CHAPTER ONE INTRODUCTION

Finance can be defined as the art and science of managing money. Virtually all individuals and organizations earn or raise money and spend or invest money. Finance is concerned with the process, institutions, markets, and instruments involved in the transfer of money among and between individuals, businesses, and governments. Why study finance?

An understanding of the concepts, techniques, and practices presented in this course will fully acquaint you with the financial manager's activities. Because most business decisions are measured in financial terms, the financial manager plays a key role in the operation of the firm. People in all areas of responsibility accounting, information systems, management, marketing, and operations- need a basic understanding of the managerial finance function. All managers in the firm, regardless of their job descriptions, work with financial personnel to justify personnel requirements, negotiate operating budgets, deal with financial performance appraisals, and sell proposals based at least in part on their financial' merits. Clearly, those managers who understand the financial decision- making process will be better able to address financial concerns, and will therefore more often get the resources they need to accomplish their own goals. To make informed decisions about where to get and put money in order to maximize value in both personal and business decisions.
To make informed decisions about where to get and put money in order to maximize value in both personal and business decisions. I know you want to ask the following question: If I have no intention of becoming a financial manger, why do I need to understand financial management? One good reason is to prepare yourself for the workplace of the future. More and more businesses are reducing management jobs and squeezing together the various layers of the corporate pyramid. This is being done to reduce costs and boost productivity. As a result, the responsibilities of the remaining management positions are being broadened. The successful manager will need to be much more of a team player that has the knowledge and ability to move not just vertically within an organization but horizontally as well. Developing cross-functional capabilities will be the rule, not the exception. Thus, a

mastery of basic financial management skills is key ingredient that will be required in the work place of your not too distant future. Finance is the study of money management, the acquiring of funds (cash) and the directing of these funds to meet particular objectives. Good financial management helps businesses to maximize returns while simultaneously minimizing risks.

Hardly anybody wants to work in a field where there is no room for experience, creativity, judgment and a pinch of luck but study of finance is not so. There are many reasons that the financial managers job is challenging and interesting. Here are four important ones. -Securities Markets -Understanding Values -Time and uncertainty -Understanding People. I. Securities Markets include Money Markets and Capital Markets. Money Markets includes: * Markets for short-term claims with original maturity of one year or less. * High-grade securities with little or no risk of default. * Examples: 1.Treasury Bills. 2. Commercial Paper. 3.Certificates of Deposit. Capital markets include: * Market for long-term securities with original maturity of more than one year. *Securities may be of considerable risk. *Example: 1.Stocks 2.Corporate bonds 3.Government bonds

Primary Markets A primary market is a market for newly created securities. The proceeds from the sale of securities in primary markets go to the issuing entity. A security can trade only once in the primary market. Secondary Markets A secondary market is a market for previously issued securities. The issuing firm is not directly affected by transactions in the secondary markets. A security can trade an unlimited number of times in secondary markets. The volume of trade in secondary markets is such higher than in primary markets. Investment Bankers An investment banker specializes in marketing new securities in the primary market. Examples of Investment bankers are: Merrill Lynch, Sigma Manufactures Merchant Bank, etc. Brokers and Dealers These generally participate in the secondary markets. A broker helps investors in buying or selling securities. A broker charges commissions, but never takes title to the security. A dealer buys securities from sellers, and sells them to buyers. Financial Intermediaries These are institutions that assist in the financing of firms. Example include; commercial banks and pension funds. These institutions invest in securities of other firms, but they are themselves financed by other financial claims. On the other hand, it is a sort of indirect financing in which savers deposit funds with the banks and financial institutions rather than directly buying bonds or shares and the financial institutions, in turn lend the

money to ultimate borrowers. The Commercial Banks, Financial Institutions, Finance and Investment Companies, Insurance Companies, Unit Trust, Pension Funds etc., are examples of financial intermediaries. II. Understanding Value Understanding how capital markets work amounts to understanding how financial assets are valued. This is a subject on which there has been remarkable progress over the past 10 to 20 years. New theories have been developed to explain the prices of bonds and stocks. And, when put to the test, these theories have worked well. I, therefore, would like to give more stress in this area because the implication of this is applying in almost all parts of the corporate finance. III. Time and Uncertainty The financial manager cannot avoid coping with time and uncertainty. Firms often have the opportunity to invest in assets which cannot pay their way in the short run and which expose the firm and its stockholders to considerable risk. The investment, if undertaken, may have to be financed by debt, which cannot be fully repaid for many years. The firm cannot walk away from such choices- someone has to decide whether the opportunity is worth more than it costs and whether the additional debt burden can be safely borne. IV. Understanding People The financial manager needs the opinions and cooperation of many people. For instance, many new investment ideas come from plant managers. The financial manager wants these ideas to be presented fairly; therefore, the proposers should have no personal incentives to be either overconfident or overcautious. Take another example. In some firms the plant manager needs permissions from the head office to buy a company car but not to lease it, and the line of least resistance may be to lease the car. In other firms the plant manager needs permission from the head office to buy or lease, and the line of least resistance may be to travel everywhere by cab. The financial manager has to be aware of these effects and has to devise procedures that will avoid as far as possible any conflicts of interest. These are not the only reasons that financial management is interesting and also challenging.

