Beruflich Dokumente
Kultur Dokumente
Chapter IV
Cost of Capital
Aim
The aim of this chapter is to:
Objectives
The objectives of this chapter are to:
determine the cost of preference shares cost of irredeemable and redeemable share
Learning outcome
At the end of this chapter, you will be able to:
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Investors view point: The measurement of the sacrifice made by the individual for capital formation"
Firm's view point: It is the minimum required rate of return needed to justify the use of capital. It is supported
by Hompton, John.
Capital Expenditure view point: The cost of capital is the minimum required rate of return or the cut off rate
used to value cash flows.
Importance to capital budgeting decision: Capital budget decision largely depends on the cost of capital of each
source. According to net present value method, present value of cash inflow must be more than the present value
of cash outflow. Hence, cost of capital is used to capital budgeting decision.
Importance to structure decision: Capital structure is the mix or proportion of the different kinds of long term
securities. A firm uses particular type of sources if the cost of capital is suitable. Hence, cost of capital helps to
take decision regarding structure.
Importance to evolution of financial performance: Cost of capital is one of the important determine which
affects the capital budgeting, capital structure and value of the firm. Hence, it helps to evaluate the financial
performance of the firm.
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Financial Management
Importance to other financial decisions: Apart from the above points, cost of capital is also used in some other
areas such as, market value of share, earning capacity of securities etc. hence, it plays a major part in the financial
management.
Retention of earnings
The cost of equity or the returns required by the equity shareholders is the same in both the cases shareholders are
providing funds to the firm to finance firm's investment proposals. Retention of earnings involves an opportunity cost.
Shareholders could receive the earnings as dividends and invest the same in alternative investments of comparable
risk to earn returns. So, irrespective of whether a firm raises equity finance by retaining earnings or issue of additional
equity shares, the cost of equity is same. But issue of additional equity shares to the public involves a flotation cost
where as there is no flotation cost for retained earnings.
Cost of Retained Earnings (Kre)
Retained earnings are those parts of net earnings that are retained by the firm for investing in capital budgeting
proposals instead of paying them as dividends to shareholders.
The opportunity cost of retained earnings is the rate of return the shareholders forgoes by not putting their funds
elsewhere, because the management has retained the funds. The opportunity cost can be well computed with the
following formulae.
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It is the most difficult and controversial cost to measure there is no common basis for computation.
4.2.2 Cost of Preference Shares
Preference share is one of the types of shares issued by companies to raise funds from public. Preference share is
the share that has two preferential rights over equity shares:
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Financial Management
Pre-tax cost =
Post-tax cost =
Where, Kdi = Pre-tax cost of debentures, I Interest , P = Principle amount or face vlue
P = Net sales proceeds , t = Tax rate
For instance: XYZ Company Ltd., decides to float perpetual 12%, debentures of Rs. 100 each. The tax rate is 50.
Calculate cost of debenture (pre and post tax cost)
Solution: Pre-tax cost =
Post-tax cost =
Cost of Redeemable Debt
Redeemable debentures are those having a maturity period or repayable after a certain given period of time. These
type of debentures are issued by many companies when they require capital for temporary needs. It is calculated
by the following formula:
Where, Kd = Cost of debentures, n = Maturity period, NI= Net interest (after tax adjustment)
Pn = Principal repayment in the year n
Where, Ke = Cost of equity capital, Rf = Rate of return required on a risk free security (%)
= Beta coefficient, Rmf = Required rate of return on the market portfolio of assets, that can be viewed as the
average rate of return on all assets.
Assumptions of CAPM
CAPM approach is based on the following assumptions
Perfect Capital Market: all investors have same information about securities
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Investors have homogenous expectations regarding the expected returns, variances and correlation of returns
among all securities.
Investors seek to maximise the expected utility of their portfolios over a single period planning horizon
For instance
The capital Ltd. Wishes to calculate its cost of equity capital using the Capital Asset Pricing Model (CAPM)
approach. Companys analyst found that its risk free rate if return equals 12%, beta equals 1.7 and the return on
market portfolio equals 14.5 %.
Solution:
= 12 + [14.5 12]1.7
= 12+4.25= 16.25 %
Determination of the source of funds to be raised and their individual share in the total capitalization of the
firm
Assignment of Weights
The weights to specific funds may be assigned based on the following:
Book values: Book value weights are based on the values found on the balance sheet. The weight applicable to a
given source of fund is simply the book value of the source of fund divided by the book value of total funds.
