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Financial Management

K.V.RAMESH
Assistant Professor
Coordinator MBA ( PE )
Institute of Public Enterprise

Lay out

Nature of Financial Management.

Investment & Financing Decisions.

Dividend Decisions.

Liquidity Decisions or Working Capital


Management.

Financial management by Jonathan Berk / Peter DeMarzo & Ashok


Thampy.
Fundamentals of Financial Management by James C.Van Horne and
John M. Wachowicz, Jr.
Fundamentals of Financial management by Brigham & Houston
Financial management by I M Pandey
Financial management by G. Sudarsana Reddy
Contemporary Financial management by Rajesh Kothari and Bobby
dutta
Financial management by Shashi K. Gupta and R.K.Sharma
Financial management by Khan and Jain
Cost accounting and Financial management Khan and Jain
Fundamentals of Financial management by Prasanna Chandra.

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.

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 firms 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 the stockholders wealth.

Profit

Vs

Wealth

The term profit is vague.

Its an prescriptive idea.

Ignores the time value of


money.

Not necessarily socially


desirable.

Ignores Risk factor.

Dividend policy.

Controversy objectives
Maximize stockholders
wealth or wealth of firm.
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 firms 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.
Symbolically

Po(1+i) - Po

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

Where

Vn = Vo ( 1 + i/m)
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)

Problems
1.

2.
3.
4.
5.
6.

7.

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.
From the above calculate the value of Rs.100 @ 10% after ten years.
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?
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.
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?
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.
year for five years in a bank and the deposit earns a compound Mr. B deposits
Rs.5000 at the beginning of each 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 DF i,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.
2.
3.

4.

5.

6.

Calculate the present value of Rs.1000 to be received after


one year @ 10% time preference rate.
Mr. X is to receive Rs.5000 after five years @ 10% p.a.
Calculate its present value.
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.
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.
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.
Calculate the present value of Rs.1000 received in perpetuity
for an infinite period taking discount rate of 10%.

Valuation of Securities
Bonds with a maturity period:
n
Vd =

Rt

Mn

(1+ Kd)t
(1+ Kd)n
Vd = Value of bond
R1, R2 ----- = Annual interest in period 1, 2 & so on.
Kd = Required rate of return
M = Maturity value of bond
n = Number of years to maturity
Note: If n becomes large we use present value tables, formula
is
Vd = (R)(ADFi,n) + (M)(DFi,n)

Bonds in Perpetuity/DDBs
Bonds which never mature or have infinite maturity period.
The value of such bonds is the discounted value of infinite
streams of interest (cash) flows.
Vd = R
Kd
Deep Discount Bonds:
n
Vddb = FV / ( 1 + r )
Or
Vddb = (FV) x (DFi,n)
Where Vddb = Value of a deep discount bond
FV = Face value at maturity
r = Required rate of return
n = Number of years to mature / Life of DDB

Problems
1.

2.

3.

4.

5.

Mr.X is considering the purchase of a 8% Rs.1000 bond


redeemable after 5years at par, required rate of return is
10%. Calculate the amount to be paid for bond.
Xltd a company is proposing to issue a 5year debenture of
Rs.1000 redeemable in equal instalments@14% interest
p.a. If an investor has a minimum required rate of return
of 12%, calculate the debentures present value.
Mr.A has a perpetual bond of the face value of Rs.1000. He
receives an interest of Rs.60 annually. What would be its
value if the required rate of return is 10%.
Mr.A has a perpetual bond of the face value of Rs.1000. He
receives an interest of Rs.60 annually. Its current value is
Rs.600. Calculate the yield to maturity.
IDBI issued deep discount bond for a maturity period of 20
years and having face value of Rs.100000. Calculate the
value of DDB if the required rate of return is 10%.

Valuation of Preference share


1.

2.

Mr.A is considering the purchase of a 7%


preference share of Rs.1000 redeemable after 5
years at par. What should be the pay now to
purchase the share assuming that the required
rate of return is 8%.
Mr.A has a irredeemable preference share of
Rs.1000. He receives an annual dividend of
Rs.80 annually. What will be its value if the
required rate of return is 10%. ( d/kp)

Valuation of Equity Share

Short term investor


Po = D1/1+ke + P1/ 1+ke
where Po refers to Current value of the share.
D1 Expected dividend
P1 Expected price of share
ke Required rate of return on equity
Mr.X is planning to buy an equity share for 1 year. The
expected dividend is Rs.7 and expected sale proceeds
Rs.200. Determine the value of the share assuming the
discount rate of 15%.
Note: If in the above case expected dividend and selling
price in the second year are Rs.7.50 and Rs.220. calculate
value of share.