What is the objective of financial management? Objective: Maximize the Value of the Firm Brealey & Myers: "Success is usually judged by value: Shareholders are made better off by any decision which increases the value of their stake in the firm... The secret of success in financial management is to increase value." Copeland & Weston: The most important theme is that the objective of the firm is to maximize the wealth of its stockholders." Brigham and Gapenski: Management's primary goal is stockholder wealth maximization, which translates into maximizing the price of the common stock. The Objective in Decision Making In traditional corporate finance, the objective in decision-making is to maximize the value of the firm. A narrower objective is to maximize stockholder wealth. When the stock is traded and markets are viewed to be efficient, the objective is to maximize the stock price. All other goals of the firm are intermediate ones leading to firm value maximization, or operate as constraints on firm value maximization.

Why traditional corporate financial theory focuses on maximizing stockholder wealth? Stock prices are easily observable and constantly updated (unlike other measures of performance, which may not be as easily observable, and certainly not updated as frequently). If investors are rational, stock prices reflect the wisdom of decisions, short term and long term, instantaneously. As it is, it is believed that market discounts all the information in the form of market price of the share. Why not profit maximization? Profitability objective may be stated in terms of profits, return on investment, or profit to-sales ratios. According to this objective, all actions such as increase income and cut down costs should be undertaken and those that are likely to have adverse impact on profitability of the enterprise should be avoided. Advocates of the profit maximization objective are of the view that this objective is simple and has the inbuilt advantage of judging economic performance of the enterprise. Further, it will direct the resources in those channels that promise maximum return. This, in turn, would help in optimal utilisation of society's economic resources. Since the finance manager is responsible for the efficient utilisation of capital, it is

plausible to pursue profitability maximisation as the operational standard to test the effectiveness of financial decisions.

However, profit maximisation objective suffers from several drawbacks rendering it an ineffective decisional criterion. These drawbacks are: (a) It is Vague (b) It Ignores Time Value factor (c) It Ignores Risk Factor The Four Major Decisions in Corporate Finance/Financial management The Allocation (Investment) decision Where do you invest the scarce resources of your business? What makes for a good investment? The Financing decision Where do you raise the funds for these investments? Generically, what mix of owners money (equity) or borrowed money (debt) do you use? The Dividend Decision How much of a firms funds should be reinvested in the business and how much should be returned to the owners? The Liquidity decision How much should a firm invest in current assets and what should be the components with their respective proportions? How to manage the working capital?

The Agency Issue The control of the modern corporation is frequently placed in the hands of professional non-owner managers. We have seen that the goal of the financial manager should be to maximize the wealth of the owners of the firm and given them decision-making authority to manage the firm. Technically, any manager who owns less than 100 percent of the firm is to some degree an agent of the other owners. In theory, most financial managers would agree with the goal of owner wealth maximization. In practice, however, managers are also concerned with their personal wealth, job security, and fringe benefits, such

as country club memberships, limousines, and posh offices, all provided at company expense. Such concerns may make managers reluctant or unwilling to take more that, moderate risk if they perceive that too much risk might result in a loss of job and damage to personal wealth. The result is a less-thanmaximum return and a potential loss of wealth for the owners.

Chapter 2 Financial System

The financial inputs emanate from the financial system, while real goods and services are part of the real system. The interaction between the real system (goods and services) and the financial system (money and capital) is necessary for the productive process. Trading in money and monetary assets constitute the activity in the financial markets and are referred to as the financial system.

What is financial system? The term "liquidity" is used to refer to cash, money and nearness to cash. Money and monetary assets are traded in the financial system. Thus, provision of liquidity and trading in liquidity are the major functions of the financial system. While cash creation is the function of the RBI, banks do credit creation and financial institutions including the RBI, banks and term-leading institutions, deal in claims on money or monetary assets. These institutions are all a part of the financial system.

The three important functions of financial markets are: 1.Financial markets facilitate price discovery. The continual interaction among numerous buyers and sellers who throng financial markets help in establishing the prices of financial assets. Well-organised financial markets seem to be remarkably efficient in price discovery. That is why financial economists say: "If you want to know what is the value of a financial asset simply look at its price in the financial market" 2. Financial markets provide liquidity to financial assets. Investors can readily sell their financial assets through the mechanism of financial markets. In the absence of financial markets, which provide such liquidity, the motivation of investors to hold financial assets will be considerably diminished. Thanks to negotiability and transferability of securities through the financial markets, it is possible for companies (and other entities) to raise long-term funds from investors with short-term and medium-term horizons. While one investor is substituted by another when a security is transacted, the company is assured of long-term availability of funds. 3. Financial markets considerably reduce the cost of transacting. The two major costs associated with transacting are search costs and information costs. Search costs comprise explicit costs such as the expenses incurred on advertising when one wants to buy or sell an asset and implicit costs such as the

effort and time one has to put in to locate a customer. Information costs refer to costs incurred in evaluating the investment merits of financial assets.

