SAS PART II

PAPER VII
SECTION I: FINANCIAL MANAGEMENT
INDEX

1. FINANCE

Sl. No.
1.
2.
3.
4.

TOPICS
Financial Management - An overview, an
understanding of basic terms / concept in
Finance.
Concept of Time Value of Money.
Capital Expenditure Decisions.
Project Appraisal and Control Techniques

FINANCIAL MANAGEMENT -AN OVERVIEW

INTRODUCTION
Finance may be defined as the art and science of managing money. The major
areas of finance are: (1) financial services and (2) managerial finance/corporate
finance/financial management. While financial services is concerned with the
design and delivery of advice and financial products to individuals, businesses
and governments within the areas of banking and related institutions, personal
financial planning, investments, real estate, insurance and so on, financial
management is concerned with the duties of the financial managers in the
business firm. Financial managers actively manage the financial affairs of any
type of business, namely, financial and non-financial, private and public, large
and small, profit-seeking and not-for-profit. They perform such varied tasks as
budgeting, financial forecasting, cash management, credit administration,
investment analysis, funds management and so on. In recent years, the
changing regulatory and economic environments coupled with the globalisation
of business activities have increased, the complexity as well as the importance
of the financial managers' duties. As a result, the financial management function
has become more demanding and complex. This Chapter provides an overview
of financial management function. It is organised into seven Sections:
. Relationship of finance and related disciplines
. Scope of financial management
. Goal /objectives ,of financial management
. Agency problem
. Organisation of the finance function
. Emerging role of finance managers in India
. An overview
FINANCE FINANCE AND RELATED DISCIPLINE
Financial management, as an integral part of overall management, is not a totally
independent area. It draws heavily on related disciplines and fields of study, such
as economics, "accounting, marketing, production and quantitative methods.
Although these disciplines are interrelated, there are key differences among
them. In this Section, we discuss these relationships.
Finance and Economics
The relevance of economics. to financial management can be described in the
light of the two
broad areas of economics: macroeconomics and
microeconomics.
Macroeconomics is concerned with the overall institutional environment in
which the firm operates. It looks at the economy as a whole. Macroeconomics is
concerned with the institutional structure of the banking system, money and
capital markets, financial intermediaries, monetary, credit and fiscal policies and
economic policies dealing with, and controlling level of, activity within an
economy. Since business firms operate in the macroeconomic environment, it is
important for financial managers to understand the broad economic environment.
Specifically, they should (1) recognise and understand how monetary policy
affects the cost and the availability of funds; (2) be versed in fiscal policy and its
effects on the economy; (3) be ware of the various financial institutions/financing

outlets; (4) understand the consequences of various levels of economic activity

and changes in economic policy for their decision environment and so on.
Microeconomics deals with the economic decisions of individuals and
organisations. It concerns itself with the determination of optimal operating
strategies. In other words, the theories of microeconomics provide for effective
operations of business firms. They are concerned with defining actions that will
permit the firms to achieve success. The concepts and theories of
microeconomics relevant to financial management are, for instance, those
involving (1) supply and demand relationships and profit maximisation strategies,
(2) issues related to the mix of productive factors, 'optimal' sales level and
product pricing strategies, (3) measurement of utility preference, risk and the
determination of value, and (4) the rationale of depreciating assets. In addition,
the primary principle that applies in financial management is marginal analysis; it
suggests that financial decisions should be made on the basis of comparison of
marginal revenue and marginal cost. Such decisions will lead to an increase in
profits of the firm. It is, therefore, important that financial managers must be
familiar with basic microeconomics.
To illustrate, the financial manager of a department store is contemplating to
replace one of its online computers with a new, more sophisticated one that
would both speed up processing time and handle a large volume of transactions.
The new computer would require a cash outlay of Rs 8,00,000 and the old
computer could be sold to net Rs 2,80,000. The total benefits from the new
computer and the old computer would be Rs 10,00,000 and Rs 3,50,000
respectively. Applying marginal analysis, we get:
Benefits with new computer
Rs
10,00,000
Less: Benefits with old computer Marginal benefits (a) Cost of new computer
3,50,000
Marginal Benefits (a)
Rs 6,50,000
Cost of new computer
Rs 8,00,000
Less: Proceeds from sale of old computer Marginal cost (b) Net benefits [(a) (b)]
Rs 2,80,000
Marginal
cost
(b)
Rs 5,20,000
Net
benefits
(a)
(b)
1,30,0000
As the store would get a net benefit of Rs 1,30,000, the old computer should be
replaced by the new one.
Thus, a knowledge of economics is necessary for a financial manager to
understand both the financial environment and the decision theories which
underline contemporary financial management. He should be familiar with these
two areas of economics. Macroeconomics provides the financial manager with an
insight into policies by which economic activity is controlled. Operating within that
institutional framework, the financial manager draws on microeconomic theories
of the operation of firms and profit maximisation. A basic knowledge of
economics is, therefore, necessary to understand both the environment and the
decision. techniques of financial management.
Finance and Accounting
The relationship between finance and accounting, conceptually speaking, has
two dimensions: CO they are closely related to the extent that accounting is an
important input in financial decision

making; and (ii) there. are key differences in viewpoints between them.
.
Accounting function is a necessary input into the finance function. That is,
accounting is a subfunction of finance. Accounting generates information/data
relating to operations/activities of the firm. The end-product of accounting
constitutes financial statements such as the balance sheet, the income statement
(profit and loss account) and the statement of changes in financial position/
sources and uses of funds statement/cash flow statement. The information
contained in these statements and reports assists financial managers in
assessing the past performance and future directions of the firm and in meeting
legal obligations, such as payment of taxes and so on. Thus, accounting and
finance are functionally closely related. Moreover, the finance (treasurer) and
accounting (controller) activities are typically within the control of the vicepresident/director (finance)/Chief financial officer (CFO) as shown in Fig. 1.2.
These functions are closely related and generally overlap; indeed, financial
management and accounting are often not easily distinguishable. In small firms
the controller often carries out the finance function and in large firms many
accountants are intimately involved in various finance activities.
But there are two key differences between finance and accounting. The first
difference relates to the treatment of funds, while the second relates to decision
making.
Treatment of Funds The viewpoint of accounting relating to the funds of the firm
is different from that of finance. The measurement of funds (income and
expenses) in accounting is based on the accrual principle/system. For instance,
revenue is recognised at the point of sale and not when collected. Similarly,
expenses are recognised when they are incurred rather than when actually paid.
The accrual-based accounting data do not reflect fully the financial
circumstances of the firm. A firm may be quite profitable in the accounting sense
in that it has earned profit (sales less expenses) but it may not be able to meet
current obligations owing to shortage of liquidity. due to uncollectable
receivables, for instance. Such a firm will not survive regardless of its levels of
profits.
,The viewpoint of finance relating to the treatment of funds is based on
cashflows. The revenues are recognised only when actually received in cash (Le.
cash inflow) and expenses are recognised on actual payment (Le. cash outflow).
This is so because the financial manager is concerned with maintaining solvency
of the firm by providing the cashflows necessary to satisfy its obligations and
acquiring and financing the assets needed to achieve the goals of the firm. Thus,
cashflow-based returns help financial managers avoid insolvency and achieve
the desired financial goals.
To illustrate, total sales of a trader during the year amounted to Rs 10,00,000
while the cost of sales was Rs 8,00,000. At the end of the year, it has yet to
collect Rs 8,00,000 from the customers. The accounting view and the financial
view of the firms performance during the year are given below.
Accounting View
View
(Income Statement)
Sales
Rs 2,00,000
Less: Cost
Rs 8,00,000
___________
Net Profit
outflow
Rs 6,00,000

Financial
Rs 10,00,000
Rs

8,00,000

(Cash Flow Statement)

Cash inflow
Less cash outflow

_____________
Rs

2,00,000

Net cash

Obviously, the firm is quite profitable in accounting sense, it is a financial failure

in, terms of actual cash flows resulting from uncollected receivables. Regardless
of its profits, the firm would not survive due to inadequate cash inflows to meet its
obligations.
Decision Making Finance and accounting also differ in respect of their
purposes. The purpose of accounting is collection and presentation of financial
data. It provides consistently developed and easily interpreted data on the past,
present and future operations of the firm. The financial manager uses such data
for financial decision making. It does not mean that accountants never make
decisions or financial managers never collect data. But the primary focus of the
functions of accountants is on collection and presentation of data while the
financial manager's major responsibility relates to financial planning, controlling
and decision making. Thus, in a sense, finance begins where accounting ends.
Finance
and
Other
Related
Disciplines
Apart from economics and accounting, finance also draws-for its day-to-day
decisions-on supportive disciplines such as marketing, production and
quantitative methods. For instance, financial managers should consider the
impact of new product development and promotion plans made in marketing area
since their plans will require capital outlays and have an impact on the projected
cash flows. Similarly, changes in the production process may necessitate capital
expenditures which the financial managers must evaluate and finance. And,
finally, the tools of analysis developed in the quantitative methods area are
helpful in analysing complex financial management problems.
The marketing, production and quantitative methods are, thus, only indirectly
related to day-today decision making by financial managers and are supportive in
nature while economics and accounting are the primary disciplines on which the
financial manager draws substantially.
The relationship between financial management and supportive disciplines is
depicted in Fig 1.1.