Capital structure weights: Under this method weights are assigned to the components of capital structure based
on the targeted capital structure. Depending on target, capital structures have some difficulties in using it. They
are
A company may not have a well defined target capital structure
It may be difficult to precisely estimate the components capital cost, if the target capital is different from
present capital structure.
Market value weights: Under this method, assigned weights to a particular component of capital structure is
equal to the market value of the component of capital dividend by the market value of all components of capital
and capital employed by the firm.
For instance a firm has the following capital structure as the latest statement
Source of finance
Amount (Rs.)
Debt Capital
30,00,000
4.0
10,00,000
8.5
20,00,000
11.5
Retained earnings
40,00,000
10.0
Total
100,00,000
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Financial Management
Solution:
Computation of cost of capital
Source of Finance
Debt
Preference share
Equity share
Retained earnings
Weights
0.30*
0.10
0.20
0.40
1.00
Weighted Cost
1.2
8.5
2.3
4.0
8.35
Controllable factors (Internal factor): Controllable factors are those factors that affect WACC, but the firm can
control them. They are:
Dividend policy
Investment policy
Uncontrollable factors (External factors): The factors those are not possible to be controlled by the firm and
mostly affects the cost of capital. These types of factors are known as external factors.
Tax rates
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Summary
Cost of capital is an integral part of investment decision as it is used to measure the worth of investment proposal
provided by the business concern.
Cost of capital is the rate of return that a firm must earn on its project investments to maintain its market value
and attract funds.
Cost of capital is the required rate of return on its investments which belongs to equity, debt and retained
earnings.
Computation of cost of capital is a very important part of the financial management to decide the capital structure
of the business concern. Following points illustrates the importance of cost of capital.
The cost of equity or the returns required by the equity shareholders is the same in both the cases shareholders
are providing funds to the firm to finance firm's investment proposals.
Shareholders could receive the earnings as dividends and invest the same in alternative investments of comparable
risk to earn returns.
Retained earnings are those parts of net earnings that are retained by the firm for investing in capital budgeting
proposals instead of paying them as dividends to shareholders
References
Paramasivan, C. & Subramanian, T., 2009. Financial Management. New Age International.
Recommended Reading
Pratt , S. P., 2010. Cost of Capital: Workbook and Technical Supplement, 4th ed., Wiley.
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Financial Management
Self Assessment
1. Existence of perfect capital market is one of the assumptions of ______.
a. WACC
b. CAPM
c. equity
d. debentures
2. Cost of the capital is the ___________ required rate of return expected by investors.
a. minimum
b. maximum
c. higher
d. reduced
3. Which of the following statements is false?
a. Cost of capital comprises of three components
b. Cost of capital is the minimum required rate of needed to justify
c. There is no cost for internally generated funds
d. CAPM approach is one of the approaches used in computation of equity capital
4. _______ value weights are based on the values found on the balance sheet
a. Book
b. Capital
c. Market
d. Weighted
5. CAPM stands for?
a. Capital asset price model
b. Capital asset pricing model
c. Capital asset pricing maturity
d. Capital assignment pricing model
6. The composite cost of capital lies between the least and most _________ funds.
a. expensive
b. costly
c. low cost
d. cheap
7. ____________debentures are those having a maturity period or repayable after a certain given period of time.
a. Redeemable
b. Irredeemable
c. Capital
d. Asset
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Financial Management
Chapter V
Capital Structure and Leverages
Aim
The aim of this chapter is to:
Objective
The objective of the chapter is to:
define leverage
Learning outcome
At the end of this chapter, you will be able to:
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Financial Management
Leverage: It is the basic and important factor, which affect the capital structure. It uses the fixed cost financing
such as debt, equity and preference share capital. It is closely related to the overall cost of capital.
Cost of Capital: Cost of capital constitutes the major part for deciding the capital structure of a firm. Normally
longterm finance such as equity and debt consist of fixed cost while mobilization. When the cost of capital
increases, value of the firm will also decrease. Hence the firm must take careful steps to reduce the cost of
capital.
Nature of the business: Use of fixed interest/dividend bearing finance depends upon the nature of the
business. If the business consists of long period of operation, it will apply for equity than debt, and it will
reduce the cost of capital.
