Sie sind auf Seite 1von 33

Amity Campus

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)

Total weightage given to these assignments is 30%. OR 30 Marks


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

_________________________________

( ) Tick mark in front of the assignments submitted


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.

12.7 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.

5.4.2 Net Operating Income Approach


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.

2. Discuss the techniques of inventory control.


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.

10.3.1 Determination of Stock Levels


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:

EOO = 2DK = 2 x 50000 x 20


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

10.3.2 Pricing of inventories


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.

3. Examine risk adjusted discount rate as a technique of


incorporating risk factor in capital budgeting.
Chapter 7 Risk Analysis in Capital Budgeting

7.2 Types and sources of Risk 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.

7.3 Risk Adjusted Discount Rate


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.

4.Critically examine the pay back period as a technique of


approval of projects.
Chapter 6 Capital Budgeting
6.9.2 Discounted pay back period

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

+ Book value of investment at the end of


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)

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

Present value of incremental savings = 30,000 x PVIFA(12%, 5)


= 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.

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 =
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

The next trial rate is 28%


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

Superiority of MIRR over IRR


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

Cost of Capital is 12%


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.

5.Examine the relationship of financial management with other


functional areas of finance
Chapter-1 Financial Management
1.4 Finance Functions
1.5 Interface Between Finance and Other Business Function

1.4 Finance Functions


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

1.4.1 Investment Decisions


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.

1.4.2 Financing Decisions


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.

1.4.3 Dividend Decisions


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.

1.4.4 Liquidity Decision


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.

1.4.5 Organization of Finance Function

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 Interface between Finance and Other Business Functions


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.

1.5.2 Finance and Marketing


Many marketing decisions have financial implication. Selections of channels of distribution, deciding on
advertisement policy, remunerating the salesmen etc have financial implications.

1.5.3 Finance and Production (Operations)


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.

1.5.4 Finance and HR


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.

5.4.3 Traditional Approach:


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.

5.4.4 Miller and Modigliani Approach


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.

5.4.4.1 Criticisms of MM Proposition


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.

Chapter - 12 Dividend Decision


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.

2. Summaries the features of DCF(Discounted cash flow)


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

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

Present value of incremental savings = 30,000 x PVIFA(12%, 5)


= 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.

3. Examine the type and sources of risk in capital budgeting.


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.

7.2 Types and sources of Risk 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
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.

7.3 Risk Adjusted Discount Rate


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

12.__________ of a project is examined by financial appraisal.


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