How to Classify Financial Markets? There are different ways of classifying financial markets. One way is to classify financial markets by the type of financial claim. The debt market is the financial market for fixed claims (debt instruments) and the equity market is the financial market for residual claims (equity instruments). A second way is to classify financial markets by the maturity of claims. The market for short-term financial claims is referred to as the money market and the market for long-term financial cli.1ims is called the capital market Traditionally the cut-off between short-term and long-term financial claims has been one year-though this dividing line is arbitrary, it is widely accepted. Since short-term financial claims are almost invariably debt claims, the money market is the market for short-term debt instruments. The capital market is the market for long-term debt instruments and equity instruments. A third way to classify financial markets is based on whether the claims represent new issues or outstanding issues. The market where issuers sell new claims is referred to as the primary market and the market where investors trade outstanding securities is called the secondary market A fourth way to classify financial markets is by the timing of delivery. A cash or spot market is one where the delivery occurs immediately and a forward or futures market is one where the' delivery occurs at a pre-determined time in future A fifth way to classify financial markets is by the nature of its organisational structure. An exchangetraded market is characterised by a centralised organisation with standardised procedures. An over-the counter market is a decentralised market with customised procedures.

Instruments in Money Market Treasury Bills Treasury bills are the most important money market instruments. They represent the obligations of the Government of India, which have a primary tenor like 91 days and 364 days. The Reserve Bank of India sells them on an auction basis every week in certain minimum denominations. They do not carry an explicit (or coupon rate). Instead, they are sold at a discount and redeemed at par.

Certificate of Deposits Certificates of deposits (CDs) represent short-term deposits, which are transferable from, to one party to another. Banks and financial institutions are the major issuers of CDs. The principal investors in CDs are banks, financial institutions, Corporates, and mutual funds. CDs are issued in either bearer or registered form. They generally have a maturity of 3 months to 1 year. CDs are issued at a discount and redeemed at par.

Commercial paper A Commercial Paper is a short term unsecured promissory note issued by the raiser of debt to the investor. For a corporate to be eligible it must have a tangible net worth of Rs 4 crore or more and have a sanctioned working capital limit sanctioned by a bank/FI. It is generally companies with very good rating which are active in the CP market, though RBI permits a minimum credit rating of CrisilP2. The tenure of CPs can be anything between 15 days to one year, though the most popular duration is 90 days.

Repos The term Repo is used as an abbreviation for Repurchase Agreement or Ready Forward. A Repo involves a simultaneous "sale and repurchase" agreement. A Repo works as follows. Party A needs short-term funds and Party B wants to make a short-term investment. Party A sells securities to Party B at a certain price and simultaneously agrees to repurchase the same after a specified time at a slightly higher price. The difference between the sale price and the repurchase price represents the interest cost to Party A and conversely the interest income for Party B. Repos are a very convenient instrument for short-term investment. They are safe and earn a predetermined return Capital Market The capital market consists of primary and secondary markets. The primary market deals with the issue of new instruments by the corporate sector such as equity shares, preference shares and debentures. The public sector consisting of Central and State governments, various public sector industrial units (PSU), statutory and other authorities such as state electricity boards and port trusts also issue bonds and shares especially as a part of disinvestments of government holdings.

CHAPTER THREE THE TIME VALUE OF MONEY UNIT ONE CHAPTER THREE THE TIME VALUE OF MONEY

Lesson 5 Chapter 3 The time value of money Unit 1 Core concepts in financial management
After reading this lesson you will be able to: Understand what is meant by "the time value of money." Describe how the interest rate can be used to adjust the value of cash flows to a single point in time. Calculate the future value of an amount invested today. Calculate the present value of a single future cash flow. Understand the relationship between present and future values. Understand in what period of time money doubles Understand shorter compounding periods Calculate & understand the relationship between effective & nominal interest rate. Use the interest factor tables and understand how they provide a short cut to calculating present and future values. You all instinctively know that money loses its value with time. Why does this happen? What does a Financial Manager have to do to accommodate this loss in the value of money with time? In this section, we will take a look at this very interesting issue. Why should financial managers be familiar with the time value of money? The time value of money shows mathematically how the timing of cash flows, combined

with the opportunity costs of capital, affect financial asset values. A thorough understanding of these concepts gives a financial manager powerful tool to maximize wealth. What is the time value of money? The time value of money serves as the foundation for all other notions in finance. It impacts business finance, consumer finance and government finance. Time value of money results from the concept of interest. This overview covers an introduction to simple interest and compound interest, illustrates the use of time value of money tables, shows a approach to solving time value of money problems and introduces the concepts of intra year compounding, annuities due, and perpetuities. A simple introduction to working time value of money problems on a financial calculator is included as well as additional resources to help understand time value of money. Time value of money The universal preference for a rupee today over a rupee at some future time is because of the following reasons: Alternative uses/ Opportunity cost Inflation Uncertainty The manner in which these three determinants combine to determine the rate of interest can be represented symbolically as Nominal or market rate of interest rate = Real rate of interest + Expected rate of Inflation + Risk of premiums to compensate uncertainty

Basics Evaluating financial transactions requires valuing uncertain future cash flows. Translating a value to the present is referred to as discounting. Translating a value to the future is referred to as compounding The principal is the amount borrowed. Interest is the compensation for the opportunity cost of funds and the uncertainty of repayment of the amount borrowed; that is, it represents both the price of time and the price of risk. The price of time is compensation for the opportunity cost of funds and the price of risk is compensation for bearing risk. Interest is compound interest if interest is paid on both the principal and any accumulated interest. Most financial transactions involve compound interest, though there are a few consumer transactions that use simple interest (that is, interest paid only on the principal or amount borrowed). Under the method of compounding, we find the future values (FV) of all the cash flows at the end of the time horizon at a particular rate of interest. Therefore, in this case we will be comparing the future value of the initial outflow of Rs. 1,000 as at the end of year 4 with the sum of the future values of the yearly cash inflows at the end of year 4. This process can be schematically represented as follows: PROCESS OF DISCOUNTING Under the method of discounting, we reckon the time value of money now, i.e. at time 0 on the time line. So, we will be comparing the initial outflow with the sum of the present values (PV) of the future inflows at a given rate of interest. Translating a value back in time -- referred to as discounting -- requires determining what a future amount or cash flow is worth today. Discounting is used in valuation because we often want to determine the value today of future value or cash flows. The equation for the present value is:

Present value = PV = FV / (1 + i) Where: PV = present value (today's value), FV = future value (a value or cash flow sometime in the future), i = interest rate per period, and n = number of compounding periods
n

And [(1 + i) ] is the compound factor. We can also represent the equation a number of different, yet equivalent ways: Where PVIFi,n is the present value interest factor, or discount factor. In other words future value is the sum of the present value and interest: Future value = Present value + interest From the formula for the present value you can see that as the number of discount periods, n, becomes larger, the discount factor becomes smaller and the present value becomes less, and as the interest rate per period, i, becomes larger, the discount factor becomes smaller and the present value becomes less. Therefore, the present value is influenced by both the interest rate (i.e., the discount rate) and the numbers of discount periods. Example Suppose you invest 1,000 in an account that pays 6% interest, compounded annually. How much will you have in the account at the end of 5 years if you make no withdrawals? After 10 years?

Solution
5

FV5 = Rs 1,000 (1 + 0.06) = Rs 1,000 (1.3382) = Rs 1,338.23

10

FV10 = Rs 1,000 (1 + 0.06)

= Rs 1,000 (1.7908) = Rs 1,790.85

What if interest was not compounded interest? Then we would have a lower balance in the account: FV5 = Rs 1,000 + [Rs 1,000(0.06) (5)] = Rs 1,300 FV10 = Rs 1,000 + [Rs 1,000 (0.06)(10)] = Rs 1,600 Simple interest is the product of the principal, the time in years, and the annual interest rate. In compound interest the principal is more than once during the time of the investment. Compound interest is another matter. It's good to receive compound interest, but not so good to pay compound interest. With compound interest, interest is calculated not only on the beginning interest, but also on any interest accumulated in the meantime. I hope you have understood the concept of simple interest and compound interest. It is explained with the help of a graph, which is self-explanatory. Now let us solve a problem fo

rr Compound Interest vs. Simple Interest Example Suppose you are faced with a choice between two accounts, Account A and Account B. Account A provides 5% interest, compounded annually and Account B provides 5.25% simple interest. Consider a deposit of Rs 10,000 today. Which account provides the highest balance at the end of 4 years? Solution
4

Account A: FV4 = Rs 10,000 (1 + 0.05) = Rs 12,155.06 Account B: FV4 = Rs 10,000 + (Rs 10,000 (0.0525)(4)] = Rs 12,100.00 Account A provides the greater future value.

Present value is simply the reciprocal of compound interest. Another way to think of present value is to adopt a stance out on the time line in the future and look back toward time 0 to see what was the beginning amount.
n

Present Value = P0 = Fn / (1+I) Table A-3 shows present value factors: Note that they are all less than one. Therefore, when multiplying a future value by these factors, the future value is discounted down to present value. The table is used in much the same way as the other time value of money tables. To find the present value of a future amount, locate the appropriate number of years and the appropriate interest rate, take the resulting factor and multiply it times the future value. How much would you have to deposit now to have Rs 15,000 in 8 years if interest is 7%? = 15000 X .582 = 8730 Rs Consider a case in which you want to determine the value today of $ 1,000 to be received five years from now. If the interest rate (i.e., discount rate) is 4%, Problem Suppose that you wish to have Rs 20,000 saved by the end of five years. And suppose you deposit funds today in account that pays 4% interest, compounded annually. How much must you deposit today to meet your goal? Solution Given: FV = Rs 20,000; n = 5; i = 4%

PV = Rs 20,000/(1 + 0.04) = Rs 20,000/1.21665 PV = Rs 16,438.54 Q. If you want to have Rs 10,000 in 3 years and you can earn 8%, how much would you have to deposit today? Rs 7938.00 Rs 25,771 Rs 12,597 Using Tables to Solve Future Value Problems A-1 for future value at the end of n yrs A-3 for present value at the beginning of the year
n

Compound Interest tables have been calculated by figuring out the (1+I) values for various time periods and interest rates. Look at Time Value of Money Future Value Factors. This table summarizes the factors for various interest rates for various years. To use the table, simply go down the left-hand column to locate the appropriate number of years. Then go out along the top row until the appropriate interest rate is located. For instance, to find the future value of Rs100 at 5% compound interest, look up five years on the table, and then go out to 5% interest. At the intersection of these two values, a factor of 1.2763 appears. Multiplying this factor times the beginning value of Rs100.00 results in Rs127.63, exactly what was calculated using the Compound Interest Formula. Note, however, that there may be slight differences between using the formula and tables due to rounding errors.

