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Uttar Pradesh

India 201303

ASSIGNMENTS

PROGRAM: MFC

SEMESTER-II

Subject Name

: Financial Management

Study COUNTRY

: Sudan LC

Permanent Enrollment Number (PEN) : MFC001652014-2016014

Roll Number

: AMF204 (T)

Student Name

: SOMAIA TAMBAL YOUSIF ELMALIK

INSTRUCTIONS

a) Students are required to submit all three assignment sets.

ASSIGNMENT

Assignment A

Assignment B

Assignment C

DETAILS

Five Subjective Questions

Three Subjective Questions + Case Study

Objective or one line Questions

MARKS

10

10

10

b)

c)

d)

e)

All assignments are to be completed as typed in word/pdf.

All questions are required to be attempted.

All the three assignments are to be completed by due dates and need to be submitted for

evaluation by Amity University.

f) The students have to attached a scan signature in the form.

Signature :

Date

_________________________________

Assignment A

Assignment B

Assignment C

Financial Management

Assignment A

1.What is stock split, What are its advantages?

Chapter - 12 Dividend Decision

12.7 Stock Split

Learning Objectives:

After studying this unit, you should be able to understand the following:.

1. Explain the importance of dividends to investors.

2. Discuss the effect of declaring dividends on share prices.

3. Mention the advantages of a stable dividend policy.

4. List out the various forms of dividend.

5. Give reasons for stock split.

A stock split is a method to increase the number of outstanding shares by proportionately reducing the face value of a

share. A stock split affects only the par value and does not have any effect on the total amount outstanding in share

capital. The reasons for splitting shares are:

To make shares attractive: The prime reason for effecting a stock split is to reduce the market price of a share to

make it more attractive to investors. Shares of some companies enter into higher trading zone making it out of reach

to small investors. Splitting the shares will place them in more popular trading range thus providing marketability

and motivating small investors to buy them.

Indication of higher future profits: Share split is generally considered a method of management communication to

investors that the company is expecting high profits in future.

Higher dividend to shareholders: When shares are split, the company does not resort to reducing the cash

dividends. If the company follows a system of stable dividend per share, the investors would surely get higher

dividends with stock split.

This theory is again propounded by Durand and is totally opposite of the Net Income Approach. He says any change

in leverage will not lead to any change in the total value of the firm, market price of shares and overall cost of

capital. The overall capitalization rate is the same for all degrees of leverage. We know that:

K0 = [B/(B+S)]Kd + [S/(B+S)]Ke

As per the NOI approach the overall capitalization rate remains constant for all degrees of leverage. The market

values the firm as a whole and the split in the capitalization rates between debt and equity is not very significant.

The increase in the ratio of debt in the capital structure increases the financial risk of equity shareholders and to

compensate this, they expect a higher return on their investments. Thus the cost of equity is

Ke = Ko +[(Ko - Kd)(B/S)]

Cost of debt: The cost of debt has two parts - explicit cost and implicit cost. Explicit cost is the given rate of

interest. The firm is assumed to borrow irrespective of the degree of leverage. This can mean that the increasing

proportion of debt does not affect the financial risk of lenders and they do not charge higher interest. Implicit cost is

increase in Ke attributable to Kd. Thus the advantage of use of debt is completely neutralized by the implicit cost

resulting in Ke and Kd being the same.

Chapter - 10 Inventory Management

10.3 Inventory management Techniques

There are many techniques of management of inventory. Some of them are:

Economic Order Quantity:

EOQ refers to the optimal order size that will result in the lowest ordering and carrying costs for an item of inventory

based on its expected usage.

EOQ model answers the following key quantum of inventory management.

a. What should be the quantity ordered for each replenishment of stock?

b. How many orders are to be paced in a year to ensure effective inventory Management?

EOQ is defined as the order quantity that minimizes the total cost associated with inventory management.

It is based on the following assumptions:

1. Constant or uniform demand. The demand or usage is even throughout the period.

2. Known demand or usage: Demand or usage for a given period is known Le deterministic.

3. Constant Unit price: Per unit price of material does not change and is constant irrespective of the order size.

4. Constant Carrying Costs

The cost of carrying is a fixed percentage of the average value of inventory.

5. Constant ordering cost

Cost per order is constant whatever be the size of the order.

6. Inventories can be replenished immediately as the stock level reaches exactly equal to zero. Consequently there is

no shortage of inventory.

7. Economic order Quantity

QX =

2DK

Kc

D = Annual usage or demand

QX = Economic order Quantity

K = ordering cost per order

kc = Pc = price per unit x percent carrying cost = carrying cost of inventory per unit per annum.

Example:

Annual consumption of raw materials is 40,000 units. Cost per unit Rs 16

Carrying cost is 15% per annum.

Cost of placing an order = Rs 480

Solution:

2 x 40000 x 480 = 4000 units

EOQ = 16 x 0.15

Example:

A company has gathered the following information:

Annual demand 30,000 units

Ordering cost per order = Rs 20 (Fixed)

Carrying cost = Rs 10 per unit per annum

Purchase cost per unit i.e. price per unit = Rs 32 per unit

Determine EOQ, total number of orders in a year and the time - gap between two orders.

Total Cost

Carrying Cost

Ordering Cost

Cost

x

Q

Solution:

QX = 2DK = 2 x 30000 x 20

Kc 10

= 346 units

K = Rs.20

Kc = Rs.10

D = 30000

The total number of orders in a year = 30,000

= 87 orders

Time gap between two orders = 365 = 4 days

1. ABC System: the inventory of an industrial firm generally comprises of thousands of items with diverse prices,

large lead time and procurement problems. It is not possible to exercise the same degree of control over all these

items. Items of high value require maximum attention while items of low value do not require same degree of

control. The firm has to be selective in its approach to control its investment in various items of inventory. Such an

approach is known as selective inventory control. ABC system belongs to selective inventory control.

ABC analysis classifies all the inventory items in an organization into three categories.

A: Items are of high value but small in number. A items require strict control.

B: Items of moderate value and size which require reasonable attention of the management.

C: Items represent relatively small value items and require simple control.

Since this method concentrates attention on the basis of the relative importance of various items of inventory it is

also known as control by importance and exception. As the items are classified in order of their relative importance

in terms of value, it is also known as proportional value Analysis.

Advantages of ABC analysis:

2. It ensures closer controls on costly elements in which firm's greater part of resources are invested.

3. By maintaining stocks at optimum level it reduces the clerical costs of inventory control.

4. Facilitates inventory control and control over usage of materials, leading to effective cost control.

Limitations:

1. A never ending problem in inventory management is adequately handling thousands of low value of c items. ABC

analysis fails to answer this problem.

2. If ABC analysis is not periodically reviewed and updated, it defeats the basic purpose of ABC approach.

Most of the industries are subject to seasonal fluctuations and sales during different months of the year are usually

different. If, however, production during every month is geared to sales demand of the month, facilities have to be

installed to cater to for the production required to meet the maximum demand. During the slack season, a large

portion of the installed facilities will remain idle with consequent uneconomic production cost. To remove this

disadvantage, attempt has to be made to obtain a stabilized production programme throughout the year. During the

slack season, there will be accumulation of finished products which will be gradually cleared as sales progressively

increase. Depending upon various factors of production, storing and cost, a normal capacity will be determined. To

meet the pressure of sales during the peak season, however, higher capacity may have to be sued for temporary

periods. Similarly, during the slack season, to avoid loss due to excessive accumulation, capacity usage may have to

be scaled down. Accordingly, there will be a maximum capacity and minimum capacity, only consumption of raw

material will accordingly vary depending upon the capacity usage.

Again, the delivery period or lead time for procuring the materials may fluctuate. Accordingly, there will be

maximum and minimum delivery period and the average of these two is taken as the normal delivery period.

Maximum Level:

Maximum level is that level above which stock of inventory should never rise. Maximum level is fixed after taking

in to account the following factors:

1. Requirement and availability of capital

2. Availability of storage space and cost of storing.

3. Keeping the quality of inventory intact

4. Price fluctuations

5. Risk of obsolescence, and

6. Restrictions, if any, imposed by the government.

Maximum Level = Ordering level - (MRC x MDP) + standard ordering quantity.

Where, MRC = minimum rate of consumption

MDP = minimum lead time.

Minimum level:

Minimum level is that level below which stock of inventory should not normally fall.

Minimum level = OL - (NRC x NL T)

Where,

OL = ordering level

NRC = Normal rate of consumption

NL T = Normal Lead Time.

Ordering level:

Ordering level is that level at which action for replenishment of inventory is initiated.

