Capital Budgeting

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Capital budgeting

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What Is Capital Budgeting?
Capital budgeting is the process of planning and taking decisions regarding the long-
term investments of the company in fixed assets. Such long-term investments are
called as capital investments and the amount spent for such long-term investments
is called as capital expenditure. By doing capital budgeting it can be determined
whether the potential long-term investment projects of the company are worth
pursuing or not. Capital budgeting is also called as investment appraisal.
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Importance Of Capital Budgeting:-
Capital budgeting decisions are very crucial for a company because of the following
reasons:-
Capital budgeting decisions have long-term implications on the operations of the

company and may affect the long-term survival of the company in case of a
wrong decision.
Capital investments involve commitment of large amount of funds which remain
blocked for a long period of time and so it is necessary to take decisions of capital
investments very carefully by doing capital budgeting.
Capital budgeting decisions are mostly irreversible because it is very difficult to
find a market for the capital goods. The only alternative is to scrap the assets and
incur heavy loss.
The company has many capital investment proposals which can be undertaken.
Capital budgeting helps in deciding which proposal or proposals are beneficial
and should be undertaken by the company.
Capital budgeting decisions have a major effect on the value of the firm and the
wealth of its shareholders. Correct capital budgeting decisions enhance the value
of the firm and maximizes the shareholders wealth.
Classification Of Capital Investment Projects:-
Capital investment projects can be classified into four types:-
(1) Replacement Projects:-
Existing fixed assets of the company are replaced with similar fixed assets on
account of them being worn out or becoming out-dated because of new inventions.
(2) Expansion Projects:-
The company expands its business by increasing the current operations to a larger
scale like increasing the production capacity to produce more products because of
high demand.
(3) Diversification projects:-
The company diversifies its business by starting a new product line different from
the existing one or enters into new markets to reduce risk.
(4) Mandatory projects:-
The company has to compulsorily undertake such projects as required by the

government and are usually related to safety or environment which do not directly
result into profits.
Capital Investment Projects May be

Independent Projects Or Mutually
Exclusive Projects:-
Independent projects are unrelated and are not dependent on each other.
Independent projects are the projects that do not compete with each other in such a
way that the acceptance of one rejects the others. Accepting or rejecting one project
does not affect the decision on other projects. All the independent projects can be
accepted if they meet the investment criteria and can be pursued simultaneously.
Mutually exclusive projects are related to each other. They compete with each other
in such a way that the acceptance of one rejects the others. Accepting or rejecting
one project affects the decision on other projects. Only one project can be accepted
which is the most profitable among the other alternative projects which meet the
investment criteria. So mutually exclusive projects cannot be pursued
simultaneously.
Capital Budgeting Techniques:-
There are various techniques or methods used in capital budgeting to evaluate the
capital investment proposals. These techniques can be divided into two heads:-
(A) Non-discounting techniques
(B) Discounting techniques
(A) Non-Discounting Techniques:-
Non-discounting methods do not consider the time value of money. There are two
non-discounting techniques used in capital budgeting which are as under:-
( 1 ) PAY BAC K P E R IOD :-
Payback period is the period within which the cost of capital investment would be
completely recovered. It indicates the number of years required to recover the
initial investment in the project from the future cash inflows generated by the
project.
The payback period in case of the project generating equal cash inflows annually is
calculated as:-
payback period = initial investment in project annual cash inflows of project

The payback period in case of the project generating unequal cash inflows annually
is calculated by adding up the cash inflows till the total is equal to the initial
investment in the project.
The management decides the maximum acceptable payback period for independent
projects. If the payback period is less than or equal to the maximum acceptable
payback period decided by management, the project is accepted and if the payback
period is more than the maximum acceptable payback period decided by
management, the project is rejected. In case of mutually exclusive projects, the
project with the shortest payback period is selected.
Advantages of payback period method:-
(i) It is simple to calculate and easy to understand.
(ii) It shows the liquidity of the project by indicating the period within which the cost
of a project can be recovered.
Disadvantages of payback period method:-
(i) It ignores the time value of money.
(ii) It ignores the cash inflows after the payback period.
Example:-
A project requires an initial investment of Rs 800000 and is expected to generate

cash inflows of Rs 200000 annually for five years (equal cash inflows each year).
The payback period of the project would be

Rs 800000 Rs 200000 = 4 years
If a project requires an initial investment of Rs 500000 and is expected to generate

cash inflows of Rs 100000, Rs 125000, Rs 75000, Rs 150000 and Rs 100000 respectively
for five years. (unequal cash inflows each year)
In this case we need to add the cash inflows. While adding the cash inflows we see
that in the first four years Rs 450000 (100000+125000+75000+150000) of the initial
investment is recovered. Fifth year generates cash inflow of Rs 100000 whereas only
Rs 50000 (500000-450000) remains to be recovered. The period which will be
required to recover Rs 50000 will be
Rs 50000 Rs 100000 12 = 6 months
So the payback period of the project would be
4.6 years i.e. 4 years and 6 months.
( 2 ) AC C OU NT ING R AT E OF R E T U R N :-
Accounting rate of return is also called as average rate of return. It calculates the
average annual accounting profit the project would generate in relation to the
average investment in the project or its average cost.
Accounting rate of return is calculated as under:-
Accounting rate of return = average annual profit depreciation & taxes average
investment in project 100
Average annual profit = profit of all the years number of years
Average investment in project = initial investment scrap value 2
The management decides the minimum acceptable average rate of return for
independent projects. If the average rate of return is more than the minimum
acceptable average rate of return decided by management, the project is accepted
and if the average rate of return is less than the minimum acceptable rate of return
decided by management, the project is rejected. In case of mutually exclusive
projects, the project yielding the highest average rate of return is selected.
Advantages of accounting rate of return method:-
(1) It is simple to calculate and easy to understand.
(2) It considers the profit of all the years involved in the life of the project.
Disadvantages of accounting rate of return method:-
(1) It ignores the time value of money.
(2) It considers accounting profit and not cash inflows.
Example:-

profit of Rs 80000, Rs 120000, Rs 130000, Rs 110000 and Rs 100000 respectively for
five years after depreciation and tax. At the end of the fifth year, the equipment in
the project can earn a scrap value of Rs 70000.
First we need to find out the average annual profit.

