is reflecting in negative as it indicates cash outflow.

2.4.2 PRESENT VALUE OF ORDINARY ANNUITY

Present value of annuity means how much would be required now in order to get series of
payments in future at a given discount rate.

Let’s say, you want to calculate the present value of 1000/- , to be received for next
3 years , discount rate is 7% p.a.

33
UNIT 2
Time Value of Money

NOTES PVIFA (r%, n)

Present value interest factor of an annuity, is the value of Rs 1 due at the END of every period
for ‘n’ number of periods discounted at rate ‘r’, for example, what would be the value of Re 1
getting due at the end of every years for next 5 years, discounted at the rate of 10% p.a. We
can calculate PVIFA from the below mentioned formula or we can see factor table(Present
value interest factors for a one rupee annuity discounted at r% for n periods)

PVIFA (10%, 5) = 3.7908

Example 8: Manav wants to deposit “x” amount today in order to get 5,000 every year at
the end of the every year for next 10 years, rate of discount is 10% p.a. Help him to know
how much amount he should deposit now?
Solution: Present Value= Annuity x PVIFA (r%, n)

Refer to Table: Present Value Interest Factors for a One-rupee Annuity Discounted at r Percent for n Periods:
PVIFA = [1 - 1/(1 + r)n] / r

Present Value = 5000x6.1444= 30,722

Or the same problem can be solved in excel as shown below:

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PRESENT VALUE ₹ -30,722.84 (Solve) NOTES

NPER 10
RATE 10%
PMT 5000
FUTURE VALUE NA
TYPE 0
FREQUENCY 1

Answer is 30,722.84/- (Negative sign in excel shows the outflow of money)

CHECK YOUR PROGRESS-II

Q.1 Ashish wants to withdraw Rs 7,000 every month from an investment in Mutual Fund
for next three years. How much he should deposit today if rate of return is 12% p.a?

2.4.3 PRESENT VALUE OF ANNUITY DUE

The Present value of an annuity due derives the today’s value of series of cash flows that are
expected to be received or paid in future. This is different from annuity or ordinary annuity in
the sense that each cash flow occurs one period sooner than the cash flow in ordinary
annuity.
Present value of annuity due (an)

Where an= present value of an annuity which has a duration of n periods

A= constant periodic flow
r = discount rate
Example 8a: Manav wants to deposit “x” amount in order to get 5,000 every year in the
beginning of the year for next 10 years, rate of discount is 10% p.a.
Using formulae to calculate above Question
Present value of annuity due (an)

=33,795.12
Alternatively, we can use factor table also.
Present value of annuity due (an) = A* PVIFA (r%,n)*(1+r)
= 5000*6.1446*1.10
=33,795.30
Or We can solve the same problem with the help of excel:
35
UNIT 2
Time Value of Money

NOTES PRESENT VALUE ₹ -33,795.12 (Solve)

NPER 10
RATE 10%
PMT 5000
FUTURE VALUE NA
TYPE 1
FREQUENCY 1

Negative value shows the cash outflow as the amount needs to be deposited now in order
to get annuity of 5000/- every year for 10 years. Type “1” shows that the annuity are
deposited at the beginning of each period.

2.4.4 CALCULATION OF ANNUITY (REGULAR INSTALMENT)

As we know, Annuities are the series of cash flows which is received or paid after fixed
interval. For Example Life Insurance premiums, Rent, Systematic investment plan (SIP) in
Mutual Fund and there are many examples like that. There are many life insurances
companies which offer various types of annuity plans. The example, “Annuity for a
guaranteed Period”is one of the plans offered by ICICI Prudential.
Let us now see few examples of Annuity calculation
Example 9: If you plan to take a loan of 20,00,000 now in order to buy house after 5years.
How much should you pay annual instalments at the end of every year if interest on loan is 12
percent?
PV= Annuity* PVIFA12%, 5
Present Value-20,00,000
Rate-12%
Term of Loan-5 year
Number of Payments- 5 (Every year there is an annual instalment)

Same problem can be solved in Excel as shown below:

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Financial Management

PRESENT VALUE 2000000 NOTES

NPER 5
RATE 12%
PMT ₹ -5,54,819.46(Solve)
FUTURE VALUE NA
TYPE 0
FREQUENCY 1

2.4.5 PERPETUITY
Perpetuity is an annuity where stream of cash flow payments is for an infinite period. One of
the examples of Perpetuity is Pension in which cash inflows are forever i.e. till the life time of
an individual.
The present value of a perpetuity commencing at the end of every period is calculated as
follows:
PV= Annuity required per period / rate of interest compounding each period
Example-10 What is the present value of perpetual annuity of Rs 2000 received at the end of
every year if interest rate is 12% p.a.
Present value = 2000/. 12 = 16666.67
Example-10a. What is the present value of perpetual annuity of Rs 1000 received at the end
of every year if interest rate is 12% p.a. compounding monthly?
Solution: Present Value = 1000/.01 = 100000
Note: if annuity required is monthly then interest rate should be converted to monthly rate
which in the above case will be 1% (12%/12).
The present value of a perpetuity commencing at the beginning of every period =
[Annuity required per period / rate of interest compounding each period PV] x (1+r)
= (A/r)* (1+r)
Example: 11
Mr. Ram is working with a government department. He is retiring next month and
would be getting a pension of Rs 8000 per month for his remaining lifetime in the
beginning of month. He has a choice of getting a lump sum value for this pension. If the
discount rate is 9%p.a. Calculate the lump sum amount that he can receive now.
PVP(∞) = A X PVIFA (0.75%, ∞) * (1+.0075)
= [8000 x (1 / 0.0075)]*(1.0075)
= 10,66,666.40*1.0075
= 10,74,666.398
Where, PVP= Present value of Perpetuity
A is the annuity
37
UNIT 2
Time Value of Money

NOTES PVIFA (0.75%,∞) is the annuity factor of Re 1 invested at .75% every month for infinity

CHECK YOUR PROGRESS-III

Q.1 Sakshi wants to deposit “x” amount in order to get 8,000 in the beginning of the period
for next 5 years, rate of discount is 12% p.a. Annuity are required semiannually.
Calculate the sum to be deposited now?

CHECK YOUR PROGRESS-IV

Q.1 Komal deposited 1,00,000 amount in a Mutual fund. How much she can withdraw
every year for next 5 years, rate of discount is 12% p.a.

2.4.6 UNEVEN CASH FLOW: PRESENT VALUE

The Present Value of a Cash Flow Stream is equal to the sum of the Present Values of the
individual cash flows.
Consider an investment which promises to pay Rs 1000 one year from now and Rs 2000 two
years from now and Rs 3000 three years from now. If discount rate is 10% p.a. then present
value of all cash flows.

Present vale shall be calculated as given below

Year Amount FVIF Total

1 10000 1000/(1.10)^1 909.09
2 20000 2000/(1.10)^2 1652.89
3 40000 3000/(1.10)^3 2253.94
Total 4815.93

CHECK YOUR PROGRESS-V

Q.1 Calculate the future value of an investment in which cash flows are as follows: Year 1-
5000/-, Year 2: 6000/-, Year 3: 8000/-, Year 4: 3500/- and Year 5: 6000/-. Rate of
interest is 15% p.a

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2.5 NOMINAL AND EFFECTIVE RATE OF INTEREST NOTES

2.5.1 NOMINAL RATE OF INTEREST
Nominal rate of interest refers to the rate of interest before adjustment for inflation (in
contrast with the real interest rate); or, for interest rates "as stated" or “quoted” without
adjustment for the full effect of compounding (also referred to as the nominal annual rate).
An interest rate is called nominal if the frequency of compounding (e.g. a month) is not
identical to the basic time unit (normally a year).
For example: 12% p.a. compounding monthly 5% p.a. compounding half yearly

2.5.2 EFFECTIVE RATE OF INTEREST

The effective interest rate is the interest rate on a loan or financial product adjusted to
incorporate the effect of compounding. It is restated from the nominal interest rate as an
interest rate with annual compound interest.
For example: 8% p.a., 4% p.a.
The effective interest rate is always calculated as if compounded annually. The effective rate
is calculated in the following way, where r is the effective rate, i the nominal rate (as a
decimal, e.g. 12% = 0.12), and n the number of compounding periods per year (for example,
12 for monthly compounding):

Sol: Using formulae

= 0.0616778 Therefore interest rate is 6.167% per annum.

Example 13: If the interest rate is 12% p.a. compounding quarterly, convert it into annual
effective?
Sol: Using formulae
r = (1 + .12/4 )⁴ - 1 = 0.1255 Therefore interest rate is 12.551% p.a.
In Excel, we use “Effect” function in excel to solve the above problem

39
UNIT 2
Time Value of Money

NOTES
Nominal Rate 12%
Frequency/Compounding 4
Effective Rate 12.551% (Solve)

2.5.3 RULE OF ‘72’

The rule of ‘72’, is a simple thumb rule used for doubling period calculation. It states that, to
know the time period in which your investments will double, simply, divide 72 by rate of
interest.
For example, what is the interest rate earned if the money is doubled in 5 years.
r = 72 / n
= 72 / 5
r = 14.4% (approx)
or
For example, in how many years the money can be doubled if the rate of interest is 10%.
n = 72 / 10
= 72 / 10
n = 7.2 years (approx)

2.6 CONTINUOUS COMPOUNDING

Compounding of interest using the shortest possible interval of time. Although continuous
compounding sounds impressive, in practice it results in virtually the same effective yield as
daily compounding. It means principal amount is earning interest and interest is earning
interest continuously.

where,
P = principal amount (initial investment), r = annual interest rate (as a decimal), t = number
of years, A = amount after time t, e=mathematical constant
Example-14 An amount of Rs 2,340.00 is deposited in a bank paying an annual interest rate of
8%,compounded continuously. Find the balance after 3 years
Use A= P×ert
P = 2340, r = 8/100 = 0.08, t = 3.
e stands for the Napier's number (base of the natural logarithm) which is approximately
2.7183.
A = 2340×e.⁰⁸*³
40 = 2974.72
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2.7 CAPITAL RECOVERY AND LOAN AMORTIZATION NOTES

2.7.1 CAPITAL RECOVERY
Capital Recovery is the annuity of an investment made today, for a specified period of time at
a given rate of interest.
PV= Annuity* PVAFn,r%

The term in the bracket is capital recovery factor.

With an interest rate of i = 12%, and n = 10 years, the CRF = 0.1769842 = 0.177 This means
that a loan of 1,00,000 at 12% interest will be paid back with 10 annual payments of
17,698.42
Annuity = Capital Recovery Factor x PV = 0.1769842x100000 = 17698.42

2.7.2 LOAN AMORTIZATION SCHEDULE

An amortization schedule is a complete table to periodic series of cash flows depicting the
amount of interest, principal amount and instalment pertaining to each period until the loan
is paid off. Loans are mostly repaid in instalments which can be monthly, quarterly or yearly.
Loan amount covers interest as well as principle component.
In amortized loan we would like to know
a. Periodic instalments repayment
b. Interest portion in particular repayment instalment
c. Principal portion in particular repayment instalment
d. Outstanding loan amount after some instalments
Example15: Anand has taken a Car loan of Rs 8,00,000 from Kotak Mahindra Bank for 5 years
at 12% p.a. reducing yearly. Calculate the following: Annual repayment instalment
Solution: Annual repayment instalment
Let X be the annual instalment
PV= Annuity* PVAF 12%, 5
or
1
⌊1 − ⌋
(1 + 𝑟) 𝑛
=𝐴∗
𝑟
8,00,000=A*3.6048 (Refer to table A-4)
A=8,00,000/3.6048=2,21926.32
41
UNIT 2
Time Value of Money

NOTES We can solve the same problem in Excel using pmt function:

PV 800000
Rate 12%
NPER 5
PMT ₹ -2,21,927.79 (Solve)
Frequency 1
Type 0

Example: 15 Ashish has taken a personal loan of Rs 10,00,000 from Kotak Mahindra Bank for
5 years at 12% p.a. reducing monthly. Prepare loan amortization schedule
Step 1: To calculate monthly Instalments or EMI (Equated Monthly instalments)

PV 800000
Rate 12%
NPER 5
PMT ₹ -17,795.56(solve)
Frequency 12
Type 0

Step 2
Loan Amortization Schedule

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NOTES

Note : Interest is calculated by applying rate of interest on reducing balance.

2.8 CONCEPT OF SINKING FUND

Sinking Fund is the fund which is kept aside for some specific purpose. In another words,
Sinking Fund is the fund which is kept aside to meet the future liabilities. For ex. A company
issues debenture and will have to be paid off in future and creating a fund will help company
to ease the burden of the huge cash outflow in future. The word “Sinking” is a misnomer and
sinking is used to depict that the debt is decreasing as it is getting paid off. Let’s take a look at
it with some examples:
43
UNIT 2
Time Value of Money

NOTES In the above-mentioned situations, the future value of annuity is given and we have to
calculate the annuity. Sinking fund is the value of accumulated funds saved equally over a
period of time. In order to calculate the sinking fund lets calculate the sinking fund factor
(SFF)
Sinking fund factor is the inverse of the future value interest factor of an annuity (FVIFA)

Calculate the SFF for 10 years at the rate of 7% pa.

If anyone needs Rs 1 at the end of 10 years, he would be required to save Rs 0.10 every years.
But if one have an opportunity to earn an interest of 7% on this savings then less than Rs 0.10
needs to be saved, and that is 0.0724. Thus, to get Rs 1 after 10 years one just requires to save
0.0724 every year.

CHECK YOUR PROGRESS-VI

Q.1 How much should we deposit each year at an interest of 6% so that it grows to
35,000/- at the end of 4th year?

2.9 LET US SUM UP

Compounding is a process to calculate the future value of an amount (FVIF) or an annuity
(FVIFA) from the present value invested.
Discounting is a process to calculate the present value of an amount (PVIF) or an annuity
(PVIFA) of a future value.
Cash flows can be lump sum or series of cash flows which can further be divided in to Even
cash flow or uneven cash flow.
Annuity can be categorised in to ordinary annuity, annuity due and perpetuity
The major difference between ordinary annuity and annuity due is that payments are made
in the beginning of the period in case of annuity due and at the end of the period in case of
ordinary annuity.
Perpetuity is an annuity where stream of cash flows payments is for infinite period. One of
the examples of Perpetuity is Pension in which cash inflows are forever i.e. till the life time of
an individual.
The effective interest rate is the interest rate on a loan or financial product restated from the
44 nominal interest rate as an interest rate with annual compound interest.
 FINC002
Financial Management

Nominal rate of interest refers to the rate of interest which is the stated rate before inflation NOTES
is adjusted
Sinking fund is the value of accumulated funds saved equally over a period of time, which can
be done by calculating the sinking fund factor (SFF)
Capital recovery is the value recovered equally over a period of time. This is possible with the
calculation of capital recovery factor (CRF).
Continuous compounding is the process of calculating interest on interest for infinite times
during the life of investment. This possible by calculating the continuous compounding
factor (CCF(r%,t))

2.10 KEYWORDS
Time value of money: A unit of money obtained today is worth more than a unit of money
obtained in future.
Interest: is the price paid for the use of another's money.
Present value: The amount of money you would need to deposit now to earn a desired
amount in the future.
Future value: the amount your original deposit will increase based on a certain interest rate
and a certain time.
Annuity: is a series of equal deposits.
Lump Sum: A lump sum means a single cash flow. For example, an investment that is
expected to pay 500 one year from now
Perpetuity: A perpetuity that has an infinite life. In other words, it is a “perpetual annuity.”
Uneven Cash Flow Stream: Any series of cash flows that are not same every period are
uneven cash flow stream. For example, a series such as: 100, 100, $100, 200, 300, 400 would
be considered an uneven cash flows.

2.11 REFERENCES AND SUGGESTED ADDITIONAL READINGS

Gulati. S, Singh. Y.P (2020), Financial Management, Mc Graw Hill
Pandey.M (2021), Financial Management, Pearson Publication, 12th Edition
Chandra, P (2019),Financial Management: Theory & Practice: Mc Graw Hill, 10th edition

2.12 SELF-ASSESSMENT QUESTIONS

Q.1 A loan of Rs 5,00,000 is to be repaid in 10 equal annual instalments. If the loan carries a
rate of interest of 10.25% p.a., the equated annual instalment is
a. Rs 83,128.66
b. Rs 82,842.65
c. Rs 82,248.65
d. Rs 83,228.66
e. Rs 82,987.55 45
UNIT 2
Time Value of Money

NOTES Q.2 Which of the following statements is not true?

a. The more frequent the compounding, the higher the future value, other things
beingequal.
b. For a given amount, the greater the discount rate, the lesser is the present value.
c. Converting an annuity to an annuity due decreases the present value.
d. Converting an annuity to an annuity due increases the present value.
e. All of the above.
Q.3 Sinking fund means fund kept aside to meet future liabilities
a. True
b. False
Q.4 Money has time value because
a. A rupee today value more than a rupee tomorrow.
b. The individuals prefer present consumption to future consumption
c. A rupee today can generate returns tomorrow if invested.
d. The nominal returns on investments are always more than inflation thereby
ensuring real returns to the investors
e. Both (a), (b) and (c) above.

2.13 CHECK YOUR PROGRESS-POSSIBLE ANSWERS

CHECK YOUR PROGRESS- I
Q.1 83564.91
Check Your Progress- II
Q.1 ₹ -2,10,752.54
CHECK YOUR PROGRESS- III
Q.1 ₹ -62,413.54
CHECK YOUR PROGRESS- IV
Q.1 27740
CHECK YOUR PROGRESS- V
Q.1 38475.28

2.14 ANSWERS TO SELF-ASSESSMENT QUESTIONS

Q.1 c
Q.2 c
Q.3 a
Q.4 e

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UNIT 3 NOTES

RISK AND RETURN

STRUCTURE
3.0 Objectives
3.1 Introduction
3.2 Measures of Return
3.3 Historical rate of return
3.4 Expected rate of Return
3.5 Measuring Risk
3.6 Determinants of required Rate of return
3.7 Fundamental Sources of Risk
3.8 Systematic and Unsystematic Risk
3.9 Beta as a measure of systematic Risk
3.10 Relationship between Risk and return
3.11 Let us sum up
3.12 Key words
3.13 References and Suggested Additional Readings
3.14 Self-Assessment Questions
3.15 Check Your Progress-Possible Answers
3.16 Answers to Self-assessment Questions

3.0 OBJECTIVES
On completion of this unit, you should be able to:
• Understand how to calculate the historical and expected rate of return
• Understand how to measure risk related to historical and expected rate of return
• Understand the factors that contribute to the calculation of the required rate of
return
• Understand various sources of risk
• Classify risk into systematic and unsystematic risk

47
UNIT 3
Risk and Return

NOTES 3.1 INTRODUCTION

Individuals and organizations make investments in their own companies and other
companies intending to make more money. The objective behind investing money is that the
future stream of cash inflows should be greater than the current amount invested today.
Wouldn't you like to multiply the money that you have today? We defer our consumption
with the motive that the investment will generate good returns in future.
Individuals/organisations expect a rate of return that compensates them for the investment
period; expected rate of inflation; and the uncertainty of the future cash flows. The investor
can be an individual, corporations, government, mutual funds, equity analysts, portfolio
managers, pension funds, etc. In Corporate Finance, we emphasize investment by
corporations, though the fundamentals of risk and return are the same across all types of
investors.
Corporations have various alternatives for investments, and they have to choose among
these investment options. For selection it is pertinent that they appraise the risk-return
tradeoffs for the existing options. Hence, you must know how to measure the return and risk
accurately.

3.2 MEASURES OF RETURN

While measuring return, the possibility is that you have already made an investment, and the
investment has grown; in this scenario, you would like to know what is your historical rate of
return.
Another possibility with the investment is that you want to ascertain how much you should
expect as a return from your investment that you have made now; this is called the expected
rate of return. Now the question arises whether you will invest for this expected rate of
return or not? For that, wouldn't you like to compare it with a minimum rate of return? Let's
say your expected rate of return from an asset is 8%. Is that good enough? To answer that,
you need to compare this with the minimum return you want from this asset. This minimum
return depends on the kind of asset you are investing in. Broadly, we compare it with the risk-
free rate of return that Government Securities can generate. If that return is, say, 6.25%,
wouldn't you like to generate more than that? As you do have an option of investing only in
risk-free asset. An investor would want to be compensated for the additional risk over and
above the risk free return that he/she is taking; this is called the risk premium. The rate with
which an investor compares the realized rate of return is called the required rate of return.
Let us understand this one by one.
Before we start, try to answer the question below:
Case One: A friend reached out to you with details regarding a piece of agricultural land
available for sale. The size of the land is one acre. He shared the following information:

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NOTES
Quintals of rice produced per acre 15
Kilograms of rice produced per acre (1 Quintal= 100 KGs) 1,500
Price of rice per KG (Rs) 70
Total revenue (Rs) 1,05,000
Watering, seed, fertiliser, planting and tillage cost (Rs) 40,000
Hired labour cost (Rs) 21,000
Harvesting costs (Rs) 17,000
Total costs (Rs) 78,000
Profit (Rs) per acre 27,000

At what price will you be ready to buy this one-acre land, assuming you have money and have
no other investment alternative?

Profit per acre = Rs 27,000.

If the going G Sec Rate is 6.25%. The economic value of the land will be

= 27,000/6.25%= 4,32,000.

If you are getting land for lesser than 4,32,000, it is going to be a good deal. Also, it depends
on what are expectations of the land price in future. In case you think that the price my shoot
up, you will be ready to pay slightly more

3.3 HISTORICAL RATE OF RETURN

3.3.1 HOLDING PERIOD RETURN

Example 1: Let's assume you bought 100 shares of KPR Mills ltd. as of 1st January 2020 at Rs
654 and Motilal Oswal Financial Services at a rate of Rs 590 on 1st July 2020. As of 31st
December 2020, the stock price is Rs 871 for KPR Mills Ltd. and Rs 603 for Motilal Oswal Fin
Services Ltd. (MOFS). You are evaluating these alternative investments. You want to know
how much the change in your wealth is due to these investments; it can be due to cash
inflows, i.e. dividends or interest, and also can be due to a price change.
The period for which you own investment is called its holding period, and the return for that
period is called holding period return (HPR)
You were holding the shares of KPR Mills for a year; the HPR for KPR Mills will be
HPR= Ending value of an investment/Beginning Value of an Investment
=871Rs/ 654Rs = 1.332
HPR of more than 1 indicates that you made money, less than one means you have lost
money, and equals one means there is no gain or loss, and if it is zero, it means you lost all the
money you invested in this investment.
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NOTES You also want to calculate HPR for your investment in Motilal Oswal Financial Services Ltd
(MOFS)
=603Rs/ 590Rs = 1.022
Can you compare the HPR of KPR Mills with MOFS?
No, you cannot simply compare the two HPRs you calculated above, as they are for different
periods, one is for six months, and another is for a year. It will help if you calculate annual HPR
Annual HPR= HPR 1/n
Where n is the number of years.

For MOFS, the investment was for six months; in years, it will be 0.5

Annual HPR for MOFS= 1.0221/.5 = 1.044

When converting shorter period returns into annual returns, the assumption we made is a
constant annualised yield for each year. We will make this assumption also when you are
holding your investments for multiple years (say five years) and calculating annualised
return.

3.3.2 HOLDING PERIOD YIELD

Investors mostly are interested in expressing their returns in percentage terms on an annual
basis. It quickly helps to compare investments across various alternatives. We can easily
convert annual HPR to annual percentage rate by calculating holding period yield (HPY). For
calculating HPY, we subtract 1 from HPR.
HPY= HPR-1
In the case of KPR Mills, HPY is 1.332 -1 = 33.2%
And in the case of MOFS, HPY is 1.044 -1 = 4.45%
In case of loss, HPY will be a negative value.
Annual HPY= HPR1/n-1
Example 2: Let's assume that these companies paid dividends. KPR paid Rs 3.75, and MOFS
paid Rs 5 during the holding period. Now, apart from capital appreciation, there is another
cash flow from dividends. HPY in such a case will be
= Cash payment received during the period + Price change over the period
Beginning investment value

Example 3: Warren Buffett, the great investor of our times, invested 100 $(for the sake of
simplicity at the beginning of the year 1964. At the end of 2019, his investment has grown to
27,44,062 $ (Amount taken from his letter to shareholders of Berkshire Hathaway Inc.)

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Year
NOTES
Amount ($)
1964 100
2019 27,44,062

The period of investment (n) is 55 years. We can calculate the Compounded annual growth
rate (CAGR) of his investments by using the HPY formula.

You must do these calculations on MS Excel as well.

3.3.3 AVERAGE RETURNS OF A SINGLE INVESTMENT

Investors who invest for a more extended time are also interested in finding returns every
year and keen to know their average returns. An investment might give higher returns in
specific years and lower returns or even negative returns in certain years over a period. You
should be aware of your annual returns and should be able to compare them with the
benchmark returns, say Sensex (Bombay Stock Exchange: BSE) returns of Nifty fifty (National
Stock Exchange: NSE) returns. In such a case, you should calculate summarised return by
calculating the mean of HPY over time.
To calculate the arithmetic mean (AM), you will have to calculate an average of the HPYs
AM= ΣHPY/n
Let's consider the data given below and calculate Arithmetic Mean
Example 4:

Year Beginning value Ending Value HPR HPY

1 1,000 1,200 1.200 0.200
2 1,200 1,355 1.129 0.129
3 1,355 1,300 0.959 -0.041

Arithmetic Mean (AM)= = .096192= 9.62%

We have another measure to calculate average returns, and that is the geometric mean. It
is the nth root of the products of the HPRs for n years minus one.
GM= (πHPR)1/n-1
Π= the product of the annual holding period returns
= (HPR1) X (HPR2) ………(HPRn)
GM= [(1.2) X (1.129) X (0.959)]1/3 -1
= (1.3) 1/3 -1
=1.091393-1=9.14%
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NOTES GM is thought to be a better measure of long term performance than AM as it reveals the
compound annual rate of return based on both the ending value and beginning value of the
investment.

3.3.4 RETURNS OF A PORTFOLIO

A porfolio comprises of two or more individual assets. For calculating porfolio returns, each
investment's returns will be calculated separately, and then the weighted average of each
return will be calculated to arrive at porfolio returns.
Return of Portfolio (Rp) = Σ Wi Ri
Let's work on the data to understand this better
Example 5:
Closing
Begining Closing

Holding Period return (HPR) = 1,18,00,000/85,00,000 = 1.388

Holding Period Yield (HPY)= 1.388-1= 38.8%
CHECK YOUR PROGRESS-I
Q.1 A stock earns the following returns over a five-year period: R1 = 0.30, R2 = -0.20, R3 = -
0.12, R4 = 0.38, R5 = 0.42, R6 = 0.36. Calculate the following: (a) arithmetic mean
return, and (b) geometric mean return.

