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Department of MBA
Salem 10
Subject: Financial Management
Topic: capital budgeting and its nature
Unit: 02
Hour: 01
CAPITAL BUDGETING
Dictionary
Meaning:
Budget:
DEFINITION:
Financial
Capital Budgeting is long term planning for making and financing proposed capital
plan
outlay.
- Charles T Hongreen
Capital Budgeting consists in planning for development of available capital for the
purpose of maximizing the long-term profitability of the firm
Key Words:
-R. M. Lynch
MEANING:
Capital Budgeting:
Capital budgeting is the process of evaluating and selecting long term
investments that are consistent with the goal of shareholders wealth maximization.
Capital
budgeting is
the process
of evaluating
and selecting
long term
investments
Teaching
Aid:
CB
Capital Expenditure:
Capital expenditure is an outlay of funds that is expected to produce benefits
over a period of time exceeding one year. These benefits may be either in the form of
increased revenues or reduced costs. Capital expenditure management includes
disposition, modification and replacement of fixed assets.
CAPITAL BUDGETING PROCESS OR STEPS INVOLVED IN CAPITAL
BUDGETING:
1. Idea Generation:
Generating the proposals for investment is the first process of capital budgeting.
For an ongoing business concern, investment proposals of various types may
originate at different levels within a firm.
The investment proposal may fall into one of the following categories:
Proposals to add new product to the product line, and
Proposal to expand production capacity in existing product lines.
Proposals to reduce the costs of the output of the existing products without altering
the scale of operation.
25
Books
Referred:
Financial
managemen
t I.M.
Pandey
2. Project Evaluation:
Project evaluation involves two steps:
Estimation of benefits and costs
Selection of an appropriate criterion to judge the desirability of the project.
The benefits and costs of the project are measured in terms of cash flows.
The estimation of the cash inflows and cash outflows mainly depends on future
uncertainties.
The risk associated with each project must be carefully analyzed from the aspects
like marketing, technical, financial and economic.
3. Project selection:
No standard administrative procedure can be laid down for approving the
investment proposal.
The screening and selection procedures are different from firm to firm.
In a real life situation all capital budgeting decisions are made by top management.
However the projects can scientifically be screened by middle level management in
consulting with the head of the finance department.
4. Financing the selected project:
After the selection of the project, the next step is financing. Financing
arrangements have to be made.
There are two broad sources available such as equity and debt. While deciding the
capital structure, the decision maker has to keep in mind some factors, which
influence capital structure.
The factors are flexibility, risk, income, control and tax benefit.
5. Execution or implementation:
Planning is paper work and implementation is physically implementing the selected
project.
Implementation of an industrial project involves the stages like engineering
designs, negotiations and contracting, construction, training and plant
commissioning.
Translating an investment proposal from paper work to concrete work is complex,
time consuming and a risky task.
6. Review of the project:
Once the project is converted from paper work into concrete work, then there is a
need to review the project.
Performance review should be done periodically, in which phase the actual
performance is compared with the pre-determined performance
26
BASED ON NATURES
DECISION
1. Mutually Exclusive
Decision
2. Accept Reject
Decision
3. Capital Rationing
Decision
BASED ON FIRMS
EXISTENCE
Revenue
Expansion
Decision
Cost Reduction
Decision
1. Expansion
decision
1. Replacement
Decision
2. Diversification
2. Modernization
Decision
Decision
not prevail in most of the business firms in actual practice. They have a fixed capital
budget. A large number of investment proposal compete for these limited funds. The firm
must therefore ration them. The firm allocates funds to projects in a manner that it
maximises long run returns. Capital rationing employs ranking of the acceptable
investment projects. The projects can be ranked on the basis of pre-determined criterion
such as the rate of return.
Unit: 02
Hour: 02
(ii)
Cash flows.
Dictionary
The basic difference between them primarily due to the inclusion of certain non- Meaning:
cash expenses in the profit and loss account. Example: depreciation. Therefore, the
accounting profit is to be adjusted for non-cash expenditure to determine the actual cash
inflow. The cash flow approach of measuring future benefits of a project is superior to the
accounting approach as cash flows are theoretically better measures of the net economic
benefits of cost associated with a proposed project.
