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Introduction
Risk exists because of the inability of the decision-maker to make perfect forecasts.
Forecasts cannot be made with perfection or certainty since the future events on
which they depend are uncertain. An investment is not risky if, we can specify a
unique sequence of cash flows for it. But the whole trouble is that cash flows cannot
be forecasted accurately, and alternative sequences of cash flows can occur
depending on the future events. Thus, risk arises in investment evaluation because
we cannot anticipate the occurrence of the possible future events with certainty and
consequently, cannot make any correct prediction about the cash flow, sequence. To
illustrate, let us suppose that a firm is considering a proposal to commit its funds in
a machine, which will help to produce a new product. The demand for this product
may be very sensitive to the general economic conditions. It may be very high under
favorable economic conditions and very low under unfavorable economic conditions.
Thus, the investment would .be profitable in the former situation and unprofitable in
the latter case. But, it is quite difficult to predict the future state of economic
conditions. Because of the uncertainty of the economic conditions, uncertainty about
the cash flows associated with the investment derives.
A large number of events influence forecasts. These events can be grouped in
different ways. However, no particular grouping of events will be useful for all
purposes. We may, for example, consider three broad categories of the events
influencing the investment forecasts:
General economic conditions This category includes events which influence the
general level of business activity. The level of business activity might be affected by
such events as internal and external economic and political situations, monetary and
fiscal policies, social conditions etc.
Industry factors This category of events may affect all companies in an industry.
For example, companies in an industry would be affected by the industrial relations
in the industry, by innovations, by change in material cost etc.
Company factors This category of events may affect only a company. The change
in management, strike in the company, a natural disaster such as flood or fire may
affect directly a particular company.
The essence of capital Budgeting is the „Balancing Act‟ of matching the available
resources with the acceptable projects. There are a large number of methods in
practice all over the world in the sphere of
capital expenditure decisions. Which ever method is selected, it should:
Net present value method is one of the discounted cash flow methods of capital
budgeting. It recognizes the time value of money and that cash flows arising at
different periods of time differ in value and are not comparable unless their
equivalent present values are found. The net present value of all inflows and outflows
of cash occurring during the entire life of a project is determined by discounting these
flows by the firm‟s cost of capital or some other pre-determined rate.
The following are the steps in the net present value method:
(a) Appropriate discounting rate has to be determined. It is the minimum required
rate of return and is called „cut-off rate‟ or „discount rate‟. The rate is generally based
on cost of capital which is suitably adjusted for the risk and uncertainty involved in
the project. Such addition to cost of capital is called „Risk return‟.
(b) Present value of cash out flows should be found with the help of the discounting
rate. If the entire investment is made initially, there is no need to discount it. The
amount of investment itself is the present value of cash out flows. However any
investments to be made at some future points of time are to be discounted to find
their present value. It should be remembered that any working capital should be
taken as cash outflow in the year in which commercial production actually starts on
the project.
(c) Present value of estimated cash inflows should also be computed. The cash flows
should be the net cash flows after tax, before depreciation. The scrap value of the
project has to be taken as a cash inflow in the last year. Similarly working capital
locked up in the project has to be assumed as „unlocked‟ at the end of final year, thus
showing it as a cash inflow in the last year of the project.
(d) Net present value (NPV) is the difference between the present value of cash inflows
and the present value of cash out flows.
NPV = P.V. of cash inflows – P.V. of cash out flows.
Profitability Index
The profitability index is also called „Benefits cost Ratio‟
Though this is treated as a separate method due to the importance of results
obtained
by its usages, it is only a refinement of the N.P.V. method. It shows the relationship
between P.V. of cash inflows and P.V. of cash outflows.
I.R.R. is also known as Trial and Error yield method. Unlike N.P.V. and P.I. methods
where the cash flows are discounted at predetermined cut-off rate, there is no specific
discounting rate under I.R.R. method. Here, the cash flows of a project are
discounted at a suitable rate arrived at by „Trial and Error‟. The rate equates the net
present value to Zero. Since the discounting rate is determined internally through
Trial and error process, it is called Internal rate of return method.
