ADVANCED FINANCIAL

MANAGEMENT
PROF. RAJIV CHANDRA
MBA (IIMA), ICWA, CS
SEMESTER 2
CLASS OF 2022
 TECHNIQUES OF CAPITAL BUDGETING
• PROCESS
– IDENTIFICATION OF POTENTIAL OPPORTUNITIES
• MONITOR EXTERNAL ENVIRONMENT REGULARLY
• FORMULATE CORPORATE STRATEGY – SWOT ANALYSIS, ETC
• SHARING STRATEGY, DIRECTION, BUDGET AVAILABILITY
• GET SUGGESTIONS – PART OF ANNUAL BUDGETING PROCESS
– ASSEMBLING OF PROPOSED INVESTMENT
• UNIT WISE
• DEPARTMENT WISE
• STANDARD FORMAT
• PROCESS OF APPRAISAL DEFINED – CAPITAL BUDGETING COMMITTEE
• CLASSIFIED INTO:
– REPLACEMENT
– EXPANSION
– NEW PRODUCTS
– OBLIGATORY / WELFARE
– R&D
– MISC.
– DECISION MAKING – DELEGATION OF AUTHORITY AT VARIOUS LEVELS
– PREPARING CAPITAL BUDGET AND APPROPRIATIONS – APPROVING BUDGETS/SMALL PROJECTS
– IMPLEMENTATION – DETAILED EXERCISE – FUND RAISING/PROJ. IMPL. TEAM
– PERFORMANCE REVIEW – MONTHLY REVIEW – PART OF UNIT/DEPT. REVIEW
• PROJECT COST, DELAYS, MILESTONES, CLEARANCES, PHYSICAL PROGRESS, PHOTOS
• BUDGET VS. ACTUALS
 INVESTMENT CRITERIA
• DISCOUNTING
– NPV
– BENEFIT COST RATIO
– IRR
• NON-DISCOUNTING
– PAYBACK PERIOD
– ACCOUNTING RATE OF RETURN (ARR)
 NPV

• YEAR 0 -1,000,000
• YEAR 1 200,000/1.1 = 200000*PVIF10%,1 YR
• YEAR 2 200,000/1.1^2
• 200000*PVIF10%,2YRS
• YEAR 3 300,000/1.1^3
• YEAR 4 300,000/1.1^4
• YEAR 5 350,000/1.1^5

• COST OF CAPITAL 10%

• NPV = SUMi=1 TO n (Ci/(1+r)^i
• NPV = -5272
• CAN USE ANNUITY TABLE IF CASHFLOW IS CONSTANT EACH
YEAR.
• C1..C5 = 200000 * PVIFA10%,5YRS=
 NPV
• FLOWS BEYOND 15 YEARS BECOME IRRELEVANT AS PV BECOMES VERY SMALL
%
• VALUE OF FIRM INCREASES BY NPV, IF PROJECT IS UNDERTAKEN
• WHEN ACQUIRING A PROJECT/COMPANY, IF PAID MORE THAN NPV, VALUE OF
FIRM DECREASES TO THE EXTENT OF EXCESS PAID
• THAT’S WHY IMPORTANT TO CHOOSE PROJECTS WITH HIGHEST NPV
• ASSUMES – INTERMEDIATE CASHFLOWS ARE REINVESTED AT COST OF CAPITAL
• TIME VARYING DISCOUNT RATES ARE PERMITTED
• LIMITATION – NPV IS EXPRESSED AS AN ABSOLUTE TERM RATHER THAN
RELATIVE
• LIFE OF THE PROJECT IS NOT CONSIDERED – WHEN COMPARING 2 DIFFERENT
PROJECTS WITH VARYING LIFE. BIASED IN FAVOUR OF LONGER TERM PROJECT