Elements of Cash flow Stream
To evaluate a project, one must determine the relevant cash flows, which art the
incremental after-tax cash flows associated with the project. The cash flow stream of a Key Words:
conventional project - a project which involves cash outflows followed by cash inflowscomprises three basic components:
Teaching
Aid:
1. Initial Investment: The initial investment is the after-tax cash outlay on capital
CB
expenditure and net working capital when the project is set-up. In general, the
initial cash outflow for a project is determined. As seen, the cost of the asset is
subject to adjustments to reflect the totality of cash flows associated with its
acquisition. These cash flows include installation costs, changes in net working
capital, sale proceeds from the disposition of any assets replaced, and tax
Books
adjustments.
Referred
2. Operating Cash Inflows: They are after tax cash inflows resulting from the
operations of the projects during its economic life. After making the initial cash
outflow that is necessary to being implementing a project, the firm hopes to benefit
from the future cash inflows generated by the projects. Generally, these future cash
flows can be determined by following the step-by-step procedure outline.
3. Terminal Cash Inflow: The terminal cash inflow is the after tax cash flow
resulting from the liquidation of the project at the end of its economic life. Finally,
turned attention to determine the project incremental cash flow in its final, or
terminal, year of existence. The apply the same step-by-step procedure for this
periods cash flow as we did to those in all the interim periods. These potential
project wind-up cash flows are:
The salvage value
Taxes
Any project termination related change in working capital
29
on a new project, they are not incremental cash flows. Thus, sunk costs are not part
of the evaluation process.
6. Opportunity Costs:
Estimating project cash flows requires considering both direct outlays and opportunity
costs. An opportunity cost is the most valuable alternative use of a resource or an asset
that the firm gives up by accepting a project. By using the asset or resource in the
proposed project, the firm forgoes the opportunity to employ the asset in its alternative
use. The cash flows that the firm forgoes represent an opportunity cost to the proposed
project. Opportunity cost can be difficult to estimate, but they are important to
recognize when estimating the relevant cash flows for analyzing a project.
7. Allocated Overhead:
For internal reporting purposes, accountants often allocate existing overhead, such as
general and administrative expenses, to each unit or division that undertakes a project,
However, if the firm's current overhead will remain unchanged by accepting a project,
the firm should exclude this allocated overhead from the project's cash flows in the
capital budgeting analysis. Here, overhead is an existing (fixed) cost, not an
incremental cost. Managers should recognize only an increase in overhead that will
result from accepting the project, such as hiring a new accountant, as part of a project's
cash flows.
8. Side Effects: Adopting and implementing new projects may have important side
effects because they affect the cash flows of other products or divisions. Project
planners should consider these potential side effects, or externalities, in the capital
budgeting analysis for the project. Side effects are complements if they enhance the
cash flows of existing assets and substitutes if the effect is negative.
BIASES IN CASH FLOW ESTIMATION.
As cash flows have to be forecasted far into the future, errors in estimation are bound to
occur. Yet, given the critical importance of cash flow forecasts in project evaluation,
adequate care should be taken to guard against certain biases which may lead to overstatement or under-statement of true project profitability.
1) Overstatement of Profitability: Knowledgeable observers of capital budgeting
believe that profitability is often over-stated because the initial investment is underestimated and the operating cash inflows are exaggerated. The principal reasons for
such optimistic bias appear to be as follows:
i.
ii.
iii.
is neither intentional nor due to inexperience. It may simply be the effect of 'masspsychology' as each person's favorable opinion may be reinforced and magnified
by others in the group. Referred to as "risky shift" or "group polarization effect" in
social psychology, this phenomenon is widely supported by empirical studies.
iv.
Salvage Values are Under-Estimated: To put the net salvage value of fixed assets
equal to just five per cent (which may more or less correspond to the book value
after 8 to 10 years) of the original cost is to ignore the fact that in real life situations
fixed assets, ever after 8 to 10 years of use, generally command a substantial
market value.
ii.
Intangible Benefits are ignored: The terminal benefits from a project cannot be
equated with just the salvage values of tangible. assets left in the project; Apart
from investment in tangible assets for which salvage values can be estimated more
easily (taking into account the factors mentioned above) major projects -are
designed to establish a market position, perfect research and engineering capability,
develop a distribution network, and build brand loyalty. To assume that these
benefits are worthless beyond an arbitrarily chosen time horizon is to overlook
important business realities. These benefits should not be ignored just because it is
difficult to quantify them.
iii Value of Future Options is Over looked: More often than not, a project has a
strategic pay-off in the form of new investment opportunities that may possibly open-up if
the project is undertaken.
