Unit IV

Time Value of Money and Capital

Budgeting
 Capital Budgeting
• Capital budgeting is the process a business undertakes
to evaluate potential major projects or investments.
Construction of a new plant or a big investment in an
outside venture are examples of projects that would
require capital budgeting before they are approved or
rejected.
• As part of capital budgeting, a company might assess a
prospective project's lifetime cash inflows and outflows
to determine whether the potential returns that
would be generated meet a sufficient target
benchmark. The process is also known as investment
appraisal.
 Types of Capital Budgeting

• Throughput Analysis:
- Throughput analysis is the most complicated
form of capital budgeting analysis but also the
most accurate in helping managers decide which
projects to pursue.
- Under this method, the entire company is
considered as a single profit-generating system.
- Throughput is measured as an amount of
material passing through that system.
 Cont….
• DCF Analysis:
- Discounted cash flow (DCF) analysis looks at the initial
cash outflow needed to fund a project, the mix of cash
inflows in the form of revenue, and other future
outflows in the form of maintenance and other costs.
• Payback Analysis:
- This analysis calculates how long it will take to recoup
the costs of an investment. The payback period is
identified by dividing the initial investment in the
project by the average yearly cash inflow that the
project will generate.
 Nature of Capital Budgeting
• Long Term Effect
• High Degree of Risk
• Huge Funds
• Irreversible Decision
• Impact Competitive Strength
• Impact on Cost Structure
 Significance of Capital Budgeting
• Long term application:
Implies that capital budgeting decisions are
helpful for an organization in the long run as
these decisions have a direct impact on the cost
structure and future prospects of the
organization. In addition, these decisions affect
the organization’s growth rate.
 Cont….
• Competitive position of an organization:
Refers to the fact that an organization can plan
its investment in various fixed assets through
capital budgeting. In addition, capital
investment decisions help the organization to
determine its profits in future. All these
decisions of the organization have a major
impact on the competitive position of an
organization.
 Cont….
• Cash forecasting:
Implies that an organization needs a large
amount of funds for its investment decisions.
With the help of capital budgeting, an
organization is aware of the required amount of
cash, thus, ensures the availability of cash at the
right time. This further helps the organization to
achieve its long-term goals without any
difficulty.
 Cont….
• Maximization of wealth:
Refers to the fact that the long-term investment
decisions of an organization helps in safeguarding
the interest of shareholders in the organization. If
an organization has invested in a planned manner,
shareholders would also be keen to invest in the
organization. This helps in maximizing the wealth of
the organization. Capital budgeting helps an
organization in many ways. Thus, an organization
needs to take into consideration various aspects.
 Time Value of Money (TVM)
• The time value of money (TVM) is the concept
that money available at the present time is
worth more than the identical sum in the
future due to its potential earning capacity.
• This core principle of finance holds that
provided money can earn interest, any
amount of money is worth more the sooner it
is received. TVM is also sometimes referred to
as present discounted value.
 TVM Formula
FV = PV x [ 1 + (i / n) ] (n x t)
• FV = Future value of money
• PV = Present value of money
• i = interest rate
• n = number of compounding periods per year
• t = number of years
 Discounting and Compounding
• Discounting:
- In economic evaluations, “discounted” is
equivalent to “present value” or “present
worth” of money.
- As we know, the value of money is dependent
on time; you prefer to have 100 dollars now
rather than five years from now, because with
100 dollars you can buy more things now than
five years from now, and the value of 100 dollars
in the future is equivalent to a lower present
value.
 Cont….
• e.g.:
- When you take loan from the bank, the
summation of all your installments will be
higher than the loan that you take. In an
investment project, flow of money can occur
in different time intervals.
- In order to evaluate the project, time value of
money should be taken into consideration,
and values should have the same base.
Otherwise, different alternatives can’t be
compared.
 Compounding
- In order to compare different alternatives in
an economic evaluation, they should have the
same base (equivalent base).
- Compound interest is a method that can help
applying the time value of money.
 Cont….
• e.g.:
- Assume you have 100 dollars now and you put
it in a bank for interest rate of 3% per year.
After one year, the bank will pay
you 100+100*0.03 =$103100+100*0.03 =$103
- Then, you will put the 103 dollars in the bank
again for another year. One year later, you will
have 103+103*0.03 =$106.09103+103*0.03 =
$106.09.
 Capital Expenditure
• A capital expense is the cost of an asset that
has usefulness, helping create profits for a
period longer than the current tax year.
• Capital Expenditure Planning:
- Separating expenditure budgets
- Departmental inputs
- Implementing a budget limit
- Measuring capital expenditure returns
 Methods of evaluating Capital
Expenditure proposals
1. The average rate of return method.
2. The payback period method (also known
as cash payback period method).
3. The net present value method.
4. The internal rate of return method.
• Method 1 and 2 are the methods that do not
use the present values. Method 3 and 4 use
the present values.
 Cont….
• Methods That Ignore Present Value (method 1
& 2):
- Methods that do not use the present value
(average rate of return method and payback
method) are easy to use. Management uses