OL = MRC X ML T

Where,

MRC = Maximum rate of consumption

ML T = Maximum lead time.

3. Average stock level

Average stock level can be computed in two ways

1. minimum level + maximum level

2

2. Minimum level + 1/2 of re-order quantity.

Average stock level indicates the average investment in that item of inventory. It is quite relevant from the point of

view of working capital management.

Managerial significance of fixation of Inventory level:

1. It ensure the smooth productions of the finished goods by making available the raw material of right quality in

right quantity at the right time.

2. It optimizes the investment in inventories. In this process, management can avoid both overstocking and shortage

of each and every essential and vital item of inventory.

3. It can help the management in identifying the dormant and slow moving items of inventory. This brings about

better co-ordination between materials management and production management on the one hand and between stores

manager and marketing manager on the other.

Re - order Point:

"When to order" is another aspect of inventory management. This is answered by re - order point. The re - order

point is that inventory level at which an order should be placed to replenish the inventory.

To arrive at the re - order point under certainty the two key required details are:

1. Lead time

2. Average usage

lead time refers to the average time required to replenish the inventory after placing orders for inventory

Re - order point = lead time x Average usage

Under certainty, re - order point refers to that inventory level which will meet the consumption needs during the lead

time.

Safety Stock: Since it is difficult to predict in advance usage and lead time accurately provision is made for handling

the uncertainty in consumption due to changes in usage rate and lead time. The firm maintains a safety stock to

manage the stock - out arising out of this uncertainty.

When safety stock is maintained, (When Variation is only in usage rate)

Re - order point = lead time x Average usage + Safety stock

Safety stock = [(maximum usage rate) - (Average usage rate)] x lead time.

Or

Safety stock when the variation in both lead time and usage rate are to be incorporated.

Safety stock = (Maximum possible usage) - (Normal usage)

Maximum possible usage = Maximum daily usage x Maximum lead time

Normal usage = Average daily usage x Average lead time

Example: A manufacturing company has an expected usage of 50,000 units of certain product during the next year.

Re cost of processing an order is Rs 20 and the carrying cost per unit per annum is Rs 0.50. Lead time for an order is

five days and the company will keep a reserve of two days usage.

Calculate 1. EOO 2. Re - order point. Assume 250 days in a year

Solution:

Kc 0.50

= 2000 units

Re order point

Dally usage =50000

250

= 200 units

Safety stock = 2 x 200 = 400 units.

Re - order point (lead time x Average usage) + safety stock

(5 x 200) + 400 = 1,400 units

There are different ways of pricing inventories used in production. If the items in inventory are homogenous

(identical except for in significant differences) it is not necessary to use specific identification method. The

convenient price is using a cost flow assumption referred to as a flow assumption.

When flow assumption is used it means that the firm makes an assumption as to the sequence in which units are

released from the stores to the production department.

The flow assumptions selected by a company need not correspond to the actual physical movement of raw materials.

When units of raw material are identical, it does not matter which units are issued from the stores to the production

department.

The method selected should match the costs with the revenue to ensure that the profits are uncertain in a manner that

reflects the conditions actually prevalent.

1. First in, first out (FIFO): It assumes that the raw materials (goods) received first are used first. The same sequence

is followed in pricing the material requisitions.

2. LIFO (last in, first out): The consignment last received is first used and if this is not sufficient for the requisitions

received from production department then the use is made from the immediate previous consignment and so on. The

requisitions are priced accordingly. This method is considered to be suitable under inflationary conditions. Under this

method the cost of production reflects the current market trend. The closing inventory of raw material will be valued

on a conservative basis under the inflationary conditions.

3. Weighted average: Material issues are priced, at the weighted average of cost of materials in stock. This method

considers various consignments in stock along with their unit's prices for pricing the material issues from stores.

4. other methods are:

a. Replacement price method: This method prices the issues at the value at which it can be procured from the market.

b. Standard price method: under this method the materials are priced at standard price. Standard price is decided

based on market conditions and efficiency parameters. The difference between the purchase price and the standard

price is analyzed through variance analysis.

10.4 Summary

Inventories form part of current assets of firm. Objectives of inventory management are.

a. Maximum customer satisfaction

b. Optimum investment in inventory and

c. Operation of the plant at the least cost structure. Inventories could be grouped into direct inventories are raw

materials, work-in- process inventories and finished goods inventory. Indirect inventories are those items which are

necessary for production process but do not become part of the finished goods. There are many reasons attributable

to holding of inventory by the managements.

incorporating risk factor in capital budgeting.

Chapter 7 Risk Analysis in Capital Budgeting

Risks in a project are many. It is possible to identify three separate and distinct types of risk in any project.

1. Stand alone risk: it is measured by the variability of expected returns of the project.

2. Portfolio risk: A firm can be viewed as portfolio of project having a certain degree of risk. When new project is

added to the existing portfolio of project, the risk profile of firm will alter. The degree of the change in the risk

depends on the covariance of return from the new project and the return from the existing portfolio of the projects. If

the return from the new project is negatively correlated with the return from portfolio, the risk of the firm will be

further diversified away.

3. Market or beta risk: It is measured by the effect of the project on the beta of the firm. The market risk for a

project is difficult to estimate.

Stand alone risk is the risk of project when the project is considered in isolation. Corporate risk is the projects risks

of the firm. Market risk is systematic risk. The market risk is the most important risk because of the direct influence

it has on stock prices.

Sources of risk: The sources of risks are

1. Project specific risk

2. Competitive or Competition risk

3. Industry specific risk

4. International risk

5. Market risk

1. Project specific risk: The source of this risk could be traced to something quite specific to the project.

Managerial deficiencies or error in estimation of cash flows or discount rate may lead to a situation of actual cash

flows realised being less than that projected. 2. Competitive risk or Competition risk: unanticipated actions of a

firms competitors will materially affect the cash flows expected from a project. Because of this the actual cash

flows a project will be less than that of the forecast.

3. Industry specific: industry specific risks are those that affect all the firms in industry. It could be again

grouped into technological risk, commodity risk and legal risk.

4. International Risk: These types of risks are faced by firms whose business consists mainly of exports or those

who procure their main raw material from international markets. For example, rupee dollar crisis affected the

software and BPOs because it drastically reduced their profitability. Another best example is that of the textile units

in Tirupur in Tamilnadu, exporting their major part of garments produced. Rupee gaining and dollar Weakening

reduced their competitiveness in the global markets. The surging Crude oil prices coupled with the governments

delay in taking decision on pricing of petro products eroded the profitability of oil marketing Companies in public

sector like Hindustan Petroleum Corporation Limited. Another example is the impact of US sub prime crisis on

certain segments of Indian economy.

The changes in international political scenario also affect the operations of certain firms.

5. Market Risk: Factors like inflation, changes in interest rates, and changing general economic conditions affect all

firms and all industries.

Firms cannot diversify this risk in the normal course of business.

Techniques used for incorporation of risk factor in capital budgeting decisions.

There are many techniques of incorporation of risk perceived in the evaluation of capital budgeting proposals. They

differ in their approach and methodology so far as incorporation of risk in the evaluation process is concerned.

Conventional techniques

Pay Back Period

The oldest and commonly used method of recognizing risk associated with a capital budgeting proposal is pay back

period. Under this method, shorter pay back period is given preference to longer ones.

For example, the following details are available in respect of two projects

Particulars

Project A (Rs)

Project B(Rs)

Initial cash outlay

10 lakhs

10 lakhs

Cash flows

Year 1

5 lakhs

2 lakhs

Year 2

Year 3

Year 4

3 lakhs

1 lakhs

1 lakhs

2 lakhs

3 lakhs

3 lakhs

Both the projects have a pay back period of 4 years. The project B is riskier than the Project A because Project A

recovers 80% of initial cash outlay in the first two years of its operation where as Project B generates higher Cash

inflows only in the latter half of the payback period.

This method considers only time related risks and ignores all other risk of the project under consideration.

Risk premium need to be incorporated in discount rate in the evaluation of risky project proposals.

Therefore the discount rate for appraisal of projects has two components.

Those components are

1. Risk free rate and risk premium

Risk adjusted Discount rate = Risk free rate + Risk premium

Risk free rate is computed based on the return on government securities.

Risk premium is the additional return that investors require as compensation for assuming the additional risk

associated with the project.

approval of projects.

Chapter 6 Capital Budgeting

6.9.2 Discounted pay back period

The length in years required to recover the initial cash out lay on the present value basis is called the discounted pay

back period. The opportunity cost of capital is used for calculating present values of cash inflows.

