Capital investment decisions

1. Introduction

1.”Financial management is more than procurement of

funds. ” What do you think are the responsibilities of a
finance manager? RTP

Discuss the functions of a Finance Manager/ chief financial

officer.

Decisions involving management of funds come under the

purview of the Finance Manager. This includes-

1. Fund requirement estimation:

a) The Finance Manager has to carefully estimate the Firm’s

requirements of funds.

b) The purpose of funds (investment in Fixed assets or

working capital) and timing of funds (ie when it is
required) should be determined, using techniques like
budgetary control and long range planning.

c) This calls for forecasting all physical activities of the firm

and translating them into monetary terms.

2. Capital structure/ financing decisions:

a) The Finance Manager has to determine the proper mix/

combination of procuring funds. Funds can be procured
from various sources for short term and long term
purposes.

b) Decisions regarding Capital Structure (called Financing

Decisions) should be taken to provide proper balance
 between – (i) Long term and Short term funds and also (ii)
Long Funds and Own Funds.

c) Long term funds are required to a) Finance fixed assets

and long term investments and b) provide for permanent
needs of working capital. Short term funds are required
for working capital purposes.

3. Cash Management Decisions: a)The Finance Manager has

to ensure that all sections/ branches/ factories/ departments
and units of the Firm have adequate funds (cash), to
facilitate smooth flow of business operations.

b) He should also ensure that there is no excessive cash

(idle funds) in any division at any point of time.

c) For this purpose, cash management and cash

disbursement/ transfer policies should be laid down.

4. Capital budgeting/ Investment Decisions:

a) Funds procured should be invested/ utilized effectively.

The Finance Manager should prescribe the asset
management policies, for Fixed Assets and Current
Assets.

b) Long Term Funds should be invested – (i) in Fixed Assets/

Projects after capital Budgeting and (ii) in Permanent
Working Capital after estimating the requirements
carefully.

5. Financial Analysis/ Performance evaluation:

a) Financial Analysis help in assessing how effectively the

funds have been utilized and in identifying methods of
improvement. So, the Finance Manager has to evaluate
financial performance of various units of the Firm.
 b) There are various tools of Financial Analysis like
Budgetary Control, Ratio Analysis, Cash Flow and Fund
Flow Analysis, Common Size Statement Analysis, Intra-
Firm comparison etc.

6. Dividend Decisions:

a) The finance Manager should assist the top management in

deciding the dividend-payout and retention ratio ie – (i)
what amount of dividend should be paid to shareholders
and (ii) what amount should be retained in the business
itself.

b) Dividend decisions depend upon factors like – (i) trend of

earnings (ii) requirement of funds for future growth, (iii)
cash flow situation, (iv) trend of share prices, and (v) tax
liability of Firm/ Shareholders.

7. Financial Negotiations / Liaison with Lenders:

The Finance Manager is required to interact and carry out

negotiations with financial institutions, banks, and public
depositors. Negotiations especially with outside financiers
require specialized skills.

8. Market Impact Analysis:

a) The Finance Manager has to monitor the Stock Exchange

quotations and behavior of share prices. This involves
analysis of major trends in the stock market and judging
their impact on the share price of the Firm.

b) Value Maximization Objective is achieved through this

analysis and action.
OVERVIEW OF FINANCIAL MANAGEMENT – ASPECTS, OBJECTIVES
AND FUNCTIONS

FINANCE MANAGER

Profit and
Wealth
PROCUREMENT OF FUNDS
Maximisation
UTILISATION OF FUNDS

(i.e. Sources of Funds)

(i.e. Application of Funds)

Objectives: To Maximize Cost

Objectives: To maximize Returns

Long Term Sources Short Term Sources Short Term Investments

Long Term Investments

Own Funds Loan Funds Current Liabilities Current Assets e.g.

Fixed Assets and Projects

(Equity) (Debt) e.g. Creditors, Stock, Debtors, Cash

Payables etc.

Capital structure Working Capital Management Decisions

Investment Decisions/

Decisions / Financing
Capital Budgeting

Decisions
2. Explain the inter – relationship between Investment,
Financing and Dividend Decisions. RTP, M 01

1. Objective: The underlying objective of all the three decisions

viz. – Investment, Financing and Dividend decisions is
“maximization of Shareholders’ Wealth”. The Finance Manager
has to consider the joint impact of these three decisions on the
market price of the company’s Shares.

2. Linkage: a) A new project (investment) needs finance. Also, a

company may have to expand / develop its operations, which
require funds. Hence, Investment Decisions are based on the
Financing Decisions.

b) The Financing Decision is influenced by, and influences the

Dividend decision, since retained earnings used in internal
financing means reduction in dividends paid to Shareholders.

c) So, the inter – relationship between the three types of decisions

should be analyzed jointly, in order to maximize the Shareholders’
Wealth.

3. Decision – Making: The 3 decision can be linked to maximize

Shareholders’ wealth, in the following way –

a) Investment Decisions:

- Investment in Long Term Projects should be made after Capital

Budgeting and uncertainty analysis.

- Projects which give reasonable returns (higher than cost) in

order to add to the surplus of the Shareholders’, should be
selected. The returns should be high enough as to distribute
reasonable dividends and also retain adequate resources for the
Company’s growth prospects.

b) Financing Decisions:
 - Proper balancing between long – term and short – term funds as
well as own funds and loan funds will help the Firm to minimize its
overall cost of capital and increase its wealth / value.

- Low cost of funds will mean higher profit margins, which can be
used for dividend distribution as well as internal financing of new
projects / growth plans.

c) Dividend Decisions:

- The optimum dividend pay – ratio ensures that shareholders’

wealth is optimized.

- Where the funds at the disposal of the Company earn a higher

return than if distributed to shareholders’ wealth maximization
can be achieved by retaining the funds, rather than declaration of
dividend.

Investment Decisions (ie

investing funds for
Dividend decision
maximizing returns)

Ie Distribution of Profits

Business Operations
resulting in Surplus ie Profit
= Returns Less Cost Retention in
Financing Decisions (ie
Business
procuring
funds from various sources at
minimum cost)
Minimum Cost
ie Internal Fund generation
3. What is Capital Budgeting? Why is it such an important
exercise? RTP

1. Capital Budgeting Process:

a) Decision making with regard to investment in fixed assets

(capital projects), Long term Projects, or

b) Evaluation of expenditure decisions, which involve current

outlays / outflows but are likely to produce benefits over a longer
period of time, or

c) Forecast of likely or expected returns from a new investment

project and to determine whether returns are adequate.

2. Importance:

a) Substantial Initial Cost: Initial Investment is substantial.

Hence commitment of resources should be made properly.

b) Irreversibility: Decisions are irreversible in nature and

commitment of resources should be made on proper evaluation.

c) Risk: The longer the time period of returns, the greater is the
risk / uncertainty associated with cash flows. Hence, decision
should be taken after a careful review of all available information.

d) Period of uncertainty: Effect of decision is known only in the

future and not immediately. Cash outflows occur immediately,
while operating inflows / returns arise over a future period – of –
time, and hence is effected by uncertainty.

e) Complexity: Decisions are based on forecasting of future

events and inflows. Quantification of future events involves
application of statistical and probabilistic techniques. Careful
judgment and application of mind is necessary.

f) Surplus: Funds are obtained by a Firm at a certain cost (ie

WACC). Even internally generated funds have an implicit cost.
Hence, there is a need to obtain a surplus over and above the
cost of funds.

4. Write short notes on the Capital Budgeting Process. RTP

Capital Investment Decisions are part of the Capital Budgeting

process, which is concerned with determining – 1) which specific
projects a Firm should accept, 2) the total amount of capital
expenditure which the firm should undertake, and 3) how the
total amount of capital expenditure should be financed.

The Capital Budgeting Process consists of the following stages:

Stage Procedure
Planning -Identify the various available investment
opportunities

-Determine the ability of the management to

exploit / utilize the opportunities.

-Reject opportunities which do not have much

merit, and prepare Proposals in respect of
investment opportunities which have
reasonable value for the Firm.

Evaluation -Determine the inflows and outflows relating to

various proposals.

-Use appropriate technique (like NPV, IRR,

MIRR, PI etc) to evaluate the proposals.
Selection -Weigh the risk – return trade – off relating to
various investment proposals

-Compare WACC or Cost of Capital with the

Return(ROCE) from various proposals.
 -Choose that project which will maximize the
Shareholders’ wealth.
Execution -After deciding on the project to be
implemented, obtain the necessary funds for
the project.

-Establish the infrastructure (assets,

equipments, etc), acquire the resources, and
implement the project, according to the
stipulated time – frame.
Control -Obtain feedback reports (Capital Expenditure
Progress Reports, Performance Reports,
Internal Audit / Inspection Reports, etc) to
monitor the implementation of the project.
Review -After the project is over, review the project –
a) to explain its success or failure, and b) to
generate ideas for new proposals to be
undertaken in future.

5. What are the various types of Capital Investment

Decisions?

