CAPITAL BUDGETINGCAPITAL BUDGETING

Dr. A.K.MisraDr. A.K.Misra

Financial Statement AnalysisFinancial Statement Analysis Financial analysis indicates the financial health

of the firm. Strengths and weaknesses of the firm can be

ascertained by various ratios estimated from the B/S and P/L A/c

Ratios are used as Benchmark for the performance of the firm.

Ratios of a firm compared with its own past ratios, with its competitors, with its industry average and the firms projected ratios.

Contd..Contd.. Ratio analysis can beRatio analysis can be::

Time series: Over a long period comparisonTime series: Over a long period comparison Industry Analysis: Compared with the industryIndustry Analysis: Compared with the industry Cross-Sectional: Compared with some firms in the Cross-Sectional: Compared with some firms in the

same industrysame industry Performa Analysis: Compared with some established Performa Analysis: Compared with some established

benchmark ratios benchmark ratios Financial Ratios can be classified asFinancial Ratios can be classified asLiquidity ratios, Solvency ratiosLiquidity ratios, Solvency ratios

Turnover ratios, Profitability ratiosTurnover ratios, Profitability ratios Equity-related ratiosEquity-related ratios

Liquidity RatiosLiquidity Ratios

Liquidity ratios measure a firm’s ability to Liquidity ratios measure a firm’s ability to meet its current obligations.meet its current obligations.

Current assetsCurrent ratio =

Current liabilitiesCurrent assets – Inventories

Quick ratio = Current liabilities

Cash + Marketable securitiesCash ratio =

Current liabilities

Drawbacks..Drawbacks.. All current assets are not liquid in nature.All current assets are not liquid in nature. Inventory cannot be converted into liquid cash Inventory cannot be converted into liquid cash

easily. easily. In case of Quick ratio cash from debtors may In case of Quick ratio cash from debtors may

be doubtful and also the conversion of debtors be doubtful and also the conversion of debtors into cash depends upon the debtors’ cycle into cash depends upon the debtors’ cycle which may be longer also. which may be longer also.

Hence, only the cash ratio indicates the actual Hence, only the cash ratio indicates the actual liquidity position of the firm and firm can liquidity position of the firm and firm can increase the cash ratio by availing the credit increase the cash ratio by availing the credit limit from financial institutions. limit from financial institutions.

Modification of Quick RatioModification of Quick Ratio

Interval Ratio: It links the average daily operating Interval Ratio: It links the average daily operating expenses with the quick cash position of the firm.expenses with the quick cash position of the firm.

Interval Ratio=Interval Ratio=

(CA-Inventory)/ Avg. daily operating expenses(CA-Inventory)/ Avg. daily operating expenses

In other words it indicates the available quick cash will In other words it indicates the available quick cash will cover how many days of operating expenses cover how many days of operating expenses

(operating expenses does not include the depreciation).(operating expenses does not include the depreciation).

Leverage RatiosLeverage Ratios Investors, suppliers and financial institutions Investors, suppliers and financial institutions

though look into the liquidity position of the though look into the liquidity position of the firm, however the provide more attention to firm, however the provide more attention to Debt paying ability of the firm.Debt paying ability of the firm.

Liquidity or the cash position is seasonal in Liquidity or the cash position is seasonal in nature and also it quite volatile in nature.nature and also it quite volatile in nature.

Though liquidity is essential for strong short-Though liquidity is essential for strong short-term financial strength, long-term financial term financial strength, long-term financial position depends upon the mobilization of long-position depends upon the mobilization of long-term capital. term capital.

For long-term solvency of the firm and to For long-term solvency of the firm and to improve the ROCE it is essential for the firm to improve the ROCE it is essential for the firm to leverage the equity capital by employing more leverage the equity capital by employing more debt capital.debt capital.

Leverage RatiosLeverage RatiosDebt Ratio = Total Debt/ Net AssetsDebt Ratio = Total Debt/ Net AssetsNet Assets= (Fixed Assets- Depreciation)+ CANet Assets= (Fixed Assets- Depreciation)+ CA - CL(Excls. Interest bearing Short-term debt)- CL(Excls. Interest bearing Short-term debt)Ratio Indicate: The financing pattern of net assetsRatio Indicate: The financing pattern of net assets

between shareholders and lenders. between shareholders and lenders. Debt-Equity Ratio= Total Debt/ Net worthDebt-Equity Ratio= Total Debt/ Net worth

Ratio Indicate: The ratio of contribution of fundsRatio Indicate: The ratio of contribution of funds between shareholders and lendersbetween shareholders and lenders

Long-term Debt to Total Long term Funds Long-term Debt to Total Long term Funds (TD+Networth )(TD+Networth )

Networth to Total Long term funds Networth to Total Long term funds

Treatment of Long-term debtTreatment of Long-term debt Preference share capital:Preference share capital:

To study the effect of leverage on ordinary To study the effect of leverage on ordinary shareholders earning, then preference capital shareholders earning, then preference capital should be considered as debt capital.should be considered as debt capital.

To study the effect of leverage as financial risk To study the effect of leverage as financial risk then preference capital should be considered as then preference capital should be considered as net worth.net worth.