Discounted pay back period for a project will be always higher than simple pay back period because the calculation

of discounted pay back period is based on discounted cash flows.

For example:

Year

Project A

PV factor at

PV of Cash

Cumulative

Cash flows

10%

flows

positive Cash

flows

0

(4,00,000)

1

(4,00,000)

1

2,00,000

0.909

1,81,800

1,81,800

2

1,75,000

0.826

1,44,550

3,26,350

3

25,000

0.751

18,775

3,45,125

4

2,00,000

0.683

1,36,600

4,81,725

5

1,50,000

0.621

93,150

5,74,875

Discounted Pay back period:

3+ 4,00,0000-3,45,125

= 3.4 years

1,36,600

Accounting rate of returns:

ARR measures the profitability of investment (project) using information taken from financial statements:

ARR=

Average Income

Average investment

= Average of post-tax operating profit

Average investment

Average investment =

Book Value of the investment in the

beginning

the life of the project or investment

2

Illustration:

The following particular refer to two projects:X

Y

Cost

40,00.

60,000

Estimated life

5 years

5 years

Salvage value

Rs.3,000

Rs.3,000

Estimate income

After tax

1

2

3

4

5

Total

Average

Average

investment

Rs.

3,000

4,000

7,000

6,000

8,000

28,000

5,600

21,500

Rs.

10,000

8,000

2,000

6,000

5,000

31,000

6,200

31,500

ARR =

5,600

6,200

21,500

31,500

=

26%

19.7%

Merits of Accounting rate of return:

1. It is based on accounting information.

2. Simple to understand

3. It considers the profits of entire economic life of the project.

4. Since it based on accounting information the business executives familiar with the accounting information

understand this technique.

Demerits:

1. It is based on accounting income and not based on cash flows, as the cash flow approach is considered superior to

accounting information based approach.

2. It does not consider the time value of money.

3. Different investment proposals which require different amounts of investment may have the same accounting rate

of return. The ARR fails to differentiate projects on the basis of the amount required for investment.

4. ARR is based on the investment required for the project. There are many approaches for the calculation of

denominator of average investment. Existence of more than one basis for arriving at the denominator of average

investment may result in adoption of many arbitrary bases.

Because of this the reliability of ARR as a technique of appraisal is reduced when two projects with the same ARR

but with differing investment amounts are to be evaluated.

Accept or reject criterion:

Any project which has an ARR more the minimum rate fixed by the management is accepted. If actual ARR is less

than the cut rate (minimum rate specified by the management ) then that project is rejected. When projects are to be

ranked for deciding on the allocation of capital on account of the need for capital rationing, project with higher ARR

are preferred to the ones with lower ARR.

Discounted cash flow method:

Discounted cash flow method or time adjusted technique is an improvement over the traditional techniques. In

evaluation of the projects the need to give weightage to the timing of return is effectively considered in all DCF

methods. DCF methods are cash flow based and take the cognizance of both the interest factors and cash flow after

the pay back period.

DCF technique involves the following:

1. Estimation of cash flows, both inflows and outflows of a project over the entire life of the project.

2. Discounting the cash flows by an appropriate interest factor (discount factor).

3. Sum of the present value of cash outflow is deducted from the sum of present value of cash inflows to arrive at net

present value of cash flows.

The most popular techniques of DCF methods are:

DCF methods are 3 types:

1. The net present value.

2. The internal rate of return.

3. Profitability index.

The net present value:

NPV method recognizes the time value of money. It correctly admits that cash flows occurring at different time

periods differ in value. Therefore, there is the need to find out the present values of all cash flows.

NPV method is the most widely used technique among the DCF methods.

Steps involved in NPV method:

1. Forecast the cash flows, both inflows and outflows of the projects to be taken up for execution.

2. Decisions on discount factor or interest factor. The appropriate discount rate is the firm s cost of capital or

required rate of return expected by the investors.

3. Compute the present value of cash inflows and outflows using the discount factor selected.

4. NPV is calculated by subtracting the PV of cash outflows from the present value of cash inflows.

Accept or reject criterion:

If NPV is positive, the project should be accepted. If NPV is negative the project should be rejected.

Accept or reject criterion can be summarized as given below:

1. NPV > Zero = accept

2. NPV < Zero = reject

NPV method can be used to select between mutually exclusive projects by examining whether incremental

investment generates a positive net present value.

Merits of NPV method:

1. It takes into account the time value of money.

2. It considers cash flows occurring over the entire life of the project.

3. NPV method is consistent with the goal of maximizing the net wealth of the company.

4. It analyses the merits of relative capital investments.

5. Since cost of capital of the firm is the hurdle rate, the NPV ensures that the project generates profits from the

investment made for it.

Demerits:

1. Forecasting of cash flows is difficult as it involves dealing with effect of elements of uncertainties on operating

activities of firm.

2. To decide on the discounting factor, there is the need to assess the investor s required rate of return. But it is not

possible to compute the discount rate precisely.

3. There are partial problems associated with the evaluation of projects with unequal lives or under funds

constraints.

For ranking of projects under NPV approach the project with the highest positive NPV is preferred to that with lower

NPV.

Problem: A company is evaluating two alternatives for distribution within the plant. Two alternatives are

1. C system with a high initial cost but low annual operating costs.

2. F system which costs less but have considerably higher operating costs. The decision to construct the plant has

already been made, and the choice here will have no effect on the overall revenues of the project. The cost of capital

of the plant is 12% and the projects expected net cash costs are listed below:

Year

0

1

2

3

4

5

Expected Net

Cash Costs

C Systems

(3,00,000)

(66,000)

(66,000)

(66,000)

(66,000)

(66,000)

F Systems

(1,20,000)

(96,000)

(96,000)

(96,000)

(96,000)

(96,000)

Which method should be chosen?

Solution: Computation of present value

Year

C Systems

F Systems

1

(66,000)

(96,000)

2

(66,000)

(96,000)

3

(66,000)

(96,000)

4

(66,000)

(96,000)

5

(66,000)

(96,000)

Incremental

30,0000

30,0000

30,0000

30,0000

30,0000

= 30,000 x 3.605 = 1,08,150

Incremental cash out lay

= 1,80,000

(71,850)

Since the present value of incremental net cash inflows of C system over F system is negative. C system is not

recommended.

Therefore, F system is recommended.

Properties of the NPV

1. NPV are additive. If two projects A and B have NPV (A) and NPV(B) then by additive rule the net present value

of the combined investment is NPV(A + B).

2. Intermediate cash inflows are reinvested at a rate of return equal to the cost of capital.

Demerits of NPV:

1. NPV expresses the absolute positive or negative present value of net cash flows. Therefore, it fails to capture the

scale of investment.

2. In the application of NPV rule in the evaluation of mutually exclusive projects with different lives, bias occurs in

favour of the long term projects.

Internal Rate of Return: It is the rate of return (i.e. discount rate) which makes the NPV of any project equal to zero.

IRR is the rate of interest which equates the PV of cash inflows with the PV of cash flows.

IRR is also called yield on investment, managerial efficiency of capital, marginal productivity of capital, rate of

return, time adjusted rate of return, IRR is the rate of return that project earns.

Evaluation of IRR:

1. IRR takes into account the time value of money

2. IRR calculates the rate of return of the project, taking into account the cash flows over the entire life of the

project.

3. It gives a rate of return that reflects the profitability of the project.

4. It is consistent with the goal of financial management i.e. maximization of net wealth of share holders.

5. IRR can be compared with the firms cost of capital.

6. To calculate the NPV the discount rate normally used is cost of capital. But to calculate IRR, there is no need to

calculate and employ the cost of capital for discounting because the project is evaluated at the rate of return

generated by the project. The rate of return is internal to the project.

Demerits:

1. IRR does not satisfy the additive principle.

2. Multiple rates of return or absence of a unique rate of return in certain projects will affect the utility of this

techniques as a tool of decision making in project evaluation.

3. In project evaluation, the projects with the highest IRR are given preference to the ones with low internal rates.

Application of this criterion to mutually exclusive projects may lead under certain situations to acceptance of

projects of low profitability at the cost of high profitability projects.

4. IRR computation is quite tedious.

Accept or Reject Criterion:

If the projects internal rate of return is greater than the firm s cost of capital, accept the proposal. Otherwise reject

the proposal.

IRR can be determine by solving the following equation for r =

IRR is also called yield on investment, managerial efficiency of capital, marginal productivity of capital, rate of

return, time adjusted rate of return, IRR is the rate of return that project earns.

Evaluation of IRR:

1. IRR takes into account the time value of money

2. IRR calculates the rate of return of the project, taking into account the cash flows over the entire life of the

project.

