To the Session on Finance…

This session will take you to World of

Finance…

And, the challenge is to understand

the intricacies of Finance…
So, let’s start our journey…

And, first of all let’s take a look at a

Balance Sheet…
 BALANCE SHEET as at March 31, 2017 and 2018
EQUITY AND LIABILITIES 2017 2018 ASSETS 2017 2018
Equity Non-current assets
a) Equity Share Capital 971.41 1,146.12 a) Property, plant and equipment 71,778.97 70,942.90
b) Hybrid Perpetual Securities 2,275.00 2,275.00 b) Capital work-in-progress 6,125.35 5,641.50
c) Other equity 48,687.60 60,368.72 c) Intangible assets 788.18 786.18
Total equity 51,934.01 63,789.84 d) Intangible assets under development 38.61 31.77
e) Investments in subsidiaries, associates and joint
Non-current liabilities 3,397.57 3,666.24
ventures
a) Financial liabilities f ) Financial assets
(i) Borrowings 24,694.37 24,568.95 (i) Investments 4,958.33 5,970.32
(ii) Derivative liabilities 179.33 70.08 (ii) Loans 211.97 213.50
(iii) Other financial liabilities 18.22 19.78 (iii) Derivative assets 0.12 12.13
b) Provisions 2,024.74 1,961.21 (iv) Other financial assets 79.49 21.21
c) Retirement benefit obligations 1,484.21 1,247.73 g) Income tax assets (net) 867.75 1,043.84
d) Deferred income 1,885.19 1,365.61 h) Other assets 3,121.64 2,140.84
e) Deferred tax liabilities (net) 6,111.27 6,259.09 Total non-current assets 91,367.98 90,470.43
f ) Other liabilities 77.74 224.71
Total non-current liabilities 36,475.07 35,717.16 Current assets
a) Inventories 10,236.85 11,023.41
Current liabilities b) Financial assets
a) Financial liabilities (i) Investments 5,309.81 14,640.37
(i) Borrowings 3,239.67 669.88 (ii) Trade receivables 2,006.52 1,875.63
(ii) Trade payables 10,717.44 11,242.75 (iii) Cash and cash equivalents 905.21 4,588.89
(iii) Derivative liabilities 270.17 16.41 (iv) Other balances with bank 65.1 107.85
(iv) Other financial liabilities 4,062.35 6,541.40 (v) Loans 27.14 74.13
b) Provisions 700.6 735.28 (vi) Derivative assets 6.26 30.07
c) Retirement benefit obligations 56.58 90.5 (vii) Other financial assets 315.06 480.62
READ &
d) Income tax liabilities (net) 465.72 454.06 c) Other assets 1,225.48 1,822.94
THINK!!!
e) Other liabilities 3,543.80 5,857.06 Total current assets 20,097.43 34,643.91
Total current liabilities 23,056.33 25,607.34
TOTAL EQUITY AND LIABILITIES 1,11,465.41 1,25,114.34 TOTAL ASSETS 1,11,465.41 1,25,114.34
Have you ever wondered what
decisions of a firm determine
the structure of a balance
sheet?
 BALANCE SHEET as at March 31, 2017 and 2018
EQUITY AND LIABILITIES 2017 2018 ASSETS 2017 2018
Equity Non-current assets
a) Equity Share Capital 971.41 1,146.12 a) Property, plant and equipment 71,778.97 70,942.90
b) Hybrid Perpetual Securities 2,275.00 2,275.00 b) Capital work-in-progress 6,125.35 5,641.50
c) Other equity 48,687.60 60,368.72 c) Intangible assets 788.18 786.18
Total equity 51,934.01 63,789.84 d) Intangible assets under development 38.61 31.77
e) Investments in subsidiaries, associates and joint
Non-current liabilities 3,397.57 3,666.24
ventures
Revisit the
a) Financial liabilities f ) Financial assets
Balance Sheet
(i) Borrowings 24,694.37 24,568.95 (i) Investments 4,958.33 5,970.32
!!!
(ii) Derivative liabilities 179.33 70.08 (ii) Loans 211.97 213.50
(iii) Other financial liabilities 18.22 19.78 (iii) Derivative assets 0.12 12.13
b) Provisions 2,024.74 1,961.21 (iv) Other financial assets 79.49 21.21
c) Retirement benefit obligations 1,484.21 1,247.73 g) Income tax assets (net) 867.75 1,043.84
d) Deferred income 1,885.19 1,365.61 h) Other assets 3,121.64 2,140.84
e) Deferred tax liabilities (net) 6,111.27 6,259.09 Total non-current assets 91,367.98 90,470.43
f ) Other liabilities 77.74 224.71
Total non-current liabilities 36,475.07 35,717.16 Current assets
a) Inventories 10,236.85 11,023.41
Current liabilities b) Financial assets
a) Financial liabilities (i) Investments 5,309.81 14,640.37
(i) Borrowings 3,239.67 669.88 (ii) Trade receivables 2,006.52 1,875.63
(ii) Trade payables 10,717.44 11,242.75 (iii) Cash and cash equivalents 905.21 4,588.89
(iii) Derivative liabilities 270.17 16.41 (iv) Other balances with bank 65.1 107.85
(iv) Other financial liabilities 4,062.35 6,541.40 (v) Loans 27.14 74.13
b) Provisions 700.6 735.28 (vi) Derivative assets 6.26 30.07
c) Retirement benefit obligations 56.58 90.5 (vii) Other financial assets 315.06 480.62
d) Income tax liabilities (net) 465.72 454.06 c) Other assets 1,225.48 1,822.94
e) Other liabilities 3,543.80 5,857.06 Total current assets 20,097.43 34,643.91
Total current liabilities 23,056.33 25,607.34
TOTAL EQUITY AND LIABILITIES 1,11,465.41 1,25,114.34 TOTAL ASSETS 1,11,465.41 1,25,114.34
 Main financial decisions impacting the
Balance Sheet of a company …