Financial
Primary Discipline
1. Investment analysis
2. Macroeconomics
2~ Working capital management:
3. Micro economics
3. Sources and cost of funds
4. Determination of capital structure
5. Dividend policy.
'
6. Analysis of risks and returns
Other Relates Discipline

Decision

Area
1. Accounting
Support

Support
1. Marketing
2. Production

3. Quantatative
method
Resulting in
Shareholders Wealth Maximisation

SCOPE OF FINANCIAL MANAGEMENT

The approach to the scope and functions of financial management is divided, for
purposes of exposition, into two broad categories: (a) The Traditional Approach,
and (b) The Modem Approach.
Traditional Approach
The traditional approach to the scope of financial management refers to its
subject-matter, in academic literature in the initial stages of its evolution, as a
separate branch of academic Study. The term 'corporation finance' was used to
describe what is now known in the academic world as 'financial management'. As
the name suggests, the concern of corporation finance was with the financing of
corporate enterprises. In other words, the scope of the finance function was
treated by the traditional approach in the narrow sense of procurement of funds
by corporate enterprise to meet their financing needs. The term 'procurement'
was used in a broad sense so as to include the whole gamut of raising funds
externally. Thus defined, the field of study dealing with finance was treated as
encompassing three interrelated aspects of raising and administering resources
from outside: (i) the institutional arrangement in the form of financial institutions
which comprise the organisation of the capital market; (ii) the financial
instruments through which funds are raised from the capital markets and the
related aspects of practices and the procedural aspects of capital markets; and
(iii) the legal and accounting relationships between a firm and its sources of
funds. The coverage of corporation finance was, therefore, conceived to describe
the rapidly evolving complex of capital market institutions, instruments and
practices. A related aspect was that firms require funds at certain episodic events
such as merger, liquidation, reorganisation and so on. A detailed description of
these major events constituted the second element of the scope of this field of
academic study. That these were the broad features of the subject-matter of
corporation finance is eloquently reflected in the academic writings around the
period during which the traditional approach dominated academic thinking. 1
Thus, the issues to which literature on finance addressed itself was how
resources could best be raised from the combination of the available sources.
The traditional approach to the scope of the finance function evolved during the
1920s and 1930s and dominated academic thinking during' th~ forties and
through the early ftfties. It has now been discarded as it suffers from serious
limitations. The weaknesses of the traditional approach fall into two broad
categories: (i) those relating to the treatment of various topics and the emphasis
attached to them; and (ii) those relating to the basic conceptual and analytical
framework of the definitions and scope of the finance function.
The first argument against the traditional approach was based on its emphasis
on issues relating to the procurement of funds by corporate enterprises. This
approach was challenged during the period when the approach dominated the
scene itself.2 Further, the traditional treatment of finance was criticised3 because
the finance function was equated with the issues involved in raising and
administering funds, the theme was woven around the viewpoint of the suppliers

of funds such as investors, investment bankers and so on, that, is the outsiders.
It implies that no consideration was given to viewpoint of those who had to take
internal financial decisions. The traditional treatment was, in other words, the
outsider-looking-in approach. The limitation was that internal decision making (ie.
insider-looking-out) was completely ignored.
The second ground of criticism of the traditional treatment was that the focus
was on financing problems of corporate enterprise. To that extent the scope of
financial management was confirmed only to a segment of the industrial
enterprises, as non-corporate organisations lay outside its scope.
Yet another basis on which the traditional approach was challenged was that
the treatment was built too closely around episodic events, such as promotion,
incorporation, merger, consolidation, reorganisation and so on. Financial
management was' confirmed to a description of these infrequent happenings in
the life of an enterprise. As a logical corollary, the day-to-day financial problems
of a normal company did not receive much attention.
Finally, the traditional treatment was found to have a lacuna to the extent that
the focus was on long-term financing. Its natural implication was that the issues
involved in working capital management were not in the purview of the finance
function.
The limitations of the traditional approach were not entirely based on treatment
or emphasis of different aspects. In other words, its weaknesses were more
fundamental. The conceptual and analytical shortcoming of this approach arose
from the fact that it confirmed financial management to issues involved in
procurement of external funds, it did not consider the important dimension of
allocation of capital. The conceptual framework of the traditional treatment
ignored what Solomon aptly described as the central issues of financial
management. These issues were reflected in the following fundamental
questions which a finance manager should address. Should an enterprise
commit capital funds to certain purposes? Do the expected returns meet financial
standards of performance? How should these standards be set and what is the
cost of capital funds to the enterprises? How does the cost vary with the mixture
of financing methods used? In the absence of the coverage of these crucial
aspects, the traditional approach implied a very narrow scope for financial
management. The modem approach provides a solution to these shortcomings.
Modem Approach
The modern approach views the term financial management in a broad sense
and provides a conceptual and analytical framework for financial decision
making. According to it, the finance function covers both acquisition of funds as
well as their allocations. Thus, apart from the issues involved in acquiring
external funds, the main concern of financial management is the efficient and
wise allocation of funds to various uses. Defined in a broad sense, it is viewed as
an integral part of overall management.
The new approach is an analytical way of viewing the financial problems of a
firm. The main contents of this approach are: What is the total volume of funds
an enterprise should commit? What specific assets should an enterprise acquire?
How should the funds required be financed? Alternatively, the principal contents
of the modem approach to financial management can be said to be: (0 how large
should an enterprise be, and how fast should it grow? (ii) In what form should it
hold assets? and (Hi) what should be the composition of its liabilities?
The three questions posed above cover between them the major' financial
problems of a firm. In other words, the financial management, according to the
new approach, is concerned with the solution of three major problems relating to
the financial operations of a firm, corresponding to the three questions of
investment, financing and dividend decisions. Thus, financial management in
modern sense of a firm can be broken down into three major decisions as

functions of finance: (D The investment decision, (ii) the financing decision, and
(iii) the dividend policy decision.
Investment Decision The investment decision relates to the selection of assets
in which funds will be invested by a firm. The assets which can be acquired fall
into two broad groups: (I) long-term assets which yield a return over a period of
time in future, (ii) short-term or current assets, defined as those assets which in
the normal course of business are convertible into cash without diminution in
value, usually within a year. The first of these involving the first category of
assets is popularly known in financial literature as capital budgeting. The aspect
of financial decision making with reference to current assets or short-term assets
is popularly termed as working capital management.
Capital Budgeting Capital budgeting is probably the most crucial financial
decision of a firm. It relates to the selection of an asset or investment proposal or
course of action whose benefits are likely to be available in future over the
lifetime of the project. The long-term assets can be either new or old/existing
ones. The first aspect of the 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. Whether an asset will be
accepted or not will depend upon the relative benefits and returns associated
with it. The measurement of the worth of the investment proposals is, therefore, a
major element in the capital budgeting exercise. This implies a discussion of the
methods of appraising investment proposals.
The second element of the capital budgeting decision is the analysis of risk and
uncertainty. Since the benefits from the investment proposals extend into the
future, their accrual is uncertain. They have to be estimated under various
assumptions of the physical volume of sale and the level of prices. An element of
risk in the sense of uncertainty of future' benefits is, thus, involved in the
exercise. The returns from capital budgeting decisions should, therefore, be
evaluated in relation to the risk associated with it.
Finally, the evaluation of the worth of a long-term project implies a certain norm
or standard against which the benefits are to be judged. The requisite norm is
known by different names such as cut-off rate, hurdle rate, required rate,
minimum rate of return and so on. This standard is broadly expressed in terms
of the cost of capital. The concept and measurement of the cost of capital is,
thus, another major aspect of capital budgeting decision. In brief, the main
elements of capital budgeting decisions are: (I) the long-term assets and their
composition, (ii) the business risk complexion of the firm, and (Hi) the concept
and measurement of the cost of capital.
Working Capital Management Working capital management is concerned
with the management of current assets. It is an important and integral part of
financial management as short-term survival is a prerequisite for long-term
success. One aspect of working capital management is the trade-off between
profitability and risk (liquidity). There is a conflict between profitability and
liquidity. If a firm does not have adequate working capital, that is, it does not
invest sufficient funds in current assets, it may become illiquid and consequently
may not have the ability to meet its current obligations and, thus, invite the risk of
bankruptcy.. If the current assets are too large, profitability is adversely affected.
The key strategies and considerations in ensuring a trade-off between profitability
and liquidity is one major dimension of working capital management. In addition,
the individual current assets should be efficiently managed so that neither

inadequate nor unnecessary funds are locked up. Thus, the management of
working capital has two basic ingredients: (1) an overview of working capital
management as a whole, and (2) efficient management of the individual current
assets such as cash, receivables and inventory.
Financing Decision the second major decision involved in financial
management is the financing decision. The investment decision is broadly
concerned with the asset-mix or the composition of the assets of a firm. The
concern of the financing decision is with the financing-mix or capital structure or
leverage. The term capital structure refers to the proportion of debt (fixedinterest sources of financing) and equity capital (variable-dividend
securities/source of funds). The financing decision of a firm relates to the choice
of the proportion of these sources to finance the investment requirements. There
are two aspects of the financing decision. First, the theory of capital structure
which shows the theoretical relationship between the employment of debt and
the return to the shareholders. The use of debt implies a higher return to the
shareholders as also the financial risk. A proper balance between debt and equity
to ensure a trade-off between risk and return to the shareholders is necessary. A
capital structure with a reasonable proportion of debt and equity capital is called
the optimum capital structure. Thus, one dimension of the financing decision
whether there is an optimum capital structure and in what proportion should
funds be raised to maximise the return to the shareholders? The second aspect
of the financing decision is the determination of to an appropriate capital
structure, given the facts of a particular case. Thus, the financing decision covers
two interrelated aspects: (1) the capital structure theory, and (2) the capital
structure decision.
Dividend Policy Decision The third major decision area of financial
management is the decision relating to the dividend policy. The dividend decision
should be analysed in' relation to the financing decision of a firm. Two
alternatives are available in dealing with the profits of a firm: (0 they can be
distributed to the shareholders in the form of dividends or (i0 they can be retained
in the business itself. The decision as to which course should be followed
depends largely on a significant element in the dividend decision, the dividendpayout ratio, that is, what proportion of net profits should be paid out to the
shareholders. The fmal decision will depend upon the preference of the
shareholders and investment opportunities available within the firm. The second
major aspect of the. dividend decision is the factors determining dividend policy
of a firm in practice. .
To conclude, the traditional approach to the functions of financial management
had a very narrow perception and was devoid of an integrated conceptual and
analytical framework. It had rightly been discarded in the ac:ldemic literature. The
modem approach to the scope of financial management has broadened its scope
which involves the solution of three major decisions, namely, investment,
fmancing and dividend. These are interrelated and should be jointly taken so that
financial decision making is optimal. The conceptual framework for optimum
financial decisions is the objective of financial management. In other words, to
ensure an optimum decision in respect of these three areas, they should be
related to the objectives of financial management.
Key Activities of the Financial Manager
The primary activities of a financial manager are: (i) performing financial
analysis and planning, (i0 making investment decisions and (HO making
financing decisions.
Performing Financial Analysis and Planning The concern of financial analysis