3. It gives a rate of return that reflects the profitability of the project.

4. It is consistent with the goal of financial management i.e. maximization of net wealth of share holders.

5. IRR can be compared with the firms cost of capital.

6. To calculate the NPV the discount rate normally used is cost of capital. But to calculate IRR, there is no need to

calculate and employ the cost of capital for discounting because the project is evaluated at the rate of return

generated by the project. The rate of return is internal to the project.

Demerits:

1. IRR does not satisfy the additive principle.

2. Multiple rates of return or absence of a unique rate of return in certain projects will affect the utility of this

techniques as a tool of decision making in project evaluation.

3. In project evaluation, the projects with the highest IRR are given preference to the ones with low internal rates.

Application of this criterion to mutually exclusive projects may lead under certain situations to acceptance of

projects of low profitability at the cost of high profitability projects.

4. IRR computation is quite tedious.

If the projects internal rate of return is greater than the firm s cost of capital, accept the proposal. Otherwise reject

the proposal.

IRR can be determine by solving the following equation for r =

CF0 = _Ct

where t = 1 to n

(1+r)t

Example: A project requires an initial out lay of Rs.1,00,000. It is expected to generate the following cash inflows:

Year

Cash

inflows

1

50,000

2

50,000

3

30,000

4

40,000

What is the IRR of the project?

Step I

Compute the average of annual cash inflows

Year

Cash

inflows

1

50,000

2

50,000

3

30,000

4

40,000

Total

1,70,000

Average = 1,70,000 = Rs.42,500

4

Step II: Divide the initial investment by the average of annual cash inflows:

=1,00,000 = 2.35

42,500

Step III: From the PVIFA table for 4 years, the annuity factor very near 2.35 is 25%. Therefore the first

initial rate is 25%.

Year

Cash flows

PV factor at

PV of Cash

25%

flows

1

50,000

0.800

40,000

2

50,000

0.640

32,000

3

30,000

0.512

15,360

4

40,000

0.410

16,400

Total

1,03,760

Since the initial investment of Rs.1,00,000 is less than the computed value at 25% of Rs.1,03,760 the next

trial rate is 26%.

Year

Cash flows

PV factor at

PV of Cash

26%

flows

1

50,000

0.7937

39,685

2

50,000

0.6299

31,495

3

30,000

0.4999

14,997

4

40,000

0.3968

15,872

Total

1,02,049

The next trial rate is 27%

Year

Cash flows

1

2

3

4

Total

50,000

50,000

30,000

40,000

Year

Cash flows

1

2

3

4

Total

50,000

50,000

30,000

40,000

PV factor at

27%

0.7874

0.6200

0.4882

0.3844

1,00,392

PV of Cash

flows

39,370

31,000

14,646

15,376

PV factor at

28%

0.7813

0.6104

0.4768

0.3725

98,789

PV of Cash

flows

39,065

30,520

14,304

14,900

Since initial investment of Rs.1,00,000 lies between 98789 (28%) and 1,00,392 (27%) the IRR by

interpolation.

27+ 1,00,392-1,00,000 X1

1,00,392-98,789

27+ 392 X1

1603

= 27 + 0.2445

= 27.2445 = 27.24%

Modified Internal Rate of Return:

MIRR is a distinct improvement over the IRR. Managers find IRR intuitively more appealing than the rupees of

NPV because IRR is expressed on a percentage rates of return. MIRR modifies IRR. MIRR is a better indicator or

relative profitability of the projects.

MIRR is defined as

PV of Costs = PV of terminal value

PVC = TV

(1+MIRR)n

PVC = PV of costs

To calculate PVC, the discount rate used is the cost of capital.

To calculate the terminal value, the future value factor is based on the cost of capital.

Then obtain MIRR on solving the following equation.

PV of Costs =

TV

(1+MIRR)n

1. MIRR assumes that cash flows from the project are reinvested at the cost of capital. The IRR assumes that the

cash flows from the project are reinvested at the

projects own IRR. Since reinvestment at the cost of capital is considered realistic and correct, the MIRR measures

the projects true profitability.

2. MIRR does not have the problem of multiple rates which we come across in IRR.

Illustration:

Year

Cash

flows

(Rs.in

million)

0

(100)

1

(100)

2

30

3

60

4

90

5

120

6

130

Present value of cost = 100 + 100

1.12

= 100 + 89.29 = 189.29

Terminal value of cash flows:

= 30(1.12)4 + 60(1.12)3 + 90(1.12)2 + 120(1.12) + 130

= 30 x 1.5735 + 60 x 1.4049 + 90 x 1.2544 + 120 x 1.12 + 130

=47.205 + 84.294 + 112.896 + 134.4 + 130

= 508.80

MIRR is obtained on solving the following equation

189.29 =

508.80

(1+MIRR)6

(1+MIRR)6 = 508.80

189.29

(1+MIRR)6 = 2.6879

MIRR = 17.9%

Profitability Index : It is also known as Benefit cost ratio.

Profitability Index is the ratio of the present value of cash inflows to initial cash outlay. The discount factor

based on the required rate of return in used to discount the cash in flows

PI = Present value of cash inflows

Initial Cash outlay

Accept or Reject Criterion:

1. Accept the project if PI is greater than 1

2. Reject the project if PI is less than 1

If profitability index is 1 then the management may accept the project because the sum of the present value of cash

inflows is equal to the sum of present value of cash outflows. It neither adds nor reduces the existing wealth of the

company.

Merits of PI:

1. It takes into account the time value of money

2. It is consistent with the principle of maximization of share holders wealth.

3. It measures the relative profitability.

Demerits

1. Estimation of cash flows and discount rate cannot be done accurately with certainty.

2. A conflict may arise between NPV and profitability index if a choice between mutually exclusive projects has to

be made.

Example

X

PV of Cash

inflows

Initial cash

outlay

NPV

Profitability

Index

4,00,000

2,00,000

2,00,000

80,000

2,00,000

2

1,20,000

2.5

As per NPV method project X should be accepted. As per profitability index project Y should be accepted. This leads

to a conflicting situation. The NPV method is to be preferred to profitability index because the NPV represents the

net increase in the firms wealth.

6.10 Summary

Capital investment proposals involve current outlay of funds in the expectation of a stream of cash in flow in

future. Various techniques are available for evaluating investment projects. They are grouped into traditional

and modern techniques. The major traditional techniques are payback period and accounting rate of return.

The important discounting criteria are net present value, internal rate of return and profitability index. A

major deficiency of payback period is that it does not take into account the time value of money. DCF

techniques overcome this limitation. Each method has both positive and negative aspects. The most popular

method for large project is the internal rate of return. Payback period and accounting rate of return are

popular for evaluating small projects.

functional areas of finance

Chapter-1 Financial Management

1.4 Finance Functions

1.5 Interface Between Finance and Other Business Function

Finance functions are closely related to financial decisions. The functions performed by a finance manager are

known as finance functions. In this course of performing these functions finance manager takes the following

decisions:1. Financing decision

2. Investment decision

3. Dividend decision

4. Liquidity decision

To survive and grow, all organizations must be innovative. It could be expansion through entering into new markets,

adding new products to its product mix, performing value added activities to enhance the customer satisfaction, or

adopting new technology that would drastically reduce the cost of production.

If the management errs in any phase of taking these decisions and executing them, the firm may become bankrupt.

Therefore, such decisions will have to be taken after into account all facts affecting the decisions and their execution.

Two critical issues to be considered in decision are:1. Evaluation of expected profitability of the new investments.

2. Rate of return required on the project.

The rate of return required by investor is normally known by hurdle rate or cut-off rate or opportunity cost of capital.

After a firm takes a decision to enter into any business or expand it s exiting business, plans to invest in buildings,

machineries etc. are conceived and executed. The process involved is called Capital Budgeting. Capital Budgeting

decision demand considerable time, attention and energy of the management.

Financing decisions relate to the acquisition of funds at the least cost. Here cost has two dimension viz explicit cost

implicit cost.

Explicit cost refers to the cost in the form of coupon rate, cost of floating and issuing the securities etc.

Implicit cost is not a visible cost but it may seriously affect the company s operation especially when it is exposed to

business and financial risk. For example, implicit cost is the failure of the organization to pay to its lenders or

debenture holders loan installment on due date on account of fluctuations in cash flow attributable to the firms

business risk.

In all financing decisions a firm has to determine the proportion of equity and debt. The composition of dept and

equity is called the capital structure of the firm.