A. BASED ON FIRM’s EXISTENCE:

1. Cost Reduction Decisions: These decisions focus on

reduction of operating cost and improving efficiency. They can be
sub – classified into –

a) Replacement Decision: To replace an existing asset with a

new and improved one – which version to choose, etc.

b) Modernization Decisions: To install new machinery in the

place of an old one which has become technologically outdated.
2. Revenue Expansion Decisions: These decisions focus on
improving sales, product lines, improved versions of products etc.
These are sub – classified into –

a) Expansion Decisions: To add capacity to existing product

lines to meet increased demand, to improve production facilities
and to increased market share of existing products.

b) Diversification Decisions: To diversify and enter into new

product lines, venture into new markets, to reduce business risk
by dealing in different products and operating in different
markets.

B. BASED ON NATURE OF DECISION:

1. Mutually Exclusive Decision: Decisions are said to be

mutually exclusive if two or more alternative proposals are such
that the acceptance of one proposal will exclude acceptance of
the other alternative proposals. For example, a firm may be
considering proposal to buy either a low cost economy model
asset or a high cost super model asset. If the economy is
purchased, it means that the super model needs not be
purchased, and vice – versa.

2. Accept – Reject Decisions: These are opposite to mutually

exclusive decisions. The accept – reject decisions occur when
proposals are independent and do not compete with each other.
The firm may accept or reject a proposal on the basis of a
minimum return on the required investment. All proposals that
give a return higher than a certain desired rate are accepted and
the rest are rejected.

3. Contingent Decisions: These are dependent proposals. The

investments in one proposal require investment in one or more
other proposals. For example if a company accepts a proposal to
set up a factory in a remote area it may have to invest in
infrastructure also, eg building of roads, houses for employees
etc.

6. What are the basic financial factors used in Project

Evaluation?

The following basic financial factors are used in project evaluation

techniques -

1. Initial Investment: This equals the cash outflow at the initial

stage, net of salvage value of old assets if any. Initial Investment
= Cost of New Assets purchased + Investment in working Capital
Less Sale value of old assets, if any.

2. Cash Flow after Taxes (CFAT): This refers to the Cash

Inflows generated by the projects at various points of time.
Generally CFAT = PAT (Profit After Tax) + Depreciation and other
amortizations.

3. Terminal Inflows: At the end of the project, there may be

terminal inflows like – a) Recovery of Working Capital investment
in the project, b) Salvage value of fixed assets etc.

4. Project Life: The time period during which the project

generates positive Cash Flow After Taxes is called Project Life. It
is determined based on – a) technological obsolescence, b)
physical deterioration, and c) fall in market demand for the
product.

5. Time value of Money: The value of money differs at different

point of time. So the Present Value of future Cash Inflows will be
computed by discounting the same at the appropriate discount
rate.

6. Discount Rate: It represents the cut – off rate for capital

investment evaluation. A project which does not earn at least the
cut – off rate should not be accepted. Generally, the rate used for
discounting is the Weighted Average Cost of Capital of the
enterprise.

7. How are Project Cash Flows estimated?

Project Cash Flows refer to the Costs (Cash Outflows) and Benefits
(cash Inflows) associated with the Project. Since future flows are
forecasted, an element of uncertainty or probability exists in
these cash flows. The following points are to be considered in the
estimation of future Cash Flows of a project -

1. Initial Investment estimation: Generally, Initial Investment

includes the cost of the following – a) new equipment, b) removal
and disposal of old equipment, c) preparing the site and erection
of equipments, and d) ancillary equipments or utilities.

Other Factors to be considered in initial investment estimation –

a) Impact of possible inflation on the value of Capital Goods,

b) Possibility of foreign exchange rate fluctuations, in case of

Imported Capital Goods,

c) Subsidy of Special Capital Incentives if any, against certain

Capital Goods.

d) Scrap Value or Net Realizable Value of old assets and

equipment.

e) Possibility of delay in the execution of the project and overruns

due to delay beyond expected time.

2. Estimation of Additional Working Capital Requirements:

a) Every Capital Project involves additional Working Capital to

finance the increase in the level of activity (i.e. the need for
maintaining higher Sundry Debtors, Stock-in-Hand, Cash and Bank
Balances, etc). So, the additional Working Capital required to
facilitate expansion or diversification should be estimated
carefully by the Finance Manager.

b) As the new capital project starts operating, the requirement

should be shown in term of Cash Outflows. At the expiry of the
useful life of the project the working capital will be released and
can, therefore, be treated as Cash Inflow.

c) In case of inflation, additional amount of working capital may

be required every year, even though there is no increase in the
activity levels.

3. Estimation of production and Sales: The possible

production and sales are based on the following –

a) Nature of the market,

b) Effect of Price Change on Demand,

c) Extent of Competition,

d) Effect of Advertisement and promotional expenditure,

e) Capacity of plant and the budgeted level of utilization.

The Gross Sale Revenue is estimated as Sale Quantity X Selling

Price per unit.

4. Estimation of Cash Expenses:

a) Major items of Cash Expenses like Raw Materials, Labor, Power

and Fuel, Repairs and Maintenance, Administrative Expenses,
Sales promotion Expenses, etc are estimated individually.

b) In expenses estimation, distinction should be drawn between –

i) Fixed Cost, which remains the same at various activity levels
and ii) Variable Cost, which varies at different levels of output.

5. Estimation of Cash Inflows: The Cash Inflows for every year

is determined in the following manner –
a) Project Earnings = EBIT X (100% - Tax Rate) (OR) EAT +
Interest Expenses (100% - Tax Rate)

b) Cash Inflows after Taxes (CAFT) = Project Earnings +

Depreciation

8. What are the principles involved in the estimation of

Project Cash Flows?

On the basis of relevance to decision-making, Costs are classified

into A) Relevant and B) Irrelevant Costs.

A) Relevant Costs: These are costs which are relevant and

useful for decision-making process.

1) Marginal Cost: Marginal Cost is the total variable cost, i.e.

Prime cost plus Variable Overheads. It is assumed that variable
cost varies directly with production whereas fixed cost remains
fixed irrespective of volume of production. Marginal Cost is a
relevant cost for decision making as this cost will be incurred in
future for additional units of production.

2) Differential Cost: It is the change in costs due to change in

the level of activity or pattern or method of production. Where the
change results in increase in cost it is called Incremental cost
whereas if costs are reduced due to decrease of output, the
difference is called Decremental costs.

3) Opportunity cost:

a) This refers to the value of sacrifice made or benefit of

opportunity foregone in accepting an alternative course of action.

b) Example: Firm may finance its expansion plan by withdrawing

money from its bank deposits. Then, the loss of interests on the
bank deposit is the opportunity cost for carrying out the
expansion plan. Similarly, if a person quits his job and enters into
business, the salary forgone from employment constitutes
opportunity cost.

c) Opportunity Cost is a relevant cost where alternatives are

available. However, opportunity cost is not recorded in formal
accounts and is computed only for decision- making and
analytical purposes.

4) Out – of – pocket Costs: These are costs which entail current

or near future outlays of cash for the decision at hand as opposed
to costs which do not require any cash outlay like depreciation.
Such costs are relevant for decision – making, as these will occur
in near future. It is that portion of total cost which involves cash
outflow.

5) Replacement Cost: It is the cost at which there could be

purchased of an asset or material identical to that which is being
replaced or revalued. It is the cost of replacement at current
market price and is relevant for decision – making.

6) Imputed Costs: These are notional costs appearing in the

cost accounts only e.g. notional rent charges, interest on capital
for which no interest has been paid. Where alternative capital
investment projects are being evaluated, it is necessary to
consider the imputed interest on capital before a decision is
arrived at, as to which is the most profitable project.

7) Discretionary Costs: These are “escapable” or “avoidable”

costs. These can be avoided if a particular course of action is not
chosen. In other words, these are costs, which are essential for
the accomplishment of a managerial objective.

8) Engineered Costs: These are costs that result specifically

from a clear cause and effect relationship between inputs and
outputs. The relationship is usually directly and personally
observable. Examples of inputs are Direct Material Costs, etc.
examples of output are the products.
B) Irrelevant Costs: These are costs which are not relevant or
useful for decision – making.

1. Sunk Cost: it is a cost which has already been incurred or

sunk in the past. It is not relevant for decision – making and is
caused by complete abandonment as against temporary shut –
down.

2. Absorbed Fixed Cost: Fixed Costs do not change due to

increase or decrease in activity. Although such fixed costs are
absorbed in cost of production at a normal rate, they are
irrelevant for managerial decision – making. However, if Fixed
Cost are specific, they become relevant.

3. Committed Cost: A cost which has been already committed

by the management is not relevant for decision – making. This
should be contrasted with discretionary costs, which are
avoidable costs.

10. Explain the main features in the preparation of project

report distinguishing between viability, feasibility,
escalation and overrun aspects. RTP

1. Definition: Project Report or Feasibility Report is a return

account of various activities to be undertaken by a firm and their
technical, financial, commercial and social viabilities.

2.Purpose: Project report states as to what business is intended

to be undertaken by the entrepreneur and whether it would be
technically possible, financially viable, commercially profitable
and socially desirable to do such a business.

