Financial Management

K.V.RAMESH
Assistant Professor
Institute of Public Enterprise
Lay out
 Nature of Financial Management.

 Investment & Financing Decisions.

 Dividend Decisions.

 Liquidity Decisions or Working Capital

Management.
books
FM by Khan and Jain
Cost accounting and FM by Khan and Jain
FM by IM Pandey
FM by Brigham and Ehrhardt
FM by Berk, DeMarzo and Ashok Thampy
Fundamentals of FM by Brigham and
Houston
Fundamentals of FM by Prasanna Chandra
FM by P.C. Tulsian
 What is Finance ?
 Finance stands for provision of money as and
when required.
 Process of raising, providing and administering
all money/funds to be used in a corporate
enterprise.
 Is concerned with the acquisition and
conservation of capital funds in meeting the
financial need and overall objectives of
business enterprise.
 Approaches to finance
Providing of funds needed by a business on
most suitable terms.

Cash.

Concerned with raising of funds and their

effective utilisation.
 Financial Management
 The ways and means of managing money.

 Planning, acquisition, allocation, and utilisation

of financial resources with the aim to achieve
objectives of the firm.

 Is the application of planning and controlling

functions to the finance function.
Stages of Evolution of FM
Traditional – occasional events

Transitional – day to day problems

Modern
 Scope of Finance Function
Estimating financial requirements.
Capital structure decisions.
Selecting source of finance.
Selecting pattern of investment.
Proper Cash management.
Implementing financial controls.
Proper use of surpluses.
 Aims of Finance function
Acquiring sufficient funds.

Proper utilisation of funds.

Increasing profitability.

Maximising firm’s value.

 Financial plan
Is a statement estimating the amount of capital and
determining its composition.
Objectives:
 Availability of adequate funds.
 Balancing of costs and risks.
 Flexibility.
 Simplicity.
 Long term view.
 Liquidity.
 Optimum use.
 Economy.
 Considerations
Nature of Industry.
Credit rating of the concern.
Future plans- Expansion and
diversification.
Availability of sources.
General economic conditions.
Government control.
Objectives of Financial
management
Profit:
Profit earning.
Profitability is a barometer for measuring efficiency
and economic prosperity of a business.
Economic and business conditions do not remain the
same all the time.
Profits are the main sources of finance for the growth
of the business.
Profitability is essential for fulfilling social goals.

Wealth:
Maximizes implies the market value of its shares.
 Profit Vs Wealth
 The term profit is  Its an prescriptive idea.
vague.
 Not necessarily socially
 Ignores the time desirable.
value of money.
 Controversy objectives
 Ignores Risk factor. Maximize stockholders
wealth or wealth of
firm.(Agencyproblems)
 Dividend policy. Ownership and
management are
separated.
Functions of a Finance manager

Financial forecasting and planning.

Acquisition of funds.
Investment of funds.
Helping in valuation decisions.
Maintain proper liquidity.
Functional areas of FM
Determining financial needs.
Selecting the source of funds.
Financial analysis and Interpretation.
C-V-P analysis.
Capital budgeting.
Working capital management.
Profit planning and control.
Dividend policy.
Organization of finance function
Board of directors

Managing Director/ Chairman

Director (F)/ VP (F)/ CFO

Treasurer and Controller ( Financial
executives)
 Responsibilities of FE
The basic responsibility of the treasurer is to
provide, manage and protect the firm’s capital.

The basic responsibility of the controller is

to check that the funds are used efficiently.
 Functions of FE
Treasurer :
Obtaining finance
Banking relationship
Investor relationship
Short- term financing
Cash management
Credit administration
Investments
Insurance
 Functions of FE
Controller:
Financial Accounting
Internal audit
Taxation
Management accounting and control
Budgeting, planning and control
Economic appraisal
Reporting to Government
 FM Process
FM is a dynamic decision-making
process include a series of
interrelated activities involving:
Financial planning
Financial decision-making
Financial analysis
Financial control
Concept of Time value of
money
 Value of the money received today is more than the
value of the same amount of money received after a
certain period.
Reasons for Time value
Higher preference for present consumption .
Purchasing power of the currency declines with time.
Money received today can be invested to earn suitable
returns.
Reasons for Time Preference of Money
The future is always uncertain and
involves risk.

People generally prefer spending than

deferring for future.

Money has time value because of

opportunities available to invest.
Timeline and Time travel

 Timeline is a linear representation of the timing of

the expected cash flows. Timelines are an
important first step in organizing and then solving
a financial problem.

 A series of cash flows lasting several periods as a

stream of cash flows.
Rules of Time travel
Only cash flows in the same units can
be compared or combined at the same
point in time.