The gross present worth of a course of action is equal to the capitalised value of the flow of
futUre expected benefit, discounted (or captialised) at a rate which reflects their certainty or
uncertainty. Wealth or net present worth is the difference between gross present worth and the
amount of capital investment required to achieve the benefits being discussed. Any financial
action which creates wealth or which has a net present worth above zero is a desirable one and
should be undertaken. Any financial action which does not meet this test should be rejected. If
two or more desirable courses of action are mutUally exclusive (Le. if only one can be
undertaken), then the decision should be to do

and planning is with (a) transforming financial data into a form that can be used to
monitor financial condition, (b) evaluating the need for increased (reduced) productive
capacity and (c) determining the additional/reduced financing required. Although this
activity relies heavily on accrual-based financial statements, its underlying objective is to
assess cash flows and develop plans to ensure adequate cash flows to support
achievement of the firm's goals
Making Investment Decisions Investment decisions determine both the mix
and the type of assets held by a firm. The mix refers to the amount of current
assets and fixed assets. Consistent with the mix, the financial manager must
determine and maintain certain optimal levels of each type of current assets. He
should 211so decide the best fixed assets to acquire and when existing fixed
assets need to be modified/replaced/liquidated. The success of a firm in
achieving its goals depends on these decisions.
Making Financing Decisions Financing decisions involve two major areas:
first, the most appropriate mix of short-term and long-term financing; second, the
best individual short-term or long-term sources of financing at a given point of
time. Many of these decisions are dictated by necessity, but some require an indepth analysis of the available financing alternatives, their costs and their longterm implications
OBJECTIVES OF FINANCIAL MANAGEMENT
To make wise decisions a clear understanding of the objectives which are sought
to be achieved is necessary. The objective provide a framework for optimum
financial decision making. In other words, they are concerned with designing a
method of operating the internal investment and financing of a firm. The term
'objective' is used in the sense of a goal or decision criterion for the three
decisions involved in financial management. It implies that what is relevant is not
the overall objective or goal of a business but a operationally useful criterion by
which to judge a specific set of mutually interrelated business decisions, namely,
investment, financing and dividend policy. Moreover, it provides a nOffi'lative
framework. That is, the focus in financial literature is on what a firm should try to
achieve and on policies that should b~ followed if certain goals are to be
achieved. The implication is that these are not necessarily followed by firms in
actual practice. They are rather employed to serve as a basis for theoretical
analysis and do not reflect contemporary empirical industry practices. Thus, the
term is used in a rather narrow sense of what a finn should anempt to achieve
with its investment, fmancing and dividend policy decisions.
Firms in practice state their vision, mission and values in broad terms and are
also concerned about technology, leadership, productivity, market standing,
image, profitability, financial resources, employees satisfaction and so on.
We discuss in this Section the alternative approaches in financial literature,
There are two widely-discussed approaches: (0 Profit (total)/Earning Per Share
(EPS) maximisation approach, and (i0 Wealth maximisation approach.

Profit/EPS
Maximisation
Decision
Criterion
According to this approach, actions that increase profits (total)/EPS should be
undertaken and those that decrease profits/EPS are to be avoided, In specific
operational terms, as applicable to financial management, the profit maximisation
criterion implies that the investment, financing and dividend policy decisions of a
firm should be oriented to the maximisation of profits/EPS.
The term 'profit' can be used in two senses. As a owner-oriented concept, it
refers to the amount and share of national income which is paid to the owners of
business, that is, those who supply equity capital. As a variant, it is described as
profitability. It is an operational concept and signifies economic efficiency. In other
words, profitability refers to a situation where output exceeds input, that is, the value
created by the use of resources is more than the total of the input resources. Used in this
sense, profitability maximisation would imply that a firm should be guided in financial
decision making by one test; select assets, projects and decisions which are profitable and
reject those which are not. In the current financial literature, there is a general agreement
that profit maximisation is used in the second sense.
The rationale behind profitability maximisation, as a guide to financial decision
making, is simple. Profit is a test of economic efficiency. It provides the yardstick
by which economic performance can be judged. Moreover, it leads to efficient
allocation of resources, as resources tend to be directed to uses which in terms
of profitability are the most desirable. Finally, it ensures maximum social welfare.
The individual search for maximum profitability provides the famous 'invisible
hand' by which total economic welfare is maximised. Financial management is
concerned with the efficient use of an important economic resource (jnput) ,
namely, capital. It is, therefore, argued that profitability maximisation should
serve as the basic criterion for financial" management decisions.
The profit maximisation criterion has, however, been questioned and criticised
on several grounds. The reasons for the opposition in academic literature fall into
two broad groups: (1) those that are based on misapprehensions about the
workability and fairness of the private enterprise itself, and (2) those that arise
out of the difficulty of applying this criterion in actual situations. It would be
recalled that the term objective, as applied to financial management, refers to an
explicit operational guide for the internal investment and financing of a firm and
not the overall goal of business operations. We, therefore, focus on the second
type of limitations to profit maximisation as an objective of financial
management.7 The main tecbnical flaws of this criterion are ambiguity, timing
of benefits, and quality of benefits.
Ambiguity One practical difficulty with profit maximisation criterion for financial
decision making is that the term profit is a vague and ambiguous concept. It has
no precise connotation. It is amenable to different interpretations by different
people. To illustrate, profit may be short-term or long-term; it may be total profit or
rate of profit; it may be before-tax or after-tax; it may return on total capital
employed or total assets or shareholders' equity and so on. If profit maximisation
is taken to be the objective, the question arises, which of these variants of profit
should a firm try to maximise? Obviously, a loose expression like profit cannot
form the basis of operational criterion for financial management.
Timing of Benefits A more important technical objection to profit maximisation,
as a guide to financial decision making, is that it ignores the differences in the
time pattern of the benefits received over the working life of the asset,
irrespective of when they were received. Consider Table 1.1.

Time-Pattern of Benefits (Profits)

Time
Alternate A(Rs in
lakh)__________Alternate B(Rs in lakh)
Period I
50
-Period II
100
100
Period III
50
100
________________________________________________________________
___________________
Total
200
200
It can be seen from Table 1.1 that the total profits associated with the
alternatives, A and B, are identical. If the profit maximisation is the decision
criterion, both the alternatives would be ranked equally. But the returns from both
the alternatives differ in one important respect, while alternative A provides higher
returns in earlier years, the returns from alternative B are larger in later years. As
a result, the two alternative courses of action are not strictly identical. This is
primarily because a basic dictum of financial planning is the earlier the better as
benefits received sooner are more valuable than benefits received later. The
reason for the superiority of benefits now over benefits later lies in the fact that
the former can be reinvested to earn a return. This is referred to as time value of
money. The profit maximisation criterion does not consider the distinction
between returns received in different time periods and treats all benefits
irrespective of the timing, as equally valuable. This is not true in actual practice
as benefits in early years should be valued more highly than equivalent benefits
in later years. The assumption of equal value is inconsistent with the real world
situation.
Quality of Benefits Probably the most important technical limitation of profit
maximisation as an operational objective, is that it ignores the quality aspect of
benefits associated with a financial course of action. The term quality here refers
to the degree of certainty with which benefits can be expected. As a rule, the
more certain the expected return, the higher is the quality of the benefits.
Conversely, the more uncertain/fluctuating is the expected benefits, the lower is
the quality of the benefits. An uncertain and fluctuating return implies risk to the
investors. It can be safely assumed that the investors are risk-averters, that is,
they want to avoid or at least minimise risk. They can, therefore, be reasonably
expected to have a preference for a return which is more certain in the sense that
it has smaller variance over the years.
The problem of uncertainty renders profit maximisation unsuitable as an
operational criterion for financial management as it considers only the size of
benefits and gives no weight to the degree of uncertainty of the future benefits.
This is illustrated in Table 1.2.
Uncertainty About Expected Benefits (Profits)

Profit(Rs

crore)
__________________________________________
State of Economy
Benefits
Recession (Period I)
Normal (Period II)

Alternate A
0
10

10
Boom (Period III)
20
Total
30

11
30

It is clear from Table 1.2 that the total returns associated with the two
alternatives are identical in a normal situation but the range of variations is very
wide in case of alternative B, while it is narrow in respect of alternative A. To put It
differently, the earnings associated with alternative B are more uncertain (risky)
as they fluctuate widely depending on the state of the economy. Obviously,
alternative A is beuer in terms of risk and uncertainty. The profit maximisation
criterion fails to reveal this.
To conclude, the profit maximisation criterion is inappropriate and unsuitable as
an operational objective of investment, financing and dividend decisions of a firm.
It is not only vague and ambiguous but it also ignores two important dimensions
of financial analysis, namely, risk, and time value of money. It follows from the
above that an appropriate operational decision criterion for financial management
should (j) be precise and exact, (ij) be based on the 'bigger the better' principle,
(iij) consider both quantity and quality dimensions of benefits, and (iv) recognise
the time value of money. The alternative to profit maxirnisation, that is, wealth
maximisation is one such measure.
Wealth Maximisation Decision Criterion
This is also known as value maximisation or net present worth maximisation. In
current academic literature value maximisation is almost universally accepted as
an appropriate operational decision criterion for financial management decisions
as it removes the technical limitations which characterise the earlier profit
maximisation criterion. Its operational features satisfy all the three requirements
of a suitable operational objective of financial course of action, namely,
exactness, quality of benefits and the time value of money.
The value of an asset should be viewed in terms of the benefits it can produce.
The worth of a course of action can similarly be judged in terms of the value of
the benefits it produces less the cost of undertaking it. A significant element in
computing the value of a financial course of action is the precise estimation of
the benefits associated with it. The wealth maximisation criterion is based on the
concept of cash flows generated by the decision rather than accounting profit
which is the basis of the measurement of benefits in the case of the profit
maximisation criterion. Cash flow is a precise concept with a definite connotation.
Measuring benefits in terms of cash flows avoids the ambiguity associated with
accounting profits. This is the first operational feature of the net present worth
maximisation criterion
The second important feature of the wealth maximisation criterion is that it
considers both the quantity and quality dimensions of benefits. At the same time,
it also incorporates the time value of money. The operational implication of the
uncertainty and timing dimensions of the benefits emanating from a financial
decision is that adjustments should be made in the cash-flow pattern, firstly, to
incorporate risk and, secondly, to make an allowance for differences in the timing
of benefits. The value of a stream of cash flows with value maximisation criterion
is calculated by discounting its element back to the present at a capitalisation
rate that reflects both time and risk. The value of a course of action must be
viewed in terms of its worth to those providing the resources necessary for its
undertaking. In applying the value maximisation criterion, the term value is used
in terms of worth to the owners, that is, ordinary shareholders. The
capitaIisation (discount) rate that is employed is, therefore, the rate that