3.Features of a Project Report:

a) Technical Feasibility: This includes analysis about the

technical requirements of the industry in relation to the project in
hand and involves an examination of issues like suitability of plant
location, adoption of appropriate technology, selection of
machinery and plant etc.

b) Economic, Financial and Commercial Viability:

-Economic Viability is concerned with a thorough analysis of

present and future market prospects for the proposed product
and involves the study of possible competitors in the market and
the firm’s relative cost advantages and disadvantages in relation
to them.

-Financial Viability includes estimation of capital requirements

and its costs, computation of operating costs, forecasting of sales
revenue, arrangement of credit, measurement of profit, finding
out the break-even points, assessment of fixed and variable
costs, cash flow estimates, etc.

-Commercial Viability includes the estimation of the selling

problems and profitability of the project. A project must,
therefore, be economically, financially and commercially viable.

c) Social Viability:

- Business entity depend heavily on specialized Financial

Institutions, funded or approved by Government, for procuring
finance, Government or its agencies would extend assistance to a
business unit only if the proposed project is socially desirable.

- Social viability becomes necessary for performing the social

responsibilities of the firm. Therefore, at the time of preparing the
project report, the social benefits of the project must be analyzed
well.

11. What are the contents of a project report?

A project report consists of the following –

1. Industry Information –

a) Information about industry and its status in the economy,

present production and demand pattern, indicating licensed,
installed capacity. Government policies and export potential.

b) Broad market trend of the product and by-products within and

outside the states/ country for 5 years.

2. Production Process-

a) Broad description of different production processes and their

relative economies.

b) Availability of technical know-how within and outside the

country.

3. Raw materials, specification and quality of raw materials

required and their sources of availability.

4. Man Power- Availability of skilled labor and other grades of

labor to meet the project’s requirements.

5. Resources/ Utilities-

a) Location of plant, its advantage and justifications.

b)Water – requirements of water for process, boiler feed, cooling

etc, sources of water available and making it usable for the
factory and to townships, etc.

c)Power – total power requirements for the factory, specification

of power and choice between purchased power and generated
power. If power to be generated – total cost of investment, choice
of fuel and the cost for fuel available to factory.

d)Fuel – its requirement for steam raising or processing source,

and price at which it will be available for factory.
e) Effluents – type and quality of effluents, their treatment and
disposal, investment in the effluent treatment and disposal,
approvals from authorities like pollution control board etc.

6. Implementation Programme- Implementation and

construction programme in the form of CPM/PERT and flow charts
indicating critical paths and schedules.

7. Cost of Project- Expenditure on Land, buildings, plant and

machinery, preliminary expenses, contingencies, cost of spares,
commissioning expences, working capital margin requirements.

8. Pattern of Finance- details of capital structure or financing

mix broad pattern, promoter’s contribution, loan components etc.

9. Cost of Production- project broad pattern for 5years vis-à-vis

design capacity, break-even point, effect of variation of cost of
raw materials, utilities, selling price etc, price trend of raw
materials and finished goods.

10. Profitability – a) Profitability for 5years after commission of

the project should be worked out.

b) Cash flow statement and pay-back period for the project.

11.Organisation and management – description of corporate

management, promoter’s experience and background,
organizational chart, key personnel, delegation of power, and
responsibility structure.

12. What are the advantages of a project report?

The advantages of a project report are-

1.Lists the objective in various spheres of business and evaluates

the objectives in the right perspective.
2. Identifies constraints on resources viz manpower, equipment,
financial and technological etc well in advance to take remedial
measures in due course of time.

3. Facilities planning of business by setting guideline for future

action. The successful implementation of a project depends upon
the projected profitability and cash flows, production scheduled
and targets as laid down in the project report.

4. Helps in procuring finance from various financial institutions

and banks which ask for such detailed information before giving
any assistance.

5. Provides a framework of the presentation of the information

regarding business required by government for granting licenses
etc.

13. What are the steps taken in project appraisal by the

financial institutions? Do these steps differ in inflationary
and deflationary conditions? RTP

1. Meaning: project appraisal is a process whereby a lending

financial institution makes an independent and objective
assessment of the various aspects of an investment proposal, for
arriving at a financing decision.

2. Purpose: appraisal exercises are aimed at determining the

viability of a project, and sometimes reshape the project so as
to upgrade its viability.

3. Steps in appraisal: major steps undertaken by financial

institutions under project appraisal are -

a) Promoter’s Capacity: Promoters capacity and competence is

examined with reference to their-

- management background,

-traits as entrepreneurs,
-business or industrial experience,

-past performance etc

Different considerations are applied in the case of new

entrepreneurs.

b) Project report: project report must be complete in all aspects

so that its appraisal becomes easy and relevant. For this purpose,
the project report should be a self- contained study with
necessary feasibility report, market surveys etc.

c) Viability Test: viability test of a project is to be carried out

by examining the project from different aspects viz, technical,
economic, financial, commercial. Management, social and other
related aspects as discussed below -

Technical feasibility It involves consideration of

technical aspects like location
and size of the project,
availability, quality and cost of
services, supplies of raw
materials, fuel, power, land,
labour, housing transportation
etc.
Economic It is done on the basis of market
analysis of the product or
service with particular.
Viability Reference to the size of the
market, projected growth in the
market demand, and the
market share expected to be
captured.
Financial vaibility It involves evaluation of project
cost in the light of period of

Management capability
Social relevance
construction work, provision for
cost escalation, timing of raising
funds, projected cost of
production and profitability, and
cash flow projections, to ensure
the potentiality of the project to
meet the current and long term
obligations.
It is an examination of the track
record of promoter’s, their
background and capabilities,
and competence of the
management team.
Social relevance of a project like
conformity with national policies
and plant priorities are also
important factors to be
considered in project appraisal.

4. Appraisal in inflationary and deflationary situations:

project appraisal during inflationary and deflationary conditions
does not differ materially from that of an appraisal during normal
conditions, except that the financial, economic and commercial
aspects require to be taken care of-

Inflationary Situations Deflationary situations

a) Project cost, prices of raw
materials and labor cost will go
up. Hence there would be a
decline in the profitability, as
the prices of end products are
controlled by the government or
a) During a recessionary period,
the stocks of finished goods
tend to accumulate resulting in
the blocking up of working
capital, and thereby
contributing to the sickness of
market. the project.

b) Market may not be prepared b) It is important to take into

to pay a higher price during an consideration the economic
inflationary period. Such a conditions while appraising a
situation impairs the financial project.
viability of the project.

14. Write a brief note on project appraisal under

inflationary conditions. N03

1. Cost escalation: It is required to make provisions for cost

escalation on all heads of cost, keeping in view the rate of
inflation of during likely period of delay in project implementation.

2. Cost of funds: The various sources of finance should be

carefully scrutinized with reference to probable revision in the
rate of interest by the lenders and the revision which could be
effected in the interest bearing securities to be issued. All these
factors will push up the cost of funds for the firm.

3. Adjustment in projections: Adjustments should be made in

profitability and cash flow projections to take care of the
inflationary pressures affecting future projections.

4. Re-evaluation of financial viability:

a) The financial viability of the project should be examined at the

revised rates and should be assessed with reference to economic
justifications of the project.
b) The appropriate measure for this aspect is the economic rate of
return for the project, which will equate the present value of
capital expenditures to net cash flows over the life of the project.

c) The rate of return should be acceptable which also

accommodates the rate of inflation per annum.

5. Choice of Project: In an inflationary situation, projects having

early pay back periods should be preferred because projects with
long payback period are more risky.

6. Approaches:

a) Adjustment of Cash flows: Projected Cash flows should be

adjusted to an inflation index, recognizing selling price increases
and cost increases annually; or

b) Adjustment of Cut-off rate: “Acceptance Rate” (Cut-off)

should be adjusted for inflations, retaining cash flow projections
at current price levels.

Note: Adjustment in both the cash flows and the cut – off rate
should not be done.

2. PROJECT EVALUATION TECHNIQUES

15. List some technique of evaluating a project’s financial

viability.

The following are some techniques of Project Evaluation –

1. Simple Payback Period

2. Discounted Payback Period

3. Payback Reciprocal

4. Accounting or Average Rate of Return (ARR)

5. Net Present Value (NPV) or Discounted Cash Flow (DCF)

6. Profitability Index (PI) or Desirability Factor or Benefit – Cost

Ratio.

7. Internal Rate of return (IRR) and Modified Internal Rate of

Return (MIRR)

16. What do you understand by Payback Period? How is it

determined?

1. Meaning: a) Payback period represents the time period

required for complete recovery of the initial investment in the
project. It is the period within which the total cash inflows from
the project equals the cost of investment in the project.

b) The lower the payback period, the better it is, since initial
investment is recouped faster.

2. Example: Suppose a project with an initial investment of Rs

100 lakhs, yields profit of Rs 20lakhs, after writing off
depreciation of Rs 5 lakhs per annum. In this case, the payback
period is computed as under –

a) CFAT per annum = PAT + Depreciation = Rs 20 + Rs 5 = Rs 25

lakhs

b) Hence Payback Period = Initial Investment/ CFAT per annum =

100/25=4years.