Possible Questions & University Questions:
1. Identify the relevant cash flow stream.
2. What are the guidelines to estimate the project cash flow?
32
Unit: 02
Hour: 3
Dictionary
Meaning:
Reciprocal:
Give and take
Equal
Mutual
Joint
Shared
Key Words:
Among the various methods, the following are commonly used by many business
concerns:
Pay-back
period may be
Traditional (or) non time value method (or) non discounted.
defined as the
Pay-back period
period of time.
Improvement of Traditional Approach to Pay-back period method
i.e. the number
Post Pay-back Profitability method
of years
Discounted Pay-back period
required for
Reciprocal Pay-back period method
cash inflow to
get back the
Average / Accounting Rate of Return.
original cost of
Discounted cash flow methods/time adjusted methods/present value method.
the project
Net present value
Profitability index.
Internal rate of return
Teaching Aid:
CB
I. Traditional Method:
1) Payback method:
The payback period refers to the length of time which will be required for the sum
of annual net cash benefits to equal the initial investment.
Books
Referred with
33
Pay-back period may be defined as the period of time. i.e. the number of years page number:
required for cash inflow to get back the original cost of the project. According to this
method, every capital expenditure pays itself back over a number of years. This method is Financial
management
also known as pay off period, break even period (or) Recoupment period.
M.Y. Khan and
Computation of the pay-back period:
P.K. Jain
(a) When annual inflows are equal:
When the cash inflows being generated by a proposal are equal per time period i.e.,
the cash inflow are in the form are annual, the pay-back period can be computed by
dividing the cash outflows by the amount of annuity.
Initial Investment
Payback period = --------------------------Annual cash inflow
Annual cash inflow is the net income from the project (or) assets after tax but
before depreciation.
(b) When annual inflows are unequal:
In case the cash inflows from the proposal are not in annuity form then the
cumulative cash flows are used to compute the payback period.
In such a case, payback period is computed by the process of cumulating
cash inflows till the time when cumulative cash inflows becomes equal to the original
investment outlay. In the formula form:
Payback period = E + B/C
E No. of years immediately proceeding the year of recovery.
B Balance of amount of Investment to be recovered.
C Savings (Cash inflow) during the year of final recovery.
If the Actual pay-back period is less than the standard pay-back period, the project
would be accepted, if not, it would be rejected.
When mutually exclusive projects are under consideration, they may be ranked
according to the length of the payback period. Thus, the project having the shortest
pay-back may be assigned rank one, following in that order so that the project with the
longer pay-back would be the lowest.
2.
3.
4.
5.
Demerits:
xxxxx
xxxxx
xxxxx
Merits:
Demerits:
It ignores depreciation.
Unit: 02
Hour: 04
Give in
Calculation of ARR
In case the expected profits (after tax) generated by a project are equal for all the year
then the annual profit itself is the average profit.
If the project is expected to generate unequal profits over different years, then the
ARR may be calculated by finding out the average annual profit and then comparing
it with the average investment of the project as follows:
Average Annual Profit (after tax)
ARR = -------------------------------------------- x 100
Average Investment in the project
Average Investment:
The average investment refers to the average annual quantum of funds that remains
invested or blocked in the proposal over its economic life. The average investment of a
proposal is affected by the method of depreciation, salvage value and the additional working
capital required by the proposal. The following two approaches are available t calculate the
average investment.
Key Words:
Average Rate
of Return
means the
average
annual yield
on the
project.
Teaching
Aid:
CB
For the firms which are adopting method of depreciation other than the
straight line method:
Find out the opening book values and the closing book values of the project
for all the years of its economic life.
Find out the average book values for all the years by taking the simple
arithmetic mean of the opening and closing book values.
Find out the average of all the yearly averages. This average will be the
average investment of the proposal.
For the firms which are adopting straight line method the following short cut
methods can be used:
Books
Referred
Financial
management
I.M. Pandey
Demerits:
Unit: 02
Hour: 05
Dictionary
Meaning:
What is discounting?
present value of all future cash inflows less the sum of the present values of all cash Aid:
outflows associated with the proposal.
CB
NPV = Discounted Cash Inflows less discounted Cash Outflows.