To move a cash flow forward in time,

must compound it.

To move a cash flow backward in time,

must use discounting.
Techniques of Time Value of Money
 Compounding Technique
Interest is compounded when the amount earned on
an initial deposit becomes part of the principal at the
end of the first compounding period.
Principal refers to the amount of money on which
interest is received.
n
Vn = Vo(1+i)
Where Vn = Future value at the period.
Vo = Value of money at time 0.
i = Interest rate.
Note: If calculations becomes difficult, the future value
of money can be calculated with the help of Compound
factor tables.
Vn = Vo (CFi,n)

Where CFi,n is compound factor at i percent and n

periods.
Simple Interest vs Compound
Interest
Interest paid/earned on original amount or on
principal borrowed is called the simple interest.
Symbolically P0(i)(n)
Where P0 refers to deposit today i.e., t = 0
i refers to interest rate per period
n refers to number of time periods
Compound Interest is the interest paid/earned on any
previous interest earned as well as on the principal
borrowed.
n
Symbolically Po(1+i) - Po
Doubling Period
The length of period which an amount is going to
take to double at a certain given rate of interest.
Rules of Thumb
Rule of 72
72/ Rate of interest

Rule of 69
0.35+ 69/ Rate of interest
If you deposit Rs.5,000 today at 6 percent rate of
interest, in how many years will this amount
double?
Multiple Compounding Periods
In case the interest is payable on quarterly basis,
compounding of interest twice a year say 30th June
and 31st December every year. The future value of
money in the above said case/cases

mn
Vn = Vo ( 1 + i/m)
Where Vn = Future value of money after n years.
Vo = Value of money at time 0
i = Interest rate
m = Number of times of compounding per year
Multi Period Compounding
The actual rate of interest realised called effective rate in
case of multi period compounding is more than the apparent
annual rate of interest called nominal rate.
Effective rate of interest is calculated with the following formula:
m
( 1 + i/m) – 1

Where i refers to nominal rate of interest

m refers to frequency of compounding per year

Compounded value of Annuity
Annuity is a series of equal payments lasting for some
specified period.
When cash flows occur at the end of each period the
annuity is called a Regular Annuity or Deferred Annuity.
If the cash flows occur at the beginning of each period
instead of at the end it is called Annuity Due.

Future value of Annuity:

Vn = (R)(ACFi,n)

Future value of Annuity Due:

Vn = (R)(ACFi,n)(1 + i)
Sinking fund
 It is a fund created out of fixed payments each
period to accumulate to a future sum after a
specified period.
 The factor used to calculate the annuity for a
given future sum is called sinking fund factor
(SFF).
 SFF is the reciprocal of the CVFA.
 Problems
1. What will be the value of Rs.100 after two years at 10%
p.a. Rate of interest if neither the principal sum of Rs.100
nor interest is withdrawn at the end of one year.
2. From the above calculate the value of Rs.100 @ 10% after
ten years.
3. If you deposit Rs.1000 in an account earning 7% simple
interest for two years. What is the accumulated interest at
the end of the second year?
4. Calculate the compound value of Rs.10,000 at the end of
third year @ 12% rate of interest when interest is
calculated on yearly and quarterly basis.
5. A company offers 12% rate of interest on deposits.
What is the effective rate of interest if the
compounding is done half yearly, quarterly and
monthly?
6. Mr. A deposits Rs.1000 at the end of every year for
four years and the deposit earns a compound interest
@ 10% p.a. Determine how much money he will
have at the end of four years.
7. Mr. B deposits Rs.5000 at the beginning of each year
for five years in a bank and the deposit earns a
compound interest @ 8% p.a. Determine how much
money he will have at the end of five years?
Discounting or Present Value Technique
Present value shows what the value is today of some future
sum of money. The Present Value Technique is known as
discounting because the present value of money to be
received in future will always be less.
V0 = Vn
1+ i
Where Vn is future value for n period
Vo is present value

Note: When we use discount factors, the present value is

calculated by: Present Value = Future Value x DFi,n
Present Value of an Annuity
If the amount of payment is R, the present value of an
annuity can be calculated with the help of annuity discount
factor tables.
Vo = (R)(ADFi,n)

Present value of an annuity due:

If the cash flows occur at the beginning of each year, the
present value of an annuity due is calculated by using
present value tables:
Vo = (R)(ADFi,n)(1 + i)

Present value of an Infinite Life Annuity:

Vo = R/i
 Problems
1. Calculate the present value of Rs.1000 to be received after
one year @ 10% time preference rate.
2. Mr. X is to receive Rs.5000 after five years @ 10% p.a.
Calculate its present value.
3. Calculate present value of the following five years cash
flows assuming a discount rate of 10%. The cash flows for
each respective year are Rs.5000, Rs.10,000, Rs.10,000,
Rs.3000 and Rs.2000.
4. Mr. X has to receive Rs.2000 per year for five years.
Calculate the present value of annuity assuming that he
can earn interest on his investment @ 10% p.a.
5. Mr. A has to receive Rs.10,000 at the beginning of each
year for five years. Calculate the present value of annuity
due assuming 10% rate of interest.
6. Calculate the present value of Rs.1000 received in
perpetuity for an infinite period taking discount rate of
10%.
 What is Cost of Capital?
 Is the minimum rate of return expected by its
investors.
 Is the rate of return that a firm requires to earn
from its projects.
 Is the minimum rate of return which will at
least maintain value of the shares.
 Definitions
 A cut-off rate for the allocation of capital to
investment of projects. It is the rate of return
on a project that will leave unchanged the
market price of the stock.
 Is the minimum required rate of earnings or the
cut-off rate of capital expenditures.
 The rate of return the firm requires from
investment in order to increase the value of the
firm in the market price.
Components of Cost of Capital
 The expected normal rate of return at zero risk
level (ro)

 Premium for business risk (b)

 The premium for financial risk on account of

pattern of capital structure (f)
Symbolically: K = ro + b + f
Form of Capital
 Debt

 Preference Capital

 Retained Earnings

 Equity Capital
Computation of Cost of Capital
Debt: Cost of debt is the rate of interest
payable on debt. Debt may be
irredeemable or redeemable.
Cost of debt before-tax: Kdb = I/P
Where ‘I’ is interest and ‘P’ is principal.
Cost of debt after-tax :
Kda = Kdb(1-t) = I/NP (1-t)
Where ‘NP’ refers to Net Proceeds
‘t’ refers to rate of tax
Factors effecting cost of debt
 Fixed interest rate

 Issue expenses

 Discount/premium/ redemption

 Income tax
Debt issued at a premium or
discount
Net proceeds received from the issue must be considered and not the
face value of securities.
Kdb = I/NP

1.Compute cost of debt capital, rate of tax 30% where X ltd issues
Rs.50,000 8% debentures:
a) at par
b) at premium of 10%
c) at discount of 5%
2. L&T Ltd issues Rs.1,00,000 9% debentures at a premium of 10%.
The cost of flotation are 2%. The rate of tax is 30%.Compute cost of
debt.
Redeemable debt
Before Tax
I + 1/n(RV-NP)
Kdb =
½(RV+NP)

Where
‘I’ is Annual Interest
‘n’ is number of years in which debt is to be redeemed.
‘RV’ is Redeemable value of debt
‘NP’ is Net proceeds of debentures.
 3. A company issues Rs.10,00,000 10%
redeemable debentures at a discount 5%. The
cost of flotation Rs.30,000.The debentures are
redeemable after 5 years. Calculate before tax
&after-tax cost of debt.

Note: Assume tax rate 30%

After Tax
I(1-t)+ 1/n(RV-NP)
Kdb =
½(RV+NP)
4. Zee ltd issued Rs.100 lakhs 12% Debentures of
Rs.100 each redeemable after 5 years. Calculate the
cost of debt in each of the following alternative cases.
Assume corporate tax rate 40%.
a) Issued at par with no flotation cost.
b) Issued at par with 5% flotation cost
c) Issued at 10% premium with 5% flotation cost
d) Issued at 10% discount with 5% flotation cost
Cost of Preference Capital
 It is a function of dividend expected by its investors.
Perpetual Kp = D/P
D refers to Annual Preference Dividend
P refers to proceeds (PSC)

Issued at a discount or premium

Kp = D/NP

Redeemable
Kpr = D+MV-NP/n
½(MV+NP)

MV refers to Maturity value of preference shares.

NP refers to Net Proceeds of preference shares.
Factors affecting the cost of preference share

 Fixed dividend rate

 Issue expenses

 Discount/ premium/ redemption

 Dividend distribution tax

Problems
 Zee ltd issues 10,000 10% Preference shares of Rs.100
each. Cost of issue is Rs.2 per share. Calculate cost of
preference capital if these are issued at par, at a premium
of 10% and at a discount of 5%.
 Lakme ltd issues 10,000 10% preference shares of
Rs.100 each redeemable after 10 years at a premium of
5%.The cost of issue is Rs.2 per share. Calculate the cost
of preference capital.
 Ponds India ltd issues 1,000 7% preference shares of
Rs.100 each redeemable at 10% premium after 5years.
Calculate the cost of preference capital.
Cost of Equity
It refers to the maximum rate of return that the
company must earn on equity finance in order
to maintain the present market price of the
stock.
Dividend yield method: Ke = D/NP or MP
Dividend yield plus growth method:
Ke = (D1/NP+G)= Do(1+g)/NP+G
Factors affecting cost of share
 Price in the beginning of year