3. Procedure for computation of Simple Payback Period:

a) Determine the initial investment (Cash Outflow) of the Project.

b) Determine the CFAT (Cash Inflows ) from the project for various
years.

c) Compute payback period as under-

In case of uniform CFAT In case of Differential
CFAT for various years

per annum

Payback period = Initial Investment -compute

cumulative CFAT at the end

CFAT per annum of every year

- Determine the year in which

cumulative CFAT exceeds
Initial Investment.

- Payback period = Time at

which cumulative CFAT =
Initial Investment (Calculated
on time proportion basis)

d) Accept if payback period is less than maximum or benchmark

period, else reject the project.

17. Bring out the advantages and disadvantages of the

Simple payback method.

A. ADVANTAGES:

1. This method is simple to understand and easy to operate.

2. It clarifies the concept of profit or surplus. Surplus arises only

if the initial investment is fully recovered. Hence, there is no profit
on any project unless the payback period is over.

3. When funds are limited, projects having shorter payback

periods should be selected, since they can be rotated more
number of times.
4. This method is suitable in the case of industries where the risk
of technological obsolescence is very high and hence only
those projects which have a shorter payback period should be
financed.

5. This method focuses on projects which generates Cash

inflows in earlier years, thereby eliminating projects bringing
cash inflows in later years. As time period of cash flows increases,
risk and uncertainty also increases. Thus payback period tries to
eliminate or minimize risk factor.

6. This method promotes liquidity by stressing on projects with

earlier cash inflows. This is a very useful evaluation tool in case of
liquidity crunch and high cost of capital.

7. The payback period can be compared to a break-even point,

the point at which the costs are fully recovered but profits are yet
to commence.

B. LIMITATIONS:

1. It stresses on capital recovery rather than profitability.

2. It does not consider the post – payback cash flows, i.e.

returns from the project after its payback period. Hence, it is not
good measure to evaluate where the comparison is between two
projects, one involving a long gestation period and the other
yielding quick results but only for a short period.

3. This method becomes an inadequate measure of evaluating

two projects where the cash inflows are uneven. There may be
projects with heavy initial inflows and very less inflows in later
years. Other projects with moderately higher but uniform CFAT
may be rejected because of longer payback.

4. This method ignores the time value of money. Cash flows

occurring at all points of time are treated equally. This goes
against the basic principle of financial analysis which stipulates
compounding or discounting of cash flows when they arise at
different points of time.

18. Outline the manner of computation of discounted

payback period.

When the payback period is computed after discounting the cash

flows by a pre determined rate (cut- off rate), it is called as the
‘Discounted Payback Period’. It is computed as under –

Step Procedures
1 Determine the total cash outflow of the project.(Initial
Investment)
2 Determine the cash inflow after taxes (CFAT) for each
year.
3 Determine the PV factor for each year and compute
discounted CFAT (DCFAT) for each year.

DCFAT = CFAT of each year X PV factor for that year.

4 Determine the cumulative DCFAT at the end of every
year.
5 Determine the year in which cumulative DCFAT exceeds
initial investment.
6 Compute discounted payback period as the time at which
cumulative DCFAT = Initial Investment. This is calculated
on “time proportion basis”.
7 Accept if discounted payback period less than maximum/
benchmark period, else reject the project.

19. What do you mean by payback reciprocal? How is it

used for project evaluation?
1. Meaning: It is the reciprocal of payback period. It is expressed
in percentage and computed as under –

Payback reciprocal = Average annual cash inflows (i.e. CFAT p.a.)

Initial Investment

2. Utility: The payback reciprocal is considered to be an

approximation of the internal rate of return, if –

a) The life of the project is at least twice the payback period and

b) The project generates equal amount of the annual cash inflows.

3. Example: A project with an initial investment of Rs 50 lakhs

and life of 10 years, generates CFAT of Rs 10 lakhs per annum. Its
payback reciprocal will be Rs 10lakhs/ Rs 50lakhs = 20%.

20. Write a brief note on Accounting or Average Rate of

Return Method (ARR).

1. Meaning: Accounting or Average Rate of Return means the

average annual yield on the project. In this method, Profit after
taxes (instead of CFAT) is used for evaluation.

2. Procedure for computation of ARR:

St Procedure
ep
1. Determine net investment of the project. Net investment =
Initial Investment less Salvage Value.
2 Determine the Profits After Tax (PAT) for each year. PAT =
CFAT less depreciation.
3 Determine the total PAT for N years, where N = Project life.
4 Compute average PAT per annum = total PAT of all years/ N
years
5 ARR = Average PAT per annum / Net Investment = sept 4 /
 Sept 1

3. Advantages:

a) simple to understand

b) easy to operate and compute

c) Income throughout the project life is considered.

4. Limitations:

a) It does not considers cash inflows (CFAT), which is important in

project evaluation rather than PAT.

b) It takes the rough average of profits of future years. The

patterns of fluctuations in profits are ignored.

c) It ignores time value of money, which is important in capital

budgeting decisions.

21. Explain the net present value method (NPV)

discounted cash flow technique (DCF).

1. Meaning: The Net present value of an investment proposal is

defined as the sum of the present values of all future cash inflows
less the sum of the present values of all cash outflows associated
with the proposal. Thus, NPV is calculated as under –

NVP = Discounted Cash Inflows Less Discounted Cash Outflows.

NPV= FV1/(1+K)1 + FV2/(1+K)2 + FV3/(1+K)3 + FV4/(1+K)4 + ……+

FVn/(1+K)n Less initial Invt0

Note: K = Cut –off rate, FV = Future Cash inflows arising at

points of time 1,2,3,4……n Initial Investment pertains to Time 0
and is hence not discounted.
2. Procedure for computation of NPV:

Ste Procedure
p
1. Determine the total cash outflow of the project and the
time periods in which they occur.
2. Compute the total discounted cash outflow = outflow X PV
factor
3. Determine the total cash inflows of the project and the time
periods in which they arise.
4. Compute the total discounted cash inflows = Inflow X PV
factor
5. Compute NVP = Discounted Cash inflows less discounted
Cash outflows (Step 4 less step 2)
6. Accept project if NPV is positive, else reject.

3. Decision making or Acceptance rule:

If Decision
NVP> 0 Accept the project. Surplus over and above the cut –
off rate is obtained.
NPV=0 Project generates cash flows at a rate just equal to
the coat of capital. Hence, it may be accepted or
rejected. This constitutes an indifference point.
NPV<0 Reject the project. The project does not provide
returns even equivalent to the cut – off rate.

4. Cash outflows: Generally, cash outflows consists of – a)

initial investment which occurs at time “0” and b) special
payments and outflows, eg Working Capital outflow which arises
in the year of commercial production, Tax paid on Capital Gain
made by sale of old asset, if any.

5. Cash inflows: cash inflows = CFAT. Also, specific cash inflows

like salvage value of new assets and recovery of working capital
at the end of the project, tax savings on loss due to sale of old
asset, should be carefully considered. The general assumption is
that all cash inflows occur at the end of each year.

6. Discounting cash inflows and outflows: Each item of cash

inflow and cash outflow is discounted to ascertain its present
value. For this purpose, the discounting rate is generally taken as
the cost of capital since the project must earn at least what is
paid out on the funds blocked in the project. The present value
tables are used to calculate the present value of various cash
flows. In case of uniform cash inflows p.a., annuity tables may be
used.

7. Use of discounting rate: of using the PV factor tables, the

relevant discount factor can be computed as 1/(1+k)n, where k =
cost of capital and n = year in which the inflow or outflow takes
place.

Hence, PV factor at the end of two years = 1/(1.10)1 = 0.9091

Similarly, PV factor at the end of two years = 1/ (1.10)2 = 0.8264

and so on.

Note: The NPV method will give valid results only if money can
be immediately reinvested at a rate of return equal to the firm’s
cost of capital.

22. What are the merits and demerits of the NPV method?

A.ADVANTAGES:
1. It considers the time value of money. Hence, it satisfies the
basic criterion for project evaluation.

2. Unlike payback period, all cash flows (Including post-payback

returns) are considered.

3. NPV constitutes addition to the wealth of shareholders and thus

focuses on the basic objective of financial management.

4. Since all cash flows are converted into present value (current
rupees), different projects can be compared on NPV basis. Thus,
each project can be evaluated independent of others o its own
merit.

B. LIMITATIONS:

1. It involves complex calculations in discounting and present

value computations.

2. It involves forecasting cash flows and application of discount

rate. Thus accuracy of NPV depends on accurate estimation of
these two factors which may be quite difficult in practice.

3. NPV and project ranking may differ at different rates, causing

inconsistency in decision – making.

4. It ignores the difference in initial outflows, size of different

proposals etc, while evaluating mutually exclusive projects.

23. What is desirability factor? How is it determined? RTP

Write a brief note on profitability index.

1. Definition: Benefit – cost ratio / profitability index or

desirability factor is the ratio of present value of operating cash
inflows to the present value of net investment cost.

