Chapter 2.

Capital Budgeting
a. Cost of Capital
The cost of capital is an important financial concept. It links the company's long term
decisions with the wealth of the shareholders as determined in the market place.
Whenever, a business organization raises funds, it has to keep in mind its cost. Hence
computation of cost of capital is very important and finance managers must have a close
look on it. In this unit, we shall discuss the concept, classification, and importance of
cost of capital the process of computing cost of capital of individual components,
weighted cost of capital, importance of cost of capital and a few misconceptions. In term
of lending rate it refers to the opportunity cost of the funds to the firm i.e. what the firm
could have earned by investing fund elsewhere. In both cases cost of capital connotes
rate of return prevailing in the market and anybody seeking capital from the market will
have to promise to pay this rate to the suppliers or anyone investing funds will receive
return at the same rate.

i. Cost of Capital – Concept

Cost of capital is the minimum required rate of return a project must earn in order to
cover the cost of raising fund being used by the firm in financing of the proposal. It may
be defined in two phase i.e. operational term and economic term. In the first, it refers to
the discount rate that would be used in determining the present value of the estimated
future cash proceeds and eventually deciding whether the project is worth undertaking
or not. Economic term further divided into two categories. In the first cost of capital is
the cost of acquiring the fund required to finance the proposed project i.e. the
borrowing rate of the firm.
ii. Basic Aspects on the concept of cost of capital
Hampton, John defines the term as "the rate of return the firm requires from investment
in order to increase the value of the firm in the market place". The following are the
basic characteristics of cost of capital :
i) Cost of capital is a rate of return, It is not a cost as such.
ii) This return, however, is calculated on the basis of actual cost of
different components of capital.
iii) A firm's cost of capital represents minimum rate of return that will
result in atleast maintaining (If not increasing) the value of its equity
shares.
iv) It is related to long term capital funds.
v) Cost of capital consists of three components:
a) Return at Zero Risk Level. (r0)
b) Premium for Business Risk (b)
c) Premium for Financial Risk (f)
vi) The cost of capital may be put in the form of the following equation :

K = ro + b + f

Where

K = Cost of Capital

ro = Return at Zero Risk Level

 b = Premium for Business Risk

f = Premium for Financial Risk

A firm's cost of capital has mainly three risks :

· Return at Zero Risk Level : This refers to the expected rate of return
when a project involves no risk whether business or financial.
· Premium for Business Risk : Business risk is possibility where in the
firm will not be able to operate successfully in the market. Greater the
business risk, the higher will be the cost of capital.
· Premium for Financ ial Risk : It refers to the risk on account of pattern
of capital structure. In other words, a firm having a higher debt content in
its capital structure is more risky as compared to a firm which has a
comparatively low debt content.

iii. Importance/ Significance of Cost of Capital

The determination of the firm's cost of capital is important from the point of view of the
following :

i) It is the basis of appraising new capital expenditure proposals. This

gives the acceptance / rejection criterion for capital expenditure
projects.
ii) The finance manager must raise capital from different sources in a
way that it optimizes the risk and cost factors. The source of funds
which have less cost involve high risk. Cost of capital helps the
managers in determining the optimal capital structure.
iii) It is the basis for evaluating the financial performance of top
management.
iv) It helps in formulating appropriate dividend policy.
v) It also helps the organization in developing an appropriate working
capital policy.

iv. Classification of Cost

There is no fixed base of classification of cost of capital. It varies according to need,
process and purpose. It may be classified as follows :

· Explicit Cost and Implicit Cost : Explicit cost is the discount rate that equates the
present value of the funds received by the firm net of underwriting costs, with the
present value of expected cash outflows. Thus, it is `the rate of return of the cash flows
of financing opportunity’. On the other hand, the implicit cost is the rate of return
associated with the best investment opportunity for the firm and its shareholders that
will be foregone if the project presently under consideration by the firm were accepted .
In the other words, explicit cost relate to raising of funds and implicit costs relate to
usage of funds.
. Component Cost and Composite Cost :Cost of each component of capital such as equity,
debenture and preference share etc. is known as component or specific cost of capital.
When these component costs are combined to determine the overall cost of capital it is
regarded as composite, or combined or weighted cost of capital. For capital budgeting
decision composite cost of capital is relatively more relevant even though the firm may
finance one proposal with only one source of funds and another proposal with another
source.

· Average Cost and Marginal Cost : The average cost is the weighted average of the costs
of each components of funds. After ascertaining costs of each source of capital,
appropriate weights are assigned to each component of capital. Marginal cost of capital
is the weighted average cost of new funds raised by the firms.

· Future Cost and Historical Cost : In financial decision making, the relevant costs are
future costs. Future cost i.e expected cost of funds to finance the projects is ascertained
with the help of historical costs.

· Specific Cost and Combined Cost : The costs of individual components of capital are
specific costs of capital. The combined cost of capital is the average cost of capital as it is
inclusive of cost of capital from all sources. In capital budgeting decisions, combined
cost of capital is used for accepting / rejecting the proposals.

v. Computation of Specific Cost of Capital

1. Cost of Equity
It is generally argued that the equity capital is free of cost. But it is not true: The reason
behind this argument is that there is no legal binding on company to pay dividend to
equity shareholders. The return to the equity shareholders solely depends upon the
discretion of the company management. Apart from the absence of any definite
commitment to receive dividend, the equity shareholders rank at the bottom as
claimants on the assets of the company at the time of liquidation. But apart from all this
argument like other sources equity share capital certainly involves a loss. The objective
of management is to maximize shareholders wealth and the maximization of market
price of share is the operational substitute of wealth maximization. Therefore the
required rate of return, which equates the present value of the expected dividends with
the market value of shares, is the equity capital. The cost of equity capital may be
defined as "The minimum, rate of return that a firm must earn on the equity-finance
portion of an investment project in order to leave unchanged the market price of the
shares". Thus the expected rate of return in equity share is just equal to the required
rate of return of investors. The measurement of this expected rate of return is the
measurement of cost of equity share capital.

A few problems in this regard are as follows :

i) The cost of equity is not the out of pocket cost of using equity capital.
 ii) The cost of equity is based upon the stream of future dividends as
expected by shareholders (very difficult to estimate).
iii) The relationship between market price with earnings is known.
Dividends also affect the market value (which one is to be considered).

The following are the approaches to computation of cost of equity capital :

(A) Cost of Internal Equity: The Dividend Growth model

1. Normal Growth

𝐃
𝐊𝐞 = + 𝐠
𝐏𝟎

Where

P0 is market Price of share

D is Dividend per share

𝐾𝑒 𝑖𝑠 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑐𝑎𝑝𝑖𝑡𝑎𝑙

g is annual growth rate

the cost of equity is, thus, equal to the expected dividend yield plus capital gain rate as
reflected be expected growth in dividends (g). The cost of retained earnings determined
by this method implies that the firm would have distributed earnings to shareholders,
they could have invested it in the shares of the firm or in the shares of other firm of
similar risk at the market price P0 to earn a rate of return equal to K e. Thus, firm should
earn a return on retained funds equal to K e to ensure growth of dividends and share
price.

2. Super normal Growth

A firm may pass through different phases of growth rate. Hence, dividends go through
different rates in future. The growth rate may be very high for few years and
afterwards, it may be supernormal in the future, and so does the cost of equity differ in
abnormal profit situations. n
DIV0 (1  g s )
t
DIV 1
P0  
n 1
 
t=1 (1  ke ) t
ke  g n (1  ke ) n

The cost of equity can be computed by solving above equation by trial and error.