Average annual profit = 80000 + 120000 + 130000 + 110000 + 100000 5
= 540000 5
= Rs 108000
Next we need to find out the average investment.

Average investment = 1000000 70000 2
= 930000 2
= Rs 465000
Accounting rate of return = 108000 465000 100

= 23.23%
(B) Discounting Techniques:-
Discounting techniques consider the time value of money. There are four
discounting techniques used in capital budgeting which are as under:-
( 1 ) D IS C OU NT E D PAY BAC K P E R IOD : -
Discounted payback period improves the payback period method by taking into
consideration the time value of money. It indicates the number of years required to
recover the initial investment in the project from the discounted cash inflows
generated by the project i.e present value of future cash inflows generated by the
project. For discounting the future cash inflows, an appropriate discount rate is used
which is usually the weighted average cost of capital.
Advantages of discounted payback period method:-
(1) It is easy to understand.
(2) It considers the time value of money.
Disadvantages of discounted payback period method:-
(1) It ignores the cash inflows after the payback period.
(2) It requires to calculate the weighted average cost of capital.
Example:-

cash inflows of Rs 150000 annually for five years. The discount rate is 15%.
First we need to calculate the discounted cash inflows for each year by using the
discount rate of 15%.
Discounted cash inflows for 1st year = 150000 (1.15) = Rs 130435
Discounted cash inflows for 2nd year = 150000 (1.15)2 = Rs 113422
Discounted cash inflows for 3rd year = 150000 (1.15)3 = Rs 98627
Discounted cash inflows for 4th year = 150000 (1.15)4 = Rs 85763
Now we need to add the discounted cash inflows. While adding the discounted cash
inflows we see that in the first three years Rs 342484 (130435+113422+98627) of the
initial investment is recovered. Fourth year generates discounted cash inflow of Rs
85763 whereas only Rs 57516 (400000-342484) remains to be recovered. The period
which will be required to recover Rs 57516 will be
Rs 57516 Rs 85763 12 = 8 months
So the discounted payback period of the project would be
3.8 years i.e. 3 years and 8 months.
( 2 ) N E T P R E SE NT VAL U E :-
Net present value is the difference between the present value of future expected
cash inflows and the present value of cash outflows. Cash outflows are the initial
investment in the project or cost of the project and any future expected cash
outflows of the project. If the present value of cash inflows is more than the present
value of cash outflows, the net present value is positive and if the present value of
cash inflows is less than the present value of cash outflows, the net present value is
negative. The cash inflows and outflows are brought to their present values by using
an appropriate discount rate which is usually weighted average cost of capital.
Net present value is calculated as under:-
Net present value = present value of cash inflows present value of cash outflows
In case of independent projects, the projects with a positive net present value are
accepted and in case of mutually exclusive projects, the project with the highest
positive net present value is selected.
Advantages of net present value method:-
(2) It is consistent with the goal of maximizing shareholder wealth.
(3) It considers cash flows from the project throughout its life.
Disadvantages of net present value method:-
(1) It may not give satisfactory results if the mutually exclusive projects involve
different investment outlay.
(2) The output of net present value method is monetary amount and not a rate of
return.
Example:-
A project requires an initial investment of Rs 1200000 and there are no other cash
outflows expected. The project is expected to generate cash inflows of Rs 300000, Rs
400000, Rs 550000 and Rs 200000 respectively for four years. At the end of the fourth
year, the machine in the project can earn a scrap value of Rs 100000. The discount
rate is 10%.
discount rate of 10% and add them.
Discounted cash inflows for 4th year = 300000 (200000+100000) (1.10)4 = Rs 204904
Total discounted cash inflows = Rs 1221433 (272727+330579+413223+204904)
Present value of cash inflows = Rs 1221433
Present value of cash outflows = Rs 1200000
Net present value = present value of cash inflows present value of cash outflows
= Rs 1221433 Rs 1200000
= Rs 21433
So the net present value of the project is Rs 21433 which is positive net present
value.
( 3 ) P ROF ITAB IL IT Y IND E X :-
Profitability index is a variation of net present value. It is the ratio of present value
of expected cash inflows to the present value of expected cash outflows of a project.
Net present value method is an absolute measure as it finds the monetary amount of
difference between the present value of expected cash inflows and present value of
expected cash outflows whereas profitability index is a relative measure as it finds
the ratio.
Profitability index is calculated as under:-
Profitability index = present value of cash inflows present value of cash outflows
In case of independent projects, those projects are accepted whose profitability
index is more than 1 and in case of mutually exclusive projects, the project with
highest profitability index is selected provided it is more than 1. Profitability index
of more than 1 suggests that the present value of projects expected cash inflows is
more than the present value of its expected cash outflows i.e. the net present value is
positive and a profitability index of less than 1 suggests that the present value of
projects expected cash inflows is less than the present value of its expected cash
outflows i.e. the net present value is negative. If the profitability index is exactly 1, it
means that the present value of projects expected cash inflows and expected cash
outflows is equal i.e. the net present value is zero.
Advantages of profitability index:-
(2) It considers the cash flows from the project throughout its life.
(3) It is useful in selecting projects when in capital rationing situation.
Disadvantage of profitability index:-
Example:-
outflows expected. The project is expected to generate cash inflows of Rs 200000, Rs
250000, Rs 150000 and Rs 150000 respectively for four years. There is no scrap value
expected. The discount rate is 12%.
discount rate of 12% and add them.
Total discounted cash inflows = Rs 579964 (178571+199298+106767+95328)
Present value of cash inflows = Rs 579964
Present value of cash outflows = Rs 700000
Profitability index = present value of cash inflows present value of cash outflows
= Rs 579964 Rs 700000
= 0.83
So the profitability index of the project is 0.83 which is less than 1.
( 4 ) IN T E R NAL R AT E OF R E T U R N : -
Internal rate of return is the rate of return on a capital investment project. It is the
discount rate at which the present value of expected cash inflows and present value
of expected cash outflows of a project is equal. In other words, it is the discount rate
at which the net present value of a project is zero.
There is no fixed formula to calculate the internal rate of return. It is found out by
trial and error method either by using a calculator or by using Microsoft excel.
Different discount rates are tried till the discount rate which brings net present
value of the project to zero is found out. If the net present value is positive, a higher
discount rate is tried and if the net present value is negative, a lower discount rate is
tried. This process is continued till the discount rate where net present value
becomes zero or close to zero is found.
The management decides the minimum acceptable rate of return for independent
projects which is usually the weighted average cost of capital. If internal rate of
return is more than the weighted average cost of capital, the project is accepted and
if the internal rate of return is less than the weighted average cost of capital, the
project is rejected. In case of mutually exclusive projects, the project yielding the
highest internal rate of return is selected provided it is more than the weighted
average cost of capital.
Advantages of internal rate of return method:-
(2) It considers cash flows from the project throughout its life.
(3) The output of internal rate of return method is in the form of a rate of return and
not a monetary amount.
Disadvantages of internal rate of return method:-
(1) It is comparatively difficult to calculate as it requires trial and error.