D-E Ratio… D-E Ratio… explanationexplanation It indicates the extent of equity capital has It indicates the extent of equity capital has

been leveraged in creating debt capital.been leveraged in creating debt capital. Higher the ratio means creditors would be Higher the ratio means creditors would be

more command in the running of the firm.more command in the running of the firm. Firm may face constrains in getting more debt Firm may face constrains in getting more debt

capital or even short-term borrowings for capital or even short-term borrowings for working capital.working capital.

Lower ratio indicates that the firm has not Lower ratio indicates that the firm has not leveraged its equity capital properly and leveraged its equity capital properly and because of which shareholders’ earning is because of which shareholders’ earning is lower.lower.

Leverage RatiosLeverage Ratios Interest coverage ratio: EBIT/Interest paymentInterest coverage ratio: EBIT/Interest payment

Earnings should be significantly more to cover Earnings should be significantly more to cover the primary obligation (interest payment)the primary obligation (interest payment)

In terms of cash flow:In terms of cash flow:Interest coverage : EBITDA/Interest paymentInterest coverage : EBITDA/Interest payment

If we include the other fixed payments: Rent, fixed If we include the other fixed payments: Rent, fixed dividend and Loans principal, then the coverage ratio:dividend and Loans principal, then the coverage ratio:

EBITDA/ (Interest rent+ before taxEBITDA/ (Interest rent+ before tax loan loan payment and fixed dividend)payment and fixed dividend)

Activities RatiosActivities RatiosIt indicates the efficiency with which firm utilizes its It indicates the efficiency with which firm utilizes its assets into sales/income. In this context various ratios assets into sales/income. In this context various ratios areare

Cost of goods sold or net salesInventory turnober

Average (or closing) inventory

Number of days in the year (say, 360) of inventory holding

Inventory turnover

Credit sales or net saDebtors turnover

Days

les

Average (or closing) debtors

Number of days in the year (say, 360) period

Debtors turnoverCollection

Turnover RatiosTurnover RatiosNet sales

Current assets turnoverCurrent assets

Net sales current assets turnover

Net current assetsNet sales

assets turnoverNet fixed assets

Net sales assets turnover

Net assets or capital

Net

Fixed

Net

employed

Interpretation of Turnover RatiosInterpretation of Turnover Ratios Inventory TurnoverInventory Turnover: :

Speed of inventory turning to receivable by sales.Speed of inventory turning to receivable by sales. High ratio indicates good inventory management.High ratio indicates good inventory management. It may also low inventory stock and low level of production It may also low inventory stock and low level of production

compared to market demand. compared to market demand. Lower ratio: Excessive production and low sales volume.Lower ratio: Excessive production and low sales volume.

Debtor Turnover:Debtor Turnover: Speed at which credit sales are made. Higher the turnover better Speed at which credit sales are made. Higher the turnover better

the credit sales management.the credit sales management.

Average Collection PeriodAverage Collection Period Average no. of days debtors remain outstanding.Average no. of days debtors remain outstanding. Lower the collection period better will be cash flows from Lower the collection period better will be cash flows from

debtors.debtors. Higher ACP indicates about firm liquidity problem.Higher ACP indicates about firm liquidity problem.

Interpretation of Turnover RatiosInterpretation of Turnover Ratios Net Asset TurnoverNet Asset Turnover: It indicates the efficiency of : It indicates the efficiency of

creation of sales by leveraging the assets.creation of sales by leveraging the assets. Total Assets turnoverTotal Assets turnover: It indicates the operating : It indicates the operating

efficiency in creating sales by leveraging the total efficiency in creating sales by leveraging the total available resources.available resources.

Fixed assets turn over: Economics scale in the Fixed assets turn over: Economics scale in the utilisation of fixed assets.utilisation of fixed assets.

Current Assets Turnover: Efficiency of net working Current Assets Turnover: Efficiency of net working capital in creation of sales. capital in creation of sales.

Profitability RatiosProfitability Ratios Profit provides risk bearing capital through Profit provides risk bearing capital through

retained earning.retained earning. Through the risk bearing capital firm can Through the risk bearing capital firm can

mobilise more debt capital so as to expand its mobilise more debt capital so as to expand its businessbusiness

Hence, monitoring of profit through profitability Hence, monitoring of profit through profitability ratio is essential.ratio is essential.

Profit, a firm get, through sales and through Profit, a firm get, through sales and through invesments. Hence, sales related ratio and invesments. Hence, sales related ratio and investment related ratios need to be estimated to investment related ratios need to be estimated to understand the profitability of a firm.understand the profitability of a firm.

Profitability RatiosProfitability Ratios before interest and tax (PBIT)

MarginNet sales

after tax (PAT) margin

Net salesPBIT

return on investmentNet assets

Profit after tax on equity

Equity (net worth)

Profit

ProfitNet

Before tax

Return

Profitability RatiosProfitability Ratios Gross Profit Margin:Gross Profit Margin: Indicates the contribution each unit Indicates the contribution each unit

of sales to profit. of sales to profit. Lower GPM indicates: Inefficient Lower GPM indicates: Inefficient use of fixed assets, higher raw material costs and use of fixed assets, higher raw material costs and even sluggish market price.even sluggish market price.Operating Profit Margin: Operating Profit Margin: It indicates the burden of It indicates the burden of operating expenditure on Gross profit. operating expenditure on Gross profit. Net profit margin:Net profit margin: It indicates the tax burden on operating It indicates the tax burden on operating profit. profit. All the three ratios need to be analyzed to understand the All the three ratios need to be analyzed to understand the burden of expenses which has influence the profit burden of expenses which has influence the profit margin from the sales. margin from the sales. Operating expenses to sales and cost of goods to sales Operating expenses to sales and cost of goods to sales need to be checked to ascertain the reduction in profit need to be checked to ascertain the reduction in profit margin.margin.