• PROJECT A – NPV = 100 I=200 BCR = PVB=300 /200=1.5 NBCR=0.5

• PROJECT B – NPV = 10000 I=5 CRORE BCR = 50010000/50000000=1.002
NBCR=.002
 BENEFIT-COST RATIO
• BCR = PVB/INVESTMENT

• NBCR = (PVB – I)/I = BCR – 1

• PV = 114500
• I = 100000
• NPV = 14500
• BCR = 114500/100000 = 1.145
• NBCR = 1.145-1 = 0.145
• RULE
– WHEN BCR>1 OR NBCR>0 ACCEPT
– WHEN BCR=1 OR NBCR=0, INDIFFERENT
– WHEN BCR<1 OR NBCR<0, REJECT
• HELPS IN RANKING THE PROJECTS
• LIMITATION – IF CASHOUTFLOWS OCCUR BEYOND YEAR 0, IT BECOMES UNSUITABLE
 IRR INTERNAL RATE OF RETURN
• RATE OF DISCOUNTING AT WHICH NPV=0
• METHOD OF TRIAL AND ERROR
• SUPPOSE 15% RESULTS IN NPV OF 801
• 16% RESULTS IN NPV OF -1364
• FIND SUM OF ABSOLUTE VALUES
• 801+1364 = 2165
• 801/2165 = 0.37
• SO IRR IS APPROX 15.37
• CRITERIA
– IF IRR>COST OF CAPITAL – ACCEPT
– IF IRR<COST OF CAPITAL – REJECT
– YEAR 0 1 2 3 4
– CASHFLOW (100000) 30000 30000 40000 45000
 RELATIONSHIP BETWEEN NPV AND IRR
• GRAPH
• IRR IS AT THE POINT WHEN NPV CURVE TOUCHES THE X AXIS
• SLOPE OF CURVE TELLS ABOUT SENSITIVITY TO DISCOUNT RATE
• BOTH LEAD TO IDENTICAL DECISION
• LIMITATIONS OF IRR
– MULTIPLE IRR RATES IF CASHFLOWS ARE NOT CONVENTIONAL
– IRR IS UNSUITABLE FOR RANKING PROJECTS
– HIGHER IRR NEED NOT MEAN HIGHER NPV – CAN USE INCREMENTAL CASH BASED
IRR.
– COST -10000 VS -50000
– INFLOW – 20000, 75000
– IRR 100%, 50%
– NPV – 7857, 16964
– INCREMENTAL -40000, C1= 55000, IRR=37.5, MUCH HIGHER THAN COST OF
CAPITAL
– LENDING VS. BORROWING
– CANT USE DIFFERENT RATES FOR DIFFERENT PERIODS
 MUTUALLY EXCLUSIVE VS. INDEPENDENT PROJECTS

• MUTUALLY EXCLUSIVE PROJECTS

• MARUTI VS FORD VS HONDA VS HYUNDAI
• NPV 500 VS 400 VS 1000 VS 800

• INDEPENDENT PROJECTS
• CEMENT 20 NPV 50
• TYRES 15 40
• PAINTS 30 10
• AUTO 40 -5
 MODIFIED IRR (MIRR)
• CALCULATE PRESENT VALUE OF THE COSTS/OUTFLOWS USING COST OF CAPITAL
• CALCULATE TERMINAL VALUE (TV) OF THE CASH INFLOWS USING COST OF CAPITAL
• WHERE PVC = TV/(1+MIRR)^n
• EXAMPLE
• YR.0 -120
• YR.1 -80
• YR.2 20
• YR.3 60
• YR.4 80
• YR.5 100
• YR.6 120
• COC = 15%
• PVC = 120+80/1.15 = 120 + 69.6 = 189.6
• TV = 20*(1.15)^4 + 60*(1.15)^3 + 80*(1.15)^2 + 100*(1.15)^1 + 120
• 34.98+91.26+105.76+115+120 = 467
• NOW, 189.6 = 467/(1+MIRR)^6
• (1+MIRR )^6= 2.463
• 1+MIRR = 1.162
• MIRR = .162 OR 16.2%
• EXPLAIN BY TIME LINE DIAGRAM
• MIRR IS DEFINITELY A BETTER OPTION THAN IRR
 REALISED YTM
• MKT PRICE = 1020
• FACE/MATURITY VALUE 1000
• COUPON 8%=80
• N=5 YEARS
• YTM = 80+(1000-1020)/5 / 0.4*1000+0.6*1020 = 80-
4=76/400+612=76/1012=7.51%
• 1020 = PVIFAr%,5yrs * 80 +PVIFr%,5yrs * 1000
• REALISED YTM, IF REINVESTMENT RATE IS 7%
• FVIFA7%,5yrs * 80 + 1000
• 1020 = PVIFr%,,5yrs * 1480
• R= (1480/1020)^(1/5)-1
 EXAMPLE
• YR 0 -1000
• YR 1 200
• YR 2 300
• YR 3 500
• YR 4 1200
• COC = 12%
• FIND IRR & MIRR
• IRR = PV OF INFLOW = PV OF OUTFLOW OR NPV=0
• NPV =
-1000+200/1+R+300/(1+r)^2+500/(1+r)^3+1200/(1+r)^4=0
• MIRR =FVIF12%,3yrs*200 + FVIF12%,2yrs * 300 +
FVIF12%,1yr * 500 + 1200=2000
• MIRR = (2000/1000)^1/4-1 =
 EXAMPLE - IRR
• TWO MUTUALLY EXCLUSIVE PROJECTS HAVE PROJECTED CASH
FLOWS AS UNDER:
• PROJECT A PROJECT B
YR. 0 -10000 -10000
YR. 1 5000 0
YR. 2 5000 0
YR. 3 5000 0
YR. 4 5000 30000

