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Introduction
Risk exists because of the inability of the decision-maker to make perfect forecasts.
Forecasts cannot be made with perfection or certainty since the future events on
which they depend are uncertain. An investment is not risky if, we can specify a
unique sequence of cash flows for it. But the whole trouble is that cash flows cannot
be forecasted accurately, and alternative sequences of cash flows can occur
depending on the future events. Thus, risk arises in investment evaluation because
we cannot anticipate the occurrence of the possible future events with certainty and
consequently, cannot make any correct prediction about the cash flow, sequence. To
illustrate, let us suppose that a firm is considering a proposal to commit its funds in
a machine, which will help to produce a new product. The demand for this product
may be very sensitive to the general economic conditions. It may be very high under
favorable economic conditions and very low under unfavorable economic conditions.
Thus, the investment would .be profitable in the former situation and unprofitable in
the latter case. But, it is quite difficult to predict the future state of economic
conditions. Because of the uncertainty of the economic conditions, uncertainty about
the cash flows associated with the investment derives.
A large number of events influence forecasts. These events can be grouped in
different ways. However, no particular grouping of events will be useful for all
purposes. We may, for example, consider three broad categories of the events
influencing the investment forecasts:
 General economic conditions This category includes events which influence the
general level of business activity. The level of business activity might be affected by
such events as internal and external economic and political situations, monetary and
fiscal policies, social conditions etc.
 Industry factors This category of events may affect all companies in an industry.
For example, companies in an industry would be affected by the industrial relations
in the industry, by innovations, by change in material cost etc.
 Company factors This category of events may affect only a company. The change
in management, strike in the company, a natural disaster such as flood or fire may
affect directly a particular company.

RISK AND UNCERTAINTY

Risk is sometimes distinguished from uncertainty. Risk is referred to a situation
where the probability distribution of the cash flow of an investment proposal is
known. On the other hand, if no information is available to formulate a probability
distribution of the cash flows the situation is known as uncertainty. Most financial
authors do not recognize this distinction and use the two terms interchangeably. We
too follow this approach.

IMPORTANCE OF CAPITAL BUDGETING

„Capital budgeting‟ is the most vital activity which can „make or mar‟ a future
financial health. The following are the reasons for its importance.
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(1) Huge amount of investment: Capital expenditure decisions can commit the firm
for huge investment over a period of time. A wrong decision can result in heavy loss.
(2) Permanent and Irreversible Commitment of funds: Capital expenditure
decisions result in commitment of funds on long term basis. Once a project is taken
up and investment is made, it is not usually possible to reverse the decision. The
reversal will be at the cost of heavy loss.
(3) Long-term impact on profitability: The Capital expenditure decisions will shape
the future revenue streams and the profitability of operations.
(4) Growth and Expansion: Business firms grow, expand, diversity and acquire
stature in the industry through their capital budgeting activities. The success of
mobilization and deployment of funds determines the future of a firm.
(5) Cost over runs: If not meticulously implemented, delay in completion of projects
will automatically result in excess costs and heavy losses.
(6) Alternatives: Limited funds at the disposal of a firm have to be deployed in the
most profitable of the alternative projects. The elimination process is a difficult one.
(7) Multiplicity of variables: Large number of factors affect the decisions on capital
expenditure. The make the „capital expenditure decisions‟ the most difficult to make.
(8) Top Management Activity: The metamorphic impact of capital expenditure
decisions automatically thrusts them on the top management. Only senior
managerial personnel can take these decisions and bear responsibility for them.

METHODS OF CAPITAL BUDGETING (OR) “METHODS OF EVALUATIONS OF

INVESTMENT PROPOSALS”
At any given time, large number of investment proposals can be there and the fund
available or funds which can be raised are always limited. So, it is not possible take
up all the proposals of Investment. It is essential to select from amongst the
competing proposals those, which give the highest benefits.

