Financial Management

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FinanciaI management study materiaI
(ReIerence: Einancial management by S.N.Maheshwari, Einancial
management by I.M. Pandey , Einancial management by Prassana
Chandra & Anna university study material)
Unit - I
FOUNDATON8 OF FNANCE
Einancial management: An Overview Time value oI money introduction
to the concept oI risk and return oI a single asset and oI a portIolio,
valuation oI bounds and shares option valuation
O81LC1IvLS AND IUNC1IONS OI IINANCIAL MANACLMLN1
Maximization oI the wealth oI equity share holders appears to be
the most appropriate goal Ior Iinancial decision making. Apart Irom the
main goal other alternatives have been suggested (ie) maximization oI
proIit, maximization oI earnings per share, maximization oI return on
equity.
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MLANINC OI IINANCIAL MANACLMLN1 According to soloman
'Einancial Management is concerned economic resource namely capital
Iunds.
Einancial management is mainly concerned with the proper
management oI Iunds. The Iinancial manager must see that the Iunds are
procured in a manner that the risk cost and control considerations are
property balanced in a given situation and there is optimum utilization oI
Iunds
O81LC1IvLS OI IINANCIAL MANACLMLN1
Basic objectives
The basic objectives oI Iinancial management are the maintenance
oI liquid assets and maximization oI the proIitability oI the Iirm.
Maintenance of Liquid assets Maintenance oI liquid assets means that
the Iirm has adequate cash in hand to meet 15 obligations at all times
Maximization of profitability A business Iirm is a proIit seeking
organization. Hence proIit maximization is also well considered to be an
important objective oI Iinancial management.
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Wealth maximization The objective is also consistent with the objective
oI maximizing the economic welIare oI the shareholders oI a company
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Other objectives
Ensuring a Iair return to shareholders
Building up reserves Ior growth and expansion
Ensuring maximum operational eIIiciency by eIIicient and
eIIective utilization oI Iinances
Ensuring Iinancial discipline in the organization
Organization of the financial function
Organization oI the Iinancial Iunction diIIers Irom company to
company depending on their respective needs and the Iinancial
philosophy. The titles used to designate the key Iinance oIIicial are also
diIIerent (viz) vice president (Iinancial) chieI executive (Iinancial)
General manager (Iinancial) etc. however in most companies the vice
president (Iinancial) has under him two oIIicers carrying out the two
important Iunctions the accounting and the Iinance Iunctions. The Iormer
is designated as controller and the later as Treasurer.
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Importance of Financial Management
Sound Iinancial management is essential in both proIit & non proIit
organization. The Iinancial management helps in monitoring Iixed assets
& in working capital.
Einancial Management also helps in cocerntaining how the
company would perIorm in Iuture. It helps in indicating whether the Iirm
will generate enough whether the Iirm will generate enough Iunds to meet
it various obligations like repayment oI the various instatements due to
loans, redemption oI other liabilities etc.
1ime value of money
What are all the time factors?
When interest an Iunds raised will have to be paid
When return an investment will be received
Whether it will be received on a consistent basis or otherwise etc
Jarious valuation concepts
Compound value concept
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Annuity concept
Present value
All these concepts are basically boned on this Iact that the money
has a time value (ie) a rupee today is much more valuable than a rupee
tomorrow.
1ime value of money
Money has a time value because oI the Iollowing reasons
1. Individuals generally preIer current consumption
2. An investor can proIitable employ a rupee received today to give
him a higher value to be received tomorrow or aIter a certain
period
3. In an inIlationary economy a rupee received today has more
purchasing power than money to be received in Iuture
Various techniques used Ior ascertaining the time value oI money
Jaluation concept
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There is a preIerence oI having money at present than at a Iuture
point oI time this means that a person will have to pay in Iuture more Ior
a rupee received today. A person may accept less Ior a rupee to be
received in Iuture.
The above statement radiates to two diIIerent concepts
1. Compound value concept
2. Present value concept
Compound value concept
In case oI this concept the interest earned on the initial principal
becomes a part oI principal at the end oI compounding period.
Eor eg. Rs. 100 is invested 10 com. In erest Ior two years the
return Ior Iirst year will be Rs. 10& Ior second year interest will be
received on Rs. 110 (ie) (10010)
Compound value concept is divided into
a) Compounding of interest over "A" years
The returns Irom an investment are generally spread over a number
a year A p(1i)
n
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b) Multiple compounding periods
Interest can be compounded even more than once in a year
A p(1i/m)
mn
In case oI semiannual complaining interest is paid twice a year bat
at halI the annual rate.
C. Future value of series of cash flows
The transactions in real liIe are not limited to one. An investor
investing money in instatements may wish to know the value oI savings
aIter in years.