 Expected dividend at the end of a year

 Growth rate
 Problems
1. A company issues 1000 equity shares for Rs.100
each at a premium of 10%. A company has been
paying 20% dividend for the past five years and
expects the same in near future. Compute the cost
of equity capital. Will it make any difference if the
market price of equity share is Rs.160?
2. A company plans to wish you 1000 new shares of
Rs.100 each at par. The flotation costs are expected
to be 5% of the share price. The company pays
dividend of Rs.10 per share initially and growth in
dividends is expected to be 5%. Compute the cost
of new issue of equity shares.
If the current price of an equity share is Rs.150.
Calculate the cost of existing equity share capital.
Cost of Retained Earnings
 Retained earnings is the residual earnings of a firm.
 It is also known as Internal equity
 It is the amount of earnings not distributed but retained
within the firm.
Is the cost of retained earnings is similar to cost of equity?
 It is the rate of return which the existing shareholders
can obtain by investing the after-tax dividends in
alternative opportunity of equal qualities.
Cost of Retained Earnings

D1
Kr = + G
NP or MP
Where D1 is expected dividend at the end of
the year
G is Rate of growth
To make adjustment in the cost of retained earnings for tax
and cost of purchasing new securities the following formula
is adopted.

Kr = (D/NP + G) (1-t)(1-b) or

Kr = Ke(1-t)(1-b)

Where Ke is rate of return available to shareholders.

‘b’ is cost of purchasing new securities or brokerage costs.

A firm’s return available to shareholders is 15%, the

average tax rate of shareholders is 40% and it is expected
that 2% is brokerage costs. What is the cost of retained
earnings.
Weighted average cost of
capital
 Is the average cost of the costs of various
sources of financing.
 It lies between the least and most
expensive funds.
 It enables the maximization of profits and
the wealth of the equity shareholders by
investing the funds in projects earning
excess of the overall cost of capital.
 Composite cost of capital or Overall cost of
capital or average cost of capital.
Factors affecting WACC
 Controllable factors.
Capital structure policy
Dividend policy
Investment policy
 Uncontrollable factors
Tax rates
Level of Interest rates
Market risk premium
Steps involved in computation
WACC
Determination of the source of funds to be raised and
their individual share in the total capitalisation.
Computation of cost of specific source of funds.
Assignment of weight to specific source of funds.
Multiply the cost of each source by appropriate
assigned weights.
Add individual source weight cost to arrive cost of
capital.
Assignment of Weights
 Book value
Weights assigned on the basis of values found on the
balance sheet.
The book value of the source of fund divided by the book
value of total funds.
Merits:
1. Simple in calculation.
2. Book values provide a usable base, when firm is not listed
or security are not actively traded.
3. Analysis of capital structure i.e.,D-E ratio
Demerits:
1. No relationship between book values and present
economic value of various sources of capital.
2. Book value proportions are not consistent with the concept
of cost of capital.
Assignment of Weights
 Market value:
Weights assigned on the basis of market value of the
component of capital.
Market value of the component of capital divided by the market
value of all components of capital.
Merits:
1. Values are closely approximate the actual amount to be
received from their sale, representing the true value of the
investors.
2. Prevailing market prices are taken into account.
Demerits:
1. Very difficult to determine the market values because of
frequent fluctuations.
2. Equity capital gets greater importance.
3. If the market value of the share is higher than the book
value, WACC would be overstated and vice-versa.
Problems
1. Following is the long-term capitalization of a company:
 40,000 Equity Shares of Rs.200 each with a market value of
Rs.160.
 10% Preference Shares (10,000) of Rs.200 each with a market
value of Rs.240.
 9% Debentures 2000 of Rs.2000 each with a market value of
Rs.2200.
 Retained earnings Rs.20 Lacs.
Additional Information:
A flotation cost of 4% was incurred for cash instrument of financing.
Redemption premium on debentures is 20%.
The current dividend of Rs.10 is expected to grow at 10% to infinity.
The term of maturity of debentures is ten years.
The company is taxed at 30%.
Preference dividend and Interest are payable annually.
Compute Weighted average cost of capital using Market Weights and
Book Weights.
2. A company has the following capital structure at the end
of March, 2010.
 12% 2007 debentures Rs.15 Lacs.
 9% Preference shares Rs.10 Lacs.
 Equity Shares of Rs.10 each Rs. 12 Lacs.
The company has the marginal tax rate of 50%. It is
expected to pay a dividend of Rs.1.50 per share this
year and this dividend is expected to grow at the annual
rate of 10% in the future.
You are required to find out the firm’s cost of capital from
the above given information.
3. The capital structure of a company consists of
equity shares of Rs.50 Lakhs;
10% preference shares of Rs.10 Lakhs and
12% debentures of Rs.30Lakhs. The cost of
equity capital for the company is 14.7 percent
and the income tax rate is 30 percent.
You are required to calculate the WACC.
4. ABC ltd has the following book value capital structure:
Equity Capital Rs 10 each, fully paid- at par Rs.15 crores
11% Preference capital Rs.100 each, fully paid at par Rs.1 crore
Retained earnings Rs.20 crores
13.5% Debentures Rs.100 each Rs.10 crores
15% Term loans Rs.12.50 crores
The expected dividend on equity share per share is Rs.3.60; the
dividend per share is expected to grow at the rate of 7%. The market
price per share is Rs.40.
Preference stock, redeemable after 10 years, currently selling at Rs.75
per share
Debentures, redeemable after 6 years, selling at Rs.80 per debenture.
Income tax 40%
Calculate WACC using Book value and market value proportions
Marginal Cost of Capital
 Marginal Cost of Capital is calculation of the
cost of additional funds to be raised.
 Marginal Weights represent the proportion
of various sources of funds to be employed
in raising additional funds.
Demerits:
 It ignores the long-term implications of the
new financing plans.
 Fails in achieving the wealth maximization
objective in the long run.
 A company is considering raising Rs100 lakh by one of
the two alternative options i.e., 14% institutional term
loan and 13% non – convertible debentures. The term
loan option would attract no major incidental cost. The
debentures would have to be issued at a discount of
2.5% and would involve Rs.1 lakh as cost of issue.
Assume a tax rate of 35%.
Advise the company as to the better option based on the
effective cost of capital in each case.
Capital Asset Pricing Model
 This model was developed by William F.Sharpe.