3.4 EXPECTED RATE OF RETURN

So far, we discussed the realised historical rate of return. We were talking about history,
which is not so difficult. Now, we will talk about the future. When talking about the future, it
is difficult to say things with complete certainty, as the future involves risk. While evaluating
future returns, it is essential to keep an eye on risk. Will an investor earn its expected rate of
return? Not necessary. There is uncertainty involved, you might get more or less than the
expected return; and this is what the risk is. Not getting what was expected.
The investor might be expecting a 9% rate of return on a particular investment option. By
probing further, s/he may admit that the return might vary under different circumstances.
Under an optimistic scenario, the return can be 17%, and under a pessimistic scenario, it can
be 7%. Under such circumstances, an investor expects different returns (probable returns)
and therefore is uncertain in suggesting a one-point estimate of returns. S/he might offer an
extensive range of possible returns; this indicates that the investment is riskier. With what
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certainty can an investor talk about the return depends on the investment avenue. NOTES
The expected return can be calculated by ascertaining three things: situations, probability of
those situations, and possible return under each condition. The probability value ranges
from 0 to 1. To arrive at the value of probability, an investor has to look at the investment
alternative's historical performance and apply her/his judgment, analysis, and expectations
about the investment option in the future.
The expected rate of return is calculated as under

An investor might be entirely sure about earning a specific return rate; in such a situation, the
probability is equal to 1, and there is only one possible situation. These investments are
primarily Risk-free investments. The Government securities in India are Risk-free
investments
Example 6: The expected return in the case of Government Securities in India can be
calculated as follows
[E(Ri)] = (1) (.065) = 6.5%
It is also possible that an investor believes that investment could provide several different
rates of return depending on various possible economic conditions.
Example 7: For example, in a strong political and economic environment, an investor might
expect a 22% rate of return; in an economically weak scenario, s/he might expect the stock
price to go down by 25%; and with no significant changes, he expects the rate of return to be
12%. Based on his experience, judgement and analysis of the future, he estimates the
probability of each situation

Economic condition Probability Rate of return Expected rate of return

Pi Ri (Pi) * (Ri)
Optimistic 0.2 0.22 0.044
Pessimistic 0.2 -0.22 -0.044
No Change 0.6 0.12 0.072
Σ (Pi) (Ri)=0.072

The expected rate of return is 7.2% in the above case.

In the situation considered above, there were three possibilities, and an investor may face
several options with different outcomes depending upon each case's uncertainty.
An investor chooses between a risky asset and a risk-free asset based on his or her risk
appetite. Assuming that an investor is risk-averse if everything else is the same, they will
select that investment which is less risky; and at a given level of risk, they will choose that
investment that offers a higher return. 53
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NOTES CHECK YOUR PROGRESS-II

Q.1 Calculate the expected rate of return for a stock; probability distribution and the rate
of returns are mentioned below:

Government Policies Probability Rate of Return

Favourable 0.4 28%
No change 0.25 12%
Unfavourable 0.35 8%

3.5 MEASURING RISK

3.5.1 MEASURING RISK OF EXPECTED RATE OF RETURN

In the previous section, we calculated the expected rate of return by evaluating the possible
returns under different conditions and assigning probability to each possible return. As you
must have noticed, there is dispersion in potential returns. In the situation considered in the
previous section, the possible returns were 22%, 12%, and -22%; and the expected return
was 7.2%. Notice the extent to which these three potential returns are likely to vary about an
expected value. See how dispersed or spread these values are as compared to the expected
value (Mean). Dispersion will help us understand the distribution of the data.
We will use statistical techniques to quantify this dispersion. These techniques will allow us
to compare the return and risk measures for various investment alternatives. The two most
widely used techniques are the variance and the standard deviation of the estimated
distribution of expected returns. Standard deviation is the square root of variance; it
measures the dispersion of a data set relative to its mean. Higher deviation occurs when the
data points are farther from the mean. Farther the data points more will be the spread,
resulting in the higher variance and higher standard deviation.

The larger the value of variance or standard deviation, the greater is the dispersion and the
more significant the uncertainty and risk associated with that investment.
Let's work on the data given in exercise 6 and 7 to calculate variance and standard deviation

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Example 8: NOTES

Example 9:

This investment has 7.2% return at risk of 15.1%. Higher the value of standard deviation,
higher is the risk. It denotes the volatility in the stock price movement.
Coefficient of Variation
Comparing the risk of two or more investment alternatives can be misleading as the
alternatives' conditions might be very different. In such a case, a relative measure of risk
must be used; the coefficient of variation comes in handy. It is a widely used relative measure
of risk and is calculated as follows:
Coefficient of variation (CV)= Standard deviation of returns/Expected rate of return
= σ/E(R)
CV for the investment in exercise 9 will be =15.1/7.2= 2.09
Let’s understand this with another example
Example 10: From your analysis you have arrived at following probability distribution and
rate of returns:

Perception about economy Probability Rate of Return

Negative .15 -5%
As it is .60 5%
Positive .25 15%

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NOTES i. What will be expected rate of return?

ii. Compute the standard deviation of the rate of return for the one-year period.
iii. Compute the coefficient of variation for your portfolio.
Ans.
I) E(Ri) = (0.15) (-5) + (0.60) (5) + (0.25) (15) = 6%
ii) Standard deviation= [(0.15) (-5- 6)2 + (0.60) (5- 6)2 + (0.25) (15 - 6)2]1/2 = 6.25%
iii) CV = SD/ E(Ri)
= 6.25/6 = 1.04

3.5.2 MEASURING RISK FOR HISTORICAL RETURNS

The measures of risk are the same as discussed in the previous section, that is, variance and
standard deviation, except that we consider the historical holding period yields in place of
expected returns and divide it with the number of observations (n)

Important point that you need to consider while calculating variance and standard deviation
for historical returns is whether you should use n or n-1 as divisor.
Which divisor to use depend on how you have calculated the mean. In case you have
calculated the mean by considering the whole population of the data, then you use divisor as
n. In case you have estimated the mean by taking sample of the data then use divisor as n-1.
Exercise 11:The annual yields of Stock P for the last four years are 0.10, 0.15, -0.05, and 0.20,
respectively.
The arithmetic mean annual of HPY for Stock P will be
AM = (0.10 + 0.15 - 0.05 + 0.20)/4 = 0.10
The standard deviation for Stock Z.

CHECK YOUR PROGRESS-III

Q.1 Calculate standard deviation with the information given below about a stock

Government Policies Probability Rate of Return

Favourable 0.4 28%
No change 0.25 12%
Unfavourable 0.35 8%

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3.6 DETERMINANTS OF REQUIRED RATE OF RETURN NOTES

Will you be expecting the same minimum return from government bonds and equity shares?
No! Any person aware of the risk associated with these investment options will expect differ-
ent minimum returns because they both have different amounts of risk associated with it.
Also, your return expectation will depend on your holding period, as it will impact the time
value of money. Wouldn't you like to be compensated for the change in value of money (time
value of money)? And, isn't it logical that you would want a return higher than the inflation
rate. The required rate of return (hurdle rate) is the minimum return an investor will accept
for owning an investment alternative as compensation for a given level of risk associated
with holding that investment alternative. Riskier projects will usually have higher RRRs than
those that are less risky.
There are three components of RRR:
• The time value of money during the period of investment
• The expected rate of inflation during the period
• The risk involved.

3.6.1 THE REAL RISK-FREE RATE (RRFR)

It is the basic interest rate, assuming no inflation and no uncertainty about future flows. An
investor in an inflation-free economy who knew with certainty what cash flow they would
receive at what time would demand the RRFR on an investment. This RRFR of interest is the
price charged for the risk-free exchange between current goods and future goods. We call
this the pure time value of money, as the only sacrifice was deferring the use of funds for
some time. RRFR is influenced by the set of investment opportunities available in the
economy, which is determined by the economy's long-run real growth rate. An emerging and
growing economy like India will have more and better opportunities to invest funds and
experience a positive rate of return. A positive relationship exists between the real growth
rate in the economy and the RRFR.

3.6.2 NOMINAL RISK-FREE RATE (NRFR)

The difference between the nominal risk-free rate and the real risk-free rate is that the
nominal risk-free rate considers inflation. As compared with RRFR, NRFR is a practical
concept. Economies will typically have some amount of inflation.
NRFR=[(1+RRFR) x (1+ Rate of Inflation)] - 1
RRFR=[(1+NRFR) / (1+ Rate of Inflation)] - 1
The return on 10 years' government securities is the best proxy for NRFR. In FY 2020-21 it
varied between 6.1% to 6.5% in India.

CHECK YOUR PROGRESS-IV

Q.1 The rate of exchange between certain future dollars and certain current dollars is
known as the pure rate of interest. True/False

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NOTES 3.6.3 RISK PREMIUM

In the previous section, we discussed NRFR, which is that return which an investor is almost
certain about. And therefore, it applies only to risk-free investments. Many investment
alternatives involve risk. Therefore, we must consider risk premium for determining RRR. For
example, the risk premium associated with an established company with a good track record
will be lower than a start-up. The risk premium is the composite amount of all kind of
uncertainty. For understanding this, it is essential to understand the significant Sources of
Risk

3.7 FUNDAMENTAL SOURCES OF RISK

3.7.1 BUSINESS RISK is the risk associated with the income flows of the business. The
business may face ups and downs in sales and its profitability. It depends on the nature of a
firm's business. The certainty of income flows to an investor is dependent on the income
flows to the company. The investor will demand the risk premium based on the sales and
profit volatility of the business. For example, an FMCG company will essentially experience
stable sales and income versus a hotel chain, where sales and earnings fluctuate
substantially over the business cycle implying high business risk.

3.7.2 Financial Risk is the risk caused by the sources of finance used in the business. There
are two primary finance sources: own money (capital) and borrowed money (debt). By
borrowing money, the company's financial risk goes up, as now they are liable to return the
money and make interest payments. These interest payments are expenses for the company
and are deducted out of revenues, resulting in less funds available to the shareholders.
Investors, therefore, accord high-risk premium to companies with high debt.

3.7.3 : LIQUIDITY RISK is the risk that is caused due to the time it takes to convert an asset into
cash without giving up capital and income; this is due to a lack of enough buyers in the
market. You may have a good piece of land, but what if you cannot sell it as there are not
enough buyers in the market. If you need funds, you will have to bring down the price of that
land. The more challenging this cash-conversion, the more is the liquidity risk. An investor
must ask the following questions when assessing the liquidity risk: how much time will it take
to convert the investment into cash? How certain is the price to be received? Government
Securities have almost zero liquidity risk as they can be bought or sold quickly at a price
practically identical to the quoted price.
3.7.4 : INTEREST RATE RISK is the risk caused by a change in overall interest rates, which
impacts the value of a bond or other fixed-rate investments. As the interest rate goes up, the
market price of existing bonds/fixed-rate securities decreases and vice versa. Investors will
be interested in buying new securities with a higher interest rate and will be interested in
purchasing the current securities below par value. In India, the Reserve Bank of India (RBI)
sets the repo rate. It is the rate at which RBI lends to commercial banks. It becomes the
benchmark rate. Interest rate changes also impact equity investments. A higher interest rate
brings down the company's profitability, as interest is one of the components of cost. Also,
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higher rates bring down participation in the stock market as investors are more inclined NOTES
towards diverting their funds to fixed income securities.

3.7.5 : EXCHANGE RATE RISK is a risk to an investor whose portfolio comprises investment in
foreign currency. Foreign Portfolio Investors (FPIs) face this risk due to changes in the foreign
exchange market. UK investor who buys Indian stocks denominated in rupees has to consider
the difference in the exchange value of the Pound Sterling to rupees, in addition to risks
mentioned above.

3.7.6 : COUNTRY RISK is the risk associated with investing in a particular country, and more
specifically, the degree to which that uncertainty could lead to losses for investors. The major
causes of this risk are the changes in the political or economic environment of a country. The
United States is believed to have the lowest country risk because it has a stable economic and
political system. The prevailing example (in the year 2021)of a country with higher country
risk is Myanmar, currently facing a military coup. The military is back in charge and has
declared a year-long state of emergency.
Exchange rate risk and country risk should be considered when an investor is investing
globally, and these would differ among countries.
The risk determinants discussed above constitute security's fundamental risk as it deals with
the intrinsic factors that should affect security's standard deviation over a period. Therefore,
a Risk premium is a function of all these risks.
Risk Premium= f (Business Risk, Financial Risk, Liquidity Risk, Interest Rate Risk,
Exchange Rate Risk, Country Risk)

CHECK YOUR PROGRESS-V

Q.1 Which of the following is not a measure of risk
a) standard deviation
b) variance
c) Expected return
d) Coefficient of variation
Q.2 How to arrive at expected returns
a) By calculating mean
b) By calculating square root of the expected returns.
c) By arriving at sum of probability multiplied by rate of return for different states of
economy

3.8 SYSTEMATIC AND UNSYSTEMATIC RISK

The Modern Portfolio Theory (MPT) and the Capital Market Theory (CAPM) developed by
Markowitz (1952, 1959) and Sharpe (1964) looks at risk from a different perspective. This
work specified that investor should use an external market measure of risk. These theories
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NOTES assume that the rational and profit-maximising investors would like to hold a diversified
portfolio of investments which results in bringing down the risk. The total risk comprises of
Unique Risk and market risk.
Total risk = Unique risk + Market risk
Total risk = Diversifiable risk + Undiversifiable risk
Total risk = Unsystematic risk + Systematic risk
The unique risk represents firm-specific factors such as variability in inventories prices,
unavailability of skilled labour of a particular kind, governance issues with the company,
competitors, product development, etc. These events affects the specific firm and not all
firms in general. An investor can bring down this by adding stocks/shares of different
industries and firms, as certain firms' favourable factors can offset another firm's adverse
factors. Also, these factors and their impact keep changing because of the change in the
business environment. This risk is also called diversifiable Risk and unsystematic Risk.
The market risk or systematic risk is inherent to the market as a whole. It is attributable to
economy-wide factors like GDP growth rate, changes in government taxation policies,
interest rates, inflation rate, etc. These factors affect all the firms to a certain extent, and
therefore this risk cannot be diversified away by adding different stocks.

3.9 BETA AS A MEASURE OF SYSTEMATIC RISK

The finance theories have defined the relevant risk measure for an individual investment as
its co-movement with the market. This co-movement is measured by assets covariance with
the market portfolio; it is an asset’s systematic risk. The portion of an individual assets total
variance is attributable to the variability of the entire market portfolio.
The formula for calculating the Beta is the covariance of the return of an asset with the
market's return, divided by the variance of the return of the market over a certain period. It
measures the sensitivity of returns of stock to movement in the market.
Beta (B) = Covariance (Return Stock, Return Market)/ Variance (market)
It is a measure of a stock's volatility concerning the overall market. The beta of market is
standardized at 1. If a stock moves less than the market, the stock's Beta is less than 1.0 and
vice-versa. High-beta stocks are supposed to be riskier but provide higher return potential;
low-beta stocks pose less risk and lower returns.

3.10 RELATIONSHIP BETWEEN RISK AND RETURN

You must have heard the adage; higher the risk, higher the return. By now, you also must
have understood that the minimum return an investor expects is the risk-free rate of return
(RFR). RFR is the same as NRFR. In case the NRFR changes because of the market conditions,
the investor will require higher return from the same investment. Beyond RFR, investors'
expectations about the return depend on the amount of risk they are ready to take. Riskier
the investment higher will be the expectations for risk premium, which happens because of
the difference in the inherent risk..Another factor which affects the risk premium required by
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an investor from a risky investment is the investor's risk aptitude. A conservative investor NOTES
may demand more return for the same amount of risk in comparison to an investor with high
risk aptitude.

3.11 LET US SUM UP

This unit provides you knowledge that will be used for subsequent units and valuable for
your day to day investment life.
We understood the concept and calculation of return and risk. Also, you must have
understood how to classify returns and risk based on the time of investment. We examined
ways to quantify returns and risk. While quantifying, we looked at returns from three
perspectives, historical rate of return, expected rate of return and required rate of return,
depending on the period. The return calculated based on past data is called historical return.
The return calculated based on forecasted data is called expected return. The minimum
return required from an investment given its riskiness is called required rate of return.
For historical returns, we calculated Historical period returns (HPR) and Historical Period
Yields (HPY). The period for which you own investment is called its holding period, and the
return for that period is called holding period return (HPR). HPR is in times, and HPY is in
percentage terms. As an investor, you must consider dividend payments received apart from
the capital appreciation in stock values. We also considered two measures of returns:
arithmetic mean, and the geometric mean for an individual asset and the weighted mean for
a portfolio of investments during a period.
We applied the concept of probability for calculating expected return and understood how
risks impact the expected rate of return.
For measuring risk, we used the concept of variance and standard deviation. The variance is a
measure of how spread out a distribution is. It is computed as the average squared deviation
of each number from its mean. To calculate standard deviation, we take square root of
variance. To quantify the risk of historical returns, we can calculate risk with full knowledge
and therefore did not apply the concept of probability. For calculating a relative measure of
risk, the coefficient of variation is used.
Arriving at the required rate of return required understanding of many factors. There are two
parts to it, one is the Nominal risk free rate of return and other is the risk premium. The
Nominal risk-free rate (NRFR), considers Real risk-free rate of return and the inflation rate. To
this, you need to add the risk premium, for which you need to know the Fundamental
Sources of Risk, that is, Business risk, Financial Risk, Liquidity Risk, Interest rate risk, Exchange
rate risk, and Political Risk.
As per Markowitz Portfolio theory, risk can be classified as Systematic and Unsystematic Risk.
Systematic risk cannot be diversified as it is attributable to market forces that are essentially
common to all investments. The unique risk (unsystematic risk) can be diversified by adding
stocks of different industries.
Beta is a measure of systematic risk; it is quantified as the covariance of the return of an asset
with the market's return, divided by the variance of the return of the market over a certain
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NOTES period. It measures the sensitivity of returns of stock to movement in the market.

3.12 KEY WORDS

Holding period return: The period for which you own investment is called its holding period,
and the return for that period is called holding period return (HPR)
Holding period yield: When the Holding period return is expressed in percentage terms, it is
referred as Holding period yield (HPY)
Arithmetic mean: Average of returns is arithmetic mean of returns.
Geometric mean: It is another measure to calculate average returns, and that is the
geometric mean. It is the nth root of the products of the HPRs for n years minus one.
Variance: It is a measure of risk.
Standard Deviation: It is measure of risk, Standard deviation will be the square root of the
variance
Coefficient of Variation: It is a measure of relative risk, calculated by dividing standard
deviation with mean

3.13 REFERENCES AND SUGGESTED ADDITIONAL READINGS

Chandra, P. (n.d.). Financial Management. Theory and Practice. Second Reprint 2011. Tata
McGraw-Hill Publishing Limited. New Delhi. McGraw-Hill Offices. Indian ….
Corporate Finance-Theory and Practice Aswath Damodaran—Google Scholar. (n.d.).
Retrieved April 7, 2021, from
https://scholar.google.com/scholar?hl=en&as_sdt=0%2C5&q=Corporate+Finance-
Theory+and+Practice+Aswath+Damodaran&btnG=
Mikhan, P., & Jain, K. (2007). Financial Management, Text, Problems and Cases. Tata. Mc
Graw-Hill Publishing Company Limited.
Richard, P., & Bill, N. (2006). Corporate Finance and Investment-Decisions & Strategies.
Pearson Education Limited.
Ross, S. A., Westerfield, R., & Jordan, B. D. (2008). Fundamentals of Corporate Fi-nance. Tata
McGraw-Hill Education.
Van Horne, J. C., &Wachowicz, J. M. (2005). Fundamentals of Financial: Manage-ment
Prinsip-PrinsipManajemenKeuangan. Penerjemah: DewiFitriasari Dan Deny Arnos Kwary.
PenerbitSalembaEmpat: Jakarta.
3.14 SELF-ASSESSMENT QUESTIONS
Exhibit 1. The probability distribution of the rate of return on a stock is given below:

State of the Economy Probability of Occurrence Rate of Return

Boom 0.60 45
Normal 0.20 16
Recession 0.20 -20

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Refer to exhibit 1 and answer the following two questions NOTES

Q.1 What is the expected return?
a) 26.2%
b) 25%
c) 27%
d) 22%
Q.2 What is the standard deviation of return?
a) 26.2%
b) 25.69%
c) 27.25%
d) 24%
Exhibit 2. A stock earns the following returns over a five-year period: R1 = 10 %, R2 = 16%, R3 =
24 %, R4 = - 2 %, R5 = 12 %, R6 = 15%.
Refer to exhibit 2 and answer the following three questions
Q.3 What is the arithmetic mean return?
a) 12.5%
b) 15%
c) 17%
d) 12%
Q.4 What is the geometric mean return?
a) 16.2%
b) 12.22%
c) 17.23%
d) 12.75%
Q.5 What is the Standard deviation?
a) 6.2%
b) 9.5%
c) 8.57%
d) 10%

3.15 CHECK YOUR PROGRESS – POSSIBLE ANSWERS

CHECK YOUR PROGRESS – I
Solution 1:
R1 = 0.30, R2 = - 0.20, R3 = - 0.12, R4 = 0.38, R5 = 0.42, R6 = 0.36
(a) Arithmetic mean = 19%
(b) Geometric Mean

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Risk and Return

NOTES = [(1.30) (0.80) (0.88) (1.38) (1.42) (1.36)]¹/⁶ – 1 = 0.1602 or 16.02 %

CHECK YOUR PROGRESS-II AND III

Solution 1:

CHECK YOUR PROGRESS – IV

Q.1 True
CHECK YOUR PROGRESS – V
Q.1 c
Q.2. c

3.16 ANSWERS TO SELF-ASSESSMENT QUESTIONS

Q.1 (a) 26.2%,
Q.2 (b) 25.69%,
Q.3 (a) 12.5%,
Q.4 (b) 12.22%
Q.5 (c) 8.57%

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UNIT 4 NOTES

VALUATION OF SECURITIES

STRUCTURE
4.0 Objectives
4.1 Introduction
4.2 Fundamentals of Valuation
4.3 Valuation of Bonds/Debentures
4.4 Valuation of Preference Shares
4.5 Equity Valuation
4.6 Other approaches to equity valuation
4.7 Let Us Sum Up
4.8 Key Words
4.9 References And Suggested Additional Readings
4.10 Self-Assessment Questions
4.11 Check Your Progress-Possible Answers
4.12 Answers to Self-Assessment Questions

4.0 OBJECTIVES
On completion of this unit, you should be able to:
• Understand the concept of Valuation
• Understand and apply the basic valuation model to Bonds
• Understand and apply the basic valuation model to preference shares
• Understand the share valuation under zero growth, constant growth and variable
growth models

4.1 INTRODUCTION
Many people around us wake up every day looking into their mobiles regarding the
movement in stock indices worldwide. They derive a lot of pleasure and excitement out of
the stock markets. And when the signals are not in their favour, they get upset and unhappy.
The financial markets affect our portfolios and the Valuation of the financial assets, which

65
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NOTES influences our personal wealth and professional lives. The participation by individual
investors in financial markets is getting bigger, and it is expected to rise further. This is
authenticated by the increased number of Demat accounts being opened by retail investors.
The number has gone up remarkably during 2020-21. As of January 2021, India’s total Demat
accounts stood at 51.5 million, compared to 40.8 million at the end of FY 20 and 35.9 million
in FY 19.
Despite this increasing number of retail investors interest in the stock markets, a fewer
number of individual investors understand how different variables in the financial markets
impact the movements and valuation of financial assets.
Adani enterprises stock's value was around 40 Rs in 2016, and in 2021 its market value is
1200 Rs. The ITC stock which was around 233 Rs in 2016 on the contrary did not move much
and by the middle of the year2021 is 214 Rs. It clearly shows that Adani Enterprises could
accomplish the objective of value maximisation which ITC could not. Question arises
• Why do these companies trade at these prices? and
• How do these priceschange?
• Does this price reflect the true value? How we arrive at value of these tradable
securities.
You should know that though these prices are governed by the forces of demand and supply
in the securities market but the true valuation of a security is primary factor, which will have a
impact on its market price. In this unit, the emphasis is on a straightforward framework that
investors can use to value bonds, preference shares and equity shares. In general, the value
of an asset is the present value of its future benefits.
Value of an asset= Present value of all future benefits accruing to its owner
These are called discounted cash flow models. The benefits of an asset will accrue in the
future. We know that the value of money is not the same across years; therefore, by applying
the concept of time value of money, we are determining the value of future cash flows.
Another critical question to raise is
Why does the financial manager need to understand how to price bonds, preference shares
and equity shares?
1. Managers are guided by the objective of financial management, i.e., Value
maximisation. They must know, how through their decisions and actions, they can
maximise the stock price. And this is possible if they understand what impacts the
stock valuation which in turn affects the stock price movements.
2. Companies reach out to markets to raise capital. Financial managers must understand
how these securities are valued so that the financing of projects can be carried out
effectively.
3. Companies also acquire and divest companies. In both these cases, managers must be
aware of the Valuation so that the acquisition/divestiture takes place at the right price.
4. The stock price is also an independent performance indicator of the company's top
66 management and is closely watched by the board. Manager's compensation is linked
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to stock price, and therefore they do take a keen interest in the determinants of stock NOTES
price
It would be best if you were thorough with all the three previous units to understand
Valuation. In the first unit, we discussed the objective of financial management. The
Value maximisation objective will guide us throughout this course. Second unit- time
value of money will help you ascertain the Present Value (PV) of Future benefits. The
risk and return Framework was discussed in unit 3; it provides you with an
understanding of risk in term of required return.