 Investment Decisions: Long-term Decisions

 Financing Decisions: Capital Structure Decisions

 Dividend Decisions: Profit Distribution Decisions

 Liquidity Decisions: Working Capital or Short-term Decisions

Who is after
these decisions?

It is the CFO of a
company who is ultimately
responsible for these
decisions.
 What is the driving OBJECTIVE of the firm
behind these financial decisions?

 Investment Decisions: Long-term Decisions

Is it Profit-
Maximization?
 Financing Decisions: Capital Structure Decisions

 Dividend Decisions: Profit Distribution Decisions

 Liquidity Decisions: Working Capital or Short-term Decisions

To appreciate the driving OBJECTIVE behind various financial
decisions, let’s have a look at some of the Vision/Mission statements of
different companies

ONGC

Tata St
eel
All these are talking about VALUE
and not about PROFIT.

It takes us to an important issue – Profit

Maximization Vs. Value Maximization.
PROFIT MAXIMIZATION
Vs. VALUE MAXIMIZATION
Why Profit Maximization?
• It is a well understood objective.
• It achieves sustainability for a firm as
without profits, none can sustain itself
for long.
• Profit is also considered as a yardstick
of efficiency.
• In a free and competitive market, profit
is the best driving and motivating force
behind all economic decisions.
• The theory of ‘Invisible Hand’ that
ensures optimum allocation of
resources for a society in a free and
competitive market also depends upon
the objective of Profit Maximization.
• It is an objective that is compatible with
society’s objective as well as firm’s
objective.
Why Value Maximization?
• Creation of shareholders’ Value takes care
of Profit, Successful Marketing Strategies,
Happy Creditors and Lenders.
• Since managers are accountable to the
shareholders, managers should work for
the maximum benefits of the shareholders.
• Shareholders’ value consists of dividend
payments and the market value of shares.
They both are accurately observable in case
of listed companies.
• If stock markets are efficient then the
valuation of the shares reflects the
fundamentals and risk involved of a
company.
• It takes a long-term view.
• This objective takes care of the time value
of money.
• Above all, this objective takes into account
both – PROFIT and RISK.
FINANCE …???
Meaning:
• The theory of Finance or Corporate
Finance is the theory of financial
decision making by business firms.
• It can be described as the study of
the decisions that every firm has
to make related to financial
matters.
• It is that managerial activity which
is concerned with the planning
and controlling of the firm’s
financial resources.
• It is management of flows of
funds/cash through out an
organization to enhance the value
of shareholders.
Basic Nature of Finance:
• It is a decision-making course – that
is to say, each topic in it is concerned
with a managerial decision making
problem.
• All decision problems dealt in it are
having money or funds as an
important dimension.
• Its approach to decision-making is
quantitative in nature.
• Finance is primarily normative in
nature.
• To make better financial decisions,
one must be aware of necessary legal,
economic and financial environment
and above all, ACCOUNTING.
BASIC PRINCIPLES of Finance…
Basic Principles of Finance

 Money has time value/opportunity cost.

 Every financial decision involves a trade-off between

RISK and RETURN.

 Financial markets are EFFICIENT.

 Accounting Profit is not relevant profit concept for

financial decisions. Profits based on cash flows are
more relevant for Financial Decision-Making.

 Options have a VALUE.

 Incremental/differential cash flows are important for

financial decision-making.
Money has time value/opportunity cost.
 VALUE OF MONEY ……!!!
• TIME VALUE OF MONEY - • TIME VALUE OF MONEY refers to the
fact that rupee in hand today is worth
INTEREST RATE more than a rupee promised at some
time in the future.

• FUTURE VALUE OF MONEY is that

• PURCHASING POWER -
value of one rupee which a person
PRICE INDEX would like to accept in future instead of
accepting it today.