reflects the time and risk preferences of the owners or suppliers of capital. As a
measure of quality (risk) and timing, it is expressed in decimal notation. A
discount rate of, say, 15 per cent is written as 0.15. A large capitalisation rate is
the result of higher risk and longer time period. Thus, a stream of cash flows that
is quite certain might be associated with a rate of 5 per cent, while a very risky
stream may carry a 15 per cent discount rate.
For the above reasons, the net present value maximisation is superior to the
profit maximisation as an operational objective. As a decision criterion, it involves
a comparison of value to cost. An action that has a discounted value-reflecting
both time and risk-that exceeds its cost can be said to create value. Such actions
should be undertaken. Conversely, actions, with less value than cost, reduce
wealth and should be rejected. In the case of mutually exclusive alternatives,
when only one has to be chosen the alternative with the greatest net present
value should be selected. In the words of Ezra Solomon,
The gross present worth of a course of action is equal to the capitalised
value of the flow of futUre expected benefit, discounted (or captialised) at a rate
which reflects their certainty or uncertainty. Wealth or net present worth is the
difference between gross present worth and the amount of capital investment
required to achieve the benefits being discussed. Any financial action which
creates wealth or which has a net present worth above zero is a desirable one
and should be undertaken. Any financial action which does not meet this test
should be rejected. If two or more desirable courses of action are mutually
exclusive (Le. if only one can be undertaken), then the decision should be to do
that which creates most wealth or shows the greatest amount of net present
worth.
Using Ezra Solomon's symbols and methods, the net present worth can
be calculated as shown below: .
(i)
w= v- C
(1.1)
Where W = Net present worth
V = Gross present worth
C = Investment (equity capital) required to acquire the asset or to purchase
the course of action
(ii)
V = FJ K
(1.2)
Where E = Size of future benefits available to the suppliers of the input capital
K = The capitalisation (discount) rate reflecting the quality
(certainty/uncertainty)and timing of benefits attached to E
(iii) E = G - (M + 1+ 1) (1.3)
Where G = Average future flow of gross annual earnings expected from the
course of action, before maintenance charges, taxes and interest and other prior
charges like preference dividend
M = Average annual reinvestment required to maintain G at the projected level
T= Expected annual outflow on account of taxes and other prior charges.
The operational objective of financial management is the maximisation of W in
Eq. (1.1). Alternatively, W can be expressed symbolically by a short-cut method
as in Eq. (1.4). Net present value (worth) or wealth is

(1.4)

A1
------------

W =
(1+K)

(1+K)

A2
2

A3
++

----------(1+K)

--------------

where ~, A1 A2, ... An represents the stream of cash flows expected to occur

from a course of action over a period of time;

K is the appropriate discount rate to measure risk and timing; and
C is the initial outlay to acquire that asset or pursue the course of action.
It can, thus, be seen that in the value maximisation decision criterion, the time
value of money and handling of the risk as measured by the uncertainty of the
expected benefits is an integral part of the exercise. It is, moreover, a precise and
unambiguous concept, and therefore, an appropriate and operationally feasible
decision criterion for financial management decisions.
It would also be noted that the focus of financial management is on the value to
the owners or suppliers of equity capital. The wealth of the owners is reflected in
the market value of shares. So wealth maximisation implies the rnaxirnisation of
the market price of shares. In other words, maxirnisation of the market price of
shares is the operational ;substitute for value/wealth/net present value
rnaximisation as a decision criterion.
In brief, what is relevant is not the overall goal of a firm but a decision criterion,
which should guide the financial course of action. Profit EPS maxirnisation was
initially the generally accepted theoretical criterion for making efficient economic
decisions, using profit as an economic concept and defining profit rnaximisation
as a criterion for economic efficiency. In current financial literature, it has been
replaced by the wealth maxirnisation decision criterion because of the
shortcomings of the former as an operational criterion, as (j) It does not take
account of uncertainty of risk, (ij) it ignores the time value of money, and (ill) it is
ambiguous in its computation. Owing to these technical limitations, profit
maximisation cannot be applied in real world situations. Its modified form is the
value rnaximisation criterion. It is important to note that value maxirnisation is
simply extension of profit rnaxirnisation to a world that is uncertain and
multiperiod in nature. Where the time period is short and degree of uncertainty is
not great, value maxirnisation and profit rnaximisation amount to essentially the
same thing.
However, two important issues are related to the value/share pricernaximisation, namely, economic value added and focus on stakeholders
Economic Value Added (EVA) It is a popular measure currently being used by
several firrns to determine whether an existing/proposed investment positively
contributes to the owners'/shareholders' wealth. The EVA is equal to after-tax
operating profits of a firm less the cost of funds used to finance investments. A
positive EVA would increase owners' value/wealth. Therefore, only investments
with positive EVA would be desirable from the viewpoint of maximizing
shareholders' wealth. To illustrate, assuming an after-tax profit of Rs 40 crore and
associated costs of financing the investments of Rs 38 crore, the EVA = Rs 2
crore (Rs 40 crore - Rs 38 crore). With a positive EVA, the investment would add
value and increase the wealth of the owners and should be accepted. The
computation of the after-tax operating profits attributable to the investment under
consideration as well as the cost of funds used to finance it would, however,
involve numerous accounting and financial issues.
The merits of EVA are: (a) its relative simplicity and (b) its strong link with the
wealth rnaximisation of the owners. It prima facie exhibits a strong link to share
prices, that is, positive EVA is associated with increase in prices of shares and
vice versa. However, EVA is, in effect, a repackaged and well-marketed
application of the NPV technique of investment decision. But EVA is certainly a
useful tool for operationalising the owners' value rnaximisation goal, particularly
with respect to the investment decision. .
Focus on Stakeholders The shareholders wealth rnaximisation as the primary
goal notwithstanding, there is a broader focus in financial management to include
the interest of the stakeholders as well as the shareholders. The stakeholders
include employees; customers, suppliers, creditors and owners and others who

have a direct link to the firm. The implication of the focus on stakeholders is that
a firm should avoid actions detrimental to them through the transfer of their
wealth to the firm arid, thus, damage their wealth. The goal should be preserve
the well-being of the stakeholders and not to maximise it.
The focus on the stakeholders does not, however, alter the shareholders'
wealth maximisation goal. It tends to limit the firm's actions to preserve the
wealth of the stakeholders. The stakeholders view is considered part of its "social
responsibility" and is expected to provide maximum long term benefit to the
shareholders by maintaining positive stakeholders relationship which would
minimize stakeholder turnover, conflict and litigation. In brief, a firm can better
achieve its goal of shareholders' wealth maximisation with the cooperation of,
rather than conflict with, its other stakeholders.
Shareholder Orientation in India Traditionally, the corporate industrial sector in
India was
. dominated by group companies with close links with the promoter groups. Their
funding primarily was through institutional borrowings from public development
finance institutions like IFCI, ICICI, IDBI! and so on. There was preponderance
of loan capital in their financial structure and shareholders equity played a rather
marginal role. It was no wonder, therefore, that corporate India paid scant
attention to shareholders' wealth maximisation with few exceptions such as
Reliance Industries Ltd. In the post-90 liberalisation era, the goal of
shareholders' wealth maximisation has emerged almost at the centre-stage. The
main contributory factors have been (0 greater dependence on capital market,
(ii) growing importance of institutional investors, (iii) tax concessions/ incentives
to shareholders and (iv) foreign exposure.
With the gradual decline in the significance of the development/public
term/term lending institutions over the years and their disappearance from the
Indian financial scene recently (as a result of their conversion/proposed
conversion into banks) and the consequent emergence of the capital market as
the main source of corporate financing, shareholders' wealth maximisation is
emerging as the prime goal of corporate financial management. Secondly, as a
result of the institutionalisation of savings, institutional investors such as mutual
funds, insurance organisations, foreign institutional investors and so on
dominate the structure of the Indian capital market. To cater to the requirements
of these institutional investors, corporates are pursuing more shareholder friendly policies as reflected in their efforts to focus on shareholders' wealth
maximisation. Thirdly, the abolition of wealth tax on equity shares and other
financial assets coupled with tax. exemption on dividends in recent years has
provided an incentive to corporates to enhance share prices and, thus, focus on
shareholders' wealth. Finally, the family-owned corporate are also undergoing
major transformation. The scions of most business families are acquiring higher
professional education in India and abroad. With the foreign exposure, they also
appreciate the importance of shareholders' wealth. Thus, shareholder
orientation is unmistakably visible in the corporate India.
____________________________

CONCEPT OF TIME VALUE OF MONEY PRESENT VALUE

1.0 OBJECTIVES
The objective is to understand the concept that money has a time value. The
notion that a rupee today is preferable to the same rupee in the future is intuitive
enough for most people to grasp. This can be grasped without the use of models
and mathematics. The principal of present value provides the backing for this and
enables us to calculate exactly how much a rupee some time in the future is
worth today. In this chapter we shall examine the following questions:
What do we mean by time value of money?
What is the basis for present value? What factors affect the timing of
cash flows and how does this affect the time value?
1.1 INTRODUCTION
The principles of present value also underlie most of what we do in Corporate
Finance by evaluating projects and valuation of company shares and a great
deal of personal finance and investment. The simplest tools in finance are often
the most powerful. Present value is a concept which shows that money has a
time value. It is an intuitive and simple concept, simple to calculate and can be
applied in a wide range of situations in corporate finance. We can use this
concept in buying a house, saving for a child's education, picking a project or
more complex situations like valuing a buyout of a company share. That money
has time value stems from the concept that the value of money gets eroded by
the concept of inflation. How often have we heard our elders say that a kilo of
rice was so cheap or that a house was so cheap and had they invested wisely it
might have been better? How often are clothes cheaper,education cheaper and
all the common essentials becoming dearer year after year? In the following
pages you will understand the concept and learn to apply .it on real life
examples.
1.2

DESCRIPTION

Dealing with Cash Flows at different points of time can be made easier using a
time line that shows both the value and timing of cash flows. The following
figure shows a cash flow of Rs 100 at the end of five years.