Size of the company: It also affects the capital structure of a firm. If the firm belongs to large scale, it can
manage the financial requirements with the help of internal sources. But if it is small size, they will go for
external finance. It consists of high cost of capital.
Legal requirements: Legal requirements are also one of the considerations while dividing the capital structure
of a firm. For example, banking companies are restricted to raise funds from some sources.
Requirement of investors: In order to collect funds from different type of investors, it will be appropriate
for the companies to issue different sources of securities.
Government policy: Promoter contribution is fixed by the company Act. It restricts to mobilize large, longterm
funds from external sources. Hence the company must consider government policy regarding the capital
structure
Profitability
Solvency
Flexibility
Conservation
Control
Considerations
Financial manager has to consider the following while developing optimum capital structure
Return on Investment (ROI)
Financial manager need to raise fixed cost sources) loans, debenture, preference shares) of funds, only when ROI
is higher that the fixed cost funds.
Tax benefit
Since debt is the cheapest source, because the interest paid on the debt is allowed as a deductible expense in
determining tax payment. Hence, a business firm should take the advantage of tax deduction.
Perceived financial risk
Use of more debt in capital structure leads to increase perceived financial risk in the minds of equity shareholders
which reduces the market price of equity share, thereby firm's wealth. Therefore financial management should not
increase debt in capital structure when ordinary shareholders perceived an excessive risk.
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Flexibility
Control
Seasonal variations
Degree of competition
Industry life-cycle
Requirements of investors
There are only two sources of funds i.e.: debt and equity.
The total financing remains constant. The firm can change the degree of leverage either by selling the shares
and retiring debt or by issuing debt and redeeming equity.
All the investors are assumed to have the same expectation about the future profits.
Business risk is constant over time and assumed to be independent of its capital structure and financial risk.
The use of debt does not change the risk perception of investors; as a result, the equity capitalisation rate, Ke,
and the debt capitalisation rate Kd, remain constant with changes in leverage.
The debt capitalisation rate is less than the equity capitalisation rate
Financial Management
Ke,
Cost
Ko
Kd
Kd.
Debt
Fig. 5.1 Net income approach
According to NI approach both the cost of debt and the cost of equity are independent of the capital structure; they
remain constant regardless of how much debt the firm uses. As a result, the overall cost of capital declines and the
firm value increases with debt. This approach has no basis in reality; the optimum capital structure would be 100
per cent debt financing under NI approach.
For instance:
Assume that a firm has an expected annual net operating income of Rs.200,000 an equity rate, Ke, of 10% and Rs.
10,00,000 of 6% debt.
Solution: The value of the firm according to Net Income approach:
Net Operating Income NI = 2, 00,000
Total cost of debt Interest = KdD (10, 00,000 X 0.6) = 60,000
Net Income available to shareholders, NOI-I = Rs.1, 40,000
Therefore:
Market Value of Equity (Rs. 140,000/.10) = 14, 00,000
Market Value of debt D (Rs. 60,000/.06) = 10, 00,000
Total = 24, 00,000
The cost of equity and debt are respectively 10% and 6% and are assumed to constant under the Net income
approach.
Ko = NOI/V = 200,000/24, 00,000 = 0.0833 = 8.33%
5.4.2 Net Operating Income (NOI) Approach
In Net operating income approach the market value of the firm is not affected by the change in capital structure, the
weighed average cost of capital is said to be constant.
Assumptions of the Net Operating Income (NOI) Approach
The market capitalises the value of the firm as a whole. Thus, the split between debt and equity is not
important
The market uses an overall capitalisation rate Ko to capitalise the net operating income. Ko depends on the
business risk. If the business risk is assumed to remain unchanged, Ko is a constant.
The use of less costly debt funds increases the risk to shareholders. This causes the equity capitalisation rate
to increase.
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Give below is the graphical representation of the net operating income approach:
Ke, Ko
Ke,
Cost
Ko
Kd
Kd.
Debt
Fig. 5.2 Net operating income approach
According to NOI approach the value of the firm and the weighted average cost of capital are independent of the
firms capital structure. In the absence of taxes, an individual holding all the debt and equity securities will receive
the same cash flows regardless of the capital structure and therefore, value of the company is the same.
For instance:
Assume that a firm annual net operating income of Rs. 2,00,000 an average cost of capital Ko, of 10% and intial
debt of Rs. 10,00,000 at 6%.