The essence of capital Budgeting is the „Balancing Act‟ of matching the available
resources with the acceptable projects. There are a large number of methods in
practice all over the world in the sphere of
capital expenditure decisions. Which ever method is selected, it should:

(1) Provide a basis for distinguishing between acceptable and non-acceptable

projects.
(2) Rank different proposals in order of priority.
(3) Have suitable approach to choose from among the alternatives available;
(4) Adopt „Criterion‟ which can assess any kind of project;
(5) Be logical by recognizing the time value of money and the importance of returns.

The following is the popular classification of various methods of capital budgeting.

(A) Traditional methods:
(1) Pay –back period method
(2) Improvement in traditional approach to pay-back period method.
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(3) Accounting rate of return or average rate of return method.
(B) Non Traditional Methods (or) Discounted cash flow methods (D.C.F. Methods)
(4) Net Present Value (N.P.V) method
(5) Profitability Index (or) Excess present Value Index Method (P.I. Method)
(6) Internal rate of return (I.R.R.) method

Net present value method is one of the discounted cash flow methods of capital
budgeting. It recognizes the time value of money and that cash flows arising at
different periods of time differ in value and are not comparable unless their
equivalent present values are found. The net present value of all inflows and outflows
of cash occurring during the entire life of a project is determined by discounting these
flows by the firm‟s cost of capital or some other pre-determined rate.
The following are the steps in the net present value method:
(a) Appropriate discounting rate has to be determined. It is the minimum required
rate of return and is called „cut-off rate‟ or „discount rate‟. The rate is generally based
on cost of capital which is suitably adjusted for the risk and uncertainty involved in
the project. Such addition to cost of capital is called „Risk return‟.
(b) Present value of cash out flows should be found with the help of the discounting
rate. If the entire investment is made initially, there is no need to discount it. The
amount of investment itself is the present value of cash out flows. However any
investments to be made at some future points of time are to be discounted to find
their present value. It should be remembered that any working capital should be
taken as cash outflow in the year in which commercial production actually starts on
the project.
(c) Present value of estimated cash inflows should also be computed. The cash flows
should be the net cash flows after tax, before depreciation. The scrap value of the
project has to be taken as a cash inflow in the last year. Similarly working capital
locked up in the project has to be assumed as „unlocked‟ at the end of final year, thus
showing it as a cash inflow in the last year of the project.
(d) Net present value (NPV) is the difference between the present value of cash inflows
and the present value of cash out flows.
NPV = P.V. of cash inflows – P.V. of cash out flows.

Merits of N.P.V. Method

(1) It recognizes the time value of money and thus better than the traditional
methods.
(2) It considers the earnings over the entire life of the project which makes a true
assessment of profitability of a project possible.
(3) It tries to maximize the profits by favouring more profitable projects.
Demerits
(1) Compared to traditional methods it is complicated to understand and operate.
(2) Comparison of projects with unequal life times may be misleading because the
amount of N.P.V. alone is considered in this methods without any weightage for the
time span.
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(3) Comparing different projects with different amounts of investments becomes
difficult in this method.

Profitability Index
The profitability index is also called „Benefits cost Ratio‟
Though this is treated as a separate method due to the importance of results
obtained
by its usages, it is only a refinement of the N.P.V. method. It shows the relationship
between P.V. of cash inflows and P.V. of cash outflows.

Internal Rate of Return (IRR) Method

Internal rate of return is „that rate of return at which the present values of cash
inflows and cash outflows are equal‟. Thus, at I.R.R. the total of discounted cash
inflows equals the total of discounted cash out flows. I.R.R. discounts the total cash
flows to the level of zero.

I.R.R. is also known as Trial and Error yield method. Unlike N.P.V. and P.I. methods
where the cash flows are discounted at predetermined cut-off rate, there is no specific
discounting rate under I.R.R. method. Here, the cash flows of a project are
discounted at a suitable rate arrived at by „Trial and Error‟. The rate equates the net
present value to Zero. Since the discounting rate is determined internally through
Trial and error process, it is called Internal rate of return method.