4.2 FUNDAMENTALS OF VALUATION

Companies acquire assets to receive benefits from them in the future; and the ownership
confers them with that right. The benefits can be through increasing production capacity or
bringing down the per-unit cost of production in physical assets. Benefits from an asset can
be monetary and guaranteed for example, in case of bonds, a fixed amount of interest is
received by the bondholder. In either case, the value of an asset is the present value of its
future benefits. As discussed in unit 1, the principle of Financial management is that the
Present Value of future benefits must be more than the price that we pay for acquiring the
asset. It is also aligned with the Value Maximisation objective.
In Finance theory, our focus is more on the tangible benefits; typically the cash flows
generated in the future.
The value of the bond equals the PV of future interest and principal payments to be paid by
the bond issuer to the bondholder.
The value of the common stock (equity shares) equals the PV of expected dividends made by
a company to its shareholders.
The value of the preferred stock (preference shares) equals the PV of dividends and
redemption amount made by a company to its preference shareholders.
The value of an apartment equals the PV of net rent payments (net of the Cost of operating
and maintaining the apartment)
It indicates that for the asset pricing, knowledge of future benefits and the appropriate
discount rate (that converts future benefits into present value) is needed. Valuing Bonds is
simpler than valuing equity, as investors know with a higher level of certainty about future
interest payments. Estimating future benefits in the equity shares is quite challenging, as
dividend is function of profit, growth rate and retention ratio; these depend on many
external and internal factors. Generally, higher discount rates are used in case of greater
uncertainty about future benefits. The valuation process also links asset's risk and return to
determine its value. If we assume future benefits to be constant, an inverse relationship
exists between risk and value.
Fundamental Valuation Model

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NOTES In this equation:

P0 = Asset’s present price (at time 0)
CFt= Expected cash flow at time t
r= required rate of return-the discount rate that reflects the risk of the asset
n= Asset's life, period over which it distributes cash flows to investors, usually measured in
years
The cash flows may be guaranteed and uniform in bonds and can be varied in equity. Also, n
may be a finite number in bonds that matures in certain years or maybe infinite in the case of
common stock with an indefinite life span. This equation holds good for almost any type of
asset.
Example 1:
Let us compute the Value of asset A and asset B, assuming a discount rate of 10 per cent, and
the expected cash flows detailed below:
Year Expected Cash flows
Asset A Asset B
1 20,000 10,000
2 20,000 18,000
3 20,000 12,000
4 20,000 25,000
5 20,000 28,000

Solution 1:
Value of the asset A = Rs 20,000 * PVIFA (10,5) = Rs 20,000 * 3.791 = Rs 75,815.74

Value of the asset B = (Rs 10,000 * PVIF (10,1) + (Rs 18,000 * PVIF (10,2) +

(Rs12,000 * PVIF (10,3) + (Rs 25,000 * PVIF (10,4) + (Rs28,000 * PVIF (10,5)

= (Rs 10,000 * 0.909) + (Rs 18,000 * 0.826) + (Rs 12,000 * 0.751) +

(Rs25,000 * 0.683) + (Rs28,000*0.621)

= 9,090.91 + 14,876.03 + 9,015.78 + 17,075.34 + 17,385.80

= Rs 67,443.85

CHECK YOUR PROGRESS-I

Q.1 Compute the Value of Asset X and asset Y, assuming a discount rate of 12 per cent, and
the expected cash flows detailed below:
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Year Expected Cash flows NOTES

Asset X Asset Y
1 30,000 18,000
2 30,000 27,000
3 30,000 32,000
4 30,000 42,000
5 30,000 45,000

4.3 VALUATION OF BONDS/DEBENTURES

4.3.1 BOND VOCABULARY

Both government and corporations frequently borrow money by issuing or selling debt
instruments from a diverse group of lenders; these instruments are called
Bonds/Debentures. Bonds come in many varieties. However, they have certain common
characteristics.
For example: Jipal Corporation wants to raise Rs 1,000 for 10 years at the rate of 8%. For 10
years Jipal will pay 6% on 1,000 (.06*Rs 1,000=60). At the end of 10 years, Jipal will repay Rs
1,000. The fixed amount of interest paid every year, Rs 60 in this example, is called bond's
coupons. The borrower usually made this payment every six months, i.e., semi-annually.
Bonds typically have a limited life, which is mentioned when the bonds are issued; this life is
called maturity. In this example, the maturity is 10 years. With every passing year, the
number of years to maturity decreases. The nominal value of bond in the books is the bond's
face value or par value. The coupon is calculated in the face value of bond. The amount paid
by the issuer to the bondholder when the bond is surrendered is its maturity value or
redemption value. Except for certain cases, most bonds are redeemable at par (i.e.
redeemed at their face value). The rate of interest that is paid every year is called the coupon
rate. It is a specified interest rate. It equals annual coupon payment divided by its par value
(80/1000 = 8%).
Cash Flows of Jipal Corporation Bond

4.3.2 BASIC BOND VALUATION EQUATION

As can be seen from the Jipal Bond's cash flows, there are two major components. One,
the annual interest cash flows. And, Second, the par value received at the end of maturity.
The Price of the bond is equal to PV of interest cash flows and PV of par value.

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Valuation of Securities

NOTES

r is the required rate of return-the discount rate that reflects the risk of the asset is also
called Cost of debt, i.e., kd. In place of r you may use the term kd.
Example 2: Let us calculate the Price of Jipal's bond by using the basic bond equation.
Solution 2:
Price of the bond

= (Rs 60 * PVIFA (6,10) + (Rs 1,000 * PVIF (6,10)

= (Rs 60 * 7.36) + (Rs 1,000 * 0.558)

= 441.6 + 558.4 = Rs 1000

The bond value is equal to the par value.

As a rule, when the required rate of return is equal to the coupon rate, the bond value equals
the par value. Though, the market value of the bond is not normally equal to its par value.

4.3.3 BOND YIELDS AND VALUES

The interest rate in the market will change over time, resulting in a change in the value of the
bonds. The cash flows stay the same. What can happen with the interest rate?
There are three possibilities
Interest rate > Coupon rate
Interest rate < Coupon rate
Interest rate = Coupon rate
When the interest rate is lower than the coupon rate, the present value of cash flows
(interest receipts) is higher, and thus the bond's value is more. On the contrary, when the
interest rate is higher than the coupon rate, the present value of cash flows (interest receipts)
is lower, and the bond is of less value. The value is the same if there is no change in the
interest rate, which rarely happens. The difference between the market interest rate
(required return) and coupon rate can be due to a change in the Cost of funds in the market
and a change in the firm's risk.
For Valuation, it is essential to know the time remaining until maturity, its face value, coupon
rate and the market interest rate of similar bonds. The required interest rate in the market in
common parlance, is referred to as yield.
Example 3:
Let us understand the impact on the value of the bond due to change in interest rate. We will
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again use Jipal Corporation used in exercise 2. Remember that the bond value was equal to NOTES
its face value in that exercise because the coupon rate and interest rate in the market were
the same.
Now let us assume that the interest rate in the market has gone up to 7%, and now it has eight
years to maturity. Now the equation will be
Solution 3:
Price of the bond
=(Rs 60 * PVIFA (7,8) + (Rs 1,000 * PVIF (7,8)
= (Rs 60 * 5.971) + (Rs 1,000 * 0.582)
= 358.26 + 582 = Rs 940
This bond should sell at Rs 940. We say that this bond, with its 6% coupon, is priced to yield
7% at Rs 940. Note that the market interest rate/ required return or yield (7%) is more than
the coupon rate (6%), the bond value (Rs 940 in this case) would be less than the par value
(Rs 1000), that is, the bond will sell at discount equal to Face value – Current Price of the
bond. Why are Jipals bonds selling at discount? These bonds are giving less than the current
rate in the market; therefore, investors are willing to buy it at less than promised repayment
of Rs 1000. The only way to get 7% is to lower its price to less than Rs 1000. Depending on the
interest rate changes, bonds will be sold at a discount or at a premium.
A Bond’s YTM is the yield to investor if the bond is held till maturity. YTM will be based on its
coupon, prevailing price and it can be different from market interest rate. The impact of
change in bond’s YTM on prices can be accessed in the same manner as of market interest
rates.
Method of calculating YTM by the approximation formula is given below.

Example 4:
Let’s apply this formula. The par value (face value) of the bond is Rs 1,000, and the Current
market price is Rs 920. The coupon rate is 10% and 10 years is Time to maturity.
Solution 4:

YTM by using approximation formula is:

YTM = Rs 100 + [(Rs 1,000-Rs 920)/10] / (Rs 1,000+Rs 920)/2

=11.25%

YTM is 11.25%. 71
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Valuation of Securities

NOTES CHECK YOUR PROGRESS-II

Q.1 For Jipal Corporation, assume that the interest rate in the market has gone down to 4%
after one year of bond issuance. Calculate the Price of the bond. Is it selling on
premium or discount? By how much?

4.3.4 SEMI-ANNUAL COUPONS

In India, the coupon payments are made twice a year, i.e., if the coupon rate is 10%, the
bondholder will receive Rs 50 each on a Rs 1000 bond, twice a year, totalling Rs 100 in the
year. Will the effective rate be different from the coupon rate as you are receiving money
twice a year? The frequency of payments is twice, i.e., for a 10 years' bond, the coupon is
received 20 times. Wouldn't that impact the time value of money? Let's see how it will
impact the equation and calculations.
Price of the bond= (I/2) * (PVIFAr/2,2n) + M *(PVIFr/2,2n)
Example 5: The face value of Jipal corporation 10 years, 8% bonds is Rs 1000, and they pay
interest semi-annually. The required rate of return of similar bonds is 12%. Compute the
value of the bond?
Solution 5:
Bondholders will receive coupons of Rs 80/2= Rs 40, 20 times in 10 years. The required
return is annually, and the interest payment received is semi-annually, so the required rate
will be 12%/2 = 6%. Let us put this in our equation.

Price of the bond = (I/2) * (PVIFAr/2,n) + M *(PVIFr/2,n)

= Rs 40 * (PVIFA6,20) + 1000 * (PVIF6,20)

= Rs 40 * 11.47+ 1000 * 0.312

=Rs 458.8 + Rs 311.8 = Rs 770.60

4.4 VALUATION OF PREFERENCE SHARES

Preference shares are also referred to as preferred stock. As can be understood from the
name, these shares have preference over equity shares (Common stock). Preference
shareholders are given dividends before the equity shareholders. Also, in case of liquidation,
they are paid from the liquidated money before the equity shareholders. These shareholders
usually do not have voting rights, unlike equity shareholders. Preference shares may be
issued with or without a maturity period. However, in India, only Redeemable Preference
Shares are allowed to be issued by a firm with a maximum maturity of 20 years.
They are similar to debt, as usually, there is a fixed rate of return as cash inflows for investors.
So the equation is the same as that of bond valuation.

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In case of no stated maturity, they are similar to perpetual bonds. And the equation will be NOTES
the one followed for perpetuity.

CHECK YOUR PROGRESS-III

Q.1 Valuation of preference shares is similar to bond valuation
a) Yes
b) No
Q.2 A company has issued Rs 100 preference shares on which it pays Rs 8 as dividend.
There is no stated maturity, and the currently similar preference shares are giving
dividend at 10 %. What is the value of these preference shares? Is it valued at a
discount or premium?

4.5 EQUITY VALUATION

4.5.1 THE BASICS
Going by the discussion above on the Valuation of bonds and Preference shares, the
Valuation of equity shares is equal to the present value of future benefits that equity
investors expect to receive. Equity shares are different from bonds and preference shares as
the cash flows are not fixed and are unspecified.
If you are an equity shareholder, what are the benefits you expect to receive from your equity
investment?
Yes, you are right. You expect dividends and want the Price of the share to go up to make a
capital gain. When you sell these shares, you give away your rights of future benefits to the
buyer of these shares. Again the buyer of the shares (Mrs X) has similar expectations. This
logic extends to the next investor (Mr Y) who buys the stock from Mrs X. Do you remember
Holding period return and Holding period yield discussed in previous Unit (Unit 3: Risk and
Return).
Exercise 6: Let's assume you bought 100 shares of KPR Mills ltd. as of 1st January 2020 at
Rs 654. As of 31st December 2020, the stock price is Rs 871. KPR paid Rs 3.75 as a dividend in
the year 2020. The return on this investment can be easily calculated as

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Valuation of Securities

NOTES The numerator of the above equation expresses Profit/Loss in monetary terms. The
denominator is the amount of investment in monetary terms; the final result is the return in
percentage terms.

If we rearrange this equation to solve for the Current Price

As can be seen from the above equation, the stock value today is the present value of cash
inflows in one year. The question arises, how do we arrive at P1? Can we change the P0 given
above to arrive at P1? Yes, we can; here's how

Similarly, P2, P3, P4...can be arrived at. By substituting P2, P3, P4 with its equation, we will get the
following equation

This is an infinite series because shares do not have any maturity. As can be observed in the
above equation, the equity valuation equation is identical to the general valuation equation,
with dividends in place of cash flows. And as discussed earlier r is the required rate of return-
the discount rate that reflects the risk of the asset, it is also referred to as ke - the Cost of
equity capital. The Discount Rate represents risk and potential returns, so a higher rate
means more risk but also higher potential returns. The discount rate associated with an
FMCG company (as it generates consistent cash flows) will be normally lower as compared
with a new entrant in technology sector (erratic cash flows). Also, in the above equation, the
computation is based on the expected growth pattern of future dividend.
Analysts/fund managers/Portfolio Managers have to estimate these two inputs, i.e.,
dividends and Required rate of return for equity valuation. These are not so easy to calculate.
The rate of return is the function of a stock's risk (Refer Unit 3). How to estimate dividends?
How will it grow over time? The current dividend is known; by judging the possible scenarios
for dividend growth, one can estimate future dividends. Let's go through various possibilities
in dividend growths.

4.5.2 ZERO GROWTH MODEL

One of the possibilities with dividend is that the company will give the same amount every
year, constant dividend without any growth. In such a situation
D1=D2=D3=…=D
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By replacing D1=D2=D3=…with D, we will get the following equation NOTES

The value of the share would equal the present value of a perpetuity of dividend discounted
at r.
Example 7: The dividend amount of Jipal Corporation is Rs 12, and is expected to remain the
same in coming years. Assuming a required rate of return of 13%, what is the Value of Jipal's
shares?
Solution 7:

4.5.3 CONSTANT GROWTH (GORDON GROWTH MODEL)

The constant growth model is one of the most used models. As the model's name suggests,
the assumption is that dividend will grow at a constant rate, g. As the dividend is growing at a
constant rate forever, the value can be calculated by using the formula for growing
perpetuity.

This model was contributed by Myron Gordon.

Example 8: The current dividend amount of Cushion Corporation ltd. (CCL) is Rs 27. CCL has
been paying dividends at a growth rate of 10% and is expected to pay at the same growth rate
in the future. What should be the Price of CCL's shares if the r or Ke is 12%.
Solution 8:
D1= 27(1.1)= Rs 29.7
P0= 29.7/ (.12-.10) = Rs 1,485

4.5.4 VARIABLE GROWTH MODEL

The above two models do not allow for changes in the growth rates of dividends. Quite a few
firms go through fast growth in certain periods when competition is lesser, followed by more
stable growth. Thus, this model considers a change in the dividend growth rate. The growth
rate g will be in two parts now, i.e., g1= initial growth rate and g2= the subsequent growth rate
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Valuation of Securities

NOTES of dividends.

This equity valuation equation is in two parts; in the first part present value of dividends
during the initial growth period is calculated; and the second part calculates the present
value of the stock price at the end of initial phase.
Let's apply the model
Example 9:
An electronic company has developed a mobile charger that fully charges the mobiles'
battery in 30 seconds. Due to the product's popularity, the company's initial growth rate is
20% per year for the first three years. By the fourth year, competitors also started developing
similar products, so now the growth rate is 6%. Currently, it is paying a dividend of Rs 8. The
required rate of return of this stock is 15%.
Solution 9:

PV of dividends during g1 phase

=(Rs 9.6 * PVIF (15,1)) + (Rs 11.52 * PVIF (15,2)) + (Rs 13.83 * PVIF (15,3))

= 8.35 + 8.71 + 9.09

= Rs 26.15
Rs 26.15 is the present value of dividends for the first three years. Now we have calculated
the Price of share at the end of year 3. As there will a stable growth rate from 4th year
onwards, we can easily apply the constant growth model. So

= 14.66/ (.15-.06) = Rs 162.88

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Rs 162.88 is the Price three years from now. We need to calculate the PV of this Price as well. NOTES
Which will be
=162.88 * PVIF (15,3)
=162.88 * 0.657 = Rs 107.01
Now will add the two values to arrive at present value of stock
= Rs 26.15 + Rs 107.01= Rs 133.16

CHECK YOUR PROGRESS-IV

Q.1 Equity shares are difficult to value because
a) It isn't easy to arrive at an appropriate risk-adjusted rate
b) It isn't easy to estimate the growth rate in dividends
c) Both of the above
d) None of the above
Q.2 A pharma company has developed a medicine that relieves pain instantly. Due to the
popularity of the medicine the initial growth rate of the company is 20% per year for
the first 3 years. By fourth year, competitors also started developing similar drug, so
now the growth rate is 5%. Currently, the company is paying Rs 2 as a dividend. The
required rate of return of this stock is 14%. Calculate the value of the stock?

4.6 OTHER APPROACHES TO EQUITY VALUATION

4.6.1 BOOK VALUE
As the name suggests, it is value as per books, which is the value as per the balance sheet.
The Book Value of the share can be arrived at by dividing net worth by the number of
outstanding shares. Net worth is the total of equity capital and other equity, i.e., reserves
and surplus. It is also arrived at by deducting all liabilities from Net Assets reflected in the
balance sheet. As these values are reached using the historical cost concept, it doesn't
provide the organization's true value. Also, it doesn't consider the future potential of the
firm.

4.6.2 LIQUIDATION VALUE

In this approach, estimation is carried out about the amount of cash received after selling all
the company's assets and after paying for all the liabilities. It depends on the composition of
the assets; if the company has a large amount of land, value can be higher than the company
owning a large amount of inventory. The liquidation of assets depends on the type and
quality of an asset.

4.6.3 PRICE EARNINGS MULTIPLES

It is a relative valuation approach. It reflects how much an investor is ready to pay for each
Rupee of earnings. It is arrived at by dividing the share's current market price with its
earnings per share (EPS). An investor using this approach will typically start with an 77
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Valuation of Securities

NOTES estimation of EPS for the coming period. Secondly, the investor will calculate the P/E of the
industry to which this stock belongs. Thirdly, the investor will obtain the expected Price by
multiplying estimated EPS with the industry P/E ratio. Many seasoned analysts use this
approach for stock valuation. They compare the P/E ratio of various companies in the same
sector.

CHECK YOUR PROGRESS-V

Q.1 Which of the following is not the other approach of Valuation of shares?
a) P/E multiple
b) Book Value
c) Liquidation value
d) Yield to maturity

4.7 LET US SUM UP

In general, the value of an asset is the present value of its future benefits. We use discounted
cash flow models to arrive at the value of financial securities. For asset pricing, knowledge of
future services and the appropriate discount rate (that converts future benefits into present
value) is needed. Both government and corporations frequently borrow money by issuing or
selling debt instruments from a diverse group of lenders; these instruments are called
Bonds. The value of the bond equals the PV of future interest and principal payments to be
paid by the bond issuer to the bondholder. The value of the preferred stock (preference
shares) equals the PV of dividends made by a company to its shareholders. As this amount
usually is constant, therefore the Valuation of preference shares is similar to bond valuation.
Estimating future benefits in equity is quite challenging, as dividend is a function of profit,
growth rate and retention ratio; these depend on many external and internal factors.
Generally, higher discount rates are used in case of greater uncertainty about future
benefits. The valuation process also links asset's risk and return to determine its Price. If we
assume future benefits to be constant, an inverse relationship exists between risk and value.
The value of the common stock (equity shares) equals the PV of expected dividends made by
a company to its shareholders. The zero-growth model can be applied in equity valuation
when the investor expects the same dividend every year. The value of the share would equal
the present value of a perpetuity of dividend discounted at r. The constant growth model is
applied when a company is giving dividend at a constant growth rate. The variable growth
rate model allows for variability in growth rates. There are two parts in this model; in the first
part, we calculate the PV of dividends during the initial growth phase, and in the second part,
we calculate the PV of the stock price of the end of the initial growth phase by applying
constant growth model. By adding the two, the stock price is arrived at.
There are other approaches to equity valuation, namely book value, liquidation value and
P/E multiples. The Book Value of the share can be arrived at by dividing net worth by the
number of outstanding shares. In Liquidation Value, we estimate the amount of cash that
would be received after selling all the company's assets and after paying for all the liabilities.
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P/E multiple reflects how much an investor is ready to pay for each Rupee of earnings. It is NOTES
arrived at by dividing the share's current market price with its earnings per share (EPS).

4.8 KEY WORDS

Discounted cash flow models: Present Value of all future benefits
Coupons: The fixed amount of interest paid every year on bonds.
Maturity: The life of the bond is its maturity.
Face value or par Value: At the time of maturity, the bond issuer repays a lump sum money to
the lender, which is the bond's face value or par value
Coupon rate: The rate of interest that is paid every year is called the coupon rate.
Yield to maturity (YTM): The required interest rate in the market is called the bond's yield to
maturity (YTM).
Dividends: The part of profit distributed to shareholders.

4.9 REFERENCES AND SUGGESTED ADDITIONAL READINGS

Chandra, P. (n.d.). Financial Management. Theory and Practice. Second Reprint 2011. Tata
McGraw-Hill Publishing Limited. New Delhi. McGraw-Hill Offices. Indian ….
Corporate Finance-Theory and Practice Aswath Damodaran—Google Scholar. (n.d.).
Retrieved April 7, 2021, from
https://scholar.google.com/scholar?hl=en&as_sdt=0%2C5&q=Corporate+Finance-
Theory+and+Practice+Aswath+Damodaran&btnG=
Mikhan, P., & Jain, K. (2007). Financial Management, Text, Problems and Cases. Tata. Mc
Graw-Hill Publishing Company Limited.
Richard, P., & Bill, N. (2006). Corporate Finance and Investment-Decisions & Strategies.
Pearson Education Limited.
Ross, S. A., Westerfield, R., & Jordan, B. D. (2008). Fundamentals of Corporate Fi-nance. Tata
McGraw-Hill Education.
Van Horne, J. C., & Wachowicz, J. M. (2005). Fundamentals of Financial: Manage-ment
Prinsip-Prinsip Manajemen Keuangan. Penerjemah: Dewi Fitriasari Dan Deny Arnos Kwary.
Penerbit Salemba Empat: Jakarta.

4.10 SELF-ASSESSMENT QUESTIONS

Q.1 The basic valuation equation must have the following
a) Cash flows
b) Discount rate/ Required rate of return
c) Life of the financial asset
d) Maturity Value, if any
e) All of the above
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NOTES Q.2 The periodic fixed payments given on bonds are called
a) Coupons
b) Interest payments
c) Dividends
d) Instalments
Q.3 Does bond price move in the opposite direction of interest rates
a) Yes
b) No
Q.4 What will be the Value of Preference shares that pay Rs 7 as a dividend and have no
maturity value? The current rate of dividend on similar preference shares is 6%
a) Rs 85
b) Rs 100
c) Rs 117
d) Rs 90
Q.5 What is the value of stock for a company that pays Rs 14 dividend every year, and the
company's rate of return of the company is 12%?
a) Rs 85.72
b) Rs 116.67
c) Rs 100
d) Rs 140
Q.6 What is the value of stock for a company that paid Rs 16 dividend this year, and the
constant growth is 10%, the company's rate of return of the company is12%?
a) Rs 800
b) Rs 1600
c) Rs 880
d) Rs 1164
Q.7 A Rs 100 par value bond bearing a coupon rate of 12% will mature after five years.
What is the value of the bond, if the discount rate is15%?
Q.8 The current dividend amount of Pattalok ltd is Rs 44. Pattalok has been paying
dividends at a growth rate of 8% and is expected to pay at the same growth rate in the
future. What should be the Price of CCL's shares if the r is 10%.

4.11 CHECK YOUR PROGRESS – POSSIBLE ANSWERS

CHECK YOUR PROGRESS – I
Q.1 Value of the asset X = Rs 1,08,143.29
Value of the asset Y = Rs1,12,598.599

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CHECK YOUR PROGRESS – II NOTES

Q.1 Price of the bond = Rs 1074
Premium of Rs 74
CHECK YOUR PROGRESS – III
Q.1 Yes
Q.2 The preference dividend of Rs. 8 is perpetuity. The present value of the preference
share is:
P0 = D / Kp
= 8 / 0.10 = Rs. 80.
It is trading at a discount as the dividend rate is lower than the market rate of dividends
of similar preference shares.
CHECK YOUR PROGRESS – IV
Q.1 C
Q.2

PV of dividends during g1 phase

=(Rs 2.4 * PVIF (14,1) + (Rs 2.88 * PVIF (14,2) + (Rs 3.46 * PVIF (14,3)

= Rs 2.11 + Rs 2.22 + Rs 2.33 = Rs 6.66

= 3.63/ (.14-.05) = Rs 40.33

= 40.33 * PVIF (14,3)

= 40.33 * 0.674 = 27.22

Now will add the two values to arrive at present value of stock

= Rs 6.66 + Rs 27.22= Rs 33.88

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NOTES CHECK YOUR PROGRESS – V

Q.1 D

4.12 ANSWERS TO SELF-ASSESSMENT QUESTIONS

Q.1 e
Q.2 a
Q.3 a
Q.4 c
Q.5 b
Q.6 c
Q.7 Rs 89.92
Q.8 Rs 2420

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UNIT 5 NOTES

BASICS OF CAPITAL BUDGETING

STRUCTURE
5.0 Objectives
5.1 Introduction
5.2 Relevance of Capital Budgeting
5.3 Types of Capital Projects
5.4. Capital Budgeting techniques to evaluate the projects
5.5 Let’s Recapitulate
5.6 Key Words
5.7 References And Suggested Additional Readings
5.8 Self-Assessment Questions
5.9 Check Your Progress-Possible Answers
5.10 Answers to Self-Assessment Questions

5.0 OBJECTIVES
On completion of this unit, you should be able to:
• Understand the meaning and relevance of Capital Budgeting decisions
• Understand different types of Capital projects
• Evaluate the Projects using the various Appraisal Criteria
• Understand the merits and demerits of all appraisal techniques

5.1 INTRODUCTION
Capital budgeting involves decision-making on how to allocate the long-term funds of the
company for long-term usage. In simple terms, it is a capital expenditure decision. Capital
expenditure decision is crucial for any company, as it involves huge capital outlay for a
relatively long period of time.
Capital expenditure decisions involve expansion and diversification of business,
replacement, and modernization of long-term assets. It involves the complex procedure of
identification, preliminary screening, feasibility study including financial appraisals of

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NOTES projects.
Why taking capital budgeting decision is a complex management task?
1. It requires a huge outflow of funds.
2. The benefits of capital expenditure are expected to occur for several years in the
highly uncertain future. The costs and benefits occur at different points in time.
Therefore, it is very important to bring all the cash flows at same time frame so
that a proper analysis can be done,

5.2 RELEVANCE OF CAPITAL BUDGETING

For the Survival and growth of any organization, investment in long-term assets is a very
important decision. Decisions are related to expansion in business, entering into new related
businesses, modernization of machinery, replacement of old machinery with new
machinery. Huge investment in plant, machinery, equipment makes this decision
irreversible. Any wrong decision would harm the sustainability of the business. These
decisions are to be aligned with the goal of the organization i.e maximization of
shareholder's wealth. All the decisions made by the firm are for the future and there are
uncertainties involved in such decisions which makes these decisions more complex. Also, it
is difficult to estimate future cash flows with accuracy.
Fig. 5.1: Relevance of Capital Budgeting

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5.3 TYPES OF CAPITAL PROJECTS NOTES

Types of Capital Projects based on Nature of Investments
Expansion and Diversification
A company may add a product line to the existing product or add capacity to existing
operations. A firm may expand its business to new business or related business. For example,
Tata Motors may enter into manufacturing of two-wheelers or Bajaj auto manufacturing
electric bikes/scooters are some of the examples of expansion. In such cases, the company
makes huge investments in an expectation of increasing revenues.
Replacement of Old machinery with new machinery with better technology
In such cases, old machinery may be functional but decisions may be about shifting to
machinery having better technology. New machinery will reduce the overall cost of
operation. Hence, it is a very crucial decision. If any manufacturing company changes from
semi-automatic to fully automatic equipment, it is an example of replacement.