Solution: Net operating Income = 2,00,000
Therefore, Market value of firm, V = S+D = 2,00,000/0.10 = 20,00,000
Market value of the debt, D = 10,00,000
Market value of the equity S= V-D = 10,00,000
Ko = NOI/V = 200,000/0.10 = 20,00,000
Here, Ke is not constant as that in NI approach. It is computed using the formula:
Ke = Ko + (Ko-Kd)D/S
= 0.10 + (0.10+0.06)10,00,000/10,00,000
= 0.10 + 0.04(1) = 0.14
To verify that the weighted average cost of capital is a constant:
Ko = Kd(D/V) + Ke(S/V)
= 0.06(10, 00,000/20, 00,000) + 0.14(10, 00,000/20, 00,000)
= 0.06(0.50) + 0.14(0.5)
= 0.03 + 0.07 = 0.10
5.4.3 Traditional Approach
This is also known as intermediate approach. It is a compromise between the NI and NOI approach. According to
this view the value of the firm can be increased or the cost of the capital can be reduced by a judicious mix of dent
and equity capital.
This approach implies that the cost of capital decreases within the reasonable limit of debt and then increases with
the leverage.
This approach has the following propositions as shown in the Fig. below:
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Financial Management
Ke,
Ko
Kd
Cost
Debt
Fig. 5.3 Traditional approach
kd remains constant until a certain degree of leverage and thereafter rises at an increasing rate
ke remains constant or rises gradually until a certain degree of leverage and thereafter rises very sharply
as a sequence to the above 2 propositions, ko decreases till a certain level, remains constant for moderate
increases in leverage and rises beyond a certain point
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Proposition III
The average cost of capital is not affected by the financing decisions as investment and financing decisions are
independent.
Criticism of MM Propositions
Risk perception
The assumption that risks are similar is wrong and the risk perceptions of investors are personal and corporate
leverage is different.
Convenience:
Investors find personal leverage inconvenient.
Transaction Costs:
Due to presence of such costs in buying and selling securities, it is necessary to invest a higher amount to earn the
same amount of return.
Taxes:
When personal taxes are considered along with corporate taxes, the Miller and Modigliani approach fails the fails
to explain the financing decision and firm's value.
5.5 Leverages
Financial decision is one of the integral and important parts of financial management in any kind of business
concern. A sound financial decision must consider the board coverage of the financial mix (Capital Structure), total
amount of capital (capitalisation) and cost of capital (Ko ). Capital structure is one of the significant things for the
management, since it influences the debt equity mix of the business concern, which affects the shareholders return
and risk. Hence, deciding the debt-equity mix plays a major role in the part of the value of the company and market
value of the shares. The debt equity mix of the company can be examined with the help of leverage. The concept of
leverage is discussed in this part. Types and effects of leverage is discussed in the part of EBIT and EPS.
Meaning of leverage
The term leverage refers to an increased means of accomplishing some purpose. Leverage is used to lifting heavy
objects, which may not be otherwise possible. In the financial point of view, leverage refers to furnish the ability to
use fixed cost assets or funds to increase the return to its shareholders.
Definition of leverage
James Horne has defined leverage as, the employment of an asset or fund for which the firm pays a fixed cost or
fixed return. Types of Leverage Leverage can be classified into three major headings according to the nature of the
finance mix of the company.
Types of Leverages
Operating leverage
Financial leverage
Fixed Costs: which do not vary with the level of production they must be paid regardless of the amount of
revenue available
Variable Costs: raw materials, direct labor, costs and so on that varies directly with the level of production
Financial Management
The degree of operating leverage may be defined as the change in the percentage of operating income (EBIT), for
a given change in % of sales revenue.
When the data is given for one year, then we have to compute operating leverage, by the following formula:
For instance:
From the following particulars of ABC Ltd., calculate degree of operating leverage.
Particulars
Sales revenue
10,00,000
12,50,000
Variable cost
6,00,000
7,50,000
Fixed cost
2,50,000
2,50,000
2009
10,00,000
6,00,000
2010
12,50,000
7,50,000
% change
25
25
25
66.67
4,00,000
2,50,000
5,00,000
2,50,000
1,50,000
2,50,000
Operating leverage 2.667 indicates that when there is 25% change in sales, the change in EBIT is 2.66 times.