3. Zero-Growth
The growth rate g will be zero if the firm does not retain any of its earnings; that is, the
firm follows a policy of 100% payout. Under such situations, dividend will be equal to
earnings and thus can be written as :-

𝑫
𝑲𝒆 =
𝑷𝟎

Where

P0 is market Price of share

D is Dividend per share

𝑲𝒆 𝒊𝒔 𝑪𝒐𝒔𝒕 𝒐𝒇 𝒆𝒒𝒖𝒊𝒕𝒚 𝒄𝒂𝒑𝒊𝒕𝒂𝒍

(B) Cost of External Equity: The Dividend Growth model

The firm’s external equity consists of funds raised externally through public or rights
issues. The minimum rate of return, which the equity shareholders require on funds
supplied by them by purchasing new shares to prevent a decline in the existing market
price of the equity share, is the cost of external equity. The firm can induce the existing
or potential shareholders to purchase new shares when it promises to earn a rate of
return equal to:

𝐃
𝐊𝐞 = + 𝐠
𝐏𝟎

Where

P0 is market Price of share

D is Dividend per share

𝑲𝒆 𝒊𝒔 𝑪𝒐𝒔𝒕 𝒐𝒇 𝒆𝒒𝒖𝒊𝒕𝒚 𝒄𝒂𝒑𝒊𝒕𝒂𝒍

g is annual growth rate

Thus, the shareholders’ required rate of return from retained earnings and external
equity is same. The cost of external equity is, however, greater than cost of internal
equity for one reason.

The selling price of the new shares may be less than the market price. In india, the new
issues of ordinary shares are generally sold at a price less than market price prevailing
at the time of announcement of the share issue. Thus, the formula for the cost of new
issue of equity for the cost of new issue of equity capital may be written as follows:

𝐃
𝐊𝐞 = + 𝐠
𝐏𝟏
Where P1 is the issue price of new equity. The cost of retained earnings will be less than
the cost of new issue of equity if P0>P1

(C) Earnings- Price Ratio and Cost of Equity

The E-P Ratio does not reflect the true expectations of the ordinary shareholders. In fact
shareholders expect to receive a stream of dividends and a final price of the share that
would result in a return ssignificantly greater than E/P ratio. Thus the dividend
valuation model gives the most of valid measure of the cost of equity.

There are exceptions, however,

(i) No growth firms:- the cost of equity will be expected

E/P ratio. EPS (1  b)
ke  1
 br (g  br )
P0
EPS1
 (b  0)
P0

Where
B is the earnings retention rate, EPS1 is the expected
earnings per share and r is the return investment (equity)

(ii) E/P ratio may be used as a measure of expansion:- a

firm is said to be expanding if investment opportunities
available to it are expected to earn a rate of return equal
to the cost of equity.
𝑬𝑷𝑺𝟏 (𝟏 − 𝒃)
𝑷𝟎 =
(𝒌𝒆 − 𝒓𝒃)

(D) Cost of Equity and Capital Asset Pricing Model(CAPM)

CAPM is an alternative method to measure the cost of equity share capital other than
the dividend method (which has been discussed above), which is directly based on risk
consideration. Risk is the variability of returns inherent in the type of security while
return defined as total economic return obtained from it. Under this method total risk
associated with the security can be divided into unsystematic and systematic. The
former refers to that risk which can be eliminated by diversification while later affect
the firms at a particular point of time which cannot be eliminated viz. political
uncertainties, government policies etc. They are also known as diversiable and
nondiversiable risk. Under this method the cost of equity share capital is calculated with
some limitation. Calculation of cost of equity share capital under this method is given as
under: -

𝑲𝒆 = 𝑹𝒇 + (𝑹𝒎 − 𝑹𝒇 )𝜷𝒋

The above equation requires the following 3 parameters to estimate a firm’s cost of
equity
 i. the risk free rate (Rf):-
The theoretical rate of return of an investment with zero risk. The risk-free rate
represents the interest an investor would expect from an absolutely risk-free
investment over a specified period of time. It is a common practice to use the
return on the short term treasury as the risk-free rate.

ii. the market Risk premium(𝑹𝒎 − 𝑹𝒇 ):-

The difference between the expected return on a market portfolio and the risk-
free rate. Market risk premium is equal to the slope of the security market line
(SML), a capital asset pricing model. Three distinct concepts are part of market
risk premium:

a. Required market risk premium: the return of a portfolio over the

risk-free rate (such as that of treasury bonds) required by an
investor;
b. Historical market risk premium: the historical differential return
of the market over treasury bonds; and
c. Expected market risk premium: the expected differential return of
the market over treasury bonds.

Also called equity premium, market premium and risk premium.

iii. the beta of the firm’s share (β):-

Beta is a key component for the capital asset pricing model (CAPM), which is
used to calculate cost of equity. Recall that the cost of capital represents the
discount rate used to arrive at the present value of a company's future cash
flows. All things being equal, the higher a company's beta is, the higher its cost of
capital discount rate. The higher the discount rate, the lower the present value
placed on the company's future cash flows. In short, beta can impact a company's
share valuation.
To followers of CAPM, beta is a useful measure. A stock's price variability is
important to consider when assessing risk. Indeed, if you think about risk as the
possibility of a stock losing its value, beta has appeal as a proxy for risk.

Intuitively, it makes plenty of sense. Think of an early-stage technology stock

with a price that bounces up and down more than the market. It's hard not to
think that stock will be riskier than, say, a safe-haven utility industry stock with a
low beta.

Besides, beta offers a clear, quantifiable measure, which makes it easy to work
with. Sure, there are variations on beta depending on things such as the market
index used and the time period measured, but broadly speaking, the notion of
beta is fairly straightforward to understand. It's a convenient measure that can
be used to calculate the costs of equity used in a valuation method that discounts
cash flows.
 2. Cost of Preference Shares
The preference share represents a special type of ownership interest in the firm.
Preference shareholders must receive their stated dividends prior to the distribution of
any earnings to the equity shareholders. In this respect preference shares are very
much like bonds or debentures with fixed interest payment. The cost of preference
shares can be estimated by dividing the preference dividend per share by the current
price per share, as the dividend can be considered a continuous level payment. It is of
two types i.e. redeemable and irredeemable.

i. Irredeemable Preference Share

The preference share may be treated as perpetual security if it is irredeemable. Thus, its
cast may be given as

𝑃𝐷𝐼𝑉
𝐾𝑝 =
𝑃0

Where:

Kp is cost of preference share

PDIV is expected preference dividend

P0 is issue price of preference share

ii. Redeemable Preference Share

These are the share which are issued with a finite maturity period

The cost of preference share is not adjusted for taxes because preference dividend is
paid after corporate taxes have been paid. Preference dividends don’t save any taxes.

3. Cost of Debentures / debt/ Public Deposits

Debt may be issued at par, or at premium or at of discount. It may be perpetual or
redeemable. The technique of computation of cost in each case has been explained in
the following paragraphs.
(a) The formula for computing the Cost of Long Term debt at par is:-

𝑰
𝑲𝒅 =
𝑩𝟎
Where:

Kd is cost of debt

I is the amount of interest

B0 is the issue price of bond

Tax Adjustment

Interest on debenture is tax deductible. It works as a tax shield and the tax liability of a
firm is reduced. Thus the effective cost of debenture is lower than the interest paid to
investor but it depends on tax rate. The real cost of capital is determined after
considering the tax shield as follows:

𝑰
𝑲𝒅 = 𝑿 (𝟏 − 𝑻)
𝑩𝟎

The tax benefit is not available, to firms having loss or no tax-paying situation.

(b) In case the debentures are issued at premium or discount,the cost of

debt should be calculated on the basis of net proceeds realised. The formula
will be as follows :
𝑰
𝑲𝒅 = 𝑿 (𝟏 − 𝑻)
𝑵𝑷
Where

Np is Net Proceeds of debt

Example: A company issue 10% irredeemable debentures of Rs. 10,000. The company is
in 50% tax bracket. Calculate cost of debt capital at par, at 10% discount and at 10%
premium

Solution:

Cost of debt at par

𝟏𝟎𝟎
𝑲𝒅 = 𝑿 (𝟏 − 𝟎. 𝟓)
𝟏𝟎𝟎𝟎𝟎
= 5%

Cost of debt issued 10% discount

𝟏𝟎𝟎
𝑲𝒅 = 𝑿 (𝟏 − 𝟎. 𝟓)
𝟗𝟎𝟎𝟎

= 5.55%
Cost of debt issued at 10% premium
𝟏𝟎𝟎
𝑲𝒅 = 𝑿 (𝟏 − 𝟎. 𝟓)
𝟏𝟏𝟎𝟎𝟎
= 4.55%

(c) For computing cost of redeemable debts, debts, the period of redemption
is considered. The cost of long term debt is the investor’s yield to maturity
adjusted by the firm’s tax rate plus distribution cost. The question of yield to
maturity arises only when the loan is taken either at discount or at premium.
The formula for cost of debt will be:-

𝟏
𝑰 + 𝒏 (𝑭 − 𝑩𝟎 )
𝑲𝒅 = 𝑿 (𝟏 − 𝑻)
𝟏
(𝑭 )
𝟐 + 𝑩𝟎

Where
n is the number of years of redemption

B0 is issue price of debt

F is redemption value of debenture

Example A firm issued 100 10% debentures, each of Rs. 100 at 5% discount. The
debentures are to be redeemed at the end of 10th year. The tax rate is 50%. Calculate
cost of debt capital.