(2) There is a problem of multiple internal rate of returns in case of unconventional
cash flows involved in a project i.e. expected cash inflows followed by expected cash
outflows in the next year and again followed by expected cash inflows next year and
so on.
(3) Internal rate of return method assumes that the cash inflows from the project
should be reinvested to yield a return equal to internal rate of return which is
unrealistic.
Example:-
outflows expected for the project. The project is expected to generate cash inflows of
Rs 300000, Rs 350000 and Rs 250000 respectively for three years. There is no scrap
value expected.
We can try to find out the internal rate of return by trying different discount rates
until the net present value of the project is zero or close to zero. If we try 24%
discount rate, the net present value comes to 684 (total discounted cash inflows of Rs
600684 minus initial investment of Rs 600000). If we try 24.1% discount rate, the net
present value comes to (-) 193 (total discounted cash inflows of Rs 599807 minus
initial investment of Rs 600000). So we can say that the discount rate that brings net
present value to zero or close to zero is between 24% and 24.1%. If we try 24.075%
discount rate, the net present value comes to (-) 15 (total discounted cash inflows of
Rs 599985 minus initial investment of Rs 600000) which is close to zero. So we can
conclude that the internal rate of return of the project is approximately 24.075%. To
get the exact internal rate of return, Microsoft excel can be used.
Capital Rationing:-
Capital rationing is a situation in which the company may not be able to undertake
all the profitable capital investment projects because of lack of adequate funds to
finance all the profitable projects. In such a situation, the company has to allot the
limited available funds among the most profitable projects. The company estimates
the amount of maximum investment it can make for undertaking all the profitable
projects. So the company creates a capital budget. Then the company ranks all the
profitable projects starting from the most profitable to the least profitable i.e. in the
descending order of their profitability and starts selecting from the most profitable
project to the next profitable one till the maximum investment amount the company
can invest is reached.
Example:-
A company has a capital budget of Rs 5000000 and has four profitable capital
investment proposals as under:-
Project A Project B Project C Project D
Initial Rs 2000000 Rs 1500000 Rs 1000000 Rs 1200000

investment
Present value Rs 2500000 Rs 1700000 Rs 1200000 Rs 1800000

of cash inflows
Profitability 1.25 1.13 1.20 1.50

index
The company will rank projects as (1) project D (2) project A (3) project C and (4)
project B based on their profitability.
Then the company will select the (1) project D first then (2) project A next and then
(3) project C.
The company cannot undertake (4) project B because of lack of funds. Project B
requires Rs 1500000 investment while the company has only Rs 800000 (5000000-
4200000) remaining out of its total capital budget of Rs 5000000 after selecting the
first three projects.(1200000+2000000+1000000)

April 12, 2016 Finance Topics accounting rate of return, capital rationing, discounted payback
period, internal rate of return, methods of capital budgeting, net present value, payback period, profitability
index, techniques of capital budgeting Leave a comment
Fixed and working capital