PI [or] desirability factor [or] benefit cost ratio =

Present value of operational cash inflows

Present value of net investment

2. Significance: Profitability index represents amount obtained

at the end of the project life, for every rupee invested in the
project. The higher the PI, the better it is , since the greater is the
return for every rupee of investment in the project.

3. Decision making or acceptance rule:

If Decision
PI>1 Accept the project. Surplus ever and above the cut – off
rate is obtained.
PI = 1 Project generates cash flows at a rate just equal to the
cost of capital. Hence, it may be accepted or rejected.
This constitutes an indifference point.
PI < 1 Reject the project. The project does not provide returns
even equivalent to the cut – off rate.
Note: when NPV > 0, PI will always be greater than 1. Both NPV
and PI use the same factors i.e. discounted cash inflows (A) and
discounted cash outflows (B), in the computation. NPV = A – B,
whereas PI = A / B.

4. Advantage:

a) This method considers the time value of money.

b) It is a better project evaluation technique than Net Present

Value and helps in ranking projects where Net Present Value is
positive.

c) It focuses on maximum return per rupee of investment and

hence is useful in case of investment in divisible project, when
availability of funds is restricted.

5. Disadvantage:
a) In case a single large project with high profitability index is
selected, possibility of accepting several small projects which
together may have NPV then the single project is excluded.

b) Situations may arise where a project with a lower profitability

index selected may generate cash flows in such a way that
another project can be taken up one or two years later, the total
NPV in such case being more than the one with a project with
highest profitability index.

c) In case of more than one proposals, which are mutually

exclusive, with different investment patterns or values,
profitability index alone cannot be used as a measure for
choosing.

24. Write short notes on Internal Rate of Return. M96

1. Meaning: Internal rate of return (IRR) is the rate at which the

sum total of discount cash inflows equals the discount cash
outflows. The internal rate of return of a project is the discount
rate which makes net present value of the project equals to zero.

IRR refers to that discount rate K, such that

FV1/(1+K)1 + FV2/(1+K)2 + FV3/(1+K)3 + FV4/(1+K)4 + ……+ FVn/

(1+K)n Less initial Invt0 = 0 (Zero)

At IRR, NPV = 0 and PI = 1

The discount rate , i.e. cost of capital is assumed to be known in

the determination of net present value, while in the IRR
calculation, the net present value is equal to zero and the
discount rate which satisfies this condition is determined.

2. Interpretation: Internal rate of return can be interpret in two

ways – a) IRR represents the rate of return on the unrecovered
investment balanced in the project.
b) IRR is the rate of return earn on the initial investment made in
the project.

Of these, the first view seems to be more realistic, since it may

not always be possible for an enterprise to reinvest intermediate
cash flows at a rate equal to the IRR.

3. Decision making or acceptance rule :

If Decision
IRR > Accept the project. Surplus over and above the cut –off
K0 rate is obtained.
IRR = Project generates cash flows at a rate just equal to the
K0 cost of capital. Hence, it may be accepted or rejected.
This constitutes an indifference point.
IRR < Reject the project. The project does not provide returns
K0 even equivalent to the cut – off rate.

4. Procedure for computation of IRR:

Step Procedure
1 Determine the total cash outflow of the project and the
time periods in which they occur.
2 Determine the total cash inflows of the project and the
time periods in which they arise.
3 Compute the NPV at an arbitrary discount rate, say
10%
4 Choose another discount rate and compute NPV. The
second discount Rate is chosen in such a way that one
of the NPV’s is negative and the other is positive.
Suppose, NPV is positive at 10% choose a higher
discount rate so as to get a negative NPV. In case NPV
is negative at 10%, choose a lower rate.
5 Compute the change in NPV over the two selected
discount rates.
6 On proportionate basis, compute the discount rate at
which NPV is zero.
5. Advantages:

a) time value of money is taken into account.

b) all cash inflows of the project, arising at different points of time

are considered.

c) decisions are immediately taken by comparing IRR with the

cost of capital.

d) It helps in achieving the basic objective of maximization of

shareholders wealth. All projects having IRR above the cost of
capital will be automatically accepted.

6. Disadvantages:

a) IRR is only an approximation and cannot be computed exactly

always.

b) It is tedious to compute in case of multiple cash outflows .

Multiple IRR’s may result, leading to difficulty in interpretation.

C) It may conflict with NPV in cash inflow / outflow patterns are

different in alternative proposals.
d) The presumption that all the future cash inflows of a proposal
are reinvested at a rate equal to the IRR may not be practically
valid.

25. Write short notes on the modified internet rate of

return (MIRR)

Modified internal rate of return is computed as under –

Step Procedure
1 Determine the total cash outflows and inflows of the
project and the time periods in which they occur.
2 Compute terminal value of all cash flows other than the
initial investment. For this purpose, terminal value of a
cash flow = Amount of Cash flow X Re-investment
Factor, where reinvestment factor = (1+ K)n
where n = number of years balance remaining in the
project.
3 Compute total of terminal values as computed under step
2. This is taken as the “inflow” from the project, to be
compared with the “outflow” i.e. the initial investment.
4 Compute MIRR, i.e. discount rate such that PV of terminal
value = initial investment.

Note: for computing MIRR, the interpolation techniques

applicable to IRR may be used.

26. How should the comparison of two mutually exclusive

projects be prepared be treated when they are of unequal
investment size?

Compare between two projects can be done based on NPV

method only if initial investment and project lives are the same.
Where project lives are different, the decisions can be obtained
by any of the following methods –

1.Equivalent annual flows method:

a) Cash flows are converted into an equivalent annual annuity

called EAB i.e., Equivalent annual benefit (in case of net inflow) or
EAC i.e., equivalent annual cost (in case of net outflow) i.e., Total
discounted cash flows / Total discount factor for the period.

b) The amounts are then compared and decisions drawn i.e., in

case of cost comparison, proposal with the lower equivalent
annual flow will be selected, and in case of benefit comparison,
proposal with the higher annual flow will be selected.

2. LCM method:

a) Evaluate the alternatives over an interval equal to the lowest

common multiple of the lives of the alternatives under
consideration.

b) Example, proposal A has 3 years and proposal B has 5 years.

Lowest common multiple period = 15 years, during which period
machine A will be replaced 5 times and machine B will be
replaced 3 times. Cash flows are extended to this period and
computations made. The final results would then be on equal
platform i.e., equal years, and hence would be comparable.

c) This is similar to the equivalent annual benefits / cost method,

discussed above.

3. Terminal value: Estimate the terminal value for the

alternatives at the end of a certain period i.e., product life. In the
above example, if the product can be produced only for 3years,
the salvage value at the end of the 3rd year should be considered
in the evaluation process.
27. Explain the annual equivalent annual flows methods
used in project – life disparity situations.

Step Procedure
1 Compute the initial investment of each alternative
2 Determine the project lives of each alternative
3 Determine the annuity factor relating to the project life
of each alternative
4 Compute equivalent annual investment (EAI) = initial
investment / relevant annuity factor
5 Compute CFAT per annum or cash outflows per annum,
of each alternative.
6 Compute equivalent annual benefit (EAB) = CFAT per
annum Less EAI OR Compute equivalent annual Costs
(EAC) = Cash outflows per annum + Cash outflows per
annum + EAI
7 Select project with maximum EAB or minimum EAC, as
the case may be.

28. Explain how investment decisions are taken in a

capital rationing situation.

1. Resource constraint: There may be situations where a firm

has a number of projects that yield a positive NPV. However, the
most important resource in investment decisions, i.e., funds is not
fully available to undertake all the projects. Such a situation is
considered as a resource constraint situation.

2. Capital rationing: In case of restricted availability of funds,

the objective of the firm is to maximize the wealth of
shareholders with the available funds. Such investment planning
is called capital rationing. There are two possible situations of
capital rationing-

(a) Generally, firms fix up maximum amount that can be invested in capital
projects, during a given period of time, say a year. This budget ceiling
imposed internally is called as Soft Capital Rationing.

(b) Theremay be market constraint on the amount of funds available for

investment during a period. This inability to obtain funds from the market,
due to external factor is called Hard Capital Rationing.

3. NPV Maximization: Whenever Capital Rationing exists, the Firm should

allocate the limited funds available in such a way that maximizes the NPV of
the Firm. The following principles may be applied in selecting the appropriate
investment proposals/combinations-

Nature of Project Indivisible Divisible

Meaning Investment should be Partial investment is
made in full, partial or possible and
proportionate investment proportionate NPV can
is not possible. be obtained.
Step involved in • Determine the • Compute PI of
decision-making combination of various projects
project to utilize and rank them
amount available. based on PI
• Compute NPV of • Projects are
each combination. selected based on
• Select combination maximum
with maximum Profitability Index.
NPV

4. Other Factors: In the above procedure, it is assumed that the investment

funds are restricted for one period only, i.e. if investment is not made
immediately, the project will lapse. However, in the following situations,
additional mathematical techniques are adopted to resolve the Capital Rationing
problem-
(a) Cost of investment projects spread over several periods.

(b)Projects providing relatively higher cash flows in earlier years, which can be
used for incre3asing the fund availability for other projects in those early years.