In the figure above '0' time on the time line depicts now, at the present
moment or today. Thus a cash flow or rupees received by you today has the
same value today. Thus it need not be adjusted for time value. Now a distinction
should be made between a period in time and a point in time. The portion of the
time line between 0 and 1 and 2 and 3, etc. refers to period 1 and period 3 which
in this example is the first year and third year. The cash flow that occurs in a
point in time -1- refers to the cash flow that occurs at the end of period 1. Finally
the discount rate which is 10 per cent in this example is specified in each period
of the time line and may be different for each period. Had the cash flows been
at
0
1 yr Rs 100
2 yrs Rs 100 3 yrs Rs 100 4 yrs Rs 100
5 yrs Rs 100

10%

10%
10%
10%
10%
Fig 1 (a) A Time Line for Cash Flows- End of Each Period
0 Rs 100 1 yr Rs 100
2 yrs Rs 100
3 yrs Rs 100
4 yrs Rs 100

5 yrs

10%
10%
10%
10%
10%
Fig 1.1(b) A Time Line for cash Flows- Beginning of Each Period
the beginning of each year instead of the end of each year, the time line would
be as redrawn above. Please note that the beginning of year 2 is the end of
year 1. It depends how you look at it.
Positive and negatives cash flows: Cash flows can neither be negative or
positive.Cash inflows are called Positive Cash Flows and Csh outflows are
called Negative Cash flows.
Notations
Notation
PV
FV
Cf
A
r
g
n

Meaning
Present Value
Future Value
Cash flow at the end of period t
Annuity-Constant Cash Flows over several periods
Discount Rate
Expected growth rate in cash flows
Number of periods over which cash flows are
received or paid

3.3

COMMON SENSE APPROACH TO PRESENT VALUE

A cash flow in the future is worthless than a. similar cash flow today

because:
People prefer present consumption to future consumption.
People would have to be offered more in the future to give up present
consumption.
Due to inflation the value of money/currency depreciates or erodes over a
period of time. This happens due to inflation. The greater the inflation the
greater is the erosion in the value of the rupee today and in the future.
Due to the uncertainty of receiving the cash flow in the future the value of
the cash flow in the future reduces further. This means there is a risk
associated with receiving the cash flow in future and this reduces the, value
associated with the cash flow. The greater the risk the greater the erosion in
value.

The process by which future cash flows are adjusted to reflect these factors is
called discounting, and the magnitude of these factors is reflected in the
discount rate.

What is Discount Rate?

The discount rate is a rate at which present and future cash flows are traded off.

It incorporates

1. The preference for currrent consumption ( greater preference

2. Expected inflation (higher inflation _ higher discount rate).
3. The uncertainty in the future cash flows (higher risk ___ higher discount

rate).
A higher discount rate will lead to a lower present value for future cash flows.

1.4

TRADE OFF IN REAL CONSUMPTION OVER TIME

Although individuals prefer present consumption to future consumption,

the degree of this preference varies across individuals. This trade off
between present consumption (Co) and future consumption (C1) can be
explained as follows. In the real world people can get the same amount of
money in each period and they can either consume it or save it or lend it. A
may choose to consume the whole amount, B may consume more money by
borrowing and C may consume less and save and lend the remaining
portion. If the preference for current consumption is strong then we have to
offer more in terms of future. consumption to give up current consumption.
Thus there is always a trade off which is always reflected by the high-real

rate of return or discount rate. If the preference for current consumption is

weak then a person can settle for a lower real rate of return or discount rate.
The assumption here is that any money. or wealth saved will always be lent
out as because it can earn a return for the saver. The story of the
grasshopper and the ant reflects this. The grasshopper may make merry and
use all of his money whereas the ant may save to enjoy during winter. Many
an old couple enjoy their retirement because they have intuitively used
the concept of time value of money properly and when their earning capacity
goes down they can enjoy the fruits of their savings ans investment
decisions.
1.5

THE CALCULATION OF PRESENT VALUE

The process of discounting future cash flows converts them into cash flows in
present value terms. Conversely the process of compounding converts present
cash flows into future cash flows.
Cash flows at different points to time cannot be compared and aggregated
unless they are all brought to the same point in time before we can compare or
aggregate them.
There are five types of cash flows:
1. Simple cash flows
2. Annuities
3. Growing Annuities
4. Perpetuities and
5. Growing Perpetuities

1. Simple cash flows

A simple cash flow is a single cash flow in a specified future time period. On
a time line
CF t = Cash Flow at Time t

This cash flow can be discounted back to the present discount rate that reflects
the uncertainty of the cash flow. Conversely,cash flows in the present can be
compounded to arrive at an expected future cash flow.
Discounting: is the process by which a cash flow which is expected to occur in
the future is brought to its present value.

Compounding: is the process by which a cash flow today is converted into its
expected future value.

Calculating Present Value

The present value of Rs 1,00,000 a year from now must be less than Rs
1,00,000 today. Thus the present value of the delayed payoff can be found out
by multiplying the payoff with the discount factor which is less than 1. If the
discount factor is more than 1 a rupee today would be worthless than a rupee
tomorrow. If C1 denotes the expected payoff at period 1, one year hence then
Present Value (PV) = Discount factor x C1
Or In the example earlier
Present Value (PV) = __CF1__
(1 + r)
Thus the discount factor is the value received today of Rs 1 received in the
future. It is usually expressed as a reciprocal of 1 plus a rate of return.
Discount factor = 1
(1 + r)
Similarly you have a compounding factor. To calculate discount factor and
compound factors we have tables to aid us in complex calculations. These
are
given as an appendix to the chapter below. The rate of return r is the reward
that investors demand for accepting a delayed payment.
You are considering investing in a house or property worth Rs 4,00,000
today and your real estate advisor has estimated that the cost would go upto
Rs 5,00,000 in a year if you sold it. That is not the only way you can earn
money as you have various investment options. You can invest in Public
Provident Fund with an interest rate of 9 per cent. How much would you have;
to invest in PPF to receive Rs 5,00,000 after a year. That is easy as the
interest rate is 9 per cent, you would have to invest Rs 5,00,000/1.09, which is
Rs 458715.59. Thus the building investment is a better option as you get a
higher rate of return. However you must bear in mind that the real estate
investment has a higher risk in terms of variability of return. Thus risk is
related to return whereas the PPF option has a lower risk and lower return.
To calculate present value, we discount the expected payoff by the rate
of return offered by equivalent investment alternatives in the capital or
financial! markets. This rate of return is often referred to as the discount

rate, hurdle rate or opportunity cost of capital. It is called opportunity cost

because it is the return forgone by investing in the project rather than
investing in securities. In our example the opportunity cost was 9 per cent.
Present value was obtained by dividing Rs 5,00,000 by 1.09.
PV = Discount factor x C1 = _1____x C1
1+r

= 5,00,000 = Rs 458715.59
1.09

3. Net Present Value

Let us suppose that your property is worth Rs 458715.59 today but you
committed Rs 4,00,000 initial outgo to purchase the property. So your NET
PRESENT VALUE is Rs 58715.59. Net Present Value is found by subtracting the
required investment
NPV= PV - Required Investment = Rs 4,58,715.59 - Rs 4,00,000
= Rs 58,715.59
In other words your investment in the property is worth more than it costs - it
makes a net contribution to value. The formula for calculating NPV can be written
as

NPV= C 0

C1
+_____
1+r

Remember that Co the cash flow at time 0 (that is today), will usually be a
negative number. In other words, Co is an investment and therefore a cash
outflow. In our example Co is - Rs 4,00,000.

Relation of Risk to Present Value

In many of our calculations we feel it is enough to compare the present values
and aggregates, however we make the unrealistic assumption of assigning the
same level of risk and only taking decisions based on the comparative returns of
alternative means of adjustments. The real estate advisor or property advisor
cannot be sure about the return in the market. If the future value of this property
is risky our calculation is wrong. Public Provident Fund is certainly less risky as it

is akin to Government security. Thus if you were asking someone else to invest in
this property along with you they may not agree to give you the present value
amount but something less than that. Thus we invoke another financial principal
that a safe rupee is worth more than a risky one. Thus we do not use the same
discount factor while comparing alternative investment avenues. The discount
rate for PPF may be 9 per cent OR 0.09 but the discount rate for the building
property may be 11 per cent or 0.11. Only after the present values are calculated
using these two different discount rates is the best investment avenue or project
decided.
Most investors avoid risk when they can do so without sacrificing return.
However, the concepts of present value and the opportunity cost of capital still
make sense for risky investments. It is still proper to discount the payoff by the
rate of return offered by an equivalent investment. But we have to think of
Expected payoffs and the expected rates of returns on other investments. You
will learn more about expected payoffs when you do Capital Budgeting Later.
For now it will be enough if you think of an expected payoff and the expected
rates of returns on other investments. You will learn more about expected
payoffs when you do Capital Budgeting Later. For now it will be enough if you
think of an expected payoff as a realistic forecast,neither pessimistic nor

optimistic.
Concept check: India has a low savings rate as compared to Japan. This
leads to greater budget and trade deficits. How does a low saving rate affect
discount rates?
Effect of Inflation on Discount Rate: The effect of inflation on present value is
evident because it reduces the purchasing power of future cash flows. This
adjustment reduces the value of future cash flows, but these real cash flows, will
have to be reduced further to reflect real returns (i.e. the trade offs between
current and future consumption) and any uncertainty associated with the cash
flows to arrive at the present value. Thus, an investor who expects to make 10.5
million Mexican pesos a year from now will have to reduce this expected cash
flow to arrive at the present value. Thus, an investor who expects 1 million Italian
Lire a year from now will have to reduce this expected cash flow to 1 reflect the
expected inflation rate in Mexico. If that inflation rate is 25 per cent,for instance,
the real cash flow will be only 0.8 million Italian lire.
The general formula for converting nominal cash flows at a future period t' to real
cash flows is Real Cash Flow = (Nominal cash flow)/(1 + inflation rate).
Effect of Risk on Discount Rate: Although both the preference for current
consumption, and expected inflation affect the present value of all cash flows not
all cash flows are equally predictable. A promised cash might not be delivered for
a number of reasons: the promisor (lnterest and investment not received as
company winds up) might default on the payment- the promisee might not be
around to receive payment - (might have died) or some other contingency or

some happening may intervene to prevent the promised payment or to reduce it.
The greater the uncertainty associated with a cash flow in the future, the higher
the discount rate used to calculate the present value of this cash flow will be and
the present value of that cash flow will consequently be lower.

Example
You have decided to invest in a construction of an office building as it is worth
more than it costs- it has positive net present value. To calculate how much it is
worth- would have to pay to achieve the same pay off by investing directly in
securities. The project's future value is equal to its future income discounted at
the rate of return offered by these securities.
We can say this another way. Our building venture is worth undertaking
because its rate of return exceeds its cost of capital. The rate of return is simply
the profit as a proportion of the initial outlay.
Return = Profit/Investment =(5,00,000-4,30,000)/4,30,000
=(70,000) /(4,30,000)
= 0.163 about 16 per cent
The cost of capital is once again the return foregone by not investing in
securities. If the office building is as risky as investing in stock market securities
where the expected return is 14 per cent then the return forgone is 14 per cent.
Since the 16 per cent return on the office building exceeds the 14 per cent
opportunity cost, you should go ahead with the project.
Hence we have two equivalent decision rules for capital investment.
Net present value rule. Accept investments that have positive net present
values.
Rate of return rule. Accept investments that offer rates of return in excess of
their opportunity costs of capital

1.6 DISCOUNTING A SIMPLE CASH FLOW - WHY IT IS IMPORTANT

Discounting a cash flow converts it into present value rupees and enables the
user to do several things. First, once cash flows are converted into present value
rupees, they can be aggregated and compared. Second, if present values are
estimated correctly the user should be indifferent between the future cash flow
and the present value of the cash flow.

