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VSA SCHOOL OF MANAGEMENT

Department of MBA
Salem 10
Subject: Financial Management
Topic: capital budgeting and its nature

Unit: 02
Hour: 01

CAPITAL BUDGETING

Dictionary
Meaning:

Budget:
DEFINITION:
Financial
Capital Budgeting is long term planning for making and financing proposed capital
plan
outlay.
- Charles T Hongreen
Capital Budgeting consists in planning for development of available capital for the
purpose of maximizing the long-term profitability of the firm
Key Words:
-R. M. Lynch
MEANING:
Capital Budgeting:
Capital budgeting is the process of evaluating and selecting long term
investments that are consistent with the goal of shareholders wealth maximization.

Capital Budgeting: Capital budgeting decision involves the decision of allocation


of capital or commitment of funds to long-term assets that would yield benefits in
the future.
Capital Budgeting decision relates to the choice of the new asset out of the
alternatives available or the reallocation of capital when an existing asset fails to
justify the funds committed

Capital
budgeting is
the process
of evaluating
and selecting
long term
investments

Teaching
Aid:
CB

Capital Expenditure:
Capital expenditure is an outlay of funds that is expected to produce benefits
over a period of time exceeding one year. These benefits may be either in the form of
increased revenues or reduced costs. Capital expenditure management includes
disposition, modification and replacement of fixed assets.
CAPITAL BUDGETING PROCESS OR STEPS INVOLVED IN CAPITAL
BUDGETING:
1. Idea Generation:
Generating the proposals for investment is the first process of capital budgeting.
For an ongoing business concern, investment proposals of various types may
originate at different levels within a firm.
The investment proposal may fall into one of the following categories:
Proposals to add new product to the product line, and
Proposal to expand production capacity in existing product lines.
Proposals to reduce the costs of the output of the existing products without altering
the scale of operation.
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Books
Referred:
Financial
managemen
t I.M.
Pandey

2. Project Evaluation:
Project evaluation involves two steps:
Estimation of benefits and costs
Selection of an appropriate criterion to judge the desirability of the project.
The benefits and costs of the project are measured in terms of cash flows.
The estimation of the cash inflows and cash outflows mainly depends on future
uncertainties.
The risk associated with each project must be carefully analyzed from the aspects
like marketing, technical, financial and economic.
3. Project selection:
No standard administrative procedure can be laid down for approving the
investment proposal.
The screening and selection procedures are different from firm to firm.
In a real life situation all capital budgeting decisions are made by top management.
However the projects can scientifically be screened by middle level management in
consulting with the head of the finance department.
4. Financing the selected project:
After the selection of the project, the next step is financing. Financing
arrangements have to be made.
There are two broad sources available such as equity and debt. While deciding the
capital structure, the decision maker has to keep in mind some factors, which
influence capital structure.
The factors are flexibility, risk, income, control and tax benefit.
5. Execution or implementation:
Planning is paper work and implementation is physically implementing the selected
project.
Implementation of an industrial project involves the stages like engineering
designs, negotiations and contracting, construction, training and plant
commissioning.
Translating an investment proposal from paper work to concrete work is complex,
time consuming and a risky task.
6. Review of the project:
Once the project is converted from paper work into concrete work, then there is a
need to review the project.
Performance review should be done periodically, in which phase the actual
performance is compared with the pre-determined performance

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NATURE OF CAPITAL BUDGETING (OR)


TYPES OF CAPITAL INVESTMENT DECISIONS
TYPES

BASED ON NATURES
DECISION

1. Mutually Exclusive

Decision
2. Accept Reject
Decision
3. Capital Rationing
Decision

BASED ON FIRMS
EXISTENCE

Revenue
Expansion
Decision

Cost Reduction
Decision

1. Expansion
decision

1. Replacement

Decision

2. Diversification

2. Modernization

Decision

Decision

BASED ON NATURES DECISION:


1. Mutually Exclusive Decisions:
Decisions are said to be mutually exclusive if two (or) more alternative proposals
are such that the acceptance of one proposal will exclude acceptance of the other
alternative proposals. For example, a company is intending to buy a new machine. There
are three competing brands, each with a different initial investment and operating costs. All
these machines compared and select the best among the alternatives. The mutually
exclusive project decisions are not independent.
2. Accept-Reject Decisions:
These are opposite to mutually exclusive decisions. The Accept-Reject
decisions occur when proposals are independent and do not complete with each other. The
firm may accept (or) reject a proposal on the basis of a minimum return on the required
investment. All proposals that give a return higher than a certain desired rate are accepted
and the rest are rejected.
3. Capital Rationing Decision:
In a situation the firm has unlimited funds, all independent investment proposals yielding
return greater than some pre-determined level are accepted. However, this situation does
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not prevail in most of the business firms in actual practice. They have a fixed capital
budget. A large number of investment proposal compete for these limited funds. The firm
must therefore ration them. The firm allocates funds to projects in a manner that it
maximises long run returns. Capital rationing employs ranking of the acceptable
investment projects. The projects can be ranked on the basis of pre-determined criterion
such as the rate of return.

BASED ON FIRMS EXISTENCE:


1. Cost Reduction Decisions:
These Decisions focus on reduction of operating cost and improving efficiency.
They can be sub classified into:
a. Replacement Decisions: To Replace an existing asset with a new and improved one
which version to choose etc.,
b. Modernization Decisions:To install new machinery in the place of an old one, which
has become technologically outdated
2. Revenue Technologically Outdated:
These Decisions focus on improving sales, product lines, improved versions of
products, etc., These are sub classified into:
a. Expansion Decision: To add capacity to existing product lines to meet increased
demand, to improve production facilities and to increase market share or existing products.
b. Diversification Decision: To diversify and enter into new product lines, venture into
new markets, to reduce business risk by dealing in different products and operating in
different markets.
Possible Questions & University Questions:
1. What is capital budgeting or define capital budgeting?
2. What is capital expenditure?
3. Explain the nature of capital budgeting decision.
4. Explain capital budgeting process or steps involved in capital budgeting.

VSA SCHOOL OF MANAGEMENT


Department of MBA
Salem 10
Subject: Financial Management
Topic: Identifying relevant cash flows

Unit: 02
Hour: 02

Cash flow vs accounting profit


Capital budgeting is concerned with investment decisions which yield return over a period
of time in future. The foremost requirement for evaluation of any capital investment
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proposal is to estimate the future benefits accruing to quantify benefits:


(i)

Accounting profit and

(ii)

Cash flows.

Dictionary
The basic difference between them primarily due to the inclusion of certain non- Meaning:
cash expenses in the profit and loss account. Example: depreciation. Therefore, the
accounting profit is to be adjusted for non-cash expenditure to determine the actual cash
inflow. The cash flow approach of measuring future benefits of a project is superior to the
accounting approach as cash flows are theoretically better measures of the net economic
benefits of cost associated with a proposed project.
Elements of Cash flow Stream
To evaluate a project, one must determine the relevant cash flows, which art the
incremental after-tax cash flows associated with the project. The cash flow stream of a Key Words:
conventional project - a project which involves cash outflows followed by cash inflowscomprises three basic components:
Teaching
Aid:
1. Initial Investment: The initial investment is the after-tax cash outlay on capital
CB
expenditure and net working capital when the project is set-up. In general, the
initial cash outflow for a project is determined. As seen, the cost of the asset is
subject to adjustments to reflect the totality of cash flows associated with its
acquisition. These cash flows include installation costs, changes in net working
capital, sale proceeds from the disposition of any assets replaced, and tax
Books
adjustments.
Referred
2. Operating Cash Inflows: They are after tax cash inflows resulting from the
operations of the projects during its economic life. After making the initial cash
outflow that is necessary to being implementing a project, the firm hopes to benefit
from the future cash inflows generated by the projects. Generally, these future cash
flows can be determined by following the step-by-step procedure outline.
3. Terminal Cash Inflow: The terminal cash inflow is the after tax cash flow
resulting from the liquidation of the project at the end of its economic life. Finally,
turned attention to determine the project incremental cash flow in its final, or
terminal, year of existence. The apply the same step-by-step procedure for this
periods cash flow as we did to those in all the interim periods. These potential
project wind-up cash flows are:
The salvage value
Taxes
Any project termination related change in working capital