Types of Capital Projects based on Interrelationship among Projects

MUTUALLY EXCLUSIVE PROJECTS
Mutually exclusive projects are those projects in which choice of one project automatically
rejects the other. For example, we are considering upgrading our manufacturing machinery
and can choose between two alternatives. The first is low-cost machinery that needs to be
replaced in 3-years and the second is a more expensive model that needs to be replaced in 5-
years. We can only choose one of these options, so they are mutually exclusive.
Example: manual vs automated production, handloom vs power loom, indigenous vs
imported machine, etc.
INDEPENDENT PROJECTS
Independent projects are those which are independent of each other which means that
choosing that project will have no impact on another. For example, A firm that manufactures
two-wheelers/scooters may enter into a sports bike or street bike manufacturing. Each of the
projects is independent of the other.
CONTINGENT PROJECTS
Contingent projects are those projects which are dependent on other projects which means
investment in such projects is dependent upon other one or more investments. For example:
If you are into manufacturing tyres then equipment for wheel balancing is also required. The
total expenditure of the manufacturing plant as well as ancillary activities would be treated
as one investment. Another example is a case of company wanting to set up a factory in a
remote area. In such a case, investment in facilities like housing, schools for employees,
construction of roads connecting Plant to city, etc will be treated as contingent.

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NOTES 5.4. CAPITAL BUDGETING TECHNIQUES TO EVALUATE PROJECTS

Evaluation Techniques
For evaluation of capital budgeting decisions, the cash flows during the life of the Project are
forecasted. These cash flows are to be accessed to check the viability of the Project with the
help of various appraisal techniques. Now we have to see some of the tools and techniques
which would help us in evaluating various projects (similar or different) and finally selecting
the one with the higher financial viability. These criteria can be broadly classified into two
categories:
Fig. 5.2: Types of Capital Budgeting Techniques

CAPITAL BUDGETING
TECHNIQUES

NON-
DISCOUNTING
DISCOUNTING

Non-discounting Techniques -These techniques compare the nominal cash flows occurring
from the project in the future with the cash outflows occurring at the beginning of the
Project. Non-discounted techniques are simple to use but the only flaw in these techniques
is that they ignore the time value of money. Making comparisons of cash flows arising at
different periods without making any adjustments for the time value of money leads to
flawed results. Some of these techniques are ‘Pay-back period’ and ‘Accounting rate of
return’.
Fig. 5.3: No Discount Techniques

Non-Discouning
Techniques

Accounting Rate
Payback Period
of Return

Discounting Techniques– Unlike the non-discounted techniques, the discounted (scientific)

techniques use the time value of money which means bringing the future cash flows at
different times to the present by using an appropriate discount rate. The discount rate, in this
case, would be the cost of capital. . These techniques are better than non-discounting
techniques as they use time value of money concepts to evaluate potential investments.
Some of these techniques are Net Present Value, Internal Rate of Return, Modified Internal
86 Rate of Return, and Profitability Index.
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Fig. 5.4: Discounting Techniques NOTES

Discounting
Techniques

Modified
Discounting Net Present Internal Rate Profitability
Internal Rate
Payback Value of Return Index
of Return

5.4.1 NON-DISCOUNTED TECHNIQUES

5.4.1.1 PAYBACK PERIOD
The payback period is one of the traditional techniques used to evaluate the project. It
measures the period in which one can recover the initial investment of the project. Let us
understand it with the help of an example: if a project with a life of 10 years involves an initial
outlay of Rs 50 lakh and is going to generate a constant annual inflow of Rs 5 lakh, the
payback period of the project = 50/5 = 10 years.

Hence, Payback period can be calculated as

The above formula can be used for an annuity of cash flows.

Example 1: Assume that the project requires an cash outlay of Rs 5,00,000/- and gives annual
cash inflow of Rs 100,000 for next 7 years. The payback period for the project is:

For Uneven cash inflows in the future, the payback period can be found out by finding
cumulative values until the total is equal to the cash outflow.
Example 2: Assume that the project has a cash outlay of Rs 1,20,000/- and the cash inflows in
7 years are:

Calculate the Payback period

Solution-2: We will add all the cash inflows until it is equal to cash outflow

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NOTES At 5th year, cash outflow is fully recovered.

So, the payback period is 5 years
Let’s consider another example
Example 3: Assume that the project has a cash outlay of Rs 1,00,000/- and the estimated
cash inflows in 6 years are the following:

As we can see above, payback will be in between 3 & 4 yr. 90,000/ are recovering till 3rd year.
Assuming that the cash flow occurs evenly during the year, the time required to recover the
remaining 10000/- (100000-90000) would be from 4th year cash flow.
Pay Back Period= 3+ (10000/20000) = 3.5 years
Acceptance Criteria
Now the question is when to accept projects considering the Payback Period? A firm may set
the appropriate cut-off period or standard period which can be compared with the payback
of the project. The project would be accepted if the payback of the project is lower than the
standard period. Ranking of mutually exclusive projects can be done with a payback period
and the one with lower payback can be selected.

Payback < Standard period Accept

Payback > Standard Period Reject

Merits of Payback Period

1. The payback period method is simple to use and easy to calculate.
2. Payback period method based on the early recovery methodology. Thus, it gives an
insight into the liquidity of the project.
3. It helps in not selecting the projects which generates cash flows in later years or in
other words which might be risky rather favoring only those projects which generate
huge inflows in earlier years.
4. It is the most cost-effective method.
Demerits of Payback Period
1. Payback ignores the time value concept which is the most important tool while
considering the cash flows.
2. Payback period of project is compared with cut off period which is chosen arbitrarily.
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Projects with long lives are compared with projects having shorter life so the decision NOTES
may be misleading.
3. Cash flows after the payback period are ignored. Payback Period cannot be considered
as the measure of profitability for the simple reason that few projects may have
substantial cash inflows at the later years. It would not be appropriate to take decision
purely based on payback. Other evaluation techniques must be considered while
taking a decision. For example:

4. Apart from the demerit above, the payback period fails to consider the timing of cash
flows. It gives equal weight to all cash flows even though cash flows are taking place at
different periods of time.
Both projects below have 2 years as payback period and both are equally acceptable
as per payback method. However, when time value of money is considered, the
project yielding large cash flows at the beginning will lead to higher value, keeping
other things constant, in comparison to project in which large cash flows are received
at the later stage. Here, project A should be considered as large cash inflows are
occurring in the early years.

CHECK YOUR PROGRESS- I

Q.1 Calculate payback, if the cash outlay is of 1,00,000 and inflows are as follows:
1st year 40,000, 2nd year 30,000, 3rd year35,000, 4th year 40,000, 5th year 30,000
and 6th year35,000.

5.4.1.2 ACCOUNTING RATE OF RETURN

The accounting rate of return measures the profitability of the investment. ARR is the ratio of
average after-tax profit divided by the average investment.
The accounting rate of return or the average rate of return is defined as follows:

Accounting Rate of Return (ARR)=

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NOTES Average income= Average after-tax profit

Average Investment = ½*Investment Book value after depreciation during life of the project
= ½ (Opening + Closing Book Value of Investment)
Example 4:

Average annual income =

= Rs 1,66,666.67
Average book value of investment = (500000 + 0) / 2
= Rs 2,50,000

Accounting Rate of Return (ARR) =

Accounting Rate of Return (ARR) = 66.66%

The project shall be accepted if the firm's target ARR is less than 66.66%.
Acceptance Criterion
ARR of a project is compared with the industry ARR or target ARR of the firm

ARR > Average rate of Industry Accept

ARR < Average rate of Industry Reject

Merits of Average Rate of Return (ARR)

1. ARR is a very simple concept and easy to apply. It is easily understood as a
performance measure.
2. ARR can be easily calculated through accounting data
Demerits of Average Rate of Return (ARR)
1. ARR ignores the time value of money.
2. The ARR depends on accounting income and not on the cash flows. Accounting
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income has its limitations if we compare it with cash flows. Cash flows are more NOTES
reliable than accounting income as it does not include non-cash expenditures. Since
cash flows and accounting income are often different and investment appraisal
emphasizes cash flows, a profitability measure based on accounting income cannot be
used as a reliable investment appraisal criterion.
3. The firm using ARR as an evaluation criterion must decide on a benchmark for judging
a project and this decision is often random. The firm often uses their book value return
as a benchmark which tends to be either very high or very low that results into wrong
decisions.

CHECK YOUR PROGRESS-II

Q.1 A project has an initial cash outflow of Rs 1,00,000/- The projects earning’s before tax
and interest are as follows:

Tax rate: 50%. Find out Accounting rate of Return

5.4.2 DISCOUNTING TECHNIQUES

5.4.2.1 DISCOUNTED PAYBACK PERIOD
Discounted Payback is a better measure over the Payback period as it takes into account the
time value of money while considering cash flows. In other words, the cash flows are
discounted before computation of payback period. In discounted payback period method,
discounted cash flows are used instead of actual cash flows using the cost of capital as the
discount rate.
Example 5:
If a project involves an initial outlay of Rs.8 lakh, and is expected to generate a net annual
inflow of Rs 4 lakh every year for the next 3 years, the opportunity cost of capital is assumed
to be 12%. the discounted payback will be as follows:
Solution-5

Calculating the present value of each cash flows separately using factor table

PV of Cash Flow 1= 4,00,000 * PVIF12%,1 = 4,00,000 * .893= 3,57,142.86

PV of Cash Flow 2= 4,00,000 * PVIF12%,2 = 4,00,000 * .797=3,18,877.550

PV of Cash Flow 3= 4,00,000 * PVIF12%,3= 4,00,000 * .712=2,84,712.100

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NOTES

Discounted Pay Back period will fall between 2nd&3rd year

= 2.43 years
On the other hand, if we consider Payback period only then it is 2yrs (800000/400000)
Discounted payback period as an appraisal criterion can be considered better than the non-
discounted payback period. Firstly, it considers the time value of the money concept,
secondly, it does not give equal weight to all cash flows. But it too suffers from other
demerits of the payback period.
Merits of Discounted Payback
1. The payback period method is simple to use and easy to calculate.
2. Payback period method based on the early recovery methodology. Thus, it gives an
insight of the liquidity of project.
3. It helps in identifying risky projects by preferring only those projects which generate
significant inflows in earlier years.
4. It is the most cost-effective method.
5. It uses the time value of the money concept
Demerits of Discounted Payback
1. The main focus of discounted payback is the early recovery of investment. It fails to
consider the cash flows which are occurring after the payback period.
2. Discounted payback cannot be considered as measure of profitability for the simple
reason that project may generate higher cash flows at the later stage.
3. Cut off period selected to compare the payback is selected arbitrarily. Even the
projects with long lives are compared with shorter life projects so the decision may be
misleading.

CHECK YOUR PROGRESS-III

Q.1 Calculate discounted payback, if the cash outlay is of 1,00,000 and inflows are as
follows:
1 t year-40,000, 2ⁿd year- 30,000, 3rd year-35,000, 4th year- 40,000, 5th year- 30,000
and 6th year-35,000.

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5.4.2.2 NET PRESENT VALUE (NPV) NOTES

Net Present Value is the classic technique of evaluating projects based on the present value
of cash flows concept. It suggests that cash flows arising at different periods can be
compared only in present value terms.
Every project would have cash outflows (investment) and a series of cash inflows. To evaluate
the project in financial terms we can follow the rule,' If the cash inflows are greater than cash
outflows in the present value terms then the project can be accepted or else rejected’. An
appropriate discount rate should be used to calculate the present value. The discount rate
would be the projects' cost of capital
Present value of cash inflows > Present Value of cash outflows
The difference (net) between the inflows and outflows in present value terms is called Net
Present Value (NPV). We can re-write the above equation as:
NPV = PV of cash inflows – PV of cash outflows
NPV = - Initial Investment + PV of cash inflows

NPV > = 0 Accept

NPV < 0 Reject

NPV equal to zero means that the project can recover exactly the amount of principal and
cost of funds and nothing more. Such projects can be accepted only if they form an
important/basic part of the product portfolio offering of the entity. We use NPV method to
select the mutually exclusive projects, NPV with higher positive value to be selected.
Example 6:
Consider the project with the following cash flows. Calculate the net present value of the
project, assuming the cost of capital is 10 percent.

(Figures in crores)
0 1 2 3 4 5
Initial Investment -2000
Cash Inflow 1000 800 800 750 600

Solution-6
Net Present Value is calculated as follows:

= -2000 + [1000 x PVIF (10%, 1) + 800 x PVIF (10%, 2) + 800 x PVIF (10%, 3) + 750 x PVIF (10%, 4) + 600 x
PVIF (10%,5)]
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NOTES = -2000 + [1000 x 0.9091 + 800 x 0.8264 + 800 x 0.7513 + 750 x 0.6830 + 600 x 0.6209]

= -2000 + [ 909.10 + 661.20 + 601.10 + 512.30 + 372.6]

= 1056.10
NPV = + Rs 1056.10 Crores, Hence, project can be Accepted
We can solve NPV problem in Excel too using NPV function in Excel
Let's solve the above example in Excel

=NPV(rate, Cash Inflows)+Cash Outflow (with negative sign)

Merits of Net Present Value
NPV technique is the most effective technique out of all evaluation techniques. Let us see
why:
1. NPV uses the time value of money which states that the rupee today is valued more
than a rupee received tomorrow.
2. It evaluates all the cash flows of projects, unlike discounted payback which ignores the
cash flows after the payback period. Hence, it is the measure of the true worth of
investment.
3. It follows the value additivity principle which states that the sum of NPVs of all projects
is equal to the NPVs of the total. NPV of A + NPV of B = NPV(A+B) which increases the
total value of the firm.
4. NPV technique is in congruence with the shareholder's wealth maximization objective
of the firm.
Demerits of Net Present Value
1. The major drawback of NPV is cash flow estimation. It is quite difficult to accurately
measure the forecasted cash flows.
2. Another major limitation is the calculation of the cost of capital of the firm which
serves as discounting rate. Calculation of the cost of capital in real life is quite
challenging and it should take into account the riskiness of project. The higher the risk
higher should be the discounting rate.
3. Most businessmen finds it difficult to apply NPV compared to ARR due to its
calculations
4. Sometimes, in the case of independent projects using a different discount rate, it may
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give misleading results. This may happen because of different patterns of cash flows. NOTES
The project which has heavy cash flows at the later stage of life can be selected at a
lower rate because these large cash flows occurring in the distant future are being
discounted at a low rate and hence leading to high NPV. However, when the same
Project is evaluated at a higher discount rate because the large cash flows are
discounted heavily now this project will be less favored in comparison to the project
yielding higher cash flows in the beginning.
For example, We have evaluated two Projects A and B by applying two different discount
rates 10% and 5%. At higher rate of 10%, Project A has a higher NPV and at a lower rate of 5%,
Project B has a higher NPV. This is because larger cash flows come in later in the timeline for
Project B.

CHECK YOUR PROGRESS-IV

Q.1 Consider the project the following cash flows. Calculate the Net Present Value of the
project, if the cost of capital is 12 percent.

5.4.2.3 PROFITABILITY INDEX

We have seen in NPV that Net Present Value is excess of benefits over cost in present value
terms. It means whenever the benefits are more than costs, the project can be considered
for investment. The evaluation of benefits and costs can be done by calculating the ratio of
the present value of inflows to present value of outflows; this is called ‘Profitability Index or
Benefit-Cost ratio’
Example 6a
Using the same cash flows from the Example:6

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NOTES
Profitability Index/ Benefit Cost Ratio =

PI / BCR= 1.52
Interpretation: BCR of 1.52 means that for every Rs 1 of costs the benefits are Rs 1.52 in
present value terms.
Acceptance Rule

PI >0 Accept
PI <0 Reject
PI=0 Accept (if there is the only project available)

Profitability Index measure is quite useful for the comparison between projects requiring
different initial cash outlay. This gives the cash inflows per unit of cash outlay. The higher the
ratio, the better it is.
Merits of Profitability Index
1. It takes into account the time value concept
2. Profitability index is consistent with the overall goal of shareholder’s wealth
maximization and considers as relative measure.
Demerits of Profitability Index
Like NPV, Profitability Index is based on the estimation of cash flows and discount rates.
which is difficult to estimate accurately.

5.4.2.4 INTERNAL RATE OF RETURN

The internal rate of return is that rate of interest at which the NPV of project is equal to zero,
or in other words, it is the minimum rate which equates the present value of the cash inflows
to the present value of the cash outflows. In NPV, we use cost of capital as discount rate
whereas in IRR, the rate is to be calculated which makes NPV zero. In simple terms, IRR is the
rate of return which the project generates on the capital invested.

Where,
I = Initial Investment
CFt = Cash inflows
r = Internal rate of return (IRR)
n = life of the project

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Example 7 NOTES

0 = -10000 + [4000 x PVIF (r%, 1) + 4000 x PVIF (r%, 2) + 3000 x PVIF (r%, 3) + 2000 x PVIF (r%, 4) +
2000 x PVIF (r%,5)]

Trial & Error Method for calculating IRR:

In trial-and-error method, to compute IRR, we try to find out two rates, one at which NPV is
negative and another one at which NPV is positive. After that by interpolation method, we
find out the IRR. Let us understand the method with the help of following steps:
Step 1- We take any rate arbitrarily and calculate NPV at that rate
We need to use Trial & Error Method to arrive at IRR. Firstly, we try arbitrarily a 20% discount
rate. The project’s NPV at 20% is:
NPV= -10000 + [4000 x PVIF (20%,1) + 4000 x PVIF (20%,2)+ 3000 x PVIF (20%,3) + 2000 x PVIF (20%,4)
+ 2000 x PVIF (20%,5)]
NPV=-384.50
Step-2 From Step-1 NPV is negative. To find positive NPV let’s try another rate lower than the
previous rate. (If in step-1, NPV is positive then discounting rate is to be increased to arrive at
negative NPV.
A negative NPV of 384.50 at 20% indicates that project's true internal rate of return is lower
than 20%. Let us try at a 15% discount rate
NPV= -10000 + [4000 x PVIF(15%,1) + 4000 x PVIF (15%,2) + 3000 x PVIF (15%,3)+ 2000 x PVIF (15%,4)
+ 2000 x PVIF (15%,5)]
NPV at 15% =613.20
Step-3 After calculating NPV at two rates, one NPV as negative and One as positive NPV,
interpolate using the formula.

NPVa
IRR = ra + (Rb – Ra)
NPVa - NPVb

ra = Lower discount rate chosen

rb = Higher discount rate chosen
Na = NPV at ra
Nb = NPV at rb
Thus the true rate should be between 15%-20%. Hence, we can use linear interpolation
method to calculate the rate of return by method of linear interpolation using the below
formula:
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NOTES

Interpretation: IRR of 18.07% means that the project would generate a return of 18.07% on
the investment made in the project. If the cost of funds is less than or equal to 18.07%, the
project can be accepted.

We can solve the above problem with the help of Excel also
IRR > k Accept
IRR < k Reject
IRR= k Accept (if there is the only project available) k is the cost of funds

Using IRR function in excel

=IRR (Values, Guess)

Here , Values: Cash outflow and cash inflows Guess: any rate or leave blank
= IRR (Values, Guess rate)
=IRR (-10,000, 4000, 4000, 3000, 2000, 2000, 15%)
=18.0%
Merits of Internal Rate of return
1. It considers time value of money.
2. It considers all the cash flow occurring over the entire investment horizon.
3. Business men usually understand in terms of rate of return on capital employed,.
4. It is in congruence with the objective of maximization of shareholders’ wealth.
Whenever IRR is greater than cost of capital, the shareholders’ wealth will be increased.
Demerits of Internal Rate of Return (IRR)
IRR is a sound investment evaluation technique but sometimes it gives misleading results.
1. The principle of value additivity does not hold good in the case of IRR. For Project A IRR
and Project B's IRR, IRR (project A)+ IRR (Project B) ≠ IRR(A+B).
2. The underlying assumption in the case of IRR is that the cash flows are reinvested at
the same rate as that of IRR. This assumption is not practical as it may not be possible
that cash flows are always reinvested at IRR. We will discuss this concept in detail in the
topic "MIRR".
3. IRR may give more than one rate at which NPV would be equal to zero i.e case of
98 multiple rates. This scenario may happen in the case of non-conventional cash flows
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i.e. when cash outflows are intermingled with cash inflows, there can be possibility of NOTES
more than one internal rates of return. This point is clarified with an example in further
discussions.

CHECK YOUR PROGRESS-V

Q.1 Calculate Internal Rate of Return from the following information:

Comparison between Net Present Value and Internal Rate of Return

Both the evaluation criteria NPV and IRR lead to acceptance or rejection of the project. In
some cases, both methods give contradictory decisions. Let us now analyze the situations in
which we get contradictory results.
Situation 1
Project with Non-Conventional Cash flows
In normal scenario in any project, there is single cash outflow initially and series of cash
inflows in subsequent years. However, in some specific projects there could be more than
one cash outflows. These projects are known as Non-Conventional Projects. In such cases,
where cash outflows are intermingled with cash inflows; problem of multiple IRR occurs.
Let us understand with the help of an example:

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NOTES Fig. 5.5: Multiply IRR

It is evident from above that project gives dual rate of return i.e. 50% and 150%. At these
rates of return, net present value of project is zero. Which of the two rates are correct? NPV is
positive when IRR is between 50% and 150%. This is one of the drawbacks of IRR. When we
have non-conventional projects where cash outflows are intermingled with cash inflows
then this situation of multiple IRR occurs. In such situation of dilemma, one should see NPV
rather than IRR.
Situation 2
Timings of Cash Flow in case of Mutually Exclusive projects; NPV profile & Crossover Rate
In this situation, cash flow pattern of projects may differ. Cash inflows of one project may
increase with time while cash inflows of other project may decrease with time. In such a
scenario, NPV and IRR may give contradictory results.
Let us understand with the help of an example:

Project R

Project S

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In above situation, NPV of Project S is higher than NPV of Project R whereas IRR of Project R is NOTES
greater than IRR of Project S. In such a situation of dilemma, which of the two projects should
be accepted?
Let us understand the NPV profiles at different cost of capital.

Discount rate Project R Project S

0.000% 677.00 938.20
5.000% 523.31 642.47
9.750% 394.36 405.57
9.800% 393.08 403.28
9.900% 390.53 398.69
10.000% 387.98 394.13
10.307% (Crossover Rate) 380.19 380.19
10.500% 375.33 371.52
10.800% 367.82 358.13
11.000% 362.84 349.28
11.250% 356.65 338.29
11.500% 350.49 327.40
12.000% 338.29 305.88
13.000% 314.32 263.87
14.000% 290.89 223.19
14.500% 279.38 203.33
15.000% 268.00 183.79
17.000% 223.76 108.63
19.000% 181.46 37.99
20.000% 161.00 4.26

We can see above, 10.307% is the rate at which NPV of both the projects are equal. We have
calculated above rate using trial and error method by equating NPV of Project S and Project
R.
Now the question is How to select the project? In such cases of contradictions, we should see
the cross over rate where NPV of both the projects are equal. If cost of capital is less than
10.307% then NPV of Project R is lower than Project S. Hence Project S is more viable to
select. In case cost of capital is greater than 10.307%, Project R have higher NPV than Project
S.
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NOTES Fig. 5.6: Cross Over Rate

Situation 3
Projects which have unequal life
Another situation when NPV and IRR gives contradictory results is when two projects have
different life span. Let’s understand with the help of an example:

Project R

Project S

From the example above, we can see that Project R’s IRR is greater than Project S’s Whereas
NPV of Project S is greater than Project R. Thus, the two methods rank the projects
differently. In such a scenario, we are in a dilemma about which project should be accepted?
We will follow the following approach
Equated Annuity approach
EAA approach is used to compare the projects with unequal lives. It calculates the equal cash
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flow of net present value assuming it be an annuity. One with higher EAA is chosen. NOTES
In the above example, the NPV of Project R at 10% is 9504.13, and the NPV of Project S is
9600.06. Let's calculate equated annuity using NPV as present value rate as 10% in both
projects by using following formulae:
PV = EAA x PVIFA
Project R EAA= 5476.18
Project S EAA=2532.47
Project R’s EAA is higher than Project S hence, Project R is selected

5.4.2.5 MODIFIED IRR (MIRR)

NPV and IRR calculations are based on the underlying rule of "reinvestment". The source of
conflict between IRR and the NPV method of evaluating the project is the assumption of the
reinvestment rate of the intermittent cash flows.
IRR assumes that the reinvestment of cash flows takes place at the internal rate of return and
remains constant across the investment horizon. Whereas NPV method assumes that
reinvestment of cash flows takes place at cost of capital which is more realistic and
applicable.
Let us understand with the help of an example
A project has a cash outlay of 13000/ and cash inflows as given below and cost of capital is
10% p.a

After calculating IRR through trial & error method, we get IRR as 12%.
If we reinvest the cash flows at 12% p.a (Which is IRR) then the terminal cash flows would be
as follows:

Total Terminal Value of invested cash flows after 5th year would be 22,913/-
Initial investment 13000/
Rate of return -12%
However, in real life it may not be possible to reinvest all the cash flows at IRR.
To overcome the drawback of the IRR method and to make it consistent with the NPV rule, a
modified method is developed which is known as modified IRR. The method works as
follows: 103
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NOTES • Find out the terminal values of all the cash flows assuming the reinvestment rate
at cost of capital.
• The total of the terminal value is treated as a single cash inflow
• With only two cash flows (initial investment and terminal value at the end of the
project) recompute the IRR. This new IRR is the modified IRR (MIRR).

Example: 8
Consider a project with cash flow of Rs 13,000. Cost of capital is 10%. Reinvestment rate is
10%

We can use MIRR Excel Function

= MIRR (values, finance_rate, reinvest_rate)
Under the modified IRR method, these cash inflows of each year are converted to Year 5 by
compounding them at a reinvestment rate equal to the cost of capital. Here, it is taken as
10%. The terminal values of all the cash inflows add to Rs 22,063. This terminal value is now
assumed to be single cash inflow in Year 5. With only two cash flows, i.e., the initial outlay in
Year 0 and terminal value in Year 5 this is equivalent to the cash flows of the project. The IRR is
recomputed. The modified IRR works out to 11.2%, [13,000(1 + r)^5 = 20,232] which is lower
than the original IRR which is 12%.
Modified IRR can now be said to reflect the true profitability of the project having assumed
reinvestment at cost of capital. As we increase the reinvestment rate, MIRR converges with
the original IRR. The least value of Modified IRR results when the reinvestment rate is zero.
Merits of Modified Internal Rate of Return (MIRR)
1. It is consistent with the NPV method.
2. MIRR is the solution to multiple IRR. It eliminates the problem of multiple IRRs if it
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exists by taking a single inflow at the beginning and a single cash outflow at the end of NOTES
the project.
3. It assumes a more realistic reinvestment rate consistent with the conservative policy
followed by most finance professionals.
Demerits of Modified Internal Rate of Return (MIRR)
1. It is complex to calculate if we compare it with other evaluation methods
2. MIRR does not lead to the same decision as NPV particularly in the case of mutually
exclusive projects.