Return on InvestmentReturn on Investment

Investment: Shareholders funds+ Lenders fundsInvestment: Shareholders funds+ Lenders funds RoI indicates the efficiency of funds use in RoI indicates the efficiency of funds use in

creation of profit after adjustment for tax.creation of profit after adjustment for tax.

RoI= EBIT(1-T)/ Capital EmployedRoI= EBIT(1-T)/ Capital Employed

Since depreciation and amortization are sources Since depreciation and amortization are sources of funds and tax is same across the industry,hence of funds and tax is same across the industry,hence the RoI can be adjusted asthe RoI can be adjusted as

RoI= EBITDA/ Capital EmployedRoI= EBITDA/ Capital Employed

Shareholders Earning Efficiency RatiosShareholders Earning Efficiency Ratios

Profit after taxEPS

Number of ordinary shares

DPSNumber of ordinary shares

DPS ratio

EPS Pr after tax

DPS yield

Market value per share

Dividends

DividendsPayout

ofit

Dividend

Shareholders Earning Efficiency RatiosShareholders Earning Efficiency Ratios

EPSEarnings yield

value per share

value per shareP / E ratio =

EPSNet worth

value per shareNumber of ordinary shares

value per shareM Bvalue

Book value per share

Mar'

Market

Market

Book

Market

Tobin s q

ket value of assets

Economic value of assets

Earning Efficiency Ratios: InterpretationEarning Efficiency Ratios: Interpretation RoE: RoE:

Extent of leverage of shareholders fundsExtent of leverage of shareholders funds It is the strength of the firm in attracting present and It is the strength of the firm in attracting present and

future investors.future investors. EPS: EPS:

Profitability of the firm per share basis which is generally Profitability of the firm per share basis which is generally compare with industry average.compare with industry average.

DPS: DPS: Earning per share in terms of dividend which is generally Earning per share in terms of dividend which is generally

compare with industry average.compare with industry average. DPR: (Dividend Payout ratio)DPR: (Dividend Payout ratio)

It indicates the % of PAT distributed among the It indicates the % of PAT distributed among the shareholders. shareholders.

(1-DP)% is the PAT retain as retained earning (1-DP)% is the PAT retain as retained earning

NEXT CLASS:NEXT CLASS:

Techniques of project selectionTechniques of project selection

CAPITAL BUDGETINGCAPITAL BUDGETING The The investment decisionsinvestment decisions of a firm are generally of a firm are generally

known as the known as the capital budgeting, or capital capital budgeting, or capital expenditure decisions.expenditure decisions.

Investment Decisions: EInvestment Decisions: Expansionxpansion, A, Acquisitioncquisition, , modernisationmodernisation and and replacementreplacement

Investment Lead to Exchange of current funds for Investment Lead to Exchange of current funds for future benefits.future benefits.

The funds are invested in long-term assets.The funds are invested in long-term assets. The future benefits will occur to the firm over a The future benefits will occur to the firm over a

series of years.series of years.

Investment Evaluation CriteriaInvestment Evaluation CriteriaThree steps are involved in the evaluation of anThree steps are involved in the evaluation of an

investment:investment:Estimation of cash flowsEstimation of cash flowsEstimation of the required rate of return (the Estimation of the required rate of return (the opportunity cost of capital)opportunity cost of capital)Application of a decision rule for making the choiceApplication of a decision rule for making the choice

Any investment should increase shareholders value. It Any investment should increase shareholders value. It should recognise the fact that bigger cash flows are should recognise the fact that bigger cash flows are preferable to smaller ones and early cash flows are preferable to smaller ones and early cash flows are preferable to later ones. It should help to choose among preferable to later ones. It should help to choose among mutually exclusive projects that project which mutually exclusive projects that project which maximises the shareholders’ wealth.maximises the shareholders’ wealth.

Evaluation CriteriaEvaluation Criteria Discounted Cash Flow (DCF) CriteriaDiscounted Cash Flow (DCF) Criteria

    Net Present Value (NPV)Net Present Value (NPV)     Internal Rate of Return (IRR)Internal Rate of Return (IRR)     Profitability Index (PI)Profitability Index (PI)

2. 2. Non-discounted Cash Flow CriteriaNon-discounted Cash Flow Criteria     Payback Period (PB)Payback Period (PB)     Discounted Payback Period (DPB)Discounted Payback Period (DPB)     Accounting Rate of Return (ARR)Accounting Rate of Return (ARR)

Net Present Value MethodNet Present Value Method Cash flows of the investment project should be Cash flows of the investment project should be

forecasted based on realistic assumptions.forecasted based on realistic assumptions. Appropriate discount rate should be identified to Appropriate discount rate should be identified to

discount the forecasted cash flows. The appropriate discount the forecasted cash flows. The appropriate discount rate is the project’s opportunity cost of discount rate is the project’s opportunity cost of capital. capital.

Present value of cash flows should be calculated Present value of cash flows should be calculated using the opportunity cost of capital as the discount using the opportunity cost of capital as the discount rate.rate.