Dept is cheap because interest payable on loan is allowed as deductions in computing taxable income on which the

company is liable to pay income tax to the Government of India. For example, if the interest rate on loan taken is

12%, tax rate applicable to the company is 50%, then when the company pays Rs.12 as interest to the lender, taxable

income of the company will be reduced by Rs.12.

In other words when actual cost is 12% with the tax rate of 50% the effective cost becomes 6% therefore, dept is

cheap.

Another thing notable in this connection is that the firm cannot avoid its obligation to pay interest and loan

installments to its lenders.

Dividend yield is an important determinant of an investor s attitude towards the security (stock) in his

portfolio management decisions. But dividend yield is the result of dividend decision. Dividend decision is a

major decision made by a finance manager. It is the decision on formulation of dividend policy. Since the

goal of financial management is maximization of wealth of shareholders, dividend policy formulation

demands the managerial attention on the impact of its policy on dividend on the market value of the shares.

Optimum dividend policy requires decision on dividend payment rates so as to maximize the market value of shares.

The payout ratio means what portion of earning per share is given to the shareholders in the form of cash dividend.

In the formulation of dividend policy, management of a company must consider the relevance of its policy on bonus

shares.

Dividend policy influences the dividend yield on shares. Since company s rating in the Capital market have a major

impact on its ability to procure funds by issuing securities in the capital markets, dividend policy, a determinant of

dividend yield has to be formulated having regard to all the crucial element in building up the corporate image. The

following need adequate consideration in deciding on dividend policy:

1. Preference of share holders - Do they want cash dividend or Capital gains?

2. Current financial requirements of the company.

3. Legal constraints on paying dividends.

4. Striking an optimum balance between desires of share holders and the company s funds requirements.

Liquidity decisions are concerned with Working Capital Management. It is Concerned with the day to day

financial operation that involve current assets and current liabilities.

The important element of liquidity decisions are:

1. Formulation of inventory policy

2. Policies on receivable management.

3. Formulation of cash management strategies

4. Policies on utilization of spontaneous finance effectively.

Financial decision are strategic in character and therefore, an efficient organization structure is required to administer

the same. Finance is like blood that flows through out the organization. In all organization CFOs play an important

role in ensuring proper reporting based on substance to the stake holders of the company. Because of the crucial role

these functions play, finance function are organized directly under the control of Board of Directors. For the survival

of the firm, there is a need to ensure both long term and short term financial solvency. Failure to achieve this will

have its impact on all other activities of the firm.

Week function performance by financial department will weaken production, marketing and HR activities of the

company. The result would be the organization becoming anemic. Once anemic, unless crucial and effective

remedial measures are taken up, it will pave way for corporate bankruptcy.

CFO reports to the Board of Directors. Under CFO, normally two senior officers manage the treasurer and controller

functions.

A Treasurer performance the following function:

1. Obtaining finance.

2. Liasoning with term lending and other financial institutions.

3. Managing working capital.

4. Managing investment in real assets.

A Controller performs:

1. Accounting and Auditing

2. Management control systems

3. Taxation and insurance

4. Budgeting and performance evaluation

5. Maintaining assets intact to ensure higher productivity of operating capital employed in the organization.

1.5.1 Finance and Accounting

Looking at the hierarchy of the finance function of an organization, the controller reports to CFO. Accounting is one

of the functions that a controller discharges. Accounting and finance are closely related. For computation of Return

on Investment, earnings per share and of various ratio for financial analysis the data base will be accounting

information.

Many marketing decisions have financial implication. Selections of channels of distribution, deciding on

advertisement policy, remunerating the salesmen etc have financial implications.

Finance and operation are closely related. Decisions on plant layout, technology selection, productions / operations,

process plant size, removing imbalance in the flow of input material in the production / operation process and batch

size are all operations management decisions but their formulation and execution cannot be done unless evaluated

from the finance angle.

Attracting and retaining the best man power in the industry cannot be done unless they are paid salary at competitive

rates. If an organization formulates & implements a policy for attracting the competent man power it has to pay the

most competitive salary packages to them. But it improves organizational capital and productivity.

1.6 Summary

Financial Management is concerned with the procurement of the least cost funds and its effective

utilization for maximization of the net wealth of the firm. There exists a close relation between the

maximization of net wealth of shareholders and the maximization of the net wealth of the company. The

broad areas of decision are capital budgeting, financing, dividend and working capital. Dividend decision

demands the managerial attention to strike a balance between the investor s expectation and the

organizations growth.

Assignment B

1. What are the assumptions of MM(Modigliani Miller)

approach?

Chapter - 5 Capital Structure

5.4.3 Traditional Approach

5.4.4 Miller and Modigliani Approach

5.4.4.1 Criticisms of MM proposition

5.1 Introduction

The capital structure of a company refers to the mix of long-term finances used by the firm. In short, it is the

financing plan of the company. With the objective of maximizing the value of the equity shares, the choice should be

that pattern of using debt and equity in a proportion that will lead towards achievement of the firm's objective. The

Capital structure should add value to the firm. Financing mix decisions are investment decisions and have no impact

on the operating earnings of the firm. Such decisions influence the firm's value through the earnings available to the

shareholders.

The value of a firm is dependent on its expected future earnings and the required rate of return. The objective of any

company is to have an ideal mix of permanent sources of funds in a manner that will maximize the company's

market price. The proper mix of funds is referred to as Optimal Capital Structure.

The capital structure decisions include debt-equity mix and dividend decisions. Both these have an effect on the EPS.

Learning Objectives:

After studying this unit, you should be able to understand the following.

1. Explain the features of ideal capital structure.

2. Name the factors affecting the capital structure.

3. Mention the various theories of capital structure.

The Traditional Approach has the following propositions:

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.

Miller and Modigliani criticize that the cost of equity remains unaffected by leverage up to a reasonable limit and Ko

being constant at all degrees of leverage. They state that the relationship between leverage and cost of capital is

elucidated as in NOI approach. The assumptions for their analysis are:

Perfect capital markets: Securities can be freely traded, that is, investors are free to buy and sell securities (both

shares and debt instruments), there are no hindrances on the borrowings, no presence of transaction costs, securities

infinitely divisible, availability of all required information at all times.

Investors behave rationa1ly, that is, they choose that combination of risk and return that is most advantageous to

them.

Homogeneity of investors risk perception, that is, all investors have the same perception of business risk and returns.

Taxes: There is no corporate or personal income tax.

Dividend pay-out is 100%, that is, the firms do not retain earnings for future activities.

Basic propositions: The following three propositions can be derived based on the above assumptions:

Proposition I: The market value of the firm is equal to the total market value of equity and total market value of

debt and is independent of the degree of leverage. It can be expressed as:

Expected NOI

Expected overall capitalization rate

V + (S+D) which is equal to O/Ko which is equal to NOI/Ko

V + (S+D) = O/Ko = NOI/Ko

Where V is the market value of the firm,

S is the market value of the firm's equity,

D is the market value of the debt,

O is the net operating income,

Ko is the capitalization rate of the risk class of the firm.

The basic argument for proposition I is that equilibrium is restored in the market by the arbitrage mechanism.

Arbitrage is the process of buying a security at lower price in one market and selling it in another market at a higher

price bringing about equilibrium. This is a balancing act. Miller and Modigliani perceive that the investors of a firm

whose value is higher will sell their shares and in return buy shares of the firm whose value is lower. They will earn

the same return at lower outlay and lower perceived risk. Such behaviours are expected to increase the share prices

whose shares are being purchased and lowering the share prices of those share which are being sold. This switching

operation will continue till the market prices of identical firms become identical.

Proposition II: The expected yield on equity is equal to discount rate (capitalization rate) applicable plus a

premium.

Ke = Ko +[(Ko-Kd)D/S]

Proposition III: The average cost of capital is not affected by the financing decisions as investment and financing

decisions are independent.

Risk perception: The assumption that risks are similar is wrong and the risk perceptions of investors are personal

and corporate leverage is different. The presence of limited liability of firms in contrast to unlimited liability of

individuals puts firms and investors on a different footing. All investors lose if a levered firm becomes bankrupt but

an investor loses not only his shares in a company but would also be liable to repay the money he borrowed.

Arbitrage process is one way of reducing risks. It is more risky to create personal leverage and invest in unlevered

firm than investing in levered firms.

Convenience: Investors find personal leverage inconvenient. This is so because it is the firm's responsibility to

observe corporate formalities and procedures whereas it is the investor's responsibility to take care of personal

leverage. Investors prefer the former rather than taking on the responsibility and thus the perfect substitutability is

subject to question.