5.5 LET US SUM UP

Capital expenditure decisions are very important decisions in corporate finance as it
involves huge investment and these decisions are irreversible taken for the long-term..
The evaluation techniques are broadly classified in two: Non-discounted and Discounted.
Non-Discounted Techniques include Payback Period and Accounting rate of return.
Discounted techniques are Net Present Value, Discount Pay Back, Internal Rate of Return,
Profitability Index and Modified Rate of Return.
The payback period of an investment calculate the number of years required to recover the
initial investment in the project. Discounted pay-back period is relatively better approach as
it considers time value of money.
The accounting rate of return is the ratio of average profit after tax to average book value of
the investment. Any company using ARR needs to determine a yardstick to compare the
returns of any project. In most cases, the yardsticks themselves suffer from subjectivity.
The net present value is the present value of the project's net cash flows less the initial
outflow. A project is acceptable only when its NPV is greater than or equal to zero.
Benefit-cost ratio measures the present value of a rupee of outflow and is very useful in
ranking projects in the order of the efficient usage of capital. If a project's BCR is greater than
or equal to 1, the project can be accepted.
The discount rate that equates the present value of the net cash flows of the project with the
initial cash outflow is the internal rate of return (IRR). Any project is acceptable if the IRR is
greater than or equal to the required rate of return, usually the company's cost of capital.
MIRR, modified internal rate of return is calculated by assuming the reinvestment rate equal
to the coat of capital. MIRR is a more conservative approach than IRR.
Equated Annualised Annuity (EAA) is used for evaluating mutually exclusive projects that are
not comparable in terms of life spans or cost patterns.

5.6 KEY WORDS

Net Present Value: The present value of a series of cash inflows minus the present value of a
series of cash outflows is called Net Present Value.
Opportunity Cost: An approach to measuring cost in terms of the value of alternatives that
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NOTES must be foregone to achieve an objective is called Opportunity cost.

Time Value of Money: The change in the value of money with time due to various factors is
known as the Time value of money.
Internal Rate of Return: The rate of return at which the net present value of a project turns
zero is called the Internal rate of return.
Capital Outlay: It means money outflow on account of acquiring any asset For ex. land,
buildings, equipment, machinery, vehicles, and the like to provide future stream of benefits

5.7 REFERENCES AND SUGGESTED ADDITIONAL READINGS

Gulati. S, Singh. Y.P (2020), Financial Management, Mc Graw Hill
Pandey.M (2021), Financial Management, Pearson Publication, 12th Edition
Chandra, P (2019),Financial Management: Theory & Practice: Mc Graw Hill, 10th edition

5.8 SELF-ASSESSMENT QUESTIONS

Q.1 If a student is awarded scholarship receivable over the next 12 months, what
calculation he should use to find out the worth of the scholarship today?
a) Present value of an amount
b) Future value of an amount
c) Present value of an annuity
d) Future value of an annuity
Q.2 Discounting technique is used to find out
a) Terminal Value
b) Compounded Value
c) Present Value
d) Future Value
Q.3 The project is accepted when
a) Profitability index is equals to zero
b) Profitability index is equals to 1
c) Profitability index is greater than 1
d) None of the Above is correct
Q.4 What is the payback period of following cash flows:
a) Year 0: -90000
b) Year 1: 45000
c) Year 2: 38000
d) Year 3: 28000
e) Year4: 25000
f) Year 5: 15000

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Q.5 What is the NPV of following cash flows if rate of interest is 12% p.a NOTES
a) Year 0 Initial Investment 3,00,000
b) Year 1 Cash inflows: 150000
c) Year 2 Cash inflows: 150000
d) Year 3 Cash inflow: 115000

5.9 CHECK YOUR PROGRESS-POSSIBLE ANSWERS

CHECK YOUR PROGRESS- I
Q.1 Payback Period=2.85 yrs
CHECK YOUR PROGRESS-II
Q.1 ARR= 26%
CHECK YOUR PROGRESS-III
Q.1 Discounted Payback= 3.109 yrs
CHECK YOUR PROGRESS-IV
Q.1 NPV=3150.30
CHECK YOUR PROGRESS-V
Q.1 IRR=11.35%

5.10 ANSWERS TO SELF-ASSESSMENT QUESTIONS

Q.1 c
Q.2 c
Q.3 c
Q.4 2.25 yrs
Q.5 35362.38

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UNIT 6

CASH FLOWS IN CAPITAL BUDGETING

STRUCTURE
6.0 Objectives
6.1 Introduction
6.2 Cashflows versus Accounting Profits
6.3 Pattern of Cashflows
6.4 Factors for determination of cashflows
6.5 Estimating Cash Flows: Type of Investment Projects
6.6 Cashflow Estimation: Type of Cashflows
6.7 Forecasting Cash Flows as Part of Capital Budgeting
6.8 Let Us Sum Up
6.9 Key Words
6.10 References And Suggested Additional Readings
6.11 Self-Assessment Questions
6.12 Check Your Progress-possible Answers
6.13 Answers to Self-Assessment Questions

6.0 OBJECTIVES
On completion of this unit, you should be able to:
• Understand the meaning and importance of cashflows for capital budgeting
decisions
• Deduce the factors affecting the cashflows
• Estimate the cashflows for capital budgeting purpose

6.1 INTRODUCTION
Investment decisions are crucial for long term profitability and growth of an organization.
The correct investment decision may lead to tremendous success for an entity. On the other
hand, a wrong decision may impact survival of the entity. It is utmost important to carefully
evaluate the alternative investment choices and select the most beneficial investment
project.

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Forecasting the cash flows correctly is a challenging task and varies with each project. For a NOTES
well-established industry the demand and supply conditions may be reasonably forecasted
and therefore cashflow estimation may be done easily. On the other hand, for a new industry
like gaming or electric vehicles it may be difficult to forecast the cashflows.
It is very important to forecast the cashflows carefully to evaluate available alternatives and
make correct investment decision. Wrong forecasting may lead to acceptance of poor
projects or rejection of good investment opportunity.

6.2 CASHFLOWS VERSUS ACCOUNTING PROFITS

As discussed in the previous unit, analysis of investment decisions is done based on expected
cashflows from the project during its lifetime. The investment evaluation techniques like
NPV, IRR etc. requires the analysis of present value of future cash inflow from the project vis-
à-vis the outflows. Though some techniques like ARR uses accounting profits for analysis of
an investment, cash flows are considered more appropriate for any metric. Accounting
profits suffers from the accounting policies and accrual system of recording. In reality, actual
amount and timing of cash flows may substantially differ from accounting profits due to
accrued expenses and incomes and non-cash outflow expenses like depreciation.
The project should be assessed based on its economic cost & benefits. The assets of the
business are purchased at the beginning through cash outlay. For calculation of accounting
profits, the cost of asset is charged over a number of years in the form of depreciation though
the cash is being paid right now. Similarly, for calculation of profits all expenses of year are
deducted while for outstanding expenses cash outflow will take place at a later time period.
The business has to pay for its cost in the form of cash, therefore cashflows are a better
measure for decision making for projects. For performance analysis, accounting profits may
be a good measure but a investment project has to be analysed based on its cashflow
generation ability from operations.
For assessment of investment project, operating cashflows after tax are to be used. Cash
outflow will take place for tax payment, therefore these operating cashflows should be
calculated net of taxes. For depreciation expense no cash outflow takes place, therefore for
calculation of cashflows, depreciation must be added back to net income to calculate cash
flows.

6.3 PATTERN OF CASHFLOWS

Cashflows can be categorized as conventional and non-conventional cash flows depending
upon the sequence in which cash outflow and inflows arise.
Conventional Cashflows
Cashflow from a project can follow conventional pattern in which Initial cash outflows are
followed by a series of cash inflows. This will happen when initial investment is made once
and then no further upgradation, additional investment is required in future, this initial cash
outflow is followed by annual cash inflows over the useful life of project.

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NOTES
For example, A Ltd. has to buy a machinery for Rs 10 lacs in the year 2020. It expects that the
investment will generate the cash inflows of Rs. 200000 for next six years. In this case cash
outflows at the beginning are followed by cash inflows in the subsequent years. Such pattern
is known as conventional cashflows or cashflows from a conventional project.
Non-Conventional Cashflows
if the cash outflows in some project occurs more than once it gives rise to non-conventional
cashflows. The initial cash outflow is followed by cash inflows and then after some years
again some cash outflows take place to buy additional machinery or upgrade the technology
etc. to be followed by next series of cash inflows. When such alternate sequence of cash
outflows and inflows takes place, they are known as non-conventional cashflows. In non-
conventional pattern, cashflows with negative sign occurs more than once. We can
understand it as there will be initial cash outflow, followed by inflows and intermittent
outflows. The pattern can be depicted as follows.

For example, B Ltd. has to buy a machinery for Rs 5 lacs in the year 2020. It expects that the
investment will generate the cash inflows of Rs. 100000 for next 4 years. In 4th year the
machinery will require an overhaul of Rs 2 lacs which will be followed by cash inflows of Rs
1.5 lacs for next four years. In this case, cash outflow at the beginning are followed by
sequence of cash inflows and intermittent cash outflows in the subsequent years. Such
pattern is known as non-conventional cashflows.

6.4 FACTORS FOR DETERMINATION OF CASHFLOWS

Following factors are to be considered for estimation of cash flows for evaluation of an
Investment Project:

6.4.1 RELEVANT CASH FLOWS

When evaluating an investment project, only those cash flows which are impacted by the
investment decision, should be taken into account to evaluate the project. In case of
expansion projects, the cashflows pertaining to only new investments are considered. If the
new project is leading to some reduction of revenue from the existing projects then this loss
of revenue should be deducted from the cash inflows of new project.
In case of replacement projects, only incremental cashflows are required to be considered. If
a machinery is being replaced with a new machinery then to calculate cashoutflows, the
sales proceeds of old machinery should be deducted from the cost of new machine. If the
investment is leading to additional cash inflows/outflows then these incremental or
marginal cashflows should be used for capital budgeting techniques like NPV, IRR etc.
Incremental cash flows
For assessment of an investment project, only the marginal or incremental cashflows from
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the project under evaluation must be considered. These are the net cashflows due to new NOTES
project and not the cashflows of entire firm.
Sunk Cost
If the firm has already incurred a cost in past that might be related to new investment
opportunity like, marketing research cost for the project, this will not change whether the
project is undertaken or not. It is known as sunk cost. Therefore, in the analysis of new
project this sunk cost should not be considered as part of initial cash outflows.
Opportunity Cost
If the firm is using an existing resource in the business which would have otherwise
generated some cash flows for the firm. This is known as opportunity cost. For evaluation of
project the opportunity cost should be considered. For example, if a firm owns a premise
which would have fetched a rental income of 12 lacs per annum in future and if the firm
decided to use this premise for business instead of giving it on rent, then present value of
future rentals should be considered as opportunity cost. It should be added to initial cash
outflows of the project for analysis purpose.
Loss/Diversion of Existing Revenue
In the evaluation of a project, we should consider whether the new investment is leading to
some diversion of revenue from existing projects to new one. Then these diversion of cash
flows should not be part of incremental cash flows calculated from the new project. For
example, if an automobile company launches a new variant of passenger car, then it is quite
probable that some of its customers who would have bought existing models of same firm,
may shift their buying decision to this new model. This shift of cash flows from previous
models should be netted out from the sales of new model to calculate the incremental cash
flows caused by the new project.
Transportation and Installation Cost
If a firm is forecasting the cash flows for an asset purchase decision like building or machinery
purchase, then they should also consider the transportation and installation charges paid at
the time of purchase. Such costs should be added to purchase price of asset to calculate the
initial cash outflow.
Inflation
When calculating the cash flows, effect of inflation should be built into the calculations of
future revenue and costs otherwise calculation of cash flows may be flawed leading to wrong
evaluation and incorrect decision.

6.4.2 IMPACT OF DEPRECIATION& TAX EFFECTS

A firm should carefully adjust the impact of depreciation in estimation of cash flows. At the
first instance, it may look that depreciation is a noncash expense, and it does not lead to any
cash outflows. Therefore, it must be just ignored while deducting the expenses from revenue
and only the cash expenses should be deducted. However, as per Income Tax Act,
depreciation is a permissible expense and its subtraction from revenue results into lowering
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NOTES pre-tax income. Due to depreciation expense taxable income goes down. This results into
lesser tax expense. The saving in taxes caused by depreciation expense is known as
Depreciation tax shield. Therefore, in estimation of cash flows first, depreciation is
subtracted along with other operating expenses from revenue of project to calculate
operating profit. Depreciation tax shield will result into less taxes when tax rate is applied on
the lower taxable income. To calculate the operating cash flows after tax, now the
depreciation is added back to operating profits after taxes. This can be understood with the
help of following example:
Example 1: Xenon Ltd. is into the business of dairy products. The firm makes the sales of Rs 12
lacs in a year. Operating cost of the firm is 55%. Farm owns the assets worth Rs 10 lacs and
rate of depreciation is 10%. IF the firm’s corporate income tax rate is 30%, calculate the
savings in taxes due to depreciation cost that is benefit of interest tax shield?
Solution:

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6.4.3 TREATMENT OF INDIRECT COST/FIXED OVERHEADS NOTES

Indirect cost/overheads are common cost which are allocated to a product. This allocation is
done based on proportionate material cost/labour cost/floor space occupied or some other
common basis. If because of new investment decision the allocation of overheads is
changing then in calculation of cashflows from a project only the additional indirect
cost/overheads,which are caused by decision should be considered. If there is no change in
the existing overheads, then they should not be counted in the calculation of cashflows. For
example, if a machinery is replaced with a modernized version of new machinery which will
occupy less space than the allocation of overheads to this machine may be reduced.
However, this reduction in allocation is not leading to any change in total overhead cost, only
the allocation to this machine is being reduced. This should not be considered in calculation
of cashflows because it is not leading to any reduction of total overhead cost. However, if the
space saved due to new machine can be put to some alternate use which will save some cost,
then this cost saving should be considered as reduction of overheads due to new machinery
and should be considered as part of cash inflows from new machine.

6.4.4 TREATMENT OF WORKING CAPITAL

When an expansion project is taken up, the firm expects the increase in sales. The increased
sales will require additional investment in working capital. To support increased sales, higher
level of inventory is to be maintained. Similarly, more funds will be tied up in credit sales. This
increased working capital remains tied up and continues to remain in rotation to support the
increased sales. This additional investment in working capital is treated as cash outflows at
the beginning of project. When the project comes to an end, this tied up working capital will
be released and therefore should be treated as terminal cash inflows. In case of
replacement projects too, any incremental working capital requirement will be treated in
similar manner.
It is important that all the cashflows of the project are taken into consideration at the time of
forecasting. If there is any gestation period that is if there is any gap between initial cash
outflows and commencement of cash inflows that should be duly considered. The growth in
cash inflows in the form of sales should be carefully forecasted based on external
environment and internal capacities. The cost components and expected increase should be
incorporated in the forecast. The impact of depreciation tax shield should be taken into
account by first deducting the depreciation from sales to calculate operating profits. The tax
should be calculated on this lower taxable income to calculate operating profit after tax.
Depreciation being a noncash expense should be added back to these operating profits after
tax to calculate the operating cash flows after tax.

CHECK YOUR PROGRESS-I

Q.1 Depreciation is deducted as expense to take the benefit of (Non-
Cash Expense/Tax Shield)
Q.2 Which of the following is a better measure to evaluate an investment project
(Net Profit/Operating Cash flows)
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NOTES 6.5 CASHFLOW ESTIMATION: TYPE OF PROJECT

The cashflow estimation depends upon the type of capital project, whether it is an expansion
project or replacement project. In case of expansion projects only the cashflows affected by
new project should be calculated while in case of replacement projects, incremental
cashflows from new project should be considered.
Expansion projects—analysis of expansion projects is relatively easy because estimating the
incremental cash flows associated with such projects is generally less complicated. The initial
cash outflows include the asset’s acquisition cost, transportation and installation costs.
Initial working capital for the project is considered as part of initial cash outflows. The
relevant operating cash flows include increase in cash sales and the cash expenses
associated with incremental sales. The impact of any changes in depreciation are to be
included and tax effects are to be adjusted in operating cashflows. The terminal cash flow
includes the salvage value or disposal proceeds of the asset after taxes and the release of net
working capital that occurred when project was installed. Once the cash flows are identified,
we can apply either NPV or IRR to determine whether the asset should be purchased.
Replacement projects—evaluation of replacement projects is more complex because
existing asset is being replaced. In case of replacement projects, the cashflows from the
existing assets are forgone and only the cashflows from replaced asset will accrue in future.
Therefore, the task includes the estimation of cashflows from new project as well as
estimation of lost cashflows from the existing project in order to calculate the incremental
cashflows. For example, if the existing assets were able to generate the revenue of Rs 100000
per month and new assets generates sales of Rs 150000 per month then only Rs 50000 is the
incremental cashflow provided by replacement project. Similarly, if the earlier project
required working capital of Rs 200000 and new project requires the initial working capital of
Rs 250000 then incremental working capital of Rs 50000 only is to be considered for analysis
of replacement project. In case of depreciation, not only the depreciation but also the tax
effects of changes in depreciation are to be considered for calculation of incremental
cashflows.

6.6 CASHFLOW ESTIMATION: TYPE OF CASHFLOWS

The cashflows pertaining to a project includes one time as well as recurring cashflows. The
cash flows are categorized as:
Initial Cash Flows
Operating Cash Flows
Terminal Cash Flows

6.6.1 INITIAL CASH FLOWS

Initial Cashflows include the cash outflows occurring at the beginning of project to buy plant
& machinery, building etc. Any transportation and installation charges at the time of
purchase are also included in initial cash outflows. Initial cash outflows also include the cash
paid for initial working capital of project or any incremental working capital cost due to
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purchase of new machinery or any other asset. These cash outflows are usually one time and NOTES
need to be incurred at the beginning of the project. Sometimes, additional capital
expenditure may be required after commencement of the project which will be considered
as cash outflows of the year in which they occur.
Initial cash flows may also be positive and includes any form of subsidy, investment
allowances etc. If an existing plant or machinery is being sold for replacement with new
machinery, then the sales proceeds of old machine are also to be considered part of initial
cash inflows. Many a times existing working capital may be released due to reduced
requirement of inventory when an old machinery is replaced with technologically improved
version. This will lead to release of some existing working capital. This should also be
included as a benefit in the initial cash flows of the new investments.

6.6.2 OPERATING CASH FLOWS

Operating cashflows are the cashflows arising from day-to-day operations of a business. The
firm make sales and incur expenses. The cash flows arising from operations are recurring in
nature. They include cash inflows in the form of sales and cash outflows on operating
expenses like regular purchase of inventory, payment of salary & wages, power & fuel, repair
& maintenance, electricity, advertising expenses etc. From the sales all operating expenses
are deducted to calculate operating profits. To calculate operating cashflows, accounting
profits needs to be adjusted for depreciation & other non-cash expenses. Though
depreciation is not part of cash expenses, but it is deducted from revenue to calculate the
accounting profits. Due to the depreciation taxable profits goes down and organization pays
less tax. The cash flows are to be calculated net of taxes therefore, benefits of tax savings due
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NOTES to depreciation expense needs to be taken into account. To calculate Operating cash flows,
depreciation is added to the operating profits after taxes.
Operating cash flows are to be forecasted for a definite period. It is assumed that due to
technological obsolescence, demand-supply changes and for other reasons every
investment will have a limited life. Operating cash flows are to be estimated over the limited
life of the project.

6.6.3 TERMINAL CASH FLOWS

Terminal cash flows arise towards the end of investment project life. They will be in the form
of salvage value of plant & machinery. The firm receives the cash proceeds from the sale of
assets at the end of project. Sometimes firm need to pay the charges for removal of an asset
from the factory premises and had to bear transportation charges. These charges should be
netted out from the sales proceeds of that asset to calculate the net cash inflows. When the
project comes to its completion then all the remaining inventory will be sold, all debtors will
be collected and no further investment in working capital is required. This is the same
working capital which was included as cash outflows at the beginning of project due to
investment in inventory and other working capital components. This release of working
capital is part of terminal cash inflows from the project. If the investment project was in the
form of an asset like machinery, then at the time of disposal of that machinery, net sales
116 proceeds, and any change in working capital due to removal of that machinery are to be
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considered as terminal cash flows. NOTES

6.6.4 CALCULATION OF DEPRECIATION& TAX EFFECTS DUE TO DEPRECIATION

As per provisions of Income Tax Act, the assets for the purpose of charging depreciation are
divided in blocks like Machinery, Building, Furniture etc. and specified rate of depreciation is
applied for each block of asset. When a firm sells the fixed asset in terminal year then
depreciation expense is calculated considering whether the asset sold was only asset in the
block or there are other assets in the block.
If the asset being sold is the single asset in the block, then depreciation is not charged in the
terminal year. The difference between the opening written down value (wdv) of the asset
and sales proceeds is treated as capital gain/(loss).
If there are other assets in the block, then depreciation will be charged in the terminal year.
From the opening written down value (wdv)of the asset the sales proceeds/salvage value of
asset will be deducted and on the balance, depreciation will be charged. Though the asset
has been sold but the balance written down value will be available in the block for charging
the depreciation in upcoming years. Both the cases can be understood with the help of
following example:
Example 2:
Beta Ltd. Purchased a machinery costing Rs 450000. Its installation and transportation
charges was Rs 50000. Machinery has a useful life of 5 years and rate of depreciation is 20%
for WDV method. Calculate the depreciation to be charged on machine in each year. The
machine was sold at Rs 180000 in the 5th year. Calculate the capital gain/loss and tax
expense/savings if the tax rate is 30% .
Solution:
Calculation of depreciation to be charged for 1st four years:

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NOTES Calculation of depreciation to be charged for terminal year:

Case I: When the machine is the single asset in the block then depreciation will not be
charged in terminal year. Calculation of capital gain/loss will be as follows:

Case II: When the machine is part of block with other assets then depreciation will be
charged in terminal year. Calculation of capital gain/loss will be as follows:

6.6.5 FINANCE COST

For capital budgeting evaluation, operating cash flows after tax are considered as the
objective is to evaluate the project. It implies that the evaluation is to be done for operational
viability irrespective of financing choice. The impact of debt financing is also reflected in the
discounting rate. For discounting of cash flows, weighted average cost of capital (WACC) is
used as discounting rate.If we will also deduct interest cost in calculation of cashflows then it
will be double counting of interest cost. The other financing cost in the form of preference
dividend and equity dividend are paid from Profit after tax and therefore they do not affect
cashflow calculation. Only caution is to be applied for interest cost and it should not be
deducted as we are calculating operating cash flows after tax while interest cost is a financing
cost.

Where EBIT*(1-T) is also known as Net Operating Profits after Taxes (NOPAT). Here we are
deducting the tax from the EBIT, which is the combined profit for equity and debt providers
and represents the operating profits, received after deduction of all the cash operating
expenses and depreciation from the revenue. We have to add back depreciation to NOPAT in
order to calculate Operating Cashflows after Tax.
Another way to calculate Operating Cash flows after tax is to add back adjusted interest cost.

CHECK YOUR PROGRESS-II

118
Q.1 Working capital is to be treated as part of Cashflows (Operating/Initial)
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Q.2 In Case of Replacement Project, Initial Cashflow will include (Cost of New NOTES
Machine Less Capital Gain/Cost of New Machine Less Sales Proceeds of Old Machine)

6.7. FORECASTING OF CASH FLOWS AS PART OF CAPITAL BUDGETING

As discussed above, to forecast the cashflows for evaluation of a project, we have to forecast
onetime initial cashflows, recurring operating cashflows after tax and onetime terminal
cashflows from a project. These cashflows are to be discounted at the risk adjusted required
rate of return or at WACC. The sum of present value of all cash inflows is to be compared with
cash outflows to assess the project viability. Let us understand the forecasting of cashflows
for expansion projects and replacement projects with the help of examples.

6.7.1. FORECASTING OF CASHFLOWS FOR EXPANSION PROJECT

The cashflow analysis requires estimation of Initial Cashflows from new project. Initial Cash
outflows includes Cost of new machine and Initial Working Capital. If there is any onetime
investment allowance, that is to be adjusted as cash inflows at the initial level.
Next Step is to calculate the operating cashflows. From the sales all operating expenses
including depreciation are to be deducted. For calculation of operating cashflows, add back
the depreciation to the after-tax profit.
For calculation of Terminal Cashflows, consider the salvage value of assets at the end of
period, tax savings on the capital loss and release of working capital in the terminal year.
Detailed Forecasting of cashflows is provided below:
Example 3: Sanchit Industries is in the business of manufacturing of Tennis sports kits. It
bought a machinery worth Rs 10 lacs at the beginning of year 2021. The machine has a
salvage value of Rs 2 lacs at the end of 8th year from the date of purchase. The machine is the
only asset in the block and depreciation is to be charged by straight line method. The firm
received an investment allowance of Rs 2 lacs from the Government for expansion in back
word region. The initial working capital requirement is Rs 2 lacs. The pricing is Rs 1000 per kit
and in the year 2021 the sale of 200 kits is expected to take place. The sales is expected to
grow at 10% for next three years and then at the rate of 6% for next 4 years. The operating
expenses of the firm are 40% of revenue. The firm has to pay the corporate income tax at the
rate of 25%. Forecast the cashflows for the project.
Solution - Step 1: Let us first calculate the depreciation on machine and loss on machine sold
in terminal year:

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NOTES Step II: For casting of Cashflows

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Present
value
NOTES
0.9259 0.8573 0.7938 0.7350 0.6806 0.6302 0.5835 0.5403
Factor
@8%
PV of
-1000000 106481 106310 106294 106425 103381 100544 97822 311303
Cashflows
Net
Present
38560
value of
Cashflows

6.7.2 FORECASTING OF CASHFLOWS FOR REPLACEMENT PROJECT

The cashflow analysis requires estimation of Initial Cashflows from replacement project.
Initial Cash outflows includes Cost of new machine. The cost of new machine is to be
adjusted for Salvage Value or Sales Proceeds and any tax savings due to capital loss on sale of
old machine. If there is capital gain on sale of old asset, then tax expense on that capital gain
is to be added to initial cash outflows. Any additional Working Capital required by new
machine is to be treated as cash outflow.
Next step is to calculate the operating cashflows. Only incremental revenue is to be
considered for calculation of operating cash flows from a replacement project. From the
incremental sales all incremental operating expenses including depreciation are to be
deducted. If there are any cost savings, they are to be added. For calculation of operating
cashflows, add back the depreciation to the incremental after-tax profit.
For calculation of Terminal Cashflows, consider the salvage value of replaced asset at the end
of period, tax savings on the capital loss and release of working capital in the terminal year. If
there are any capital gain, then tax expense on that gain is to be treated as terminal cash
outflow. Detailed forecasting of cashflows for the replacement project is provided below:
Example 4: Zenold Ltd. Is in the business of manufacturing all types of stationary products.
The firm is using a machinery which was bought 3 years ago at the cost of Rs 10 lacs, with
useful life of 6 years and the depreciation is charged at the rate of 15%. The machine has
salvage value of Rs 300000 in 4th year, and it is the part of block of assets on which same rate
of depreciation is charged. The machine is to be replaced with modernised version of
machine costing Rs 12 lacs with a useful life of 6 years. The new machine will be able to
produce more output which will lead to additional revenue of Rs 200000 per year. As the
sales will increase due to increased output, additional working capital of Rs 100000 has to be
employed at the time of purchase of new machine. The existing operating cost margin is
40%. The new machine will lead to cost savings of Rs 25000 per year as machine is automated
and no operator is required to run the new machine. This new machine will also be part of
same block of assets on which 15% depreciation is charged. At the end of 6 years the salvage
value of machine will be Rs 400000. The firm’s required rate of return is 8%. Recommend
whether the firm should replace the existing machinery with new machinery. The firm is in
the tax bracket of 30%.
Solution: Forecasting of replacement cashflows is more tedious and requires the analysis of
incremental cashflows. Let us first calculate the Cashflows related to Sale of Old Machine:
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NOTES Calculation of Capital Loss & Tax Saving on Sale of Old Machine:

Calculation of Incremental Depreciation, Capital Loss & Tax Saving on Sale of Old Machine:

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Calculation of Incremental Cashflows from this Replacement Project: NOTES

As the Net Present Value is positive for Incremental Cashflows from the Replacement of Old
Machinery with new one, it is advisable to the firm to go ahead with replacement proposal.