D is constant

The value of share shall be calculated by using annuity


discount factor tables.

Po = (D) (ADFi,n) + (Pn ) (DFi,n)


Mr.X expects a dividend of Rs.5 per share for each of ten
years and a selling price of Rs.80 at the end of ten
years.
Calculate the present value of share if his
required rate of return is 12%.

Dividend Valuation Model

The concept of this model is that many investors do not


contemplate selling their share in the near future.

t
Po = Dt / (1+ke)
t=1

No growth:
Po = D/Ke
Constant growth: Po = D1 =

Do(1+g)

Ke - g
Ke - g
Where Do is current dividend
D1 is expected dividend
Ke is required rate of return on equity
g

is expected percent growth in dividend

Problems
1.

2.

3.

A company is expected to pay a dividend of Rs.6 per


share.
The dividends are expected to grow
perpetually at a rate of 9%. What is the value of its
share, if the required rate of return is 15%?
The current price of a companys share is Rs.200.
The company is expected to pay a dividend of Rs.5
per share with an annual growth rate of 10%. If an
investors required rate of return is 12%, should he
buy the share?
The current price of a companys share is Rs.75 and
dividend per share is Rs.5. Calculate the dividend
growth rate , if its capitalisation rate is 12%.

Rate of Return on Equity Share


Po

D1
Ke - g
OR
D1

Ke

Po + g

The expected rate of return re, can be calculated with


the following formula:
D1
re =

P1-P0
+

Po
P0
The market price of a share is Rs.80. The company is
expected to pay a dividend of Rs.4 and the share can
be sold at Rs.88. Calculate return on share. Advise
the investor to buy or not if his capitalisation rate is
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

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 50% 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 floatation are 2%. The
rate of tax is 60%.Compute cost of debt.

Redeemable debt
Before Tax
I + 1/n(RV-NP)
Kdb =
(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 floatation
Rs.30,000.The
debentures
are
redeemable after 5 years. Calculate
before tax assuming tax rate 50%.
Note: calculate after-tax cost of debt.

After Tax
I(1-t)+ 1/n(RV-NP)
Kdb =
(RV+NP)

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
Issued at a discount or premium
Kp = D/NP
Redeemable
Kpr = D+MV-NP/n
(MV+NP)
MV refers to Maturity value of preference shares.
NP refers to Net Proceeds of preference shares.

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 after 5years at par. Calculate
the cost of preference capital.

Cost of Retained Earnings

It is the rate of return which the existing shareholders


can obtain by investing the after-tax dividends in
alternative opportunity of equal qualities.
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 firms 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.

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

Problems
1.

2.

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?
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.

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
Following is the long-term capitalization of a company:

1.

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 firms cost of capital
from the above given information.

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.

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 + (Rm Rf)
Where Ke refers to Cost of equity capital
Rf refers to Risk-free rate of return
Rm refers to Market return of a diversified
portfolio
refers to Beta co-efficient of the firms
portfolio.

Problems
1.

2.

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.
The Capital Ltd. wishes to calculate its cost of equity
capital using CAPM. Companys 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%.

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
firms 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

Problems
1.

2.

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.
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.

2.

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.
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
Rs.
0
1
2
3
4
5

Outflows
1,50,000
30,000
30,000
60,000
80,000
30,000

Rs.

Inflows
20,000

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 companys
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.

Profitability Index OR Benefit-Cost Ratio

It is the relationship between present


value of cash inflows and 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 companys 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
1
2
3
4
5
6
7
8
9
10

Net Cash flow (Rs.)


7,000
7,000
7,000
7,000
7,000
8,000
10,000
15,000
10,000
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 2010. 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 2010
500
Nil
End of 2011
2,000
3,400
End of 2012
3,500
3,400
End of 2013
2,500
3,400
End of 2014
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.

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