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GUIDELINES FOR ESTIMATING PROJECT CASH FLOWS


1. Identify Incremental Cash flows:
Incremental cash flows are the changes in cash flows that are attributable to
the decision to invest in a given project. Cash flows not attributable to a new project are
irrelevant to the investment decision-making process. When a firm decides whether to
replace an old machine with a new, more efficient one, the relevant cash flows consist of
those generated by the new machine less those that would have been retained by keeping
the old machine.
The decision should hinge on the differences in cash flows between the two
machines. Favourable incremental net cash flows resulting from making the decision will
provide the relevant data needed to make the decision. Although the principle of
incremental analysis is a simple idea, applying it in practice is often difficult.
2. Focus on After-Tax Flows:
The only cash flows relevant to capital budgeting are those generated by a
project and still remaining after paying taxes. This is true for all phases of a project's life.
Considering a project's untaxed revenues overstates its benefit because the firm cannot
invest all these funds in other projects or pay them out to shareholders. Some more
common tax provisions influencing cash flows involve depreciation expense as well as
gains and losses from the sale of existing fixed assets.
3. Postpone Considering Financing Costs:
A common mistake in estimating cash flows involves the treatment of interest
expense and other financial cash flows attributable to financing the project. Financing
costs are payments that the company makes to the parties supplying capital to finance the
project. These costs may include interest paid to lenders or dividends paid to shareholders.
As a general principle, capital budgeting analyses require separating investment (capital
budgeting) and financing decisions, i.e., analysts should evaluate a capital budgeting
project independently of the source of funds used to finance' the project.
4. Net Operating Working Capital:
Adopting a project may require a change in a firm's Net Operating Working
Capital (NOWC), which is the change in all current assets that do not pay interest less the
change in all current liabilities that do not charge interest. For example, a project that
entails producing and selling a new product will probably require the firm to increase its
inventories and to hold more cash to conduct additional transactions
5. Sunk Costs: A sunk cost is an outlay incurred before making an investment
decision and represents a historical cost. Past expenditures on a project should not
influence the decision whether to undertake, continue, or end a project because
they are not incremental cash flows. Instead, decision-makers should base their
decision on future costs and benefits. Sunk costs are irrelevant because the decision
to adopt or reject the proposed project will not result in any change in the project's
cash flows related to these costs, the firm has already incurred the sunk cost with or
without the project. Because these sunk costs are irrevocable and have no bearing
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on a new project, they are not incremental cash flows. Thus, sunk costs are not part
of the evaluation process.
6. Opportunity Costs:
Estimating project cash flows requires considering both direct outlays and opportunity
costs. An opportunity cost is the most valuable alternative use of a resource or an asset
that the firm gives up by accepting a project. By using the asset or resource in the
proposed project, the firm forgoes the opportunity to employ the asset in its alternative
use. The cash flows that the firm forgoes represent an opportunity cost to the proposed
project. Opportunity cost can be difficult to estimate, but they are important to
recognize when estimating the relevant cash flows for analyzing a project.
7. Allocated Overhead:
For internal reporting purposes, accountants often allocate existing overhead, such as
general and administrative expenses, to each unit or division that undertakes a project,
However, if the firm's current overhead will remain unchanged by accepting a project,
the firm should exclude this allocated overhead from the project's cash flows in the
capital budgeting analysis. Here, overhead is an existing (fixed) cost, not an
incremental cost. Managers should recognize only an increase in overhead that will
result from accepting the project, such as hiring a new accountant, as part of a project's
cash flows.
8. Side Effects: Adopting and implementing new projects may have important side
effects because they affect the cash flows of other products or divisions. Project
planners should consider these potential side effects, or externalities, in the capital
budgeting analysis for the project. Side effects are complements if they enhance the
cash flows of existing assets and substitutes if the effect is negative.
BIASES IN CASH FLOW ESTIMATION.
As cash flows have to be forecasted far into the future, errors in estimation are bound to
occur. Yet, given the critical importance of cash flow forecasts in project evaluation,
adequate care should be taken to guard against certain biases which may lead to overstatement or under-statement of true project profitability.
1) Overstatement of Profitability: Knowledgeable observers of capital budgeting
believe that profitability is often over-stated because the initial investment is underestimated and the operating cash inflows are exaggerated. The principal reasons for
such optimistic bias appear to be as follows:
i.

Intentional Over-Statement: In a bid to present their projects in a favorable light,


proj.ect sponsors may intentionally over-estimate the benefits and under-estimate
the costs. Given the uncertainties characterizing the future, project sponsors enjoy
some latitude in twisting the figures the way they want.

ii.

Lack of Experience: Inadequate experience on the part of project sponsors


generally leads overoptimistic estimates. Experience often induces conservatism
that checks over-optimistic tendencies. Inexperience, on the other hand, may lead
to wishful thinking.

iii.

Myopic Euphoria: Individuals responsible for preparing forecasts may become


too involved and lose their sense of proportion. The lack of objectivity In this case
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is neither intentional nor due to inexperience. It may simply be the effect of 'masspsychology' as each person's favorable opinion may be reinforced and magnified
by others in the group. Referred to as "risky shift" or "group polarization effect" in
social psychology, this phenomenon is widely supported by empirical studies.
iv.

Capital Rationing: Companies typically operate under-capital-rationing, which


maybe externally determined or internally imposed. An awareness of such
constraint induces project sponsors to exaggerate the benefits of projects proposed
by them. After all every sponsor is keen that his proposal finds a place in the
limited capital budget when there is competition among various claimants.

2) Under-Statement of Profitability: The problem of optimistic bias that may lead to an


over-statement of project cash flows and profitability. There can be an opposite kind of
bias relating to the terminal benefit which may depress a project's true profitability. To
understand this bias let us look at how the terminal cash flow is estimated in practice.
Typically it is defined as:
Net salvage value of fixed assets + Net recovery of working capital margin.
Generally, the net salvage value of fixed assets is put equal to five per cent of the
original cost and the net recovery of working capital margin is set equal to its original
book value (under the assumption that current assets do not depreciate).
The above approach almost invariably leads to under-estimation of the terminal benefit of
the project, due to the following reasons:
i.

Salvage Values are Under-Estimated: To put the net salvage value of fixed assets
equal to just five per cent (which may more or less correspond to the book value
after 8 to 10 years) of the original cost is to ignore the fact that in real life situations
fixed assets, ever after 8 to 10 years of use, generally command a substantial
market value.

ii.

Intangible Benefits are ignored: The terminal benefits from a project cannot be
equated with just the salvage values of tangible. assets left in the project; Apart
from investment in tangible assets for which salvage values can be estimated more
easily (taking into account the factors mentioned above) major projects -are
designed to establish a market position, perfect research and engineering capability,
develop a distribution network, and build brand loyalty. To assume that these
benefits are worthless beyond an arbitrarily chosen time horizon is to overlook
important business realities. These benefits should not be ignored just because it is
difficult to quantify them.

iii Value of Future Options is Over looked: More often than not, a project has a
strategic pay-off in the form of new investment opportunities that may possibly open-up if
the project is undertaken.
Possible Questions & University Questions:
1. Identify the relevant cash flow stream.
2. What are the guidelines to estimate the project cash flow?

32

VSA SCHOOL OF MANAGEMENT


Department of MBA
Salem 10
Subject: Financial Management
Topic: Methods and Techniques

Unit: 02
Hour: 3

CAPITAL BUDGETING APPRAISAL METHODS AND TECHNIQUES/


EVALUATION OF INVESTMENT:
Three steps are involved in the evaluation of an investment.

Estimation of Cash Flows.


Estimation of the required rate of returns.
Application of a decision rule for making the choice.

Any appraisal method should provide for the following:


1.
2.
3.
4.
5.

A basis of distinguishing between acceptable and non-acceptable projects.


Ranking of projects in order of their desirability.
Choosing among several alternatives.
A criterion which is applicable to any conceivable project.
Recognizing the fact that bigger benefits are preferable to smaller ones and early
benefits are preferable to later one.