Cash Outflow consist of :
1. Initial Investment and
2. Special payment and outflows. E.g., working capital outflow which arises in the year
of commercial production. Tax paid on Capital Gain made by sale of old assets, if any.
Cash Inflows = Profit after tax + Depreciation
Also, specific cash inflows like salvage value of new Assets and recovery
of working capital at the end of the project, tax savings on loss due to sale of old asset, Books
should be carefully considered. The general assumptions are that all cash inflows occur at Referred
the end of each year.
Financial
Management
Discounting rate:
I.M. Pandey
Instead of using the PV factor tables, the relevant discount factor can be computed
as 1/ (1+K).
Where,
K Cost of Capital.
n year in which the inflow (or) outflow takes place.
Hence, PV factor at 10% after one year 1/1.10 = 0.9091
Similarly, PV factor at the end of 2 years 1(1.10) = 0.8264 and so on.
Merits:
It considers the time value of money. Hence it satisfies the basic criterion for project
evaluation.
Unlike payback period, all cash flows are considered.
NPV constitutes addition to the wealth of shareholders and thus focus on the basic
objectives of financial management.
Since all cash flows are converted into present value (current rupees), different projects
can be compared on NPV basis. Thus, each project, can be evaluated independent of
others on its own merits.
Demerits:
39
Unit: 02
Hour: 06
Key Words:
Projects with
PI > 1 are
accepted and
PI < 1 are
rejected.
Teaching
Aid:
CB
Merits:
Demerits:
Once a single large project with high NPV is selected, possibility of accepting several
small projects which together may have higher NPV than the single project is
excluded.
Situations may arise where a project with a lower profitability index selected may
generate cash flows in such a way that another project can be taken up one or two
years later, the total NPV in such case being more than the one with a project with
highest profitability Index.
Financial
Management
I.M. Pandey
equals the discounted cash outflows. The Internal rate of return of a project is the discount
rate which makes net present value of the project equal to zero.
Acceptance Rule:
If IRR > Cut Off rate i.e., Cost of Capital, then accept the project.
If IRR = Cut Off rate i.e., Cost of Capital, then the firm is indifferent, either accept (or)
reject the project.
If IRR < Cut Off rate i.e., Cost of Capital, then reject the project.
Merits:
Demerits:
Method of Calculation:
1. When Cash inflows/savings are even for all the year:
The factor to be located in the relevant annuity table II is calculated by using the following
simple equation.
F = I/C
When, F Factors to be located
I Original Investment
C Cash inflows per year.
The factor, thus calculated is located in table II (or) the line representing the no. of
years corresponding to the estimated useful life of the assets and the relevant percentage of
the discount which represents the rate of return.
investment are equal (or) nearly equal. However, the exact rate may be interpolated
with the help of the following formula.
Positive NPV
IRR = Lower Rate + ---------------------------------------------- x Difference in Rate
Difference in calculated present value
Unit: 02
Hour: 07
42
CAPITAL RATIONING
When necessary funds are available; the management can take up all profitable
projects.
When funds are insufficient, the firm has to choose some more profitable projects and
reject some less profitable investment proposals.
Thus, because of lack of funds, the firm is able to invest in all profitable projects the
extent to which the funds are sufficient. Moreover, the executives with the required
managerial skills to fruitfully utilize the funds may also be a constraint. This situation is
described as a capital rationing.
Capital rationing refers to a situation where the firm is constrained for external or
internal reasons to secure the necessary funds to invest in all profitable investment proposals.
43
1. External factors
External factors mainly refer to the situation in capital market. Fluctuations in capital
market may force a firm to have capital rationing of its investment proposals. Such
fluctuations arise due to deficiencies in market information, due to a difference between the
interest rates of borrowing and lending, due to rigidities that affect the free flow of capital
between firms. Because of such situations in capital market, the firm is unable to obtain
necessary capital to finance all its profitable investment proposals.
2. Internal factors
Internal factors refer to investment restrictions imposed by the firm itself. Various
types of restrictions can be imposed by the management. By adopting a conservative policy,
it may decide not to obtain additional capital by incurring a debt to finance its investment
proposals. It may also impose the maximum limits up to which investment can be made by
its middle level management. By stipulating a minimum rate of return to be higher than the
cost of capital, the management may resort to capital rationing.
