FINANCIAL MANAGEMENT

3-credit 30-hour Core Course for MBA (IB) 2013-15

Dr. Niti Nandini Chatnani
Associate Professor
Indian Institute of Foreign Trade, New Delhi
Sessions 9, 10 and 11
Recap of Session 8:

1. ___________ is the composite number that represents the claims of all suppliers
of capital to the firm on an aggregate basis.

2. Cost of ______ is the rate that equates the internal rate of return of the cash flows
of a bond with its market price.

3. If a firm with a tax rate of 40% can borrow by issuing bonds carrying an annual
coupon of 16%, the cost of debt for this firm is __________.

4. The approximate cost of preference capital for a firm that has issued preference
shares with a face value of Rs.100 and a promised dividend of Rs. 12 per annum
is _________ if its issue costs are 3%.

5. Retained earnings, though like equity capital, are cheaper because there are no
__________ and ___________ costs and no ___________


6. The shares of firm a quoted in the market at Rs.220. If this firm ahs paid a dividend
of Rs.10 last year, and the expected dividend this year is Rs.11, the firms cost of
equity capital is _________.

7. Market price in excess of the issue price of a bond implies an increase in the cots
of debt and vice versa. True/False

8. When using the CAPM to estimate cost of equity for an unlisted firm, the beta used
must be

A. That of the firm itself
B. That of a similar listed firm
C. Weighted average of A and B
D. Average of A and B


Case: Gupta Bricks - I
Capital Budgeting Decisions:

These are the long-term investment decisions of a firm

Include expansion, replacement or renewal of long-term assets

Involve an exchange of current funds for future benefits, wherein future benefits
come to the firm for a long time in the future and the funds are invested in long-term
assets

These decisions are involve sizeable capital outlays, and commit the firm to some
course of action

The decisions can be risky, difficult to make, irreversible to a large extent, and may
affect the risk complexion of a firm

Firms treat their Capital Budgeting and Financing Decisions separately, without
regard to the specific method of financing used

Capital Budgeting Process


Proposal Generation

Review and Analysis

Decision Making

Implementation

Follow-up
Most Time and Effort
consuming
Mostly ignored
Key motives for making capex:

1. Expansion
2. Replacement
3. Renewal
4. Others
a. Advertising
b. Research & Development
c. Management Consulting
d. Installation of Pollution Control and Safety Devices

Basic Terminology:

1. Independent versus Mutually Exclusive Projects
2. Unlimited Funds versus Capital Rationing
3. Accept- Reject versus Ranking Approaches
4. Conventional versus Non-Conventional Cash Flow Patterns

Investment Evaluation:

- Requires:

1. Estimation of cash flows (not profits)
2. Estimation of the required rate of return on investments
3. Application of an evaluation technique (or a decision rule)

- Evaluation Techniques:

1. Non-discounted Methods:
(a)Payback Period (PBP)
(b)Accounting Rate of Return (ARR)*

2. Discounted Methods
(a)Net Present Value (NPV)
(b)Internal Rate of Return (IRR)
(c)Profitability Index (PI) *based on profits; not used in practice

Cost of
Capital
Return on
Capital
The cost of capital, or discount rate, or required rate of return, or opportunity cost, is
an important link between the investment decision and the financing decision
It is the minimum or hurdle rate for the return a firms investment must earn

Pay Back Period (PBP):

The amount of time required for a firm to recover its initial investment in a project, as
calculated from its cash flows

Decision Criterion:

If PBP < Minimum Acceptable PBP, then accept the project
If PBP > Minimum Acceptable PBP, then reject the project

Pros and Cons of PBP:

Simple to compute and easy to understand
Can be viewed as a measure of risk exposure


Minimum Acceptable PBP is set subjectively
Time Value of money is not integrated into PBP calculations
Cash flows that occur after PBP are not considered


Net Present Value (NPV):

The value left after subtracting a projects initial investment from the present value of
its cash inflows, discounted at a rate equal to the firms cost of capital