2. Present value or discounting concept
The present value concept is exact opposite oI the complaining
technique concept while in case oI present value concept, they estimate
the preset worth oI a Iuture payment / installment or series oI payments
adjusted Ior the time value oI money. The interest can be earned on the
money is termed as 'discounting rate.
Present value can be divided into
1. Present value after :n` years
9
n
i) (1
A
pv
With this Iormula the amount can be directly calculate any deposit
or would be willing to accept at present, with a time preIerence rate or
discount rate oI X
2. Present value of a series cash flow
In a business situation it is very natural that returns received by a
Iirm are spread over a number oI years series oI returns the present value
oI each expected inIlows will be calculated
) 1 (
.........
) 1 ( ) 1 ( i) (1
A
p
3
3
2
2
1
1
3. Present value of an annuity

In the above case there was a mixed stream oI cash inIlows. An
individual or depositor may receive only constant returns over a number
oI years. To Iind out the present value oI annuity either by Iind the
present value oI each cash Ilow or use the annuity table.
4. Present value of a perceptual Annuity
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A person may like to Iind out the present value oI his investment in
case he is going to get a constant return year aIter year. An annuity oI this
kind which goes on Iorever is called perpetuity
5. Capm-Capital asset pricing model Relationship between Risk and
Return
Securities are risky because their returns are variable
The most commonly used measure oI risk or variability is standard
deviation
The risk oI a security can be split into two parts unique risk &
market risk
Unique risk stems Irom speciIic Iactors whereas market risk
emanates Irom economy wide Iactors
PortIolio diversiIication washes away unique risk but not market
risk. Hence the risk oI a Iully diversiIied partygoer is it market risk.
The contribution oI a security to the risk oI a Iully diversiIied
portIolio is measured by it beta which reIlects it sensitivity to the
general market movement.
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Methods of Risk Management
1. Avoidance oI risk
2. Prevention oI risk
3. Retention oI risk
4. TransIer oI risk
5. Insurance
Sources of risk
1. Interest rate risk - (reduction in interest rate)
2. Market risk - (It will aIIect equity shareholders)
3. InIlation risk - (Share value will come down)
4. Business risk - (innovation oI new product by
competitors)
5. Einancial risk - (proportion between Dept& equity)
6. Liquidity risk
Concept of risk and return of a single asset & of a portfolio
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Risk
Risk may be deIined as 'the chance oI Iuture loss that can be
Ioreseen.
In other words in case oI risk an estimate can be made about the
degree oI happening oI the loss. This is usually done by assigning
probabilities to the risk on the basis oI part data & the probable trend.
Return
The return represents the beneIits derived by a business Irom its
operations
Measurement of return
1. ProIit approach
2. Income
a. Exiling beIore interest & Tax (EBIT)
b. Exiling beIore Tax (EBT)
c. Earning aIter tax (EAT)
3. Cash Ilow approach
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4. Rations approach
Return of a single Asset
The rate oI return on an asset Ior a given period (usually a period oI
one year) is deIined as Iollows
Rate oI return Annual incent Ending price Beginning price
Beginning price
Return on single asset
Purchase oI shares oI the company at the beginning oI a
yrmktprice oI the Rs.225. The par value oI each sh is rs. 10, then total
investment
22510022.500
Rupee return
During the yr iI the co pd dividend 25 then dividend per share
would be (25)
100
25
Rs.10 2.50
Dividend (Dividend rate par value) No
Dividend Dividend per sh No. oI shs
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Dividend 2.50100250
Percentage return
Percentage returns are Irequently calculated on per share basis. The
return has 2 components the divined income and the capital gain
Rate oI returns Divided yield gain yield
Unrealized capital gain or loss
II an investor holds a share & does not sell it at the end oI period
the diIIerence between the beginning & ending share prices is the
unrealized capital gain (or loss).
Risk & Return of a portfolio
A portIolio is a bundle or a combination oI individual assets or
securities. The portIolio theory provides a normative approach to
investors to make decisions to invest their wealth in assets or securities
under risk. It is based on the assumption that investors are risk averse.
This implies that investors hold well diversiIied portIolios instead
oI investing their entire wealth in a single or a Iew assets one important
conclusion oI portIolio theory is that iI the investor hold a well diversiIied
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portIolio oI assets then their concern should be the expected rat oI return
& risk oI the portIolio rather than individual assets & the contribution oI
individual asset to the portIolio risk.
The second assumption oI the portIolio theory is that the returns oI
assets are normally distributed. This means that the mean (the expected
value) & variance (or std deviation) analysis is the Ioundation oI portIolio
decisions. PortIolio theory is considered as a Irame work Ior valuing risky
assets. The Iramework is reIerred to as the
1. Capital asset pricing Model (APM)
2. Arbitrage pricing theory (APT) an alternative model Ior valuing
risky assets
Portfolio return: 2 asset case
The return oI a portIolio is equal to the weighted average oI the
returns oI individual assets in the portIolio with weights being equal to
the proportion oI investment value in each asset.