29. Do the Profitability Index (PI) and Net Present Value (NPV) criterion
of investment proposals lead to the same acceptance-rejection and ranking
decisions? In what situations will they give conflicting result?

1. Acceptance-Rejection Decision:

(a) Both NPV&PI techniques recognize the time value of money.

(b) The discount rate used in NPV and PI methods are the same.

(c) Both NPV and PI use the same factors i.e. Discounted Cash Inflow (A) and
Discounted Cash Outflows (B), in the computation. NPV=A-B, whereas
PI=A/B.

(d) When NPV>0, PI will always be greater than 1. Also when NPV<0, PI will
be less than 1.

(e) Hence, for a given project, NPV and PI method give the same Accept or
Reject decision.

2. Ranking criteria: However, if one project is to be selected out of two

mutually exclusive projects, the NPV and PI method may give conflicting
ranking criteria. An example is given below-

Project P Q
Discounted Cash Inflows Rs.10 Lakhs Rs.5 Lakhs

Less: Discounted Cash Outflows Rs.5 Lakhs Rs.2 Lakhs

Net Present Value Rs.5 Lakhs Rs.3 Lakhs
Profitability 2.00 2.50
Project P has a better ranking based on NPV while Project Q will be preferred if
PI were to be used for decision –making. Thus, there is a conflict in Ranking,
between NPV and PI methods. This is because NPV gives the ranking in terms
of absolute value of rupees, whereas PI gives ranking for every rupee of
investment, i.e. in terms of ratio.

3. Decision-making: Generally the NPV method should be preferred since

NPV indicates the economic contribution or surplus of the project in absolute
terms. However, in capital rationing situation, for deciding between mutually
exclusive projects, PI is a better evaluation technique.

30. In case of NPV and IRR, which method is superior in project

evaluation? M 02, M 01

1. Causes for Conflict: Higher the NPV, higher will be the IRR. However,
NPV and IRR may give conflicting result in the evaluation of different projects,
in the following situations-

(a) Initial Investment Disparity- i.e. Different Project Sizes,

(b) Project Life Disparity-I.e. Different in Project Lives,

(c) Outflow Patterns-i.e. when Cash Outflows arise at different point of time
during the Project Life, rather than as Initial Investment (Time 0) only.

(d) Cash Flow Disparity-when there is a huge difference between initial CFAT
and later years’ CFAT. A project with heavy initial CFAT than compared to
later years will have higher IRR and vice versa.

2. Superiority of NPV: In Case of conflicting decisions based on NPV and

IRR, the NPV method must prevail. Decisions are based on NPV, due to the
comparative of NPV, as given from the following points –

a) NPV represents the surplus from the project but IRR represents the point
of no surplus – no deficit.

b) NPV considers Cost of capital as constant. Under IRR, the discount rate
is determined by reverse working, by setting NPV = 0.
 c) NPV aids decision – making by itself i.e., projects with positive NPV are
accepted. IRR by itself does not aid decision – making. For example, a
project with IRR = 18% will be accepted if Ko < 18%. However, the
project will be rejected if Ko = 21% (say > 18%).

d) NPV method considers the timing difference in cash flows at the

appropriate discount rate. IRR is greatly affected by the volatility /
variance in cash flows patterns.

e) IRR presumes that intermediate cash inflows will be reinvested at the

rate (IRR), whereas in the case of NPV method, intermediate cash
inflows are presumed to be reinvested at the cut – off rate. The later
presumption viz. Reinvestment at the cut – off rate, is more realistic than
reinvestment at IRR.

f) There may be projects with negative IRR / Multiple IRR etc, if cash
outflows arise at different points of time. This leads to difficulty in
interpretation. NPV does not pose such interpretation problems.

31. Explain the concept of “social cost – benefit analysis”. Is it relevant for
private enterprises also? RTP

1. Meaning:

a) In evaluation of investment proposals, the return on investment factor is

considered dominant. However, since scarce resources are employed, the social
impact of investment proposals should also be considered. Such analysis is called
Social Cost Benefit Analysis (SCBA).

b) The purpose of SCBA to supplement and strengthen the existing techniques of

financial analysis.

2. Need for social cost benefit analysis (SCBA):

a) Market prices used to measure costs and benefits in project analysis, do not
represent social values due to imperfections in market.
b) Monetary Cost Benefit Analysis fails to consider the external effects of a
project, which may be positive like development of infrastructure or negative like
pollution and imbalance in environment.

c) Taxes and subsidies are monetary costs and gains, but these are only transfer
payments from social point of view and therefore irrelevant.

d) SCBA is essential for measuring the redistribution effect of benefits of a project

as benefits going to poorer section are more important than one going to sections
which are economically better off.

e) Projects manufacturing life necessities like medicines, or creating infrastructure

like electricity generation are more important than projects for manufacture of
liquor and cigarettes. Thus merit wants are important appraisal criterion for SCBA.

3. Procedure: Social Cost Benefit Analysis involves the following steps:

Step Procedure
1 Determine the problem to be considered.

2 Ascertain alternative solutions / projects to the problem

3 Estimate and analyst the social costs and benefits.

4 Appraise the estimated social costs and benefits.

5 Decide on the optimal solution.

4. Relevance of Social Cost Benefit Analysis for Private Enterprises:

a) Social cost benefit analysis is important for private corporation also which have
a moral responsibility to undertake socially desirable projects.

b) If the private sector includes social cost benefit analysis in its project evaluation
techniques, it will ensure that it is not ignoring its own long – term interest, since
in the long – run only projects that are socially beneficial and acceptable, will
survive.
c) Methodology of social cost benefit analysis can be adopted either from the
guidelines issued by the United Nations Industrial Development Organization
(UNIDO) or the Organization of economic corporation and development (OECD).
Financial institutions e.g., IDBI, IFCI, etc even insist on social cost benefit analysis
of a private sector project before sanctioning any loan.

d) Private enterprise cannot afford to lose sight of social aspects of a project.

3. Risk Analysis

Inflation affects various aspects of financial management. Issues to be addressed

while considering inflation in various aspects of financial management are as
follows –

1. Financial decisions:

a) This involves identifying the source from which the finance manager
should raise the quantum of funds required by a company.

b) Debenture holder and preference shareholders are interested in fixed

income while equity shareholders are interested in higher profits to earn
high dividend. The finance manager is required to estimate the amount of
profits he is going to earn in future.

c) While estimating the revenue and costs, he must take into consideration
the inflation factor, since under inflationary conditions, expectations of
equity shareholders will rise.

2. Investment Decision:

a) Investment decisions will be biased, if the impact of inflation is not

correctly factored in the analysis. This is because cash flows of an
investment project occur over a long period of time.

b) Non – consideration or inappropriate consideration will give rise to

wrong profitability values, and will result in incorrect decisions.
 3. Working Capital Decisions:

a) Impact of inflation should be considered while estimating the

requirements of working capital. Due to the increasing input prices and
manufacturing costs, more funds will be blocked in inventories and
receivables.

b) Even though working capital management is over a shorter period,

inflation rate may vary wildly even in short periods of time.

4.Dividend payout policy:

a) While taking dividend decisions, the finance manager has to consider the
inflation factor, and ensure that the capital of the company remains intact,
even after the payment of dividend.

b) In any inflationary situation, the depreciation provided on the basis of

historical costs of assets would not provide adequate funds for
replacement of fixed assets at the expiry of their useful lives.

c) Therefore, more profits may have to be retained than what has been
retained by way of depreciation. This is more relevant in case of those
industries, where technological changes industries, where technological
changes will render the existing infrastructure redundant at a rapid pace.

33. What is Sensitivity Analysis? RTP, N02

1. Meaning :

a) Sensitivity analysis shows the measure of sensitivity of a decision due to

changes in the values of one or more parameters.

b) In this analysis, each variable is fixed except one, which is changed to see the
effect on NPV or IRR. It is a study which determines how changes or errors in the
values of parameters affect the output of a model.

2. Objectives:

Sensitivity Analysis seeks to provide the decision maker with information

concerning –
 a) The behavior of the measure of economic effectiveness due to errors in
estimating various values of the parameters; and

b) The potential for reversal in the preferences as for economic investment

alternatives.

3. Steps in Sensitivity analysis:

Step Description of procedure

1 Conduct a base case analysis based on expectations for the future
cash flows and ascertain Net Present Value, Internal Rate of Return
and Profitability Index.
2 Identity key assumptions (variables) made in the base analysis.
3 Change one assumption at a time, and find the NPV, IRR or PI after
the change.
4 Determine the extent of change in NPV / IRR / PI, due to change in
variables, i.e., extent of sensitivity.
5 Summarize the conclusions based on findings obtained in Step 4.
The extent of change in NPV / IRR / PI reflects the extent of inverse
of extent of sensitivity.

4. Criticisms:

a) Assumptions of Unrelated Variables – Not valid : Sensitivity analysis

assumes variables to be completely unrelated to each other, which is generally
not the case. It is only when the combined effect of changes in the set of inter –
related variables is considered, a proper conclusion can be arrived at.