NPV= CF
t
- CF
0
(1+k)
t

Decision Criterion:
If NPV > 0, then accept the project
If NPV < 0, then reject the project

Pros and Cons:

Integrates time value of money into calculations
Is in sync with the wealth maximization goal

Absolute Measure

t=1
n
Internal Rate of Return (IRR):

The discount rate that equates NPV of a project with 0. The compound annual
rate of return a firm will earn it it invests in the project and earns the cash inflows

CF
t
- CF
0
(1+ IRR)
t

Decision Criterion:

If IRR > the firms cost of capital, then accept the project
If IRR < the firms cost of capital, then reject the project

Pros and Cons:

Easy to communicate and compare

Difficult to compute
Assumes intermediate cash flows are reinvested at IRR
Multiple IRRs can result in case of non-conventional cash flows
Provides conflicting rankings for mutually exclusive projects
t=1
n
DETERMINING THE NPV and IRR
Firm's Cost of Capital 10%
Year End Cash Flow
Year Project A Project B
0 -42000 -45000
1 14000 28000
2 14000 12000
3 14000 10000
4 14000 10000
5 14000 10000
PV of Cash Flows $53,071.01 $55,924.40
NPV $11,071.01 $10,924.40
Choice of Project
IRR 20% 22%
Choice of Project
Modified Internal Rate of Return (MIRR):

An improved version of the internal rate of return (IRR) approach
MIRR = [nSum of Terminal Cash Flows other than Initial Investment ] -1
Initial Investment


Decision Criterion:

If MIRR > the firms cost of capital, then accept the project
If MIRR < the firms cost of capital, then reject the project

In case of mutually exclusive projects, the project with higher MIRR should be preferred.

Does not require the assumption that the project cash flows are reinvested at the IRR
Factors in a discrete reinvestment rate into the model

MIRR Example:

You are an assistant to Rajan, the corporate finance director at BTC, a civil engineering firm. Two of the
company's recent bids are accepted.
The first relates to construction of a new airport in Jaipur.
The second relates to construction of a motorway connecting Jaipur with Ahmedabad.
Both the projects are expected to take 3 years.
The applicable finance rate is 10% and the project's cash flows are given below:

Year Airport Motorway
0 (12,000,000) (18,000,000)
1 6,000,000 8,000,000
2 8,000,000 10,000,000
3 4,000,000 10,000,000

The company submitted bids for both projects because both had positive net present values.
The CEO of BTC has asked Rajan to recommend which project the company should accept. The CEO is
a fan of the IRR approach. Rajan, on the other hand, is worried about the shortcomings of the IRR
approach. He believes that the economy might slow down a little in next few years and a lower
reinvestment rate should be factored in. He has asked you to calculate MIRR for both the projects.
You double-check whenever and wherever possible, so you decide to calculate the MIRR using the
manual formula approach and then verify the results using MS Excel MIRR function.
NPV Profiles:

Depict project NPVs for various discount rates
Allow projects to be compared graphically




NPV Profiles
Discount
Rate
NPV of
A
NPV of
B
0% 25000 28000
5% 18612 17251
10% 11071 10924
15% 4930 5686
20% 0
22% 0
Example:
Consider the following two projects:

Cash flow Project A Project B
Year 0 -1000 -1000
Year 1 500 100
Year 2 400 300
Year 3 300 400
Year 4 100 600
The firms WACC is 10%. For each project, find its:

1. PBP and Discounted PBP
2. NPV
3. IRR
4. PI
5. MIRR
Comment on the acceptability of both A and B in each case.
Choosing projects under Capital Rationing:

Exists when budgets are created for long-term investments
Soft versus hard forms of capital rationing
Two approaches:

1. IRR Approach
Involves graphing project IRRs in descending order against total initial investment,
to determine the group of acceptable projects