Dictionary
Meaning:
Reciprocal:
Give and take
Equal
Mutual
Joint
Shared

Key Words:
Among the various methods, the following are commonly used by many business
concerns:
Pay-back
period may be
Traditional (or) non time value method (or) non discounted.
defined as the
Pay-back period
period of time.
Improvement of Traditional Approach to Pay-back period method
i.e. the number
Post Pay-back Profitability method
of years
Discounted Pay-back period
required for
Reciprocal Pay-back period method
cash inflow to
get back the
Average / Accounting Rate of Return.
original cost of
Discounted cash flow methods/time adjusted methods/present value method.
the project
Net present value
Profitability index.
Internal rate of return
Teaching Aid:
CB

I. Traditional Method:
1) Payback method:

The payback period refers to the length of time which will be required for the sum
of annual net cash benefits to equal the initial investment.
Books
Referred with
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Pay-back period may be defined as the period of time. i.e. the number of years page number:
required for cash inflow to get back the original cost of the project. According to this
method, every capital expenditure pays itself back over a number of years. This method is Financial
management
also known as pay off period, break even period (or) Recoupment period.
M.Y. Khan and
Computation of the pay-back period:
P.K. Jain
(a) When annual inflows are equal:
When the cash inflows being generated by a proposal are equal per time period i.e.,
the cash inflow are in the form are annual, the pay-back period can be computed by
dividing the cash outflows by the amount of annuity.
Initial Investment
Payback period = --------------------------Annual cash inflow

Annual cash inflow is the net income from the project (or) assets after tax but
before depreciation.
(b) When annual inflows are unequal:
In case the cash inflows from the proposal are not in annuity form then the
cumulative cash flows are used to compute the payback period.
In such a case, payback period is computed by the process of cumulating
cash inflows till the time when cumulative cash inflows becomes equal to the original
investment outlay. In the formula form:
Payback period = E + B/C
E No. of years immediately proceeding the year of recovery.
B Balance of amount of Investment to be recovered.
C Savings (Cash inflow) during the year of final recovery.

Accept or Reject Criterion:

If the Actual pay-back period is less than the standard pay-back period, the project
would be accepted, if not, it would be rejected.
When mutually exclusive projects are under consideration, they may be ranked
according to the length of the payback period. Thus, the project having the shortest
pay-back may be assigned rank one, following in that order so that the project with the
longer pay-back would be the lowest.

Under which circumstances, the Payback method is advisable?


1. When the cost of the project is small.
34

2.
3.
4.
5.

When the project requires shorter period to accomplish.


When the project goes for immediate production.
When the promoter thinks that competition may damage the prospects of the concern.
When the promoter considers that the industry may face technological competition and
problem of obsolescence.
6. When the project lacks long term stability.
Merits:

It involves simple calculation


Selection or rejection of the project can be made easily
The result obtained under this method is more reliable.
It is the best method for evaluating high-risk projects

Demerits:

It is based on the principle of rule of thumb.


It does not recognize the importance of time value of money.
It does not consider the profitability of economic life of the project.
It does not recognize the pattern of cash flows and its timing.
Pay-back period concept does not reflect all the relevant dimensions of profitability.

Improvement of traditional approach to pay-back period metho


1A) Pay-back profitability Method or Post Pay-back Profitability Method:
Under this method, the cash inflow generated from a project during the economic
life is taken into account whereas in pay-back period the cash inflows were considered
only to the extent of recovering the original investment. But in the practical situation, after
the pay-back period, a project or a machine is still capable of generating cash inflows.
Therefore, to evaluate the project the entire amount of earnings or cash inflows must be
considered.
Computations of post pay-back profitability:
Total cash inflow generated during the economic life of a project

xxxxx

Less: Original investment

xxxxx

Post pay-back profitability

xxxxx

Merits:

It is based on simple calculations


Less time consuming
It is easy to follow and even a non-finance executive can also understand the concept.
It takes into account the earnings of the project of entire life.

Demerits:

It is based on the principle of rule of thumb.


It doesnt consider the impact of time value of money.
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It ignores depreciation.

1B) Discounted pay-back method


This method is also designed to overcome the limitations of the pay-back period
method. When savings are not leveled, it is better to calculate the pay-back period by
taking into consideration the present value of cash inflows. Discounted pay-back method
helps to measure the present value of all cash inflows and outflows at an appropriate
discount rate.
The time period at which the cumulated present value of cash inflows equals the
present value of cash outflows is known as discounted pay-back period. This method takes
into account both the interest factor as well as the return after pay-back period.
1C) Reciprocal pay-back period method
This method helps to measure the expected rate of return of income generate by a
project. Pay-back reciprocal is exactly equal to the unadjusted rate of return. Unadjusted
rate means a rate which has not been adjusted by taking into account the time value of
money. It is useful where the flows are relatively consistent and the life of the asset is at
least double the payback period. If the pay-back period is same as the life of the asset, the
reciprocal would be one. This can be calculated by the following formula:

Annual Cash Inflows


Reciprocal Pay-back period = ---------------------------------- x 100
Total Investment
Possible Questions & University Questions:
1. Explain the traditional method of evaluating investment decision.
2. Explain pay-back period method in appraising capital budget.

VSA SCHOOL OF MANAGEMENT


Department of MBA
Salem 10
Subject: Financial Management
Topic: Accounting rate of return

Unit: 02
Hour: 04

2) Average Rate of Return (ARR) or Accounting Rate of Return:


Accounting / Average Rate of Return means the average annual yield on the
project. In this method, profits after taxes are used for evaluation.
Dictionary
Meaning:
It may be defined as the annualized net income earned on the average funds
invested in a project. In other words, the annual returns of a project are expressed as a
Yield:
percentage of the net Investment in the project.
Return
36

Give in
Calculation of ARR

In case the expected profits (after tax) generated by a project are equal for all the year
then the annual profit itself is the average profit.
If the project is expected to generate unequal profits over different years, then the
ARR may be calculated by finding out the average annual profit and then comparing
it with the average investment of the project as follows:
Average Annual Profit (after tax)
ARR = -------------------------------------------- x 100
Average Investment in the project

Average Investment:
The average investment refers to the average annual quantum of funds that remains
invested or blocked in the proposal over its economic life. The average investment of a
proposal is affected by the method of depreciation, salvage value and the additional working
capital required by the proposal. The following two approaches are available t calculate the
average investment.

Key Words:
Average Rate
of Return
means the
average
annual yield
on the
project.

(i) Initial cash outlay as average investment:


In this case, the original cost of investment and the installation expenses, if any, is
taken as the amount invested in the project.
(ii) Average annual book value after depreciation as average investment:

Teaching
Aid:
CB

For the firms which are adopting method of depreciation other than the
straight line method:

Find out the opening book values and the closing book values of the project
for all the years of its economic life.
Find out the average book values for all the years by taking the simple
arithmetic mean of the opening and closing book values.
Find out the average of all the yearly averages. This average will be the
average investment of the proposal.
For the firms which are adopting straight line method the following short cut
methods can be used:

Average Investment = [(Original Investment + Installation expenses Scrap value)/2] +


Scrap value.
Average Investment = [(Original Investment + Installation expenses Scrap value)/2] +
Scrap value + Additional Working capital.
Merits:

This method is very simple to understand


It is based on book figures which are easily available.
The benefits over the entire life of the project are considered.
37

Books
Referred
Financial
management
I.M. Pandey

It ignores the salvage value of the project.

Demerits:

It is based on accounting profit and not on cash flow.


It does not take into consideration, the time value of money.
The method ignores fluctuation in the profit from year to year.
It considers only the Rate of Return and not the length of project lives.

Possible Questions & University Questions:


1. Explain the Average rate of return in detail.

VSA SCHOOL OF MANAGEMENT


Department of MBA
Salem 10
Subject: Financial Management
Topic: DCF Techniques, Net Present Value

Unit: 02
Hour: 05
Dictionary
Meaning:

II. Discounted Cash Flow Techniques (DCF):

Investments are essentially current capital expenditure incurred at present in


Working
anticipation of future returns. Hence, the timing of expected future cash flow is important
capital:
in the investment decision. For example, investors play a higher value on recent returns
than on future ones. Hence, the technique that discounts the future value into them present
Day to day
values at a specified time value (discount rate) is called as DCF technique.
Requirement
(Current
Asset
Current
Discounting is reducing the values of future cash flows to make it directly comparable Liabilities)
to the values at present.
The rate at which the future cash flows are reduced to their present value is termed as
discount rate.
Key Words:
The Economic life of a project is used as the discounting period. However, the length
of discounting period depends on factors such as the life of equipment with the largest NPV =
Discounted
life span, technological change, availability of Raw materials, market stability, etc.
The market rate of interest is normally considered for discounting. But the cost of Cash Inflows
capital computed based on the overall capital structure of the company or on the basis less discounted
Cash Outflows.
of financial pattern would be an appropriate discount rate.