1. DETERMINE IRR.
2. FIND NPV TAKNG REQUIRED RATE OF RETURN 10%.
3. WHICH PROJECT WOULD YOU SELECT AND WHY? WHAT
ASSUMPTIONS ARE INHERENT IN YOUR DECISION?
 NPV
PROJ. A 10.00% PROJ. B 10.00%
CASH DISCOUN PRESENT CASH DISCOUN PRESENT
YEARS YEARS
FLOW T FACTOR VALUE FLOW T FACTOR VALUE

0 -10000 1 -10000 0 -10000 1 -10000

1 5000 0.90909 4545 1 0 0.90909 0
2 5000 0.82645 4132 2 0 0.82645 0
3 5000 0.75131 3757 3 0 0.75131 0
4 5000 0.68301 3415 4 30000 0.68301 20490
NPV =   5849 NPV =   10490
 IRR
34.90% 31.60%

YEARS CASH DISCOUN PRESENT CASH DISCOUNT PRESENT

FLOW T FACTOR VALUE YEARS
FLOW FACTOR VALUE

0 -10000 1 -10000 0 -10000 1 -10000

1 5000 0.74129 3706 1 0 0.75988 0
2 5000 0.549511 2748 2 0 0.57742 0
3 5000 0.407347 2037 3 0 0.43877 0

4 5000 0.301962 1510 4 30000 0.33341 10002

NPV =   1 NPV =   2
31.61%
34.90%
=10000/500 PVIFr,4 = =10000/30000
PVIFAr,4 = 0
0.333333
r = 35% 34.9 2
r= 31.60%
 MIRR
31.60%
0.15

CASH CASH DISCOUNT PRESENT

YEARS FV YEARS
FLOW FLOW FACTOR VALUE
 

0 -10000 -10000 0 -10000 1 -10000

1 5000 7604 0 1 0 0.75988 0

2 5000 6613 0 2 0 0.57742 0

3 0 0.43877 0
3 5000 5750 0
4 30000 0.33341 10002
4 5000 5000 24967
NPV =   2
  MIRR = 26%
MIRR = 31.61%
 PAYBACK PERIOD
• SIMPLE PAYBACK
• YR 0 -1000
• MTH 1 300 CUM 300
• MTH 2 350 650 BALANCE = 1000-650=350
• MTH 3 450 1100
• PAYBACK IS LESS THAN 3 MONTHS . 2+350/450=2.8 MONTHS
• DISCOUNTED PAYBACK
• YR 0 -1000
• MTH 1 300 PV 300/1.01 = 298
• MTH 2 350 PV 350/1.01^2 = 3250 CUM 298+325=623
• MTH 3 450 PV 450/1.01^3 = 400 CUM = 1023
• 2+(1000-623/400) 2.95 MTHS
• EXAMPLES
 ACCOUNTING RATE OF RETURN
• ACCOUNTING RATE OF RETURN / AVERAGE RATE OF RETURN =
– PROFIT AFTER TAX/BOOK VALUE OF INVESTMENT
• INVESTMENT PAT
• YR.1 90000 20000
• YR.2 80000 22000
• YR.3 70000 24000
• YR.4 60000 26000
• YR.5 50000 28000
• = 1/5(20+22+24+26+28)/1/5(90+80+70+60+50)
• = 34%
• HIGHER THE RETURN, BETTER IT IS
• READILY AVAILABLE DATA AND EASILY UNDERSTOOD
• DEFINE ACCEPTABLE RANGE – SAY ABOVE 20%
• LIMITATION – BASED ON PROFIT, NOT CASHFLOWS
• NOT DISCOUNTED, TIME VALUE OF MONEY NOT CONSIDERED
• RETURNS – 25000*4 VS 40000+30000+20000+10000 VS. 10+20+30+40
 EXAMPLES
• A LTD IS CONSIDERING A NEW PRODUCT LINE. THE CASH FLOW
IS EXPECTED TO BE AS UNDER:
YR 0 -700000
YR 1 -1000000
YR 2 250000
YR 3 300000
YR 4 350000
YRS 5 – 10 400000
1. IF REQUIRED RATE OF RETURN IS 15%, WHAT IS THE NPV? IS IT
ACCEPTABLE?
2. WHAT IS THE IRR?
3. WHAT WOULD BE THE CASE IF REQUIRED RATE OF RETURN IS
10%?
4. WHAT IS THE PROJECTS PAYBACK PERIOD?
 EXAMPLE