What Is Fixed Capital?
Fixed capital is that portion of the total capital of the company which is invested in
tangible fixed assets such as land and building, plant and machinery, furniture, etc
as well as in intangible fixed assets such as goodwill, patents, copyrights, etc that
stay in the business permanently or at least for more than one accounting year.
What Is Working Capital?
Working capital is that portion of the total capital of the company which is required
for conducting the day-to-day operations of business. It is required on a continuous
basis in business.
Working capital can be gross working capital or net working capital.
Gross working capital means all the current assets of the company such as cash,
debtors, inventories, etc and net working capital means all the currents assets of the
company minus all the current liabilities of the company such as creditors, short-
term loans, etc.
Gross working capital = all current assets
Net working capital = all current assets all current liabilities
Working capital could be positive or negative. If the currents assets exceed the
current liabilities, it is called as positive working capital and if the current liabilities
exceed the current assets, it is called as negative working capital or working capital
deficit.
Working capital is also called as circulating capital.
Difference Between Fixed Capital And Working

Capital:-
Fixed Capital Working Capital
Fixed capital is long-term in nature. Working capital is short-term in nature.

Fixed capital investment stays in the Working capital investment stays in the
business for a long period of time i.e. business for a short period of time i.e.
many years. for a year.
Fixed capital is not required Working capital is required

continuously in business. It is required continuously to conduct day-to-day
mostly when a company wants to make operations of business such as purchase
a big investment such as purchase of of raw materials, paying salaries, etc.
some fixed asset or expansion of
business.
Fixed capital investments have low Working capital has high liquidity. For
liquidity. For e.g. an fixed asset cannot e.g. A company can convert its current
be sold easily to get cash. For that a assets such as debtors into cash
certain asset disposal procedure has to relatively easily.
be followed.
The main sources of fixed capital are The main sources of working capital are
shares, debentures and long-term loans profits retained by the company, fixed
which are repayable after many years. deposits, trade creditors, short-term
loans, shares and debentures.
The amount of fixed capital required is The amount of working capital required
more than working capital. is less than fixed capital.
Operating Cycle:-
Operating cycle is an important measure of the working capital management and

operating efficiency of the company. Operating cycle is the average amount of time a
company takes to turn the cash used to purchase inventory of raw materials into
cash again by its eventual sale as finished products. Operating cycle starts when the
company spends money to purchase stock of raw materials and ends when the
company receives money from the customers who buy the finished products made
from those raw materials. Operating cycle is also called as cash conversion cycle.
The company purchases raw materials from the suppliers on credit or cash. If they
are purchased on credit, the suppliers are termed as creditors and the company pays
them some time after the purchase of raw materials from them as per the credit
terms given by them. The raw materials so purchased are kept in the storeroom for
some time. Then the raw materials lie in the factory as work-in-progress till the
process of converting them into finished products takes place. After the raw
materials are turned into finished products, they are kept in the godown till the time
they are sold. Then the finished products are finally sold to the customers on credit
or cash. If they are sold on credit, the customers are termed as debtors and they pay
the company some time after the sale of goods to them as per the credit terms given
to them. This whole process is called as operating cycle of the company.
Operating cycle is generally measured in days, and shorter the operating cycle, the
better. Shorter operating cycle ensures liquidity and reduces the need of financing.
Shorter operating cycle ensures that the cash does not get tied up in the operations
of the business and can also be utilized for other activities of the company.
operating cycle is made up of three elements days inventory outstanding, days