What is discounting?

1) Net Present Value (NPV):


The Net Present Value of an Investment proposal is defined as the sum of the Teaching
38

present value of all future cash inflows less the sum of the present values of all cash Aid:
outflows associated with the proposal.
CB
NPV = Discounted Cash Inflows less discounted Cash Outflows.
Cash Outflow consist of :
1. Initial Investment and
2. Special payment and outflows. E.g., working capital outflow which arises in the year
of commercial production. Tax paid on Capital Gain made by sale of old assets, if any.
Cash Inflows = Profit after tax + Depreciation
Also, specific cash inflows like salvage value of new Assets and recovery
of working capital at the end of the project, tax savings on loss due to sale of old asset, Books
should be carefully considered. The general assumptions are that all cash inflows occur at Referred
the end of each year.
Financial
Management
Discounting rate:
I.M. Pandey
Instead of using the PV factor tables, the relevant discount factor can be computed
as 1/ (1+K).
Where,
K Cost of Capital.
n year in which the inflow (or) outflow takes place.
Hence, PV factor at 10% after one year 1/1.10 = 0.9091
Similarly, PV factor at the end of 2 years 1(1.10) = 0.8264 and so on.
Merits:

It considers the time value of money. Hence it satisfies the basic criterion for project
evaluation.
Unlike payback period, all cash flows are considered.
NPV constitutes addition to the wealth of shareholders and thus focus on the basic
objectives of financial management.
Since all cash flows are converted into present value (current rupees), different projects
can be compared on NPV basis. Thus, each project, can be evaluated independent of
others on its own merits.

Demerits:

It involves complex calculations.


It involves forecasting cash flow and application of discount rate. Thus accuracy of
NPV depends on accurate estimation of these two factors which may be quite difficult
in practice.
NPV and ranking of project may differ at different proposals, etc., while evaluating
mutually exclusive projects.

Possible Questions & University Questions:


1. Explain the DCF techniques and Net present value.

39

VSA SCHOOL OF MANAGEMENT


Department of MBA
Salem 10
Subject: Financial Management
Topic: Profitability Index and IRR

Unit: 02
Hour: 06

2) Profitability Index (PI):


Where different investment proposals each involving different initial investments
and cash inflows are to be compared, the technique of Profitability Index (PI) is used.

Profitability Index (PI) =

Total of Discounted Cash Inflows


Total of Discounted Cash Outflows

Key Words:
Projects with
PI > 1 are
accepted and
PI < 1 are
rejected.

Accept or Reject Criterion:


PI represents the amount obtained at the end of the project life, for every rupee
invested in the project at the initial state. Hence, Projects with PI > 1 are accepted and PI
< 1 are rejected.

Teaching
Aid:
CB

Merits:

The method considers the time value of money


It is a better project evaluation technique than NPV and helps in ranking projects
where NPV is positive.
It focuses on maximum return per rupee of investment and hence is useful in case of Books
Referred
investment in divisible projects, when funds are not fully available.

Demerits:

Once a single large project with high NPV is selected, possibility of accepting several
small projects which together may have higher NPV than the single project is
excluded.
Situations may arise where a project with a lower profitability index selected may
generate cash flows in such a way that another project can be taken up one or two
years later, the total NPV in such case being more than the one with a project with
highest profitability Index.

3) Internal Rate of Return (IRR):


Internal Rate of Return is the rate at which the sum total of discounted cash inflows
40

Financial
Management
I.M. Pandey

equals the discounted cash outflows. The Internal rate of return of a project is the discount
rate which makes net present value of the project equal to zero.

Acceptance Rule:
If IRR > Cut Off rate i.e., Cost of Capital, then accept the project.
If IRR = Cut Off rate i.e., Cost of Capital, then the firm is indifferent, either accept (or)
reject the project.
If IRR < Cut Off rate i.e., Cost of Capital, then reject the project.
Merits:

Time value of money is taken into account.


All cash inflows of the project arising at different points of time are considered.
Decisions are immediately taken by comparing IRR with the cost of capital.
It helps in achieving the basic objective of maximization of shareholders wealth.

Demerits:

It is tedious to compute in case of multiple Cash Outflows.


Multiple IRRs may result, leading to difficulty in interpretation.

Method of Calculation:
1. When Cash inflows/savings are even for all the year:
The factor to be located in the relevant annuity table II is calculated by using the following
simple equation.
F = I/C
When, F Factors to be located
I Original Investment
C Cash inflows per year.
The factor, thus calculated is located in table II (or) the line representing the no. of
years corresponding to the estimated useful life of the assets and the relevant percentage of
the discount which represents the rate of return.

2. When Cash inflows/savings are not even:


In this process, cash inflows are to be discounted by a number of trial rates. Total
of such present values should be compared with the cost of investment.
If the calculated total present value of cash inflow is lower than the cost of
investment, then the further interpolation is carried on at lower rate.
On the other hand, a higher rate should be attempted if the present value of Inflows
is higher than the cost of investment.
This process continues till the present value of cash inflows and the cost of
41

investment are equal (or) nearly equal. However, the exact rate may be interpolated
with the help of the following formula.

Positive NPV
IRR = Lower Rate + ---------------------------------------------- x Difference in Rate
Difference in calculated present value

Accept or Reject Criterion:


If the Internal Rate of Return is more than the required rate, the project is
profitable, otherwise it should be rejected.

Possible Questions & University Questions:


1. Explain the Profitability Index and Internal Rate of Return.

VSA SCHOOL OF MANAGEMENT


Department of MBA
Salem 10
Subject: Financial Management
Topic: Project selection under capital rationing

Unit: 02
Hour: 07

42

COMPARE AND CONTRAST NPV WITH IRR


NPV Vs IRR:
The IRR approach solves for a rate unique to each project, while the NPV
approach solves for the trade off cash inflows and outflows using a general required rate of
return.
On the basis of the above discussion of NPV and IRR, a comparison between
the two may be attempted as follows:

a. Superiority of IRR over NPV:


1. IRR gives percentage return while the NPV gives absolute return.
2. For IRR, the availability of required rate of return is not a pre-requisite while for
NPV it is must.
b. Superiority of NPV over IRR:
1. NPV shows expected increase in the wealth of the shareholders.
2. NPV gives clear cut accept-reject decision rule, while the IRR may give multiple
results also.
3. The NPV of different projects are additive while IRR cannot be added.
4. NPV gives better ranking as compared to the IRR

CAPITAL RATIONING

When necessary funds are available; the management can take up all profitable
projects.
When funds are insufficient, the firm has to choose some more profitable projects and
reject some less profitable investment proposals.
Thus, because of lack of funds, the firm is able to invest in all profitable projects the
extent to which the funds are sufficient. Moreover, the executives with the required
managerial skills to fruitfully utilize the funds may also be a constraint. This situation is
described as a capital rationing.
Capital rationing refers to a situation where the firm is constrained for external or
internal reasons to secure the necessary funds to invest in all profitable investment proposals.

Reasons for Capital Rationing


The situation of capital rationing may arise due to both:
1. External factors; or
2. Internal constrains imposed by the management

43

1. External factors
External factors mainly refer to the situation in capital market. Fluctuations in capital
market may force a firm to have capital rationing of its investment proposals. Such
fluctuations arise due to deficiencies in market information, due to a difference between the
interest rates of borrowing and lending, due to rigidities that affect the free flow of capital
between firms. Because of such situations in capital market, the firm is unable to obtain
necessary capital to finance all its profitable investment proposals.

2. Internal factors
Internal factors refer to investment restrictions imposed by the firm itself. Various
types of restrictions can be imposed by the management. By adopting a conservative policy,
it may decide not to obtain additional capital by incurring a debt to finance its investment
proposals. It may also impose the maximum limits up to which investment can be made by
its middle level management. By stipulating a minimum rate of return to be higher than the
cost of capital, the management may resort to capital rationing.