CHECK YOUR PROGRESS-III

Q.1 In case of replacement project, capital gain on sale of old machine will lead to Tax
Effects in the form of (Cash inflows/Cash outflows)
Q.2 The launch of new product line will result in loss of some revenue in existing product.
This should be (ignored/added to cash inflows of new product/deducted
from cash inflows of new product)

6.8 LET US SUM UP

Forecasting of Cashflows is an important aspect for evaluation of capital budgeting projects.
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NOTES The wrong estimation of cashflows may lead to acceptance of unviable project and vice-
versa. In forecasting of cash flows only the relevant cashflows, which are affected by decision
should be considered. The impact of depreciation tax shield, additional working capital and
fixed overheads has to be taken into account for analysis of cash flows. The cashflows are of
three types namely,
I) Initial Cashflows
ii) Operating Cashflows
iii) Terminal Cashflows.
Initial cashflows include the onetime cashflows at the time of commencement of investment
project. This includes cost of purchase of Plant & Machinery, Initial Working Capital and any
investment allowance/subsidy from the government. Operating cashflows include recurring
cashflows from the operations of firm. It is calculated by adding back depreciation to the
operating profits after tax as depreciation is the non-cash expense and does not results in any
outflows of cash. Terminal Cashflows include the onetime cashflows occurring at the time of
completion of investment project. It includes salvage value of assets to be disposed, release
of working capital and any tax expenses/savings due to profit/loss on disposal of assets. The
cashflows are to be forecasted for expansion projects or replacement projects. To analyse a
project only the incremental cashflows are to be taken into account. If there is any loss of
existing cashflows due to new project, then it is to be adjusted in the cashflows of new
project. The forecasted cashflows are to be adjusted for time value of money. The sum of
present value of forecasted cashflows is to be compared to the cash outflows to decide on
the acceptance of investment project.

6.9 KEY WORDS

Initial Cashflows: The cashflows occurring at the beginning of Project. For example, Cost of
Machinery
Operating Cashflows: Day to day cashflows pertaining to operations of business. For
example, Sales, Rent paid etc.
Terminal Cashflows: The cashflows occurring at the end of Project. For example, Salvage
value of Machinery
• Depreciation: Decline in the value of a fixed asset due to time, wear & tear, usage
etc.
• Depreciation Tax Shield: Tax savings due to depreciation cost
• Working Capital: Day to day funds required to run the business
• Finance Cost: Cost of financing raised for the business
• Capital Gain/(Loss): Difference between cost and sales proceeds of an asset/
investment

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6.10 REFERENCES AND SUGGESTED ADDITIONAL READINGS NOTES

• Khan, M.Y. and Jain, P.K. (2018).Financial Management: Text, Problems and
Cases (8 ed.). India: McGraw Hill
• Chandra, Prasanna (2019). Financial Management: Theory & PracticeCases (10
ed.). India: McGraw Hill
• Pandey, I. M. (2021). Financial Management (12 ed.). India: Pearson Education.
• http://sbesley.myweb.usf.edu/notes/capbud-CF.pdf
• https://resource.cdn.icai.org/62104bosinp8cp7.pdf

6.11 SELF-ASSESSMENT QUESTIONS

MULTIPLE CHOICE QUESTIONS
Q.1 Which of the following is an example of Terminal Cashflows:
a) Additional Working Capital
b) Revenue
c) Release of Working Capital
d) Purchase of Machinery
Q.2 Sales proceeds of old machinery for replacement with new machine is an example of:
a) Initial Cashflows
b) Operating Cashflows
c) Terminal Cashflows
d) Recurring Cashflows
Q.3 Any increase in existing fixed cost allocation to replace machine should be treated as:
a) Increase in Cash Inflow
b) Increase in Cash Outflow
c) No change in Cashflow
d) Onetime Cash Outflow
Analytical Questions:
Q.1 The Net Profit of ABC Ltd. is Rs 8000 for the year. Finance cost is Rs 1000. Depreciation
at the rate of 10% was charged on an asset with book value of Rs 10000. The firm is in
the tax bracket of 25%. Calculate the operating cash flows after tax for the year.
Q.2 Delta Ltd. purchased a machine at the cost Rs 5 lacs. Its useful life is 5 years and
depreciation is charged at the rate of 15%. The salvage value of machine at the end of
5th years is Rs 100000.Calculate the tax savings or tax expense in the terminal year.
The machine is the single asset in the block and firm’s tax rate is 20%.
Q.3 Orange Ltd launched new variant of its smart phone Elexier-V. The new product is
expected to generate cashflows of Rs 1 lac each year for next 5 years. However, it is
expected that due to new variant, sales of existing phones will reduce by Rs 10000

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NOTES each year. The new version, due to its popularity will lead to sales cost reduction by
10% which is currently Rs 50000 per year. Calculate the incremental cashflows for
each year from new product.
Q.4 Discuss the impact of Depreciation Tax Shield on forecasting of cashflows. Why
depreciation is to be deducted as expense to calculate cashflows in spite of being a
non-cash expense, explain with the help of a suitable example.
Q.5 Discuss the importance of cashflows for assessment of a project and factors which are
to be considered for forecasting cashflows.
Q.6 Compare and contrast the cashflow forecasting for expansion projects vis-à-vis
replacement project.
Q.7 Give examples of Initial cash flows, operating cashflows and terminal cashflows with
their explanations.

6.12 CHECK YOUR PROGRESS-POSSIBLE ANSWERS

CHECK YOUR PROGRESS-I
Q.1 Tax Shield
Q.2 Operating Cashflows
CHECK YOUR PROGRESS-II
Q.1 Initial
Q.2 Cost of New Machine Less Sales Proceeds of Old Machine
CHECK YOUR PROGRESS-III
Q.1 Cash Outflow
Q.2 deducted from cash inflows of new product

6.13 ANSWERS TO SELF-ASSESSMENT QUESTIONS

ANSWERS TO MULTIPLE CHOICE QUESTIONS
Q.1 C
Q.2 A
Q.3 C

ANSWERS TO ANALYTICAL QUESTIONS

Q.1 Operating Cashflows = Net Profit + Depreciation + Int*(1-T)
= 8000+1000+1000*(1-0.25) = 9750

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Q.2 Solution: NOTES

Q.3 Incremental Cash Flows per year from new product:

Cash flows from new product = 100000
Less: Loss of cashflows on existing products= (10000)
Add: Savings in sales cost = 5000
Net Incremental Cashflows from new product = 95000

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UNIT 7

COST OF CAPITAL

STRUCTURE
7.0 Objectives
7.1 Introduction
7.2 Relevance of Capital structure
7.3 Concept of Opportunity Cost of capital
7.4 Factors Affecting Cost of Capital
7.5 Cost associated with Different Long-Term Sources of Finance
7.6 Weighted Average Cost of Capital
7.7 Let’s Recapitulate
7.8 Key Words
7.9 References And Suggested Additional Readings
7.10 Self-Assessment Questions
7.11 Check Your Progress- Possible Answers
7.12 Answers to Self-Assessment Questions

7.0 OBJECTIVES
On completion of this unit, you should be able to:
• Understand the concept of Cost of Capital
• Know the significance of cost of capital
• Understand the costs associated with the Long-term sources of Finance; Cost of
Equity, Cost of Debt, Cost of Preference Capital and Cost of Retained Earnings
• know the concept of Weighted Average Cost of Capital and its calculation
• Understand the factors affecting the Cost of Capital.

7.1 INTRODUCTION
We know to run a business we need funds or capital. Finance is the bloodline of very business
activity. But the question is How a business gets money? Is it free of cost? No, money is
always available at a cost. There are various ways by which business can raise funds

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a. Equity Share capital NOTES

b. Debt Capital/ Borrowed capital
c. Preference Share capital
d. Retained Earnings
Every source has its cost. The cost of capital is the rate which a company must earn in order to
meet the expectations of various investors like shareholders, Bond holders, etc... In simple
words, we can say it is the minimum rate which an investor would require, hence it is the
required rate of return by the investor.
If a company is not earning minimum rate of return, then investors would not like to part
their money and it would be difficult to raise funds for the company. Equity shareholder’s
expect dividend and capital appreciation on their investment. If they expect that a company
will not be able to generate required return, then they would not invest in its shares and
invest in the company which will give them their expected returns.

7.2 SIGNIFICANCE OF COST OF CAPITAL

1. Yardstick to Evaluate Projects
One of the most significant purpose of using cost of capital is to evaluate the
investment proposals. In the chapter” Basics of capital Budgeting”, we have seen
there are various evaluation techniques which help the company to appraise the
projects. For example, one of the very important technique to evaluate projects is Net
Present Value. Project would be accepted if Net present value is positive otherwise
rejected. NPV is the difference between present value of cash inflows and present
value of cash outflows. Present value of cash flows is determined using discount rate
which is nothing but cost of capital. In IRR method also, we use cost of capital to
compare the calculated IRR. If IRR is greater than cost of capital then the projects can
be accepted. In this context, we call cost of capital as “Hurdle Rate”.
2. Designing the Optimal Capital Structure Mix
Every company wants to maximise the wealth of shareholder, in order to achieve that
one of the focus area is to form the optimal capital structure which means mix of
equity and debt in the proportion that will lead to minimisation of cost. A company can
have all equity or mix of equity and debt. It all depends upon the cost of each source
which a finance manager would compare and choose the source which has lower cost.
Debt in capital structure reduces the overall cost of capital as it is the tax deductible
expense but increase the financial risk of the firm due to the fixed obligations. Hence,
in designing the financial policy of using debt and equity, the firm aims at wealth
maximization by ensuring the trade-off between cost of capital and risk.
Performance Evaluation of Managers, Dividend decisions, Working capital
management, many other crucial decisions by top management are greatly
influenced by cost of capital.

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NOTES 7.3 CONCEPT OF OPPORTUNITY COST OF CAPITAL

It is important to understand the concept of opportunity cost of capital so that decision can
be taken to choose the best alternative. Opportunity cost of capital is the benefit forgone on
next best alternative with similar risk which is sacrificed, to choose the current one. For
example: An investor can choose between investing in Fixed deposit with 6.5% p.a rate of
interest or public provident fund with 7% rate of return. Both the options have equivalent
risk. If you decide to invest in Fixed deposit then you have forgone the opportunity of
investing in public provident fund.

7.3.1 RISK AND REQUIRED RETURN OF SHAREHOLDERS AND DEBT HOLDERS

Fig: 7.1: Risk Characteristics

Investors due to different risk characteristics in different investment avenues will expect
different rates of return. Higher the risk of a security, higher would be the expectation of
return. Government Bonds are less risky than corporate bonds as they are backed up by
government. Creditors / Bond holders have priority claim over assets hence they are less
risky than preference share capital. But preference shareholders have priority over equity
shareholders in terms of getting dividend so they are less risky than equity shareholders. The
payment of dividend to equity shareholders is not mandatory and price of shares fluctuates
more. Hence it is the most risky than any other capital. Risk characteristic of each security is
shown above in Fig-7.1.

7.4 FACTORS AFFECTING COST OF CAPITAL

1. Tax Rates- Debt is the tax-deductible expense so if the tax rate is higher then it is
prudent for company to go for Debt Capital in order to keep cost of capital lower.
2. Dividend Policy- Dividend policy is also an important factor affecting cost of capital.
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When a company makes profits, it can either distribute it in the form of dividends or NOTES
retain them. In both the cases, shareholders would benefit. Cost of Equity would have
direct impact of firm’s dividend policy. Choice of dividend policy would change the
cost associated with raising funds through equity.
3. Risk- Both Financial risk and Business risk affects the cost of capital of a firm. Financial
risk means use of high debt in the capital structure i.e due to financing decision
whereas business risk is due to the investment decisions. Higher the risk, higher would
the cost of capital. Any investor would expect higher return in case of higher risk in the
company. Hence, cost of capital would be high.
4. Level of Interest rates- Interest rate depends upon the demand and supply of funds in
the economy. Cost of Debt is greatly influenced by general interest rates in the
economy prevailing at the time of raising the funds. Hence, it would affect the cost of
capital.
Capital structure, Investment policy, market conditions in the economy are some
other factors that will influence cost of capital. Most of the factors are systematic
(Uncontrollable) and keep on changing with time. Management must regularly review
the cost of capital and take appropriate decisions from time to time.

7.5 COST ASSOCIATED WITH DIFFERENT LONG-TERM SOURCES OF FINANCE

Fig. 7.2: Cost of Various source of Capital

Cost of Debt

Cost of Preference Share capital

Cost of Equity

Cost of Retained Earnings

7.5.1 COST OF DEBT

A firm can raise debt capital either in the form of loan or by issuing the bonds/debentures to
investors in the market.

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NOTES Debt can be raised through various sources as depicted in Fig:7.3

Fig. 7.3: Sources of Debt

Loans from
Banks

Issue of
Bill
Debentures/
Discounting
Bonds

Borrowings
Inter from Non
Corporate Banking
Loans Financial
Institutioins

FEATURES OF BONDS
• Credit instrument- A debt security is a type of loan. Debenture holder is a creditor
of the company.
• Par value – Face Value and Issue Price: Each bond carries a face value which may
be for example, Rs 1000. This is the nominal value of bond. It is used for
accounting purpose and coupon is calculated on face value. Corporate bond may
be issued at a discount, at par or at a premium with reference to its face value. The
price at which a bond is issued to investor is known as its issue price.
• Maturity date – Fixed maturity date, when the bonds must be re paid or
redeemed.
• Issue date – when the bond was issued
• Coupon Rate: Bonds carry a coupon rate which may be fixed rate (for example
12%) or a floating rate linked to some base rate. For example, a floater bond may
have coupon such as “5 year G-Sec rate + 2%”. Where 5 year G-sec rate is base rate
and keeps on changing as the rates of central government securities change while
2% is the spread which remains fixed for the entire tenure of the bond. Coupon
payments are made to investors periodically for example coupon may be paid
quarterly, semi-annually or annually.
• Redemption value is the amount which is paid to investor at the time of maturity
of bond. Face value and redemption value-are mostly same but different in some
cases.
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7.5.1.2 CATEGORIES OF BONDS NOTES

Bonds can be divided into various categories:
Fig. 7.4: Types of Bonds

1. Perpetual Bonds- Bonds which do not have any maturity period.

2. Plain vanilla Bonds- These Bonds are redeemable in nature having coupon or fixed
interest rate with fixed maturity period.
3. Zero coupon Bonds- Bonds which do not have any coupon; they are issued at discount
and redeemable at par. There are other types of Bonds too but in this section we will
focus on above three types of bonds.

7.5.1.3 INTEREST TAX SHIELD

Debt in the capital structure helps the company to save tax as interest on debt is the tax-
deductible expense. Let us understand this with the help of an example: Income tax is
calculated on the net income before tax (Income – Expenditure). If the expenditure increases
the net income would fall, and hence the tax liability is also reduced. This reduction in the tax
liability due to existence of interest expenditure in a firm’s cost structure is called interest tax
shield. This benefit is not available, if the company raises the funds through Preference share
capital or equity capital. The return to holders of these instruments is paid in the form of
dividend. Dividend is paid out of the earnings available after tax. Therefore, payment of
dividend does not result in any tax deductions. On the other hand, if company raises funds
through debt then return to holders of debt is given in the form of interest. Interest is paid
from the income before tax, which leads to reduction in the tax to be paid by the firm. The tax
saving caused by interest cost is called Interest Tax Shield. Let’s understand this with the help
of following example:
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NOTES Calculation of Interest Tax Shield

Profit & loss account of ‘X’ Ltd for the year ending 31st Mar 2019
(₹ crore)
Expenditures Amount Income Amount
Total expenditure 0 Total Income 100
Net taxable income 100
Total 100 Total 100

Suppose the Income tax is charged at the rate of 30%, then the tax amount would be ₹ 30
crore (100 x 0.30).
Now to see the tax shield effect, let us take the same example, assuming the company has
raised a loan of ₹ 200 crores from SBI @ of 10% p.a. The interest paid on the loan is genuine
expenditure incurred for earning the business income and is allowed as a tax-deductible
expenditure.

Profit & loss account of ‘X’ Ltd for the year ending 31st Mar 2019

(₹ crore)
Expenditures Amount Income Amount
Interest 20 Total Income 100
Net taxable income 80
Total 100 Total 100

The tax amount would be ₹ 24 crore (80 x 0.30). Thus, generating a tax saving of ₹ 6 crore
(30 – 24). The tax saving resulted due to tax deductible expenditure of ₹ 20 cr.

Fig. 7.3: Cost of Debt

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Fig: 7.4: Redemption of Debt NOTES

Debt is raised through many sources. It is raised at a fixed rate of interest which the borrower
has to pay to the lender. Debentures or Bonds may be issued at par i.e. at the face value or
below or above the face value
Let’s understand with the help of an example:
Suppose a company issues 7% Debentures with a face value ₹ 100/- for 5 years. If a company
issues it at par, a premium of 5% or discount of 5% then the value would be as follows:

7.5.1.4 COST OF DEBT ISSUED AT PAR

What is the Cost of Debt?
Every company incurs some cost to raise funds. The return which a bondholder expects from
the company becomes the cost of debt for the company. In other words, an investor would
part the money only if he would get some return on investments. The return expected by
investors becomes the cost for the company. Debt is considered to be less risky for an
investor. Hence, the expected return would be less in the case of debt as compared to equity.
Case-1 Cost of Debt issued at par and redeemed at par
If the debt is issued at par, net proceeds collected by the firm would be equal to the
redemption value. In other words, we can say, amount borrowed by firm would be equal to
the maturity amount. No premium or discount would be there in this case.

Coupon amount= Amount of Interest

P0 is the issue price of the Bond/Debenture

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NOTES Example 1:
ABC Ltd issues 7%, ₹ 100 Face value Bond at par and redemption is also at par. What is the
cost of debt if tax rate is 30%?
Coupon amount= 7%*100= ₹ 7, P0= 100, t= .30

We have multiplied Interest with (1-t) as coupon/Interest is tax deductible.

7.5.1.5 CASE-2 COST OF DEBT IN CASE OF ISSUED AT A PREMIUM

The cost of a debenture to the company is the rate which equates the amount borrowed
from the issue of debenture to the future cash flows in the form of coupon payments and
maturity amount or principal repayment.

P = C (1 – t) x PVIFA(kd%, n) + R x PVIF(kd%, n)

where,
C = Coupon (interest)
kd = post-tax cost of debenture capital
t = Corporate tax rate
R = Redemption value
P = Net amount realized per debenture
n = maturity period.

An approximation formula as given below can also be used.

Example 2:
ABC Ltd has issued debentures for ₹ 100 crores. carries a rate of interest of 12 percent with a
face value of ₹ 100. The debenture is redeemable at a premium of 5 percent after 10 years
and interest is payable annually.
If corporate tax rate is 30%, calculate the cost of the debenture to the company?

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Solution NOTES
Given Coupon = ₹.12 (12% of 100), tax = 0.3, Price= ₹.100, and n = 10 year ₹, Redemption =
₹.105
the cost per debenture (kd) will be:

kd= 8.68%

7.5.1.6 CASE -3 COST OF DEBT ISSUED AT A DISCOUNT

Example 3:
ABC Ltd has issued debentures for ₹ 100 crores having face value of ₹.100 and carries a rate of
interest of 11 percent. The interest is payable annually and the debenture is redeemable at
par after 10 years.
If ABC Ltd issues debenture at a discount of 5% and the corporate tax rate is 30%, calculate
the cost of the debenture to the company?
Solution-3
Given Coupon = ₹.11 (11% of 100), tax = 0.3, Price= ₹ 95 (100-5%*100), and n = 10 yea ₹,
Redemption = ₹.100
the cost per debenture (kd) will be:

7.5.1.7 COST OF DEBT USING PRESENT VALUE METHOD (YIELD TO MATURITY APPROACH)
We can use Present value method also to calculate the cost of redeemable debt by
discounting the future cash flows by using Internal rate of return. IRR have been discussed in
the unit “Basics of Capital Budgeting”. In case of Debt instrument, yield to maturity is the
Internal rate of return. YTM is the rate which equates the present value of cash inflows and
present value of cash outflows.

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NOTES Example 4:
10% Bond, Face Value ₹100 redeeming after 5 years, Tax rate is 35%, issued at ₹85. What is
the Cost of Debt?
Step 1: Identify the cash inflows and cash outflows from the Bond
Step:2 Take two discount rates and calculate Net present Value
Step3 : Calculate IRR using trial and error method
Below example, we are taking two discount rates 10% & 15%

ra =Lower discount rate chosen

rb = Higher discount rate chosen
Na = NPV at ra
Nb = NPV at rb

= 10.60%

Alternatively, we can use IRR function in Excel

=IRR (Values, Guess)

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Here, Values: Cash outflow and cash inflows Guess: any rate or leave blank NOTES

= IRR (Values, Guess rate)

Here, for the firm, cost is 10.6% which is more than the coupon rate of 10%. This is so because
company will receive only Rs 85 for bond with face value of Rs 100 and will pay coupon of
10% on the face value. The cost of firm will be higher than coupon rate which is 10.6%
The effective cost of debt will be Kd*(1-T) = 10.6%*(1-.035) = 6.89%

7.5.1.8 COST OF IRREDEEMABLE DEBENTURES / BONDS

Perpetual Bonds as discussed earlier are type of bond which does not have maturity period.
Or in other words which are not redeemable by the issuer. We can calculate cost of
irredeemable debentures or perpetual bonds as follows

kd= cost of debt

Interest = Annual interest payment
t= tax rate
Net Proceeds= Price less issue expenses
For example: A company issues 5000, 10% debentures at a face value of ₹ 100 each issued at
a discount of 5%. Underwriting cost and other issue expenses are 1%. Tax rate is assumed to
be 50%. In this case, out of ₹ 100, ₹ 94 is net realised amount by the company. Cost of debt
would be as follows:

7.5.1.9 COST OF ZERO-COUPON BOND

As we know, zero coupon bond is the bond which are issued at discount and redeemable at
par and there will be no coupon or interest.
Example 5:
A ZCB issued at 2000/- redeemable after 10 years at 10,000. What is the cost of debt?

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NOTES CHECK YOUR PROGRESS-I

Q.1 PQT Ltd has issued debentures with a face value of ₹.100 and carries a rate of interest
of 12 percent. The debenture is redeemable at par after 5years and coupons are paid
annually. Tax rate:50%, Calculate Cost of Debt.
Q.2 Perpetual Bonds carries fixed coupon rate having fixed maturity date. True/ False
Q.3 Cost of debt is Tax Deductible. True/ False
Q.4 There is no coupon in Zero Coupon Bonds. True / False

7.5.2 COST OF PREFERENCE CAPITAL

Let’s understand Preference share capital
Preference shares are the share capital which carries fixed dividend and investors enjoys the
preference of getting the dividend prior to equity shareholders. At the time of liquidation,
preference shareholders will get preference over equity shareholders. It is important to note
that dividends are paid out of profits and it is not an expense hence it is not tax-deductible
unlike interest paid to the bondholder.
Fig. 7.5: There are different categories of preference shares:

7.5.2.1 COST OF REDEEMABLE PREFERENCE SHARES

Redeemable Preference Shares are those which have a definite maturity period. In India
firm’s are allowed to issue only redeemable preference shares with a maximum maturity of
20 years.
The cost of a redeemable preference share (kp) is the rate at which cash received from
preference capital issue equals to the amount to be paid by the company in the form of fixed

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. dividend payment and principal payments, which can be NOTES

P = D x PVIFA(kp%, n) + R x PVIF(kp%, n)
where,
kp = cost of preference capital
D = preference dividend per share payable annually
R = redemption price
P = net amount realized per share and
n = maturity period
An approximation formula as given below can also be used.

Example 6
Vedanta Ltd issues redeemable preference shares. Face value of each preference share is
Rs.100 and carries a dividend rate of 13 percent payable annually. The share is redeemable
after 10 years at par. is Amount realized per share would be ₹.98, what is the cost of the
preference capital?
Solution
Given that D = 13, R = 100, Price= 98 and n = 12

7.5.2.2 COST OF IRREDEEMABLE PREFERENCE SHARES

Irredeemable Preference Shares are those which do not have a definite maturity period.
These are like perpetual bonds.

A dividend is an expected dividend calculated on the face value

P0 is the issue price of preference share
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NOTES Example 7:
NHAI issues irredeemable preference shares at ₹ 100/-face value with a 12% dividend at par.
What is the cost of a preference share?