sales outstanding and days payables outstanding. The formula for calculating
operating cycle is :-
Operating cycle = days inventory outstanding + days sales outstanding days payables
outstanding.
December 24, 2015 Finance Topics cash conversion cycle, fixed capital, fixed capital vs working
capital, operating cycle, working capital Leave a comment
Capital structure and cost of capital
What Is Capital Structure?
Capital structure is the mix or combination of various sources of funds that are used
by a company to finance its operations and growth. There are two main sources of
finance that are used by a company:- (1) Debt, which consists of long-term debt and
short-term debt. (2) Equity, which consists of common shares and preference shares.
A company should have an optimal capital structure. Optimal capital structure has
the optimal or ideal balance between the debt and equity in the capital structure. An
optimal capital structure minimizes the weighted average cost of capital and
maximizes the value of the firm.
What Is Cost Of Capital?
The company raises funds from various sources to finance its operations and
growth. Each of these sources have a cost associated with them. So cost of capital is
the cost of raising the funds from various sources. Cost of capital can also be defined
as the minimum rate of return which the investors expect for providing capital to
the company. Cost of capital plays a very important role in deciding the capital
structure of a company and also in the capital budgeting decisions.
Cost of capital is comprised of :-
(1) Cost of debt.
(2) Cost of preferred equity i.e. preference shares.
(3) Cost of common equity i.e. equity shares.
(1) Cost Of Debt:-
Cost of debt is the rate of interest that the company pays on its borrowings such as
debentures, bonds, term loans from banks and financial institutions and short-term
debt. Interest on debt is a tax-deductible expense so generally after- tax cost of debt
is considered. The rate of interest can be calculated from the interest expenses of the
company as a percentage of the outstanding debt. For e.g. if the interest expenses of
the company for the year 2015 are Rs 246.40 crores and the outstanding debt of the
company for the year 2014 is Rs 1540 crores. So the cost of debt of the company
would be 16% (246.40 100 1540). This is the before-tax cost of debt. Now we need
to calculate the after-tax cost of debt. Let us assume that the tax rate is 20%. So the
after tax-cost of debt of the company would be 12.8% {16 (1 0.20)}.
(2) Cost Of Preferred Equity:-
Preference shares carry a fixed rate of dividend and the dividend is not tax-
deductible. Preference shares have the properties of both debt instruments and
equity shares. The cost of preferred equity is the rate of dividend fixed by the
company on its preference shares. The rate of preference dividend can be calculated
as under:-
Preference dividend net proceeds from issue of preference shares 100
For e.g. if a company received Rs 1240 crores from the issue of preference shares
and paid Rs 173.60 crore annually as dividend on those shares. So the cost of
preferred equity would be 14% (173.60 1240 100).
(3) Cost Of Common Equity:-
Unlike the debt and preferred shares, common shares do not have a fixed cost
associated with them. Cost of common equity is the return that the common
shareholders expect from their investment in common shares and if the company
does not deliver the expected return, the common shareholders would sell their
shares and the price of shares would fall. The most commonly used method for
calculating the cost of common equity is Capital Asset Pricing Model (CAPM). The
formula for calculating cost of common equity under Capital Asset Pricing Model is:-
Risk-free rate + (beta risk premium)
Risk-free rate:- Risk-free rate is the risk-free interest rate that is obtained by
investing in risk-free securities like government bonds.
Beta:- Beta measures how much the price of a companys stock moves against the
market as a whole. The market has a beta of 1. The price of the companys stock that
moves more than the market has a beta above 1 and the price of the companys stock
that moves less than the market has a beta below 1.
Risk premium:- It is the equity market risk premium which the common
shareholders expect over and above the risk-free rate to compensate them for taking
extra risk by investing in common shares.
For e.g. the risk-free interest rate for a 10-year-old government bond is 8%. The beta
of companys common stock is 1.3 and the risk premium expected by the common
shareholders is 6%. So the cost of common equity would be 15.8%
{8 + (1.3 6)}.
Weighted Average Cost Of Capital:-
Weighted Average Cost of Capital (WACC) is the combined average cost of all the
sources of capital i.e. debt, preferred equity and common equity used by a company.
So all the sources of capital are taken into consideration to calculate the Weighted
Average Cost of Capital. WACC can also be defined as the average rate of return
which all the investors expect for providing capital to the company. For calculating
WACC, cost of each source of capital is weighted in proportion to the share each
source of capital has in the companys capital structure.
Example Of Weighted Average Cost Of Capital:-
For calculating Weighted Average Cost of Capital following things are needed:-
Market value of debt and cost of debt.
Market value of preferred equity and cost of preferred equity.
Market value of common equity and cost of common equity.
Market value of debt is not easily available. So we have to take the value of debt
which is in the companys balance sheet. Earlier we had taken the value of debt as Rs
1540 crores and calculated the after-tax cost of debt as 12.8%. We will use the same
figures in the calculation of WACC.
Market value of preferred equity is also not available easily. So we have to take the
value of preference share capital in the companys balance sheet. Earlier we had
taken the value of preference share capital as Rs 1240 crores and calculated the cost
of preferred equity as 14%. We will use the same figures in the calculation of WACC.
Let us assume that the total market value of common equity is Rs 16800 crores. We
had earlier calculated the cost of common equity as 15.8%. So we will take the same
in the calculation of WACC.
So now we have all the required information to calculate WACC. We can find out the
WACC by using the below method:-
Market value of debt (market value of debt + market value of preferred equity +
market value of common equity) cost of debt
1540 (1540 + 1240 + 16800) 12.80 = 1.00
Market value of preferred equity (market value of debt + market value of preferred
equity + market value of common equity) cost of preferred equity
1240 (1540 + 1240 + 16800) 14 = 0.89
Market value of common equity (market value of debt + market value of preferred
equity + market value of common equity) cost of common equity
16800 (1540 + 1240 + 16800) 15.80 = 13.56
1.00 + 0.89 + 13.56 = 15.45
So the weighted Average Cost of Capital of the company is 15.45%.
November 18, 2015 Finance Topics capital structure, cost of capital, cost of common equity,
cost of debt, cost of preferred equity, WACC, weighted average cost of capital Leave a comment
Financial ratios
There are various kinds of financial ratios which are calculated and used by the
investors and analysts. These financial ratios are calculated from the information in
the financial statements of the company and are used in the fundamental analysis of
the company. The financial ratios are compared with the financial ratios of the last
few years of the same company (intra-firm comparison) and with the financial ratios
of other companies in the same industry (inter-firm comparison).
Financial ratios can be classified into the following