• PRESENT VALUE OF MONEY is that

• VALUE OF MONEY IN value of one rupee at present which
INTERNATIONAL MARKET would make a person indifferent
between this amount and the rupee
-FOREIGN EXCHANGE which he would get at some time in
future.
RATE

INTEREST RATE vs DISCOUNT RATE

INTEREST MAY BE...

• SIMPLE INTEREST RATE

• COMPOUND INTEREST RATE

COMPOUNDING vs DISCOUNTING
 COMPOUNDING

• COMPOUNDING is the process of accumulating interest in

an investment over time so as to obtain FUTURE AMOUNT.
• RELATION BETWEEN INTEREST RATE, TIME AND
COMPOUNDING
FUTURE VALUE OF Re.1 FOR DIFFERENT PERIODS AND RATES

10 25%

F 8
U
7 20%
T
U
R 6
E
5
15%
V 4
A
L 3 10%
U
E 2 5%
0%
1

0
0 1 2 3 4 5 6 7 8 9 10
YEARS
 DISCOUNTING
• DISCOUNTING is a process of reducing the future value so as to obtain
the present value.
• RELATION BETWEEN DISCOUNT RATE, TIME AND DISCOUNTING
PRESENT VALUE OF Re.1 FOR DIFFERENT PERIODS AND RATES

0%
1

0.9
P
0.8
R
E 0.7
S 5%
E 0.6
N
T 0.5
10%
V 0.4
A
L 0.3 15%
U
E 0.2 20%

0.1
25%
0
0 1 2 3 4 5 6 7 8 9 10
YEARS
 t
FUTURE VALUE OF AN ANNUITY OF Re.1 = [(1+r)-1]/r
Rates 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%
Years

1 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000
2 2.020 2.040 2.060 2.080 2.100 2.120 2.140 2.160 2.180 2.200
3 3.060 3.122 3.184 3.246 3.310 3.374 3.440 3.506 3.572 3.640
4 4.122 4.246 4.375 4.506 4.641 4.779 4.921 5.066 5.215 5.368
5 5.204 5.416 5.637 5.867 6.105 6.353 6.610 6.877 7.154 7.442
6 6.308 6.633 6.975 7.336 7.716 8.115 8.536 8.977 9.442 9.930
7 7.434 7.898 8.394 8.923 9.487 10.089 10.730 11.414 12.142 12.916
8 8.583 9.214 9.897 10.637 11.436 12.300 13.233 14.240 15.327 16.499
9 9.755 10.583 11.491 12.488 13.579 14.776 16.085 17.519 19.086 20.799
10 10.950 12.006 13.181 14.487 15.937 17.549 19.337 21.321 23.521 25.959
11 12.169 13.486 14.972 16.645 18.531 20.655 23.045 25.733 28.755 32.150
12 13.412 15.026 16.870 18.977 21.384 24.133 27.271 30.850 34.931 39.581
13 14.680 16.627 18.882 21.495 24.523 28.029 32.089 36.786 42.219 48.497
14 15.974 18.292 21.015 24.215 27.975 32.393 37.581 43.672 50.818 59.196
15 17.293 20.024 23.276 27.152 31.772 37.280 43.842 51.660 60.965 72.035
16 18.639 21.825 25.673 30.324 35.950 42.753 50.980 60.925 72.939 87.442
17 20.012 23.698 28.213 33.750 40.545 48.884 59.118 71.673 87.068 105.931
18 21.412 25.645 30.906 37.450 45.599 55.750 68.394 84.141 103.740 128.117
19 22.841 27.671 33.760 41.446 51.159 63.440 78.969 98.603 123.414 154.740
20 24.297 29.778 36.786 45.762 57.275 72.052 91.025 115.380 146.628 186.688
 t
PRESENT VALUE OF AN ANNUITY OF Re.1 = [1-1/(1+r) ]/r
Rates 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%
Years