Merits of I.R.R. Method

1. Like all the other D.C.F. based methods, I.R.R. also takes into account the time
value of money and can be applied where the cash inflows are even or unequal.
2. It also considers the profitability of a project over its entire economic life and thus
the true profitability of a project can be assessed.
3. Cost of capital or pre-determined cut-off rate is not a pre-requisite for applying
I.R.R. method. Hence it is better than the N.P.V. and P.I. methods in all those
situations where determining cost of capital is difficult.
4. I.R.R. provides for ranking of various proposals because it is a percentage return.
5. It provides for maximizing profitability.
2.6.5.4.4 Demerits
1. It is complicated method and may lead to cumbersome calculations.
2. The underlying assumption of I.R.R. that the earnings are reinvested at I.R.R. for
the remaining life of the project is not a justifiable assumption. From this point of
view, N.P.V. and P.I. which assume reinvestment at cost of capital rate are better.
3. The results obtained through NPV or PI methods may differ from that obtained
through I.R.R. depending on the size, life and timings of the cash flows.
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Monte Carlo simulation

The Monte Carlo simulation or simply the simulation analysis considers the
interactions among variables and probabilities of the change in variables.1 It does not
give the project‟s NPV as a single number rather it computes the probability
distribution of NPV. The simulation analysis is an extension of scenario analysis. In
simulation analysis a computer generates a very large number of scenarios according
to the probability distributions of the variables. The simulation analysis involves the
following steps:
 First, you should identify variables that influence cash inflows and outflows. For
example, when a firm introduces a new product in the market these variables are
initial investment, market size, market growth, market share, price, variable costs,
fixed costs, product life cycle, and terminal value.
 Second, specify the formulae that relate variables. For example, revenue depends
on by sales volume and price; sales volume is given by market size, market share,
and market growth. Similarly, operating expenses depend on production, sales and
variable and fixed costs.
 Third, indicate the probability distribution for each variable. Some variables will
have more uncertainty than others. For example, it is quite difficult to predict price or
market growth with confidence.
 Fourth, develop a computer programme that randomly selects one value from the
probability distribution of each variable and uses these values to calculate the
project‟s NPV. The computer generates a large number of such scenarios, calculates
NPVs and stores them. The stored values are printed as a probability distribution of
the project‟s NPVs along with the expected NPV and its standard
deviation. The risk-free rate should be used as the discount rate to compute the
project‟s NPV. Since simulation is performed to account for the risk of the project‟s
cash flows, the discount rate should reflect only the time value of money.

Steps in Decision Tree Approach

A present decision depends upon future events, and the alternatives of a whole
sequence of decisions in future are affected by the present decision as well as future
events. Thus, the consequence of each decision is influenced by the outcome of a
chance event. At the time of taking decisions, the outcome of the chance event is not
known, but a probability distribution can be assigned to it. A decision tree is a
graphic display of the relationship between a present decision and future events,
future decisions and their consequences. The sequence of events is mapped out over
time in a format similar to the branches of a tree. While constructing and using a
decision tree, some important steps should be considered:
 Define investment The investment proposal should be defined. Marketing,
production or any other department may sponsor the proposal. It may be either to
enter a new market or to produce a new product.
 Identify decision alternatives The decision alternatives should be clearly identified.
For example, if a company is thinking of building a plant to produce a new product, it
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may construct a large plant, a medium-sized plant, or a small plant initially- and
expand it later on or construct no plant. Each alternative will have different
consequences.
 Draw a decision tree The decision tree should be graphed indicating the decision
points, chance events and other data. The relevant data such as the projected cash
flows, probability distributions, the expected present value etc., should be located on
the decision tree branches.

CAPITAL RATIONING V/S PORTFOLIO

Capital rationing is allocation of available fund to list most profitable projects. In
capital rationing projects are listed according to profitability then available funds are
allotted to the projects to ensure maximum profitability. There may be lot of
profitable projects but only few projects are selected according availability of funds.
In the portfolio all the funds are not invested in one projects rather invested in few
projects mainly to diversify the risk. In the portfolio selection minimizing the risk is
more important whereas in capital rationing maximizing the profit is the main
objective.