An example shows how simple it is to use the tables to calculate future amounts. You deposit Rs2000 today at 6% interest. How much will you have in 5 years? =2000*1.338=2676 The following exercise should aid in using tables to solve future value problems. Please answer the questions below by using tables 1. You invest Rs 5,000 today. You will earn 8% interest. How much will you have in 4 years? (Pick the closest answer) Rs 6,802.50 Rs 6,843.00 Rs 3,675 2.You have Rs 450,000 to invest. If you think you can earn 7%, how much could you accumulate in 10 years? ? (Pick the closest answer) Rs 25,415 Rs 722,610 Rs 722,610 3.If a commodity costs Rs500 now and inflation is expected to go up at the rate of 10% per year, how much will the commodity cost in 5 years? Rs 805.25 Rs 3,052.55 Cannot tell from this information

Now we will talk about the cases when the interest is given semi annually, quarterly, monthly. The interest rate per compounding period is found by taking the annual rate and dividing it by the number of times per year the cash flows are compounded. The total number of compounding periods is found by multiplying the number of years by the number of times per year cash flows is compounded. The formula for this shorter compounding period is = PV0 (1+i/m)n*m Consider the following example. You deposited Rs 1000 for 5 yrs in a bank that offers 10% interest p.a. compounded semiannually, what will be the future value. =1000 (1+. 10/2) 5*2 For instance, suppose someone were to invest Rs 5,000 at 8% interest, compounded semiannually, and hold it for five years. The interest rate per compounding period would be 4%, (8% / 2) The number of compounding periods would be 10 (5 x 2) To solve, find the future value of a single sum looking up 4% and 10 periods in the Future Value table. FV = PV (FVIF) FV = Rs 5,000(1.480) FV = Rs 7,400 Now let us solve a problem for Frequency of Compounding FVn

Problem Suppose you invest Rs 20,000 in an account that pays 12% interest, compounded monthly. How much do you have in the account at the end of 5 years?
60

Solution FV = Rs 20,000 (1 + 0.01)

= Rs 20,000 (1.8167) = Rs 36,333.93

In what period of time money will be doubled? Investor most of the times wants to know that in what period of time his money will be doubled. For this the rule of 72 is used. Suppose the rate of interest is 12%, the doubling period will be 72/12=6 yrs. Apart from this rule we do use another rule, which gives better results, is the rule of 69 = .35 + 69 int rate = .35 + 69 12 = .35 + 5.75 = 6.1 yrs Practice Problems What is the balance in an account at the end of 10 years if Rs 2,500 is deposited today and the account earns 4% interest, compounded annually? Quarterly? If you deposit Rs10 in an account that pays 5% interest, compounded annually, how much will you have at the end of 10 years? 50 years? 100 years? How much will be in an account at the end of five years the amount deposited today is Rs 10,000 and interest is 8% per year, compounded semi-annually?

Answers 1.Annual compounding: FV = Rs 2,500 (1 + 0.04) 10 = Rs 2,500 (1.4802) = Rs 3,700.61 Quarterly compounding: FV = Rs 2,500 (1 + 0.01) 40 = Rs 2,500 (1.4889) = Rs3,722.16 2. 10 years:
10

FV = Rs10 (1+0.05) 50 years:

= Rs10 (1.6289) = Rs16.29

50

FV = Rs10 (1 + 0.05) 100 years:

= Rs10 (11.4674) = Rs114.67

100

FV = Rs10 (1 + 0.05)

= Rs10 (131.50) = Rs 1,315.01

3. FV = Rs 10,000 (1+0.04) 10 = Rs10,000 (1.4802) = Rs14,802.44 For example, assume you deposit Rs. 10,000 in a bank, which offers 10% interest per annum compounded semi-annually which means that interest is paid every six months. Now, amount in the beginning = Rs. 10,000 Rs. Interest @ 10% p.a. for first six = 500 Months 10000 x 21.0 =10500 Interest for second 6 months = 10500 x 21.0 = 525 Amount at the end of the year = 11,025

Instead, if the compounding is done annually, the amount at the end of the year will be 10,000 (1 + 0.1) = Rs, 11000. This difference of Rs. 25 is because under semi-annual compounding, the interest for first 6 moths earns interest in the second 6 months. The generalized formula for these shorter compounding periods is FVn = PV mxnMK +1 Where FVn = future value after n years PV = cash flow today K = Nominal Interest rate per annum M = Number of times compounding is done during a year N = Number of years for which compounding is done. Example Under the Vijaya Cash Certificate scheme of Vijaya Bank, deposits can be made for periods ranging from 6 months to 10 years. Every quarter, interest will be added on to the principal. The rate of interest applied is 9% p.a. for periods form 12 to 13 months and 10% p.a. for periods form 24 to 120 months. An amount of Rs. 1,000 invested for 2 years will grow to Fn = PV mnMK +1

Where m = frequency of compounding during a year

= 1000 8410.1
8

= 1000 (1.025) = 1000 x 1.2184 = Rs. 1218 Effective vs. Nominal Rate of interest We have seen above that the accumulation under the semi-annual compounding scheme exceeds the accumulation under the annual compounding scheme compounding scheme, the nominal rate of interest is 10% per annum, under the scheme where compounding is done semi annually, the principal amount grows at the rate of 10.25 percent per annum. This 1025 percent is called the effective rate of interest which is the rate of interest per annum under annual compounding that produces the same effect as that produced by an interest rate of 10 percent under semi annual compounding. The general relationship between the effective an nominal rates of interest is as follows: = 11
m

+k

where r = effective rate of interest k = nominal rate of interest m = frequency of compounding per year. Example Find out the effective rate of interest, if the nominal rate of interest is 12% and is quarterly compounded?