44
Unit: 02
Hour: 08
45
Financial
Management:
I.M.Pandey
Thus, discount rate means the minimum requisite rate of return on funds
committed to the project. The primary Purpose of measuring the cost of capital is its use as
a financial standard for evaluating investment projects.
Implications of Expected Rate of Inflation on the Capital Budgeting
1) The Company should raise the output price above the expected rate of inflation.
Unless it has lower Net Present Value which may lead to forego the proposals and
vice versa.
2) If the company is unable to raise the output price, it can make some internal
adjustments through careful management of working capital.
3) With respect of discount rate, the adjustment should be made through capital
structure.
Possible Questions & University Questions:
1. What is inflation and its implications?
VSA SCHOOL OF MANAGEMENT
Department of MBA
Salem 10
Subject: Financial Management
Topic: Cost of capital
Unit: 02
Hour: 7
Dictionary
Meaning:
Bond:
Debt
instrument
The term cost of capital refers to the rate of return on investment projects necessary
to leave unchallenged the market price of a firms stocks. It is the rate of return required by
Key Words:
those who supply the capital. The cost of capital is a weighted average of the cost of each
type of capital.
cost of
capital refers
In simple words, cost of capital refers to minimum rate of return a firm must earn to minimum
on its investment so that the market value of the companys equity shares does not fall. rate of return
This is consonance with the overall firms objective of wealth maximization.
a firm must
earn on its
Definition:
investment
46
The cost of capital is the minimum required rate of earnings or the cut-off rate for
the allocation of capital to investments of projects. It is the rate of return on a project that
will leave unchanged the market price of the stock
- James C. Van Horne
Teaching
Aid:
CB
Cost of capital may be defined as the rate of return the firm requires from its
investment in order to increase the value of the firm in the market place.
Books
Referred
47
Unit: 02
Hour: 08
TYPES OF COST
Dictionary
Meaning:
Explicit Cost: The Explicit cost of any source of finance may be defined as the
discount rate that equates the present value of the funds received by the firm net of Dividend:
underwriting costs, with the present value of the expected cash outflows. These outflows
may be interested payment, repayment of principal (or) dividend. This may be calculated Bonus
Share
by computing value according to the following equation.
Surplus
Implicit Cost: The Implicit Cost may be defined as the rate of return associated Payment
with the best investment opportunity for the firm and its shareholders that will be forgone Extra
if the project presently under consideration by the firm were accepted.
2. Future and Historical Cost:
Future Cost refers to the expected cost of funds to finance the project, while
historical cost is the cost, which has already been incurred for financing a particular
project. In financial decision making, the relevant costs are future costs and not the
historical costs. However, historical costs are useful in projecting the future costs and
providing an appraisal of the past performance when compared with standard (or) Teaching
predetermined cost.
Aid:
CB
3. Specific Cost and Combined Cost:
Specific Cost: The Cost of each component of capital (i.e., equity shares,
preference shares, debentures, loans, etc.) is known as specific Cost of Capital. In order to
determine the average cost of capital of the firm it becomes necessary first to consider the Books
Referred
cost of specific methods of financing.
with page
Combined Cost: The composite / combined cost of capital is inclusive of all cost number:
of capital from all sources i.e., equity shares, preference shares, debentures and other
loans. In capital investment decisions, the composite cost of capital will be used as a basis Financial
Management:
for accepting (or) rejecting the proposal even though the company may finance one
I.M.Pandey
proposal from one source of financing while another proposal from another source of
financing.
4. Average Cost and Marginal Cost:
Average Cost: The Average Cost of Capital is the weighted average of the costs of
each component of funds employed by the firm. The weights are in proportion of the share
48
Unit: 02
Hour: 09
49
Ke = D / NP
Where, Ke = Cost of Equity Capital
D = Expected dividend per share
NP = Net proceeds per share
Drawbacks
1.
2.
3.
4.