The project should be accepted if NPV is positive The project should be accepted if NPV is positive (i.e., NPV > 0).(i.e., NPV > 0).

Net Present Value MethodNet Present Value Method

Net present value should be found out by subtracting Net present value should be found out by subtracting present value of cash outflows from present value of present value of cash outflows from present value of cash inflows. cash inflows.

Acceptance Rule: NPV: +: Accepted, :-: Rejected Acceptance Rule: NPV: +: Accepted, :-: Rejected NPV : O: may be accepted or rejected NPV : O: may be accepted or rejected

Higher NPA consider for mutually exclusive projectsHigher NPA consider for mutually exclusive projects

31 202 3

01

NPV(1 ) (1 ) (1 ) (1 )

NPV(1 )

nn

nt

tt

C CC CC

k k k k

CC

k

Calculating Net Present ValueCalculating Net Present Value

Assume that Project Assume that Project XX costs Rs 2,500 now and is expected costs Rs 2,500 now and is expected to generate year-end cash inflows of Rs 900, Rs 800, Rs to generate year-end cash inflows of Rs 900, Rs 800, Rs 700, Rs 600 and Rs 500 in years 1 through 5. The 700, Rs 600 and Rs 500 in years 1 through 5. The opportunity cost of the capital may be assumed to be 10 opportunity cost of the capital may be assumed to be 10 per cent.per cent.

2 3 4 5

1, 0.10 2, 0.10 3, 0.10

4, 0.10 5, 0.

Rs 900 Rs 800 Rs 700 Rs 600 Rs 500NPV Rs 2,500

(1+0.10) (1+0.10) (1+0.10) (1+0.10) (1+0.10)

NPV [Rs 900(PVF ) + Rs 800(PVF ) + Rs 700(PVF )

+ Rs 600(PVF ) + Rs 500(PVF

10)] Rs 2,500

NPV [Rs 900 0.909 + Rs 800 0.826 + Rs 700 0.751 + Rs 600 0.683

+ Rs 500 0.620] Rs 2,500

NPV Rs 2,725 Rs 2,500 = + Rs 225

Evaluation of the NPV MethodEvaluation of the NPV Method NPV is most acceptable investment rule for NPV is most acceptable investment rule for

the following reasons:the following reasons: Time value Time value Measure of true profitability Measure of true profitability Shareholder valueShareholder value

Limitations:Limitations: Involved cash flow estimation Involved cash flow estimation Discount rate difficult to determineDiscount rate difficult to determine Mutually exclusive projects Mutually exclusive projects Ranking of projects Ranking of projects

Internal Rate of Return MethodInternal Rate of Return Method

The internal rate of return (IRR) is the rate that equates the The internal rate of return (IRR) is the rate that equates the investment outlay with the present value of cash inflow investment outlay with the present value of cash inflow received. This also implies that the rate of return is the received. This also implies that the rate of return is the discount rate which makes NPV = 0. discount rate which makes NPV = 0.

31 20 2 3

01

01

(1 ) (1 ) (1 ) (1 )

(1 )

0(1 )

nn

nt

tt

nt

tt

C CC CC

r r r r

CC

r

CC

r

Acceptance Rule As Per IRRAcceptance Rule As Per IRR

Accept the project when Accept the project when rr > > k.k. Reject the project when Reject the project when rr < < k.k. May accept the project when May accept the project when rr = = k.k. In case of independent projects, IRR and NPV In case of independent projects, IRR and NPV

rules will give the same results if the firm has rules will give the same results if the firm has no shortage of funds.no shortage of funds.

Evaluation of IRR MethodEvaluation of IRR Method IRR method has following merits:IRR method has following merits:

Time value Time value Profitability measure Profitability measure Acceptance rule Acceptance rule Shareholder value Shareholder value

IRR method may suffer from:IRR method may suffer from: Multiple rates Multiple rates Mutually exclusive projects Mutually exclusive projects

Profitability IndexProfitability Index Profitability indexProfitability index is the ratio of the present value of is the ratio of the present value of

cash inflows, at the required rate of return, to the cash inflows, at the required rate of return, to the initial cash outflow of the investmentinitial cash outflow of the investment..

Acceptance RuleAcceptance Rule

The following are the PThe following are the PII acceptance rules: acceptance rules: Accept the project when PI is greater than one. PI > 1Accept the project when PI is greater than one. PI > 1 Reject the project when PI is less than one. PI < 1Reject the project when PI is less than one. PI < 1 May accept the project when PI is equal to one. PI = 1May accept the project when PI is equal to one. PI = 1

The project with positive NPV will have PI greater The project with positive NPV will have PI greater than one. PI less than means that the project’s NPV is than one. PI less than means that the project’s NPV is negative.negative.

ExampleExample

Payback Period MethodPayback Period Method Payback Payback is the number of years required to recover the is the number of years required to recover the

original cash outlay invested in a project. original cash outlay invested in a project. If the project generates constant annual cash inflows, If the project generates constant annual cash inflows,

the payback period can be computed by dividing cash the payback period can be computed by dividing cash outlay by the annual cash inflow. That is:outlay by the annual cash inflow. That is:

Unequal cash flowsUnequal cash flows In case of unequal cash inflows, In case of unequal cash inflows, the payback period can be found out by adding up the the payback period can be found out by adding up the cash inflows until the total is equal to the initial cash cash inflows until the total is equal to the initial cash outlay.outlay.