broad categories:-
Profit margin ratios

Turnover ratios
Solvency ratios
Liquidity ratios
Investment valuation ratios
Profit Margin Ratios:-
Profit margin ratios indicate how efficiently the company is able to generate profit
from its operations. Following are the various types of profit margin ratios:-
Gross Margin Ratio:-
Gross margin ratio is also called as gross profit ratio. Gross margin ratio compares
the gross profit of the company to the net sales. Gross profit is calculated by
subtracting the cost of goods sold from the net sales. Cost of goods sold indicates all
the direct costs incurred by the company on all the products sold. Gross margin ratio
should be high enough to cover the indirect costs, taxes, interest and depreciation
expenses.
Formula for calculating gross margin ratio:-
Gross margin ratio = gross profit net sales 100
Net Margin Ratio:-
Net margin ratio is also called as net profit ratio. Net margin ratio compares the net
profit of the company to the net sales. Net profit is the profit earned by the company
after subtracting all the expenses incurred by the company. A company should have
a high net margin ratio which is possible if all the concerned expenses incurred by
the company are kept in control.
Formula for calculating net margin ratio:-
Net margin ratio = net profit net sales 100
Operating Margin Ratio:-
Operating margin ratio is also called as operating profit ratio or EBITDA ratio.
Operating margin ratio compares the operating profit of the company to the net
sales. Operating profit is calculated by subtracting the cost of goods sold and
operating expenses from the net sales. Operating expenses are the indirect costs of
the company. Operating margin ratio should be high enough to cover taxes, interest,
depreciation and amortization expenses.
Formula for calculating operating margin ratio:-
Operating margin ratio = operating profit net sales 100
Return On Equity Ratio:-
Return on equity ratio shows how much profit the company generates with the
money invested by both the preference and equity shareholders. It measures how
efficiently the company generates profit for every unit of shareholders equity.
Formula for calculating return on equity ratio:-
Return on equity ratio = net profit average shareholders equity 100
Shareholders equity = equity share capital + preference share capital + reserves and
surplus
Average shareholders equity = shareholders equity (current year) + shareholders
equity (previous year) 2
Return On Common Equity Ratio:-
Return on common equity ratio shows how much profit the company generates with
the money invested by equity shareholders i.e common shareholders. It measures
how efficiently the company generates profit for every unit of common shareholders
equity.
Formula for calculating return on common equity ratio:-
Return on common equity ratio = net profit preference dividend average
common shareholders equity 100
Common shareholders equity = equity share capital + reserves and surplus
Average common shareholders equity = common shareholders equity (current year)
+ common shareholders equity (previous year) 2
Return On Capital Employed Ratio:-
Return on capital employed shows how much profit the company generates with the
total capital employed by the company. It measures how efficiently the company
generates profit for every unit of capital invested.
Formula for calculating return on capital employed ratio:-
Return on capital employed ratio = earnings before interest and tax average
capital employed 100
Capital employed = equity share capital + preference share capital + reserves and
surplus + long-term debt
Average capital employed = capital employed (current year) + capital employed
(previous year) 2
Return On Assets Ratio:-
Return on assets ratio shows how much profit the company generates by using its
assets. It measures how efficiently the company generates profit for every unit of
asset the company has.
Formula for calculating return on assets ratio:-
Return on assets ratio = net profit average total assets 100
Total assets = long-term assets + current assets
Average total assets = total assets (current year) + total assets (previous year) 2
Turnover Ratios:-
Turnover ratios are also called as activity ratios. Turnover ratios indicate how
efficiently the company runs its various operations. Following are the various types
of turnover ratios:-
Accounts Receivable Turnover ratio:-
Accounts receivable turnover ratio is also called as debtors turnover ratio. Accounts
receivable turnover ratio shows how efficiently the company issues credit to its
customers and recovers it . It indicates how many times the company collects its
average accounts receivable during a period. A high accounts receivable turnover
ratio is considered as good.
Formula for calculating accounts receivable turnover ratio:-
Accounts receivable turnover ratio = credit sales average accounts
receivables
accounts receivables = debtors
average accounts receivables = debtors (current year) + debtors (previous year) 2
A variant of the accounts receivable turnover ratio called as average collection

period is also calculated. Average collection period indicates the number of days, on
an average, the company takes to collect its accounts receivable. It measures the
average number of days the company requires to convert its accounts receivables
into cash. A lower average collection period is considered as a good sign as it implies
that the company is taking less time to recover credit given to the customers thus
ensuring liquidity.
Formula for calculating average collection period:-
Average collection period = 365 accounts receivable turnover ratio
Accounts Payable Turnover Ratio:-
Accounts payable turnover ratio is also called as creditors turnover ratio. Accounts
payable turnover ratio shows the rate at which the company pays its suppliers for
the credit purchases made from them. It indicates how many times the company
pays its average accounts payable during a period. A low accounts payable turnover
ratio is considered as good.
Formula for calculating accounts payable turnover ratio:-
Accounts payable turnover ratio = credit purchases average
accounts payables
Accounts payables = creditors
Average accounts payables = creditors (current year) + creditors (previous year) 2
A variant of the accounts payable turnover ratio called as average payment period
is also calculated. Average payment period indicates the number of days, on an
average, the company takes to pay its accounts payable. It measures the average
number of days the company requires to pay the suppliers for the credit purchases
made from them. A higher average payment period is considered as a good sign as it
implies that the company can pay its credit bills after a longer period of time thus
ensuring liquidity.
Formula for calculating average payment period:-

Average payment period = 365 accounts payable turnover ratio
Inventory Turnover Ratio:-
Inventory turnover ratio is also called as stock turnover ratio. Inventory turnover
ratio shows how efficiently the company turns its inventory into sales. It indicates
how many times, on an average, the company sold and replaced its inventory during
a period. A high inventory turnover ratio is considered as good.
Formula for calculating inventory turnover ratio:-
Inventory turnover ratio = cost of goods sold average inventory
Average inventory = inventory (Current year) + inventory (previous year) 2
A variant of the inventory turnover ratio called as inventory turnover days or days
inventory outstanding is also calculated. Inventory turnover days indicate the
number of days, on an average, the company takes to turn its inventory into sales. If
the inventory turnover days are less, it is considered as a good sign as it implies that
the sales of the company are rapid and not much of the companys capital is tied up
in inventory.
Formula for calculating inventory turnover days:-
Inventory turnover days = 365 inventory turnover ratio
Assets Turnover Ratio:-
Assets turnover ratio shows how efficiently the company uses its assets to generate
sales. A high assets turnover ratio is considered as good which shows that the
company is efficiently using its assets to generate sales.
Formula for calculating assets turnover ratio:-
Assets turnover ratio = net sales average total assets
Total assets = long-term assets + current assets
Average total assets = total assets (current year) + total assets (previous year) 2
Solvency Ratios:-
Solvency ratios are also called as leverage ratios. Solvency ratios indicate the
companys capacity to meet its debt obligations especially long-term debt obligations.
They determine the chances of companys survival in the long run. There are two
types of solvency ratios which are as under:-
Debt-To-Equity Ratio:-
Debt-to-equity-ratio is also called as financial leverage ratio. Debt-to-equity ratio