SELECTION PROCESS UNDER CAPITAL RATIONING


Under the situation of capital rationing, the firm is not in a position to accept all profitable
investment proposals. By comparing the profitable investment proposals, the firm has to
select the relatively more profitable proposals and to reject the others. The said selection Key Words:
Ranking
process involves the following two steps:
projects on
1. Ranking projects on the basis of profitability measured by the most suitable the basis of
capital evaluation method.
profitability
2. Selection projects in the descending order of profitability until the funds are measured.
exhausted, i.e., the project with the highest rank has to be selected first and then
the project with next highest rank and so on. This process can be continued till all Teaching
the funds available for investment become exhausted.
Aid:
CB
While ranking the projects, the profitable criterion can be measured by adopting NPV,
IRR or Profitability Index Methods. The preference can be given to the IRR method, as it is Books
easy to understand.
Referred
Financial
Management:
I.M.Pandey
Possible Questions & University Questions:
1. Explain about capital rationing?
2. Compare and contrast NPV with IRR.

44

VSA SCHOOL OF MANAGEMENT


Department of MBA
Salem 10
Subject: Financial Management
Topic: Inflation and capital budgeting

Unit: 02
Hour: 08

INFLATION AND CAPITAL BUDGETING

Inflation and Cash Flows


Estimating the cash flows is the first step which requires the estimation of cost and
Dictionary
benefits of different proposals being considered for decision-making. Usually, two Meaning:
alternatives are suggested for measuring the 'Cost and benefits of a proposal' i.e. the
accounting profits and the cash flows.
Inflation:
In reality, estimating the cash flows is most important as well as difficult task. It is because Price rise
Price
of uncertainty and accounting ambiguity.
Increases
Accounting profit is the resultant figure on the basis of several accounting concepts and
policies. Adequate care should be taken while adjusting the accounting data, otherwise
errors would arise in estimating cash flows. The term cash flow is used to describe the cash
oriented measures of return, generated by a proposal. Though it may not be possible to Key Words:
obtain exact cash-effect measurement, it is possible to generate useful approximations
discount rate
based on available accounting data. The costs are denoted as cash outflows whereas the means the
benefits are denoted as cash inflows.
minimum
requisite rate
Effects of Inflation on Cash Flows
of return on
funds
Often there is a tendency to assume erroneously that, when, both net revenues
committed to
and the project cost rise proportionately, the inflation would not have much impact. These the project
lines of arguments seem to be convincing and it is correct for two reasons. First, the rate
used for discounting cash flows is generally expressed in nominal terms. It would be
inappropriate and inconsistent to use a nominal rate to discount cash flows which are not
adjusted for the impact of inflation. Second, selling prices and costs show different degrees
of responsiveness to inflation.
Teaching
Aid:
The discount rate has become one of the central concepts of finance. Some of CB
its manifestations include familiar concepts such as opportunity cost, capital cost,
borrowing rate, lending rate and the rate of return on stocks or bonds. It is greatly
influenced in computing NPV. The selection of proper rate is critical which helps for
making correct decision. In order to compute net present value, it is necessary to discount Books
future benefits and costs. This discounting reflects the time value of money. Benefits and Referred
costs are worth more if they are experienced sooner. The higher the discount rate, the
Inflation and Discount Rate

45

lower is the present value of future cash flows.


For typical investments, with costs concentrated in early periods and benefits
following in later periods, raising the discount rate tends to reduce the net present value.

Financial
Management:
I.M.Pandey

Thus, discount rate means the minimum requisite rate of return on funds
committed to the project. The primary Purpose of measuring the cost of capital is its use as
a financial standard for evaluating investment projects.
Implications of Expected Rate of Inflation on the Capital Budgeting
1) The Company should raise the output price above the expected rate of inflation.
Unless it has lower Net Present Value which may lead to forego the proposals and
vice versa.
2) If the company is unable to raise the output price, it can make some internal
adjustments through careful management of working capital.
3) With respect of discount rate, the adjustment should be made through capital
structure.
Possible Questions & University Questions:
1. What is inflation and its implications?
VSA SCHOOL OF MANAGEMENT
Department of MBA
Salem 10
Subject: Financial Management
Topic: Cost of capital

Unit: 02
Hour: 7

Introduction to Cost of capital:


Generally, most of the companies are financed by way of debt, bonds and equity.
An investors investment in long-term funds such as shares, debentures, public deposits,
etc. of a company are on the basis of expecting good rate or return. It is important because
acceptance or rejection of an investment decision depends on the cost of capital of a firm.
Thus, to the company, the cost of capital is the minimum rate of return that the company
must earn on its investments to satisfy the expectations of its investors.
Meaning:

Dictionary
Meaning:
Bond:
Debt
instrument

The term cost of capital refers to the rate of return on investment projects necessary
to leave unchallenged the market price of a firms stocks. It is the rate of return required by
Key Words:
those who supply the capital. The cost of capital is a weighted average of the cost of each
type of capital.
cost of
capital refers
In simple words, cost of capital refers to minimum rate of return a firm must earn to minimum
on its investment so that the market value of the companys equity shares does not fall. rate of return
This is consonance with the overall firms objective of wealth maximization.
a firm must
earn on its
Definition:
investment

46

The cost of capital is the minimum required rate of earnings or the cut-off rate for
the allocation of capital to investments of projects. It is the rate of return on a project that
will leave unchanged the market price of the stock
- James C. Van Horne

Teaching
Aid:
CB

Cost of capital may be defined as the rate of return the firm requires from its
investment in order to increase the value of the firm in the market place.

FACTORS AFFECTING THE COST OF CAPITAL OF A FIRM

Books
Referred

1. Risk-free Interest Rate:


Financial
The risk-free interest rate, If, is the interest rate on the risk free and default-free securities. Management:
For example, the securities issued by the Government of India are taken as risk-free and I.M.Pandey
default-free in respect of payment of periodic interest as well as principal repayment on
maturity.
2. Business risk: The business risk is related to the response of the firms Earnings
Before Interest and Taxes, EBIT, to change in sales revenue. Every project has its
effect on the business risk of the firm. If a firm accepts a proposal which is more
risky than average present risk, the investor will probably raise the cost of funds so
as to be compensated for the increased risk.
3. Financial risk: The particular composition and mixing of different sources of
finance, known as the financial plan or the capital structure, can affect the return
available to the investors. The financial risk is often defined as the likelihood that
the firm would not be able to meet its fixed financial charges. Higher the
proportion of fixed cost securities in the overall capital structure, greater would be
the financial risk. The investors in such a case require to be compensated for this
increased risk.
4. Other Considerations: The investors may also like to add a premium with
reference to other factors. One such factor may be the liquidity or marketability of
the investment. Higher the liquidity available with an investment, lower would be
the premium demanded by the investors.

Possible Questions & University Questions:


1. What is cost of capital?
2. What are the various factors affecting cost of capital?

47

VSA SCHOOL OF MANAGEMENT


Department of MBA
Salem 10
Subject: Financial Management
Topic: concept and Types of cost of capital

Unit: 02
Hour: 08

TYPES OF COST
Dictionary
Meaning:

1. Explicit Cost and Implicit cost:

Explicit Cost: The Explicit cost of any source of finance may be defined as the
discount rate that equates the present value of the funds received by the firm net of Dividend:
underwriting costs, with the present value of the expected cash outflows. These outflows
may be interested payment, repayment of principal (or) dividend. This may be calculated Bonus
Share
by computing value according to the following equation.
Surplus
Implicit Cost: The Implicit Cost may be defined as the rate of return associated Payment
with the best investment opportunity for the firm and its shareholders that will be forgone Extra
if the project presently under consideration by the firm were accepted.
2. Future and Historical Cost:
Future Cost refers to the expected cost of funds to finance the project, while
historical cost is the cost, which has already been incurred for financing a particular
project. In financial decision making, the relevant costs are future costs and not the
historical costs. However, historical costs are useful in projecting the future costs and
providing an appraisal of the past performance when compared with standard (or) Teaching
predetermined cost.
Aid:
CB
3. Specific Cost and Combined Cost:
Specific Cost: The Cost of each component of capital (i.e., equity shares,
preference shares, debentures, loans, etc.) is known as specific Cost of Capital. In order to
determine the average cost of capital of the firm it becomes necessary first to consider the Books
Referred
cost of specific methods of financing.
with page
Combined Cost: The composite / combined cost of capital is inclusive of all cost number:
of capital from all sources i.e., equity shares, preference shares, debentures and other
loans. In capital investment decisions, the composite cost of capital will be used as a basis Financial
Management:
for accepting (or) rejecting the proposal even though the company may finance one
I.M.Pandey
proposal from one source of financing while another proposal from another source of
financing.
4. Average Cost and Marginal Cost:
Average Cost: The Average Cost of Capital is the weighted average of the costs of
each component of funds employed by the firm. The weights are in proportion of the share

48

of each components of capital in the total capital structure.