Solution

𝟏
𝟏𝟎𝟎𝟎 + 𝟏𝟎 (𝟏𝟎𝟎𝟎𝟎 − 𝟗𝟓𝟎𝟎)
𝑲𝒅 = 𝑿 (𝟏 − 𝟎. 𝟓)
𝟏
(𝟏𝟎𝟎𝟎𝟎 + 𝟗𝟓𝟎𝟎)
𝟐

=5.385%

vi. Weighted Average Cost of Capital (WACC)

In order to evaluate a capital expenditure project, overall or average cost of capital is
required.
The overall cost of capital is the rate of return that must be earned by the firm in order
to satisfy the requirements of different investors. It is the minimum rate of return on the
asset of the firm, so it is preferably calculated as weighted average rather than the
simple average. Weights being the proportion of each source of funds in the capital
structure. It is given through historical, target or marginal proportion. Historical
weights are based on the firm's existing capital structure. It is of two types i.e. Book
value weight and market value weight. The weight is said to the book value weight if the
proportions of different sources are ascertained on the basis of the face values i.e. the
accounting value, if the weights are given according to the proportion of each source at
its market value (market price of the securities), is called market value weight. Target
weight are based upon the proportion of the various type of capital the firm wishes to
maintain whereas marginal weights consider the actual proportions of each type of
capital expected to be used in financing a given project.

1. Steps involved in computation of WACC

The following steps are involved for calculating the firm’s WACC:

1. Cost of capital components. First, we calculate or infer the cost of each kind of
capital that the enterprise uses, namely debt and equity.

A. Debt capital. The cost of debt capital is equivalent to actual or imputed

interest rate on the company's debt, adjusted for the tax-deductibility of interest
expenses. Specifically: The after-tax cost of debt-capital = The Yield-to-Maturity on long-
term debt x (1 minus the marginal tax rate in %) We enter the marginal corporate tax
rate in the worksheet "WACC."

B. Equity capital. Equity shareholders, unlike debt holders, do not demand an

explicit return on their capital. However, equity shareholders do face an implicit
opportunity cost for investing in a specific company, because they could invest in an
alternative company with a similar risk profile. Thus, we infer the opportunity cost of
equity capital. We can do this by using the "Capital Asset Pricing Model" (CAPM). This
model says that equity shareholders demand a minimum rate of return equal to the
return from a risk-free investment plus a return for bearing extra risk. This extra risk is
often called the "equity risk premium", and is equivalent to the risk premium of the
market as a whole times a multiplier--called "beta"—that measures how risky a specific
security is relative to the total market. Thus, the cost of equity capital = Risk-Free Rate +
(Beta times Market Risk Premium).

2. Capital structure. Next, we calculate the proportion that debt and equity capital
contribute to the entire enterprise, using the market values of total debt and equity to
reflect the investments on which those investors expect to earn a minimum return.

3. Weighting the components. Finally, we weight the cost of each kind of capital by the
proportion that each contributes to the entire capital structure. This gives us the
Weighted Average Cost of Capital (WACC), the average cost of each dollar of cash
employed in the business.

Where
 Ko is WACC,

Kd is cost of debt

Ke is cost of equity

D is the amount of debt

E is the amount of equity

T is the tax rate

2. Marginal Cost of Capital

The above concepts will be applicable only when the firm's total financing and its
pattern of financing is given and other things remain constant but practically any
investment proposal may require funds to be realised from new internal or external
sources and increase the total funds also. This cost of capital of additional funds is called
the marginal cost of capital. If this additional fund collected from more than one sources
i.e. combination of debt and preference share capital, the weighted average cost of
capital of the new financing is called Weighted Marginal Cost of Capital (WMCC).

The weighted average cost of capital generally tends to rise as the firm seeks more and
more capital. This may happen because the supply schedule of capital is typically
upward sloping - as suppliers provide more capital, the rate of return required by them
tends to increase. A schedule or a graph showing the relationship between additional
financing and the weighted average cost of capital is called the weighted marginal cost
of capital schedule.

Determination of Weighted Marginal Cost of capital schedule

The determination of WMCC involves the following steps:

1. Estimation of cost of each source of financing for various levels of its use through
an analysis of current market conditions and an assessment of the investors'
expectations.

2. Identification of the levels of total new financing at which the cost of the new
components would change, given the capital structure policy of the firm. These
levels are called as breaking points.

3. Calculation of WACC for various ranges of total financing between the breaking
points.
 4. Preparation of WMCC schedule which reflects the WACC for each level of total
new financing.

3. Factors Affecting WACC

1. Factors outside a firm’s control:

a. Interest rate levels
b. Market risk premium
c. Tax rates
2. Factors within a firm’s control:
a. Investment policy
b. Capital structure policy
c. Dividend policy

b. Investment Decisions

One of the most important finance functions is to intelligently allocate capital to long
term assets. This activity is also known as capital budgeting. It is important to allocate
capital in those long term assets so as to get maximum yield in future. Following are the
two aspects of investment decision

a.Evaluation of new investment in terms of profitability

b.Comparison of cut off rate against new investment and prevailing investment.

Since the future is uncertain therefore there are difficulties in calculation of expected
return. Along with uncertainty comes the risk factor which has to be taken into
consideration. This risk factor plays a very significant role in calculating the expected
return of the prospective investment. Therefore while considering investment proposal
it is important to take into consideration both expected return and the risk involved.

Investment decision not only involves allocating capital to long term assets but also
involves decisions of using funds which are obtained by selling those assets which
become less profitable and less productive. It wise decisions to decompose depreciated
assets which are not adding value and utilize those funds in securing other beneficial
assets. An opportunity cost of capital needs to be calculating while dissolving such
assets. The correct cut off rate is calculated by using this opportunity cost of the
required rate of return (RRR)

i. Nature and Criteria for Evaluation

Factors influencing investment decision

Capital investment decisions are not governed by one or two factors, because the
investment problem is not simply one of replacing old equipment by a new one, but is
concerned with replacing an existing process in a system with another process which
makes the entire system more effective. We discuss below some of the relevant factors
that affects investment decisions:

(i) Management Outlook: lf the management is progressive and has an aggressively

marketing and growth outlook, it will encourage innovation and favour capital
proposals which ensure better productivity on quality or both. In some industries
where the product being manufactured is a simple standardized one, innovation is
difficult and management would be extremely cost conscious. In contrast, in industries
such as chemicals and electronics, a firm cannot survive, if it follows a policy of 'make-
do' with its existing equipment. The management has to be progressive and innovation
must be encouraged in such cases.

(ii) Competitor’s Strategy: Competitors' strategy regarding capital investment exerts

significant influence on the investment decision of a company. If competitors continue
to install more equipment and succeed in turning out better products, the existence of
the company not following suit would be seriously threatened. This reaction to a rival's
policy regarding capital investment often forces decision on a company'

(iii) Opportunities created by technological change: Technological changes create

new equipment which may represent a major change in process, so that there emerges
the need for re-evaluation of existing capital equipment in a company. Some changes
may justify new investments. Sometimes the old equipment which has to be replaced by
new equipment as a result of technical innovation may be downgraded to some other
applications, A proper evaluation of this aspect is necessary, but is often not given due
consideration. In this connection, we may note that the cost of new equipment is a
major factor in investment decisions. However the management should think in terms
of incremental cost, not the full accounting cost of the new equipment because cost of
new equipment is partly offset by the salvage value of the replaced equipment. In such
analysis an index called the disposal ratio becomes relevant.