Other things remaining equal, the present value of a cash flow will decrease as
the discount rate increases and continue to decrease the further into the future
the cash flow occurs. Thus present value is a decreasing function of the discount
rate.

1.7COMPOUNDING A CASH FLOW - WHY IT IS IMPORTANT

Current cash flows can be moved into the future by compounding the cash flow
at the appropriate discount rate.
The future value of a simple cash flow is
Future Value of a Simple Cash Flow = CFo (1+ r)'
where CF o = Cash Flow Now ,r = Discount Rate
Again, the compounding effect increases with both the discount rate and the
compounding period.
Compounding. is the process by which cash flows are converted from present
value to future value rupees.
Ibbotson and Sinquefield's Study
As the length of the holding period is extended, small differences in discount
rates can lead to large differences in future value. In a study of returns on stocks
and bonds between 1926 and 1992, Ibbotson and Sinquefield found that stocks
on the average made 12.4 per cent Treasury Bonds made 5.2 percent, and
Treasury Bills made 3.6 per cent. Assuming that these returns continue into the
future, the table below provides the future value of dollar 100 invested n each
category at the end off a number of holding periods - 1 year, 5 years, 10 years,
20 years, 30 years and 40 years.
The differences in future value from investing at these different rates of return
are small for short compounding periods( such as one year) but become larger
as the compounding period is extended. For instance, with a 40 year time
horizon, the future value of investing in stocks, at an average return of 12.4 per
cent, is more than 12 times larger than the future value of investing in Treasury
bonds at an average return of 5.2 per cent and more than 25 times the future
value of investing in Treasury Bills at an average return of 3.6 per cent.

Future Value of Investments - Asset Classes

Holding Period

Stocks

112.40

5
10

179.40
321.86

T. Bonds
105.20
128.85
166.02

T. Bills
103.60
119.34
142.43

20

1035.92

30

3334.18

40

10731.30

275.62
457.59
759.68

202.86
288.93
411.52

Concept Check
Most pension funds allow individuals to decide where their pension funds
will be invested- stocks (equity), bonds (debt) or money market accounts,
etc. Where would you choose to invest your pension fund? Do you think
your allocation should change as you get older ? Why?
The Rule of 72- A shortcut to estimating the Compounding effect
In a pinch, the rule of 72 provides an approximate answer to the question
"How quickly will this amount double in value?" by dividing 72 by the
discount on interest rate used in the analysis. Thus, a cash flow growing at 6
per cent will, double in value in approximately 12 years, while a cash flow
growing at 9 percent will double in value in approximately 8 years.

Effective Interest Rate

This is the true rate of interest, taking into account the compounding effects
of more frequent interest payments.

The Frequency of Discounting and Compounding

The frequency of compounding affects both the future and present values of
cash flows. In the examples above, the Cash flows were assumed to be
discounted and compounded annually - that is, interest payments and income
were computed at the end of each year, based on the balance at the beginning
of each year. In some cases however the interest may be computed more
frequently, such as on a monthly or semi annual basis. In these cases, the
present and future values may be very different from those computed on annual
basis; the stated interest rate on an annual basis can deviate significantly from
the effective or true interest rate. The effective interest rate can be computed as
follows.
Effective Interest Rate= (1+Stated Annual Interest Rate) n
---------------------------------------------------1
N
Where N=number of compounding periods (2=semi annual;12 =monthly)

For Instance, a 10 per cent annual interest rate, if there is semi annual
compounding works out to an effective interest rate of
Effective Interest Rate = (1.052 - 1) =(1.1025 - 1.0) = 10.25 per cent
As compounding becomes continuous, the effective interest rate can be
computed as follows:
Effective Interest Rate = (exp )r - 1
where exp = exponential function
r = stated annual interest rate
The Table below provides the effective rates as a function of the compoundin!g
frequency.

Effect of Compounding Frequency on Effective Interest Rates

Frequency

Rate(% )

Annual

10

Semi-Annual
Monthly

10
10

2
12

Formula

Effective Annual
Rate(%)

.10

10

(1 +.10/2)2 -1
10.25
(1 +.10112)12 - 1
10.47,
(1 +.10/365)365 Daily
10
365
10.5156
1
Continuous
10
continuous e,10 - 1
1 O5171
As you can see, as compounding becomes more frequent, the effective rate
increases, and the present value of future cash flows decreases.
For example the home loans which various companies offer you require
monthly repayments and may have monthly compounding. Thus the interest rate
quoted to you may be too low and actually quite deceptive. To get the effective
Annual rate you should use the formula above and see what the actual effective
interest rate is.

Annuity
An annuity is a constant cash flow occurring at regular intervals of time.

Annuities

An annuity is a constant cash flow that occurs at regular intervals at fixed period
of time. Defining A to be the annuity time, the time line for an annuity may be
drawn as follows:
A
A
A
A

0
4

An annuity can occur at the end of each period, as in this time line, or at the,;
beginning of each period.

Present Value of an end-of-the period annuity

The present value of an annuity can be calculated by taking each cash flow and
discounting it back to the present and then adding up the present values.
Alternatively, a formula can be used in the calculation. In the case of annuities
that occur at the end of each period, this formula can be written as
(1- 1 )
PV of an Annuity =PV(A, r, n)=A ( (1+r)n )
( r )
where A = Annuity
r = Discount Rate
n = Number of years
Accordingly the notation used internationally for the present value of an.
annuity is PV(A, r, n).
Suppose you start a rent-a-car business and want to buy an automobile.
You have choice of buying the car cash down for Rs 400,000 or paying Rs
90,000 a year for five years for the same car. What would you rather do, if the
opportunity cost is 12% then calculate your decision?
PV of Rs 90,000 each year for the next 5 years
1

( 1 - -------)
(
5)

= 90,000

( (1.12)

= 3,24,429.75

0.12)

Obviously it is better to take the auto loan rather than pay cash down and
naturally no auto loan company or bank will come up with such a scheme. The
present values of your instalments versus cash down will always be higher but if
you do not have the money right now or you can get a higher return by using this
loan then it is worthwhile taking the loan. Thus you will also have to look 'into
your inflows by hiring out the carls in your rent-a-car business.
When the present values of your instalment payments exceed the cash down
price it is better to pay cash down and acquire the asset.
Alternatively above you could have discounted each instalment separately land
added up the present values for all five and arrived at the same figure. Nowadays
spreadsheets like excel are used to calculate the values of different annuities or
using advanced programme calculators which all insurance company agents use.
Thus using the formulas programmed in the spreadsheet and changing the
variables like amount, time and rate of interest/discount factor you can calculate
the present value of different annuities and take financial decisions both personal
and commercial.

Concept Check
Often you have a choice of buying an asset like a car, computer, plane,
etc. Is it appropriate to compare the present value of just your lease
payments to your purchase price? Why or why not?
Future Value of End-of-the-Period Annuities
n some cases, an individual may plan to set aside a fixed annuity each period for
a number of periods and will want to know how much he or she will have at the
end of the period. The future value of an end-of-the-period annuity can be
calculated as follows
FV of an annuity = FV(A, r ,n)= A{ (1+r)n - 1}
r
Thus the standard notation widely practiced for Future Value of an annuity is FV(
A, r , n)
Concept Check
Knowing the future value formula can you calculate the future value of Rs 5000
tax exempted PPF you deposit every year for twenty years? Or for forty yean
Assume you start at age 25 years.

If it is taxed obviously you have a lower return.

Juggling the above formula if you know the future value of what you have
repay and you want to set aside a fixed sum even year so that you can repay the
sum you can calculate the annuity.
Thus Annuity given future value - which means you are given the future value
and are looking for the annuity - A (FV, r, n) can be calculated as follow
Annuity given the future value= A (FV, r, n) = FV{__r__}
( 1+r)n -1
Balloon Repayment Loan: A balloon Repayment loan refers to a Ioan on
which only interest is paid for the life of the Ioan, and the-entire principal is paid
at the end of the loan's life. Companies that borrow money using balloon
repayment loans like bonds or debentures often set aside money in sinking funds
during the life of the loan to ensure they have enough at maturity to pay the
principal on the loan or the face value of the bonds. Thus any company will have
to set aside a fixed amount each year till the date of redeeming of bonds/
debentures to avoid defaulting on repayment to bondholders or debenture
holders. The size of the sinking fund will vary with the change in interest rate.
Sinking Fund: A sinking fund is a fund to which firms make annual contributions
in order to have enough funds to meet a large financial liability in future.

Concept Check
Do Insurance Companies and Pension Funds provide for sinking funds? When
insurance is only a contingent/uncertain liability why do these companies also
provide for sinking funds?
Effect of Annuities at the Beginning of Each Year
The annuities we talked about till now are end of the period cash flows. Both the
present and future values are affected if the cash flow occurs at the beginning of
each period instead of the end. To illustrate this effect, consider an annuity of Rs
100 at the end of each year for the next four years,with a discount rate of 10%.
Rs 100

Rs 100

Rs 100

Rs

100

0
4

10%

10%

10%

10%

Rs 100

Rs 100

Rs 100

Rs 100

4
Rs 100

Fig 1.4
Because the first of these annuities occurs right now, and the remaining cash flows
take the form of an end-of-the-period annuity over three years. The present value of
this annuity can be written as follows:
PV of Rs 100 at beginning = 100 + 100[1- 1___
3
of each of next four year

1.10__
0.10

In general, the present value of a beginning of- a- period annuity over an year
can be written as follows
PV of Period Annuities at beginning = A + A [1-__1_
of each of next n years

(1+r) n-1
_________
r

This present value will be higher than the present value of an equivalen to
annuity at the end of each period.
The future value of a beginning-of-a-period annuity typically can be estimated
by allowing for one additional period of compounding for each cash flow:
PV of Period Annuities at beginning = A (1+r) (1+r) n-1
of each of next n years

_________
r

This future value will be higher than the future value of an equivalent annuity at
the end of each period. Thus if you invest your annuity at the beginning of each
year instead of the end of each year, your future value will be higher.