Marginal Cost: Marginal Cost of Capital, on the other hand, is the weighted
average cost of new funds raised by the firm for capital budgeting and financing decision,
the marginal cost of capital is the most important factor to be considered.

Possible Questions & University Questions:


1. What are the various types of costs?
VSA SCHOOL OF MANAGEMENT
Department of MBA
Salem 10
Subject: Financial Management
Topic: Methods of computing cost of capital

Unit: 02
Hour: 09

VARIOUS METHODS OF COMPUTING COST OF CAPITAL


The cost of each component of capital will have to be separately assessed. A firm
may be in a position to use debt-financing at a lower rate of interest. But this is possible
only up to a certain point, at which the overall cost of capital, is reduced.
Computation of overall cost of capital of a firm involves:
A. Computation of cost of specific source of finance, and
B. Computation of weighted average cost of capital.
A. Computation of Specific source of Finance
Computation of each specific source of finance, viz, debt, preference share capital,
equity share capital and retained earnings is discussed as below:
1. Cost Debt Capital:
The cost of debt is the rate of interest payable on debt.
(i) Cost of Irredeemable debt
Before tax = Kdb = Interest (I) / Net proceeds (NP)
After tax = Kda = [Interest (1-tax rate)] / Net proceeds (NP)
(ii) Cost of Redeemable debt
Usually, the debt is issued to be redeemed after a certain period during the
life time of a firm. Such a debt issue is known as Redeemable debt. The cost of

49

redeemable debt capital may be computed as:


(a) Before tax = Interest + (RV-Net proceeds) / N
(RV + Net Proceeds)/2
(b) After tax = Interest (1-tax rate) + (RV-Net proceeds) / N
(RV + Net Proceeds)/2

RV = Redeemable value of debt


N = Life of the redeemable debt.

2) Cost of preference capital:


Preference capital carries a fixed rate of dividend though this dividend is
payable at the discretion of the board of directors, companies intend to pay the stated
preference dividend regularly and preference shareholders expect to receive preference
dividend regularly. The cost of preference capital which is irredeemable is the value of K p
in the following expression.
Kp = Preference Dividend / Net Proceeds of issue
Sometimes Redeemable Preference Shares are issued which can be redeemed or
cancelled on maturity date. The cost of redeemable preference share capital can be
calculated as:
Kp = Preference Dividend + (RV Net proceeds) / N
(RV+ Net Proceeds) / 2

RV = Redeemable value of preference shares


N = Life of the redeemable preference shares.

3) Cost of Equity Capital:


Cost of equity capital (K e) represents the expectations of equity shareholders from
a company. Based on investors behavior and expectations, the cost of equity capital can
be determined by any of the following approaches.

1. Dividend Yield method or Dividend / Price approach:


According to this method, the cost of equity capital is the discount rate that
equates the present value of expected future dividends per share with the net proceeds (or
current market price) of a share. Formula,

(a) Calculation of Cost of New Equity


50

Ke = D / NP
Where, Ke = Cost of Equity Capital
D = Expected dividend per share
NP = Net proceeds per share
Drawbacks
1.
2.
3.
4.

Gives more importance to dividend


Ignores the growth in the capital value of the shares.
Ignores the earnings on retained earnings.
It may not be adequate to deal with the problem of determining the cost of
equity share capital
5. It neglects the fact that stock market price rise may be due to retained earnings
also.
(b) Calculation of cost of existing equity shares
According to this approach, the determination of cost existing equity shares
is based on the market price of the companys shares. The cost of existing equity
shares is calculated with the help of the following formula:
Ke = D / MP
Where, Ke = Cost of Equity Capital
D = Expected dividend per share
MP = Market Price per share
The basic assumptions underlying this method are that the investors give prime
importance to dividends and risk in the firm remains unchanged.
2. Dividend Yield plus Growth in dividend method:
When the dividends of the firm are expected to grow at a constant rate and the
dividend pay-out ratio is constant this method may be used to compute the cost of equity
capital. According to this method the cost of equity capital is based on the dividends and
the growth rate.
Ke = (D / NP) + g
Where, g = Rate of growth in dividends
In case cost of existing equity share capital is to be calculated, the NP should be
changed with MP (market price per share) in the above formula.
Ke = (D / MP) + g
Assumptions
51

This approach is based on the following assumptions:


1.
2.
3.
4.

Expected dividends determine the market value of shares.


The growth rate will be constant over a period of time.
Future earnings will grow at a constant rate.
The market price is influenced only by variations in earnings.

3. Earnings Yield method or Earnings / Price approach:


According to this method, the cost of equity capital is the discount rate that
equates the present value of expected future earnings per share with the net proceeds (or
current market price) of a share.
Formula,
Ke = Earnings per share
Net proceeds
Where, the cost of existing capital is to be calculated
Ke =

Earnings per share

Market price per share


4. Realised Yield approach:
According to this approach investor is presumed to be interested in present
dividends and future earnings, which are reflections of past track record. This method
takes into account the actual average rate of return realized in the past, may be applied to
compute the cost of equity share capital. To calculate the average rate of return realized,
dividends received in the past alongwith the gain realized at the time of sale of shares
should be considered. The cost of equity capital is said to be the realized rate of return by
shareholders.

Assumptions:
1. The company should remain fundamentally the same irregardless of risk.
2. The shareholders are required to bear the risk for expecting the same rate of
return
3. The shareholders reinvestment opportunity rate must be equal to the realized
yield
4. Cost of Retained Earnings
The cost of retained earnings may be considered as the rate of return which the
existing shareholders can obtain by investing the after-tax dividends in alternative
opportunity of equal qualities. It is, thus, the opportunity cost of dividends foregone by
shareholders. Cost of retained earnings can be computed with the help of following
52

formula:
Kr = (D / NP) + G
Where, G = Rate of growth in dividends
Shareholders cannot obtain the entire amount of retained profits by way of
dividends. Some adjustment has to be made for tax. Moreover, if the shareholders wish to
invest their after-tax dividend income in alternative securities, they may have to incur
some costs of purchasing the securities, such as brokerage. To make adjustment in the cost
of retained earnings for tax and costs of purchasing new securities, the following formula
may be adopted:
Kr = [(D / NP) + G] x (1-tax rate) x (1-brokerage cost)

Possible Questions & University Questions:


1. What are the various methods of measuring cost of capital?

VSA SCHOOL OF MANAGEMENT


Department of MBA
Salem 10
Subject: Financial Management
Topic: Weighted average cost of capital

Unit: 02
Hour: 10

WEIGHTED AVERAGE COST OF CAPITAL


Weighted average cost of capital is the average cost of the costs of
various sources of financing. Weighted average cost of capital is also known as composite
cost of capital, overall cost of capital or average cost of capital. Once the specific cost of
individual sources of finance is determined, we can compute the weighted average cost of
capital by putting weights to the specific costs of capital in proportion of the various
sources of funds to the total. The WACC may be described as follows:
WACC = Ke.We + Kd.Wd + Kp.Wp

Dictionary
Meaning:
Marginal:
Minor
Subsidiary
Secondary

Key Words:

Where, WACC = Weighted average cost of capital


Ke = Cost of equity capital

53

In WACC,
there must be
a system of
assigning

Kd = After tax cost of debt


Kp = Cost of preference shares
We = Proportion of equity capital in capital structure

weights to
different
specific cost
of capital.