Disposal ratio = (Salvage value, Alternative use value) / Installed cost

(iv) Market forecast: Both short and long run market forecasts are influential factors
in capital investment decisions. In order to participate in long-run forecast for market
potential critical decisions on capital investment have to be taken.
(v) Fiscal Incentives:Tax concessions either on new investment incomes or investment
allowance allowed on new investment decisions, the method for allowing depreciation
deduction allowance also influence new investment decisions.

(vi) Cash flow Budget: The analysis of cash-flow budget which shows the flow of funds
into and out of the company may affect capital investment decision in two ways. 'First,
the analysis may indicate that a company may acquire necessary cash to purchase the
equipment not immediately but after say, one year, or it may show that the purchase of
capital assets now may generate the demand for major capital additions after two years
and such expenditure might clash with anticipated other expenditures which cannot be
postponed. Secondly, the cash flow budget shows the timing of cash flows for
alternative investments and thus helps management in selecting the desired investment
project.

(vii) Non-economic factors: new equipment may make the workshop a pleasant place
and permit more socializing on the job. The effect would be reduced absenteeism and
increased productivity. It may be difficult to evaluate the benefits in monetary terms
and as such we call this as non-economic factor. Let us take one more example. Suppose
the installation of a new machine ensures greater safety in operation. It is difficult to
measure the resulting monetary saving through avoidance of an unknown number of
injuries. Even then, these factors give tangible results and do influence

Three steps are involved in the evaluation of an investment:

• Estimation of cash flows

• Estimation of the required rate of return (the cast of capital)

• Application of a decision rule for decision rule for making the choice

Investment decision rule

The investment decision rules may be referred to as capital budgeting techniques, or

investment criteria. A sound appraisal technique should be used to measure the
economic worth of an investment project. The essential property of a sound technique is
that is should maximize the shareholders wealth. The following other characteristics
should also be possessed by a sound investment evaluation criterion:

• It should consider all cash flows to determine the true profitability of then project.
• It should provide for an objective and unambiguous way of separate good projects
from bad projects.
• It should help ranking of projects according to their true profitability.
• It should recognize the fact that bigger cash flows are preferable to smaller ones and
early cash flows are preferable to later ones.

• It should help to choose among mutually exclusive projects that project which
maximizes the shareholders wealth.

• It should be a criterion which is applicable to any conceivable investment project

independent of others.

These conditions will be clarified as we discuss the features of various investment

criteria in the following posts.

Investment Appraisal Criteria

A number of investment appraisal criteria or capital budgeting techniques are in use of

practice. They may be grouped in the following two categories:

1. Discounted cash flow criteria

 Net present value

 Internal rate of return
 Profitability index (PI)

2. Not discounted cash flow criteria

 Payback period
 Accounting rate of return
 Discounted payback period

Discounted payback is a variation of the payback method. It involves discounted

method, but it is not a true measure of investment profitability. We will show in our
following posts the net present value criterion is the most valid technique of evaluating
an investment project. It is consistent with the objective of maximizing the shareholders
wealth.

ii. Methods for Evaluation

1. NPV
NET PRESENT VALUE :- It is net present value of all the cash flows that occur during
the entire life span of a project: The outflows will have negative values while the inflows
will have positive values. Obviously, if the present value of inflows is greater than
outflows, we get a positive NPV and if the present value of outflows is greater than
inflows, we get a negative NPV. The positive NPV means a net gain in value
maximization and, therefore, any project which gives a positive NPV is an acceptable
project and if it gives a negative NPV, then the project should not be accepted. NPV can
be expressed as follows;
 𝑛
𝐴𝑡
𝑁𝑃𝑉 = ∑ − 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
(1 + 𝑖)𝑡
𝑡=1

Where
At= cash flow at time t
i =The rate of interest or cost of capital at which funds are to be discounted
Investment= The initial amount spent on a project
If initial investment is also treated as a cash flow then it can be written as follows
𝑛
𝐴𝑡
𝑁𝑃𝑉 = ∑
(1 + 𝑖)𝑡
𝑡=0

Acceptance Rule & Ranking Rule

The acceptance rule for NPV is that, if it is positive, then the proposal should be
accepted and if it is negative then it can not be accepted. In case of same size projects,
the higher the value of NPV the higher would be the ranking of a project.

Example:-A firm is considering an investment proposal worth Rs.80,000. The CFATs

(cash flows after tax) are expected to be as follows. The rate of discount is 10%. Find out
whether the project is worthwhile or not.
Year CFATs(Rs.)
1 15,000
2 22,000
3 27,000
4 29,000
5 21,000

Solution
𝒏
𝑨𝒕
𝑵𝑷𝑽 = ∑ − 𝑰𝒏𝒊𝒕𝒊𝒂𝒍 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
(𝟏 + 𝒊)𝒕
𝒕=𝟏

𝟏𝟓𝟎𝟎𝟎 𝟐𝟐𝟎𝟎𝟎 𝟐𝟕𝟎𝟎𝟎 𝟐𝟗𝟎𝟎𝟎 𝟐𝟏𝟎𝟎𝟎

𝑵𝑷𝑽 = (𝟏.𝟏)𝟏
+ (𝟏.𝟏)𝟐
+ (𝟏.𝟏)𝟑
+ (𝟏.𝟏)𝟒
+ (𝟏.𝟏)𝟓
– 80000

= 84,950.50 - 80,000 = Rs. 4,950.50

In this project the PV of inflows is Rs. 84950.50 while the PV of outflows is Rs. 80,000.
Hence the NPV is Rs. 4950.50 which makes the project an acceptable project because
NPV is positive.

Interpretations of NPV: - NPV is the absolute value of a net gain in future. This may be
treated as a net addition to the value of the firm and therefore, is also called unrealized
capital gain. Another interpretation of NPV is that it represents the maximum price that
a firm should pay for foregoing the right to undertake the project or to sell the project to
some other party.
It also represents the amount that a firm could raise from the market at given rate of
inertest, in addition to the initial cost of the project, and ensure that this will be paid off
from the receipts of the project. For example; A firm is undertaking a project at a cost of
Rs. 50,000 with a positive NPV of Rs. 10,000. In this case, the firm can not borrow
merely Rs. 50,000 to meet the initial cost, but can also raise Rs. 10,000 (for any other
purpose) and be rest assured that this sum with interest can be paid off from the
proceeds of the given project.

Properties of NPV: - The NPV method is a very scientific and appropriate technique of
capital budgeting and is therefore, widely used for investment decision making. The
following properties can be identified. It is based on cash flows over the entire life of
project.
(i) It considers time value of money.
(ii) It is an absolute value.
(iii) It possesses the property of additions, i.e. the total NPV of two projects is the
summation of their individual NPVs.
(iv) NPV for different rates of interest can be found separately, and
(v) It allows different rates of interest for different time period in the life of a project.

Limitations of NPV
It gives the absolute value and therefore, comparison between two different projects is
not easy, especially when they are of different sizes.
(i) Many a times, it is not possible to know in advance the rate of interest at which
discounting is to be done. Similarly a given NPV may not be appropriate if the rate of
interest has changed.
(ii) It may lead to wrong decision making especially when limited funds are available
and we have to choose between different options.

2. IRR
INTERNAL RATE OF RETURN (IRR): - The NPV and PI are both based on a given rate
of discount and, therefore, the NPV and PI values change as soon as the rate of discount
is changing. Hence, any project which is acceptable at, say, 10% rate of discount may not
be the same at, say, 12% rate. Therefore, there is need to find out a technique which is
autonomous in it self and not dependent upon any externally determined rate of
interest. The relationship between, the rate of discount and the NPV can be presented in
the following diagram.

Relationship between NPV and rate of discount

The above diagram shows an inverse relationship between NPV and rate of interest. At
zero rate of interest the NPV is maximum at M level. As the rate of interest increases, the
NPV gradually falls. At R rate of interest the NPV is zero and beyond this, it is even
negative. The rate R in the above case is called the Internal Rate of Return (IRR). We
may, therefore, say that IRR is that rate of discount at which NPV is zero. It can be
expressed as follows.