1 0.980 0.962 0.943 0.926 0.909 0.893 0.877 0.862 0.847 0.833
2 1.942 1.886 1.833 1.783 1.736 1.690 1.647 1.605 1.566 1.528
3 2.884 2.775 2.673 2.577 2.487 2.402 2.322 2.246 2.174 2.106
4 3.808 3.630 3.465 3.312 3.170 3.037 2.914 2.798 2.690 2.589
5 4.713 4.452 4.212 3.993 3.791 3.605 3.433 3.274 3.127 2.991
6 5.601 5.242 4.917 4.623 4.355 4.111 3.889 3.685 3.498 3.326
7 6.472 6.002 5.582 5.206 4.868 4.564 4.288 4.039 3.812 3.605
8 7.325 6.733 6.210 5.747 5.335 4.968 4.639 4.344 4.078 3.837
9 8.162 7.435 6.802 6.247 5.759 5.328 4.946 4.607 4.303 4.031
10 8.983 8.111 7.360 6.710 6.145 5.650 5.216 4.833 4.494 4.192
11 9.787 8.760 7.887 7.139 6.495 5.938 5.453 5.029 4.656 4.327
12 10.575 9.385 8.384 7.536 6.814 6.194 5.660 5.197 4.793 4.439
13 11.348 9.986 8.853 7.904 7.103 6.424 5.842 5.342 4.910 4.533
14 12.106 10.563 9.295 8.244 7.367 6.628 6.002 5.468 5.008 4.611
15 12.849 11.118 9.712 8.559 7.606 6.811 6.142 5.575 5.092 4.675
16 13.578 11.652 10.106 8.851 7.824 6.974 6.265 5.668 5.162 4.730
17 14.292 12.166 10.477 9.122 8.022 7.120 6.373 5.749 5.222 4.775
18 14.992 12.659 10.828 9.372 8.201 7.250 6.467 5.818 5.273 4.812
19 15.678 13.134 11.158 9.604 8.365 7.366 6.550 5.877 5.316 4.843
20 16.351 13.590 11.470 9.818 8.514 7.469 6.623 5.929 5.353 4.870
Every financial decision involves a trade-off
between RISK and RETURN.
RETURN IS …
RETURN...

• RETURN presents-
– benefits
– gains
– profits
– interest
– yield
– the extra we get when we invest some money.
• It is a positive parameter in the sense that more of it is more
desirable.
Should we calculate RETURN …
Before tax or After Tax for
financial decision making?
LET’S NOW
UNDERSTAND -
WHAT IS RISK?
RISK IS ………
RISK IS UNDERSTOOD AS A NEGATIVE PARAMETER…
HAVING DIFFERENT SHADES!!!
 Risk is a threat.
 Risk prevents the project to realize its expected
goals.
 Risk is a fear.
 Risk is pessimism.
 Risk is expected loss.
 Risk is a chance of loss.
 Risk comes out from unexpected undesirable
events.
 Risk is unwanted.
 Risk is variation, fluctuation and volatility.
 Risk is dynamic.
 Risk arises due to uncertainty.
 Risk is because of change.
 Risk is an odd thing out.
RISK IS USUALLY MEASURED AS ...
• the PROBABILITY OF LOSS
• the EXPECTED LOSS
• VARIATIONS & FLUCTUATIONS:
– Range
– Mean Absolute Deviation
– Standard Deviation/Variance/Coefficient of Variation
– Semi-Variance
– Variance from Subjective Expected Value
– Co-variance
• the SENSITIVITY OF RETURN TO
POSSIBLE CHANGES - percentage
changes.
Types of Risk…
– Systematic Risk
– Unsystematic Risk
– Market Risk
– Interest Rate Risk
– Purchasing Power Risk or Inflation Risk
– Foreign Exchange Risk
– Business Risk - Operating Leverage
– Financial Risk - Financial Leverage
– Management Risk
– Industry Risk
– Economy/Country Risk
– Credit Risk/Default Risk
– System Risk
RELATION BETWEEN RETURN AND RISK

• Can we say that a person who has taken high risk will
get higher return?
• Should a person go for higher risk if he/she has to earn
higher return?
• Should a person be compensated by higher return for
taking higher risk?
• Is it HIGH RISK HIGH RETURN? Or, Is it HIGH
RETURN HIGH RISK?
• PESO PROBLEM: A situation in which what appear to be
abnormally high returns on an investment are in fact
compensation for bearing the risk of an event that has not yet
taken place.
In the Ultimate Analysis, the structure of Finance is…

The Maximization of
Objective
Shareholders Value

Parameters
impacting
objective

Risk & Return

Main
Decisions

Working
Investment Financing Dividend Capital
Decisions Decisions Decisions Decisions
What next…?
Time to think and start talking about …
FINANCE!!!
CAPITAL BUDGETING DECISIONS –
LONG-TERM INVESTMENT DECISIONS
Do not forget that the basic OBJECTIVE of
Finance is …VALUE CREATION!!!!!!
VALUE CREATION MODEL

INVESTMENT

VALUE

CAPITAL
THEREFORE,

OUR TASK IS …
To understand - how to make

Long Term Investment

Decisions With The Objective To
Create Value.
A Case Study …
•A Solar Energy Company is considering to install a Solar Power Project in Tamil Nadu. It is going
to be a photovoltaic power station spread over an area of 2,500 acres in a place in Ramanathapuram
district, 90 km from Madurai, in the state of Tamil Nadu, India. The project is expected to be
commissioned by the end of 2019. With a generating capacity of 648 MWp at a single location, it is
going to be one of the world's largest solar park.