Wd = Proportion of debt in capital structure


Wp = Proportion of preference capital in capital structure

Teaching
In order to calculate the WACC, there must be a system of assigning weights to Aid:
CB
different specific cost of capital. The following considerations are worth noting while
assigning weights to specific cost of capital to find out the WACC.
Historical, Marginal and Target weights:
Books
Referred

(a) Historical or Existing weights:


Historical or existing weights are the weights based on the actual or existing
proportions of different sources in the overall capital structure. Such weighting system is
based on the actual proportions at the time when the WACC is being calculated. The
weighting system is the proportions in which the funds already been raised by the firm.
(b) Marginal weights:
The marginal weights refer to the proportions in which the firm wants to raise
funds from different sources. In other words the proportions in which additional funds
required to finance the investment proposals will be raised are known as marginal weights.
So, in case of marginal weights, the firm in fact, calculates the actual WACC of the
incremental funds.
(c) Target Weights:
The target weights refer to the proportion in which the firm plans to raise the funds
from various sources in the long run. In the target weights system, the firm in the first
instance decides about the shape of the optimal capital structure and proportion of different
sources in this optimal capital structure.
Book value versus Market Value Weights:
(a) Book Value Weights:
The weights are said to be book value weights if the proportions of different
sources are ascertained on the basis of the face values i.e., the accounting values. The
book value weights can be easily calculated by taking the relevant information from the
capital structure as given in the balance sheet of the firm.
(b) Market Value Weights:
The weights may also be calculated on the basis of the market values of different
sources i.e., the proportion of each source at its market value. In order to calculate the
market value weights, the firm has to find out the current market price of the securities in
54

Financial
management
Sudharsan
Reddy

each categories. The advantages of using the market value weights are:

The market value weights are consistent with the concept of maintaining
market value in the definition of the overall cost of capital.
The market value weights provide current estimate of the investors
required rate of return.
The market value weights yields goods estimates of the cost of capital that
would be incurred if the firm requires additional funds from the market.
However, the market values weights suffer from some limitations as follows:

Not only that the market values of all types of securities issued have to be
obtained but also that the market value of equity share is to be segregated
into capital and retained earnings.
The market values are subject to change from time to time and so the
concept of optimal capital structure in terms of market values does not
remain relevant any longer.

Possible Questions & University Questions:


1. How to calculate weighted average cost of capital?
VSA SCHOOL OF MANAGEMENT
Department of MBA
Salem 10
Subject: Financial Management
Topic: Problems

Unit: 02
Hour: 11

55

Non-Discounted cash flow techniques:


A non-discount method of capital budgeting does not explicitly consider the time value of
money. In other words, each dollar earned in the future is assumed to have the same value
as each dollar that was invested many years earlier. The payback method and Accounting
rate of return are some of the techniques used in capital budgeting that does not consider
the time value of money.
Payback period method
The number of years required to recover the initial outlay of the investment is called
payback period. It is the investment with short term payback period is preferred
Payback period = initial investment / Annual or net cash inflow
Payback period problems:
1. The project requires 100000 and yields annual cash inflow of 20000 for 8 years.
Calculate payback period.
2. The project requires an initial investment of 20000 and the annual cash inflows of 5
years are 6000, 8000, 5000, 12000, 4000 respectively. Calculate payback period.
3. Ram limited company purchases of new machine which will carry out some
operations performed by labor X and Y are alternative models. Calculate the
payback period and recommend which model you would prefer.
Particulars

Project X

Project Y

Cost of machine

150000

250000

Estimated life

5 years

6 years

Cost of indirect materials

6000

8000

Estimated savings in Scrap

10000

15000

Additional
cost
of 19000
maintenance
Estimated savings in direct 150
wages per employee
Total no. of employees
600

27000

Taxation

50%

200
600

50%

4. Consider the following projects and Calculate the payback period?


Project

C0

C1

C2

C3

C4

A
B
C
D

1000
1000
300
300

600
200
100
0

200
200
100
0

200
600
100
300

1000
1000
600
600

56

Average Rate of Return/ Accounting Rate of Return (ARR)/ Return on Investment


Users accounting information are revealed by financial statements to measure profitability
of an investment the accounting rate of return is the ratio of average after tax profit divided
by the average investment. Average investment is the half of the original investment.
ARR = Average annual profits / Net investment project * 100
Average return on Average investment method = Average annual profit after
depreciation and tax / Average investment * 100
Average investment = total investment / 2
1. A project requires an investment of Rs.500000 and as a scrap value of Rs.20000
after 5 years. It is expected to yield profits after depreciation and taxes during the 5
years amounting to Rs.40000, 60000, 70000, 50000, and 20000. Calculate the
average rate of return on investment and average rate on average investment.
2. Calculate the average rate of return for project A & B from the following
information
Particulars

Project A

Project B

Investment

20000

30000

Estimated life

4 years

5 years

Projected net income (after interest, depreciation and tax)


Year

2000

3000

1500

3000

1500

2000

1000

1000

1000

TOTAL

6000

10000

If the required rate of return is 12% which project should be undertaken?

DISCOUNTED CASH FLOW TECHNIQUES:


It is an evaluation of the future net cash flows generated by capital project by discounting
them to the present day value. The discounting technique converts cash inflow and outflow
for different years into the respective values at the same point of time allows for time value
of money.
Net present value (NPV)
The objective of the firm is to create wealth by using existing and future resources to
produce goods and service. To create wealth, inflows must exceed the present value of all
57

anticipated cash outflows. The net present value is obtained by discounting all cash
outflows and inflows attributable to a capital investment project by choosen percentage.
The method discounts the net cash flow from the investment by the minimum required rate
of return and deducts the initial investment to give the yield from the funds invested.
Steps to calculate:
1. Determine the discount rate
2. Compute the present value of total investment outlay at the determined rate.
3. Calculate the NPV of each project by subtracting the present value of cash inflows
from the present value of cash outflows for each project
4. If NPV is positive (or) zero that proposal may be accepted otherwise it should be
rejected. Suppose two or more proposal are having positive return the project
which has highest NPV to be selected
NPV Problems:
1. A firm invests in project X Rs.2500 now and expected to generate yearend cash
flow of Rs.900, 800, 700, 600 and 500 in years of 1 through 5. The opportunity
cost of the capital may be assumed to be 10%.
2. The following two projects A and B required an investment of Rs.200000 each.
The income returns after taxes for these projects are as follows:
Year

80000

20000

80000

40000

40000

40000

20000

40000

60000

60000

Present value if the companies cost of capital is 10% & 16%.


VSA SCHOOL OF MANAGEMENT
Department of MBA
Salem 10
Subject: Financial Management
Topic: Problems

Unit: 02
Hour: 12

58

Net Present Value (NPV)


1. Calculate the NPV for a small size project requiring an initial investment of
Rs.20000 and which provides net cash inflows of Rs.6000 each year for 6 years.
Assume the cost of funds to be 8% per annum and that there is no scrap value. (The
present value of an annuity for 6 years and 8% is 4.623)
2. From the following information calculate NPV of two projects and suggest which
of two things should be invested. Assume the decision rate 10%
Particulars

Project X

Project Y

Initial investment

20000

30000

Estimated life

5 years

5 years

Scrap value

1000

2000

Cash flows are as follows


Year

Cash flow X 5000


Cash flow Y 20000

10000
10000

10000
5000

3000
3000

2000
2000

Internal rate of return


It is a modern technique of capital budgeting that takes into account the time value of
money. It is also known as time adjusted rate of return or yield method. In the NPV
method, the net present value is determine by discounting the future cash flows of a project
at a pre-determined rate called cut-off rate, but under the IRR method the cash flow of a
project are discounted at a suitable rate of trial and error method, which equates the NPV
calculated to the amount of investment. Under this method the discount rate is determined
internally.
The rate of discount at which present value of cash inflow is equal to present value of cash
outflow
Internal Rate of Return (IRR) problems:
1. Calculate IRR, consider the cash flow of a project.
Year

Cash flow
100000
30000
30000
40000
45000
2. A project cost Rs.16000 and its expected to generate cash inflows of Rs.8000,
7000, and 6000 at the end of each year for next 3 years. Calculate IRR.
3. A firms cost of capital is 2.5% is considering two mutually exclusive project X&
Y
Year

59

70000

70000

10000

50000

20000

40000

30000

20000

45000

10000

60000

10000

Profitability Index (PI)


Profitability Index / benefit cost ratio Problems:
Profitability Index = present value of annual cash flows/ Initial investment
Net profitability Index = NPV/ Initial investment
The ratio of the present value of cash flow to the initial outlay is profitability index or
benefit cost ratio.
Acceptance rule:
(i)
(ii)
(iii)

Accept if P.I > 1


Reject if P.I < 1
Project may be accepted if P.I = 1

Profitability Index = Present Value of annual cash flows/ Initial Investment


1. The initial outlay of a project is 50000 and it generates cash inflows of 20000,
15000, 25000, and 10000 in 4 years using present value index method appraise
profitability of the proposed investment, assuming 10% rate of discount.
2. The initial outlay of a project is 100000 and it can generate cash inflow of 40000,
30000, 50000, and 20000 in year 1 through 4. Assume a 10% rate of discount.