2. NPV Approach
Based on the use of present values to determine the group of projects that will
maximise owners wealth


Project Initial
Investment
IRR in % PV of
Cash
Flows
A 80,000 12 100,000
B 70,000 20 112,000
C 100,000 16 145,000
D 40,000 8 36,000
E 60,000 15 79,000
F 110,000 11 126,500
Budgeted for investment = 250,000
Cut-off Rate = 10%
The objective of a firm that operates under capital rationing is to use its budget to
generate the highest present values of inflows
1. Using the IRR Approach

Selected Projects = B, C and E
Total Investment = 230,000
Total Present Value = 336,000
NPV of Projects B, C and E = 106,000

2. Using NPV Approach

Selected Projects = B, C and A
Total Investment = 250,000
Total Present Value = 357,000
NPV of Projects B, C and A = 107,000

Project F is not selected under the NPV approach due to budget constraints.
Estimation of Cash Flows:

Cash flows are different from accounting profits
Relevant Cash Flows are the firms Incremental Cash Flows, which are


C
f
to firm with project C
f
to firm without project

Major Components of Cash Flows:
1. Initial Investment;
2. Operating Cash Inflows
3. Terminal Cash Flows

Expansion versus Replacement Cash Flows
All Capital Budgeting Decisions can be viewed as Replacement Decisions.
Expansion Decisions are merely Replacement Decisions in which all cash flows
from old asset are zero.



Cash Flows for Replacement Decisions:

Initial Investment =

Initial investment needed - After-tax cash inflows
to acquire new asset from liquidation of old asset

Operating Cash Inflows =

Operating cash inflows - Operating cash inflows
from new asset from old asset

Terminal Cash Flow =

After-tax cash flows
from termination of new asset
Determining a projects incremental cash flows:


A note on Sunk Costs and Opportunity Costs

Sunk Costs: Cash outlays that have already been made (past outlays) and therefore,
have no effect on the cash flows relevant to a current decision. These are not
considered as incremental cash flows.

Opportunity Costs: Cash flows that could be realized from the best alternative use of
an owned asset. These are considered as incremental cash flows.


Step 1: Finding the Initial Investment

Occurs ate time 0 when expenditure is made
Includes all cash outflows occurring at time 0 reduced by all cash
inflows occurring at time 0

Installed cost of new asset =
Cost of new asset +
Installation Cost
- After-tax proceeds from sale of old asset =
Proceeds from sale of old asset
Tax on sale of old assets
Changes in Net Working Capital
______________________________________
Initial Investment

Installed Cost: The cost of an asset plus its installation cost, equals the assets
depreciable value

Book Value: the strict accounting value of an asset, calculated by subtracting its
accumulated depreciation from its installed cost

Tax on Sale of old asset: Tax that depends on the relationship between the old
assets sale price, initial purchase price and book value, and on existing government
tax rules

Recaptured depreciation: The portion of an assets sale price that is above its book
value and below it initial purchase price

Changes in Net Working Capital: The difference between a change in current assets
and a change in current liabilities. Accompany capex
Finding the Operating Cash Inflows:

These occur over the projects life
Are measured as cash flows, not accounting profits

Revenues
- Expenses (excluding depreciation)
_______________________________
Profits Before Depreciation and Tax
- Depreciation
_______________________________
Net Profits Before Tax
- Tax
_______________________________
Net Profits After Tax
+ Depreciation
_______________________________
Operating Cash Inflows

Finding the Terminal Cash Flow:

This occurs in terminal year of projects life
Results from termination/liquidation of project

After-tax proceeds from sale of new asset =
Proceeds from sale of new asset
Tax on sale of new asset
Changes in Net Working Capital
____________________________________
Terminal Cash Flow
Identifying the relevant cash flows:

Initial capex, includes costs of fixed assets including shipping and installation costs
Non Cash Charges (typically depreciation) are included only for tax shields offered
Changes in Net Working Capital, are costs over and above capex and usually
accompany capex
Interest Expenses are not included in project cash flows and are treated as financing
cash flows
Sunk costs are not incremental costs and are ignored
Opportunity costs inherent in use of assets
Side effects impact the incremental cash flows and are included
Timing of cash flows are relevant because of TVoM
Terminal cash flow includes working capital released and salvage value of assets
realized