The expected rate oI return on a portIolio (portIolio return) is the
weighted average oI the expected rates oI return on assets in the portIolio
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The expected rate oI portIolio
Weight oI security expected rate return on security weight
oI security Y x expected return on security y.
Portfolio risk - two assets case
The risk oI individual assets two assets is measured by their
variance or std deviation. The portIolio return is the weighted average oI
returns on individual assents. The portIolio variance or std deviation
depends on the co-movement oI 2 assets.
Calculation of covariance (Measure the co-movement)
1. Determine the expected return on assets
2. Determine the divination oI possible return
3. Determine the sum oI the product oI each deviation oI returns oI
2 assets.
Jaluation of bonds & shares
Securities like shares & bonds are called Iinancial assets.
How to value bonds & shares
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Book value:
Assets are recorded B.V may include intangible assets at
acquisition cost minus amortized value.
B.V per share is determined as net worth divided by the no oI
shares outstanding Book value reIlects historical cost rather than value
(value is what an assets is worth today)
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Replacement value
R.V. is the amount that a company would be required to spend iI it
were to replace it existing assets in the current condition. It is diIIicult to
Iind cost oI assets currently being used by the company.
Liquidation value
L.V. is the amt that a company could realize oI it sold its assets
aIter having terminated it business liquidation value is generally a
minimum value which a company might accept iI it sold its business.
Going concern value
G.C.V. is the amt that a company could relies iI it sold it business
as an operating business G.C.V. would always since it reIlects the Iuture
value oI assets & value oI intangibles.
Market value
M.V. oI an asset or security is the current price at which the asset
or the security is being sold or bought in the market MV the share is
expected to be higher than the book value per share Ior proIitable.
Bonds values yields
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Bonds maybe classiIied into 3 categories
1. Bonds with maturity
2. Pure discount bounds
3. Perpetual bonds
1. Bonds with maturity
The government & Companies mostly issue bonds that speciIy the
interest rate (coupon) & the maturity period. The present value oI a bond
is the discounted value oI it cash Ilows that is the annual interest
payments plus bond`s termite or maturity value. The discount rate oI the
interest rate that investors could earn on bonds with similar could earn on
bonds with similar.
a) Jalue of Bonds with maturity
YTM is the Maxell oI a bond`s rate oI return that considers bath
the interest income & any capital gain or loss. YTM is bonds internal rate
oI return
b) Current yield
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Current yield is the annual interest divided by the bounds current
value Ior (eg.) the annual interest is Rs. 60 on the current investment
883.40.
The current rate oI return or the current yield is 60/883.4068 . II
the bond`s current price were less than is maturity value its overall rate iI
return would be less than the current yield.
c) Yield to call
A no oI companies bonds with back or call provision. Thus a bond
be redeemed or called beIore maturity.
d) Bond values & semiannual interest payment
It is a practice oI many companies in India to pay interest on bonds
semi annually (eg) 10 yr bond oI Rs. 1000 w hen an annual rate oI
interest oI 12. The interest is paid halI yearly.
2. Pure Discount Bonds
It does not carry an explicit rate oI interest. It provides Ior the
payment oI lump sum amount at a Iuture date in exchange Ior the current
price oI the bond. The diIIerence between the Iace value oI the bond its
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purchase price gives the return or YTM to the investor pure discount
bonds are called deep descant bonds or zero interest bonds or zero coupon
bonds.
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3. Perceptual Bonds
PB has an indeIinite liIe thereIore it has no maturity value PB or
debentures are mainly Iound in practice. In case oI perpetual bonds as
there is no maturity or terminal value the value oI the bonds would
simply be the discounted value oI the inIinite stream oI interest Ilows.
How to determine the value of the bonds
Bond vale & changes (i) interest rate
The value oI the bond declines as the mkt interest rate (distaste)
increases the easiness bonds cash Ilows (interest & principal repayment)
are discounted at higher interest rates.
Bond maturity & interest rate risk
Value oI the bard depends upon the market interest rate. As interest
rate changes the value oI the bond also var. there is an inverse
relationship between the value oI a bond & the interest rate. The bond
value world decline when the interest rate vises & vice versa
Interest rates have the tendency oI rising or Ialling in practice. Thus
the investors oI bonds are exposed to the interest rate risk.
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Bond durations & interest rate sensitivity
Bond prices are sensitive to change in the interest rates & they are
inversely related to the interest relates. The bonds duration is measured as
the weighted average oI times to each cash Ilow interest payment or
repayment oI principal. The intensity oI the price sensitivity depends on a
bonds maturity & the coupon rate oI interest. Longer the maturity oI bond
the higher will be its sensitivity in the interest rate changes.