Assumptions:
1. The company should remain fundamentally the same irregardless of risk.
2. The shareholders are required to bear the risk for expecting the same rate of
return
3. The shareholders reinvestment opportunity rate must be equal to the realized
yield
4. Cost of Retained Earnings
The cost of retained earnings may be considered as the rate of return which the
existing shareholders can obtain by investing the after-tax dividends in alternative
opportunity of equal qualities. It is, thus, the opportunity cost of dividends foregone by
shareholders. Cost of retained earnings can be computed with the help of following
52
formula:
Kr = (D / NP) + G
Where, G = Rate of growth in dividends
Shareholders cannot obtain the entire amount of retained profits by way of
dividends. Some adjustment has to be made for tax. Moreover, if the shareholders wish to
invest their after-tax dividend income in alternative securities, they may have to incur
some costs of purchasing the securities, such as brokerage. To make adjustment in the cost
of retained earnings for tax and costs of purchasing new securities, the following formula
may be adopted:
Kr = [(D / NP) + G] x (1-tax rate) x (1-brokerage cost)
Unit: 02
Hour: 10
Dictionary
Meaning:
Marginal:
Minor
Subsidiary
Secondary
Key Words:
53
In WACC,
there must be
a system of
assigning
weights to
different
specific cost
of capital.
Teaching
In order to calculate the WACC, there must be a system of assigning weights to Aid:
CB
different specific cost of capital. The following considerations are worth noting while
assigning weights to specific cost of capital to find out the WACC.
Historical, Marginal and Target weights:
Books
Referred
Financial
management
Sudharsan
Reddy
each categories. The advantages of using the market value weights are:
The market value weights are consistent with the concept of maintaining
market value in the definition of the overall cost of capital.
The market value weights provide current estimate of the investors
required rate of return.
The market value weights yields goods estimates of the cost of capital that
would be incurred if the firm requires additional funds from the market.
However, the market values weights suffer from some limitations as follows:
Not only that the market values of all types of securities issued have to be
obtained but also that the market value of equity share is to be segregated
into capital and retained earnings.
The market values are subject to change from time to time and so the
concept of optimal capital structure in terms of market values does not
remain relevant any longer.
Unit: 02
Hour: 11
55
Project X
Project Y
Cost of machine
150000
250000
Estimated life
5 years
6 years
6000
8000
10000
15000
Additional
cost
of 19000
maintenance
Estimated savings in direct 150
wages per employee
Total no. of employees
600
27000
Taxation
50%
200
600
50%
C0
C1
C2
C3
C4
A
B
C
D
1000
1000
300
300
600
200
100
0
200
200
100
0
200
600
100
300
1000
1000
600
600
56
Project A
Project B
Investment
20000
30000
Estimated life
4 years
5 years
2000
3000
1500
3000
1500
2000
1000
1000
1000
TOTAL
6000
10000
anticipated cash outflows. The net present value is obtained by discounting all cash
outflows and inflows attributable to a capital investment project by choosen percentage.
The method discounts the net cash flow from the investment by the minimum required rate
of return and deducts the initial investment to give the yield from the funds invested.
Steps to calculate:
1. Determine the discount rate
2. Compute the present value of total investment outlay at the determined rate.
3. Calculate the NPV of each project by subtracting the present value of cash inflows
from the present value of cash outflows for each project
4. If NPV is positive (or) zero that proposal may be accepted otherwise it should be
rejected. Suppose two or more proposal are having positive return the project
which has highest NPV to be selected
NPV Problems:
1. A firm invests in project X Rs.2500 now and expected to generate yearend cash
flow of Rs.900, 800, 700, 600 and 500 in years of 1 through 5. The opportunity
cost of the capital may be assumed to be 10%.
2. The following two projects A and B required an investment of Rs.200000 each.
The income returns after taxes for these projects are as follows:
Year
80000
20000
80000
40000
40000
40000
20000
40000
60000
60000
Unit: 02
Hour: 12
58
Project X
Project Y
Initial investment
20000
30000
Estimated life
5 years
5 years
Scrap value
1000
2000
10000
10000
10000
5000
3000
3000
2000
2000
Cash flow
100000
30000
30000
40000
45000
2. A project cost Rs.16000 and its expected to generate cash inflows of Rs.8000,
7000, and 6000 at the end of each year for next 3 years. Calculate IRR.
3. A firms cost of capital is 2.5% is considering two mutually exclusive project X&
Y
Year
59
70000
70000
10000
50000
20000
40000
30000
20000
45000
10000
60000
10000
Unit: 02
Hour: 13
60
CFBT
10000
10692
12769
13462
20385
COMPUTE:
i)
ii)
iii)
iv)
Payback period
Average rate of return
NPV at 10% discount rate
Profitability index at 10% discount rate
Required
initial NPV at the appropriate cost of
investment
capital
A
100000
20000
B
300000
35000
C
50000
16000
D
200000
25000
E
100000
30000
Total fund available is Rs.300000. determine the optimal contribution of projects
assuming that the projects are divisible.