0Initial InvestmentPayback = =

Annual Cash Inflow

C

C

Evaluation of PaybackEvaluation of Payback Certain virtues:Certain virtues:

Simplicity Simplicity Cost effective Cost effective Short-term effects Short-term effects Risk shield Risk shield LiquidityLiquidity

Serious limitations: Serious limitations: Cash flows after payback Cash flows after payback Cash flows ignored Cash flows ignored Cash flow patterns Cash flow patterns Administrative difficulties Administrative difficulties Inconsistent with shareholder valueInconsistent with shareholder value

Discounted Payback PeriodDiscounted Payback Period The The discounted payback perioddiscounted payback period is the number of is the number of

periods taken in recovering the investment outlay periods taken in recovering the investment outlay on the present value basis. on the present value basis.

The discounted payback period still fails to The discounted payback period still fails to consider the cash flows occurring after the consider the cash flows occurring after the payback period.payback period.

ExampleExample

Acceptance Rule as Per Payback MethodAcceptance Rule as Per Payback Method

The project would be accepted if its payback The project would be accepted if its payback period is less than the maximum or period is less than the maximum or standard standard paybackpayback period set by management. period set by management.

As a ranking method, it gives highest ranking As a ranking method, it gives highest ranking to the project, which has the shortest payback to the project, which has the shortest payback period and lowest ranking to the project with period and lowest ranking to the project with highest payback period.highest payback period.

Evaluation of PaybackEvaluation of Payback Certain virtues:Certain virtues:

Simplicity Simplicity Cost effective Cost effective Short-term effects Short-term effects Risk shield Risk shield LiquidityLiquidity

Serious limitations: Serious limitations: Cash flows after payback Cash flows after payback Cash flows ignored Cash flows ignored Cash flow patterns Cash flow patterns Administrative difficulties Administrative difficulties Inconsistent with shareholder valueInconsistent with shareholder value

Accounting Rate of Return MethodAccounting Rate of Return Method

The accounting rate of return is the ratio of the average The accounting rate of return is the ratio of the average after-tax profit divided by the average investment. The after-tax profit divided by the average investment. The average investment would be equal to half of the average investment would be equal to half of the original investment if it were depreciated constantly. original investment if it were depreciated constantly.

A variation of the ARR method is to divide average A variation of the ARR method is to divide average earnings after taxes by the original cost of the project earnings after taxes by the original cost of the project instead of the average costinstead of the average cost

Average incomeARR =

Average investment

Acceptance RuleAcceptance Rule

This method will accept all those projects This method will accept all those projects whose ARR is higher than the minimum rate whose ARR is higher than the minimum rate established by the management and reject established by the management and reject those projects which have ARR less than the those projects which have ARR less than the minimum rate.minimum rate.

This method would rank a project as number This method would rank a project as number one if it has highest ARR and lowest rank one if it has highest ARR and lowest rank would be assigned to the project with lowest would be assigned to the project with lowest ARR.ARR.

Evaluation of ARR MethodEvaluation of ARR Method The ARR method may claim some meritsThe ARR method may claim some merits

Simplicity Simplicity Accounting data Accounting data Accounting profitabilityAccounting profitability

Serious shortcomingSerious shortcoming Cash flows ignored Cash flows ignored Time value ignored Time value ignored Arbitrary cut-off Arbitrary cut-off

DeterminingDeterminingCash Flows forCash Flows for

Investment AnalysisInvestment Analysis

ObjectivesObjectives Conceptual difference between profit and Conceptual difference between profit and

cash flow.cash flow. The approach for calculating incremental The approach for calculating incremental

cash flows. cash flows. Highlight the interaction between financing Highlight the interaction between financing

and investment decisionsand investment decisions..

Cash Flows Versus ProfitCash Flows Versus Profit Cash flow is not the same thing as profit, at Cash flow is not the same thing as profit, at

least, for two reasons:least, for two reasons: FirstFirst, profit, as measured by an accountant, is based on , profit, as measured by an accountant, is based on

accrual concept.accrual concept. SecondSecond, for computing profit, expenditures are , for computing profit, expenditures are

arbitrarily divided into revenue and capital arbitrarily divided into revenue and capital expenditures.expenditures.

CF (REV EXP DEP) DEP CAPEX

CF Profit DEP CAPEX

Incremental Cash FlowsIncremental Cash Flows Every investment involves a comparison of Every investment involves a comparison of

alternatives:alternatives: When the incremental cash flows for an investment When the incremental cash flows for an investment

are calculated by comparing with a hypothetical are calculated by comparing with a hypothetical zero-cash-flow project, we call them zero-cash-flow project, we call them absolute cash absolute cash flowsflows..

The incremental cash flows found out by The incremental cash flows found out by comparison between two comparison between two realreal alternatives can be alternatives can be called called relative cash flowsrelative cash flows..

The principle of incremental cash flows The principle of incremental cash flows assumes greater importance in the case of assumes greater importance in the case of replacement decisions.replacement decisions.