Transaction costs: Another cost that interferes in the system of balancing with arbitrage process is the presence of

transaction costs. Due to the 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 to

explain the financing decision and firm's value.

Agency costs: A firm requiring loan approach creditors and creditors may sometimes impose protective covenants to

protect their positions. Such restriction may be in the nature of obtaining prior approval of creditors for further loans,

appointment of key persons, restriction on dividend pay-outs, limiting further issue of capital, limiting new

investments or expansion schemes etc.

5.5 Summary

According to the NI Approach, overall cost of capital continuously decreases as and when debt goes up in the capital

structure. Optimal capital structure exists when the firm borrows maximum.

NOI Approach believes that capital structure is not relevant. Ko is dependent business risk which is assumed to be

constant.

Traditional Approach tells us that Ko decreases with leverage in the beginning, reaches its maximum point and

further increases.

Miller and Modigliani Approach also believe that capital structure is not relevant.

12.4 Miller and Modigliani Model

The MM hypothesis seeks to explain that a firm's dividend policy is irrelevant and has no effect on the share prices

of the firm. This model advocates that it is the investment policy through which the firm can increase its share value

and hence this should be given more importance.

Assumptions

Existence of perfect capital markets: All investors are rational and have access to all information free of cost.

There are no floatation or transaction costs, securities are infinitely divisible and no single investor is large enough to

influence the share value.

No taxes: There are no taxes, implying there is no difference between capital gains and dividends.

Constant investment policy: The investment policy of the company does not change. The implication is that there

is no change in the business risk position and the rate of return.

No Risk - Certainty about future investments, dividends and profits of the firm. This assumption was, however,

dropped at a later stage.

Based on the above assumptions, Miller and Modigliani have explained the irrelevance of dividend as the crux of the

arbitrage argument. The arbitrage process refers to setting off or balancing two transactions which are entered into

simultaneously. The two transactions are paying out dividends and raising external funds to finance additional

investment programs. If the firm pays out dividend, it will have to raise capital by selling new shares for financing

activities. The arbitrage process will neutralize the increase in share value (due to dividends) with the issue of new

shares. This makes the investor indifferent to dividend earnings and capital gains as the share value is more

dependent on the future earnings of the firm than on its current dividend policy.

Symbolically, the model is given as:

Step I: The market price of a share in the beginning is equal to the PVof dividends paid and market price at the end

of the period.

P0 =

1*

(D1 + P1)

(1 + Ke)

Where P0 is the current market price,

P1 is market price at the end of period 1,

D1 is dividends to be paid at the end of period 1,

Ke is the cost of equity capital.

Step II: Assuming there is no external financing, the value of the firm is:

nP0 =

1*

(nD1 + nP1)

(1 + Ke)

Where n is number of shares outstanding.

Step III: If the firm's internal sources of financing its investment opportunities fall short of funds required, new

shares are issued at the end of year 1 at price P1. The capitalized value of the dividends to be received during the

period plus the value of the number of shares outstanding is less than the value of new shares.

nP0 = =

1*

(nD1 + (n + n1)P1 - n1p1)

(1 + Ke)

Firms will have to raise additional capital to fund their investment requirements after utilizing their retained

earnings, that is,

n1P1 = 1- (E - nD1) which can be written as n1P1 = 1- E + nD1

Where I is total investment required,

nD1 is total dividends paid,

E is earnings during the period,

(E - nD1) is retained earnings.

Step IV: The value of share is thus:

nP0 = =

1*

(nD1 + (n + n1) P1 -I + E - nD1)

(1 + Ke)

Example:

A company has a capitalization rate of 10%. It currently has outstanding shares worth 25000 shares selling currently

at Rs. 100 each. The firm expects to have a net income of Rs. 400000 for the current financial year and it is

contemplating to pay a dividend of Rs. 4 per share. The company also requires Rs. 600000 to fund its investment

requirement. Show that under MM model, the dividend payment does not affect the value of the firm.

Solution:

Case I: When dividends are paid:

Step I: P0 =

1 * (D1 + P1)

(1 + Ke)

100 = 1/(1+0.1) * (4 + P1)

P1 = Rs. 106

Step II: n1P1 = 1-(E-nD1), nD1 is 25000*4

n1P1 = 600000 - (400000 - 100000) = Rs. 300000

Step III: Number of additional shares to be issued 300000/106 = 2831 shares

Step IV: The firm value

(n+n1) P1-I+E

nP0 = =

(1 + Ke)

(25000 + 2831) * 106600000 + 400000 equals Rs. 2500000

(1 + Ke)

Case II: When dividends are not paid:

Step I: PO =

1*

(01 + P1)

(1 + Ke)

100= 1/(1+0.1)*(O+P1)

P1 = Rs. 110

Step II: n1P1 = 1- (E - nD1), nD1 is 25000*4

n1 P1 = 600000 - (400000 - 0) = Rs. 200000

Step III: Number of additional shares to be issued

200000/110 = 1819 shares

Step IV: The firm value

nPO = = (n+n1)P1-I+E

(1 + Ke)

(25000 + 2831) * 106600000 + 400000 equals Rs. 2500000

(1 + 0.1)

Thus, the value of the firm remains the same in both the cases whether or not dividends are declared.

Critical Analysis of MM Hypothesis:

Floatation costs: Miller and Modigliani have assumed the absence of floatation costs. Floatation costs refer to the

cost involved in raising capital from the market, that is, the costs incurred towards underwriting commission,

brokerage and other costs. These costs ordinarily account to around 10%-15% of the total issue and they cannot be

ignored given the enormity of these costs. The presence of these costs affects the balancing nature of retained

earnings and external financing. External financing is definitely costlier than retained earnings. For instance, if a

share is issued worth Rs. 100 and floatation costs are 12%, the net proceeds are only Rs.88.

Transaction costs: This is another assumption made by MM that there are no transaction costs like brokerage

involved in capital market. These are the costs associated with sale of securities by investors. This theory implies that

if the company does not pay dividends, the investors desirous of current income sell part of their holdings without

any cost incurred. This is very unrealistic as the sale of securities involves cost, investors wishing to get current

income should sell higher number of shares to get the income they are to receive.

Under-pricing of shares: If the company has to raise funds from the market, it should sell shares at a price lesser

than the prevailing market price to attract new shareholders. This follows that at lower prices, the firm should sell

more shares to replace the dividend amount.

Market conditions: If the market conditions are bad and the firm has some lucrative opportunities, it is not worthapproaching new investors at this juncture, given the presence of floatation costs. In such cases, the firms should

depend on retained earnings and low pay-out ratio to fuel such opportunities.

technique.

Chapter 6 Capital Budgeting

Structure:

6.1 Introduction

Objective

6.2 Importance of Capital budgeting

6.3 Complexities involved in Capital Budgeting Decisions

6.4 Phases of Capital Expenditure Decisions

6.5 Identification of Investment Opportunities

6.6 Rationale of Capital Budgeting Proposals

6.7 Capital Budgeting Process

6.7.1 Technical Appraisal

6.7.2 Economic Appraisal

6.8 Investment Evaluation

6.9 Appraisal criteria

6.9.1 Traditional Techniques

6.9.2 Discounted pay back period

The length in years required to recover the initial cash out lay on the present value basis is called the discounted pay

back period. The opportunity cost of capital is used for calculating present values of cash inflows.

Discounted pay back period for a project will be always higher than simple pay back period because the calculation

of discounted pay back period is based on discounted cash flows.

Discounted cash flow method:

Discounted cash flow method or time adjusted technique is an improvement over the traditional techniques. In

evaluation of the projects the need to give weightage to the timing of return is effectively considered in all DCF

methods. DCF methods are cash flow based and take the cognizance of both the interest factors and cash flow after

the pay back period.

DCF technique involves the following:

1. Estimation of cash flows, both inflows and outflows of a project over the entire life of the project.

2. Discounting the cash flows by an appropriate interest factor (discount factor).

3. Sum of the present value of cash outflow is deducted from the sum of present value of cash inflows to arrive at net

present value of cash flows.

The most popular techniques of DCF methods are:

DCF methods are 3 types:

1. The net present value.

2. The internal rate of return.

3. Profitability index.

The net present value:

NPV method recognizes the time value of money. It correctly admits that cash flows occurring at different time

periods differ in value. Therefore, there is the need to find out the present values of all cash flows.

NPV method is the most widely used technique among the DCF methods.

Steps involved in NPV method:

1. Forecast the cash flows, both inflows and outflows of the projects to be taken up for execution.

2. Decisions on discount factor or interest factor. The appropriate discount rate is the firm s cost of capital or

required rate of return expected by the investors.