Option valuation
Options may reIer to choice or alternative or privilege or
opportunity Ior preIerence or right. Option is a claim without any
liability. An option is a contract that gives the holder a right without any
obligations to buy or sell an asset to any agreed price on or beIore a
speciIied period oI time.
The option to buy an asset is known as a call option & the option to
sell an asset is known as a put option. The price at which option can be
exercised is called an exercise price or a strike price.
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Factors determining option value
The option holder will exercise his option only when it is
beneIicial. The call option will be beneIicial to is buyer when the exercise
price is less than the price oI the share (the underlying asset) when the
call option is art oI the money (i.e.) the exercise price to more that the
price oI the undying asset) the minimum value oI the (all option at
expiration will be zero). The value oI the option depends on the Iollowing
Iactors.
1. Exercise price & the share
2. Volatility oI return on share
3. Time to explication
At the expiration date the holders will know the share price & he will
exercise his option iI the exercise price is lower than the sh. Price. The
excess oI the sh.price over the exercise price is the value oI the option at
the expiration oI the option at expiration oI the option. II the sh.price is
more that the exercise price a call option is said to be the money.
Suppose you hold a 2 month option on the share or Bright ways
company. The exercise price ot Rs. 100 & the current market price is Rs.
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100. The option will be worthless iI the share price remains Rs. 100 at
maturity.
Interest rate
The holder oI a call option pays exercise. Price not when he buys
the option rather later can when he exercise is option. Thus the present
value oI the exercise price will depend on the interest rate.
Option expiration
The present value oI the exercise price also depends on the time to
expiration oI the option. (The present value oI the exercise price will be
less time to expiration is longer & consequently the value oI option will
be higher).
Risk Return Relationship possibility of something and happening
Risk
Risk may be deIined as the chance oI Iuture loss that can be
Ioreseen. In other words in case oI risk an estimate can be made about the
degree oI happening oI the loss. This is usually done by assigning
probabilities to the risk on the basis oI past data and the probable trends.
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Certainty
Uncertainty may be deIined as the unIoreseen change Ior Iuture
loss or damages. In case oI uncertainty since the Iirm cannot anticipate
the Iuture loss and hence it cannot directly in deal with it in its planning
process and is possible in the case oI risk.
Return
The return represents the beneIits derived by a business Irom its
operations.
Measurement of return
1. ProIit approach
2. Income approach
a. Earning beIore interest & Tax (EBIT)
b. Earning beIore tax (EBT)
c. Earning aIter tax (EAT)
3. Cash Ilow approach
4. Ratios approach
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Relationship between Risk & Return
The rate oI return required to a great extent depends upon the risk
involved higher the risk. Greater is the return expected by the Iirm. The
rate oI return required by the business consists oI 3 components.
1. Return at Zero Risk
This reIers to the expected rate oI return where a project involves
no risk whether business or Iinancial
2. Premium for Business Risk
The term business risk reIers to the variability in operating proIit
(EBIT) due to changes in sales. In case oI a projects having more than the
normal or average risk the Iirm will expect a higher rate oI return than the
normal rate.
3. Premium of financial Risk
The term Iinancial risk reIers to the risk on account oI pattern oI
capital structure. (debt equity mix). A Iirm having higher debt content in
its capital structure expects a higher rate oI return as compared to a Iirm
which has comparatively debt content.
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This is become in the Iencer case the Iirm requires higher operating
proIit to cover periodic interest payments and repayment oI principal at
the time oI maturity as compared to the latter.
The above 3 components may be put in the Iorm oI Iollowing
equation
Rate oI return r
0
bI
r0 return as zero risk
b premium Ior business risk
I premium Ior Iinancial risk
Criteria for evaluating proposals to minimize risk
1. Select the least risky proposal
2. Apply hurdle rates The Iirm may decide the minimum acceptable
return below which is not going to accept the proposal.
3. Avoid propose is with Iluctuating risk
4. Adopt weighted Average approach on the basis oI risk & return oI
the project.
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UNIT- 2
INVESTMENT DECISIONS
Capital budgeting
Principles & techniques Nature oI capital budgeting, identiIying relevant
cash Ilows, evaluation techniques, payback, Accounting rate oI return,
Net present value, Internal Rate oI return, proIitability index, Comparison
oI DCE techniques. Project selection under capital rationing inIlation &
capital budgeting concept & measurement oI cost oI capital, speciIic
costs and overall cost oI capital.
Capital budgeting
Capitalbudget is budget Ior capital projects the exercise involves
ascertaining cash inIlows & outIlows matching & evaluation with
outIlows appropriately &evaluation oI the desirability oI the project
under consideration
Capital budget is the planned expenditure on capital investments Ior
projects .It is a long term plan Ior proposed capital outlays & the means
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oI Iinancing capital budget help the mgmt to avoid over investment &
under investment the investment oI huge amount oI expenditure
includes.