EFFECTS OF INFLATION ON CAPITAL BUDGETING DECISIONS

In today‟s complex business environment, making capital budgeting decisions are
among the most important and multifaceted of all management decisions as it
represents major commitments of company‟s resources and have serious
consequences on the profitability and financial stability of a company. It is important
to evaluate the proposals rationally with respect to both the economic feasibility of
individual projects and the relative net benefits of alternative and mutually exclusive
projects. It has inspired many research scholars and is primarily concerned with
sizable investments in long-term assets, with longterm life.

The growing internationalization of business brings stiff competition which requires a

proper evaluation and weightage on capital budgeting appraisal issues viz. differing
project life cycle, impact of inflation, analysis and allowance for risk. Therefore
financial managers must consider these issues carefully when making capital
budgeting decisions. Inflation is one of the important parameters that govern the
financial issues on capital budgeting decisions

Measuring Inflation: Inflation is measured by observing the change in the price of a

large number of goods and services in an economy, usually based on data collected
by government agencies. The prices of goods and services are combined to give a
price index or average price level, the average price of the basket of products. The
inflation rate is the rate of increase in this index; while the price level might be seen
as measuring the size of a balloon, inflation refers to the increase in its size. There is
no single true measure of inflation, because the value of inflation will depend on the
weight given to each good in the index.
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Inflation and Gross Domestic Product (GDP): Inflation and GDP growth are
probably the two most important macroeconomic variables. The Gross Domestic
Product (GDP) is the key indicator used to measure the health of a country's
economy. The GDP of a country is defined as the market value of all final goods and
services produced within a country in a given period of time. Usually, GDP is
expressed as a comparison to the previous quarter or year. For example, if the year-
to-year GDP was up by 3%, it means that the economy has grown by 3% over the last
year.
INFLATION AND CAPITAL BUDGETING DECISIONS
Capital budgeting results would be unrealistic if the effects of inflation are not
correctly factored in the analysis6.For evaluating the capital budgeting decisions; we
require information about cash flows-inflows as well as outflows. In the capital
budgeting procedure, estimating the cash flows is the first step which requires the
estimation of cost and benefits of different proposals being considered for decision-
making. The estimation of cost and benefits may be made on the basis of input data
being provided by experts in production, marketing, accounting or any other
department. Mostly accounting information is the basis for estimating cash flows.
The Managerial Accountant‟s task is to design the organization‟s information system
or Management Accounting System (MAS) in order to facilitate managerial decision
making. MAS parameters have to be designed on the basis for commonalities in the
decision process of executives involved in strategic capital budgeting decisions.
Inflation and Cash Flows: As mentioned above, estimating the cash flows is the
first step which requires the estimation of cost and benefits of different proposals
being considered for decision-making. Usually, two alternatives are suggested for
measuring the 'Cost and benefits of a proposal i.e., the accounting profits and the
cash flows. In reality, estimating the cash flows is most important as well as difficult
task. It is because of uncertainty and accounting ambiguity8
Cash Flows Vs Accounting Profit: The evaluation of any capital investment
proposal is based on the future benefits accruing for the investment proposal. For
this, two alternative criteria are available to quantify the benefits namely, Accounting
Profit and Cash flows. This basic difference between them is primarily due to the
inclusion of certain non-cash items like depreciation.

Effects of Inflation on Cash Flows: Often there is a tendency to assume

erroneously that, when, both net revenues and the project cost rise proportionately,
the inflation would not have much impact. These lines of arguments seem to be
convincing, and it is correct for two reasons. First, the rate used for discounting cash
flows is generally expressed in nominal terms. It would be inappropriate and
inconsistent to use a nominal rate to discount cash flows which are not adjusted for
the impact of inflation