The Monte Carlo simulation or simply the simulation analysis considers the
interactions among variables and probabilities of the change in variables.1 It does not
give the project‟s NPV as a single number rather it computes the probability
distribution of NPV. The simulation analysis is an extension of scenario analysis. In
simulation analysis a computer generates a very large number of scenarios according
to the probability distributions of the variables. The simulation analysis involves the
following steps:
First, you should identify variables that influence cash inflows and outflows. For
example, when a firm introduces a new product in the market these variables are
initial investment, market size, market growth, market share, price, variable costs,
fixed costs, product life cycle, and terminal value.
Second, specify the formulae that relate variables. For example, revenue depends
on by sales volume and price; sales volume is given by market size, market share,
and market growth. Similarly, operating expenses depend on production, sales and
variable and fixed costs.
Third, indicate the probability distribution for each variable. Some variables will
have more uncertainty than others. For example, it is quite difficult to predict price or
market growth with confidence.
Fourth, develop a computer programme that randomly selects one value from the
probability distribution of each variable and uses these values to calculate the
project‟s NPV. The computer generates a large number of such scenarios, calculates
NPVs and stores them. The stored values are printed as a probability distribution of
the project‟s NPVs along with the expected NPV and its standard
deviation. The risk-free rate should be used as the discount rate to compute the
project‟s NPV. Since simulation is performed to account for the risk of the project‟s
cash flows, the discount rate should reflect only the time value of money.
Inflation and Discount Rate: The discount rate has become one of the central
concepts of finance. Some of its manifestations include familiar concepts such as
opportunity cost, capital cost, borrowing rate, lending rate and the rate of return on
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stocks or bonds11. It is greatly influenced in computing NPV. The selection of proper
rate is critical which helps for making correct decision. In order to compute net
present value, it is necessary to discount future benefits and costs. This discounting
reflects the time value of money. Benefits and costs are worth more if they are
experienced sooner. The higher the discount rate, the lower is the present value of
future cash flows.
LEASE AGREEMENTS
Leasing industry plays an important role in the economic development of a country by
providing money incentives to lessee. The lessee does not have to pay the cost of asset at
the time of signing the contract of leases. Leas ing contracts are more flexible so lessees
can structure the leasing contracts accordi ng to their needs for finance. The lessee can
also pass on the risk of obsolescence to the lessor by acquiring those appliances, which
have high technological obsolescence. To day, most of us are familiar with leases of
houses, apartments, offices
TYPES OF LEASE AGREEMENTS
Lease agreements are basically of two types. They are (a) Financial lease and (b)
Operating lease. The other variations in lease agreements are (c) Sale and lease back
(d) Leveraged leasing and (e) Direct leasing.
FINANCIAL LEASE
Long-term, non-cancellable lease contracts are known as financial leases. The essential
point of financial lease agreement is that it contains a condition whereby the lessor
agrees to transfer the title for the asset at the end of the lease period at a nominal cost.
At lease it must give an option to the lessee to purchase the asset he has used at the
expiry of the lease. Under this lease the lessor recovers 90% of the fair value of the asset
as lease rentals and the lease period is 75% of the economic life of the asset. The lease
agreement is irrevocable. Practically all the risks incidental to the asset ownership and
all the benefits arising there from are transferred to the lessee who bears the cost of
maintenance, insurance and repairs. Only title deeds remain with the lessor. Financial
lease is also known as „capital lease‟. In India, financial leases are very popular with
high-cost and high technology equipment.
OPERATING LEASE
An operating lease stands in contrast to the financial lease in almost all aspects. This
lease agreement gives to the lessee only a limited right to use the asset. The lessor is
responsible for the upkeep and maintenance of the asset. The lessee is not given any
uplift to purchase the asset at the end of the lease period. Normally the lease is for a
short period and even otherwise is revocable at a short notice. Mines, Computers
hardware, trucks and automobiles are found suitable for operating lease because the
rate of obsolescence is very high in this kind of assets.