ExampleExampleA firm wants to replace an old equipment which A firm wants to replace an old equipment which is capable of generating CFs of Rs.2000/-, is capable of generating CFs of Rs.2000/-, Rs.1000/- and Rs.500/- during the next 3 yrs. It Rs.1000/- and Rs.500/- during the next 3 yrs. It has book value Rs.5000/- and market value has book value Rs.5000/- and market value Rs.3000/-.The new equipment needs a initial Rs.3000/-.The new equipment needs a initial outflow of Rs.10000/- and it is estimated to outflow of Rs.10000/- and it is estimated to generate Rs.8000/- Rs.7000/- and Rs.4500/- for generate Rs.8000/- Rs.7000/- and Rs.4500/- for the next 3 yrs. If tax do not exist, evaluate the the next 3 yrs. If tax do not exist, evaluate the investment decision. investment decision.

Components of Cash FlowsComponents of Cash Flows

Initial InvestmentInitial Investment Net Cash FlowsNet Cash Flows

Revenues and ExpensesRevenues and Expenses Depreciation and TaxesDepreciation and Taxes Change in Net Working CapitalChange in Net Working Capital

Change in accounts receivable  Change in accounts receivable   Change in inventory  Change in inventory   Change in accounts payable  Change in accounts payable  

Change in Capital ExpenditureChange in Capital Expenditure Free Cash FlowsFree Cash Flows

An investment requires an initial cash outflow of An investment requires an initial cash outflow of Rs.50000/- and it is expected to generate annual Rs.50000/- and it is expected to generate annual cash sales of Rs.25000 /- and needs cash expenses cash sales of Rs.25000 /- and needs cash expenses of Rs.10000/-. If the life of the project is 5yr, of Rs.10000/-. If the life of the project is 5yr, evaluate the investment decision without tax and evaluate the investment decision without tax and also with a tax rate of 30%. also with a tax rate of 30%.

ExampleExample

Components of Cash FlowsComponents of Cash Flows

Terminal Cash FlowsTerminal Cash Flows Salvage ValueSalvage Value

Salvage value of the new asset Salvage value of the new asset Salvage value of the existing asset now Salvage value of the existing asset now Salvage value of the existing asset at the end of its normal Salvage value of the existing asset at the end of its normal Tax effect of salvage value  Tax effect of salvage value  

Release of Net Working CapitalRelease of Net Working Capital

Depreciation for Tax PurposesDepreciation for Tax Purposes Two most popular methods of charging Two most popular methods of charging

depreciation are: depreciation are: Straight-line Straight-line Diminishing balance or written-down value (WDV) Diminishing balance or written-down value (WDV)

methods.methods. For reporting to the shareholders, companies in For reporting to the shareholders, companies in

India could charge depreciation either on the India could charge depreciation either on the straight-line or the written-down value basis. straight-line or the written-down value basis.

For the tax purposes, depreciation is computed For the tax purposes, depreciation is computed on the written down value (WDV) of the on the written down value (WDV) of the block of assets.block of assets.

Salvage Value and Tax Salvage Value and Tax EffectsEffects

As per the current tax rules in India, the after-As per the current tax rules in India, the after-tax salvage value should be calculated as tax salvage value should be calculated as follows:follows: Book value > Salvage value:Book value > Salvage value:

After-tax salvage value = Salvage value + PV of depreciation After-tax salvage value = Salvage value + PV of depreciation tax shield on (BV – SV)tax shield on (BV – SV)

Salvage value > Book value:Salvage value > Book value: After-tax salvage value = Salvage value – PV of depreciation After-tax salvage value = Salvage value – PV of depreciation

tax shield lost on (SV tax shield lost on (SV BV) BV)

PVDTS BV SVn n n

T d

k d

Terminal Value for a New Terminal Value for a New BusinessBusiness

The terminal value included the salvage value of the The terminal value included the salvage value of the asset and the release of the working capital.asset and the release of the working capital.

Managers make assumption of horizon period Managers make assumption of horizon period because detailed calculations for a long period because detailed calculations for a long period become quite intricate. The financial analysis of become quite intricate. The financial analysis of such projects should incorporate an estimate of the such projects should incorporate an estimate of the value of cash flows after the horizon period without value of cash flows after the horizon period without involving detailed calculations.involving detailed calculations.

A simple method of estimating the terminal value at A simple method of estimating the terminal value at the end of the horizon period is to employ the the end of the horizon period is to employ the following formula, which is a variation of the following formula, which is a variation of the dividend—growth model:dividend—growth model: 1

NCF 1 NCFTV n n

n

g

k g k g

Cash Flow Estimates for Cash Flow Estimates for Replacement DecisionsReplacement Decisions

The initial investment of the new machine The initial investment of the new machine will be reduced by the cash proceeds from will be reduced by the cash proceeds from the sale of the existing machine:the sale of the existing machine:

The annual cash flows are found on The annual cash flows are found on incremental basis.incremental basis.

The incremental cash proceeds from The incremental cash proceeds from salvage value is considered. salvage value is considered.