Effective rate of interest = (1 + mk) 1 = (+ 412.0) 1

4 4 m

= (1 + 0.03) -1 = 1.126 -1 = 0.126 = 12.6% p.a. compounded quarterly

By now you should have clear understanding of

Compounding Discounting Doubling period (Rule of 72) Doubling period (Rule of 69) Shorter compounding periods Effective vs. Nominal Rate of interest

By now you should be an expert in using the following two tables:

A-1 The Compound Sum of one rupee FVIF A-3 The Present Value of one rupee PVIF

IMPORTANT The inverse of FVIF is PVIF i.e. inverse of FVIF is PVIF.

ANNUITY
Till now we talked about the future value of single payment made at the time zero (PV0). Now we will speak about annuities. An annuity is an equal annual series of cash flows. Annuities may be equal annual deposits, equal annual withdrawals, equal annual payments, or equal annual receipts. The key is equal, annual cash flows. Note that the cash flows occur at the end of the year. This makes the cash flow an ordinary annuity. If the cash flows were at the beginning of the year, they would be an annuity due. Annuity = Equal Annual Series of Cash Flows

MATHEMETICAL PROBLEMS

CAPITAL BUDGETING PRINCIPLES & TECHNIQUES

Lesson 9 Chapter 4 Capital Budgeting Unit 2 Long-term investment decisions

After reading this lesson you will be able to: Understand what capital investments are What the capital budgeting decision process involves. Understand why capital investment decisions are so important. Understanding the different types of project. Understand certain basics before you start taking decisions As we discussed in first session that every business has four basic decisions to make: Which projects to take? (Investment decisions) How to finance these projects? (Financing decisions) How much to return to investors? (Dividend decisions) How to manage working capital and its components? (Liquidity decisions) Capital budgeting is a required managerial tool. One duty of a financial manager is to choose investments with satisfactory cash flows and rates of return. Therefore, a financial manager must be able to decide whether an investment is worth undertaking and be able to choose intelligently between two or more alternatives. To do this, a sound procedure to evaluate, compare, and select projects is needed. This procedure is called capital budgeting.

Capital Budgeting process starts with the recognition that a good investment opportunity exists. For example: a truck manufacturer is considering investment in a new plant; an airliner is planning to buy a fleet of jet aircrafts; a commercial bank is thinking of an ambitious computerization programme; a pharmaceutical firm is evaluating a major R&D programme. All these situations involve capital expenditures/ investment decision. Investments decisions of a firm are generally known as Capital Budgeting or Capital expenditure decisions NATURE OF INVESTMENT DECISIONS From the above discussion, you must be clear about the distinctive features of capital investment: They have long-term consequences They often involve substantial outlays They may be difficult or expensive to reverse Now that you know the nature of investment decisions, lets discuss the various forms of investment decisions:

IMPORTANT Capital budgeting is the firms decision to invest its current funds most efficiently inthe long -term assets in the anticipation of an expected flow of benefits over a series ofyears. Capital budgeting is investment decision-making as to whether a project is worth undertaking. Capital budgeting is basically concerned with the justification of capital expenditures. Current expenditures are short-term and are completely written off in the same year that expenses occur. Capital expenditures are long-term and are amortized over a period of years.

1. Replacement projects: Firms routinely invest in equipments meant to replace obsolete and inefficient equipments, even though they may in serviceable condition. The objective of such investments is to reduce costs (of labour, raw material, and power), increase yield, and improve quality. Replacement projects can be evaluated in a fairly straightforward manner; though at times the analysis may be quite detailed. 2. Expansion projects: These investments are meant to increase capacity and/ or widen the distribution network. Such investments call for an explicit forecast of growth. Since, this can be risky and complex, expansion projects normally warrant more careful analysis than replacement projects. Decisions relating to such projects are taken by the top management. 3. Diversification projects: These investments are aimed at producing new products or services or entering into entirely new geographical areas. Often diversification projects entail substantial risks, involve large outlays, and require considerable managerial efforts and attention. Given their strategic importance, such projects call for a very thorough evaluation, both quantitative and qualitative. Further, they require a significant involvement of the board of directors. 4. Research and development projects: Traditionally, R%D projects absorbed a very small proportion of capital budget in most Indian companies. Things however are changing. Companies are now allocating more funds to R&D projects, more so in knowledge intensive industries. R&D projects are characterised by numerous uncertainties and typically involve sequential decision-making. Hence the standard DCF analysis is not applicable to them. Such projects are decided on the basis of managerial judgment. Firms, which rely more on quantitative methods, use decision tree analysis and option analysis to evaluate R&D projects.

5. Mandatory investments: These are expenditure required to comply with statutory requirements. e.g., pollution control equipment, medical dispensary, fire fitting equipment etc. These are often non-revenue producing investments. In analysing such investments the focus is mainly on finding the most cost-effective way of fulfilling a given statutory need.

