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Sr Title ICMR Ch. PC Ch. IMP Ch.

2 Overview of Financial Markets 3 Sources of Long-Term Finance 4 Raising Long-term Finance

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2* 10* -

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2 17 18*

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20, 21 20, 21, 23

6 Time Value of Money 7 Valuation of Securities 8 Cost of Capital 9 Basics of Capital Expenditure Decisions 10 Analysis of Project Cash Flows

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3* 5* 11* 18* -

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6 7 14 11 12*

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2 3 9 8 10, 11

*Book preference

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Reference Books 1. Financial Management, Prasanna Chandra, 7th Edition, Chapter 12

Chapter 10, 11

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1. Cash Flow Estimation 2. Identifying the Relevant Cash Flows 3. Cash Flow Analysis

5. Evaluating Projects with Unequal Life 6. Adjusting Cash Flow for Inflation

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It is an analysis of invest inflows and cash inflows. It is most important and most difficult step in capital budgeting. Important because of project viability decisions and difficult because of forecasting error. For example, Alaska pipeline project, initial cost estimate was about $700 million, however final cost was about $7 billion.

Year 0 1 2

15

6

40

7

30

8

20

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Following principles are followed while estimating the cash flows of a project Separation Principle Incremental Principle Post-tax Principle Consistency Principle

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Separation Principle There are two sides of a project viz. investment side (or asset side) and financing side. Cash flows associated with these sides should be separated.

For example, a firm is considering a one-year project that requires an investment of Rs. 1,000 in fixed assets and working capital at time 0. The project is expected to generate a cash inflow of Rs. 1200 at the end of year 1. This is the only cash inflow expected from the project. Project is financed by debt carrying an interest rate of 15% maturing after 1 year.

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Project

Financing Side Time Cash Flow 0 + 1,000 1 - 1,150 Cost of capital: 15%

Investment Side Time Cash Flow 0 - 1,000 1 + 1,200 Cost of return: 20%

Note that the cash flows on investment side do not show cost of financing (interest in our example). Financing costs are included in the cash flows on the financing side, which reflects in cost of capital. Cost of capital is used as a hurdle rate against which rate of return on investment side is judged. 8 / 23

Important point to be noted that the cash flows on investment side should not include financing costs, because they will be reflected in the cost of capital against which the rate of return will be evaluated. Operationally, this means that interest on debt is ignored while computing profits and taxes thereon. Alternatively, if interest is deducted in the process of arriving at profit after tax, an amount equal to interest(1-tax rate) should be added to profit after tax. Note that

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Profit before interest and tax (1 tax rate) = (Profit before tax + interest) (1 tax rate) = (Profit before tax) (1-tax rate)+ interest(1-tax rate) = Profit after tax + interest(1-tax rate) Thus, whether the tax rate is applied directly to the Profit before interest and tax or whether tax-adjusted interest, which is simply Interest(1-tax rate) is added to the profit after tax, we get the same result.

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Incremental Principle Cash flow of a project must be measured in incremental terms. To find a projects incremental cash flows, you have to look at what happens to the cash flows of the firm with the project and without the project. The difference between the two reflects the incremental cash flows attributable to the project. That is

Project cash flow for year t = Cash flow for the firm with the project for year t Cash flow for the firm without the project for year t

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While estimating the incremental cash flows of a project, following guidelines must be used. Consider All Incidental Effects: These include some enhancements and some detract effects on profitability. All these effects must be taken into account. Ignore Sunk Costs: A sunk cost refers to an outlay already incurred in the past or already committed irrevocably. Include Opportunity Costs: Opportunity cost is the value of the next best alternative forgone. If a project uses resources already available with the firm, there is a potential for an opportunity cost.

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Question the Allocation of Overhead Costs: Costs which are only indirectly related to a project or service are referred to as overhead costs. They include general administrative expenses, managerial salaries, legal expenses, rent and so on. Estimate Working Capital Properly: Working capital (or more precisely, net working capital) is defined as (current assets, loans and advances) (current liabilities and provisions). Outlays on working capital have to be properly considered while project cash flows. Working capital changes over time.

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Post-tax Principle

Average tax rate is the total tax as a proportion of the total income of the business. The marginal tax rate is the tax rate applicable to the income at margin i.e. the next rupee of income. The marginal tax rate is higher than the average tax rate because of various tax incentives.

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Consistency Principle Cash flows and the discount rates applied to these cash flows must be consistent with respect to the investor group and inflation. Investor groups are of equity shareholders and lenders. In dealing with inflation, you have two choices. You can use expected inflation in the estimates of future cash flows and apply a nominal discount rate to the same. Else, you can estimate the future cash flows in real terms and apply a real discount rate to the same.

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Projects have following components of cash flows

Initial investment

Annual net cash flows Terminal cash flows

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Initial investment

is purchased. A major element of the initial investment is gross outlay or original value (OV) of the asset.

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Annual net cash flows

from operations after an initial cash outlay has been made. Cash flows should always be estimated on an after-tax basis.

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Terminal cash flows

additional cash flows or salvage value. Salvage value is defined as the market price of an investment at the time of its sale. The cash proceeds net of taxes from the sale of the assets will be treated as cash inflow in the terminal (last) year.

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Cash flows for new projects or expansion projects is relatively easy. In such cases, the initial investment, operating cash inflows and terminal cash flows are the after-tax cash flows associated with the proposed project. Estimating the cash flows for a replacement project is somewhat complicated because you have to determine the incremental cash outflows and inflows in relation to the existing project. Biases in cash flow estimation As the cash flows have to be forecasted far into the future, errors occur in estimation. Biases may lead to over stating or under stating of true project profitability. 20 / 23

The choice between projects with different lives should be made by evaluating them for equal periods of time. Example A firm has to choose between two projects X and Y which have different lives.

0 X 120 1 30 2 30 3 30 4 40 NPV, 10% 215.1

60

40

40

129.42

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Cash Flows

0

Y1 Y2 Y = Y1 + Y2 X 60 0 60 120

1

40 0 40 30

2

40 60 100 30

3

0 40 40 30

4

0 40 40 30

NPV, 10%

129.42 106.96 236.38 215.10

Correct procedure to compare NPVs of the projects for equal periods of time.

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A common problem which complicates the investment decision making is inflation. The rule is to be consistent in treating inflation in the cash flows and the discount rate. Inflation is a fact of life all over the world. Because the cash flows of a project occur over a long period of time, a firm should be concerned about the inflation on the projects profitability. Capital budgeting results will be biased if the inflation is not correctly factored in the analysis. Nominal rate = (1 + real rate) x (1 + inflation rate) -1

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