Rate of discount and NPV relationship

 𝒏
𝑨𝒕
𝑵𝑷𝑽 = ∑ − 𝑰𝒏𝒊𝒕𝒊𝒂𝒍 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 = 𝟎
(𝟏 + 𝒊)𝒕
𝒕=𝟏

The rate of interest at which the above equation holds good is the IRR. The relationship
between discount rate and rate of discount for the previous Example of NPV is
calculated as follows.

Rate % NPV (Rs.)

9 7320.67
10 4950.50
11 2677.54
12 496.06
13 - 1600.02
14 - 3611.29

The above information shows that as the discount rate increase the NPV goes on
diminishing. It can therefore be understood that a project which is acceptable at a given
rate of discount, say 11% may not be accepted at 13% or 14%. It is therefore essential
to know, the cut-off rate where positive NPV converts into a negative NPV. This cut off
rate is the Internal Rate of Return (IRR) where NPV is zero. It can be expressed as
follows

The Internal Rate of Return IRR can be calculated by use of log or by a scientific
calculator or by computer instantly.
However, the following method can be used for the purpose.

x
IRR = r +
x−y

Where r = the closest rate at which NPV is positive

x = value of positive NPV at that level
y = value of negative NPV at next higher rate
For example, in the above illustration, the value of r = 12%, the value of x = 496.06 and
the value of y = - 1600.02. Hence the IRR is

= 12 +( 496.06+2096.08 )
= 12 + .2367 = 12.2367%

Acceptance and Ranking Rule for IRR: - The IRR should be greater than the given
discount rate (cost of capital) to make a project acceptable. If IRR is less than the cost of
capital then, the proposal can not be accepted as it will lead to a negative NPV.
Since, IRR is a rate of return, the project with a higher IRR should be ranked higher than
the other project which has a lower IRR.
Virtues of IRR:-
1. It considers cash flows of projects in their entirety.
2. It takes into account time value of money.
3. It is useful in ranking of projects because it is a rate and not any absolute value.
4. It is independent of any externally determined rate (discount rate or cost of
capital), and hence ranking of projects will not change with variation in cost of
capital.
5. It is particularly useful as it helps a businessman and also a financer in assessing
the margin of safety in a project.
6. It is more appealing to the businessmen who are used to thinking in terms of cost
and return.

3. ARR
The Accounting Rate of Return also called the Average Rate of Return (ARR) is the
average of the rate of return for different years for the whole life of an asset. It is a ratio
between the Net Profit After Tax and the amount of initial investment made in the
project.

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝐴𝑇
𝐴𝑅𝑅 =
𝐼𝑛𝑖𝑡𝑖𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Example:- A company wishes to make an investment of Rs. 50,000 in a machine. The
machine has a life of 5 years. The profit after tax on account of this machine for next five
years is Rs. 7,500; Rs. 8,200; Rs. 7,900; Rs. 8,900 and Rs. 6,500 respectively. Calculate
the ARR for this investment purpose.

Solution:-
Average PAT=(7,500+8,200+7,900+8,900+6,500)/5

7800
𝐴𝑅𝑅 = 𝑋 100
50000

ARR=15.6%
Another view about ARR is that since we take average of the PAT for calculating ARR we
should also use average level of investment for the project. In such a situation the
equation for calculating ARR should be modified as follows.
 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝑟𝑜𝑓𝑖𝑡 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥
𝐴𝑅𝑅 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Average Investment would be found by taking the average book value for each year. The
following Illustration will explain this:

Example:- A company decided to make an investment in a new project which costs Rs.
1,00,000. The working life of the project is expected to be 5 years after which it is
expected to be sold for a scrap value of Rs. 10,000. The company’s incremental PAT is
expected to be Rs.6,000, Rs.7,000, Rs.8,000, Rs. 7,500 and Rs. 6,500 for the next 5 years.
Assuming depreciation on a straight line basis and tax rate 40%, find out the ARR.

Annual Depreciation=(100000-10000)/5
= 18000

ARR=(7000/55000)*100=12.72%

On the basis of initial Investment

ARR=(7000/100000)*100=7%

Average investment can also be found as

Average investment=(initial investment+scrap value)/2
=(100000+10000)/2=55000

Thus we find a wide gap between the two concepts. It may be further noted that some
authors prefers to calculate ARR on the basis of EBIT (Earnings Before Interest and Tax)
and not PAT (Profit After Tax).

Acceptance & Ranking Rule:-

When we adopt ARR as the decision criteria, then the acceptance rule is that the
calculated ARR should be greater than some specified rate. We will reject those
proposals which have an ARR lower than this specified rate. So far as ranking of projects
is concerned, the project with a higher ARR should be ranked higher than other project
which has a lower ARR.
Evaluation of ARR Method:-
The ARR method is a relatively simple method involving the calculation of averages. It is
also based on easily understood accounting information like EBIT/PAT, depreciation,
investment etc. However, when it is evaluated for its suitability as a investment criteria
for making long term investment decisions, we find it deficient in several respects.
Firstly, it is ill defined; we do not know whether to use EBIT or PAT; Initial Investment
or Average Investment. Each variable will give different values of ARR. Moreover,
accounting information itself is not very certain and subject to great manipulation;
Thirdly the average of income, whether EBIT or PAT ignores time value of money and
hence not suitable for scientific decision making, and lastly the bench mark rate, against
which the calculated ARR will be compared is arbitrary and there is no scientific basis
for deciding it.

4. Pay Back Period

The Payback- period is the time duration required to recover the initial cash outflows.
This method is based on cash flows and not on accounting data like the ARR. Ordinary
people not well versed in appraisal techniques, often use very simple technique to judge
the profitability of any investment proposal. They think in terms of initial expenditure
(outflow) and the time duration in which this amount can be recovered. Suppose
somebody spent Rs.50,000 on any project and expects that within 3 year he can get
back this amount, then the payback period is 3 years. Payback period of any proposal
can be calculated as follows;
If the cash inflows are uniform then

Payback period = Initial cash outflow/Annual cash inflows

If the cash inflows are not uniform then Payback period = time period in which the
cumulative cash flows are equal to initial inflows.

Illustration: - (6.4) A company is considering a proposal to spend Rs. 1,00,000 on a

new proposal. The cash inflows are expected as follows. Year 1, Rs. 20,000, year 2, Rs.
30,000, year 3, 33,000, year 4, 40,000, year 5, Rs. 40,000. The payback period in this
case would be calculated as follows.

S.No Cash Inflows Cumulative cash Inflows

1 20,000 20,000
2 30,000 50,000
3 30,000 80,000
4 40,000 1,20,000
5 40,000 1,60,000

The cumulative column shows that Rs.1,00,000 cumulative figure comes between year 3
and 4. Fourth year adds Rs. 40,000, whereas only Rs. 20,000 needs to be added in Rs.
80,000 to make it equal to Rs. 1,00,000 (the initial investment ). Assuming a uniform
collection rate Rs. 20,000 can be recovered in ½ year, i.e. in 6 months. So the payback
period is

3+(200000/40000)= 3.5 Yrs

or three years and six months.

Acceptance Rule and Ranking Rule: - If the calculated payback is less than any
predicted value then an investment proposal is acceptable, otherwise it will be rejected.
So far as ranking is concerned, the lower the value of the payback the higher will be the
ranking of any investment proposal.

Evaluation of payback method:-

It is a simple method in concept and understanding. That is why even lay men can
understand and use it with ease. Moreover, since its emphasis is on early recovery of
investment, it automatically takes care of risk. Projects with smaller payback are
considered safe and secure as compared to the projects with longer payback.

The payback method, however, suffers from serious drawbacks. Firstly it takes into
account only early cash flows which determine the payback and ignores those which
come later. This may be often leading to wrong conclusions.