Can you tell me why capital expenditures are deemed important? Lets have a brain storming session on this. As discussed by you Capital Budgeting is an extremely important aspect of a firm's financial management. How a firm finances its investments and how it manages its short-term operations are definitely issues of concerns but how it allocates its capital (the capital budgeting decision) really affects the strategic asset allocation. That is why the process of capital budgeting is also referred to as strategic asset allocation. Some of the special reasons of its importance can be identified are as follows:
They influence the firms growth in the long run

A firms decision to invest in long-term assets has a decisive influence on the rate and direction of its growth. A wrong decision can prove disastrous for the continued survival of the firm; unwanted or unprofitable expansion of assets will result in heavy operating costs to the firm. On the other hand, inadequate investment in assets would make it difficult for the firm to compete successfully and maintain its market share.
They affect the risk of the firm

A long-term commitment of funds may also change the risk complexity of the firm. If the adoption of investment increases average gain but causes frequent fluctuations in its earnings, the firm will become more risky
They involve commitment of large amount of funds

Investment decisions generally involve large amount of funds, which make it imperative for the firm to plan its investment programmes very carefully and make an advance arrangement for procuring finances internally or externally.
They are irreversible, and if reversible it is at substantial loss

Most investment decisions are irreversible. It is difficult to find a market for such capital items once they have been acquired. The firm will incur heavy losses if such assets are scrapped.
They are among the most difficult decisions to make

Investments decisions are the most complex ones. They are an assessment of future events, which are difficult to predict. It is really a complex problem to correctly estimate the future cash flow of an investment. Economic, social, & technological forces cause the uncertainty in cash flow. Now let us move on to how does a capital budgeting process starts? Or what are the phases of capital budgeting process? As it is clearly from the above discussion that capital budgeting is a complex process as it involves decisions to the investment of current funds for the benefit to be achieved in future and the future is always uncertain. A capital budgeting process may involve a number of steps depending upon the size of the concern, nature of projects, their numbers, complexities and diversities etc. Let us analyse the procedure and the various stages involved in the capital budgeting process.

CAPITAL BUDGETING PROCESS Although this diagram is self-explanatory let us have a small discussion on it. Identification Of Investment Proposals Screening The Proposals Evaluation Of Various Proposals Establishing Priorities Final Approval Implementing Proposal Performance Review

A Brief Overview
Step 1. Identification of Investment Proposals Investment opportunities have to be identified or searched for: they do not occur automat-ically. The capital budgeting process begins with the identification of investment proposals. The first step in capital budgeting process is the conception of a profit-making idea. Investment proposals of various types may originate at different levels within a firm, depending on their nature. They may originate from the level of workers to top management level. For example, most of the proposals, in the nature of cost reduction or replacement or process for product improvement take place at plant level, the proposal for adding new product may emanate from the marketing department or from plant manager who thinks of a better way of utilising idle capacity. Suggestions for replacing an old machine or improving the production techniques arise at the factory level. The departmental head analyses the various proposals in the light of the corporate strategies and submits suitable proposals to the capital expenditure planning committee in case of large organisation or to the officers concerned with the process of term investment decisions. A continuous flow of profitable capital expenditure proposals is itself an indication of a healthy and vital business concern. Although business may pursue many goals, survivals and profitability are the two of the most important objectives. Step 2. Screening the Proposals Screening and selection procedures would differ from firm to firm. Each proposal is then subjected to a preliminary screening process in order to assess whether it is technically feasible; resources required are available and the expected returns are adequate to compensate for the risk involved. In large organisations, a capital expenditure planning committee is established for screening of various proposals received from different departments. The committee views these proposals from various angles to ensure that these are in accordance with the corporate strategies or selection criterion of the firm and

also do not lead to departmental imbalances. All care must be taken in selecting a criterion to judge the desirability of the projects. The criterion selected should be a true measure of the investment projects profitability, and as far as possible, it must be consistent with the firm's objective of maximising its market value. This stage involves the comparison of the proposals with other projects according to criteria of the firm. This is done either by financial manager or by a capital expenditure planning committee. Such criteria should encompass the supply and cost of the expected returns from alternative investment opportunities. Step 3. Evaluation of Various Proposals The next step in the capital budgeting process is to evaluate the profitability of various proposals. If a proposal satisfies the screening process, it is then analysed in more detail by gathering technical, economic and other data. Projects are also classified, for example, products or expansion or improvement and ranked within each classification w.r.t. Profitability, risk and degree of urgency. There are many methods which may be used for this purpose such as pay back period method, rate of return method, net present value method etc. Step 4. Establishing Priorities After evaluation of various proposals, the unprofitable or uneconomic proposals are rejected. The accepted proposals i.e. profitable proposals are put in priority. It may not be possible for the firm to invest immediately in all the acceptable proposals. Thus, it is essential to rank the various proposals and to establish priorities after considering urgency, profitability involved therein.

Step 5. Final Approval Proposals finally recommended by the committee are sent to the top management along with a detailed report, both of capital expenditures and of sources of capital. Financial manager will present several alternative capital expenditure budgets. When capital expenditure proposals are finally selected, funds are allocated for them. Projects are then sent to the committee for incorporating them in the capital budget. Step 6. Implementing Proposals Preparation of a capital expenditure budgeting and incorporation of a particular proposal in the budget does not itself authorise to go ahead with the implementation of the project. A request for the authority to spend the amount should further be made to the capital expenditure committee, which may like to review the profitability of the project in the changed circumstances. Further, while implementing the project, it is better to assign responsibilities for completing the project within the given time frame and cost limit so as to avoid unnecessary delays and cost over runs. Net work techniques used in the project management such as PERT and CPM can also be applied to and monitor the implementation of the projects. Step 7. Performance Review Last but not the least important step in the capital budgeting process is an evaluation of performance of the project, after it has been fully implemented. It is the duty of the top management or executive committee to ensure that funds are spent in accordance with the allocation made in the capital budget. A control over such capital expenditure is very much essential and for that purpose a monthly report showing the amount allocated,