Example: Generally, when one variables changes, it may have an impact on

other variables as well. If quantity of goods sold is reduced by 30% in
sensitivity analysis, without adjusting the cost per unit, it would be
inappropriate, since the scale of activity will have a bearing on cost / price per
unit.
(b) Arbitrary: while using sensitivity analysis the financial analyst uses different
valves of the uncertain variables purely on adhoc basis. Assigning value in such an
arbitrary fashion is unscientific.

34. Explain the Certainty Equivalent Approach to Capital Budgeting. M02

1. Meaning: certainty equivalent approach recognize risk in capital budgeting

analysis, by adjusting estimate cash flow and employs risk free to discount the
adjusted cash flows.

2. Features:

Expected (a) The certainty equivalent approach adjust future cash

cash flow flows than the discount rate
(b) Expected cash flow is converted to equivalent riskless
amount. The greater the risk of expected cash flow ,
the smaller is the certain equivalent value for receipts,
and longer the certainty equivalent value for payment
Measurement (a) The certainty equivalent approach, the cash flow of
of Risk the proposal is adjusted so as to reflect the risk
element. This is superior to the risk adjusted discount
approach as it can measure risk more accurately.
(b) The approach explicitly recognizes risk but the
procedure for reducing the forecast of the cash flow is
implicit, and likely to be inconsistent from one
investment to another.

35 “Decision Tree Analysis is Helpful in Managerial Decision.” Explain RTP

1. Meaning: Decision tree analysis is the technique of solving /evaluating a

decision making problem by the mapping all feasible alternatives action,
assigning respective weight and evaluating the net effect of the different
at the starting point i.e. point of first alternative.

2. Assignment of the weights/ probabilities: Probabilities are the assign

for future uncertain event, for each alternative at each stage, as based on
the chance estimated by the Firm.
3. Components: Each decision tree has the two components or type of
nodes –

(a) Decision point, represent by the square boxes : Point where more
than one decision can be taken

(b) Chance point, represented by the circle: A decision which may

result in two or more outcome

4. Step:

(a) Identification and definition of the investment proposal.

(b) Identification of the decision alternatives

(c) Identification / estimation of possible outcome for each decision, i.e

assignment of probability and estimation of the cash flow.

(d) Drawing the branch of the tree showing the decision point, chance
events and other data indicating there in the projected cash flow,
probabilities and expected payoffs.

(e) Determination of the optimal decision (decision which result the

maximum net expected profit) at various decision point, and
elimination of the alternatives branches in the basic of the dominance.

(f) Evaluation of the project at the starting point, by the analysis of result
at each decision point by backward computation.

5. Benefits:

(a) Elimination unprofitable investments: Working backward from the

future to the present help in the eliminating unprofitable branches or
potentially unsafe decision and uncertain optimum decision point.

(b) Assumptions: the approach clearly set the implicit assumption and
calculation for all concerned with a project to see, question and revise.

(c) Easier to understand and interpret: Decision tree approach enables

a decision maker to visualize assumption and alternative in a graphic
form, which is much easier to understand, than plain fact and figures.
 6. Limitation/ shortcoming

(a) Decision tree analysis is applicable only to those projects with clearly
delineated stages. Not all the project can be clearly delineated for the
proposed of Decision Tree Analysis

(b) It can be applied only for project with sufficient information available
in respect of probabilities for the outcomes.

36. How would the standard deviation of the present value distribution help
in Capital Budgeting Decision ?
1. Meaning : Standard deviation is a statistical measure of dispersion, which
measure the deviation from a central number i.e the mean.
2. Applicability : Evaluation done in respect of two or more project giving the
similar cash flow
3. Purpose :
(a) It help to measure extent of the variation. Standard deviation give
deviation in value, while coefficient of variation give the extend of
deviation with reference to the central value
(b)It can be used to identify which of the project least, in tream of cash
flow
(c) If it is assumed that probability distribution is approximately normal, it
will be easy to calculate the probability of a cash budgeting generating
the NPV less than or more than the specified amount.
4. Decision: the project which have lower efficient of variation( variation per
unit ) will be preferred , if project sized are heterogeneous (different ).

37. Write a short note on Hiller’s model to risk analysis.

1. Standard deviation as a measured of Uncertainty: Uncertainty or the risk
associated with the capital expenditure proposal is shown by the standard
deviation of the expected cash flow.
2. Inference :lower the standard deviation ( i.e the deviation of cash flow from
the mean cash flow)
 3. Utility :
(a) The approach will recognized the uncertainty involve with the future
project as it consider a range of cash flow for a given period.
(b) In the case of two project, giving the same or almost same mean cash
flow ,and if the standard deviation of the cash flow from the two project
differ , one with the lower standard deviation should be chosen.
(c) Hiller’s model the finance manger in taking up the capital budgeting
decision, much more objective by factoring both risk uncertainty and
time value of the money.
[Notes: This is the same as scenario analysis; accept that in some scenario
analysis, generally three conditions are considered to exist in all the years, in
Hillier’s model, more than three cash sets of cash flows may also be considered]

38. Write a brief note on Standard Deviation as a measure of Risk Analysis.

1. Meaning: Project Standard Deviation is the Present Value of Standard

Deviation over the life of the project.

2. Scenario: The two scenarios under which the Standard Deviation of a project is
computed are-(a) Case 1- Cash Flows are perfectly correlated.

(b) Case 2-Cash Flows are independent.

3. Method of computation:

Case 1- Cash Flows are perfectly Case 2-Cash Flows are

correlated
1. Standard Deviation is computed
on a daily basis over the life of
the project.
2. The yearly standard deviations
are discounted, to ascertain the
present value of yearly standard
deviations.
3. The discounted standard
deviations are aggregated.
4. The resultant sum is the standard
independent.
1. The yearly standard deviations
over the life of the project are
discounted to find the present
value of standard deviation.
2. Present value of standard
deviations are squared and then
aggregated.
3. The square root of the aggregate
sum is the project standard
deviation.
 deviation of the project.
4. Then the formula applicable to
find out the Project Standard
Deviation is -
√(PV yEAR1)2 + (PVyear2)2 +
……+(PV year n)2
Where

(PV yEAR1)2 – present value of

standard deviation in year 1.
(PVyear2)2 - present value of
standard deviation in year 2.
(PV year n)2 – present value in
standard deviation in the final
year.

4 .Expected NPV: Expected NPV is the same if the Cash Flows are perfectly
correlated as well as when the Cash Flows are independent.

39. Write short notes on the Discount Rate or Cut-off Rate in Capital
Budgeting decisions.

1. Opportunity Cost: Funds available with a company for investment purposes

are procured at a certain cost (WACC). These funds also have alternative uses, e.g.
investment in risk-free securities or in other projects. If cash is invested in a
project, it cannot be invested elsewhere to earn a return. Hence, funds invested in a
project involve Opportunity Cost.

2. Surplus making Projects: A firm should therefore invest in Capital Projects,

only if they yield a return in excess of the Opportunity Cost of investment. The
Opportunity Cost of the investment is known alternatively as-(a) Minimum
Required Rate of Return, or (b) Cost of Capital, or (c) Discount Rate , or (d) Cut-
off Rate, or (e) Interest rate.

3. Example: Suppose, Interest on Government Bonds is 6%. If a Firm invests in a

Project with zero-risk, it should earn a return in excess of 6%. If the yield from the
project is less than 6% and the Company has no other project that can yield this
return, the amount available should be distributed to Shareholders as dividends.
The Shareholders can themselves invest the amounts so received and earn 6%
return (from Government Bonds).

4. Risk Aspect and WACC: Every project undertaken by a firm entails some risk.
Hence, Interest Rate on Government Bonds (Risk-Free Rate) cannot be used as
Cut-Off Rate for decision-making purposes.

5. Constant WACC: As per the Net Operating Income and Modigliani & Miller
approach to Cost of Capital, the overall cost of capital of a Firm is constant
irrespective of the level of debt-equity mix. Hence, while evaluating an investment
proposal, the financing alternative (debt-equity mix) is not considered. Overall
Cost of Capital or Discount Rate is considered constant for the Firm.

40. Explain the components of an appropriate discount rate.

1. Risk premium model: An appropriate discount rate (RD) for a given project is a
function of the following factors-

(a) Risk Free Rate of Return [RN]: If a project with a risk is going to yield a
return lower than the Risk Free Rate of Return, the Firm would be well off by
investing its funds in the risk here security. Therefore, this is the minimum rate of
return that is expected of any other investment alternatives.

(b) Risk premium [RP]: extra return would mean extra risk. Risk premium is the
additional return that is expected for any risky investment. It comprises of the
following-

• Firm’s Normal Risk: This is an adjustment for the Firm’s normal risk. This
may arise due to its capital structure, financing policy, management risk,
nature of its constitution etc.

• Project’s Risk: This is an adjustment for the differential risk for a particular
project. Example: For a new project, whose target customers are all abroad,
the cash flows will be affected by Exchange Rate fluctuations. Hence, this
project will carry a higher risk than other existing projects, where this
exchange rate fluctuation is not a factor.
(c)Formula: Theoretically, the appropriate discount rate is the sum of the Risk
Free Rate and the Risk Free Premium. Mathematically, the relationship is
expressed as follows-

1+ RD = (1+RF) X (1 + RN) X (1 + RP)

Where, (1+RF) X (1 + RN) constitute the average cost of capital of the

Firm.