Example:-
Cash flows
Year Project X Project Y
0 -60,000 -60,000
1 10,000 30,000
2 20,000 20,000
3 30,000 10,000
The payback for the above two projects is 3 years, but if we analyze the timings of cash
flows we find that project Y is superior because the higher cash flows are occurring
initially and will have a higher value if time value of money is taken into consideration.
Thirdly, Payback period is considered only a measure of capital recovery and it is not a
perfect measure for profitability.
In spite of these limitations of the payback method, it is still widely used in modern
project appraisal mainly because of its simplicity and ease of calculation. However, it is
used only for a preliminary screening and not for final decision making. For example, a
financial institution may decide that it will consider the projects only if they have a
payback of up to 4 years. In such a case the projects with a payback less than 4 years
will be considered but a final decision would be based on more scientific methods and
not merely on payback period.

DISCOUNTED PAYBACK
The concept of discounted cash flows for calculating payback period has emerged in
recent years. It is suggested by some authors that in order to overcome the limitation of
payback that it does not use time value of money, we may use the discounted cash flows
in order to calculate the payback period. Obviously the discounted payback will be
longer than the simple payback period.
Example:- A company is considering a project with an initial outflow of Rs. 1,00,000,
the cash inflows from the project are expected to be as follows. Find out the payback
period by traditional method as well as by discounted method @ 10% rate of discount.
Year Cash flows(Rs.)
1 20,000
2 30,000
3 30,000
4 40,000
5 30,000
6 20,000
Solution

Year. Cash Flows Cumulative Discounted Discounted

Cash Flows Cash Flows Cumulative
1 20,000 20,000 18182 18182
2 30,000 50,000 24793 42975
3 30,000 80,000 22539 65514
4 40,000 1,20,000 27321 92835
5 30,000 1,50,000 18628 1,11,463
6 20,000 1,70,000 11289 1,22,752

The discounted payback considers the time value of money but simply for this reason it
does not become a superior technique because it will still retain other limitations of
payback method. Moreover, it is not in consonance with the traditional view of payback
and hence is not very popular.

5. Profitability Index
NPV is an absolute value and therefore is not appropriate for comparing the relative
profitability between different projects. In order to overcome this limitation of NPV, we
make one modification in it to make it a relative measurement. This is called
Profitability Index (P.I.) or Benefit Cost Ratio (B-C Ratio). The P.I. is as follows.

𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒𝑠 𝑜𝑓 𝑖𝑛𝑓𝑙𝑜𝑤𝑠

𝑃𝐼 =
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒𝑠 𝑜𝑓 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠
Acceptance and Ranking Rule: - If the P.I. is greater than I, then the project is to be
accepted and if it is less than I then it is to be rejected. However, if we have, several
projects then the project with a higher P.I. or B.C. ratio should have a higher ranking.

iii. Cash Flow V/s Profits

Capital budgeting or capital expenditure decisions pertain to fixed assets or long term
assets which by definition refer to assets which are in operation, and yield a return over
a period of time, usually exceeding a year. The capital budgeting, therefore involves a
current outlay or series of outlays of cash resources in return for an anticipated flow of
future benefits. These future benefits can be measured by the ways of calculating
accounting profits and cash flows. The main difference between accounting profits and
cash flows is the existence of non-cash item such as depreciation in the accounting
profits. Therefore, the accounting profits have to be adjusted for non-cash expenses and
incomes to arrive at the cash inflows.

Why Cash flows are preferred to Accounting profits?

1. In any project, the timing of cash outflows and inflows are very important. There
is time value for money. Any project should be appraised based on the timing of
cash flows. There is a difference between `5,000 received in the 1st year and the
same amount received after 10 years. Hence the importance of time value of
money. The cash flow method considers the timing of cash inflows and outflows
and discounts those flows according to the time of occurrence. Whereas,
accounting profits ignore the time value of money. As per the accounting profit,
profit is generated once you sell the goods and not when you realize payment for
it. If you receive the payment in advance or at the time of sale, you can very well
re-invest in the business when a good opportunity arises. Isn’t it?

2. For capital budgeting analysis, investment is in the form of cash outflow. So,
naturally the management needs to compare the costs(outflows) and
benefits(inflows) arising out of the project. This can be effectively measured only
by means of cash flow method. You need cash to buy an asset. It is an outflow.
But accounting profit method, ignores expenditure of buying asset at the time of
purchase. It records the expenditure of an asset over the entire economic life of
the project in the form of depreciation, which is a non-cash item. Hence, even in
this case, time value is ignored. The accounting profit does not reflect the
requirement of cash at outflow and inflow stages of time. Moreover, this does not
actually reflect the actual outflows and inflows. So, only the cash flow method is
the right choice for evaluating a capital budgeting decision.

3. In cash flow method, there is only one way of calculation: cash outflows and cash
inflows would be considered. Whereas, accounting profit calculation involves
 several ways of calculation. There are various principles in accounting which can
be followed and ultimately would result in different profit calculations. For
example, one may depreciate an asset using straight-line method, residual
method, units of usage method etc. In another case, you may value an inventory
either by using LIFO, FIFO or average cost method. All these will result in
different profits in respective calculations and cash flow method avoids all these
differences.

Because of all the above reasons, we can say that Cash flow method is the most
appropriate method for evaluating investment decisions and capital budgeting.

iv. Components of Cash Flows

A typical investment will have three components of cash flows:

1. Initial investment
2. Annual net cash flows
3. Terminal cash flows

1. Initial investment

Initial investment is the net cash outlay in the period in which an asset is purchased. A
major element of the initial investment is gross outlay or original value of the asset,
which comprises of its cost (including accessories and spare parts) and freight and
installation charges. Original value is included in the existing block of assets for
computing annual depreciation. Similar types of assets are included in one block of
assets. Original value minus depreciation is the assets book value. When an asset is
purchased for expanding revenues, it may require a lump sum investment in net
working capital also. Thus initial investment will be equal to: gross investment plus
increase in the net working capital. Further, in case of replacement decisions, the
existing asset will have to be sold if the new asset acquired. The sale of the existing asset
provides cash inflow. The cash proceeds from the sale of the existing assets should be
subtracted to arrive at the initial investment. We shall use the term Co to represent
initial investment. In practice, a large investment project may comprise of a number of
cost components and involve a huge initial net cash outlay.

2. Annual net cash flows

An investment is expected to generate annual flows from operations after the initial
cash outlay has been made. Cash flows should always be estimated on an after tax basis.
Some people advocate computing of cash flows before tax basis and discounting them at
the before-tax discount rate to find net present value. Unfortunately, this will not work
in practice since there does not exist an easy and meaningful way for adjusting the
discount rate on a before-tax basis. We shall refer to the after-tax cash flows as net cash
flows and use the terms C1, C2, C3...... respectively for in period 1, 2, 3.........n. Net cash
flow is simply the difference between cash receipts and cash payments including taxes.
Net cash flow will mostly consists of annual cash flows occurring from the operation of
an investment, but it is also be affected by changes in net working capital and capital
expenditures during the life of the investment. To illustrate, we first take the simple
case where cash flows occur only from operations. Let us assume that all revenues
(sales) are received in cash and all expenses are paid in cash (obviously cash expenses
will exclude depreciation since it is a not-cash expense). Thus, the definition of net flow
will be:

Net cash flow = Revenue - Expense - Taxes

Notice that in equation taxes are deducted for calculating the after-tax flows. Taxes are
computed on the accounting profit, which treats depreciation as a deductible expense.

3. Terminal cash flows

The last or terminal year of an investment may have additional flows.

• Salvage value

Salvage value is the most common example of terminal flows. Salvage value may be
defined as the market price of an investment at the time of its sale. The cash proceeds
net of taxes from the sale of the assets will be treated as cash inflow in the terminal
(last) year. As per the existing tax laws, no immediate tax liability (or tax savings) will
arise on the sale of an asset because the value of the asset sold is adjusted in the
depreciation base assets. In the case of a replacement decisions, in addition to the
salvage value of the new investment at the end of its life, two other salvage values have
to be considered:

1. The salvage value of the existing asset now (at the time of replacement decision)

2. The salvage value of the existing asset at the end of its life, if it were not replaced.

If the existing asset is replaced, its salvage value not will increase the current cash
inflow, or will decrease the initial cash outlay of the net assets. However, the firm will
have to forgo its end-of-life salvage value. This means reduced cash inflow in the last
year of the new investment. The effects of the salvage values of existing and new assets
may be summarized as flows:

• Salvage value of the new asset. It will increase cash inflow in the terminal
(last) period of the new investment.
• Salvage value of the existing asset now. It will reduce the initial cash
outlay of the new asset.
• Salvage value of the existing asset at the end of its nominal life. It will
reduce the cash flow of the new investment of in the period in which the
existing asset is sold.