3. Compute the present value of cash inflows and outflows using the discount factor selected.

4. NPV is calculated by subtracting the PV of cash outflows from the present value of cash inflows.

Accept or reject criterion:

If NPV is positive, the project should be accepted. If NPV is negative the project should be rejected.

Accept or reject criterion can be summarized as given below:

1. NPV > Zero = accept

2. NPV < Zero = reject

NPV method can be used to select between mutually exclusive projects by examining whether incremental

investment generates a positive net present value.

Merits of NPV method:

1. It takes into account the time value of money.

2. It considers cash flows occurring over the entire life of the project.

3. NPV method is consistent with the goal of maximizing the net wealth of the company.

4. It analyses the merits of relative capital investments.

5. Since cost of capital of the firm is the hurdle rate, the NPV ensures that the project generates profits from the

investment made for it.

Demerits:

1. Forecasting of cash flows is difficult as it involves dealing with effect of elements of uncertainties on operating

activities of firm.

2. To decide on the discounting factor, there is the need to assess the investor s required rate of return. But it is not

possible to compute the discount rate precisely.

3. There are partial problems associated with the evaluation of projects with unequal lives or under funds

constraints.

For ranking of projects under NPV approach the project with the highest positive NPV is preferred to that with lower

NPV.

Problem: A company is evaluating two alternatives for distribution within the plant. Two alternatives are

1. C system with a high initial cost but low annual operating costs.

2. F system which costs less but have considerably higher operating costs. The decision to construct the plant has

already been made, and the choice here will have no effect on the overall revenues of the project. The cost of capital

of the plant is 12% and the projects expected net cash costs are listed below:

Year

Expected Net Cash

Costs

C Systems

F Systems

0

(3,00,000)

(1,20,000)

1

(66,000)

(96,000)

2

(66,000)

(96,000)

3

(66,000)

(96,000)

4

(66,000)

(96,000)

5

(66,000)

(96,000)

What is present value of costs of each alternative?

Which method should be chosen?

Solution: Computation of present value

Year

C Systems

F Systems

1

(66,000)

(96,000)

2

(66,000)

(96,000)

3

(66,000)

(96,000)

4

(66,000)

(96,000)

5

(66,000)

(96,000)

Incremental

30,0000

30,0000

30,0000

30,0000

30,0000

= 30,000 x 3.605 = 1,08,150

Incremental cash out lay = 1,80,000

(71,850)

Since the present value of incremental net cash inflows of C system over F system is negative. C system is not

recommended.

Therefore, F system is recommended.

Properties of the NPV

1. NPV are additive. If two projects A and B have NPV (A) and NPV(B) then by additive rule the net present value

of the combined investment is NPV(A + B).

2. Intermediate cash inflows are reinvested at a rate of return equal to the cost of capital.

Demerits of NPV:

1. NPV expresses the absolute positive or negative present value of net cash flows. Therefore, it fails to capture the

scale of investment.

2. In the application of NPV rule in the evaluation of mutually exclusive projects with different lives, bias occurs in

favour of the long term projects.

Internal Rate of Return: It is the rate of return (i.e. discount rate) which makes the NPV of any project equal to zero.

IRR is the rate of interest which equates the PV of cash inflows with the PV of cash flows.

IRR is also called yield on investment, managerial efficiency of capital, marginal productivity of capital, rate of

return, time adjusted rate of return, IRR is the rate of return that project earns.

6.10 Summary

Capital investment proposals involve current outlay of funds in the expectation of a stream of cash in flow in future.

Various techniques are available for evaluating investment projects. They are grouped into traditional and modern

techniques. The major traditional techniques are payback period and accounting rate of return. The important

discounting criteria are net present value, internal rate of return and profitability index. A major deficiency of

payback period is that it does not take into account the time value of money. DCF techniques overcome this

limitation. Each method has both positive and negative aspects. The most popular method for large project is the

internal rate of return. Payback period and accounting rate of return are popular for evaluating small projects.

7.1 Introduction

In the previous chapter on capital budgeting the project appraisal techniques were applied on the assumption that the

project will generate a given set of cash flows.

It is quite obvious that one of the limitations of DCF techniques is the difficulty in estimating cash flows with certain

degree of certainty. Certain projects when taken up by the firm will change the business risk complexion of the firm.

This business risk complexion of the firm influences the required rate of return of the investors. Suppliers of capital

to the firm tend to be risk averse and the acceptance of a project that changes the risk profile of the firm may change

their perception of required rates of return for investing in firm s project. Generally the projects that generate high

returns are risky. This will naturally alter the business risk of the firm. Because of this high risk perception associated

with the new project a firm is forced to asses the impact of the risk on the firm s cash flows and the discount factor

to be employed in the process of evaluation.

Definition of Risk: Risk may be defined as the variation of actual cash flows from the expected cash flows.

There are many factors that affect forecasts of investment, cost and revenue.

1. The business is affected by changes in political situations, monetary policies, taxation, interest rates, policies of

the central bank of the country on lending by banks etc.

2. Industry specific factors influence the demand for the products of the industry to which the firm belongs.

3. Company specific factors like change in management, wage negotiation with the workers, strikes or lockouts

affect companys cost and revenue position.

Therefore, risk analysis in capital budgeting is part and parcel of enterprise risk management. The best business

decision may not yield the desired results because the uncertain conditions likely to emerge in future can materially

alter the fortunes of the company.

Learning Objectives:

After studying this unit, you should be able to understand the following:

1. Define risk in capital budgeting.

2. Examine the importance of risk analysis in capital budgeting.

3. Methods of incorporating the risk factor in capital budgeting decision.

4. Understand the types and sources of risk in capital budgeting decision.

Chapter 7 Risk Analysis in Capital Budgeting

Structure:

7.1 Introduction

Objectives

7.2 Types and sources of Risk in Capital Budgeting

7.3 Risk Adjusted Discount Rate

7.4 Certainty Equivalent

7.5 Sensitivity Analysis

7.6 Probability Distribution Approach

7.7 Decision tree approach

7.8 Summary

7.2 Types and sources of Risk in Capital Budgeting

Learning Objectives:

After studying this unit, you should be able to understand the following:

1. Define risk in capital budgeting.

2. Examine the importance of risk analysis in capital budgeting.

3. Methods of incorporating the risk factor in capital budgeting decision.

4. Understand the types and sources of risk in capital budgeting decision.

Risks in a project are many. It is possible to identify three separate and distinct types of risk in any project.

1. Stand alone risk: it is measured by the variability of expected returns of the project.

2. Portfolio risk: A firm can be viewed as portfolio of project having a certain degree of risk. When new project is

added to the existing portfolio of project, the risk profile of firm will alter. The degree of the change in the risk

depends on the covariance of return from the new project and the return from the existing portfolio of the projects. If

the return from the new project is negatively correlated with the return from portfolio, the risk of the firm will be

further diversified away.

3. Market or beta risk: It is measured by the effect of the project on the beta of the firm. The market risk for a

project is difficult to estimate.

Stand alone risk is the risk of project when the project is considered in isolation. Corporate risk is the projects risks

of the firm. Market risk is systematic risk. The market risk is the most important risk because of the direct influence

it has on stock prices.

Sources of risk: The sources of risks are

1. Project specific risk

2. Competitive or Competition risk

4. International risk

5. Market risk

1. Project specific risk: The source of this risk could be traced to something quite specific to the project.

Managerial deficiencies or error in estimation of cash flows or discount rate may lead to a situation of actual cash

flows realised being less than that projected.

2. Competitive risk or Competition risk: unanticipated actions of a firms competitors will materially affect the

cash flows expected from a project. Because of this the actual cash flows a project will be less than that of the

forecast.

3. Industry specific: industry specific risks are those that affect all the firms in industry. It could be again

grouped into technological risk, commodity risk and legal risk.

4. International Risk: These types of risks are faced by firms whose business consists mainly of exports or those

who procure their main raw material from international markets. For example, rupee dollar crisis affected the

software and BPOs because it drastically reduced their profitability. Another best example is that of the textile units

in Tirupur in Tamilnadu, exporting their major part of garments produced. Rupee gaining and dollar Weakening

reduced their competitiveness in the global markets. The surging Crude oil prices coupled with the governments

delay in taking decision on pricing of petro products eroded the profitability of oil marketing Companies in public

sector like Hindustan Petroleum Corporation Limited. Another example is the impact of US sub prime crisis on

certain segments of Indian economy.

The changes in international political scenario also affect the operations of certain firms.

5. Market Risk: Factors like inflation, changes in interest rates, and changing general economic conditions affect all

firms and all industries.