indicates the relative proportion of borrowed capital i.e. debt and owned capital i.e.
shareholders equity in the capital structure of the company. A low debt-to-equity
ratio is considered as good indicating that the company has less amount of debt in its
capital structure and hence more stable. A high debt-to-equity ratio is considered as
bad indicating that the company has higher amount of debt in its capital structure
and hence less stable. Debt has to be repaid so there are more chances of the
company becoming insolvent if it is not able to repay the high amount of debt it has
taken.
Formula for calculating debt-to-equity ratio:-
Debt-to-equity ratio = total debt total equity
Total debt = long-term debt + short-term debt
Total equity = preference share capital + equity share capital + reserves and surplus
If the preference shares are redeemable then they are taken as debt.
Interest Coverage Ratio:-
Interest coverage ratio is also called as times interest earned ratio. Interest coverage
ratio determines how easily the company can pay interest on its outstanding debt. It
shows how well the earnings of the company cover the interest costs. A high interest
coverage ratio is considered as good indicating that the company is earning
sufficiently to easily meet its interest expenses. Whereas a low interest coverage
ratio indicates that the company is not earning enough to easily meet its interest
expenses and is in danger of becoming insolvent if the earnings become even less.
Formula for calculating interest coverage ratio:-
Interest coverage ratio = earnings before interest and tax interest expense
Liquidity Ratios:-
Liquidity ratios indicate the companys capacity to meet its short-term debt
obligations. They test the short-term solvency of the company. There are three types
of liquidity ratios which are as under:-
Current Ratio:-
Current ratio is also called as working capital ratio. Current ratio tests the liquidity
of the company by finding out the proportion of current assets available to pay the
current liabilities. Higher the current ratio, the better it is. Higher current ratio
indicates that the company has higher amount of current assets compared to current
liabilities and can easily pay off the current liabilities from the current assets.
Whereas a lower current ratio is not good as it indicates that the company has lower
amount of current assets compared to current liabilities and the company may
struggle to pay off the current liabilities from the current assets.
Formula for calculating current ratio:-
Current ratio = current assets current liabilities
Quick Ratio:-
Quick ratio is also called as acid test ratio. Quick ratio refines the current ratio by
removing inventory from the current assets as inventory cannot be liquidated easily.
Quick ratio is a better indicator of liquidity than current ratio.
Formula for calculating quick ratio:-
Quick ratio = current assets inventory current liabilities
Cash Ratio:-
Cash ratio refines the quick ratio by removing any receivables from the current
assets. Cash ratio considers only highly liquid current assets and cash itself.
Formula for calculating cash ratio:-
Cash ratio = cash and cash equivalents + marketable securities current
liabilities
Investment Valuation Ratios:-
Investment valuation ratios are also called as market valuation ratios. Investment
valuation ratios are used by investors and analysts in the relative valuation of
companies. Following are the various types of investment valuation ratios:-
Price/Earnings Ratio:-
Price/earning ratio or P/E ratio is also called as price/earning multiple or P/E

multiple. price/earnings ratio tells how much the investors are willing to pay for the
companys earnings. It tells the price that the investors are ready to pay for each unit
of profit earned by the company.
Higher the price/earnings ratio, the more investors are willing to pay for each unit
of companys profit as they are expecting higher earnings growth of the company in
future and so are paying more for todays earnings. Growth investors view high
price/earnings ratio stocks as an attractive investment opportunity. while the value
investors view high price/earnings ratio stocks as overvalued and hence not good for
investment.
Lower the price/earnings ratio, the less investors are willing to pay for each unit of
companys profit as they do not expect much earnings growth of the company in
future. Value investors view low price/earnings ratio stocks as an attractive
investment opportunity as they consider stocks with low price/earnings ratios to be
currently undervalued and will perform better in future. While the growth investors
view low price/earnings ratio stocks as not good for investment as they do not expect
the companys earnings to grow much in future.
Formula for calculating price/earnings ratio:-
Price/earnings ratio = market price per share earnings per share
Earnings per share = net profit preference dividend number of equity shares
outstanding
Price/Earnings Growth Ratio:-
Price/earnings growth ratio or PEG ratio refines the price/earnings ratio by including
the companys estimated earnings growth. It compares the stocks price/earnings
ratio with its estimated earnings per share growth. Price/earnings growth ratio is
used along with the price/earning ratio. Price/earnings growth ratio can offer a
suggestion to the growth investors as to whether a stocks high price/earnings ratio is
a refection of promising earnings growth prospects of the company or excessive
high price of the stock. Price/earnings growth ratio can also offer a suggestion to the
value investors as to whether a stocks low price/earnings ratio is because of under-
valuation of the stock or poor earnings growth prospects of the company.
Price/earnings growth ratio varies from person to person as expected earnings per
share growth rate is an estimate.
Formula for calculating price/earnings growth ratio:-
Price/earnings growth ratio = price/earnings ratio expected
earnings per share growth
Price/Book Ratio:-
Price/book ratio or P/B ratio is used to compare the companys book value to its
current market price. A higher price/book ratio indicates that the stock is currently
over-valued and not good for investment. While a lower price/book ratio indicates
that the stock is currently under-valued and good for investment. However a lower
price/book value ratio might also indicate that something is wrong with the
company. Price/book ratio is generally used for companies with more liquid assets
such as banks and financial companies.
Formula for calculating price/book ratio:-
Price/book ratio = market price per share book value per share
Book value per share = equity share capital + reserves and surplus revaluation
reserves number of equity shares outstanding
Enterprise value/EBITDA Ratio:-
Enterprise value/EBITDA ratio or EV/EBITDA ratio is also called as enterprise