2. Inflation Adjusted Rate: Appropriate discount rate for evaluating the projects
cash flows, which are expressed in nominal terms ( i.e. the actual estimated cash
flow in money terms), should be a factor of the following-

(a) Real Rate of Return [RR]: This is the discount rate that should be applied in
respect of cash flows in a static economy, i.e. there is no inflation/deflation or cash
flows are not affected by inflation.

(b) Inflation [I]: Real Rate should be adjusted for inflation, i.e. increased by the
inflation rate to ascertain the appropriate discount rate.

(c) Formula: Theoretically, the appropriate discount rate is the sum of the Real
Discount Rate and Inflation Rate. Mathematically, the relationship is expressed as
follows-

1 + RD = (1 + RR) X (1+I)

41. Explain the Risk Adjusted Discount Rate Method.

1. Meaning: Risk Adjusted Discount Rate is the normal discount rate adjusted
upwards or downwards for the element of risk to reflect Project Risk.

2. Adjustment for Risk:

Relationship Appropriate Discount Rate

Risk of Project=Risk of the other Average Cost of Capital
Investment of the Firm

Risk of Project>Risk of the other

Higher than average cost of capital
Investment of the Firm
 Risk of Project<Risk of the other
Investment of the Firm
Lesser than average cost of capital

3. Formula: Risk Adjusted Discount Rate={(1+ Cost of Capital)X(1+ Premium for

Risk)]-1

4. Project Evaluation:

(a) Identity cash flows.

(b) Compute the risk adjusted discount rate [RADR].

(c) Discount the cash flow at the RADR and identity the NPV.

(d) If the NPV is positive, the Project may be accepted, else Project is rejected.

5. Limitations:

(a) It is difficult to estimate risk premium associated with a project consistently.

Generally, it is estimated on an adhoc basis.

(b) This method assumes that risk increase with time at a constant rate, which may
not be valid.

42.What are the differences between Certainty Equivalent Method and Risk
Adjusted Discount Rate Method?

Certainly equivalent Risk Adjusted Discount

Method rate method
Certainty equivalent method Risk adjusted discount rate
adjusts the cash flows of a project method adjusts discount rate
for risk. (WACC) for risk.
Certainty equivalent method is Risk adjusted discount rate
superior, since the cash flows are method does not consider the risk
 adjusted for risk over time under over time.
this method.

43. Write short notes on breakeven analysis.

1. Accounting Breakeven Analysis: Accounting breakeven analysis seeks to

estimate the revenues that will be needed in order for a project or Company to
break even, (i.e. Aggregate of Cash Inflows=Investment Cost) in accounting terms.

2. Financial breakeven Analysis:

(a) This is a takeoff from accounting breakeven Analysis, and considers time value
of money. Financial breakeven analysis seeks to estimate the annual cash flow
needed to make the NPV zero.

(b) Financial breakeven takes into consideration of opportunity cost of funds. It is

usually a higher hurdle than the accounting breakeven.

44. Write short notes on Scenario Analysis.

1. Meaning: Scenario Analysis is an analysis of the NPV or IRR of a project under

a series of specific scenarios, based on macro-economics, industry and firm-
specific factors.

2. Steps: The steps in a Scenario Analysis are-

Step Description of Procedure

1 The biggest source of uncertainty for the future success of the
project is selected as the factor around which scenarios will be
built
2 The value each of the variable in the investment analysis
( revenue , growth operating margin ,etc) will take on under its
scenario are estimated
3 NPV and IRR under its scenario are estimated
4 A decision is made on the project , based on the NPV under on
 the scenario rather than just the base case i.e mean NPV

3. Limitation:

(a) There are no clearly delineated scenario in many cases

(b) If there many important variable to consider, there may give rise to a
huge number of scenario for analysis

(c) There is no clear road map to indicate how the decision –maker will used
result of the scenario analysis.

4. Best case and worst case analysis these are variant of the scenario analysis.

(a) In a best case analysis , all the input are set at the most optimistic level

(b) In the worst case analysis, input are all measure at the most pietistic
level, for computer NPV and IRR

45. Explain the Hert’s Model to Risk Analysis .

Write short on stimulation at the tool of risk analysis in capital budgeting

decision

M87, M88

1. Meaning of the stimulation:

(a) Stimulation is the quantitative procedure will describe a process by

developing of that process and then conduction a series of organize trial
and error experiment to predict the behavior of the process.

2. Basis: Capital investment investment decision and financial decision are

complex, and therefore can’t be express by a mathematical models
unsolvable mathematical model are build to run them on trial data to
stimulate the behavior of the system

3. Flexibility: Stimulation is the flexible tool of operational research ,used for

capital budgeting decision
4. Step in Stimulation:

Step Description
1 Define the problem or system intended to be stimulated.
2 Formulate the model intended to be used
3 Test the model and compare its behavior with the behavior of the
actual problem environment.
4 Identify and collect the data needed to test the model.
5 Run the stimulation
6 Analyze the system of the stimulation and, if desired, change the
solution that is being evaluated
7 Return the stimulation to test new solution
8 Validate the stimulation, ie increase the chances that any
interference that may be drawn about the real situation from
running the stimulation will be valid

5. Capital budgeting

a) Distribution is defined for each variable, based on either past data or on

estimate for the future.

b) Mean is calculated for each variable for the available data.

c) Variability should be found out and a normal distribution may be derived

d) After deriving the distributions of all the input variables i.e. mean ,
standard deviation and shape of distributions for each variable,
stimulation experiment will be performed by considering different levels
of these factors.

e) Several trial runs can be done to cover most of the possible stimulation
for analysis.
6. Benefits [N96]

a) Simplicity: It is a description of the behavior of some system or process ,

enhance easier to understand and explain , than a complex mathematical
model. It does not require simplifications and assumptions to the extent
required in analytical solution

b) Testing of alternatives: It provides the way for the decisions maker to

select and alternative, test it and make improvements thereto. Thus,
stimulation avoids the cost of real world experimentations when the best
solution is found.

c) Alteration of model: The effect of certain informational, organizational

an environmental changes on the operation of a system can be studied and
if necessary alteration in the model of the system can be made.

d) Model experimentation: Stimulation can serve as a pre service test to try

out new policies and decision rule for operating a system before running
the risk of experimenting on the real system.

e) Allow time factors: Stimulation allows the manager to incorporate time

into an analysis. In a computer stimulation of business operation, the
manager can compress the result of several years or periods into a few
mins of running time.

f) Suitability: Stimulation suitable even in cases

• Of large complex problem where analytical results are not

available

• Where mathematical convenient distributions are not applicable to

the problem, as a result of which analytical analysis is not possible

• Where the actual environment is difficult to observe

g) Anticipation of bottle neck: When new elements are introduced into a

system, stimulation helps to anticipate bottle neck and other problems that
may arise in the behavior of the system.
 7. Shortcomings : [N02]

a) Lack of precession: Stimulation is not précised. It is not an optimization

process and does not yield and answer but merely provides a set of the
system’s response to different operating conditions

b) Time and cost: A good stimulation model may be very expensive. It may
take even years to develop a usable corporate planning model.

c) Absence of randomness: All situations cannot be evaluated using

simulation. Only situations involving uncertainty can be measured. When
there is a situation without a random component, all simulated
experiments would produce the same answer.

d) Method – Not a solution – Simulation generates only a way to evaluate

solutions. It does not provide solution techniques.

e) Applicability – all situations cannot converted into a simulation model.

f) Different results – Different irritations may provide different solutions

and may cause confusion to the evaluator.

46. Write a brief note on options in capital budgeting.

1. Meaning : Options is right to do an activity, which does not carry any

obligations to do the same. Options in capital budgeting refers to those rights or
choices purchased, whereby, the firm can choose whether or not exercise the
options depending upon the outcomes till that point.

2. Circumstances:

a) The concept of options in capital budgeting arises in scenarios of uncertainty in

cash flows. Since capital budgeting involves huge capital outlay and generally the
decision is not reversible, negative effect of uncertainty can cripple an
organization.

b) Generally, the variability or otherwise of a project will be known only after a

certain point in time. Only at that time a clearer picture may also result in losing an
opportunity.
3. Examples:

a) Options to expand: an important option is to expand production if conditions

turn favorable and to contract production if conditions turn bad. The former is
sometimes called a growth options, and the later may actually involve the
shutdown of production.

b) Option to abandon: if a project has abandonment value, selling off the project
on “as is where is” basis. This represents a put option (i.e. right to sell). Example:
A flat promoter may dispose of his unfinished building to an industrial house or
another flat promoter, instead of proceeding further to sell it as individual units.

c) Option to postpone: the option to postpone, also known as an investment

timing option. For some projects there is the option to wait, thereby obtaining new
information.

4. computation:

Value of option = NPV with option less NPV without option

Note: generally, the price of the option would be available, and the requirement
would be to ascertain the project worth by considering the value of option as an
alternative cash flow.