 This model explains as to what kind of relationship

exists between risk and return namely
Relationship between Risk and Return for an
efficient portfolio.

Relationship between Risk and Return for an

individual security.
Importance CAPM
 It provides a bench mark for evaluating various
investments.

 It helps us to make an informed guess about the

return that can be expected from an asset that
has not yet been traded in the market.
Assumptions
 Investors have same information about securities.
 Security returns are normally distributed.
 There are no restrictions on investments.
 Investors can borrow and lend freely at a riskless rate of
interest.
 The market is perfect i.e., no taxes, no transaction costs,
securities are completely divisible and market is
competitive.
 Investors have homogeneous expectations.
 Investors seek to maximize the expected utility of their
portfolios over a single period planning horizon.
 Value of Equity Share
 It is a function of cash inflows expected by the
investors and the risk associated with cash inflows.
 It is calculated by discounting the future stream of
dividends at the required rate of return called the
Capitalization rate.
 The required rate of return depends upon the element
of risk associated with investment in shares and is
equal to risk-free rate of interest plus the premium for
risk.
 CAPM
 The premium for risk is the difference between
market return from a diversified portfolio and
the risk-free rate of return ie., beta co-efficient.
Ke = Rf + β(Rm – Rf)
Where Ke refers to Cost of equity capital
(Rm – Rf) refers to market risk premium
β refers to Beta co-efficient of the firm’s
portfolio.
 Problems
1. You are given the following facts about a firm:
Risk-free rate of return is 11%.
Beta co-efficient of the firm is 1.25.
Compute the cost of equity capital using CAPM
assuming a market return of 15% next year. What
would be the cost of equity if beta rises to 1.75.
2. The Capital Ltd. wishes to calculate its cost of equity
capital using CAPM. Company’s analyst found that
its risk-free rate of return equals to 12%, beta equals
1.7 and the return on market portfolio equals to
14.5%.
Dividend decisions
Determinants of Dividend policy
 Legal restrictions.
 Magnitude and trend of Earnings.
 Desire and type of Shareholders.
 Nature of Industry.
 Age of the company.
 Future financial requirements.
 Taxation policy.
 Inflation.
 Control.
 Stability of dividends.
 Liquid resources.
Schools of thought

 Theory of Irrelevance.