Hire purchase is a type of installment credit under which the hire purchaser, called the
hirer, agrees to take the goods on hire at a stated rental, which is inclusive of the
repayment of principal as well as interest, with an option to purchase. Under this
transaction, the hire purchaser acquires the property (goods) immediately on signing the
hire purchase agreement but the ownership or title of the same is transferred only when
the last installment is paid. The hire purchase system is regulated by the Hire Purchase
Act 1972. This Act defines a hire purchases “an agreement under which goods are let on
hire and under which the hirer has an option to purchase them in accordance with the
terms of the agreement and includes an agreement under which
1) The owner delivers possession of goods thereof to a person on condition that such
person pays the agreed amount in periodic installments.
2) The property in the goods is to pass to such person on the payment of the last of such
installments, and
3) Such person has a right to terminate the agreement at any time before the property so
passes”. Hire purchase should be distinguished from installment sale wherein property
passes to the purchaser with the payment of the first installment. But in case of HP
(ownership remains with the seller until the last installment is paid) buyer gets
ownership after paying the last installment. HP also differs from leasing.
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Meaning of Capital Structure
a. Type of securities to be issued are equity shares, preference shares and long
term borrowings (Debentures).
b. Relative ratio of securities can be determined by process of capital gearing. On
this basis, the companies are divided into two-
i. Highly geared companies - Those companies whose proportion of equity
capitalization is small.
ii. Low geared companies - Those companies whose equity capital
dominates total capitalization.
1. Trading on Equity- The word “equity” denotes the ownership of the company.
Trading on equity means taking advantage of equity share capital to borrowed
funds on reasonable basis. It refers to additional profits that equity
shareholders earn because of issuance of debentures and preference shares. It
is based on the thought that if the rate of dividend on preference capital and
the rate of interest on borrowed capital is lower than the general rate of
company‟s earnings, equity shareholders are at advantage which means a
company should go for a judicious blend of preference shares, equity shares as
well as debentures. Trading on equity becomes more important when
expectations of shareholders are high.
2. Degree of control- In a company, it is the directors who are so called elected
representatives of equity shareholders. These members have got maximum
voting rights in a concern as compared to the preference shareholders and
debenture holders. Preference shareholders have reasonably less voting rights
while debenture holders have no voting rights. If the company‟s management
policies are such that they want to retain their voting rights in their hands, the
capital structure consists of debenture holders and loans rather than equity
shares.
3. Flexibility of financial plan- In an enterprise, the capital structure should be
such that there is both contractions as well as relaxation in plans. Debentures
and loans can be refunded back as the time requires. While equity capital
cannot be refunded at any point which provides rigidity to plans. Therefore, in
order to make the capital structure possible, the company should go for issue
of debentures and other loans.
4. Choice of investors- The company‟s policy generally is to have different
categories of investors for securities. Therefore, a capital structure should give
enough choice to all kind of investors to invest. Bold and adventurous investors
generally go for equity shares and loans and debentures are generally raised
keeping into mind conscious investors.
5. Capital market condition- In the lifetime of the company, the market price of
the shares has got an important influence. During the depression period, the
company‟s capital structure generally consists of debentures and loans. While
in period of boons and inflation, the company‟s capital should consist of share
capital generally equity shares.
6. Period of financing- When company wants to raise finance for short period, it
goes for loans from banks and other institutions; while for long period it goes
for issue of shares and debentures.
7. Cost of financing- In a capital structure, the company has to look to the factor
of cost when securities are raised. It is seen that debentures at the time of
profit earning of company prove to be a cheaper source of finance as compared
to equity shares where equity shareholders demand an extra share in profits.
8. Stability of sales- An established business which has a growing market and
high sales turnover, the company is in position to meet fixed commitments.
Interest on debentures has to be paid regardless of profit. Therefore, when
sales are high, thereby the profits are high and company is in better position to
meet such fixed commitments like interest on debentures and dividends on
preference shares. If company is having unstable sales, then the company is
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not in position to meet fixed obligations. So, equity capital proves to be safe in
such cases.
9. Sizes of a company- Small size business firms capital structure generally
consists of loans from banks and retained profits. While on the other hand, big
companies having goodwill, stability and an established profit can easily go for
issuance of shares and debentures as well as loans and borrowings from
financial institutions. The bigger the size, the wider is total capitalization.
i.