Firms cannot diversify this risk in the normal course of business.

Techniques used for incorporation of risk factor in capital budgeting decisions.

There are many techniques of incorporation of risk perceived in the evaluation of capital budgeting proposals. They

differ in their approach and methodology so far as incorporation of risk in the evaluation process is concerned.

Conventional techniques

Pay Back Period

The oldest and commonly used method of recognizing risk associated with a capital budgeting proposal is pay back

period. Under this method, shorter pay back period is given preference to longer ones.

For example, the following details are available in respect of two projects.

Particulars

Project A (Rs)

Project B(Rs)

Initial cash outlay

10 lakhs

10 lakhs

Cash flows

Year 1

5 lakhs

2 lakhs

Year 2

3 lakhs

2 lakhs

Year 3

1 lakhs

3 lakhs

Year 4

1 lakhs

3 lakhs

Both the projects have a pay back period of 4 years. The project B is riskier than the Project A because Project A

recovers 80% of initial cash outlay in the first two years of its operation where as Project B generates higher Cash

inflows only in the latter half of the payback period.

This method considers only time related risks and ignores all other risk of the project under consideration.

Risk premium need to be incorporated in discount rate in the evaluation of risky project proposals.

Therefore the discount rate for appraisal of projects has two components.

Those components are

1. Risk free rate and risk premium

Risk adjusted Discount rate = Risk free rate + Risk premium

Risk free rate is computed based on the return on government securities.

Risk premium is the additional return that investors require as compensation for assuming the additional risk

associated with the project.

7.8 Summary

Risk in project evaluation arises on account of the inability of the firm to predict the performance of the firm with

certainty. Risk in capital budgeting decision may be defined as the variability of actual return from the expected.

There are many factors that affect forecasts of investment, costs and revenues of a project. It is possible to identify

three types of risk in any project, viz stand alone risk, corporate risk and market risk. The sources of risks are:

a. Project

b. Competition

c. Industry

d. International factors and

e. Market

The techniques for incorporation of risk factor in capital budgeting decision could be grouped into conventional

techniques and statistical techniques.

4.(a) Deepak steel has issued non convertible debentures for Rs.5 Cr. Each

debenture is of par value of Rs.100, carrying a coupon rate of 14%, interest is

payable annually and they are redeemable after 7yrs at a premium of 5 %. The

company issued the Non convertible debentures at a discount of 3 %. What is the

cost of debenture to the company? Tax rate is 40%.

(b) Supersonic Industries Ltd. has entered into an agreement with Indian Overseas

bank for a loan of Rs.10Cr. with an interest rate of 10%. What is the cost of loan if

the tax rate is 45%?

Assignment 3

(40 MCQs)

1. We all live under conditions of ____________ and _______________.

a) Risk, return

b) Risk, uncertainty

c) Return, premium

d) Uncertainty, premium

2. Find the present value of Rs.1,00,000 receivable after 10 yrs.if 10% is time preference for money.

a)

38400

b)

38500

c)

38600

d)

38700

3 What is the future value of a regular annuity of Re.1 earning a rate of 12% interest p.a. for 5 Years?

a)

5.353

b)

6.353

c)

7.353

d)

7.153

4.If a borrower promises to pay Rs.20000 eight years from now in return for a loan of Rs.12550 today,

what is the annual interest being offered?

a)

6% approx

b)

7% approx

c)

8% approx

d)

9% approx

5.A loan of Rs.5,00,000 is to be repaid in 10 equal instalments. If the loan carries

12% interest p.a.. What is the value of one installment?

a)

68492

b)

78492

c)

88492

d)

98492

6 If you deposite Rs.10,000 today in a bank that offers 8% interest, in how many years will this amount

double by 72 rule?

a)

9

b)

8

c)

7

d)

6

7 An employee of a bank deposits Rs.30,000 into his FD A/c at the end of each year for 20 yrs. What is

the amount he will accumulate in his FD at the end of 20 years, if the rate of interest is 9%.

a) 1534800

b) 1535000

c) 1535200

d) 1535400

8 ____________ decisions could be grouped into two categories.

a) Make or buy

b) Capital budgeting

c) Fixed capital

d) Working capital

9._____________ and revenue generation are the two important categories of capital budgeting.

a) Cost reduction

b) Production

c) Investment

d) dividend

10._________ appraisal examines the project from the social point of view.

a) Financial

b) Cost

c) Economic

d) Technical

11.All technical aspects of the implementation of the project are considered in ______ appraisal.

a) Financial

b) Cost

c) Economic

d) Technical

a) Financial viability

b) Cost viability

c) Economic viability

d) Technical viability

13.Among the elements that are to be examined under commercial appraisal, the most crucial one is the

__________.

a) Supply of the product

b) Demand for the product

c) Cost of the product

d) Elements of cost

14. Formulating is the third step in the evaluation of investment proposal.

a) No

b) Yes

15. A __________ is not a relevant cost for the project decision.

a) Sunk cost

b) Direct cost

c) Indirect cost

d) Works cost

16. Effect of a project on the working of other parts of a firm is known as __________.

a) Separation principal

b) Formulation

c) Externalities

d) After effects

17.The essence of separation principal is the necessity to treat __________elements of a project

separately from that of ___________ elements.

a) Production, operations

b) Financing, production

c) Investment, financing

d) Investment, production

18. Payback period ______________ time vlue of money.

a) Ignores

b) Considers

c) None of the above

19. IRR gives a rate of return that reflects the ______________ of the project.

a) Cost

b) Profitability

c) Cash inflows

d) Cash outflows

20. The methods of appraising an investment proposal can be grouped into _____ methods and

___________ methods.

a) Traditional, modern

b) Primary, secondary

c) First, second

d) old, new

21.The time gap between acquisition of resources from suppliers and collection of

customers is known as ________.

a) Financial year

cash from

b) Calendar year

c) Operating cycle

d) Current cycle

22.__________ is the average length of time required to produce and sell the

product .

a) Inventory period

b) Stock cycle

c) Inventory conversion period

d) None of the above

23. __________ is the average length of time required to convert the firms receivables into cash.

a) Receivables period

b) Receivables cycle

c) Receivables conversion period

d) None of the above

24. ______________ is length of time between firms actual cash expenditure and

its own receipt.

a) Cash conversion period

b) Cash cycle

c) Cash period

d) Cash and bank cycle

25. Capital intensive industries require ____________ amount of working capital.

a) Lower

b) Medium

c) Higher

d) None of the above

26. There is a ______________ between volume of sales and the size of working

capital of a firm.

a) Positive direct correlation

b) Negative direct correlation

c) Negative indirect correlation

d) Positive indirect correlation

27.Under inflationing conditions same level of inventory will require ____________ investment in

working capital.

a) Decreased

b) Increased

c) Same

d) zero

28. Longer the manufacturing cycle ______ the investment in working capital.

a) Larger

b) smaller

29. ____________ is used to estimate working capital requirement of a firm.

a) Trend analysis

b) Risk analysis

c) Capital rationing

d) Operating cycle

30. Operating cycle approach is based on the assumption that production and sales occur on

____________.

a) Continuous basis

b) Alternate basis

c) Alternate & Continuous basis

d) None of the above

31. ____________ is considered to be superior to RADR.

a) IRR

b) NPV

c) CE

D) PI

32. ____________ analyse the changes in the project NPV on account of a given change in one of the

input variables of the project.

a) Sensitivity analysis

b) Profitability Index

c) Project evaluation

d) Risk analysis

33.Examining and defining the mathematical relation between the variable of the NPV is one of the

steps of _____________.

a) Sensitivity analysis

b) Profitability Index

c) Project evaluation

d) Risk analysis

34.Forecasts under Sensitivity analysis are made under different ____________.

a) Political conditions

b) Economic conditions

c) Industry conditions

d) Regional conditions

35. Receiving a required inventory item at the exact time needed.

a) ABC

b) JIT

c) FOB

d) PERT

36. Post completion audit is ____________ in the phases of capital budgeting decisions.

a) First Step

b) Last step

c) Middle step

d) None of the above

37. Why is a discount rate used to calculate net present value?

a) Money has value

b) Money has enhancing value

c) Money has diminishing value

d) Money has constant value

38. What does net present value give?

a) future values of present cash flows

b) present value of present cash flow

c) present value of future cash flows

d) future values of future cash flows

39.Of what is sinking fund an example of ?

a) Perpetuity

b) Annuity

c) Gratuity

d) None of the above

40. What stream of cash flows continues indefinitely?

a) Perpetuity,

b) Annuity

c) Futurity

d) None of the above

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