Additional Aspects of Additional Aspects of Incremental Cash Flow Incremental Cash Flow

AnalysisAnalysis Allocated OverheadsAllocated Overheads Opportunity Costs of ResourcesOpportunity Costs of Resources Incidental EffectsIncidental Effects

Contingent costsContingent costs     Cannibalisation Cannibalisation    Revenue enhancementRevenue enhancement    

Sunk CostsSunk Costs Tax IncentivesTax Incentives

Investment allowanceInvestment allowance  Until   Until Investment deposit schemeInvestment deposit scheme     Other tax incentivesOther tax incentives    

Investment Decisions Under Investment Decisions Under InflationInflation

Executives generally estimate cash flows assuming unit Executives generally estimate cash flows assuming unit costs and selling price prevailing in year zero to remain costs and selling price prevailing in year zero to remain unchanged. They argue that if there is inflation, prices can unchanged. They argue that if there is inflation, prices can be increased to cover increasing costs; therefore, the impact be increased to cover increasing costs; therefore, the impact on the project’s profitability would be the same if they on the project’s profitability would be the same if they assume rate of inflation to be zero.assume rate of inflation to be zero.

This line of argument, although seems to be convincing, is This line of argument, although seems to be convincing, is fallacious for two reasons.fallacious for two reasons. FirstFirst, the discount rate used for discounting cash flows is generally , the discount rate used for discounting cash flows is generally

expressed in expressed in nominalnominal terms. It would be inappropriate and inconsistent to terms. It would be inappropriate and inconsistent to use a nominal rate to discount constant cash flows. use a nominal rate to discount constant cash flows.

SSecondecond, selling prices and costs show different degrees of responsiveness , selling prices and costs show different degrees of responsiveness to inflation:to inflation:

The The depreciation tax shielddepreciation tax shield remains unaffected by inflation since depreciation remains unaffected by inflation since depreciation is allowed on the book value of an asset, irrespective of its replacement or is allowed on the book value of an asset, irrespective of its replacement or market price, for tax purposes.market price, for tax purposes.

Nominal Vs. Real Rates of Nominal Vs. Real Rates of ReturnReturn

For a correct analysis, two For a correct analysis, two alternatives are available:alternatives are available: either the cash flows should be either the cash flows should be

converted into nominal terms and converted into nominal terms and then discounted at the nominal then discounted at the nominal required rate of return, orrequired rate of return, or

the discount rate should be the discount rate should be converted into real terms and converted into real terms and used to discount the real cash used to discount the real cash flows.flows.

Always remember:Always remember: Discount Discount nominal cash flows at nominal cash flows at nominal discount rate; or nominal discount rate; or discount real cash flows at discount real cash flows at real discount rate.real discount rate.

1rate)inflation +rate)(1discount Real+(1=ratediscount Nominal

Financing Effects in Financing Effects in Investment EvaluationInvestment Evaluation

According to the conventional capital budgeting According to the conventional capital budgeting approach cash flows should not be adjusted for the approach cash flows should not be adjusted for the financing effects. financing effects.

The adjustment for the financing effect is made in The adjustment for the financing effect is made in the discount rate. The firm’s weighted average cost the discount rate. The firm’s weighted average cost of capital (WACC) is used as the discount rate.of capital (WACC) is used as the discount rate.

It is important to note that this approach of It is important to note that this approach of adjusting for the finance effect is based on the adjusting for the finance effect is based on the assumptions that:assumptions that: The investment project has the same risk as the firm.The investment project has the same risk as the firm. The investment project does not cause any change in the The investment project does not cause any change in the

firm’s target capital structure.firm’s target capital structure.

The Cost of CapitalThe Cost of Capital

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IntroductionIntroduction

The The project’s cost of capitalproject’s cost of capital is the is the minimum required rate of return on funds minimum required rate of return on funds committed to the project, which depends on committed to the project, which depends on the riskiness of its cash flows.the riskiness of its cash flows.

The firm’s cost of capitalThe firm’s cost of capital will be the will be the overall, or average, required rate of return overall, or average, required rate of return on the aggregate of investment projectson the aggregate of investment projects..

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Significance of the Cost of Significance of the Cost of CapitalCapital

Evaluating investment decisions,Evaluating investment decisions, Designing a firm’s debt policy, andDesigning a firm’s debt policy, and Appraising the financial performance of top Appraising the financial performance of top

management.management.

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The Concept of the Opportunity Cost The Concept of the Opportunity Cost of Capitalof Capital

The opportunity cost is the rate of return The opportunity cost is the rate of return foregone on the next best alternative foregone on the next best alternative investment opportunity of investment opportunity of comparable riskcomparable risk..

OCC

. Equity shares

Risk

. Preference shares. Corporate bonds. Government bonds. Risk-free security

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Weighted Average Cost of Capital Weighted Average Cost of Capital Vs. Specific Costs of CapitalVs. Specific Costs of Capital

The cost of capital of each source of capital is known as The cost of capital of each source of capital is known as componentcomponent,, oror specificspecific, , cost of capitalcost of capital. .

The overall cost is also called the The overall cost is also called the weighted average cost weighted average cost of capitalof capital (WACC). (WACC).

Relevant cost in the investment decisions is the Relevant cost in the investment decisions is the future costfuture cost or the or the marginal costmarginal cost. .

Marginal cost is the new or the incremental cost that the Marginal cost is the new or the incremental cost that the firm incurs if it were to raise capital now, or in the near firm incurs if it were to raise capital now, or in the near future. future.

The The historical cost historical cost that was incurred in the past in raising that was incurred in the past in raising capital is not relevant in financial decision-making. capital is not relevant in financial decision-making.