Sometimes removal costs may have to be incurred to replace an existing asset. Salvage
value should be computed after adjusting these costs.
 v. Incremental Approach for Cash Flow estimation
The additional operating cash flow that an organization receives from taking on a new
project. A positive incremental cash flow means that the company's cash flow will
increase with the acceptance of the project.
'Incremental Cash Flow'
There are several components that must be identified when looking at incremental cash
flows: the initial outlay, cash flows from taking on the project, terminal cost or value and
the scale and timing of the project. A positive incremental cash flow is a good indication
that an organization should spend some time and money investing in the project.

Incremental cash flow analysis is the increase or decrease in cash flows that are
specifically attributable to a management action. For example, if a management team is
reviewing a proposal to improve the capacity of a machine, the entire cash flow
resulting from the use of that machine is not the point upon which the decision must be
made, but rather the incremental cost of improving the machine, and the incremental
revenue that results from having additional capacity.

Incremental Cash Flow Example

For example, assume that a machine produces 1,000 cans per hour, and an upgrade to
the machinery will result in an increase in the theoretical capacity to 1,500 cans per
hour, for an incremental change of 500 cans per hour. The cost of the upgrade is
`100,000, and the profit from each can is `.04. Since the machine runs 8 hours a day for
five days per week, the increase in capacity will result in an added cash inflow of
`41,600, which is calculated as follows:
(500 cans per hour) x `.04 = `20 per hour incremental cash inflow
= (`20 per hour of cash inflow) x (40 hours per week) x (52 weeks per year)
= `41,600
This incremental investment translates into a payback of 2.4 years, which is a
reasonable return period for most investments. However, from an incremental
perspective, why not run the machine a bit longer each day to obtain the same
production that the machine would yield with the enhanced equipment? If the machine
operator is paid `10 per hour and the same person stays late to work an extra 4 hours
per day to run the machine, the added overtime cost per year will be only `15,600 (4
hours per day x 260 days x `15/hour), which is far less expensive than the equipment
option. In addition, there may be no incremental need for the added capacity, since we
do not know that the machine must be run at full capacity at all times. By using overtime
instead of a fixed investment, we can scale back the use of the machine on a day-to-day
basis to exactly match production to sales. This example shows that you must review
the specific cash flows that will change as a result of a specific management decision to
see if it will result in a positive incremental change in cash flows.

vi. Depreciation – Concept; Tax Treatment

Depreciation is a fascinating concept in the world of accountancy. Ordinarily it is meant
as, a “decrease in price or value over time”, or “decrease in value of an asset due to
obsolescence or use”. In accountancy, while depreciation is definitely related to the
“decrease in value of an asset”, the process is not that simple. An asset is something that
is bought by an enterprise for use in production or service, and not for sale. The
enterprise does not purchase the asset with an object to sell that, but to use it in the
business process.
Moreover, the time period of use of such asset is more than one year. Both these thing-
“object to sell” not there, and “more than one year” of use in business process,
differentiates the Asset from the Inventory. The Asset that we are speaking here is a
Capital Asset, while inventory is a Current Asset. The money spent on inventory is
expensed in the very year in which they are bought – meaning, such money is shown as
an expense in the Profit & Loss A/c of that year. In contrast, the money spent on
purchase of a capital asset continues as a balance in the Balance Sheet for certain
number of years or more specifically, till the capital asset has any economic value for the
business entity. In contrast, the money spent on purchasing an Asset is not shown as
expense of that year’s P/L A/c. This is because of the same two reasons – “object to sell”
not there, and “more than one year” of use in business process. There is another concept
that is important in understanding the concept of depreciation. This is the concept of
“Matching” (or the matching principle). This means that when the profit is to be found
out, the basis of profit should be related to the expense incurred in earning that profit.
eg. if in a year an enterprise buys raw material of 50 kg (@ Rs. 10), and only 40 kg of
that raw material is used in manufacture of that year. The sale revenue being Rs. 700.
Then profit would be 700-400=300. The balancing amount for 10 kg that was not used
ie. Rs. 100, would be shown as Stock in the Asset side of Balance
Sheet.
While it is quite easy to estimate the inventory used in the year, what about the fixed
asset, that is being used in the production or manufacturing process. After all, fixed
asset is also contributing to the production and earning of revenue of the year.
Now, this element of fixed asset that is being used up in production process is also
entering as a cost for the revenue that is being earned.
This element of fixed asset that is (estimated as) being used up in the year (in
production for generating revenue) is called depreciation. It is an estimate because
what is being used up is not visible to the eyes.
These estimates are primarily based on experience or usual business practice or
prescribed by law. T he two most used methods are the Straight Line Method (SLM) and
the Written Down Value (WDV). I would not go into the details of these here, except for
saying that the amount of depreciation for the year is taken as an expense in the year’s
P/L A/c. A few related dimensions of depreciation require understanding.

Firstly, depreciation can be viewed as a deferred expenditure over the life period of the
Asset or as an expense that is amortised over a period of time. However this would not
be the right interpretation. Similarly the interpretation that depreciation is a measure of
weartear is again missing the point. Wear-tear is a general term, more akin to
maintenance costs, and not an accounting concept.
Secondly, the amount of depreciation is deductible for tax purposes ie. no tax is levied
on that amount of profit that is remaining with the business as depreciation. T his
means that it is the amount of profit that is remaining with the business (that has
already been expensed in the year in which the asset was bought) in the current year.
The amount of depreciation that is shown as an expense in the particular financial year,
is basically a non-cash expense for that year. ie. In that particular financial year, money
does not go out. (it is another matter that the money, a capital expense, has already
occurred in the year in which the asset was purchased). Usually the businesses plough
back such money and reinvest them into the business operations. In the P&L, the
Provision for Depreciation is shown as deduction from Fixed Assets on the Asset side of
B/S.
A third point is that Land is not treated as a depreciable item. Land does not depreciate.
(In fact, the value of land only increases on revaluation, if any. Though in accounts land
is usually carried at cost of purchase till some compelling reason is there for
revaluation.)
A fourth point is that the depreciation provision is not available for distribution to
shareholders for dividend purpose. The reason relates to various cases in past when
businesses would not deduct depreciation and show an inflated profit. A profit without
deducting depreciation would mean a misrepresentation of factual financial position of
the entity. This also means that depreciation is neither a reserve that is available to
shareholders, nor it is any unrealised gain.
Now a days, it is prescribed by law that dividend can be distributed only after deduction
of depreciation.

c. Leverages
In the arena of financing decisions, the capital structure decision assumes greater
significance. As it deals with debt equity composition of the organization, the resultant
risk and return for shareholders is of utmost concern for finance managers. If the
borrowed funds are more than owners’ funds, it results in increase in shareholders’
earnings. At the same time, it also increases the risk of the organization. In a situation
where the proportion of the equity funds is more than the proportion of the borrowed
funds, the return as well as risk of the shareholders will be very low. This underlines the
importance of having an optimal capital structure where risk and return to
shareholders be matched. The effect of capital structure where risk and return to
shareholders may judiciously help the finance managers to decide their short term and
long term strategies. The behaviour and application of leverage helps in examining the
whole issue in right perspective.

CONCEPT AND TYPES OF LEVERAGES

The dictionary meaning of the term leverage refers to : an increased means for
accomplishing some purpose”. It helps us in lifting heavy objects by the magnification of
force when a lever is applied to a function.

James Horne has defined leverage as the employment of an asset or funds for which the
firm pays a fixed cost or fixed return.

Christy and Roder defines leverage as the tendency for profits to change at a faster rate
than sales.