these methods initially to screen proposals. If
a proposal meets the minimum standards set
by management, it is subject to further
analysis otherwise it is dropped from further
consideration.
 Cont….
- Methods that ignore present values are
normally used for the evaluation of capital
investment proposals that have relatively short
useful lives. In such cases, management focuses
on the expected income to be earned from the
investment and the total net cash to be received
rather than the timing of the cash flows.
 Cont….
• Methods That Use Present Value (method 3 &
4):
- Methods that use present values (net present
value method and internal rate of return
method) in the capital investment analysis take
into account the time value of money. The
concept is that the money has value over time
because it can be invested to earn
interest income.
 Cont….
- A dollar in hand today is more valuable than a
dollar to be received a year from today.
- For example, if we invest $5,000 today to earn
a 10% interest per year, we will have $5,500
after one year.
- Thus $5,000 is the present value of $5,500 to
be received a year from today if the rate of
interest is 10%.
- Usually a combination of methods is used to
evaluate capital investment proposals.
 Cont….
- According to a survey of different industries
the use of capital investment analysis is as
follows: Percent
Method Use of net present value age of
use
Average
rate of No 46%
return
Payback
No 71%
period
Net
present Yes 64%
value
Internal
rate of Yes 69%
return
 Under Capitalization
• Undercapitalization occurs when a company
does not have sufficient capital to conduct
normal business operations and pay
creditors.
• This can occur when the company is not
generating enough cash flow or is unable to
access forms of financing such as debt or
equity.
 Over Capitalization
• Overcapitalization occurs when a company has
issued more debt and equity than its assets
are worth.
• The market value of the company is less than
the total capitalized value of the company.
• An overcapitalized company might be paying
more in interest and dividend payments than
it has the ability to sustain long-term.
 Cont….
• The heavy debt burden and associated
interest payments might be a strain on profits
and reduce the amount of retained funds the
company has to invest in research and
development or other projects.
• To escape the situation, the company may
need to reduce its debt load or buy back
shares to reduce the company's dividend
payments. Restructuring the company's
capital is a solution to this problem.
 Capital Structure
• The capital structure is the particular
combination of debt and equity used by a
company to finance its overall operations and
growth.
• Debt comes in the form of bond issues or
loans, while equity may come in the form of
common stock, preferred stock, or retained
earnings. Short-term such as working capital
requirements is also considered to be part of
the capital structure.
 Computation of cost of capital
• Measurement of specific costs of capital
- Cost of equity capital (Ke)
- Cost of debt/debenture capital (Kd)
- Cost of preference share capital (Kp)
- Cost of retained earnings (Kr)
 Cont….
• Measurement of overall cost of capital OR
Weighted average cost of capital (WACC)
- Assigning weights to specific costs
- Multiplying the cost of each of the sources by
the appropriate weights
- Dividing the total weighted cost by the total
weights.
 Trading on Equity
• Trading on equity, which is also referred to as
financial leverage, occurs when a corporation
uses bonds, other debt, and preferred
stock to increase its earnings on its common
stock.
- To illustrate trading on equity, let's assume
that a corporation uses long term debt to
purchase assets that are expected to earn
more than the interest on the debt.
- The earnings in excess of the interest
expense on the new debt will increase the
earnings of the corporation's common
stockholders.
- The increase in earnings indicates that the
corporation was successful in trading on
equity. If the newly purchased assets earn less
than the interest expense on the new debt,
the earnings of the common stockholders will
 Leverages
• Leverage results from using borrowed capital
as a funding source when investing to expand
the firm's asset base and generate returns on
risk capital.
• Leverage is an investment strategy of using
borrowed money—specifically, the use of
various financial instruments or borrowed
capital—to increase the potential return of an
investment.
 Cont….
• Leverage can also refer to the amount
of debt a firm uses to finance assets.
• When one refers to a company, property
or investment as "highly leveraged," it means
that item has more debt than equity.
 Types of Leverage
• Operating leverage:
Operating leverage refers to the use of fixed
operating costs such as depreciation, insurance
of assets, repairs and maintenance, property
taxes etc. in the operations of a firm. But it does
not include interest on debt capital. Higher the
proportion of fixed operating cost as compared
to variable cost, higher is the operating leverage,
and vice versa.
 Cont….
• Financial leverage:
Financial leverage is primarily concerned with
the financial activities which involve raising of
funds from the sources for which a firm has to
bear fixed charges such as interest expenses,
loan fees etc. These sources include long-term
debt (i.e., debentures, bonds etc.) and
preference share capital.
 Cont….
• Combined leverage:
Both operating and financial leverages are
closely concerned with ascertaining the firm’s
ability to cover fixed costs or fixed rate of
interest obligation, if we combine them, the
result is total leverage and the risk associated
with combined leverage is known as total risk. It
measures the effect of a percentage change in
sales on percentage change in earning per share
(EPS).
 Significance of Leverage
• Measurement of Operating Risk
• Measurement of Financial Risk
• Managing Risk
• Designing Appropriate Capital Structure Mix
• Increase Profitability.
All the Best!!