•The commissioned five sub-stations of the Project are supposed to connect the solar park with the
National Grid. The Solar Power Project would require an investment of around ₹4,850 crore. The
solar plant will consist of 2.5 million solar modules, 380,000 foundations, 27,000 metres of
structures, 576 inverters, 154 transformers, and almost 6,000 km of cables. Construction of the
structures needed to mount the solar panels would require about 30,000 tonnes of galvanised steel.
Around 8,000 workers may install an average of 11 MW of capacity per day to complete the project
within 9-10 months.

•The entire solar park would be connected to a 400 kV substation of the Tamil Nadu Transmission
Corp. The solar panels will be cleaned daily by a self-charged robotic system.

•Given the solar resources, it is expected that an annual generation of 1.35 TWh/yr may be possible.
It is assumed that technical life time of project would be 25 years. The expected tariff on the
average is expected to be Rs. 5.50 kWh.

•Do you think that this project of the Solar Energy Company will be worth taking?

• It is an investment decision – Capital Budgeting Decision.

CAPITAL BUDGETING DECISIONS
Capital Budgeting Decisions:
• The capital budgeting decisions are
related to the allocation of
investible funds to different long-
term assets.
• They denote a situation where the
lump-sum funds are invested in
the initial stages of a project and
the returns are expected over a
long period.
• The underlying philosophy of
capital budgeting decisions is -
“Invest Today, Enjoy Fruit
Tomorrow!!!!”
Nature of Capital Budgeting Decision
• Long - term decisions.
• Involves one or few times outflow of cash
but promises a future stream of cash-
inflows.
• Involves huge amount of investment.
• Generally irreversible decisions; if tried then
it is very costly to undone them.
• Determines the assets side of a firm’s
balance sheet.
• Determines the earning capacity of a firm.
• These decisions are highly risky.
• These decisions are of strategic importance.
• These decisions are taken at comparatively
higher levels in the management.
CAPITAL BUDGETING DECISIONS…

Types: Where do we see the IMPACT of

Capital Budgeting Decisions???

• Project Selection
• … on the Assets side of the
balance sheet – FIXED ASSETS.
• Decisions related to
Modernization, expansion
and renovation etc. • … on the CAPACITY of the firm
to do the business.

• Purchase of Machines
• … on the GROWTH of the firm.
• Replacement of machines
• … on the RISK of the firm.

• … on the PROFITS of the firm.

Where do we see the IMPACT of Capital Budgeting
Decisions???
• … on the Assets side of the balance sheet –
FIXED ASSETS.

• … on the CAPACITY of the firm to do the

business.

• … on the GROWTH of the firm.

• … on the RISK of the firm.

• … on the PROFITS of the firm.

Capital Budgeting Process

• The phases of Capital Budgeting Process

has the following phases:
– Identification,
– Development,

– Selection, and
– Post-audit
Proper Evaluation of Capital Budgeting
Decisions requires…
• One, proper estimation of cash
outlays.
• Second, proper estimation of
subsequent cash flows.
• Third, proper choice of selection
criteria.
• Fourth, proper evaluation of risk.

We shall discuss them one by one.

First, estimation of the initial cash
outlays…
Please Note that …

• We have to determine only … INCREMENTAL CASH

FLOWS.

• We have to determine only … RELEVANT CASH

FLOWS.
Please remember the basic Principles
of cash flows estimation
Separation Principle
• It is an investment decision and hence, any cash flows
related to financing decision should be kept separate.

Incremental Principle
• Cash flows in a project are to be measured in terms of
INCREMENTAL manner.

Post-Tax Principle
• All cash flows are to be determined only AFTER TAX.

Consistency Principle
• Since a project is to be evaluated from the perspective
of a firm, cash flows are to be estimated for the FIRM.
Estimation of relevant cash outlays for
a capital expenditure
• The cost of a fixed assets comprises -
• its purchase price, including import duties and other non-
refundable taxes;
• cost of bringing the asset to its working condition;

• cost of site preparation;

• initial delivery and handling charges;

• installation cost;

• trial run cost

• interest cost during construction period; and

• professional fees of architects and engineers.

• Such a cost be reduced by the inflows from the sale of the old asset.
Some guiding rules to determine
relevant cash flows
• Rule#1: All costs and revenue generated before/prior to the
investment appraisal decisions should be ignored. It basically means
that ignore SUNK COST.

• Rule#2: Ignore all non-incremental cashflows. That is, exclude all

those cash flows that would be there whether there is project or not.

• Rule#3: All allocated costs should be ignored.

• Rule#4: Any increase in net working capital due to a project should

be taken as a part of Project Cost.

• Rule#5: All relevant cash flows are to be considered till the date of
operation/ commercial use/available for use.

• Rule#6: All the cash flows are to be determined from the firm’s point
of view and not from the equity point of view.
Second, estimation of the cash flows
subsequently…
In this challenge, we have to estimate cash
flows…

• …during the life of the investment asset; and

• …at the end of the life of an asset – Terminal Cash

Flows.
Estimation of relevant cash flows subsequently -
some guiding principles…
• It requires determination of net cash flows due to operation/use of the asset.
• Depreciation and all other non-cash charges should be ignored.
• Ignore all financing cash flows and their tax effects as capital budgeting decisions
are real decisions and hence, their analysis should not be affected by the financing
decisions.
• Cash flows should be determined as if they are occurring to the firm and not to
shareholders.
• Ignore all allocated expenses.