Application of operating leverage
It is helpful to know how operating profit would change with a given change in units produced.
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OR
For instance
A firm has sales of 1, 00,000 units at Rs. 10/ unit. Variable cost of the produced products is 60% of the total sales
revenue. Fixed cost id Rs. 2, 00,000. The firm has used a debt of Rs. 5, 00,000 at 20% interest. Calculate the operating
leverage and financial leverage.
Solution: Calculation of EBT
Particulars
Sales Revenue (1,00,000 units X Rs.10/unit)
Amount (Rs.)
10,00,000
6,00,000
4,00,000
2,00,000
Contribution
2,00,000
1,00,000
1,00,000
It is helpful to know how EPS would change with a change in operating profit.
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Financial Management
The degree of combined leverage may be defined as the % change in EPS due to the % change in sales. Thus
combined leverage is:
For instance:
ABC corporation has sales of Rs. 40 lakhs, variable cost 70% of the sales and fixed cost is Rs. 8,00,000. The firm
has raised Rs. 20 lakhs funds by issue of debentures at the rate of 10%. Compute operating, financial and combined
leverages.
Solution: Calculation of EBT or PBT
Particulars
Sales revenue
Less: Variable cost (40,00,000 X 0.70)
Contribution
Less: Fixed Cost
EBIT
Less: interest (20,00,000 X 0.10)
EBT
Amount (Rs.)
40,00,000
28,00,000
12,00,000
8,00,000
4,00,000
2,00,000
2,00,000
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Summary
Capital is the major part of all kinds of business activities, which are decided by the size, and nature of the
business concern.
The term capital structure refers to the relationship between the various long-term source financing such as
equity capital, preference share capital and debt capital.
Optimum capital structure is the capital structure at which the weighted average cost of capital is minimum and
thereby the value of the firm is maximum.
Optimum capital structure may be defined as the capital structure or combination of debt and equity, that leads
to the maximum value of the firm
The capital structure should be determined keeping in mind the objective of wealth maximisation.
Construction of optimum capital structure is possible only when there is a appropriate mix of debt and equity.
Equity and debt are the two important sources of long-term sources of finance of a firm.
In the financial point of view, leverage refers to furnish the ability to use fixed cost assets or funds to increase
the return to its shareholders.
References
Paramasivan, C. & Subramanian, T., 2009. Financial Management. New Age International.
Khan, M. Y.., 2004. Financial Management: Text, Problems And Cases, 2nd ed., Tata McGraw-Hill
Education.
2011. Capital Structure class II, [Video online] Available at: <http://www.youtube.com/watch?v=6vtuNgGxbso>
[Accessed 29 May 2013].
Recommended Reading
Brigham,E. F., 2003. Fundamentals of Financial Management. 10th ed., South-Western College Pub.
Brigham, E. F. & Ehrhardt, M. C., 2008. Financial management: theory and practice, 12th ed., Cengage
Learning.
Gitman, 2007. Principles Of Managerial Finance, 11th ed., Pearson Education India.
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Financial Management
Self Assessment
1. Optimum capital structure may be defined as the capital structure or combination of debt and __________, that
leads to the maximum value of the firm.
a. liabilities
b. assets
c. equity
d. cost
2. Contribution is equal to sales minus _________ cost.
a. fixed
b. variable
c. operating
d. semi-variable
3. Which of the following statements is false?
a. Optimum capital structure may be defined as the capital structure or combination of debt and equity, that
leads to the maximum value of the firm.
b. Use debt to any extent to maximise EPS.
c. Financial leverage is multiplied by financial leverage to get combined leverage.
d. Financial leverage is also known as trading on equity.
4. S-V-EBIT =?
a. Variable cost
b. Fixed cost
c. Operating cost
d. Profit
5. The use of leverage is essential to maximise ____________.
a. profit
b. loss
c. earnings
d. contribution
6. Total assets Current liabilities =?
a. Optimal capital structure
b. Financial leverage
c. Operating leverage
d. Capital structure
7. _________ of operating leverage and high degree of financial leverage is ideal situation
a. Low degree
b. High degree
c. Medium degree
d. Optimum degree
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Financial Management
Chapter VI
Capital Budgeting
Aim
The aim of this chapter is to:
Objectives
The objectives of this chapter are to:
Learning outcome
At the end of this chapter, you will be able to:
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6.1 Introduction
The term Capital Budgeting refers to the long-term planning for proposed capital outlays or expenditure for the
purpose of maximising return on investments. The capital expenditure may be:
Cost of acquisition of fixed assets, e.g., land, building and machinery etc.