Expansion oI existing business
Staring new projects
Replacement projects
Modernization& diversiIication oI projects
Research&n development projects
Capital bud is the process oI deciding whether or not to commit
resources to a capital project whose beneIits would be spread over
general time period.
According to Lynch
'Capital bud consists in planning, development oI available capital
Ior the purpose oI maximizing the long term proIitability oI the concern
Accordingto Horn gren
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'Capital bud is long term planning Ior making and Iinancing proposed
capital outlays
SIGNIFICANCE OF CAPITAL BUDGETING
1. DEALS WITH RIGHT KIND OF EVALUATION
A project may be scientiIically evaluated so that no under
Iavor or disIavor is shown. A good project must not be rejected & a bad
project must not be selected.
2. INVOLVES CAPITAL RATIONING
The available Iunds must be allocated to competing project in the order
oI project potentials usually the indivisibility oI project poses the
problem oI capital rationing because required Iunds and available Iunds
may not be the same.
3. CLEAR SYSTEM OF FORECASING
The building blocks oI capital budgeting exercise are mostly estimates oI
prices and variable cost per unit output quantity oI output that can be
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sold the tax rate the cost oI capital the useIul liIe oI the project etc over a
period oI years.
4. CAPITAL BUDGETING - A SIGNIFICANT TASK
Capital investment proposals involve i)longer gestation period
development oI an idea (ii) huge capital outlay (iii) technological
considerations needing technological Iorecasting (iv) measuring oI
dealing with project risks. All these make capital budgeting a signiIicant
task.
ADVANTAGES OF CAPITAL BUDGETING
1.It is helpIul Ior taking proper decisions
1. It inIluences the Iirms growth in the long run.
2. It indicates proper timings Ior purchase oI Iixed assets.
3. It avoids over investment or under investment in Iixedassets.
4. It provides a sound policy Ior depreciation & replacement oI Iixed
assets.
5. It serves as a means oI controlling expenditure.
LIMITATIONS OF CAPITAL BUDGETING
1. It is a very diIIicult task.
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2. None oI the various methods oI capital appraisal available is Iree
Irom drawbacks.
3. They are irreversible or reversible at substantial loss.
APPRAISAL OF CAPITAL PRO1ECTS.
Appraisal means examinations & evaluation. The cost oI capital projects
include the initial investment at the inception oI the project Initial
investment made in Land, building, machinery, plant, equipment,
Iurniture, Iixtures etc. Investment in these Iixed assets is one time.
Eurther a onetime investment in working capital is needed in the
beginning, which is Iully salvaged at the end oI the liIe oI the project &
tax.
The net cash earning are computed as Iollows
Cash earning ((P-V)(Q-E-D-I)(I-T)D)
P Price per unit
V VariableCost
Q Quantity produced & sold
E Total Iixed expensed exclusive oI depn
D stand Ior depn on Iixed assets
I Interest on borrowed capital
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T Tax rate.
BeneIits are estimated the same may be compared with costs oI the
capital projects to Iind out whether costs exceed beneIits or beneIits
exceed costs This process oI estimation oI cost & beneIits &
comparison oI the same is called. CapitalAppraisal.
CAPITAL BUDGETTING TECHNIQUES. OR METHODS USED
FOR CAPITAL PRO1ECT APPRAISAL
TWO METHODs
1. Traditional or non discounted cash Ilow or non time value
techniques.
2. Modern, discounted cash Ilow techniques Time value techniques.
TRADITIONAL METHOD
1. Pay back, pay oII or recoupment period method
2. Post pay back proIitability method
3. Accounting rate oI return, Average rate oI return or investment
method
Modern/discounted cash flow method:
1. Discounted pay back
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2. Net present value
3. ProIitability index or cost beneIit ratio method
4. Internal rate oI return.
A. Payback period (PBP) method
Payback period reIers to the number oI years one has to wait to setback
the capital invested in Iixed assets in the beginning. It is a traditional &
simple method oI evaluating the projects .It does not take the eIIect oI
time value oI money.
II the annual cash inIlows are uniIorm the Iormula will be
Payback period
The selection oI the project to based on the earning capacity oI a project
Here the Iin mgr`s aim is to know how soon the original investments are
recovered he has to compare. It the payback period is more than the cut
oII rate (rate oI interest Ior capital) the proposal are rejected iI the
payback period to less than the cut oII rate such proposals are selected
Ior investment.
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Pay back profitability method or post payback profitability method
To remove the drawbacks oI payback period Post pay back proIitability
method was developed under this method the cash inIlow generated
Irom a project during the economic liIe is taken into account where as in
pay back. Period the cash inIlows were considered only to the extent oI
recovering the original investment.