amount spent, approved but not spent should be prepared and submitted to the controller. The evaluation is made through post completion audit by way of comparison of actual expenditure on project with the budgeted one, and also by comparing the actual return from the investment with the anticipated return. The unfavorable variances, if any, should be looked into and the causes of the same be identified so that corrective action may be taken in future. I hope all the seven steps narrated above are clear to you and you would have understood the meaning & importance of all of them. It is the evaluation of project that is the most important point for you as a student of management right now but before we do that it will be very important for you all to understand certain basics. UNLIMITED FUNDS VERSUS CAPITAL RATIONING The availability of funds for capital expenditures affects the firm's decisions. If a firm has unlimited funds for investment, making capital budgeting decisions are quite simple: All independent projects that will provide returns greater than some predetermined level can be accepted. Typically, though, firms are not in such a situation; they instead operate under capital rationing. This means that they have only a fixed number of dollars available for capital expenditures and that numerous projects will compete for these dollars. The firm must therefore ration its funds by allocating them to projects that will maximize share value. Capita rationing is a situation where a constraint (or budget ceiling) is placed on the total size of capital expenditure during a particular period. ACCEPT-REJECT VERSUS RANKING APPROACHES Two basic approaches to capital budgeting decisions are available. The accept- reject approach involves evaluating capital expenditure proposals to determine whether they meet the firms minimum acceptance criterion. This approach can be used then the firm

has unlimited funds, as a preliminary step when evaluating mutually exclusive projects, or in a situation in which capital must be rationed. In these cases only the acceptable projects should be considered. The second method, the ranking approach, involves ranking projects on the basis of some predetermined measure, such as the rate of return. The project with the highest return is ranked first, and the project with the lowest return is ranked last. Only acceptable projects should be ranked. Ranking is useful in selecting the best of a group of mutually exclusive projects and in evaluating projects with a view to capital rationing. CONVENTIONAL VERSUS NONCONVENTIONAL CASH FLOW PATTERNS Cash flow patterns associated with capital investment projects can be classified as conventional or non-conventional. A conventional cash flow pattern consists of an initial outflow followed by only a series of inflows. For example, a firm may spend Rs.10, 000 today and as a result expect to receive equal annual cash inflows of Rs.2,000 each year for the next 8 years. A non-conventional cash flow pattern is one in which an initial outflow is not followed by only a series of inflows. For example, the purchase of a machine may require an initial cash outflow of Rs.20,000 and may generate cash inflows of Rs.5,000 each year for 4 years. In the fifth year after purchase, an outflow of Rs.8,000 may be required to overhaul the machine, after which it generates inflows of Rs.5,000 each year for 5 years. Difficulties often arise in evaluating projects with non-conventional pattern of cash flow. We will discuss this in detail in coming session. ANNUITY VERSUS MIXED STREAM CASH FLOWS As discussed in lesson time value of money, annuity is a stream of equal annual cash flows. A series of cash flows exhibiting any pattern other than that of an annuity is a mixed stream of cash flows.

To evaluate capital expenditure alternatives, the firm must determine the relevant cash flows, which are the incremental after-tax cash outflow (investment) and resulting subsequent inflows. The incremental cash flows represent the additional cash flows-outflows or inflows-expected to result from a proposed capital expenditure. Cash flows, rather than accounting figures, are used because cash flows directly affect the firm's ability to pay bills and purchase assets. Furthermore, accounting figures and cash flows are not necessarily the same, due to the presence of certain non-cash expenses on the firm's income statement. EXPANSION VERSUS REPLACEMENT CASH FLOWS Developing relevant cash flow estimates is most straightforward in the case of expansion decisions. In this case, the initial investment, operating cash inflows, and terminal cash flow are merely the after-tax cash outflow and inflows associated with the proposed outlay. Identifying relevant cash flows for replacement decisions is more complicated; the firm must find the incremental cash outflow and inflows that would result from the proposed replacement. The initial investment in this case is the difference between the initial investment needed to acquire the new asset and any after-tax cash inflows expected from liquidation today of the asset being replaced. The operating cash inflows are the difference between the operating cash inflows from the new asset and those from the replaced asset. The terminal cash flow is the difference between the after-tax cash flows expected upon termination of the new and the old assets. INDEPENDENT PROJECTS Independent projects are those where cash flows are unrelated or independent from one another. The acceptance of one project does not necessarily eliminate other projects. MUTUALLY EXCLUSIVE PROJECTS

Mutually exclusive projects are projects that are competing with one another. The acceptance of mutually exclusive projects automatically eliminates other mutually exclusive projects that are competing with one another. We will discuss evaluation of projects by various techniques of project evaluation in the coming session

Chapter 4 Capital Budgeting Unit 2 Long-term investment decisions

OPPORTUNITY COSTS Sometimes a proposed investment project may use the existing resources of the firm for which explicit, or adequate, cash outlays may not exist. The opportunity costs of such projects should be considered. Opportunity costs are the expected benefits, which the company would have derived from those resources if they were not committed to the proposed project. SUNK COSTS Sunk costs are cash outlays incurred in the past. They are the results of past decisions, and cannot be changed by future decisions. Since they do not influence future decisions, they are irrelevant costs. They are unavoidable and irrecoverable historical costs; they should simply be ignored in the investment analysis.