CHECK YOUR PROGRESS-II

Q.1 REC issues irredeemable preference shares at ₹ 100/-face value with a 10% dividend at
par. What is the cost of a preference share?
Q.2 Preference shares carries Fixed rate of dividend. True/ False
Q.3 Cost of Preference share should be calculated on after tax basis. True / False

7.5.3 COST OF EQUITY

Equity share capital is one of the long-term financing sources of the company. Equity shares
are issued to the general public. These are non-redeemable and carry voting rights in the
company. Equity shareholders being the owners of the company carry the right to share the
profit after all the commitments are met. After meeting all commitments, left-out profit is
either distributed to the shareholders in the form of dividends or retained for further
expansion of business. Retained profits are also called internal equity. If the company is
raising fresh funds for expansion then it would be termed as external equity. Now the
question is, Is there any cost of equity? Of course, yes as nothing comes free. The
shareholders do have certain expectations in terms of return if they are investing in the
company. If this money would have been invested somewhere else then they would have
earned some return. This return is termed as opportunity cost i.e. cost of next best
alternative forgone. That means the cost of equity is nothing but the opportunity cost.
It is difficult to measure the return required by equity shareholders accurately as dividends
are not mandatorily to be given by company. Also, equity shares do not have any maturity
period unlike most of the debentures are.
There are several ways to estimate rate of return. Two popular methods are Dividend
capitalization approach and capital asset pricing model.
Fig. 7.6: Approaches to Lost of Equity

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7.5.3.1 DIVIDEND CAPITALIZATION APPROACH NOTES

Equity shareholders earn a return from shares in two ways: one is dividends and the other is
capital appreciation in share. According to the dividend capitalization approach, the intrinsic
value or fair value of an equity stock is equal to the sum of the present values of the cash
inflows. Cash inflows in case of equity are dividends, assuming that the share is held till
perpetuity

𝑛 𝐷𝑡
𝑃𝑒 = ∑ 𝑡
𝑡=1 (1 + 𝑘𝑒 )
where,
Pe = price per equity share
Dt = Expected Dividend after year “t”
ke = Cost of Equity or Required rate of return by investors
It is challenging to forecast the dividend accurately perpetually so above model cannot be
used as it is. Therefore, the growth in dividends can be categorized as nil or constant growth
or supernormal growth and the above equation can be modified accordingly.
Dividend Pattern can be following ways:
Fig. 7.7: Dividend Pattern

7.5.3.1 A CONSTANT GROWTH

The cost of equity is the rate at which present value of share equals to the present value of
future cash flows which are expected dividends . For instance,. Assuming there is a constant
growth rate in future dividends, the above equation can be written as:
𝐷1
𝑃0 =
𝑘𝑒 − 𝑔
The cost of equity capital (ke) will be:
𝐷1
𝑘𝑒 = +𝑔
𝑃𝑒
The above equation is based on certain assumptions:
1. Dividend (D1) > 0
2. Dividends grow at a constant growth rate (g) and g <ke.
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Cost of Capital

NOTES 3. The market price of a share is the discounted value of expected dividends.
Example 8:
The current market price per share of Cample Ltd is Rs.500. The dividend expected per share
after a year is Rs.10 and the dividend per share is expected to grow at a constant rate of 10%
per annum. Calculate the cost of the equity capital to the company?
Solution
𝐷1
𝑘𝑒 = +𝑔
𝑃𝑒
10
= + 0.10
500
𝑘𝑒 = 12%

7.5.3.1B ZERO GROWTH

Cost of Equity can also be calculated if companies have zero growth pattern in dividends. The
cost of equity on which a constant amount of dividend is expected forever is as follows:
𝐷1
𝑘𝑒 =
𝑃𝑒

The growth rate (g) will be equal to 0 if dividend payout would be 100%. Under this situation,
dividends would be equal to their earnings.
𝐸𝑃𝑆1
𝑘𝑒 =
𝑃𝑒

Example 9:
The market price per share of Synergy Ltd is ₹.100. The dividend per share is expected to be
constant at ₹ 10/ forever. Calculate the cost of the equity capital to the company?
10
𝑘𝑒 = = 10%
100

7.5.3.1C SUPERNORMAL GROWTH

A company may pass through many phases of growth. A growth may vary in the future. It may
be very high for some yea₹ and then may stabilize at a constant rate for an indefinite period.
The dividend capitalization approach may also be used to calculate the cost of equity under
supernormal growth assumptions.

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The cost of equity (ke) can be calculated by solving above equation through trial-and-error NOTES
method
Example 10:
Assume that a company’s share is currently selling for 100/- Current dividend (D0) is ₹ 5/- and
are expected to grow at 15% p.a over next 3 yea₹ and then stabilize at 5% p.a forever. What is
company’s cost of equity?
Solution: Using super normal growth model, we can put all the information given in the
question in the equation

Solving ke by Trial and Error, we found ke= 11%

7.5.3.2 CAPITAL ASSETS PRICING MODEL APPROACH

According to this approach, the cost of equity is reflected by the following equation:

Ke= Rf+ßi (Rm-Rf)

where, ke = Cost of Equity or Required rate of return

Rf = risk-free rate of return

ßi= beta of security I
Rm =Market Return

CAPM Model represents the relationship between required rate of return and risk. It equates
the required return with two components risk free rate (reward for waiting/time) and risk
premium(reward for taking the risk). In CAPM, only systematic risk is taken in to
consideration which is measured by Beta. Systematic risk is the external risk or market
specific risk that cannot be eliminated by diversification.
Let us understand Beta (measure of systematic risk) Beta measures the sensitivity of
company’s stock with that of the market. It measures the response as to how much
company’s shares fluctuate with respect to the market fluctuations. Beta of the market is
always 1. Higher beta stocks mean more fluctuation hence more risk.
Under this approach, Cost of Equity depends upon two factors risk free rate of return + risk
premium
It is the compensation for taking risk which depends upon beta. Higher beta means higher
risk so higher risk premium. Lower beta means lower risk
How to calculate Beta?

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Cost of Capital

NOTES

Variance denotes the risk and covariance denotes co-movement between stock and market
index
Fig. 7.7: Cost of equity as per Capital Asset Pricing Model

Example10:
Let’ assume SBI has beta of 1.2, Return from market is 12.5% and risk free return is 6.5%.
Calculate cost of equity
Solution:
ke= 6.5+(12.5-6.5)*1.2= 13.7%

CHECK YOUR PROGRESS-III

Q.1. In CAPM, Beta measures the risk associated with company with respect to market.
True/ False
Q.2 Calculate Cost of Equity: Dividend is expected to grow at constant rate of 5%. Price of
ABC Ltd share is 200/-. And Expected Dividend is ₹10/- per share.

7.5.4 COST OF RETAINED EARNINGS

Company can decide to either retain the earnings and reinvest back in the company or
distribute the earnings in the form of dividends. If the earnings are reinvested then equity
shareholders needs to be compensated for using that money. With the premise that use of
money comes with the cost, there will be cost of retained earnings too. The cost of retained
earnings simply represents a shareholder's expected return from the firm's common stock.
Hence, cost of retained earnings would be equal to cost of equity.
As the new shares would not be issued if the earnings are retained so there would not be any
floatation cost. Hence, the cost of retained earnings would be less than the cost of Equity
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Floatation cost is the cost incurred by company while raising money through public issue. NOTES
Costs like underwriting fees, legal costs, registration fees and any other expenses incurred in
bringing initial public offer.

7.5.4.1 ADJUSTMENT FOR FLOATATION COST IN CALCULATION OF COST OF EXTERNAL

EQUITY
In case, there are certain floatation costs involved in the process of raising equity from the
market then the concept of external equity arises. Cost of External Equity is the rate which
equates the net proceeds from the raising the funds to the present value of dividends
expected to be received in future with the adjustment in the floatation cost. Under the
dividend capitalization model, the following formula can be used for calculating the cost of
external equity:

where,
K´e = cost of external equity
D1 = dividend expected at the end of year 1
P0 = current market price per share
g = constant growth rate applicable to dividends
f = floatation costs as a percentage of the current market price.

K´e = ke / (1- floatation cost)

where,
ke = rate of return required by the equity investors
K´e = cost of external equity
f = floatation costs as a percentage of the current market price.
Example 11:
Indraprastha Gas Ltd has got ₹.400 lakh of retained earnings and ₹.400 lakh of external
equity through a public issue. Required return of equity investo ₹ is 15% The cost of raising
funds is 5%. The cost of retained earnings and the cost of external equity can be determined
as follows:
Cost of retained earnings:

kr = ke i.e., 15%

Cost of external equity raised by the company:

K´e = ke / (1- f)
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NOTES = 0.15 / (1- 0.05)

K´e = 15.7%

7.6 WEIGHTED AVERAGE COST OF CAPITAL

Weighted average cost of capital is the total cost of raising the capital. We know that each
type of capital Equity, Debt, Preference share and retained are used in proportions and each
have different costs. After the calculation of cost of respective capital, they are multiplied
with proportion of funds raised in each capital. Following steps are involved for calculating
WACC.
1. Calculate cost of each source of funds.
2. Multiply the cost of each source by the proportion in the capital structure.
3. Add all the weights* proportion calculated in step 2
Fig 7.8: Weighted Average Cost of Capitals

Now the question arises whether a firm should consider the market value in calculating the
weights or Book Value
Let us first understand Book Value and Market Value

Book value: Values which are reflecting in the books of accounts are Book value. For ex. If the
firm raises capital using Equity shares worth 10,00,000 (1,00,000 shares @₹ 10/ each) then
₹ 10/- is the Book value per share and 10,00,000 is the total Book value. If Debentures are
also issued worth 5,00,000 (50,000 Debentures @ ₹ 100 each) then WACC as per Book Value
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would be as follows if ke=12% and After tax kd=9% NOTES

WACC= We*ke+Wd*kd

We= 10,00,000/60,00,000=.1667

Wd=50,00,000/60,00,000= .8333

WACC= 0.1667*12+0.8333*9= 9.16%

Using Book Value as weight have many disadvantages. Firstly, raising finance at
predetermine ratio is not realistic. Secondly, there are economic and other factors
determine the cost of raising funds. However, cost of capital using book value weight is easy
to calculate and supports the conservative approach of company.
Market Value: We all know that value of equity share and Debentures cannot be stagnant
and it fluctuates continuously. Both are tradeable in the secondary market. Lets assume
Equity share whose face value is ₹ 10/- and now the value of share increase to ₹50/-.
Similarly, value of Debenture, lets say is now 98/- per debenture. However, the books of
accounts will represent the earlier figure which are far from reality. Now WACC as per Market
Value weights would be as follows:

WACC= We*ke+Wd*kd

Equity= 50*1,00,000= 50,00,000, Debenture= 98*50000= 49,00,000

We= 50,00,000/99,00,000=.5051

Wd=49,00,000/99,00,000= .4949

WACC= .5051*12+.4949*9=10.51%
So, we can see that market value of cost of capital depicts the current situation whereas Book
value are based on accounting policies and reflect the historical values. Market Value is more
realistic as the value of equity and Debt are continuously adjusted with the changes in the
current value. It is very difficult to get market value of each component particularly Debt as
these are quite illiquid in the market. Market value weights also keeps on fluctuating due to
continuous fluctuations in equity prices.
Example 12
Equity Capital (1 lakh shares at par value) Rs.10/
12%Preference Capital (10,000 shares at par value) Rs.100/-
15% Debentures, Non-Convertible (70,000 debenture) Face Value Rs. 100/-
The current market price of equity share is ₹.30. Expected dividend per share is Rs.5.00
which is growing at a constant rate of 10 percent. The 12% redeemable preference shares
after 8 years issued at par (face value-100) and are currently priced at ₹.90 per share.
15% debentures are redeemable after 5year at par and their current market price is Rs.90
per share. The tax rate applicable to the firm is 50 percent. Calculate the weighted average 149
UNIT 7
Cost of Capital

NOTES cost of capital.

Solution-10
We will be following steps to calculate WACC
Step 1: Calculate the costs of the various sources of finance.
Cost of Equity

Cost of Preference Shares

Cost of Debt

Note: Market price can be as net amount realizable per share or debenture.
Step 2: Calculate the weights associated with the various sources of finance
Step 3: Multiply the costs of the various sources of finance with the corresponding weights
and add these weighted costs to determine the weighted average cost of capital
(WACC). Therefore,

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NOTES

with

with

We can see from above that there is difference in the WACC as per market values and WACC
as per Book Value. Market value gives more realistic value.

7.7 LET US SUM UP

Every business needs funds for day to day operations and for long term use. Funds are raised
through investors in the form of Equity, Bonds and Preference shares
Money received from various investors has cost to it. That cost is the cost of capital.
Cost of Debt is the cost from raising debt capital. Investors expected certain return from the
debt so its cost is the yield earned by investor which is interest (coupon) payments.
Equity includes equity capital and reserves & surplus. Dividends are not fixed in case of
equity shares and not mandatory for company to declare. Cost of equity is the opportunity
cost and risk factor.
Beta measures the risk of company with respect to market.
• Cost of Equity using CAPM approach is calculated as Rf+ ßi (Rm-Rf)
• Three Steps are involved in calculating WACC. First calculation of each cost
associated with sources of funds, secondly calculating the weights to each
component. Thirdly, product of cost as well as weights to determine WACC.
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NOTES 7.8 KEY WORDS

Cost of capital: is the weighted average of the costs of funds from all sources.
Capital Asset Pricing Model (CAPM): A model that establishes the relationship between
required return and risk.
Capital structure: The mix of the various debt and equity capital in the structure of the firm.
Dividend yield: Return earned on dividend streams
Face value: Stated value of any asset.
Perpetual Bonds: Bonds which have indefinite period.
Premium: If a bond is selling above its face value.
Risk free rate: The interest rate on a safe (not risky), asset
Risk premium: The difference between expected return and risk free return

7.9 REFERENCES AND SUGGESTED ADDITIONAL READINGS

Gulati. S, Singh. Y. P (2020), Financial Management, Mc Graw Hill
Pandey. M (2021), Financial Management, Pearson Publication, 12th Edition
Chandra, P (2019), Financial Management: Theory & Practice: Mc Graw Hill, 10th edition

7.10 SELF-ASSESSMENT QUESTIONS

Q.1 Beta of stock equals to 1 indicates
a. Stock is as volatile as market
b. Stock is more volatile than market
c. Stock is less volatile than market
d. None is true
Q.2 Which of the following is the characteristic of zero-coupon bonds?
a. Issued at par
b. Issued at premium.
c. It does not pay any coupon or interest
d. Perpetual in nature
Q.3 Cost of capital is
a. Return expected by investors
b. Dividend earned by shareholders
c. Floatation cost
d. Cost of legal expenses
Q.4 Cost of capital of Government Securities is
a. Return on Post office schemes
b. Considers as risk free rate

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c. Return on Equity NOTES

d. All of the above
Q.5 A company has retained earnings of Rs.72 lakhs and equity capital of Rs.38 lakhs. If the
equity investors expect a rate of return of 17% and the cost of issuing fresh equity is
6%, the cost of the external equity is
a. 16.4%
b. 17.4%
c. 17.7%
d. 18.1%
e. 19.1%.

7.11 CHECK YOUR PROGRESS- POSSIBLE ANSWERS

CHECK YOUR PROGRESS- I
Q.1 6%
Q.2 False
Q.3 True
Q.4 True
CHECK YOUR PROGRESS- II
Q.1 10%
Q.2 True
Q.3 False
CHECK YOUR PROGRESS- III
Q.1 True
Q.2 10%

7.12 ANSWERS TO SELF-ASSESSMENT QUESTIONS

Q.1 a
Q.2 c
Q.3 a
Q.4 b
Q.5 d

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UNIT 8

CAPITAL STRUCTURE

STRUCTURE
8.0 Objectives
8.1 Introduction
8.2 Equity vs. Debt
8.3 Factors affecting Capital Structure
8.4 Designing Optimal Capital Structure
8.5 Capital Structure Theories
8.6 Let Us Sum Up
8.7 Key Words
8.8 References And Suggested Additional Readings
8.9 Self-Assessment Questions
8.10 Check Your Progress-Possible Answers
8.11 Answers to Self-Assessment Questions

8.0 OBJECTIVES
On completion of this unit, you should be able to:
• Understand meaning & characteristics of different sources of capital
• Deduce the factors which impact the capital structure
• Appreciate the critical considerations for designing of optimal capital structure
• Understand the implications of various theories of capital structure

8.1 INTRODUCTION
Capital Structure reflects the composition of sources of funds used by an entity. A firm can
raise the funds through equity capital, debt capital, preference share capital or it can utilize
the retained earnings for financing a project of the firm. The firm has to decide the judicious
mix of sources of funds with reference to its unique business and financial risk. The decision
on composition of various sources of funds in the capital structure of a firm demands the
trade-off between the risk, cost & dilution of control. Each source of fund has its own pros
and cons. Let us discuss the benefits, cost and risk associated with each source of fund and
designing the capital structure of a firm.

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8.2 EQUITY VS. DEBT NOTES

8.2.1 MEANING & CHARACTERISTICS OF EQUITY CAPITAL
Equity Capital is the ownership capital contributed by promoters and shareholders of a firm.
These shareholders include the large institutional investors as well as small shareholders.
Residual Claim of Equity holders& Negligible risk for the firm
Equity capital is also known as risk capital introduced by owners in the business because
owners/shareholders enjoy the reward as well as bear the risk of ownership. They have the
last claims on earnings. Only after the claims of all other stakeholders are paid, the equity
shareholders can be paid the portion of remaining profits. These distributed profits are
known as dividends. The rate of dividend to be paid to shareholders is not fixed. After paying
to raw material suppliers, suppliers of other services, employees, interest to lenders and
taxes to governments, whatever profits are left, they are used to pay dividends. Rate of
dividend is decided by Board of Directors of firm keeping in consideration the profits
available for shareholders, past dividend rates, expected future performance of firm and
expectations of the shareholders. This rate of dividend is applied on the share capital which is
equal to number of shares outstanding multiplied by face value of shares.
The shareholders also have the last claim on the assets of the firm in case of liquidation of
firm. Once the claims of operational creditors, statutory liabilities and lenders are paid off,
the remaining assets will belong to shareholders. As the claims of shareholders on earnings
and assets are residual in nature, the equity funding does not pose any risk/threat to
existence of firm.
High Required Return on Equity
Because the shareholders are bearing the risk on their investments, they will require high
returns on their investments to compensate for the risk. Though the firm doesn’t have any
legal compulsions to pay them, but the investors will provide equity funding to a firm only
when they expect future growth and profitability which will result into high share price and
thereby wealth maximization of shareholders. Therefore, it is difficult for a firm to raise
equity funding unless it has sound operations, and bright future prospects.
Dilution of Control in Equity Funding
Shareholders enjoys the voting rights and control the affairs of firm. Shareholders of a
company elect the Board of Directors, which takes the decisions on their behalf. In case of
closely held company in which promoters have large shareholdings, promoter group enjoys
the significant control on the business decisions& operations. If a company raises funds from
the public in the form of equity, it leads to dilution of control. In case of widely held company
in which shareholding is scattered and spread among promoters & associates, institutional
shareholders and retail investors, major business decisions are taken by Board of Directors
elected by shareholders and day to day business is managed by management appointed by
the Board of Directors.

8.2.2 MEANING & CHARACTERISTICS OF DEBT CAPITAL

Debt is the borrowed capital invested in a business. A firm may raise the debt capital in the 155
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NOTES form of bank loans or by issuing bond/debentures to the general public. A bond/debenture is
a debt instrument floated by a firm in market to raise the funds in the form of borrowings.
The debt security offers a periodic coupon to its subscribers and repayment of principal on
maturity of debt paper. These bonds/debentures can be subscribed by the large institutional
as well as retail investors.
Priority Claim of Debtholders and High risk for firm
The payment of interest and principal is mandatory on the debt capital. Irrespective of
profits earned or losses incurred by a firm, interest and principal repayment has to be
honored whenever falls due. The debtholders have very strong claims on the firm’s earnings
and their claims are to be honored on priority. The delay in payment or default in the
payment of interest and principal results into legal consequences and may force the firm
into liquidation. Debtholders have priority claims on assets of firm in case of liquidation.
Their claims are to be paid before making any payment to providers of other sources of funds
namely, Preference Shareholders and Equity Shareholders. This makes the debt capital a
risky source of funds for a firm and their usage demands caution on the part of management.
Ease of Raising Funds through Debt
Now you must be thinking that if the debt capital is so risky then why the management raise
the money through debt. Why can’t they raise entire capital in the form of equity which
almost doesn’t pose any risk to the existence of a firm. The answer lies in the fact that once
the promoter’s savings are exhausted and firm needs the money for expansion, it is not easy
to raise the money from investors in the form of equity. Shareholders will commit their hard-
earned money only to a firm which has the potential to grow and offers them high expected
return in future. It is relatively easy for a firm to raise the money through bank loan or by
issuing bonds/debentures in the market because debt is relatively safer for the lenders. The
statutory requirement to mandatorily pay interest and principal repayment gives the bond
holders or bankers enough confidence to provide funds to the firm as they are offered fixed
periodic returns and compulsory repayment of principal on maturity.
Low Cost of Debt and Tax Deductibility of Interest
Interest rate on bonds or bank loans is always lower than cost of equity because of its
certainty of payment. Secondly, the interest payment on debt is tax-deductible in nature.
Tax-deductibility of interest payment arises from the fact that as per law, in the hierarchy of
payments to be made by a firm, interest is deducted from income prior to the payment of
taxes. This results into lower taxable income and firm ends up paying less taxes on its income.
This benefit is not available in case of other forms of financing namely preference share and
equity capital. The Preference dividend and dividend of equity shares is to be paid after
making the payment of taxes by the firm. Therefore, though dividends are causing the
financing cash outflow from the firm, they do not entail any tax benefit to the firm on their
payment. In case of debt because the payment of interest is made before tax payment, the
outflow of interest causes, profit before tax to decrease to the extent of interest expense
amount. This results into significant reduction in the tax amount to be paid by the firm. This
tax saving which is caused by presence of fixed interest cost in the cost-structure of firm is
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known as interest tax shield. Such benefit does not accrue to the firm if it raises the funds NOTES
through preference shares or ordinary equity shares. The benefit of interest tax shield makes
the debt a cost-effective source of funds. Effective cost of debt will eventually be lower than
the quoted or nominal cost of debt by the percentage of tax saved on interest expense.
Low Dilution of Control
Debt holders have no voting rights and generally do not interfere in the decision making and
day-to-day affairs of the firm. The controlling shareholders enjoy the full control and
decision-making power in the organization. There is no dilution of control at low to medium
level of debt in the capital structure of firm. However, debtholders protect their interest
through restrictive covenants. When the debt continues to increase and debt levels go up
then debt holders impose strict restrictive covenants like restrictions on further borrowing,
restrictions on further expansion etc. This helps them to ensure that their interest will
remain protected.
The relatively easy availability of debt and cost-effectiveness makes debt a preferred choice
for the firm though its excessive use is unwarranted due to its riskiness. The management
has to weigh the benefits against the risk posed by debt funding and should decide the
optimum proportion of debt in its capital structure. Let us elaborate on the factors affecting
the choice of capital structure in a firm.

CHECK YOUR PROGRESS-I

Q.1 The dilution of control is caused by the financing (equity/debt)
Q.2 The debt financing entails the cost and risk financing to
the firm. (high, low/low, high)

8.3 FACTORS AFFECTING THE CAPITAL STRUCTURE

There are several factors which have to be taken into account when designing the capital
structure of a firm.
i. Trading on Equity
A firm can design the capital structure by choosing the different combinations of
sources of funds. These sources include:
Equity Capital: The cost of equity is not fixed, and it will vary depending upon the
business and financial risk of the entity raising the funds. Equity holders will demand
higher return to fund the high-risk projects. However, as the returns to equity are not
committed, use of equity does not make firm risky.
Preference Shares: Use of fixed cost Preference Shares. The dividend on preference
shares is fixed. However, it is not mandatory to be paid in case of insufficient profits.
Debt: The cost of debt is fixed, and it is mandatory to be paid. This interest cost is tax
deductible and therefore effective cost of debt is less than quoted interest cost.
Use of fixed cost debt in the capital structure of firm is called Trading on Equity or
capital gearing. Use of fixed cost fund is beneficial for shareholders. Though this
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NOTES benefit is available in case of preference shares too but it is more pronounced in usage
of debt as preference dividends are not tax deductible and their cost is higher than
debt. Use of debt increase the return for shareholders when cost of debt is less than
the return on Investment (ROI). When the Return on Investment (ROI) of firm is more
than cost of debt(kd) that is ROI>kd, it increases the Earnings for Shareholders as the
returns earned on the capital invested, over and above the cost of debt belongs to
equity holders. This results into magnified Earnings per Share (EPS) and Return on
Equity (RoE). However, use of debt is risky due to mandatory payment of interest.
Therefore, in designing the capital structure the optimum level of leverage is
preferred, which keeps the risk in manageable limits and brings the benefits of trading
on equity.
EBIT-EPS analysis is an important consideration in designing the capital structure. At
different levels of EBIT, the effect on EPS is assessed for different combinations of debt,
equity & preference shares. Considering most probable level of EBIT, the financing
plan which results in maximum EPS is opted. We will discuss the EBIT-EPS analysis in
detail in next unit on ‘Leverage’.
ii Stability of Cashflows
A firm which has stable revenue and thereby stable stream of cash flows is more
capable of managing the risk of debt. As stable cashflows will allow to meet the
compulsory payment of interest and principal on debt. Firms with relatively stable
cashflows in different business cycles can therefore use more leverage to get the
benefit of more returns to equity holders.
iii. Growth in Sales
The firms in the growth phase of their life cycle will see increasing revenue and
cashflows over a period. Such firms are more capable to service the debt. Therefore,
high growth firms can use high level of debt to get the benefit of increased returns on
equity through debt usage.
iv. Cost of Capital
The cost of capital is the combined cost of capital of all the sources of funds, and it is
measured as Weighted Average Cost of Capital (WAACC). The adequate combination
of different sources of funds which will help to minimize the WACC should be preferred
as it will result in maximization of value of firm. The financing plan which helps to keep
the debt in manageable limits so that risk remains in control and cost of debt as well as
equity does not start rising should be preferred capital structure.
v. Control
Another important consideration in designing the capital structure is owner-
management control in the firm. The decision making and management of firm
remains in the hands of promoters and controlling shareholders. Raising the funds in
the form of equity results into widely held shareholding among large number of
shareholders. This may dilute the control of promoter/controlling shareholder group.
The equity comes with the benefit of no compulsory returns to equity holders and
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therefore no risk for the firm. However, the raising of large funds through equity will NOTES
result in dilution of control. On the other hand, use of debt funds and preference
shares does not result in any dilution of control because of no voting rights. The cost of
these fixed cost funds is also less in comparison to equity. However, fixed commitment
leads to risk. A proper balance must be maintained so that there is less dilution of
control as well as manageable risk.
vi. Risk
In designing the capital structure, riskiness of different sources of funds should be
considered. The preference shares and debt financing come with fixed commitment of
preference dividend and interest cost, respectively. The interest and principal
repayment on debt is mandatory as per law and therefore high usage of debt financing
makes the firm risky. The non-payment of these financing charges may force the firm
into bankruptcy. Though cost of these fixed cost funds is less than equity and that do
not result into dilution of control, the high usage of leverage will increase the risk.
Therefore, in designing capital structure the aspect of risk is to be taken into account
and fixed cost funds should be kept at adequate level.
vii. Flexibility
The capital structure is to be designed in a manner that it can be changed in future, if
required. If the firm has raised the funds through debt, it can repay it in case of high
availability of internal funds in the future. The high fixed cost funds can be replaced
with low-costdebt if cheaper debt is available in future. The use of preference shares
and debt allows the flexibility in capital structure as they can be redeemed when
needed or can be refinanced by a substitute source of funds. This flexibility is not
available in equity financing. Only option to buy back equity that too after complying
with all the legal conditions for buyback.
viii. Market Conditions
The prevailing market conditions at the time of raising the funds will also affect the
capital structure of a firm. If the equity market is conducive to raise the funds through
IPO then firm may prefer to raise the funds through equity as it can get higher
premium on shares issued in good times. On the other hand, if market interest rates
are low then it prefers debt financing to get the benefit of low cost funds.
ix. Internal Conditions of a Firm
A firm with low existing debt may find it easy to raise the debt capital. A firm with high
existing level of debt may not be able to raise the debt funding and therefore has to
resort to equity financing. On the other hand, equity funding may be difficult for a firm
which is small and has slow growth. The prospective equity investors may not be
willing to part their funds for a firm which does not offer promising returns. In such
conditions, debt financing is the only feasible option available for the firm.
x. Other Factors
There are other factors which also affect the financing of firm like purpose of
financing, floatation cost, legal requirements etc. if the project for which funds are 159
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NOTES being raised entails less business risk, then debt may be a preferred source of financing
to take the benefit of low cost. On the other hand, if business risk of investment is
already high due to volatile revenue or fixed operating cost then additional financing
risk due to debt financing is not advisable and equity financing should be preferred.
Floatation Cost is the cost of floating the new issue in the market. Floatation cost is
measured as a percentage of size of public issue. In case of large issues, there may be
saving on floatation cost. It is generally less in case of debt issue in comparison to
equity issue. Internal financing does not entail any floatation cost.
The legal aspects also affect the decision of capital structure. Post issue, legal
requirements are more stringent in case of debt financing and sometimes may put a
restriction on operational and strategic flexibility of firm in the form of restrictive
covenants put by lenders. The mandatory payment of debt charges may force the firm
into bankruptcy in bad times. On the other hands, there are more regulatory
requirements in raising the funds through equity. As the firm is raising risk capital it has
to ensure full compliance with the capital market regulations as well as company law
requirements.
Thus, designing the optimal capital structure requires balancing of many opposite
forces. Financing plan should be such that there is a trade-off between risk& cost and
at the same time benefits of leverage through trading on equity and dilution of
control, flexibility aspects should be considered to reach an optimal capital structure
for the firm. It will be different for different firms depending upon the business risk,
growth prospects, asset base and existing capital structure of the firm.