Accounting Rate of Return method/Average rate of return
ARR is the Capital investment proposals are judged on the basis oI their
relative proIitability accounting Concepts, over the entire economic liIe
oI the projects& then the averageyield is calculated. Such a rate is
termed as ARR. It may be calculated according to any one oI the
methods.
i) x100
ii) x100
The term average annual net earnings is the average oI earnings (aIter
depn&tax) over the whole oI the economic liIe oI the project.
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The amt oI average investment can be calculated according to any oI the
Iollowing methods.
a)
b)
c)
d)
Accept/ Reject Criteria
Normally business enterprises Iix a minimum rate Any project expected
to give a return below this rate will be rejected.
In case oI several projects where a choice has to be made the diIIerent
projects may be ranked in the ascend/descending order oI their rate oI
return. Projects below the minimum rate will be rejected & Project
giving higher rate will be selected.
Merits
1. It is simple & Common sense Oriented
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2. ProIits oI all years are taken in to account.
Demerits
1. Time Value oI money is not considered
2. Risk involved in the project is not considered.
3. Annual average proIits might be the same Ior diIIerent project.
4. ARR has several variants & it lacks uniIormity
MODERN METHOD (DISCOUNTED CASH FLOW
METHOD)
Discounted cash flow method or Time adjusted Techniques.
The DCE techniques are an improvement on the payback period method.
It takes both the interest Iactor as well as the return aIter payback
period. This method involves 3 stages.
i)Calculations oI cash Ilows (i.e) inIlows & outIlows (preIerably aIter
tax) over the Iull liIe oI the asset.
ii) Discounting the cash Ilows so calculated by a discount Iactor.
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iii) Aggregating oI discounted cash inIlows & comparing the total with
the discounted cash outIlows.
DCET thus recognizes that Re 1 oI today (the cash outIlow) is worth
more than Re 1 received at a Iuture date (Cash inIlow)
DCE methods Ior evaluating capital investment proposal are divided into
1 NPV method
Best method under discount cash Ilow. It considered cash inIlows & cash
outIlows associated with each project. The PV oI these cash inIlow are
compared with cash outIlows then calculated at the rate oI return
acceptable to the management. This rate oI return is considered as the
cut oII rate & is generally acc determined on the basis oI cast oI capital
suitably adjusted to allow Ior the risk element involved in the project
cash out Ilow represent the investment. The working capital is taken as
a cash outIlow in the year the project starts commercial production
proIit aIter tax but beIore depreciation represents cash inIlow.The NPV
is the diII between the total present value oI Iuture cash inIlow & the
total present value oI Iuture cash outIlows.
40
The equation Ior calculation NPV in cash oI conventional cash Ilows
can be
In case oI non conventional cash inIlows the equation is
R Cash inIlows at diII time periods
K cost oI capital or cut oII rate
Z cash outIlows at diIIerent time periods.
Accept / Reject criteria
In case the NPV is positive (P.V oI cash inIlows is more than PV oI cash
outIlows) The project should be accepted However iI the NPV is
negative (PV oI cash inIlow is less than the present value oI cash
outIlows) the accept/reject criterion can be put as Iollows
NPV~ Zero accept the proposal
41
NPV Zero reject proposal
PV~ C accept proposal
PV C the proposal
PV- Present value oI cash inIlow &
C- Present value oI cash out Ilow (or) outlays.
b) Excess Present value Index/ BeneIit cost ratio
This is a reIinement oI the net present value method. Instead oI working
cut the NPV a PV index is Iound out oI PV oI cash inIlows & the total
oI the PV oI Iuture cash outIlows.
Excess PV index or beneIits cost (B/C) ratio
Excess PV index provides ready comparison between investment
proposals oI diIIerent magnitudes. Eor eg project A requiring an
investment Rs.1,00,00 shows excess PV oI Rs.20,000 while another
project B requiring loan investment oI Rs 10,000 shows an excess on pv
42
oI Rs 5000. It absolute Iigs oI NPV are compared project mayA seem to
be proIitable.
However iI excess PV index method is Iollowed project B would
prove to be proIitable.
C) Internal Rate of Return
IRR is that rate at which the sum oI discount cash inIlows equals
the sum oI discount cash inIlows equals the sum oI discount cash
outIlows In other worth it is the rate which discounts the cash Ilow to
Zero. It can be stated in the Iorm oI a ratio as Iollows.
Thus in case oI this method the discount rate is not known but the cash
outIlows & cash inIlows are known Ior eg iI a sum oI Rs 800 invested
in a project becomes Rs.100at the end oI a yr the rate oI return comes to
25 cal as Iollows.
43
I Cash outIlow )
R Cash inIlow
R Rate oI return yielded by the Investment or (IRR)
Or 800r800 1,000
Or 800r 200
Or r25
In case oI return is over a number oI years the calculation would take
the Iollowing pattern in case oI conventional cash Ilow
Where
I cash outlay (outIlow) at diIIerent time period.