INFLATION AND CAPITAL BUDGETING
Inflation is defined as increase in the average price of goods and services. The accepted
measure of general inflation is the retail price index which is based on the assumed
expenditure patents of an average family. It is a monetary alignment in an economy and it
can be defined as the changes in purchasing power in a currency from period to period
relative to some basket of goods and services.
INFLATION PROBLEM:
3. A machine cost Rs.10000 and its expected to yield the following net cash returns
(estimated current price)
Year
Rs.
5000
8000
6000
We expect inflation to be at the rate of 5% per annum. The cost of capital is 15.5% per
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annum.
Unit: 02
Hour: 14
Unit: 02
Hour: 15
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COST OF CAPITAL
The objective of business firm is to maximize the wealth of shareholders. The management
should invest in projects which give a return in excess of cost of funds invested in the
projects of the business. The cost of capital is the minimum rate of return expected by its
investors. The cost of capital is the rate of return, the company has to pay various suppliers
of funds in the company. A decision to invest in a particular project depends upon the cost
of capital which is the minimum rate of return expected by investors. Generally higher the
risk involve in a firm, higher the cost of capital
Concept of cost of capital
1. Cost of capital is not a cost
2. It is the minimum rate of return
Cost of equity share capital
1. A company plans to issue 1000 new shares of Rs.100 each, the floatation cost are
expected to be 5 % of the share price the company pays a dividend of Rs.10 per
share initially and growth dividend is expected to be 5 %. Compute the cost of new
issue of equity shares. If the market price of an equity share is Rs.150. calculate the
cost of existing equity share capital.
DIVIDEND YIELD METHOD
Dividend per share is expected current market price. The present value of all expected
future dividends per share with the net proceeds of sale (or) the current market price of
a share this method is based on assumptions that the market value of shares is directly
related to the future dividends on the share.
Another assumption is that the future dividend per share is expected to be constant and
the company is expected to earn at least yield to keep the shareholders constant
that new shares will be issued at a price of Rs.52 per share and the cost of new
issue will be 2 per share.
2. Right starts ltd has its equity share of Rs.10 each quoted in market price of Rs.56.
a constant expected annual growth rate of 6% and dividend of Rs. 3.60 per share
has been paid for current year. Calculate the cost of capital
3. The shares of apple ltd selling at Rs.24 per share the firm had paid dividend at 1.30
per share last year. The estimated growth of company is 5% per year. Determine
the cost of equity of the company.
COST OF RETAINED EARNINGS
Maintain as reserve from the capital for expansion, diversification, uncertainties, and
branches.
The retained earnings is one of the major sources of finance available for the
established companies to finance in expansion and diversification programs. These
funds are also taken into account while calculating cost of equity. Retained earnings
are not distributed to the shareholders. A company can use the funds within the
company for further profitable investment opportunities
1. The cost of equity capital is 24%. The personal taxation of individual shareholders
is 35%. Calculate the cost of retained earnings.
WEIGHTED AVERAGE COST OF CAPITAL/ OVERALL COST OF CAPITAL
1. As the average cost of companies finance (equity, debentures, bank loan) weighted
according to the proportions each element bears to the total of capital. Weighting is
usually based on market valuation current yields and cost after tax.
2. Guna cements ltd has the following capital structure.
Particulars
Market
Book value
Cost of tax (%)
value
Equity share capital 80
120
18
Preference
share 30
20
15
capital
Fully
secured 40
40
14
debentures
Calculate the companies weighted average cost of capital.
INDIFFERENCE POINT
1. Calculate the level of EBIT at which the indifference point following financial
alternatives
Ordinary share capital is 10, 00, 000 (or)
15% debentures of Rs.5, 00, 000 and ordinary share capital of Rs. 5, 00, 000, tax
rate 50% earning price Rs.10 per share
2. Ordinary share capital of Rs.10, 00, 000 (or)
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13% preference share capital of Rs.5,00,000 and ordinary share capital of Rs.5, 00,
000, ordinary share price Rs.10 per share
UNIT 2 (COMPLETED)
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