Financial Management Unit II I) Capital Budgeting II) Is the process of evaluating & selecting long term investments with

nts with a goal of maximizing share holders wealth. It is investment decision in long term or fixed assets Importance Affect profitability Impact competitive position Affects risk profile Planning to de done for financing Involve huge investments Irreversible & can bankrupt the company

III)Difficulties Cash outflows at present & cash inflow in future Time frame long , therefore risk increases Difficult to forecast cash inflows IV)Types of capital budgeting decisions (1) affecting revenue Diversification Expansion (2) affecting costs Replacement (3) Mutually exclusive are projects that compete with one another, the acceptance of one project implies that the other project is rejected (4) independent are projects that do not compete with one another. A number of projects can be accepted at the same time provided sufficient capital is available (5) contingent the subsequent expenditure required for the successful working of the main project. V) Capital Rationing Is the financial situation where a firm has only fixed amount to allocate among competing capital expenditure. VI)Cash flow concept Vs accounting profit The basic difference between these concepts is the inclusion of certain non cash expenses ( such as depreciation) to calculate profit Reasons why cash flows are preferred- (i) Economic value the investments is in cash basis therefore the benefits are also measured using cash flows.(ii) avoids

accounting ambiguities where profits can be altered by changing policies (iii) time value of money VII) Determination of relevant cash flows Cash flow before depreciation & tax depreciation = PBT tax% on PBT = PAT + Dep = CFAT VIII) Components of capital budgeting Cash Outflow Annual cash flows Depreciation Tax Discount rate EVALUATION TECHNIQUES I) Non discounted cash flow method (A) ARR measures the profitability of investment ARR = Avg PAT/Avg invst * 100 Where AVG PAT = sun of all profits/ no of years AVG invst = total invst/2 Accept reject criteria Accept if ARR > cut off rate Reject if ARR < cut off rate Evaluation Advantages (i) All profits from project considered (ii) Easy Disadvantages (i) Profits not cash flows are considered (ii) Time value of money ignored (B) Payback method Pay back period is the time taken to recover original investment For methodology refer class notes Accept reject criteria Accept if PB > cut off period Reject if PB < cut off periodEvaluation Advantages (i) based on cash flows(ii) Easy Disadvantages (i) cash flows after pay back period are not considered (ii) Time value of money ignored II) Discounted cash flow method (DCF Methods) (A) NPV is the excess of present value of cash inflow over cash outflows. For methodology refer class notes Accept reject criteria Accept if NPV > zero Reject if NPV < zero Evaluation Advantages (i) based on cash flows(ii) Time value of money considered (iii) total benefits from project considered

Disadvantages (i) difficult to calculate (ii) Difficult to determine the rate of return required. (B) Profitability Index measures the present value of returns per rupee invested PI = PV of cash inflows/ pv of cash outflows Accept reject criteria Accept if PI> 1 Reject if PI < 1 Evaluation Advantages (i) based on cash flows(ii) Time value of money considered (iii) total benefits from project considered Disadvantages (i) difficult to calculate (ii) Difficult to determine the rate of return required. ( C ) IRR - is the discount rate that equates the present value of cash inflows with the initial investment. It is the rate at which NPV = zero For methodology refer class notes Accept reject criteria Accept if IRR > K Reject if IRR < K, cost of capital Evaluation Advantages (i) based on cash flows(ii) Time value of money considered (iii) total benefits from project considered Disadvantages (i) difficult to calculate (ii) Difficult to determine the rate of return required COMPARISON OF DIFFERENT TECHNIQUES
I) NPV vs IRR

Similarities NPV and IRR generally provide the same accept and reject decisions when two projects are being evaluated. The two methods will give a same result under the following situations: Conventional investments ie investments involving cash outflow in the initial years and then cash inflows in subsequent years. Independent projects the acceptance of a project does not include the acceptance of any other project.