R Cash inIlow at diII time period
44
r rate oI return yielded by the investment or (IRR)
Since I & R are known Iactors r is the only Iactors to be calculated
However calculations will becomes very diIIicult over a long period iI
worked out according to the above equations. Tabular values are
thereIore used.IRR is calculated according to the methods on the basis
oI Tabular values as Iollows.
1) Where cash inIlows are uniIorm
In the cone oI these projects which result in uniIorm cash inIlows
IRR can be calculated by locating the in annuity Table II TheIactor to
calculated as Iollows
E Iactor to be located
I original investment
C Cash inIlow year.
When cash inIlows are not uniIorm the IRR is calculated by
making trial calculation in an attempt to compute the correct interest
rate which equates the PV oI cash inIlows with the pr oI cash outIlows.
43
Decision Tree approach
DTA is a versatile tool used Ior decision making under conditions
oI risk the Ieatures oI this approach are
1) It takes into account the result oI all expected outcomes
2) It is suitable where decisions are to be made to sequential a part
that is iI this has happened already what will happen next & what
decision has to Iollow.
3) Every possible outcome to weighted using joint probability model
& expected outcome worked out.
4) A tree Iorm pictorial presentation oI all possible outcomes is
presented here & hence the term decision tree is used.
Capital Rationing
Capital rationing arise at any time there is budget ceiling constraint
on the amount oI Iunds that can be invested during a speciIic period
such constraints are prevalent in a no oI Iirms. Particularly in those that
have a policy oI Iinancing all capital expenditure internally.
46
C.R. reIers to a situation where the Iirm is constrained Ior external
or selI imposed reasons to obtain necessary Iunds to invest in all
proIitable investment projects under CR the mgmt has to determine the
proIitable opportunities`& then to rank them according to their relative
probabilities.Capital rationing means distribution oI capital in Iavor oI
more acceptable proposal
Reason for capital rationing
Cap rationing may be due to external Iactors & interest constraints
imposed by management. External occurs because oI the imperIections
may caused by.
1. DeIiciencies in market inIormation.
2. A diIIerence between the interest rate at which the Iirm can obtain
capital in the market & the interest rate it could earn by lending its own
capital to others in the market.
3. Hamper the Iree how oI capital between Iirms Internals cap rat due
to selI imposed restrictions by the mgmt oI the Iirm such restrictions
are
a. Decision not to obtain additional debt capital
b. Ceiling on the amts to be invested by divisional mgrs.
47
c. Condition that the rate oI return should be higher than the cost oI
capital
Selection of project under capital Rationing
There are 2 ways oI selecting the project.
1. IRR or ProIitability index will be taken as a base Ior selecting a
project according to priority. The ProIitability will indicate whether it is
Ieasible to invest on a project or not.
2. The project can also be selected Ior investment on the basis oI
proIitability within the estimated amount while selecting the project
wealth maximization concept is considered This means the Iirms can go
on thinking oI investing in projects which yield proIit & also increase
the image oI the Iirm in capital market& in terms oI maintaining
solvency & liquidity While estimating the Iuture earnings. NPV oI
Iuture earnings will be taken into a/c.
Measurement of specific cost
This is the combined cost oI the speciIic costs
associated with speciIic sources oI Iinancing the cost oI the diII sources
48
oI Iinancing represents the components oI combined cost the
computation oI the cost oI capital involves 2 steps.
i. The computation oI the diIIerent elements oI the cost in terms oI the cost
oI the diIIerent sources oI Iinance( speciIic costs) (ii) the calculation oI
the overall cost by combining the speciIic costs into made upon various
source speciIic costs into composite cost.
The Iirst step in the measurement oI the cost oI capital oI the Iirmis the
calculation oI the cost oI individual sources oI raising Iunds Irom the
viewpoint oI cap budget decision the long term sources oI Iunds are
relevant as they constitute the major sources oI Iinancing oI Iixed asset.
In calculating the cost oI capital thereIore the Iocus is on long term Iunds
In other words the speciIic costs have to be calculated Ior.
i)Long term debt (including debentures)
ii) PreIerence shares
iii) Equity capital &
iv) Retained earnings
1.Cost of debt
49
The cost oI Iunds raised through debt in the Iorm oI debentures or
loan Irom Iinancial institutions can be determined.
We need data regarding.
i)Net cash proceeds (inIlows) (the issue price oI debs/amt oI
loan minus all Iloatation costs)
ii) Net cash outIlow in term oI the amt oI periodic
interest payment & repayment oI principal in installments or
in lump sum on maturity.