Growing Annuities
A growing annuity is a cash flow that grows at a constant rate for a specified
period of time. If A is the current cash flow, and g is the expected growth rate,;
the time line for a growing annuity is as follows:
A(1+ g)1

A(1+ g) 2

A(1+ g)3

A(1+

g)4

Note that to qualify as a growing annuity, the growth rate in each period ha~ to
be the same as the growth rate in the prior period.

The Process of Discounting a Growing Annuity

The present value of a growing annuity can be estimated by using the following
formula:

PV of a Growing Annuity = A(1+g) { 1 _ (1 + g)" }

(1+r)"
r9
The present value of a growing annuity can be estimated in all cases but one if the growth rate is equal to the discount rate. In that case, the preseni value is
equal to the nominal sums of the annuities over the period, without the growth
effect.
PV of a Growing Annuity for n years (when r = g) = nA
It is important to note that the expanded formulation works even when th~
growth rate is greater than the discount rate.

Perpetuity
A perpetuity is a constant cash flow paid (or received) at regular time intervals
forever.

Thus a lifetime pension can be considered as perpetually or rentals received

from exploitation of land which is passed on from generation to generation.
The present value of a perpetuity can be written as
PV of Perpetuity = A
r
A Console Bond is a bond that has no maturity and pays a fixed coupon (rate of
interest).
Assume that you have a 6 per cent coupon console bond. The original face
value = Rs 1000. The current value of this bond if the interest rate is 9 per cent
is as follows.
Current value of Console Bond = Rs 6010.09 = Rs 667
The value of a Console bond will be equal to its face value only if the coupon
rate is equal to the interest rate. In this case Rs 1000, Le. 60/0.06

Growing Perpetuties
A growing perpetuity is a cash flow that is expected to grow at a constant rate.
forever. The present value of a growing perpetuity can be-written as
PV of Growing Perpetuity =

C___
(r - g)

A growing perpetuity is a constant cash flow, growing at a constant rate, and

paid at regular time intervals forever.
Although a growing annuity and a growing perpetuity share several features,
the fact that a growing perpetuity lasts forever puts constraints on the growth
rate. It has to be less than the discount rate for the formula to work.

Recommended Readings
Financial Management By Khan & Jain

CAPITAL EXPENDITURE DECISIONS

OBJECTIVES
This chapter provides a broad overview of the field of project appraisal and
capital budgeting. It is divided into five sections as follows:
Capital expenditures: importance and difficulties
Phases of capital budgeting
Levels of decision-making
Facets of project analysis
Feasibility study: a schematic diagram
Objectives of capital budgeting

CAPITAL EXPENDITURE DECISIONS

Capital Expenditures: Importance and Difficulties

Importance
Capital expenditure decisions often represent the most important decisions taken
by a firm. Their importance stems from three inter-related reasons:
Long-term effects: The consequences of capital expenditure decisions extend far
into the future. The scope of current manufacturing activities of a firm is
governed largely by capital expenditures in the past. Likewise current capital
expenditure decisions provide the framework for future activities. Capital
investment decisions have an enormous bearing on the basic character of a firm.
Irreversibility: The market for used capital equipment in general is iIlorganised. Further, for some types of capital equipments,custom made to
meet specific requirement, the market may virtually be non-existent. Once
such an equipment is acquired, reversal of decision may mean scrapping
the capital equipment. Thus, a wrong capital investment decision, often
cannot be reversed without incurring a substantial loss
Substantial outlays: Capital expenditures usually involve substantial
outlays. An integrated steel plant, for example, involves an outlay of
several thousand millions. Capital costs tend to increase with
advanced.

Difficulties
While capital expenditure decisions are extremely important, they also post
difficulties which stem from three principal sources:
.

Measurement problems: Identifying and measuring the costs and benefits

of a capital expenditure proposal tends to be difficult. This is more so when
a capital expenditure has a bearing on some other activities of the firm
(like cutting into the sales of some existing product) or has some intangible
consequences (like improving the morale of workers).

Uncertainty: A capital expenditure decision involves costs and benefits that

extend far into future. It is impossible to predict exactly what will happen in
future. Hence, there is usually a great deal of uncertainty characterising the
costs and benefits of a capital expenditure decision.

Temporal spread: The costs and benefits associated with a capital

expenditure decision are spread out over a long period of time, usually 10-20
years for industrial projects and 20-50 years for infrastructural projects. Such
a temporal spread creates some problems in estimating discount rates and
establishing equivalences.

PHASES OF CAPITAL BUDGETING

Capital budgeting is a complex process which may be divided into five broad
phases: planning, analysis, selection, implementation, and review. Exhibit
11.1portrays the relationship among these phases. The solid arrows reflect the
main sequence: planning precedes analysis; analysis precedes selection; and
so on. The dashed arrows indicate that the phases of capital budgeting are not
related in a simple, sequential manner. Instead, there are several feedback
loops reflecting the iterative nature of the process.

Planning
The planning phase of a firm's capital budgeting process is concerned with the
articulation of its broad investment strategy and the generation and preliminary
screening of project proposals. The investment strategy of the firm delineates
the broad areas or types of investments the firm plans to undertake. This
provides the framework which shapes, guides, and circumscribes the
identification of individual project opportunities.

Exhibit 11.1 Capital Budgeting Process

Once a project proposal is identified, it needs to be examined. To begin with, a

preliminary project analysis is done. A prelude to the full blown feasibility study,
this exercise is meant to assess (i) whether the project is prima facie worthwhile
to justify a feasibility study and (ii) What aspects of the project are critical to its
viability and hence warrant an in-depth investigation.

Analysis
If the preliminary screening suggests that the project is prima facie worthwhile,
detailed analysis of the marketing, technical, financial, economic, and ecological
aspects is undertaken. The questions and issues raised in such a detailed
analysis are described in the following section. The focus of this phase of capital
expenditure decisions is on gathering, preparing, and summarising relevant
information about various project proposals which are being considered for
inclusion in the capital budget. Based on the information developed in this
analysis, the stream of costs and benefits associated with the project can be
defined.

Selection
Selection follows, and often overlaps, analysis. It addresses the question-Is the
project worthwhile? A wide range of appraisal criteria have been suggested to
judge the worthwhileness of a project. They are divided into two broad categories,
viz., non-discounting criteria and discounting criteria. The principal non-discounting
criteria are the payback period and the accounting rate of return. The key
discounting criteria are the net present value, the internal rate of return, and the
benefit cost ratio. The selection rules associated with these criteria are as
follows:
________________________________________________________________
_
Criterion

Accept

Reject

Payback period(PBP)
PBP< target period
Accounting rate of return(ARR) ARR>target rate
rate

PBP> Target period

ARR<Target

Net present value(NPV)

NPV>0

NPV<0

Internal rate of return(IRR)

IRR>cost of capital IRR< cost of capital

Benefit cost ratio(BCR)

BCR>1

BCR<1

________________________________________________________________
_
To apply the various appraisal criteria suitable cut-off values (hurdle rate target

rate, and cost of capital) have to be specified. These essentially a

function of

the mix of financing and the level of project risk. While the former can be defined
with relative ease, the latter truly tests the ability of the project evaluator. Indeed
despite a wide range of tools and techniques for risk analysis (sensitivity
analysis, scenario analysis, Monte Carlo simulation, decision tree analysis
portfolio theory, capital asset pricing model, and so on), risk analysis remains the
most intractable part of the project evaluation exercise.

Implementation
The implementation phase for an industrial project, which involves setting of
manufacturing facilities, consists of several stages: (i) project and engineering
designs, (ii) negotiations and contracting, (iii) construction, (iv) training, and (v)
plant commissioning. What is done in these stages is briefly described below
_

_______________________________________________________________
_
Stages

Concerned with

Project and engineering designs

Site probing and prospecting, preparation

of blueprint and plant designs , plant
engineering, selection of specific
machineries and equipment.

Negotiations and contracting

Negotiating and drawing up of legal

contracts with respect to project financing,
acquisition of technology, construction of
building and civil works, provision of

utilities, supply of machinery and

equipment, marketing arrangements, etc.
Construction

Site preparation, construction of

buildings and civil works, erection
and installation of machinery and
equipment.

Training

Training of engineers, technicians, and

workers. (This can proceed
simultaneously along with the
construction work)

Plant commissioning

Start up of the plant. (This is a brief but

commissioning is technically crucial
stage in the project development cycle.)

Translating an investment proposal into a concrete project is a complex timeconsuming, and risk-fraught task. Delays in implementation,which is common,
can lead to substantial cost overruns. For expeditious implementation at a
reasonable cost, the following are helpful.

1. Adequate formulation of projects: A major reason for delay is inadequate

formulation of projects. Put differently, if necessary homework in terms of
preliminary studies and comprehensive and detailed formulation of the project
is not done, many surprises and shocks are likely to Spring on the way.
Hence, the need for adequate formulation of the project cannot be overemphasised.

2. Use of the principle of responsibility accounting : Assigning specific

responsibilities to project managers for completing the project within the
defined time frame and cost limits is helpful in expeditious execution and cost
control.
3. Use of network techniques: For project planning and control two basic
techniques are available - PERT (Programme Evaluation Review Technique)
and CPM (Critical Path Method). These techniques have, of late, merged and
are being referred to by a common terminology, that is network techniques.
With the help of these techniques, monitoring becomes easier.

Review
Once the project is commissioned the review phase has to be set in motion.
Performance review should be done periodically to compare actual performance
with projected performance. A feedback device is useful in several ways: (i) It

throws light on how realistic were the assumptions underlying the project; (ii)
It provides a documented log of experience that is highly valuable in future
decision-making; (iii) It suggests corrective action to be taken in the light of
actual performance; (iv) It helps in uncovering judgemental biases; (v) It induces
a desired caution among project sponsors.

LEVELS OF DECISION-MAKING
Operating

Administrative

decisions

Strategic

decisions

Where is the decision

Lower level

Middle level

taken
management

management

management

How structured is the

Routine

Semi-structured

decision
Top level

Unstructured

decision
What is the level of
resource

Minor resource

Moderate resource Major

resource commitment

commitment

commitment

What is the time horizon Short-term

Medium term

commitment
Long-term

The three levels (operating, administrative, and strategic) of decision making can
be readily applied to capital expenditure budgeting decision. Examples are given
below:
Operating capital budgeting decision
Administrative capital budgeting decision

: Minor office equipment

: Balancing equipment

Strategic capital budgeting decision

: Diversification project

While the methods and techniques covered in this book are applicable to all
levels of capital budgeting decision. Our discussion will mainly be oriented
towards administrative and strategic budgeting decisions.