 Theory of Relevance
Modigliani and Miller approach
 The dividend policy has no effect on the market price
of the shares and the value of the firm is determined by
the earning capacity of the firm or its investment
policy.
 MM observed “Under conditions of perfect capital
markets, rational investors, absence of tax
discrimination between dividend income and capital
appreciation, given the firm’s investment policy, its
dividend policy may have no influence on the market
price of the shares.”
Assumptions
There are perfect capital markets.
Investors behave rationally.
Information about the company is available to all
without any cost.
There are no floatation and transaction costs.
No investor is large enough to effect the market price
of shares.
There are either no taxes or there are no differences in
the tax rates applicable to dividends and capital gains.
The firm has a rigid investment policy.
Arguments for
Market price of a share (P1) = Po (1+ke) -D1

Number of shares to be issued (m) = I - (E – nD1)

P1
Value of the firm ( nPo ) = (n+m) P1 – (I – E)
1+ke
Where n refers to number of shares outstanding at the beginning
of the period.
ke refers to cost of equity capital.
I is Investment required.
E refers to Total earnings of the firm during the period.
Problem
Carewell ltd., the rate of capitalisation rate is
10%.It has outstanding 5,000 shares selling at
Rs.100 each. The firm is contemplating the
declaration of dividend of Rs.6 per share at the
end of the current financial year. The company
expects to have a net income of Rs 50,000 and
has a proposal for making new investments of
Rs.1,00,000. Show that under the MM-
hypothesis, the payment of dividend does not
affect the value of the firm.
Theory of Relevance
 Walter’s approach
Dividend decisions are relevant and affect the value of the
firm.
The relationship between the IRR earned by the firm and its
cost of capital is very significant in determining the
dividend policy to sub serve the ultimate goal of
maximising the wealth of the shareholders.
Assumptions:
• The investments are financed through retained earnings
only and the firm does not use external sources of funds.
• Earnings and dividends do not change while determining
the value.
• The IRR and the cost of capital of the firm are constant.
• The firm has a very long life.
Walter’s formula

Market price of a share:

D+r/k ( E – D )
k
Where D is dividend per share.
r is IRR.
k is cost of capital or capitalisation rate.
E is EPS.
Gordon’s approach
 The value of a rupee of dividend income is more than
the value of a rupee of capital gain.
 Uncertainty of future and the shareholders discount
future dividends at a higher rate.
 The market value of a share is equal to the present
value of future stream of dividends.

Market price of share: E (1- b )

k- br

Where E is EPS.
b is retention ratio.
r is rate of return.
k is capitalisation rate.
 Problems
1. From the following information calculate the value of the
share of the firm according to Gordon’s model if the
payment ratio is 40%, 60% and 90%.
Rate of return on investment 15%.
Cost of capital is 10% and EPS Rs.20.

2. XYZ Ltd., earns Rs. Rs.8 per share and is capitalised at a

rate of 10%. It has 20% rate of return on investment. What
should be the price per share at 20% dividend pay out ratio
according to Walter’s formula? What is the market price
per share at the optimum pay-out ratio.
3.The following information relates to three companies:
A Ltd B Ltd C Ltd
EPS (Rs.)
10 10 10
Capitalisation rate ( %) 10 10 10
IRR ( % ) 15 10 8

a) What is the market value of share under Walter’s

model, if the payout is 40% and 80%.
b) What is the market value of share under the Gordon
model, if the retention rate is 40% and 60%.
Unit- 2 Investment Decisions
Capital budgeting is the process of making
investment decisions in capital expenditures.
It is that expenditure incurred at one point of
time whereas benefits of expenditure are
realised at different points of time in future.
It is concerned with the allocation of the
firm’s scarce financial resources among the
available market opportunities.
Investment Decisions
Capital budgeting is the process of making
investment decisions in capital expenditures.
It is that expenditure incurred at one point of
time whereas benefits of expenditure are
realised at different points of time in future.
It is concerned with the allocation of the
firm’s scarce financial resources among the
available market opportunities.
Distinction of capital budgeting
decisions
 Involves the exchange of current funds for the
benefits to be achieved in future.
 Future benefits are expected to be realised over
a series of years.
 Funds invested are in non-flexible and long
term activities.
 Involve huge funds and are irreversible
decisions.
 Are strategic investment decisions.
Nature of Investment decisions
Large investments.

Long-term commitment of funds.

Irreversible in nature.

Long-term effect on profitability.

Difficulties of Investment decisions.

National importance.
Capital budgeting process
Identification on Investment proposals.
Screening the proposals.
Evaluation of various proposals.
Fixing priorities.
Final approval and preparation of capital
expenditure budget.
Implementing proposal.
Performance review.
Techniques of Financial
Evaluation

 Pay-back period.
 Discounted pay-back.
 Accounting rate of return.
 Net present value.
 Internal rate of return.
 Profitability Index.
PAY-BACK PERIOD
This method throws light as to the length of the period by which the
entire investment would be recouped from out of the future cash
flows.