2) Cost oI preIerence shares
The computation oI the cost oI preIerence shares is diIIicult as
compared to the cost or debt .It is true that a Iixed dividend rate is
stipulated on preIerence share holders have some right compared
toOrdinary shares holders.
i)PreIerence shareholders prior right to receive dividend over equity
holders.
ii) PreIerence Shares are cumulative
Two types oI preI. shares
i)Irredeemable
30
ii) Redeemable
3.Cost ofEquity capital
The cost oI equity capital is relatively the highest among all the
sources The investors purchase the shares in the expectation oI a certain
rate oI return the equity shares involve the highest degree oI risk as they
also expect higher return & thereIore higher cost is associated with them.
iv) Cost of retained earnings
. That retained earning does not involve any Iormal arrangement to
become a source oI Iunds. In other words there is no obligation on a Iirm
to pay a return on retained earnings. Retained earnings may appear to
carry no cost; on the contrary they do involve cost like any other sources.
Overall cost of capital
Over all composite cost oI capital deIined as weighted average oI
the cost oI each speciIic type oI Iund. The overall proportions oI various.
Sources oI sit Iunds in the capital structure oI a Iirm are diIIerent. The
overall cost oI capital show take into a/c the relative proportions oI diII
sources & hence the weighted avg.
31
The computation oI overall cost oI capital involves the Iollowing
1. Assigning weights to speciIics cost
2. Multiplying the cost oI each oI the sources by the
appropriate weights
3. Dividing the total weighted cost by the total weights
This is Iollowed by the mechanics oI computation
Computation oI overall cost oI capital symbolically.
Assignment of weights
The aspects relevant to the selection oI appropriate weights are
i)Historical weights vs Marginal weights
ii) Historical weights can be book value weights (or) (b)
mkt value weight
a) Marginal weights
The use oI m-weights involves weighting the speciIics costs by the
proportion oI each type oI Iund to the total Iunds to be raised. The
marginal weight represents the percentage share oI diIIerent
Iinancing sources the Iirm intents to raise/employ. The basis
32
oIassigning relative weight is thereIore new/add/incremental issue
oI Iunds & hence marginal weights.
In using marginal weights we are concerned with the actual amount
oI each type oI Iinancing used in raising additional Iunds to Iinance
new projects by the company. Another merit oI marginal weight is
that their use reIlects the Iacts that the Iirm does not have a great
deal oI control over the amount oI Iinance obtained thro retained
earnings or other sources which are inIluenced by several Iactors
such as temper oI the mkt, investors preIerence & soon.
B, Historical weights
The alternative to the use oI marginal weights is to use historical.
Weights. The relative proportions oI various sources to the existing
capital structure are used to assign weights.The basis oI weights
system is the Iunds already employed by the Iirm.
C,Book value & mkt value weights
In- use oI mkt value weight Ior calculations the cost oI capital is
more appearing than the use oI book value weights because.
33
1. Market values oI securities closely approximate the actual
amt to be relieved Irom their sale while selling the security.
2. The cost oI the speciIic sources oI Iinance .
CAPITAL ASSET. PRICING MODEL APPROACH
(CAPM)
Another technique used to estimate the cost oI equity is the
(CAPM approach)
CAPM explains the behavior oI security prices &
provides a mechanism whereby investors could assess the
impact oI proposed security investment on their overall
portIolio risk& return It describes the risk return trade oII Ior
securities. The basis assumption oI CAPM are related to (a) the
eIIiciency oI the security markets & (b) Investor preIerences.
The risk to which security investment is exposed to Ialls into 2
groups
(i) DiversiIiable (unsystematic)
(ii) Non diversiIiable (systematic)
Diversifiable
34
The Iirst represents that portion oI the total risk oI an investment
that can be eliminated /minimized through diversiIication the risk vary
Irom Iirm to Iirm the sources oI such risk include mgmt capabilities&
decisions, strikes, unique government regulation, availability oI raw
materials, competition, level oI operating etc.
Non diversifiable risk
An unsystematic risk can be eliminated by an investor through
diversiIication.
Project selection under inflations
Normally cash Ilows oI an investment project occur over a long
period oI time a Iirm should usually concerned about the impact oI
inIlation on the projects proIitability The capital budgeting results will be
based iI the impact oI inIlation is not correctly Iactored in the analysis.
Due to inIlation prices oI certain products may be controlled by
govt(eg) drugs & pharmaceutical some cost may wages may at a
higher rate than Iuel power or even raw material. The WORKING capital
oI an investment project during inIlation
33
The salvage value oI projects may also aIIected by inIlation during
rising price Iirm may able to sell an onset at the end oI its useIul liIe.
The rate oI inIlation is taken into account with the help oI Iollowing
points.
NOMINAL VS REAL RATES OE RETURN
Eg. Jose deposits Rs.100 SBI -1yr 10 interest receives RS-110
10 - Nominal rate oI return
100- real rate oI return
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