Inflation and Discount Rate: The discount rate has become one of the central
concepts of finance. Some of its manifestations include familiar concepts such as
opportunity cost, capital cost, borrowing rate, lending rate and the rate of return on
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stocks or bonds11. It is greatly influenced in computing NPV. The selection of proper
rate is critical which helps for making correct decision. In order to compute net
present value, it is necessary to discount future benefits and costs. This discounting
reflects the time value of money. Benefits and costs are worth more if they are
experienced sooner. The higher the discount rate, the lower is the present value of
future cash flows.
LEASE AGREEMENTS
Leasing industry plays an important role in the economic development of a country by
providing money incentives to lessee. The lessee does not have to pay the cost of asset at
the time of signing the contract of leases. Leas ing contracts are more flexible so lessees
can structure the leasing contracts accordi ng to their needs for finance. The lessee can
also pass on the risk of obsolescence to the lessor by acquiring those appliances, which
have high technological obsolescence. To day, most of us are familiar with leases of
houses, apartments, offices
TYPES OF LEASE AGREEMENTS
Lease agreements are basically of two types. They are (a) Financial lease and (b)
Operating lease. The other variations in lease agreements are (c) Sale and lease back
(d) Leveraged leasing and (e) Direct leasing.

FINANCIAL LEASE

Long-term, non-cancellable lease contracts are known as financial leases. The essential
point of financial lease agreement is that it contains a condition whereby the lessor
agrees to transfer the title for the asset at the end of the lease period at a nominal cost.
At lease it must give an option to the lessee to purchase the asset he has used at the
expiry of the lease. Under this lease the lessor recovers 90% of the fair value of the asset
as lease rentals and the lease period is 75% of the economic life of the asset. The lease
agreement is irrevocable. Practically all the risks incidental to the asset ownership and
all the benefits arising there from are transferred to the lessee who bears the cost of
maintenance, insurance and repairs. Only title deeds remain with the lessor. Financial
lease is also known as „capital lease‟. In India, financial leases are very popular with
high-cost and high technology equipment.
OPERATING LEASE
An operating lease stands in contrast to the financial lease in almost all aspects. This
lease agreement gives to the lessee only a limited right to use the asset. The lessor is
responsible for the upkeep and maintenance of the asset. The lessee is not given any
uplift to purchase the asset at the end of the lease period. Normally the lease is for a
short period and even otherwise is revocable at a short notice. Mines, Computers
hardware, trucks and automobiles are found suitable for operating lease because the
rate of obsolescence is very high in this kind of assets.

SALE AND LEASE BACK

It is a sub-part of finance lease. Under this, the owner of an asset sells the asset to a
party (the buyer), who in turn leases back the same asset to the owner in consideration
of lease rentals. However, under this arrangement, the assets are not physically
exchanged but it all happens in records only. This is nothing but a paper transaction.
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Sale and lease back transaction is suitable for tho se assets, which are not subjected
depreciation but appreciation, say land. The advent age of this method is that the lessee
can satisfy himself completely regarding the quality of the asset and after possession of
the asset convert the sale into a lease arrangement
LEVERAGED LEASING
Under leveraged leasing arrangement, a third party is involved beside lessor and lessee.
The lessor borrows a part of the purchase cost (say 80%) of the asset from the third party
i.e., lender and the asset so purchased is held as security against the loan. The lender is
paid off from the lease rentals directly by the lessee and the surplus after meeting the
claims of the lender goes to the lessor. The lessor, the owner of the asset is entitled to
depreciation allowance associated with the asset.
DIRECT LEASING
Under direct leasing, a firm acquires the right to use an asset from the manufacturer
directly. The ownership of the asset leased out remains with the manufacturer itself. The
major types of direct lessor include manufacturers, finance companies, independent
lease companies, special purpose leasing companies etc

CONCEPT AND MEANING OF HIRE PURCHASE

Hire purchase is a type of installment credit under which the hire purchaser, called the
hirer, agrees to take the goods on hire at a stated rental, which is inclusive of the
repayment of principal as well as interest, with an option to purchase. Under this
transaction, the hire purchaser acquires the property (goods) immediately on signing the
hire purchase agreement but the ownership or title of the same is transferred only when
the last installment is paid. The hire purchase system is regulated by the Hire Purchase
Act 1972. This Act defines a hire purchases “an agreement under which goods are let on
hire and under which the hirer has an option to purchase them in accordance with the
terms of the agreement and includes an agreement under which