multiple. Enterprise value/EBITDA ratio compares the enterprise value with
earnings before interest, tax, depreciation and amortization (EBITDA). If the
enterprise value/EBITDA ratio is lower, it is considered that the companys stock is
under-valued and hence good for investment and the company is a good takeover
candidate from the acquirers perspective. While a higher enterprise value/EBITDA
ratio means that the companys stock is over-valued and hence not good for
investment and the company is not a good takeover candidate from the acquirers
perspective.
Formula for calculating enterprise value/EBITDA ratio:-
Enterprise value/EBITDA ratio = enterprise value EBITDA
Enterprise value = market value of equity + market value of debt cash
Dividend Yield Ratio:-
Dividend yield ratio shows the relationship between dividend per share and the
market price per share. It indicates how much a company pays out in dividend each
year in relation to the market price of its shares. Dividend yield ratio is useful for the
investors who are more interested in the dividend income than capital gains.
Generally, higher the dividend yield ratio, the better it is. But sometimes a high
dividend yield ratio may be because of decrease in the market price of the
companys stock recently because of poor financial performance and the company
may have to reduce the amount of dividend in future.
Formula for calculating dividend yield ratio:-
Dividend yield ratio = annual dividend per share market price per share 100
Dividend Payout Ratio:-
Dividend payout ratio shows the portion of net profit of the company that is paid to
the shareholders in the form of dividends during the year. In other words, dividend
payout ratio shows the portion of net profit, the company gives as dividend to the
shareholders and the portion of net profit, the company retains in the business for
its operations. A high dividend payout ratio means that the company is paying a
large portion of the net profit as dividend to its shareholders and retaining less
portion of net profit in the business. While a low dividend payout ratio means the
company is doing the opposite. A high dividend payout ratio is preferable to the
investors who are more interested in earning regular dividend income instead of
capital gains.
Formula for calculating dividend payout ratio:-
Dividend payout ratio = annual dividend per share earnings per share 100

Capital Budgeting

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Capital Budgeting

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12/9/2017 Finance Topics Archives - Finance and Accounting simplified

Category: Finance Topics

What Is Capital Budgeting?

Importance Of Capital Budgeting:-

Capital budgeting decisions have long-term implications on the operations of the

Classification Of Capital Investment Projects:-

Capital investment projects can be classified into four types:-

(1) Replacement Projects:-

(2) Expansion Projects:-

(3) Diversification projects:-

(4) Mandatory projects:-

The company has to compulsorily undertake such projects as required by the

Capital Investment Projects May be

Capital Budgeting Techniques:-

(A) Non-Discounting Techniques:-

( 1 ) PAY BAC K P E R IOD :-

payback period = initial investment in project annual cash inflows of project

A project requires an initial investment of Rs 800000 and is expected to generate

The payback period of the project would be

If a project requires an initial investment of Rs 500000 and is expected to generate

A project requires an initial investment of Rs 1000000 and is expected to generate

First we need to find out the average annual profit.

Next we need to find out the average investment.

Accounting rate of return = 108000 465000 100

(B) Discounting Techniques:-

( 1 ) D IS C OU NT E D PAY BAC K P E R IOD : -

A project requires an initial investment of Rs 400000 and is expected to generate

( 3 ) P ROF ITAB IL IT Y IND E X :-

So the profitability index of the project is 0.83 which is less than 1.

(1) It is comparatively difficult to calculate as it requires trial and error.

Project A Project B Project C Project D

Initial Rs 2000000 Rs 1500000 Rs 1000000 Rs 1200000

Present value Rs 2500000 Rs 1700000 Rs 1200000 Rs 1800000

Profitability 1.25 1.13 1.20 1.50

Fixed and working capital

What Is Fixed Capital?

What Is Working Capital?

Difference Between Fixed Capital And Working

Fixed Capital Working Capital

Fixed capital is long-term in nature. Working capital is short-term in nature.

Fixed capital is not required Working capital is required

Operating cycle is an important measure of the working capital management and

operating cycle is made up of three elements days inventory outstanding, days

Capital structure and cost of capital

What Is Capital Structure?

What Is Cost Of Capital?

(1) Cost Of Debt:-

(2) Cost Of Preferred Equity:-

(3) Cost Of Common Equity:-

Weighted Average Cost Of Capital:-

Example Of Weighted Average Cost Of Capital:-

1540 (1540 + 1240 + 16800) 12.80 = 1.00

1240 (1540 + 1240 + 16800) 14 = 0.89

16800 (1540 + 1240 + 16800) 15.80 = 13.56

1.00 + 0.89 + 13.56 = 15.45

So the weighted Average Cost of Capital of the company is 15.45%.

Financial ratios can be classified into the following

Profit margin ratios

Profit Margin Ratios:-

Gross Margin Ratio:-

Net Margin Ratio:-

Operating Margin Ratio:-

Return On Equity Ratio:-

Return On Common Equity Ratio:-