Capital budgeting decisions involve long-term implication for the firm, and influence its risk complexion.
Capital decisions are required to assessment of future events which are uncertain.
In most cases, capital budgeting decisions are irreversible. This is because it is very difficult to find a market
for the capital goods. The only alternative available is to scrap the asset, and incur heavy loss.
Capital budgeting ensures the selection of right source of finance at the right time.
Many firms fail, because they have too much or too little capital equipment.
Investment decision taken by individual concern is of national importance because it determines employment,
economic activities and economic growth.
To ensure the effective control of capital expenditure in order to achieve by forecasting the long-term financial
requirements.
To make estimation of capital expenditure during the budget period and to see that the benefits and costs may
be measured in terms of cash flow.
Determining the required quantum takes place as per authorisation and sanctions.
To facilitate co-ordination of inter-departmental project funds among the competing capital projects.
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Financial Management
Careful estimates of revenues to be earned and costs to be incurred in future in respect of the project under
consideration.
Evaluation of various proposals in order of priority having regard to the amount available for investment.
Proposals should be controlled in order to avoid costly delays and cost over-runs.
Care should be taken to think all the implication of long range capital investment and working capital
requirements.
It should recognise the fact that bigger benefits are preferable to smaller ones and early benefits are preferable
to latter benefits
Evaluation of measures of investment worth on the basis of profitability and uncertainty or risk
Capital Expenditure Increases Revenue: It is the expenditure which brings more revenue to the firm either by
expanding the existing production facilities or development of new production line.
Capital Expenditure Reduces Costs: Such a capital expenditure reduces the cost of present product and thereby
increases the profitability of existing operations. It can be done by replacement of old machine by a new one.
Independent Proposals
Independent Proposals: These proposals are said be to economically independent which are accepted or rejected on
the basis of minimum return on investment required. Independent proposals do not depend upon each other.
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Dependent Proposals or Contingent Proposals: In this case, when the acceptance of one proposal is contingent upon
the acceptance of other proposals, it is called as Dependent or Contingent Proposals. For example; construction
of new building on account of installation of new plant and machinery describes it.
Mutually Exclusive Proposals: Mutually Exclusive Proposals refer to the acceptance of one proposal results in the
automatic rejection of the other proposal. Then the two investments are mutually exclusive. In other words, one can be
rejected and the other can be accepted. It is easier for a firm to take capital budgeting decisions on such projects.
In the case of constant annual cash inflows: If the project generates constant cash flow the Pay-back period can be
computed by dividing cash outlays (original investment) by annual cash inflows. The following formula can be
used to ascertain pay-back period:
Pay-back Period =
Example 1:
A project requires initial investment of Rs. 40,000 and it will generate an annual cash inflow of Rs. 10,000 for 6
years. You are required to find out pay-back period.
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Financial Management
Solution:
Calculation of Pay-back period:
Pay-back Period =
=
= 4 years
Pay-back period is 4 years, i.e., the investment is fully recovered in 4 years.
Example 2: In the case of Uneven or Unequal Cash Inflows
In the case of uneven or unequal cash inflows, the Pay-back period is determined with the help of cumulative cash
inflow. It can be calculated by adding up the cash inflows until the total is equal to the initial investment.
From the following information you are required to calculate pay-back period:
A project requires initial investment of Rs. 40,000 and generates cash inflows of Rs. 16,000, Rs. 14,000, Rs. 8,000
and Rs. 6,000 in the first, second, third, and fourth year respectively.
Solution:
Year
1
2
3
4
The above table shows that at the end of 4th years the cumulative cash inflows exceeds the investment of Rs. 40.000.
Thus the pay-back period is as follows:
Pay-back Period = 3 Years+
= 3 Years+
= 3.33 Years
Accept or Reject Criterion
Investment decisions based on pay-back period are used by many firms to accept or reject an investment proposal.
Among the mutually exclusive or alternative projects whose pay-back periods are lower than the cut off period, the
project would be accepted, if not it would be rejected.
Advantages of Pay-back Period Method
It enables the firm to select an investment which yields a quick return on cash funds.