• Do not forget to take into account the effect of an investment decision on the
remaining business.

• Take the net cash flows after tax without recognizing the benefits of tax on interest
amount as the discount rate used for discounting future cash flows is determined
after tax.

• Remember to incorporate the opportunity cost of resources used to generate cash

flows and ignore any sunk cost.
 Estimation of Terminal Cash Flows - Some
guiding principles

• Identify cash flows from the Salvage Value of the Asset(s).

• Release of Net Working Capital

• Consider any dismantle costs at the termination time

• Any cost to be paid to some agency/authority for some legal

compliances
Third, proper selection criteria …
TECHNIQUES OF EVALUATING CAPITAL BUDGETING
DECISIONS
• Techniques of capital budgeting
Selection Criteria:
decisions are tools/
benchmarks/methods/decision-
 Pay Back Period Method
criterion that helps in making a
final choice for an investment
project.  Net Present Value

• They are only guides and means to

 Internal Rate of Return
final decision-making.
• All they do is help to communicate
 Profitability Index
information to the decision maker.
• They can never replace managerial
judgements, but they can help to
make that judgement more sound.
EXAMPLE – Question
ESTIMATING PAY BACK PERIOD
Pay Back Period is the period of time required for the cash
Meaning inflows over the years to recover the initial cash outflows

Consider the following project with associated cash flows:

Year Cash Inflows (Rs. in Crores)
0 Rs. (100.00)
1 Rs. 15.00
2 Rs. 28.00
3 Rs. 40.00
4 Rs. 30.00
5 Rs. 50.00
EXAMPLE – Answer
ESTIMATING PAY BACK PERIOD

CALCULATION OF THE PAY BACK PERIOD

Cash Inflows (Rs. in CUMULATIVE

Year
Crores) CASH FLOWS

0 Rs. (100.00)  
1 Rs. 15.00 -85.000
2 Rs. 28.00 -57.000
3 Rs. 40.00 -17.000
4 Rs. 30.00 13.000
5 Rs. 50.00 63.000

PAY BACK PERIOD 3.57 Years

that's - 3 Years and 7

Months
Net present value (NPV)

Meaning NPV is the difference between the present value of

cash inflows and present value of cash outflows

NPV = Present value of cash inflows – present value of cash outflows

Discount Rate
Cash flows Discounted cash
flows
Discount rate is the desired rate of return on an investment or is the rate
of return the company would like to earn or is a rate a company could
have earned by investing the same funds in the best available alternative
investment that has the same risk. A Company may determine:
• a minimum rate of return that all capital projects must meet- this
minimum could be based on an industry average, or
• overall cost of capital which can also be used as the desired rate of return -
cost of capital is the cost that an organisation has incurred in raising
funds
EXAMPLE – Question
ESTIMATING NPV

Consider the following project with associated cash flows:

Year Cash Inflows (Rs. in Crores)

0 Rs. (100.00)
1 Rs. 15.00
2 Rs. 28.00
3 Rs. 40.00
4 Rs. 30.00
5 Rs. 50.00

Use Discount Rate

= 15%
EXAMPLE – Answer
ESTIMATING NPV
 Appreciate Relation between NPV and Discount Rate

NPV

Discount Rate
Internal rate of return (IRR)

IRR is that rate of return where the present value of cash

Meaning
inflows = present value of cash outflows; or is that
discount rate at which NPV becomes zero

A project is generally accepted if its IRR > Required rate of return

Kindly IRR assumes that all cash flows are reinvested at the
Note SAME RATE which is equal to IRR.
EXAMPLE – Question
ESTIMATING IRR
Consider the following project with associated cash flows:
EXAMPLE – Answer
ESTIMATING IRR

Cash Inflows (Rs. in

Year
Crores)
0 Rs. (1,500.00)
1 Rs. 225.00
2 Rs. 250.00
3 Rs. 350.00
4 Rs. 500.00
5 Rs. 680.00
6 Rs. 525.00
7 Rs. 375.00
IRR 17.00%
NPV Vs. IRR
NPV: IRR:
• NPV is unique. • IRR is easy to understand.