8.4 DESIGNING OPTIMAL CAPITAL STRUCTURE

An Optimum Capital Structure includes the following characteristics:
(i) Profitability: The capital structure of the firm should be designed in a manner that it
minimises the cost of capital and maximises the Earnings per Share (EPS) and Return
on Equity (ROE). The high use of cost-effective debt will help to reduce overall cost of
capital and thereby increasing profitability. At the same time, it will make the firm
riskier. On the other hand, high use of equity will increase the cost of capital thereby
reducing profitability. However, equity gives the benefit of negligible risk to the firm as
there are no mandatory payments to the shareholders. The cost of capital will be
minimized when there is a trade-off between risk and profitability.
(ii) Solvency: The level of debt should be kept in manageable limits so that firm’s solvency
remains intact. If the level of debt is high, then during bad times the firm may face
difficulty in the payment of interest and principal. The delayed payment or non-
payment of interest and principal may force the firm into liquidation.
(iii) Flexibility: The capital structure should be such that it gives enough flexibility and
allows the firm to choose the desirable debt & equity mix in future. If the firm has
already exhausted higher credit limits, then it may not be able to raise low-cost debt in
future. Also, the prospective equity investor will require higher return to invest in the
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firm as the firm has become risky due to high debt levels. NOTES
(iv) Conservatism: Firm’s capital structure should be designed conservatively, and the
level of debt should be such that company’s cashflows are sufficient to service the
interest and principal repayments even during the sluggish business environment.
(v) Control: The capital structure should be such that there is no excessive dilution of
control, and the controlling shareholders are able to exercise control and take value
enhancing decisions. If the firm opts the large equity funding, shareholding will be
scattered among large number of shareholders and promoter group will face dilution
of control.

CHECK YOUR PROGRESS-II

Q.1 The use of fixed cost funds to increase the return for shareholders is known as
. (Trading on Equity/Interest Tax Shield)
Q.2 Debt Financing will be suitable for a firm with cashflows. (Stable/High)

8.5 CAPITAL STRUCTURE THEORIES

In finance literature, there have been many researchers who looked into the aspects of an
optimum capital structure and whether capital structure is a relevant decision for value
maximization of a firm. Some of them argued that there exists an optimal capital structure.
Optimal capital structure implies the appropriate mix of debt and equity which brings the
benefit of trading on equity and low cost of debt and at the same time ensures that debt is
kept under manageable limits and risk does not rises. These theories include NI approach
and Traditional approach which favors that an optimal capital structure is a possibility, and a
firm should aspire to achieve this target capital structure which minimizes cost and therefore
maximizes the value.
There are other theories like NOI approach and Modigilliani & Millar approach which argues
that value of a firm is the result of its investment decisions which affects its operating
earnings and thereby value of firm. Merely by changing the financing decision a firm cannot
command higher value. There are extensions of MM theory like Trade-Off Theory and
Pecking Order Theory. Trade-off theory suggests that a firm aspires for a target capital
structure while the pecking order theory does not talk about existence of an optimal capital
structure. Rather, it argues that choice of source of fund is affected by signaling of
information and cost. Let us discuss the most important of these theories which is
Modigiliani and Miller approach who propounded that under the assumptions of perfect
capital market, the firms value is unaffected by choice of capital structure.

8.5.1 MODIGILIANI & MILLER HYPOTHESIS ON RELEVANCE OF CAPITAL STRUCTURE FOR

FIRM’S VALUATION
Modigliani & Miller work on relevance of capital structure spanned over several years.
Initially they proposed that if the capital markets are perfect then the value of a firm cannot
be affected by decision on capital structure. They proved that value of a firm is a function of
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NOTES its investment decisions and simply by changing the capital structure the firm’s value and
cost of capital cannot be changed. Therefore, Capital Structure decision is irrelevant with
regard to its impact on value of firm.
However, in their subsequent research work, they deduced that in the presence of corporate
taxes, capital structure decisions make a difference and affects the value of firm. The MM
Hypothesis on capital structure is divided into without taxes and with taxes. Let us
understand the impact of capital structure on firm’s value and overall cost of capital as
presented by Modigliani & Miller

8.5.1.1 MM HYPOTHESIS WITHOUT TAXES

MM propounded that if the capital markets are perfect, a firm’s value is independent of its
capital structure. The assumption of perfect capital market implies the following
characteristics of markets:
1. Investors are rational: This means that investors differentiate between the risk free
and risky investments. They will demand higher returns i.e. risk premium for making
an investment in the risky avenue. They want the returns which is commensurate with
the risk taken by them.
Rational behaviour also means that investor’s buying and selling behaviour will not be
influenced by greed or fear.
2. Symmetry of Information: This implies that Investors have symmetrical access to
information. It also implies that investors have the similar capabilities to analyze the
available information.
3. Uniform Borrowing & Lending Rates: This assumption implies that investors can
borrow and lend at risk free rate. This also means that individuals can borrow and lend
at a rate similar to corporates.
4. Divisibility of Shares: This means that investors need not buy and sell shares in
defined lot sizes. They can buy and sell as small quantity of shares as one stock.
5. No Transaction Cost: The assumption of absence of transaction cost implies that
investors can buy and sell shares without bearing any brokerages, transaction taxes or
any other charges. This means that gross value for purchase/sales of shares is equal to
the actual value paid or received by the shareholders.
6. No Taxes: This assumption implies that there are no taxes on the income of individuals
as well as corporates.
7. Homogenous Risk Classes: It is possible to classify the business in homogenous risk
classes based on their business risk and industry. This becomes the basis of arbitrage in
case of price difference between two businesses in same risk class with similar
operating earnings and only using different capital structure.
Under these assumptions of perfect capital market, MM propounded the following
three arguments in favor of irrelevance of capital structure on the value of firm.
I. The value of firm is determined by the projects in which it invests money. Value of a
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firm can increase if an organization is growing and making investment in the profitable NOTES
projects. The value will be destroyed if the company makes the investments which are
unprofitable or compromises future profits for the sake of present profits. Value if firm
is a function of Operating Income or EBIT and Overall cost of capital. Operating Income
or EBIT will change when the firm’s investments or Operations becomes more
efficient.
ii. The decision to make a change in capital structure from all equity firm to include the
debt in its capital structure does not result in the reduction of overall cost of capital.
When a firm begins to use the low-cost debt as a source of funds it becomes riskier. The
firm’s shareholders will start demanding higher returns to compensate for the
increased risk. This will result into off-setting of benefit of low-cost debt by the
increased cost of equity. The overall cost of capital will remain same and value of firm
being the function of EBIT & Cost of Capital will remain unchanged simply because of a
change made in capital structure.
iii. MM said if the two firms are exactly the same except their capital structure, they
cannot command different prices in the markets. If there is a temporary difference in
the value of levered and unlevered firms then it will present an arbitrage opportunity
to investors. Investors will indulge in selling the stocks of firms with higher prices and
invest in the firm with lower price and will be able to earn the same returns with lesser
investments or will be able to earn higher return on same investment. Because of
investors sale & purchase actions, the prices of high-priced will start coming down and
vice-versa till the time equilibrium is restored.
Let us understand the MM Hypothesis without taxes in detail with the help of
arbitrage process and impact of change in capital structure on cost of capital.

Preposition I- Arbitrage Process

Example:
When the value of levered firm is more than unlevered firm
There are two firms operating in Food FMCG Industry namely Brit Ltd. and Parl Ltd. Both the
firms are exactly same from operations perspective. Only difference between the two is their
financing pattern. Brit Ltd uses 5%debt of Rs 600000 in its capital structure and Parl Ltd is
funded through equity only. Both the firms have exactly same operating profit (EBIT) of Rs
200000. The Equity capitalization rate of Brit Ltd. is 12% and for Parl Ltd. 10%.

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NOTES

Market value of levered firm, Brit Ltd. is Rs 2016666.67 which include around 58% equity and
balance debt. Present market value of unlevered firm, Parl Ltd. is Rs 2000000. An investor
Riddhi holds 10% in the levered firm. Under the perfect market assumptions this difference
in market value of two firms which are exactly same except their capital structure will offer an
arbitrage opportunity to investors to sell the shares of overvalued firm and buy the shares of
operationally similar firm at lower price and make profits. Investor will be able to do this by
replacing the corporate leverage by personal lever age called as home-made leverage by
ModiGilliani & MIller. In MM perfect world the corporate and individuals can borrow and
lend at same rate. Let us see how this arbitrage process will work.
Step I: Riddhi is holding 10% stake in the Levered Firm. By virtue of being 10% owner it also
owes 10% of the firm’s liability. When the Brit Ltd. shares are overpriced, she will sell
her 10% stake.
Step II: Investor will borrow from market & thereby create home made leverage to replace
the corporate leverage of Brit Ltd. She borrows equivalent to 10% of debt of Brit Ltd
at the similar borrowing rate.
Step III: This money will be invested in unlevered firm Perl Ltd. 10% stake and it will result
into better financial rewards to investor. The process is explained in following table:

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NOTES

Income is same and surplus cash of 1666.67 with investor makes an attractive case for
arbitrage.
When the value of Unlevered firm is more than levered firm
In this case, arbitrage will work in opposite direction. Investors will sell the stake of unlevered
firm and buy the shares of levered firm to make more profits. This is explained as follows:

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NOTES Parl Ltd. (U)

Operating Profit (EBIT) 200000 200000

Interest (5% Debt) 0.00

Earnings available to Equity Shareholders 200000

Equity Capitalization Rate (Ke) 10%

Total Market Value of Equity (E) 2000000

Market Value of Debt (D) 0.00

Value of Firm (V = E+D) 2000000

Overall Capitalization Rate (Ko= EBIT/V) 10.00%

Debt Equity Ratio (D/E) 0.46 0.00

Investor Current Income 10% 20000

Investor Sells 10% Stake in Unlevered firm

200000

Invests in 10% Equity of Levered Firm 130769

60000

Invests in 10% Debt of Levered Firm

Total Investment in Brit Ltd. 190769

Income from Equity Investment in Brit Ltd. 17000

Income from Debt Investment in Brit Ltd. 3000

Total Income to Investor from Investment in Brit Ltd. 20000

Balance Funds in hand 9231

Income from Equity Investment in Parl Ltd. 200000

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Income is same and surplus cash of 9230.77 with investor makes an attractive case for NOTES
arbitrage.
Due to the arbitrage process, the shares of the overpriced firm will start coming down as
investors are selling them to buy the underpriced firm’s stock. This will result in increase in
price of underpriced stock. This process will continue till the time equilibrium is restored in
the stock price of levered and unlevered firm, which otherwise have similar operations.

Preposition-II
Impact of Change in Capital Structure on Cost of Capital
MM argued that when a firm uses the higher level of debt to take the benefit of its low cost, it
will not be able to reduce overall cost of capital (Ko). They explained that when an all-equity
firm begins to increase the level of debt then due to increasing proportion of low cost source
of fund in total capital, the overall cost of capital (Ko) should come down. But this does not
happen because when the level of debt goes up, the firm becomes riskier and equity
shareholders will require higher returns resulting into increased cost of equity (Ke). The
increase in cost of equity (Ke) will exactly offset the benefit of low-cost debt and therefore
overall cost of capital (Ko) will remain constant at all the levels of debt. This is demonstrated
by MM by derivation of equation explained below.
Overall Cost of capital is calculated with the help of following equation:

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NOTES

As per equation, Cost of Equity (Ke) for levered firm is more than cost of capital of an all-
equity firm by a factor which is directly proportional to Debt/Equity ratio in the firm, implying
that as the level of debt goes up, cost of equity goes up in the same proportion. This keeps the
overall cost of capital (Ko) or WACC constant. This is also depicted in the figure8.1. At very
high levels of debt, cost of debt will start rising due to increased risk. At such high debt level,
the firm almost belongs to debt holders, and they will share the risk. At such high levels of
debt equity holders required return will either increase at a decreasing rate or may even
slightly come down, this will result in keeping the overall cost of capital constant at all levels
of debt.
Fig. 8.1: MM Preposition II - Cost of Capital

Cost of Value of
Capital (%) Ke company (s)

WAAC
Kd

Gearing (D/E) Gearing (D/E)

Criticism of MM Hypothesis
The limitations of MM Hypothesis lie in its assumptions. There are many assumptions which
do not holds true in real life. This leads to impracticability of arbitrage process which is the
foundation of MM Hypothesis to prove irrelevance of capital structure in value maximization
of firm. Let us understand the criticism/limitations of MM Hypothesis without taxes.
i. Similar Borrowing and Lending Rate: The concept of Home Made leverage, which
enables the arbitrage process is based on the assumption that individuals can borrow
and lend the money at the rates similar to corporates. In reality, corporates have larger
borrowing power than individuals and can therefore borrow at more competitive
rates. The rate at which individuals will be able to borrow will be normally higher than
corporate borrowing rate. This implies that corporate leverage can not be exactly
replaced by homemade leverage of investors.

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ii. Homemade Leverage is not an exact substitute of corporate leverage: When an NOTES
investor invests in a levered firm then his exposure to the debt is limited to his
proportionate shareholding in the firm. In case of homemade leverage, the individual
has to bear the entire risk. The investors liability will be unlimited towards the
repayment of personal debt. This is not the case for corporate leverage as investors
liability is limited to only equivalent to his investment in levered firm. Therefore,
homemade leverage is not the perfect substitute of corporate leverage.
iii. For a realistic arbitrage process, transaction cost should be absent. However, in reallife
this assumption is not true. The investors have to pay brokerage and taxes everytime
they buy or sell the shares. This reduces the net gains to investors. The investors will
indulge in arbitrage only if the gain from price difference is more than the transaction
costs. The existence of transaction cost leads to arbitrage process not working fully
and possibility of some price difference between the prices of levered and unlevered
firm which are otherwise similar.
iv. Restrictions on Institutional Borrowings: The investors in stocks include the individual
as well as institutional investors. Institutional investors are bound by the rules &
regulations and may not be free to borrow as per their wish. They hold large stakes in
the firms. The restrictions on institutional borrowings does not allow for homemade
leverage to these large institutional investors and makes the complete arbitrage
process unrealistic.
v. Existence of Corporate Taxes: The assumption of absence of corporate taxes is very
important in proving the irrelevance of debt in value maximisation of firm. However, In
real life, corporate taxes exist. The interest paid on debt is tax deductible which makes
debt financing a cheaper source of fund and therefore makes the capital structure a
relevant decision for value maximization of a firm.

8.5.1.2 MM HYPOTHESIS WITH TAXES

Every year a levered firm will be able to save the tax due to presence of interest in its cost
structure. The saving in tax due to presence of interest is known as interest tax shield.
A firm with a level of debt equal to D will be able to save some tax every year which will be
equal to:

Here, D is the amount of Debt

Kd Is the Cost of Debt (in percentage)
T is Tax Rate
This becomes an infinite series of tax saving every year with no growth.
The present value of this infinite series of interest tax shield discounted at the rate of cost of
debt (Kd) is calculated as follows:

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NOTES

The present value of an infinite Geometric progression is mathematically equal to a/1-r.

Where a is the first term of series and r is the ratio between two terms.

Therefore, a firm with leverage is able to make the tax savings throughout its life. The present
value of this infinite series of tax saving, as derived above, is equal to TD. Therefore keeping
other things constant, a levered firm will be able to command more value in comparison to
an exactly similar unlevered firm. The difference in the value will be equal to Present value of
infinite Tax Savings in the form of Interest Tax Shield which is equal to TD. This can be
depicted in the form of following equation:

Here Vu = Value of Unlevered Firm

VL = Value of Levered Firm
TD = Present Value of infinite series of Interest Tax Shield accruing to Levered Firm
Therefore, as per MM Hypothesis with Taxes, Value of a levered firm will be higher than an
unlevered firm by an amount of PV of Tax Shield. As per MM, use of debt is beneficial for a
firm. Higher the amount of debt used by a firm more will be the benefit to levered firm.

Calculation of Interest Tax Shield for a given year:

The tax saving caused by debt i.e. Interest Tax Shield available to a levered firm every year can
be understood with the help of following example:
Example
The two firms are identical in its operations and earning the operating income (EBIT) of 16%
on their capital invested. All Equity firm has raised the entire capital of Rs 1000000 through
equity financing. The Debt-Equity firm has raised Rs 600000 through 8% debt and Rs 400000
through equity. The tax rate is 30%. Show the impact of debt financing on the tax expenses
and return for equity holders of the firm. Face value of each share is Rs 10.

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NOTES

From the above example it is clear that the two firms have exactly the same operations and
earnings. They can be considered as Siamese twins in terms of their operations. The only
difference is financing of capital. You can see that firm using the debt financing option is able
to save taxes of Rs 14400 due to existence of interest cost. This saving occurs because the
interest cost is a tax-deductible expense. Tax deductibility of interest cost implies that
interest cost is deducted from operating income before the payment of taxes. Therefore, the
taxable income (PBT) of firm comes down by the amount equal to interest cost. This results in
reduced taxes as the taxable income has come down. This benefit is not available to an all-
equity firm because the dividend to be paid to equity holders is not a mandatory expense
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NOTES and it is paid out of profits after taxes. Therefore, taxable income (PBT) of all equity firm is
higher than debt-equity firm. This results into higher taxes to be paid by all equity firm. The
tax savings accruing to the levered firm due to interest cost is known as ‘Interest Tax Shield’. It
can be seen from above example that the total earnings available to levered firm capital
providers are in excess to the earnings available to capital providers of unlevered firm. The
difference between the earnings available for all the providers of capital of a levered and
unlevered firm is exactly equal to interest tax shield.

8.5.2 TRADE-OFF THEORY

Trade-off theory suggests that there should be trade-off between cost and benefits
associated with debt. When the debt is increased in the capital structure of the firm, the
value of firm increases due to interest tax shield. The benefit of interest tax shield accrues to
a firm every year and value addition caused by it is equal to present value of this infinite
series of interest tax shield which is equal to TD.
However, when level of debt increases beyond the manageable limits then cost of financial
distress increases. Cost of Financial Distress includes the cost caused by the increased level
of debt. This increased debt makes the firm risky due to mandatory payment of interest &
principle irrespective of firms profits & cashflows. The risk is more when the business activity
is down and cashflows of the firm are stretched. Due to increased risk, the required return of
shareholders increases, and debt providers will also start demanding high returns. If the firm
is unable to honor the debt obligations, then it may force the firm into bankruptcy.
Cost of financial distress includes direct and indirect cost of bankruptcy and agency cost.
Direct cost includes the cost due to bankruptcy proceedings, legal cost, administrative cost.
The assets of the firm might have to be sold due to liquidation proceedings at distressed
prices. Indirect cost includes the cost of supplier, managers, employees, investors,
shareholder-debtholders conflicts etc. When the financial distress becomes too high then
operational creditors like suppliers, employees also become more cautious and they may
start demanding their dues, suppliers may stop credits to the firm or demand more
favourable payment terms, employees may leave the organization. The agency cost may
include two kind of issues, the conflict of interest increases between shareholders and
managers and between shareholders and debt holders. The managers may take the
decisions which protects their interest though it may be detrimental for the firm and destroy
the value. To protect their interest, debt holders may put certain restrictive covenants which
will put a limitation on flexibility of operations on the firm.
Thus, debt imposes two contrasting effects on the value of firm, interest tax shield benefits
cause value addition and cost of financial distress results in value destruction.
Value of Levered Firm = Value of Unlevered Firm + PV of Interest Tax shield -Cost of Financial
Distress
A firm should increase the debt until the point benefit of interest tax shield is higher than the
cost of financial distress. The level of debt beyond which cashflows of firm will be unable to
service the debt is the maximum level of debt a firm should resort to. It is the point at which
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benefit of interest tax shield is optimum and cost of financial distress is in control. This is NOTES
depicted in figure 8.2.
As depicted in the figure, value of levered firm is more than the unlevered firm. Value of
unlevered firm is depicted by a horizontal line. The benefits of debt in the form of PV of
Interest Tax Shield increases as the debt increases. This pulls-up the value of levered firm as
depicted by the highest increasing line in the diagram. On the other hand cost of financial
distress set-off the benefits caused by Interest tax Shield and pulls down the value of firm
shown as middle line in the figure. The optimum level of debt is one where the difference of
difference of PV of interest tax shield and cost of financial distress is optimum as represented
in the figure. Up to this point marginal benefit of debt is positive and use of debt will result in
value addition. Beyond this point, marginal benefit of debt will be negative and will result in
value destruction.
Fig. 8.2: Optimal Capital Structure – Trade Off Theory

Maximum
value of firm

Costs of
PV of interest financial distress
tax shields

Value of
unlevered
firm
Debt
level
Optimal debt level

The optimum level of debt is one at which there is a trade-off between cost of financial
distress and benefit of interest tax shield. This optimum level will vary from firm to firm or
industry to industry. A firm with stable cash flows and strong tangible assets have large debt
capacity and therefore, can enjoy the benefits of interest tax shield. The firm with volatile
cash flows and less strong asset base will find that cost of financial distress outweighs the
benefits of tax shield and therefore, should have lower levels of debt.
The theory is capable of explaining why capital structures differ between industries, whereas
it cannot explain why profitable companies within the industry have lower debt ratios (trade-
off theory predicts the opposite as profitable firms have a larger scope for tax shields and
therefore subsequently should have higher debt levels).

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NOTES 8.5.3 THE PECKING ORDER THEORY OF CAPITAL STRUCTURE

Pecking Order Theory is based on the premise of information asymmetry between the
managers and investors. It argues that managers have more information about the
operations and financials of an organization. If they need to raise the funds, they will raise in
a manner so that least information is revealed and ensure positive signalling to the investors.
Unlike the trade-off theory, it does not emphasize on a target capital structure. Rather the
managers will use the sources of funds in the order so that least information goes out to
investors.
As per pecking order theory there are three sources of capital, internal equity, debt and
external equity. Internal Equity is the retained earnings available to a firm, which is
shareholder’s money retained in the business. Myres developed this theory and stated that
there is no target debt-equity ratio. Out of these three sources debt is most cost effective due
to tax benefits. Internal Equity is costlier than debt but less costly than external equity
because of no floatation cost, transaction taxes etc.
The firm will raise the funds in the following order:
i. First the Internal Equity is used as no information needs to be revealed to investors
ii. If the internal financing is not sufficient then managers will prefer to raise the funds
through cost effective debt financing. If the managers of firm are more sure about
future profits then they would like to raise the funds through debt as issue of debt will
require compulsory debt servicing in future. Raising of funds through debt allows the
mangers to raise funds without sending any negative signals in the market.
Sometimes the managers would like to issue the debt to manage financial crisis
situation and they will raise the funds just before negative news goes out. Therefore,
sometimes even debt issue may send negative signals
iii. If the firm is unable to raise the funds from debt then only managers will prefer to raise
the funds through costly external equity. Issue of equity sends adverse signals to
market as it is perceived that managers will raise the funds through equity when
shares are overpriced.
The pecking order theory states that internal financing is preferred over external
financing, and if external finance is required, firms should issue debt first and equity as
a last resort. Moreover, the pecking order seems to explain why profitable firms have
low debt ratios. This happens not because they have low target debt ratios, but
because they do not need to obtain external financing. Thus, unlike the trade-off
theory, the pecking order theory explains differences in capital structures within
industries.

CHECK YOUR PROGRESS-III

Q.1 Investors can borrow and lend at a rate similar to corporate as per theory
of capital structure. (MM Theory/Trade-off)
Q.2 Cost of Financial Distress discourages the usage of as per theory.
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Q.3 As per packing order theory the preferred financing is in the sequence of NOTES
(Internal Equity, Debt, External Equity/ Internal Equity, External Equity, Debt)

8.6 LET US SUM UP

Capital Structure designing is an important decision, and it affects the profitability and value
of the entity. It is to be designed considering the cost, risk and various characteristics of
different sources of finance. Equity financing leads to negligible risk for the firm as the return
to shareholders are not mandatory. If the firm is making profit, it will distribute the dividends
to the shareholders. However, equity shareholders require higher returns due to risky nature
of their investment. Debt financing results into low-cost financing because payment of
interest is mandatory on debt. Due to less risk for debt providers, they will provide the funds
at lesser rate of return in comparison to equity holders. The tax benefit on interest expense
leads to the lesser effective cost of debt. However, debt funding poses the risk due to
mandatory payment of interest and principal repayment.
Designing of optimal capital structure should consider the various aspects like flexibility,
riskiness, cost, dilution of control etc. The composition should be such that firm does not
become risky. The debt financing should not be excessively used to avoid the risk of
insolvency. The capital structure should use adequate level of debt so that firm takes the
benefit of low-cost debt financing and interest tax shield benefits. The dilution of control is
the result of equity financing to public at large. This will lead to widely held shareholding and
promoter group control may be diluted as the large institutional investors will have a say in
the affairs of business. Capital structure should be flexible enough to allow the firm to
change the structure in future to take benefit of low-cost debt availability in future or rising
capital market.
There are many theories of capital structure, some of them argues that capital structure is an
irrelevant decision and does not have any impact on firm value. Value is created by the
investment choices made by the firm and not by the funding choices made for those
investments. Modigilliani & Miller in their hypothesis without taxes argued that two
identical firm cannot command different market value only because of the difference in their
capital structure. They supported their hypothesis by the investor actions in the form of
arbitrage process, which ensures that any temporary price difference in such firms will
quickly disappear and equilibrium will be restored in the prices of two otherwise identical
firms which have different capital structure.
On the other hand, some theories favours that capital structure decision is a relevant
decision and affects the value of firm. The argument in favour of relevance of capital
structure is that cost of capital is affected by the judicious mix of debt & equity. Because the
cost of capital is reduced, the value of firm will be optimized by designing an optimal
structure.
Modigilliani & Miller Hypothesis with Taxes favours the debt financing and argues that use of
debt results in the tax savings for a levered firm. This benefit is not available to an unlevered
firm. Therefore, value of levered firm will be greater than unlevered firm. Trade-off theory
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