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This method does not consider income beyond the pay-back period
It does not indicate how to maximise value and ignores the relative profitability of the project
It does not consider cost of capital and interest factor which are very important factors in taking sound investment
decisions.
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Financial Management
Year
1
2
3
4
5
The above table shows that at the end of 3rd year the Cumulative Cash Inflows exceeds the investment of Rs. 1,
00,000. Thus the Pay-back Period is as follows:
Pay-back Period = 2 Years +
= 2 Years +
= 2 Years + 0.833 = 2.833 Years
(2) Calculation of Discounted Pay-back Period 10% Interest Rate
Year
Cash Inflows
Present Value of
Cash Inflows
(Z x3)
4
Rs.
Cumulative Value
of Cash Inflows
1
1
2
3
4
5
10,000
40,000
60,000
20,000
--
0.9091
0.8265
0.7513
0.6830
0.6209
9,091
33,060
45,078
13,660
--
9.091
42,151
87,229
1,00,889
1,00,889
Rs.
From the above table, it is observed that up to the 4th year Rs. 1, 00,000 is recovered. Because the Discounting
Cumulative Cash Inflows exceeds the original cash outlays of Rs. 1, 00,000. Thus the Discounted Pay-back Period
is calculated as follows:
Pay-back Period = 3 Years +
= 3 Years+
= 3 Years + 0.935 == 3.935 Years
6.9.3 Average Rate of Return Method (ARR) or Accounting Rate of Return Method
Average Rate of Return Method is also termed as Accounting Rate of Return Method. This method focuses on the
average net income generated in a project in relation to the projects average investment outlay. This method involves
accounting profits not cash flows and is similar to the pe1formance measure of return on capital employed.
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Where,
Average investment would be equal to the Original investment plus salvage value divided by 2.
Average Investment =
(or)
=
Advantages
It considers all the years involved in the life of a project rather than only pay-back years
Disadvantages
There may be difficulty in accurately establishing rates of interest over the cash flow period.
Lack of adequate expertise in order to properly apply the techniques and interpret results.
These techniques are based on cash flows, whereas reported earnings are based on profits.
The inclusion of Discounted Cash Flow Analysis may cause projected earnings to fluctuate considerably and thus
have an adverse on share prices.
6.9.5 Net Present Value Method (NPV)
This is one of the Discounted Cash Flow techniques which explicitly recognise the time value of money. In this
method all cash inflows and outflows are converted into present value (i.e., value at the present time) applying an
appropriate rate of interest (usually cost of capital).
In other words, Net Present Value Method discount inflows and outflows to their present value at the appropriate
cost of capital and set the present value of cash inflow against the present value of outflow to calculate Net Present
Value. Thus, the Net Present Value is obtained by subtracting the present value of cash outflows from the present
value of cash inflows.
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Financial Management
It recognises the time value of money and is thus scientific in its approach.
All the cash flows spread over the entire life of the project are used for calculations.
It is consistent with the objectives of maximising the welfare of the owners as it depicts the positive or otherwise
present value of the proposals.
Disadvantages
When the projects in consideration involve different amounts of investment, the Net Present Value Method
may not give satisfactory results.
Evaluation
A popular discounted cash flow method, the internal rate of return criterion has several virtues:
It considers the cash flows over the entire life of the project.
It makes more meaningful and acceptable to users because it satisfies them in terms of the rate of return on
capital.
Limitations
The internal rate of return figure cannot distinguish between lending and borrowings and hence high internal
rate of return need not necessarily be a desirable feature.
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Rule of Acceptance
As per the Benefit Cost Ratio or Profitability Index a project with Profitability Index greater than one should be
accepted as it will have Positive Net Present Value. Likewise if Profitability Index is less than one the project is not
beneficial and should not be accepted.
Advantages of Profitability Index:
For calculations when compared with internal rate of return method it requires less time.
As this method is capable of calculating incremental benefit cost ratio, it can be used to choose between mutually
exclusive projects.
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Summary
The term Capital Budgeting refers to the long-term planning for proposed capital outlays or expenditure for the
purpose of maximising return on investments.
Capital Budget is also known as Investment Decision Making or Capital Expenditure Decisions or Planning
Capital Expenditure etc.
According to Hamption, John. J., Capital budgeting is concerned with the firms formal process for the
acquisition and investment of capital.