VSA SCHOOL OF MANAGEMENT


Department of MBA
Salem 10
Subject: Financial Management
Topic: Problems

Unit: 02
Hour: 13

60

COMPARISON OF DISCOUNTED CASH FLOW TECHNIQUES


1. A company considering an investment proposal to install a new milling control at a cost
of Rs.50000. the facility has a life expectancy of 5 years without any salvage value. The
firm uses SLM of depreciation and the same is used for tax purposes. The tax rate is
assumed to be 35%. The estimated cash flows before depreciation and tax(CFBT) from the
investment proposal are as follows:
Year

CFBT

10000

10692

12769

13462

20385

COMPUTE:
i)
ii)
iii)
iv)

Payback period
Average rate of return
NPV at 10% discount rate
Profitability index at 10% discount rate

CAPITAL RATIONING PROBLEM


2. Determine the optimal project mix on the basis of the assumption that the project are
divisible
Project

Required
initial NPV at the appropriate cost of
investment
capital
A
100000
20000
B
300000
35000
C
50000
16000
D
200000
25000
E
100000
30000
Total fund available is Rs.300000. determine the optimal contribution of projects
assuming that the projects are divisible.
INFLATION AND CAPITAL BUDGETING
Inflation is defined as increase in the average price of goods and services. The accepted
measure of general inflation is the retail price index which is based on the assumed
expenditure patents of an average family. It is a monetary alignment in an economy and it
can be defined as the changes in purchasing power in a currency from period to period
relative to some basket of goods and services.
INFLATION PROBLEM:
3. A machine cost Rs.10000 and its expected to yield the following net cash returns
(estimated current price)
Year

Rs.

5000

8000

6000

We expect inflation to be at the rate of 5% per annum. The cost of capital is 15.5% per

61

annum.

VSA SCHOOL OF MANAGEMENT


Department of MBA
Salem 10
Subject: Financial Management
Topic: Problems

Unit: 02
Hour: 14

DETERMINATION OF COST OF CAPITAL:


1. X ltd issues of Rs.50,000, 8% debentures at par. The tax rate applicable to the company is 50%.
Compute the cost of debt capital
2. Y ltd issues of Rs.50,000, 8% debentures at premium of 10%, The tax rate applicable to the
company is 60%. Compute Kdb?
3. A ltd issues of Rs.50,000, 8% debentures at a discount of 5%, The tax rate applicable to the
company is 50%. Compute the cost of debt?
4. X ltd issues of Rs.1,00,000, 9% debentures at premium of 10%, the cost of floatation are 2%. The
tax rate applicable to the company is 60%. Compute cost of debt?
5. A company issues of Rs.100000 at 10% redeemable debentures at a discount of 5%. The cost of
floatation amount to Rs.30000. The debentures are redeemable after 5 years. Calculate before tax
and after tax cost of debt assuming a tax rate of 50%?
6. X ltd issues 12% debentures of face value of Rs.100 each and realises Rs.95 per debenture. The
debentures are redeemable after 10 years at a premium of 10%.
7. The company issues Rs.10000 at 10% preference shares of Rs.100 each. Cost of issue is Rs.2 per
share. Calculate of cost of preference share capital if these shares are
i)
At par
ii)
At premium of 10%/
iii)
At a discount of 5%
8. Y ltd issues preference shares of face value of Rs.100 each carrying 14%/ dividend and he
realises Rs.92 per share. The shares repayable after 12 years.
9. A company issues of Rs.10000 at 10% preference share of Rs.100 each redeemable after 10 years,
at a premium of 5%, cost of issue is 2 per share. Calculate cost of preference share capital.
10. A company issues 1000 at 7% preference share of Rs.100 at a premium of 10%, redeemable after 5
years. Compute cost of preference share capital.

VSA SCHOOL OF MANAGEMENT


Department of MBA
Salem 10
Subject: Financial Management
Topic: Problems

Unit: 02
Hour: 15

62

COST OF CAPITAL
The objective of business firm is to maximize the wealth of shareholders. The management
should invest in projects which give a return in excess of cost of funds invested in the
projects of the business. The cost of capital is the minimum rate of return expected by its
investors. The cost of capital is the rate of return, the company has to pay various suppliers
of funds in the company. A decision to invest in a particular project depends upon the cost
of capital which is the minimum rate of return expected by investors. Generally higher the
risk involve in a firm, higher the cost of capital
Concept of cost of capital
1. Cost of capital is not a cost
2. It is the minimum rate of return
Cost of equity share capital
1. A company plans to issue 1000 new shares of Rs.100 each, the floatation cost are
expected to be 5 % of the share price the company pays a dividend of Rs.10 per
share initially and growth dividend is expected to be 5 %. Compute the cost of new
issue of equity shares. If the market price of an equity share is Rs.150. calculate the
cost of existing equity share capital.
DIVIDEND YIELD METHOD
Dividend per share is expected current market price. The present value of all expected
future dividends per share with the net proceeds of sale (or) the current market price of
a share this method is based on assumptions that the market value of shares is directly
related to the future dividends on the share.
Another assumption is that the future dividend per share is expected to be constant and
the company is expected to earn at least yield to keep the shareholders constant

current market price


Present value
Market value
Future dividend

DIVIDEND GROWTH MODEL


Shareholders will normally expect dividend to increase year after year. In this method an
allowance for future growth in dividend is added to the current dividend yield
Problems
1. A firm is considering an expenditure of Rs.60, 00,000 for expanding its operations
the relevant information is as follows. Number of existing equity share 10, 00, 000
market value of existing share Rs.60, net earnings Rs.90, 00, 000. Compute the
cost of existing equity share capital and the cost of new equity capital. Assuming
63

that new shares will be issued at a price of Rs.52 per share and the cost of new
issue will be 2 per share.
2. Right starts ltd has its equity share of Rs.10 each quoted in market price of Rs.56.
a constant expected annual growth rate of 6% and dividend of Rs. 3.60 per share
has been paid for current year. Calculate the cost of capital
3. The shares of apple ltd selling at Rs.24 per share the firm had paid dividend at 1.30
per share last year. The estimated growth of company is 5% per year. Determine
the cost of equity of the company.
COST OF RETAINED EARNINGS
Maintain as reserve from the capital for expansion, diversification, uncertainties, and
branches.
The retained earnings is one of the major sources of finance available for the
established companies to finance in expansion and diversification programs. These
funds are also taken into account while calculating cost of equity. Retained earnings
are not distributed to the shareholders. A company can use the funds within the
company for further profitable investment opportunities
1. The cost of equity capital is 24%. The personal taxation of individual shareholders
is 35%. Calculate the cost of retained earnings.
WEIGHTED AVERAGE COST OF CAPITAL/ OVERALL COST OF CAPITAL
1. As the average cost of companies finance (equity, debentures, bank loan) weighted
according to the proportions each element bears to the total of capital. Weighting is
usually based on market valuation current yields and cost after tax.
2. Guna cements ltd has the following capital structure.
Particulars

Market
Book value
Cost of tax (%)
value
Equity share capital 80
120
18
Preference
share 30
20
15
capital
Fully
secured 40
40
14
debentures
Calculate the companies weighted average cost of capital.
INDIFFERENCE POINT
1. Calculate the level of EBIT at which the indifference point following financial
alternatives
Ordinary share capital is 10, 00, 000 (or)
15% debentures of Rs.5, 00, 000 and ordinary share capital of Rs. 5, 00, 000, tax
rate 50% earning price Rs.10 per share
2. Ordinary share capital of Rs.10, 00, 000 (or)

64

13% preference share capital of Rs.5,00,000 and ordinary share capital of Rs.5, 00,
000, ordinary share price Rs.10 per share
UNIT 2 (COMPLETED)

65