A few essential characteristics of leverage are as follows :

(a) Leverage is applied to the employment of an asset or funds.

(b) Profits tend to change at a faster rate than sales.

(c) There is risk return relationship which is basically found in the same direction.
(d) If higher is the leverage, higher will be the risk and higher will be the expected
returns.

i. Types of Leverages
1. Operating Leverages
It takes place when a change in revenue produces a greater change in EBIT. It is related
to fixed costs. A firm with relatively high fixed costs uses much of its marginal
contribution to cover fixed costs.

Meaning

It refers to heavy usage of fixed assets. A few definitions are as follows : “The use of
fixed operating costs to magnify a change in profits relative to a given change in Sales”
Walker & Petty

“If a high percentage of a firm’s total costs are fixed costs, then the firm is said to have a
high degree of operating leverage. E F Brigham

It is a function of three factors:

 Fixed costs
 Contribution
 Volume of Sales
A few specific characteristics of operating leverage are as follows:

 It affects assets side of Balance sheet

 It is related to composition of fixed assets
 It is related in fluctuations in business risk
 It affects capital structure and return on total assets.
COMPUTATION OF OL
The operating leverage can be calculated by the following formula

𝑪
𝑶𝑳 =
𝑬𝑩𝑰𝑻
Where

OL is operating Leverage

C is contribution=(Sales-Variable cost)

EBIT is Earning Before Interest and Tax

If contribution is more than fixed cost, it is favourable financial leverage. In case of vice-
versa, it is unfavourable financial leverage.

Example The following are the details

 Selling price per unit Rs. 20

Variable cost per unit Rs. 12

Actual sales 200 units

Installed capacity 300 units

Calculated operating leverage in each of the following two

situations.

(i) when fixed costs are Rs. 1000

(ii) when fixed costs are Rs. 800.

Solution

BEHAVIOUR OF OPERATING LEVERAGE

The behaviour of operating leverage may be measured by the degree of operating

leverage. The degree of operating leverage is the percentage change in the profits
resulting from a percentage change in the sales. It may be put in the form of the
following formula :

% ∆ 𝐸𝐵𝐼𝑇
𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝑂𝐿 =
%∆𝑆𝑎𝑙𝑒𝑠

% ∆ 𝐸𝐵𝐼𝑇 𝑖𝑠 𝑝𝑒𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑡𝑎𝑥

% ∆ 𝑆𝑎𝑙𝑒𝑠 𝑖𝑠 𝑝𝑒𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑎𝑙𝑒𝑠

Example:- The following are the details

Selling Price Per Unit Rs. 20

 Variable Cost per unit Rs. 12

Actual Sales 200 units

Fixed cost 1000

Calculate degree of operating leverage when sales will be

(a) 150 units

(b) 250 units

(c) 300 units

Solution :

Computation of degree of operating leverage

Items Present (i) (ii) (iii)

Sales in Unit 200 150 250 300
Sales in 4000 3000 5000 6000
Less Variable 2400 1800 3000 3600
Cost in 1600 1200 2000 2400
Contribution 1000 1000 1000 1000
Less Fixed cost 600 200 1000 1400
EBIT in 200 67 133
Degree of OL 25 25 50
-8 +2.67 +2.67

If a firm has a high degree of operating leverage, small change in sales will have large
effect on operating income. Similarly, the operating profits of such a firm will suffer loss
as compared to decrease in its sales. There will not be any operating leverage, if there
are no fixed costs.

APPLICATIONS

The operating leverage indicates the impact of change in sales on operating income. If a
firm has a high degree of operating leverage, small change in sales will have large effect
on operating income. A few areas of application are as follows:

(1) Operating leverage has an important role in capital budgeting decisions. In fact, this
concept was originally developed for use in capital budgeting.

(2) Long term profit planning is also possible by looking at quantum of fixed cost
investment and its possible effects.
(3) Generally, a high degree of operating leverage increases the risk of a firm for
deciding capital structure in favour of debt, the impact of further increase in risk will
influence capital structure decision.

2. Financial Leverages
It refers to usage of debt in capital structure. It is the use of fixed cost capital (debt) in
the total capitalization of the firm. Fixed cost capital includes loans, debentures and
preferences share capital.

MEANING

Financial leverage is expressed as the firm’s ability to use fixed financial cost in such a
manner so as to have magnifying impact on the EPS due to any change in EBIT (Earning
Before Interest and Taxes). In other words, financial leverage is a process of using debt
capital to increase the return on equity.

According to Guthman “Financial leverage is the ability of the firm to use fixed financial
changes to magnify the effect of changes in EBIT on the firms EPS.

The following are the essentials of financial leverage :

1.
It relates to liabilities side of balance sheet
2.
It is related to capital structure
3.
It is related to financial risk
4.
It affects earning after tax and earnings per share
5.
It may be favourable or unfavourable. Unfavourable leverage
occurs when the firm does not earn as much as the funds cost.
COMPUTATION OF FINANCIAL LEVERAGE

𝑬𝑩𝑰𝑻
𝑭𝑳 =
𝑬𝑩𝑻

where EBIT refers to earnings before interest and tax

EBT refers to earnings before tax but after interest

Some authorities have used the term financial leverage in the context of establishing
relationship between EBIT and EPS. The financial leverage shows the percentage
change in EPS in relation to percentage change in EBIT.

BEHAVIOUR

The behaviour of financial leverage may be measured by the degree of financial

leverage. The degree of financial leverage may be in the form of the following equation :

%∆𝑬𝑩𝑻
𝑫𝒆𝒈𝒓𝒆𝒆 𝒐𝒇 𝑭𝑳 =
%∆𝑬𝑩𝑰𝑻
Where % ∆ 𝐸𝐵𝐼𝑇 𝑖𝑠 𝑝𝑒𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑛𝑑 𝑡𝑎𝑥

% ∆ 𝐸𝐵𝑇 𝑖𝑠 𝑝𝑒𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑏𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥 𝑎𝑛𝑑 𝑎𝑓𝑡𝑒𝑟 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡

Also it can be calculated in terms of EPS:-

%∆𝑬𝑷𝑺
𝑫𝒆𝒈𝒓𝒆𝒆 𝒐𝒇 𝑭𝑳 =
%∆𝑬𝑩𝑻

Example :-A Ltd. has the following capital structure :

Equity share capital (of Rs. 100 each) 1,00,000

10% Preference share capital (of Rs. 100 each) 2,00,000

10% debentures (of Rs. 100 each) 2,00,000

If EBIT is (i) Rs. 1,00,000 (ii) Rs. 80,000 and (iii) Rs. 1,20,000,

Calculate financial leverage under three situations. Assume 50% tax rate.

APPLICATIONS
Financial leverage is useful in

(i) Capital structure planning

(ii) Profit Planning

Financial leverage helps the finance managers while devising the capital structure of the
company. A high financial leverage means high fixed financial costs and high financial
risk. Increase in fixed financial costs may force the company into liquidation.

3. Combined Leverages
Both operating and financial leverage magnify the returns. There is combined effect of
these leverages on income. Both the leverages are closely concerned with the firm's
capacity to meet its fixed costs (both operating and financial). In case both the leverages
are combined, the result obtained will disclose the effect of change in sales over change
taxable profit.

Composite Leverage = Operating Leverage * Financial Leverage

𝑪𝒐𝒏𝒕𝒓𝒊𝒃𝒖𝒕𝒊𝒐𝒏
It may be expressed as 𝑬𝑩𝑻

The degree of combined leverage is computed in the following manner :

%∆𝐸𝑃𝑆
𝐷𝑒𝑔𝑟𝑒𝑒 𝑜𝑓 𝐶𝐿 =
%∆𝑆𝑎𝑙𝑒𝑠 𝑉𝑜𝑙𝑢𝑚𝑒

Example:- following particulars are available :

Sales Rs. 1,00,000

Variable Cost Rs. 70,000

Fixed Cost Rs. 20,000

Long term loans Rs. 50,000

At 10 percent

Compute the combined leverage.

Solution : OL=30000/10000=3

FL=10000/5000=2

CL=30000/5000=6=3*2=6