Capital budgeting decisions involve long-term implication for the firm, and influence its risk complexion.
Investment decision taken by individual concern is of national importance because it determines employment,
economic activities and economic growth.
Capital Expenditure Increases Revenue is the expenditure which brings more revenue to the firm either by
expanding the existing production facilities or development of new production line.
There are number of appraisal methods which may be recommended for evaluating the capital investment
proposals.
One of the limitations of the pay-back period method is that it ignores the post pay-back returns of project.
Discounted pay-back method helps to measure the present value of all cash inflows and outflows at an appropriate
discount rate.
Average Rate of Return Method is also termed as Accounting Rate of Return Method.
Discount cash flow is a method of capital investment appraisal which takes into account both the overall
profitability of projects and also the timing of return.
Net Present Value is obtained by subtracting the present value of cash outflows from the present value of cash
inflows.
Internal Rate of Return Method is also called as Time Adjusted Rate of Return Method.
Horngren and Foster define Internal Rate of Return as the rate of interest at which the present value of expected
cash inflows from a project equals the present value of expected cash outflows of the project.
As per the Benefit Cost Ratio or Profitability Index a project with Profitability Index greater than one should
be accepted as it will have Positive Net Present Value.
Reference
Peterson, P. P. & Fabozzi, J. F., 2004. Capital Budgeting: Theory and Practice, John Wiley & Sons.
Periasamy, P., 2010. A TEXTBOOK OF FINANCIAL COST AND MANAGEMENT ACCOUNTING, Global
Media.
Irfanullah, A., 2011. CFA Level I Capital Budgeting Video Lecture by Mr. Arif Irfanullah part 2 [Video online]
Available at: <http://www.youtube.com/watch?v=qfzQwqLdXH0> [Accessed 16 May 2013].
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Recommended Reading
Jacobs & Davina, F., 2006. A Reviews of Capital Budgeting Practices, International Monetary Fund.
Dayananda, D., 2002. Capital Budgeting: Financial Appraisal of Investment Projects, 2nd ed. Cambridge
University Press.
Baker, K. H. & English, P., 2011. Capital Budgeting Valuation: Financial Analysis for Todays Investment
Projects, John Wiley & Sons.
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Financial Management
Self Assessment
1. ___________ is concerned with the firms formal process for the acquisition and investment of capital.
a. Investment
b. Capital budgeting
c. Capital expenditure
d. Planning
2. Which of the following statements is false?
a. Capital budgeting involves commitment of small amount of funds.
b. Wrong sale forecast; may lead to over or under investment of resources.
c. Many firms fail, because they have too much or too little capital equipment.
d. Capital decisions are required to assessment of future events which are uncertain.
3. ____________ is the expenditure which brings more revenue to the firm either by expanding the existing
production facilities or development of new production line.
a. Mutually Exclusive Proposals
b. Independent Proposals
c. Capital Expenditure Increases Revenue
d. Capital Expenditure Reduces Costs
4. What reduces the cost of present product and thereby increases the profitability of existing operations?
a. Mutually Exclusive Proposals
b. Independent Proposals
c. Capital Expenditure Increases Revenue
d. Capital Expenditure Reduces Costs
5. ____________ refer to the acceptance of one proposal results in the automatic rejection of the other proposal.
a. Mutually Exclusive Proposals
b. Dependent Proposals
c. Contingent Proposals
d. Independent Proposals
6. Which proposals are said be to economically independent?
a. Mutually Exclusive Proposals
b. Independent Proposals
c. Dependent Proposals
d. Contingent Proposals
7. Which of the following formula calculates Profitability Index?
a. Average Rate of Return (ARR) =
b. Lower Interest Rate +
c. Reciprocal Pay-back Period =
d. Profitability Index =
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8. ____________ is defined as the number of years required to recover the initial investment in full with the help
of the stream of annual cash flows generated by the project.
a. Profitability Index Method
b. Internal Rate of Return Method
c. Pay out Period Method
d. Net Present Value Method
9. If the project generates constant cash flow the pay-back period can be computed by dividing __________ by
annual cash inflows.
a. constant annual cash inflows
b. investment proposals
c. cash inflows
d. cash outlays
10. ____________ is a method of capital investment appraisal which takes into account both the overall profitability
of projects and also the timing of return.
a. Discount cash flow
b. Cash flow
c. Net present value method
d. Internal rate of return method
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