• NPV can be calculated by taking
different discount rates for different
time periods.
• If more than one cash outflows are
occurring between future cash inflows,
there can be multiple IRR, the
interpretation of which is difficult.
NPV vs IRR

• NPV can be used to compare

50 PROJECT - A

projects with different sizes. 0

1%

4%

7%

10%

13%

16%

18%

19%

22%

25%

28%

31%
3%

6%

9%

12%

15%

21%

24%

27%

30%
-50

• NPV is additive. -100

-150

-200

• IRR is based on the assumption that all

future cash inflows are reinvested at IRR
does not seem a realistic assumption.
NPV is a better
choice over IRR. • IRR is not additive.
Now, let’s move to a case…
…Where we are taking capital budgeting
decisions under FUND CONSTRAINT!!!
Suggest which projects should be selected if there is a
budget of Rs. 100 crores.

RANK THE FOLLOWING PROJECTS ASSUMING THAT WE HAVE A CAPITAL BUDGET OF

Rs. 100 CRORES

PROJECTS COST OF PROJECTS NPV IRR

P1 Rs. 20.00 Rs. 9.00 15.25%

P2 Rs. 40.00 Rs.15.00 14.75%

P3 Rs. 30.00 Rs.10.00 16.00%

P4 Rs. 70.00 Rs.20.00 18.00%

P5 Rs. 80.00 Rs.25.00 17.50%

P6 Rs. 10.00 Rs. 6.00 15.00%

Use PROFITABILITY INDEX.

• PI = (NPV/Cost of the Project)

RANK THE FOLLOWING PROJECTS ASSUMING THAT WE HAVE A CAPITAL BUDGET OF
Rs. 100 CRORES

PROJECTS COST OF PROJECTS NPV Profitability Index

P6 Rs. 10.00 Rs. 6.00 60.00%

P1 Rs. 20.00 Rs. 9.00 45.00%

P2 Rs. 40.00 Rs.15.00 37.50%

P3 Rs. 30.00 Rs.10.00 33.33%

P5 Rs. 80.00 Rs.25.00 31.25%

P4 Rs. 70.00 Rs.20.00 28.57%

What next…?
• Our next CHALLENGE of capital budgeting
decision – Measuring and Managing RISK!

Risk Vs. Uncertainty

Please recall the following about risk...
• the PROBABILITY OF LOSS
• the EXPECTED LOSS
• VARIATIONS & FLUCTUATIONS:
– Range
– Mean Absolute Deviation
– Standard Deviation/Variance/Coefficient of Variation
– Semi-Variance
– Variance from Subjective Expected Value
– Co-variance
• the SENSITIVITY OF RETURN TO
POSSIBLE CHANGES - percentage
changes.
HOW TO GO ABOUT RISK
ANALYSIS?

• Whatever way one goes for Risk Analysis, that

must be a systematic and in a planned way.
• There are many ways that are broadly
classified as thus:
– CRUDE METHODS
– QUANTITATIVE METHODS
CRUDE WAYS OF RISK ANALYSIS

• Conservative estimates of the revenues

• Worst estimates of the project duration

• Worst estimates of cost of project

• Safety margins/ contingencies in the costs

• Subjective judgements
QUANTITATIVE TOOLS FOR RISK
ESTIMATION AND ANALYSIS

 PAY BACK PERIOD

 RISK ADJUSTED METHODS :

– RISK ADJUSTED DISCOUNT RATE METHOD

– CERTAINTY EQUIVALENT METHOD

 SENSITIVITY ANALYSIS

 SCENARIO ANALYSIS

 SIMULATION METHODS
PAY BACK PERIOD…

• … no of years within which one recover

the amount invested in a project.

• Higher the payback period, higher is the

degree of risk.
RISK ADJUSTED METHODS

• There are two ways through which the risk can be

incorporated in our process of capital budgeting
decisions.
• They are –
– RISK ADJUSTED DISCOUNT RATE METHOD; and
– CERTAINTY EQUIVALENT METHOD
SENSITIVITY ANALYSIS
• It is a quantitative process to
perform “what if” analysis. It
starts with some change in some
variable's)/parameter(s) and
studies the consequent impact
on the variable(s) of the interest.
The usual practice is to change
the sales volume/capacity
utilization and then study its
impact on NPV or IRR.
Objectives:
– To test reliability,
robustness, consistency and
sensitivity of the estimates
of a project; and
– To determine the likelihood
impact of the undesirable
and uncertain events on the
viability of a project.

• Such an analysis can be performed

either by changing the variables by
some percentage or by an absolute
amount.
Other Methods…

• Scenario Analysis:
– It is a way of predicting probable values of parameters of interest
based on certain future potential events.
– It is used to predict what might happen to a project if specific events
occur or don’t occur.
– It is similar to Sensitivity Analysis except in it we can change a
number of assumptions simultaneously and then, study the effect of
the same on, say, NPV and IRR.

• Simulation Methods:
– In it, a model is made representing ‘the true project’ and then,
experimentations are done on the same and try to gauge what will
be the behaviour of the real project and probable outcomes of the
same.
– After experimentation, based on the results obtained necessary
inferences are made about the proposed project.
Having discussed about risk, the next
challenge is how to MANAGE RISK?