Project Appraisal and Control techniques

PROFITABILITY STUDY-VARIOUS FACTS OF PROJECT
ANALYSIS
The important facets of project analysis are:
Market analysis
Technical analysis
Financial analysis

 Economic analysis
Ecological analysis

Market Analysis
Market analysis is concern with primarily two questions:
What would be the aggregate demand of the proposed product/service in
future
What would be the market share of the project under appraisal?

To answer the above question, the

variety

market analyst requires a wide

of information and appropriate forecasting methods. The kinds of information

required are:

Consumption trends in the past and the present consumption

Past and present supply position

Production possibilities and constraints

Import and exports

Structure of competition

Cost structure

Elasticity of demand

Consumer behaviour, innovations, motivations, attitudes, references and

requirements

Distribution channels and marketing policies in useful

Administrative, technical and legal constraints

Technical Analysis
Analysis of the technical and engineering aspects of a project needs to be done
continually when a project is formulated. Technical analysis seeks to determine
whether the prerequisites for the successful commissioning of the Project have
been considered and reasonably good choices have been made with respect to

location, size, process, etc. The important questions raised in technical

analysis are:

Whether the preliminary tests and studies have been done or provided

for?
Whether the availability of raw materials, power, and other inputs has
been established?
Whether the selected scale of operation is optimal?
Whether the production process chosen is suitable?
Whether the equipment and machines chosen are appropriate?
Whether the auxiliary equipments and supplementary engineering
works
have been provided for ?
Whether provision has been made for the treatment of effluents?
Whether the proposed layout of the site, buildings, and plant is sound?
Whether work schedules have been realistically drawn up?
Whether the technology proposed to be employed is appropriate from
the social point of view?
Financial Analysis
Financial analysis seeks to ascertain whether the proposed project will be
financially viable in the sense of being able to meet the burden of servicing debt
and whether the proposed project will satisfy the return expectations of those
who provide the capital. The aspects which have to be looked into while
conducting financial appraisal are:
Investment outlay and cost of project
Means of financing
Cost of capital
Projected profitability
Break-even point
Cash flows of the project
Investment worthwhileness judged in terms of various criteria of merit
Projected financial position
Level of risk

Economic Analysis
Economic analysis, also referred to as social cost benefit analysis, is concerned
with judging a project from the larger social point of view. In such an
evaluation the focus is on the social costs and benefits of a project which may

often be different from its monetary costs and benefits. The questions sought
to be answered in social cost benefits analysis are:

What are the direct economic benefits and costs of the project
measured in terms of shadow (efficiency) prices and not in terms of
market prices?
What would be the impact of the project on the distribution of income
in the society?
What would be the impact of the project on the level of savings and
investment in the society?
What would be the contribution of the project towards the fulfillment of
certain merit wants like self-sufficiency, employment, and social
order?

Ecological Analysis
In recent years, environmental concerns have assumed a great deal of
significance-and rightly so. Ecological analysis should be done particularly
for major projects which have significant ecological implications like power
plants and irrigation schemes, and environmental-polluting industries (like
bulk drugs, chemicals, and leather processing-). The key questions r~sed
in ecological analysis are:
. What is the likely damage caused by the project to the environment?
. What is the cost of restoration measures required to ensure that the
damage to the environment is contained within acceptable limits?
Exhibit 11.2 summarises the key issues considered indifferent types of
analysis:
Exhibit 11.2 Key Issues in Project Analysis
Market Analysis

________Potential Market
Market Share

Technical Analysis

_________Technical Viability
Sensible Choices

Financial Analysis

___________Risk Return

Economics Analysis

___________Benefits and Cost in shadow Prices

Other Impact

Ecological Analysis

_________ Environmental Damage

Restoration Measures

Feasibility Study: A Schematic Diagram

We have looked at the five broad phases of capital budgeting and

examined the key facets of project analysis. The feasibility study is
concerned with the first three phases of capital budgeting, viz., planning,
analysis, and selection (evaluation) and involves market, technical,
financial, economic, and ecological analysis.
Objectives of Capital Budgeting

Financial theory, in general, rests on the premise that the goal of financial
management (which subsumes investment decision-making) should be
to maximise the present wealth of the firm's equity shareholders. For a
firm whose equity shares are actively traded on the stock market, the
wealth of the equity shareholders is reflected in the market value of the
equity shares. Hence, the goal of financial management for such firms
should be to maximise the market value of equity shares.
The pursuit of the welfare of equity shareholders is justified on the
grounds that it contributes to an efficient allocation of capital in the
economy. The bases for allocation of savings in the economy are
expected return and risk. Since equity share prices are based on
expected return and risk, efforts to maximise equity share prices would
result in an efficient allocation of resources. Another justification may be
provided for the goal of shareholder wealth maximisation.
Equity shareholders provide the venture (risk) capital required to start
a business firm and appoint the management of the firm indirectly
through the board of directors. Hence, it behoves on corporate
managements to promote the welfare of equity shareholders.
What about a public sector firm the equity stock of which, being fully
owned, by the government, is not traded on the stock market? In such a
case, the goal of financial management should be to maximise the
present value of the stream of equity returns. Of course, in determining
the present value of the stream of equity returns, an appropriate
discount rate has to be applied. A similar observation may be made with
respect to other companies whose equity shares are either not traded or
very poorly traded.
Alternatives
Are there other goals, besides the goal of maximum shareholder wealth
expressing the shareholders viewpoint? Several alternatives have bee,n
suggested: maximisation of profit, maximisation of earnings per share,

maximisation of return on equity (defined as equity earnings/net worth).

Maximisation of profit is not as inclusive a goal as maximisation of

shareholders
wealth. It suffers from several limitations:

Profit in absolute terms is not a proper guide to decision-making. It

Should

be expressed on a per share basis or related to investment.

It leaves considerations of timing and duration undefined. There is no guide

for
comparing profit now with profit in future or for comparing profit
streams
of different durations.
It glosses over the factor of risk. It cannot, for example, discriminate
between an investment. project which generates a certain profit of Rs
50,000 and an investment project which has a variable profit outcome
with an expected value of Rs 50,000.
The goals of maximisation of earnings per share and maximisation
of retum on equity do not suffer from the first limitation mentioned above.
They, however suffer from the other limitations and hence are not suitable.
In view of the shortcomings of the alternatives discussed above,
maximisation of the wealth of equity shareholders (as reflected in the
market price of equity) appears to be the most appropriate goal for
financial decision-making. Though the strict validity of this goal rests on
certain rigid assumptions about capital markets, it can be reasonably
defined as a guide for financial decision making under fairly plausible
assumptions.

Other Concerns of the Business

Do firms really act or should solely act to further shareholders welfare? This does
not seem to be the issue here. Firms may pursue or ought to pursue several other
goals. Business firms seek to achieve a high rate of growth, enjoy a substantial
market share, attain product and technological leadership, promote employee
welfare, further customer satisfaction, support education and research, improve
community life, and solve other societal problems. Some of these goals, may, of
course, be in consonance with the goal of shareholder wealth maximisation. For
a rapid growth rate, a dominant market position, and a higher customer
satisfaction may lead to increasing returns for equity shareholders. Even efforts
toward solving societal problems may further the interest of shareholders in the
long run by improving the image of the firm and strengthening its relationship with
the environment. When these other goals seem to conflict with the goal of
maximising the wealth of equity shareholders, it is helpful to know the cost of

pursuing these goals. The trade-off has to be understood. It should be

appreciated that the maximisation of the wealth of equity shareholders constitutes
the principal guarantee for efficient allocation of resources in the economy and
hence is to be regarded as the normative goal from the financial point of view.
Basic Considerations: Risk and Return
Suppose a firm is evaluating an investment proposal. What aspects are relevant
from the financial angle? From the financial point of view the relevant
dimension are return and risk. Take another decision situation in which the
firm is considering a financing proposal. The aspects along which such a
proposal is examined are cost and risk. Since cost is the inverse of return,
here too the basic dimensions are return and risk. In general, we find that
these are the two basic dimensions of financial analysis.
What is the relationship between return, risk and market value of equity?
Higher the return, ceteris paribus, higher the market value; higher the risk,
ceteris paribus, lower the market value. Exhibit 11.4 shows the schematic
diagram of how decisions, return, risk, and market value are related.
Exhibit 11.4 Decision, Return,Risk and market value
Return

Investment
Decision

Financing
Decision

Market Value of
the Firm

Risk

It may be emphasized that typically, risk and return go hand in hand.

This means that in a decision situation, an alternative which has a
higher return tends to have higher risk too. Likewise, an alternative
which has a lower return tends to have a lower risk. In financial
analysis, the trade-off between risk and return needs to be carefully
analysed.

Let Us Sum Up
Essentially a capital project represents a scheme for investing
resources that can be analysed and appraised reasonably
independently.
The basic characteristic of a capital project is that it typically involves a
current outlay (or current and future outlays) of funds in the
expectation of a stream of benefits extending far into future.
Capital expenditure decisions often represent the most important
decisions taken by a firm. Their importance stems from three interrelated reasons: long-term effects, irreversibility, and substantial
outlays.

While capital expenditure decisions are extremely important, they pose

difficulties which stem from three principal sources: measurement

problems, uncertainty, and temporal spread.

Capital budgeting is a complex process which may be divided into five

broad

phases: planning, analysis, selection, implementation, and review.

One can look at capital budgeting decisions at three levels: operating,
administrative, and strategic.
The important facets of project analysis are: market analysis, technical
analysis, financial analysis, economic analysis, and ecological analysis.
Financial theory, in general, rests on the premise that the goal of
financial management should be to maximise the present wealth of
the firm's equity shareholders. Business firms may pursue other
goals. When these other goals conflict with the goal of maximising the
wealth of equity shareholders, the trade-off has to be understood.

Keywords
Accounting rate of return method: A selection criterion using average net
income and investment outlay to compute a rate of return for a project. The
method ignores the time value of money and cash flows.
Capital budget: The schedule of investment project selected to be
undertaken over some interval of time.
Internal rate of return method: A selection method using the compounding
rate of return on the cash flow of a project.
Net present value: A selection method using the difference between the
present value of the cash inflows of the project and the investment outlay.
The method evaluates differential cash flow between proposals.
Payback method: A selection method in which a firm sets a maximum
pay. back period during which cash inflow must be sufficient to recover
the initial outlay. This method ignores the time value of money and cash
flows beyond the pay back period.

Recommended reading:
Financial Management by Khan and Jain
Financial Management by I M Panday