Differences

NPV and IRR will sometimes give different results ie NPV might give accept decision while IRR might give reject decisions. This happens in case of mutually exclusive projects. Also the 2 methods may give conflicting decisions under the following circumstances:
Different initial investments Different pattern of cash inflows Different project life

Resolving differences When NPV & IRR give conflicting decisions, the decision given by NPV can be accepted as it is a superior method and is in line with shareholders wealth maximization principle.
II) NPV vs PI

NPV and PI generally provide the same accept and reject decisions when two projects are being evaluated. However, differences may arise when mutually exclusive projects are being considered.

When NPV & PI give conflicting decisions, the decision given by NPV can be accepted as it is a superior method and is in line with shareholders wealth maximization principle.
III) Capital Rationing

Capital Rationing is the choice of investment proposals when the available capital is limited. For eg, a company may have capital of Rs 10 lakhs, and the available investment projects may be as follows:

Project A B C D E

Investment reqd 5 lakhs 2 lakhs 3 lakhs 2 lakhs 3 lakhs

In such situations all 3 projects may be profitable but cannot be accepted as the cost outlay is Rs 15 lakhs. This is a case of capital rationing.

In such situations, the company must select a combination of projects that maximize shareholders wealth. STEPS : 1) Identify acceptable projects based on PI or IRR

Project A B C D E

Investment reqdPI 5 lakhs 2 lakhs 3 lakhs 2 lakhs 3 lakhs 1.6 1.5 1.1 1.2 1.3

2) Rank the projects based on PI or IRR Project A B E D C Investment reqdPI 5 lakhs 2 lakhs 3 lakhs 2 lakhs 3 lakhs 1.6 1.5 1.3 1.2 1.1

3) Selection of combination of projects based on availability of capital

Select projects A, B & E. Total investment is 5 lakhs + 2 lakhs +3 lakhs=10 lakhs

IV)Inflation and capital budgeting

Inflation is the overall general upward price movement of goods and services in

an economy. Capital budgeting will give unrealistic results if the impact of inflation is not correctly included in analysis. Therefore, cash flows need to be adjusted for inflation to give realistic results.
Steps 1) Cash flows to be adjusted for inflation: Multiply cash flows with discount rate for inflation. For eg if cost of capital is 12%, inflation rate is 10%, cash outflow is 2 lakhs & CFAT are as follows Year 1 2 Cash Flows 1 Lakh 1 Lakh Inflation rate at 10% 1/ (1+.10)1=.909 1/(1+.10)2=.826 Real Cash flows 90900 82600

2) Calculate the rate of return (1+n) = (1+r)/(1+i) (1+n)= 1.12/1.1 (1+n) = 1.018 n=.018 n=2% app 3) Multiply Real cah flows with the present values @2% and get sum of PV of cash inflows 4) NPV = Sum of PV of cash inflows Cash outlay

COST OF CAPITAL I) Definition

Cost of capital refers to a rate which represents the average cost at which a firm raises its finances. Cost of capital is the minimum r a t e o f return that a firm must earn on its investments so as to leave its market value unchanged.

II)

Importance

 It is used as the discount rate while computing NPV It is the rate with which IRR is compared Hence it is useful for capital budgeting decisions Incorrect computation of cost of capital will lead to wrong capital budgeting decisions. Necessary for designing capital structure III) Specific Vs Weighted Average cost of capital Specific is the cost of specific cost of capital such as debt, equity, preference capital & retained earnings. Weighted average cost of capital is the combination of costs of all types of capital used by a company. IV) Explicit Vs Implicit costs Explicit costs are the incremental cash outflow that arises due to raising capital. For eg interest charges paid while raising funds from debentures or loans, dividend paid on equity shares and on preference shares. Implicit cost of capital is opportunity cost, if money is used one of best alternatives for effective use of resources. It is the rate of return associated with the best investment opportunity that the firm and shareholders have foregone. The implicit cost is associated with retained earnings. V) Debt is cheaper than equity Tax deductible nature of interest outflow leads to savings for the company. Hence debt is cheaper than equity Cost of raising funds through equity is very high. Life of debt is fixed VI) Cost of retained earnings Implicit cost or opportunity cost VII) For calculating specific cost of capital refer class notes.