1) The owner delivers possession of goods thereof to a person on condition that such
person pays the agreed amount in periodic installments.
2) The property in the goods is to pass to such person on the payment of the last of such
installments, and
3) Such person has a right to terminate the agreement at any time before the property so
passes”. Hire purchase should be distinguished from installment sale wherein property
passes to the purchaser with the payment of the first installment. But in case of HP
(ownership remains with the seller until the last installment is paid) buyer gets
ownership after paying the last installment. HP also differs from leasing.
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Meaning of Capital Structure

Capital Structure is referred to as the ratio of different kinds of securities raised by a

firm as long-term finance. The capital structure involves two decisions-

a. Type of securities to be issued are equity shares, preference shares and long
term borrowings (Debentures).
b. Relative ratio of securities can be determined by process of capital gearing. On
this basis, the companies are divided into two-
i. Highly geared companies - Those companies whose proportion of equity
capitalization is small.
ii. Low geared companies - Those companies whose equity capital
dominates total capitalization.

Factors Determining Capital Structure

1. Trading on Equity- The word “equity” denotes the ownership of the company.
Trading on equity means taking advantage of equity share capital to borrowed
funds on reasonable basis. It refers to additional profits that equity
shareholders earn because of issuance of debentures and preference shares. It
is based on the thought that if the rate of dividend on preference capital and
the rate of interest on borrowed capital is lower than the general rate of
company‟s earnings, equity shareholders are at advantage which means a
company should go for a judicious blend of preference shares, equity shares as
well as debentures. Trading on equity becomes more important when
expectations of shareholders are high.
2. Degree of control- In a company, it is the directors who are so called elected
representatives of equity shareholders. These members have got maximum
voting rights in a concern as compared to the preference shareholders and
debenture holders. Preference shareholders have reasonably less voting rights
while debenture holders have no voting rights. If the company‟s management
policies are such that they want to retain their voting rights in their hands, the
capital structure consists of debenture holders and loans rather than equity
shares.
3. Flexibility of financial plan- In an enterprise, the capital structure should be
such that there is both contractions as well as relaxation in plans. Debentures
and loans can be refunded back as the time requires. While equity capital
cannot be refunded at any point which provides rigidity to plans. Therefore, in
order to make the capital structure possible, the company should go for issue
of debentures and other loans.
4. Choice of investors- The company‟s policy generally is to have different
categories of investors for securities. Therefore, a capital structure should give
enough choice to all kind of investors to invest. Bold and adventurous investors
generally go for equity shares and loans and debentures are generally raised
keeping into mind conscious investors.
5. Capital market condition- In the lifetime of the company, the market price of
the shares has got an important influence. During the depression period, the
company‟s capital structure generally consists of debentures and loans. While
in period of boons and inflation, the company‟s capital should consist of share
capital generally equity shares.
6. Period of financing- When company wants to raise finance for short period, it
goes for loans from banks and other institutions; while for long period it goes
for issue of shares and debentures.
7. Cost of financing- In a capital structure, the company has to look to the factor
of cost when securities are raised. It is seen that debentures at the time of
profit earning of company prove to be a cheaper source of finance as compared
to equity shares where equity shareholders demand an extra share in profits.
8. Stability of sales- An established business which has a growing market and
high sales turnover, the company is in position to meet fixed commitments.
Interest on debentures has to be paid regardless of profit. Therefore, when
sales are high, thereby the profits are high and company is in better position to
meet such fixed commitments like interest on debentures and dividends on
preference shares. If company is having unstable sales, then the company is
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not in position to meet fixed obligations. So, equity capital proves to be safe in
such cases.
9. Sizes of a company- Small size business firms capital structure generally
consists of loans from banks and retained profits. While on the other hand, big
companies having goodwill, stability and an established profit can easily go for
issuance of shares and debentures as well as loans and borrowings from
financial institutions. The bigger the size, the wider is total capitalization.

i.