REQD. RETURN 15%

YEARS CASH FLOW DISCOUNT FACTOR PRESENT VALUE

0 -700000 1 -700000
1 -1000000 0.86957 -869565
2 250000 0.75614 189036
3 300000 0.65752 197255
4 350000 0.57175 200114
5 400000 0.49718 198871
6 400000 0.43233 172931
7 400000 0.37594 150375
8 400000 0.32690 130761
9 400000 0.28426 113705
10 400000 0.24718 98874
NPV =   -117645
 NPV USING ANNUITY

A PVIFA15%,10 yr 5.0188 YEARS CASH FLOW DISCOUNT PRESENT

FACTOR VALUE
B PVIFA15%,4 yr 2.855
0 -700000 1 -700000
A-B 2.1638
1 -1000000 0.86957 -869565
2 250000 0.75614 189036
3 300000 0.65752 197255
A PVIFA15%,6 yr 3.7845 4 350000 0.57175 200114
B PVIF15%,4 yr 0.57175 5-10 400000 2.1638 865515
A*B 2.1638 NPV =   -117646
 IRR
14%
CASH DISCOUNT PRESEN
YEARS FLOW FACTOR T VALUE
0 -700000 1 -700000
- -
100000
1 0 0.87719 -877193
2 250000 0.76947 192367
3 300000 0.67497 202491
4 350000 0.59208 207228
5 400000 0.51937 207747
6 400000 0.45559 182235
7 400000 0.39964 159855
8 400000 0.35056 140224
9 400000 0.30751 123003
10 400000 0.26974 107898
NPV =   -54145
13%
CASH DISCOUN PRESEN
YEARS FLOW T FACTOR T VALUE
0 -700000 1 -700000
100000
1 0 0.88496 -884956
2 250000 0.78315 195787
3 300000 0.69305 207915
4 350000 0.61332 214662
5 400000 0.54276 217104
6 400000 0.48032 192127
7 400000 0.42506 170024
8 400000 0.37616 150464
9 400000 0.33288 133154
10 400000 0.29459 117835
NPV =   14116

=13+14116/(14116+54145)
 CASE
ABC LTD IS CONSIDERING 3 INVESTMENT PROPOSALS:
1. PRODUCE A NEW LINE OF ALUMINIUM PANS
2. EXPAND ITS EXISTING COOKER LINE TO INCLUDE
SEVERAL NEW SIZES, AND
3. DEVELOP A NEW, HIGHER QUALITY LINE OF COOKERS.
IF ONLY THE PROJECT IN QUESTION IS UNDERTAKEN, THE
EXPECTED PRESENT VALUES AND INVESTMENT REQUIRED
ARE
PROJECT INVESTMENT ($) PV OF C/FLOW ($)
1 200,000 290,000
2 115,000 185,000
3 270,000 400,000
 CHOOSING RELATED PROJECTS
IF PROJECTS 1 AND 2 ARE UNDERTAKEN, THERE WILL BE NO
ECONOMIES/SYNERGIES; THE INVESTMENT AND PRESENT
VALUES WOULD BE THE SUM OF THE PARTS
WITH PROJECTS 1 AND 3, ECONOMIES ARE POSSIBLE IN
INVESTMENT, AS ONE OF THE MACHINES CAN BE USED IN BOTH
THE PROCESSES. TOTAL INVESTMENT REQUIRED FOR 1+3 IS
$440,000.
IF PROJECTS 2 AND 3 ARE UNDERTAKEN, THERE ARE ECONOMIES
TO BE ACHIEVED IN MARKETING AND PRODUCING THE
PRODUCTS BUT NOT IN INVESTMENT. THE EXPECTED PRESENT
VALUE OF FUTURE CASH FLOW FOR 2+3 IS $620,000.
IF ALL 3 PROJECTS ARE UNDERTAKEN SIMULTANEOUSLY, THE
ECONOMIES NOTED WOULD STILL HOLD. HOWEVER, A $125,000
EXTENSION TO THE PLANT WILL BE NECESSARY, AS SPACE IS NOT
AVAILABLE FOR ALL 3 PROJECTS.
WHICH PROJECT/PROJECTS SHOULD BE CHOSEN/UNDERTAKEN?
CHOOSING RELATED PROJECTS
 CHOOSING RELATED PROJECTS
PROJECT INVESTMENT PV OF C/F NPV
1 200,000 290,000 90,000
2 115,000 185,000 70,000
3 270,000 400,000 130,000
1 AND 2 315,000 290+185=475,000 160,000
1 AND 3 440,000 290+400=690,000 250,000
2 AND 3 385,000 620,000 235,000
1,2, AND 3 680,000 290+620=910,000 230,000
CONCLUSION

THANK YOU