Cash flow means net profit after tax before depreciation.

Advantages:
 Simple to understand and easy to calculate.
 A project with a shorter pay-back period is preferred to the one
having a longer pay-back period.
 This method is suited to a firm which has shortage of cash.
Disadvantages
 It does not take into account the cash inflows earned after the pay-
back period and hence true profitability of the projects cannot be
correctly assessed.
 Ignores the time value of money.
 It does not take into consideration the cost of capital.
 It treats each asset individually in isolation with other assets.

Cash outlay of the project

PB =
Annual Cash inflows
Discounted Payback
 Refers to the period within which the entire
cost of the project is expected to be completely
recovered by way of discounted cash flows.
 Cash inflow means earnings after tax before
depreciation.
 Discounted Cash inflow means present value of
cash inflows using cost of capital as discount
rate.
Problems
1. There are two projects X and Y. Each project requires
an investment of Rs. 20,000. You are required rank
these projects according to PB method. The following
are the net profit before depreciation and after tax of the
two projects for their respective years. Project X
Rs.1000, Rs.2000, Rs.4000, Rs. 5000 and Rs.8000.
Project Y, Rs.2000, Rs.4000, Rs.6000, Rs.8000.
2. Calculate discounted pay-back period from the
following information:
Cost of project Rs.6 Lacs, Life of project 5 years.
Annual Cash inflow Rs.2 Lacs, Cut off rate 10%.
Accounting Rate of Return
This method takes into account the earnings expected
from the investments over their whole life. Under this
method concept of profit is used rather than cash inflows.
The term profit refers to net profit after tax and
depreciation. The project with higher rate of return is
selected.

Average annual profit

ARR =
Net investment in the project
Merits / Demerits
Merits:
 This method is fairly a simple calculation of averages.
 This method takes calculations of average rate of return
for the entire life of the project by taking the terminal
salvage / scrap value.

Demerits:
 Does not take into account time value of money.
 It does not take into account the quickness or the rapidity
with which the investment is recouped.
Problems
1. A project requires an investment of Rs.5 Lacs and has a scrap value of Rs.20,000
after five years. It is expected to yield profits after depreciation and taxes during
the five years amounting to Rs.40,000, Rs.60,000, Rs.70,000, Rs.50,000 and
Rs.20,000. Calculate the average rate of return on the investment.
2. Calculate the average rate of return for projects A and B from the following:
Project A
Project B
Investments (Rs.) 20,000 30,000
Expected Life (Years) 4 5
Projected net income after tax and depreciation:
Years
1 2,000 3,000
2 1,500 3,000
3 1,500 2,000
4 1,000 1,000
5 - 1,000
If the required rate of return is 12%, which project should be undertaken?
Net Present Value
A rupee in hand today is certainly more valuable than the rupee which
is received after a period of time. This method attempts to calculate the
return on investments by introducing the factor of time element. The
NPV method is based on the fact that the cash flow arising at different
periods of time differ in value and are not comparable unless there
equivalent present values are formed.
Merits:
 It recognizes the time value of money
 It takes into account the earnings over the entire life of the project and
true profitability of the investment proposal can be evaluated.
 It takes into consideration the objective of maximum profitability.
 Demerits
 More difficult to understand and operate.
 While comparing projects with unequal
investment of funds, NPV may not give good
results.
 It is not easy to determine the appropriate
discount rate.
Problems
1. No project is acceptable unless the yield is 10%. Cash inflows of a certain project along with
cash outflows are give below:

Years Outflows Inflows

Rs. Rs.
0 1,50,000 -

1 30,000 20,000

2 30,000

3 60,000

4 80,000

5 30,000

The salvage value at the end of the fifth year is Rs.40,000. Calculate NPV.
2. A company is considering investment in a project that
costs Rs.2 Lacs. The project has an expected life of
five years and zero salvage value. The company uses
straight line method of depreciation. The company’s
rate of tax is 40%. The estimated earnings before
depreciation and before tax from the project are
Rs.70,000, 80,000, 1,20,000, 90,000 and 60,000
respectively. You are required to calculate the net
present value at 10% and advise the company.
Internal Rate of Return
 Time adjusted rate of return or discounted cash flow or
discounted rate of return or trial and error yield
method.
 It is defined as the rate of discount at which the present
value of cash inflows is equal to the present value of
cash out flows.
 Accept the proposal if the IRR is higher than or equal
to the minimum required rate of return.
 In case of alternative proposals, select the proposal
with the highest rate of return as long as the rates are
higher than the cutoff rate.
Steps
 Determine the future net cash flows during the entire
economic life of the project.
Net cash inflows are estimated future profits before
depreciation but after taxes.
 Determine rate of discount at which the PV of cash
inflows is equal to PV of cash outflows.
a) When annual cash flows are equal:
Calculate PV factor = Initial outlay / annual cash flow
Refer PV annuity tables and find out the rate at
which the calculated PV factor is equal to the PV given
in the table.
Steps
b) When annual cash flows are unequal over the life
of the asset.
 Prepare the cash flow table using an arbitrary assumed
discount rate to discount the net cash flow to the PV.
 Find out the NPV by deducing the PV of total cash flows.
 If NPV is positive, apply higher rate of discount.
 If higher discount rate still gives a positive NPV increase the
discount rate further until NPV becomes negative.
 If the NPV is negative at this higher rate, the IRR must be
between these two rates.
Merits / Demerits
Merits:
 It takes into account time value of money.
 It considers the profitability of the projects over its entire
life.
 It provides for uniform ranking of various proposals.
 It is method which ensures reliable technique of capital
budgeting.
Demerits:
 It is difficult to understand.
 It is difficult method of evaluation of investment proposals.
 This method assumes that the earnings are re-invested in the
project, which is not justified.
Differences between NPV & IRR
 Size disparity

 Time disparity

 Projects with unequal lives

 Re-investment rate assumption

NPV method is a superior to that of IRR.

Modified Internal rate of return/Incremental Approach
Is that rate of compounding which makes the initial cash
outflow in zeroth year equal to the terminal value of the
cash inflows.
when the IRR of two mutually exclusive projects whose
initial outlays are different exceeds the required rate of
return, IRR of the incremental outlay of the project
requiring a bigger initial investment should be calculated.

If the IRR of the differential cash flows exceeds the

required rate of return, the project having greater
investment outlays should be selected , otherwise rejected.
Profitability Index or Benefit-Cost Ratio
or Desirability factor

 It is the relationship between present value of

cash inflows and Initial outflows.
 A proposal is acceptable if the PI is greater
than one
Problems
1. A company is considering an investment proposal to
purchase a machine costing Rs.2,50,000. The
machine has life expectancy of five years and has no
salvage value. The company’s tax rate is 40%. The
firm uses straight line method of depreciation. The
estimated cash flows before tax after depreciation are
as follows: Rs.60,000, 70,000, 90,000, 1,00,000 and
1,50,000.
Calculate pay-back period, average rate of return,
NPV and profitability index at 10% discount rate.
2. A company has investment opportunity costing Rs.40,000 with the following expected net
cash flow after taxes and before depreciation.

Year Net Cash flow (Rs.)

1 7,000
2 7,000
3 7,000
4 7,000
5 7,000
6 8,000
7 10,000
8 15,000
9 10,000
10 4,000
Using 10% as the cost of capital, determine the following:
Pay-back period, NPV and PI at 10% discount factor, IRR with the help of 10% and 15%
discount factor.
3. A company can make either of two investments at the beginning of 2012. Assuming
required rate of return @ 10% per annum. Evaluate the investment proposals under
pay-back period, NPV, IRR, PI and discounted pay-back period.
The forecast particulars are given below:
Proposal A Proposal B
Cost of Investment (Rs.) 20,000 28,000
Life (Years) 4 5
Scrap Value Nil Nil
Net Income (after dep & tax) Rs.
End of 2012 500 Nil
End of 2013 2,000 3,400
End of 2014 3,500 3,400
End of 2015 2,500 3,400
End of 2016 - 3,400

It is estimated that each of the alternative proposals will require additional networking
capital of Rs.2,000 which will be received back in full after the expiry of each project
life. Depreciation is provided under straight line method. The present value of Re.1 to
be received at the end of each year, at 10% and 14% may be utilized.
4. PR Engineering Ltd is considering the purchase of a new machine which will carry out
some operations which are the present performed by the manual labour. The following
information related to the two alternative models “Me” and “My” are available.
Cost of machines Rs.8Lakhs and Rs.10.20 Lakhs, expected life 6 years and the scrap
value Rs.20,000 and Rs.30,000.
Estimated net income before depreciation and tax
Years Rs. Rs.
1 2,50,000 2,70,000
2 2,30,000 3,60,000
3 1,80,000 3,80,000
4 2,00,000 2,80,000
5 1,80,000 2,60,000
6 1,60,000 1,85,000

Corporate tax is 30% and company’s required rate of return on investment proposals is
10%. Depreciation will be charged on straight line basis.

Calculate Pay back period and NPV. Kindly recommend the proposal and why ?