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Cost of DebtCost of Debt

Debt Issued at ParDebt Issued at Par

Tax adjustment Tax adjustment    Irredeemable Preference Share Irredeemable Preference Share    Redeemable Preference Share Redeemable Preference Share   

0

INTdk i

B

After-tax cost of debt (1 )dk T

0

PDIVpk

P

01

PDIV = +

(1 ) (1 )

nt n

t nt

p p

PP

k k

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Cost of Equity CapitalCost of Equity Capital

Is Equity Capital Free of Cost? No, it has Is Equity Capital Free of Cost? No, it has an opportunity cost.an opportunity cost.

Cost of Internal Equity: The Dividend—Cost of Internal Equity: The Dividend—Growth ModelGrowth Model Normal growthNormal growth    

10

DIV

( )e

Pk g

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Cost of Equity CapitalCost of Equity Capital

Cost of External Equity: The Dividend—Cost of External Equity: The Dividend—Growth ModelGrowth Model

Earnings–Price Ratio and the Cost of Earnings–Price Ratio and the Cost of EquityEquity

1

0

DIVek g

P

1

0

1

0

EPS (1 ) ( )

EPS ( 0)

e

bk br g br

P

bP

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The Capital Asset Pricing Model (CAPM)The Capital Asset Pricing Model (CAPM)

As per the CAPM, the required rate of As per the CAPM, the required rate of return on equity is given by the following return on equity is given by the following relationship:relationship:

Equation requires the following three Equation requires the following three parameters to estimate a firm’s cost of parameters to estimate a firm’s cost of equity:equity: The risk-free rate (The risk-free rate (RRff) )

The market risk premium (The market risk premium (RRmm – – RRff)) The beta of the firm’s share (The beta of the firm’s share ())

( )e f m f jk R R R

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Cost of Equity: CAPM Vs. Cost of Equity: CAPM Vs. Dividend—Growth ModelDividend—Growth Model

The dividend-growth approach has limited The dividend-growth approach has limited application in practice application in practice It assumes that the dividend per share will grow at a It assumes that the dividend per share will grow at a

constant rate, constant rate, gg, forever. , forever. The expected dividend growth rate, The expected dividend growth rate, g,g, should be less should be less

than the cost of equity,than the cost of equity, k kee, to arrive at the simple growth , to arrive at the simple growth

formula.formula. The dividend–growth approach also fails to deal with The dividend–growth approach also fails to deal with

risk directly. risk directly.

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Cost of Equity: CAPM Vs. Dividend—Cost of Equity: CAPM Vs. Dividend—Growth ModelGrowth Model

CAPM has a wider application although it CAPM has a wider application although it is based on restrictive assumptions:is based on restrictive assumptions: The only condition for its use is that the company’s The only condition for its use is that the company’s

share is quoted on the stock exchange. share is quoted on the stock exchange. All variables in the CAPM are market determined and All variables in the CAPM are market determined and

except the company specific share price data, they are except the company specific share price data, they are common to all companies.common to all companies.

The value of beta is determined in an objective manner The value of beta is determined in an objective manner by using sound statistical methods. One practical by using sound statistical methods. One practical problem with the use of beta, however, is that it does problem with the use of beta, however, is that it does

not not probably remain stable over probably remain stable over time.time.

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The Weighted Average Cost of CapitalThe Weighted Average Cost of Capital The following steps are involved for The following steps are involved for

calculating the firm’s WACC:calculating the firm’s WACC: Calculate the cost of specific sources of fundsCalculate the cost of specific sources of funds Multiply the cost of each source by its proportion in the Multiply the cost of each source by its proportion in the

capital structure.capital structure. Add the weighted component costs to get the WACC.Add the weighted component costs to get the WACC.

WACC is in fact the weighted marginal cost of WACC is in fact the weighted marginal cost of capital (WMCC); that is, the capital (WMCC); that is, the weighted average weighted average cost of new capital given the firm’cost of new capital given the firm’ss target target capital structurecapital structure..

(1 )

(1 )

o d d d e

o d e

k k T w k w

D Ek k T k

D E D E

7171 Financial Management, Ninth Edition Financial Management, Ninth Edition © I M Pandey© I M Pandey

Vikas Publishing House Pvt. Ltd.Vikas Publishing House Pvt. Ltd.

Book Value Versus Market Value Book Value Versus Market Value WeightsWeights

Market-value weights are theoretically Market-value weights are theoretically superior to book-value weights:superior to book-value weights: They reflect economic values and are not influenced by They reflect economic values and are not influenced by

accounting policies.accounting policies. They are also consistent with the market-determined They are also consistent with the market-determined

component costs.component costs. The difficulty in using market-value The difficulty in using market-value

weights:weights: The market prices of securities fluctuate widely and The market prices of securities fluctuate widely and

frequently. frequently. A market value based target capital structure means A market value based target capital structure means

that the amounts of debt and equity are continuously that the amounts of debt and equity are continuously adjusted as the value of the firm changes.adjusted as the value of the firm changes.

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The Cost of Capital for ProjectsThe Cost of Capital for Projects

For example, projects may be classified as:For example, projects may be classified as: Low risk projectsLow risk projects

discount rate < the firm’s WACC discount rate < the firm’s WACC Medium risk projectsMedium risk projects

discount rate = the firm’s WACCdiscount rate = the firm’s WACC High risk projectsHigh risk projects

discount rate > the firm’s WACCdiscount rate > the firm’s WACC