Example:

Given the following background information for a project, calculate its NPV:
Installed Cost: 600
Required NWC Investment: 400
Life: 3 years
Annual Sales: 1000
Annual Costs: 500
Straight Line Depreciation to 0; Salvage Value: 100
Tax Rate: 34%
Required Return: 12%

Project Cash Flows:

Initial cash flows:
Capex = 600
NWC = 400

Annual and Terminal Cash flows:




Year 0 Year 1 Year 2 Year 3
Sales -1000 (Initial C/F) 1000 1000 1000
Cost of Sales 500 500 500
EBIDT 500 500 500
Depreciation 200 200 200
EBIT 300 300 300
Salvage Value 100 (BV=0)
Taxes 102 102 136
PAT 198 198 264
CFAT(add Depcn. +
NWC )
-1000 398 398 864
Dealing with Inflation:

When cash flows are expressed in terms of the time of their receipt, they are nominal cash flows

When cash flows are expressed in year 0 terms, they are real cash flows

Inflation must be treated consistently in capital budgeting

Nominal cash flows must be discounted at nominal rates and real cash flows at real rates

Fisher Effect Formula:

1+Nominal Rate = (1 + Real Rate)(1 + Inflation Rate)

Nominal Cash Flow = Real Cash Flow (1 + Inflation Rate)
t

The approximation, Nominal Rate = Real Rate + Inflation Rate works well when Real Rate + Inflation
Rate is small
Example:
Initial Investment = 300, depreciated to 0 by SLM; no salvage value
Sales = 140 units; SP = 2; CP = 1
Tax Rate = 35%; WACC = 15%
Case1: Real Cash flows and Nominal WACC
Year 0 1 2 3
Initial Investment -300
Revenues !40 @ 2 280 280 280
Costs 140 @ 1 140 140 140
Gross Profits 140 140 140
Depreciation (to 0) 100 100 100
PBT 40 40 40
Tax @ 35% 14 14 14
NPAT 26 26 26
CFAT 126 126 126
PV @ 15% $287.69
NPV ($12.31)
Case 2: Nominal Cash flows and Nominal
WACC
Year 0 1 2 3
Initial Investment -300
Revenues 140 @ 2 294 308.7 324.135
Costs 140 @ 1 147 154.35 162.0675
Gross Profits 147 154.35 162.0675
Depreciation (to 0) 100 100 100
PBT 47 54.35 62.0675
Tax @ 35% 16.45 19.0225 21.72363
NPAT 30.55 35.3275 40.34388
CFAT 130.55 135.3275 140.3439
PV @ 15% $308.13
NPV $8.13
Case 3: Real Cash flows and Real WACC (Using Fisher Formula)
Year 0 1 2 3
Initial Investment -300
Revenues !40 @ 2 280 280 280
Costs 140 @ 1 140 140 140
Gross Profits 140 140 140
Depreciation (to 0) 100 100 100
PBT 40 40 40
Tax @ 35% 14 14 14
NPAT 26 26 26
CFAT 126 126 126
PV @ 10% $313.34
NPV $13.34
Dealing with Project Risk:

1. Sensitivity Analysis

A behavioural approach that uses several possible values for a given variable to
assess that variables impact on the projects NPV. Helps establish a range for NPV
and the variable NPV is most sensitive to

2. Scenario Analysis

A behavioural approach that evaluates the impact of the simultaneous change in a
number of variables on the projects NPV

3. Break-Even Analysis

An approach that asks what is the minimum level of sales that must be achieved for
project NPV to be 0

4. Risk Adjusted Discount Rates

The discount rate that must be earned on a given project to compensate the firm
for the risk inherent in a project. Logic closely linked to the CAPM. Widely used in
practice

5. Pay Back Period