AVOID THE RISK

REDUCE THE
TRANSFER
THE RISK

RISK
RISK - KITE

ACCEPT THE RISK

Learning mitigating the risk…
• Delays in various clearances such
as Environment • Ways to mitigate
• Unsuitable Technology from the
supplier of technology risk:
• Force majeure including the act of
GOD – Avoid the risk;
• Non availability of debt at the
reasonable prices – Reduce the risk;
• Undesirable movements in the – Transfer the risk; and
foreign exchange rates
• Changes in laws regarding polluting – Accept the risk.
industries in a particular area.
• Increase in the cost of basic raw
material
• Delays in completion of projects on
time
By now, you must be feeling good about
Finance!!!
While we were discussing capital budgeting
decisions, are you not wondering how the
companies are determining their discount rate?

That is going to be our next

item in the agenda …
Cost of Capital…
Now, let’s start with our Agenda…

As the cost of capital is taken as

Discount Rate for capital
budgeting decision.
Please note that …
• Every rupee spent by a company has a COST!!!!

• Cost of Capital determines  Discount Rate 

NPV; therefore, to increase the VALUE FOR
SHAREHOLDERS, REDUCE THE COST OF CAPITAL:

↓ Cost of Capital  ↓r  ↑NPV ↑Value for shareholders

Cost of Capital …

• It is the minimum rate of return that a firm must earn on its investments so
as to leave market price of its shares unchanged.

• It is also referred to as cut-off rate, target rate, hurdle rate, required rate of
return and so on.
Cost of Capital …Continued
• It is defined as the weighted average cost of
capital (k0) of all long-term sources of finance.
The major long-term sources of funds are -
• Debt,
• Preference shares,
• Equity capital, and
• Retained earnings.
Cost of Capital …Continued
• Please note that cost of capital is –

OPPORTUNITY COST!!!!!!
 Itis Expected rate of return that investors could
earn elsewhere on investments with similar
characteristics.
COST OF CAPITAL RISK USE OF CAPITAL

FUNDS/CAPITAL

DEBT
BASIC
STRUCTURE
PREFERENCE SHARES

EQUITY CAPITAL

RETAINED EARNINGS
Cost of Capital means…

• WEIGHTED AVERAGE COST OF CAPITAL

(WACC)
WEIGHTED AVERAGE COST OF CAPITAL (WACC)

• If a firm uses all possible sources of financing,

the cost of capital must include the cost of each,
weighted to proportion of each in the firm’s
capital structure.
Weighted Average Cost of Capital
• Assuming that a firm is using only Debt and Equity, the
weighted average cost of capital (WACC) is capital
structure-weighted average of the after-tax cost of
debt and equity

 D   E 
WACC    kd (1  Tc )    ke
 DE   DE 
COST OF DEBT/BORROWED FUNDS

• Cost of debt is always calculated in terms of–

PREVAILING INTEREST RATE

• Cost of borrowed funds is –

THE INTEREST RATE TO BE PAID

• After tax cost will be: Interest Rate (1-t) where ‘t‘ is the
tax rate.
COST OF PREFERENCE SHARES

• Cost of preference shares is always calculated in terms of–

The Dividend paid on them

COST OF EQUITY
• Cost of equity is determined by using VALUATION
APPROACH to equity because there is a negative
relation between the VALUE and COST of Equity –
higher the cost of equity, lower the value of equity!

• If we know the value of equity and the relevant

parameters of valuation, then one can easily determine
the cost of equity.
HOW TO DETERMINE THE VALUE OF SHARE
………??????

• One of the tool to determine the cost

of equity is -
 Capital Asset Pricing Model (CAPM)
Capital Asset Pricing Model

• Using CAPM, one can determine cost of an equity.

E(R i )  R F  (R M - R F )i
Beta is a measure of systematic risk of a security. It represents
sensitivity of a security return with market return. We calculate beta
as –
COST OF EQUITY USING CAPM…EXAMPLE
• Assume that in a market, CAPM works. If the risk free rate is
7.60%, the return on the market benchmark is 14.50% and
the beta is 1.25, then you are required to determine the
cost of equity.
Cost of Retained Earnings…

• Cost of retained earnings is calculated by taking the

cost of equity; that is to say, the cost of retained
earnings is equal to the cost of equity.
Friends, in this session, we try to learn…
• Basics of Finance – which is viewed as managing the
financial sources or funds of a company so as to
MAXIMIZE SHAREHOLDERS’ VALUE.

• We also discussed about basic principles of Finance.

• We tried to learn about time value of money.

• Then, we discussed about capital budgeting decisions

– Pay Back Period, NPV, IRR and also, learnt about
risk and management of risk of a project.

• After all these, we moved to discuss cost of capital

which is defined as weighted average cost of capital
(WACC) of debt, preference shares, equity and
retained earnings.

• Finally, we talked about CAPM and beta.

THANK
YOU