Unit-2

Financial Management

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Chapter IV

Cost of Capital

Aim

The aim of this chapter is to:

explain the concept of cost of capital•

elucidatethecostofdifferentsourcesoffinance•

explicate the capital asset pricing model approach•

Objectives

The objectives of this chapter are to:

definethecostofequity•

determine the cost of preference shares – cost of irredeemable and redeemable share•

enlist the factors affecti• ng WACC

Learning outcome

At the end of this chapter, you will be able to:

understand the concept of Weighted Average Cost of Capital (WACC)•

identify the steps involved in the computation of WACC•

describe the importance of cost of capital•

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4.1 Introduction to Cost of CapitalCost of capital is an integral part of investment decision as it is used to measure the worth of investment proposal providedbythebusinessconcern.Itisusedasadiscountrateindeterminingthepresentvalueoffuturecashflowsassociated with capital projects. Cost of capital is also called as cut-off rate, target rate, hurdle rate and required rateofreturn.Whenthefirmsareusingdifferentsourcesoffinance,thefinancemanagermusttakecarefuldecisionwithregardtothecostofcapital;becauseitiscloselyassociatedwiththevalueofthefirmandtheearningcapacityofthefirm.

Meaning of Cost of Capital Costofcapitalistherateofreturnthatafirmmustearnonitsprojectinvestmentstomaintainitsmarketvalueand attract funds. Cost of capital is the required rate of return on its investments which belongs to equity, debt and retainedearnings.Ifafirmfailstoearnreturnattheexpectedrate,themarketvalueoftheshareswillfallanditwill result in the reduction of overall wealth of the shareholders.

DefinitionsThe following importantdefinitionsarecommonlyused tounderstand themeaningandconceptof thecostofcapital. AccordingtothedefinitionofJohnJ.Hampton“Costofcapitalistherateofreturnthefirmrequiredfrominvestmentinordertoincreasethevalueofthefirminthemarketplace”.

AccordingtothedefinitionofSolomonEzra,“Costofcapitalistheminimumrequiredrateofearningsorthecut-offrateofcapitalexpenditure”.

AccordingtothedefinitionofJamesC.VanHorne,Costofcapitalis“Acut-offratefortheallocationofcapitalto investment of projects. It is the rate of return on a project that will leave unchanged the market price of the stock”.

AccordingtothedefinitionofWilliamandDonaldson,“Costofcapitalmaybedefinedastheratethatmustbeearnedonthenetproceedstoprovidethecostelementsoftheburdenatthetimetheyaredue”.

Cost of capital from three different viewpointsInvestorsviewpoint:Themeasurementofthesacrificemadebytheindividualforcapitalformation"•Firm's view point: It is the minimum required rate of return needed to justify the use of capital. It is supported •by Hompton, John.Capital Expenditure view point: The cost of capital is the minimum required rate of return or the cut off rate •usedtovaluecashflows.

Importance of cost of capitalComputationofcostofcapitalisaveryimportantpartofthefinancialmanagementtodecidethecapitalstructureof the business concern. Following points illustrates the importance of cost of capital.

Importance to capital budgeting decision: Capital budget decision largely depends on the cost of capital of each •source.Accordingtonetpresentvaluemethod,presentvalueofcashinflowmustbemorethanthepresentvalueofcashoutflow.Hence,costofcapitalisusedtocapitalbudgetingdecision.Importance to structure decision: Capital structure is the mix or proportion of the different kinds of long term •securities.Afirmusesparticulartypeofsourcesifthecostofcapitalissuitable.Hence,costofcapitalhelpstotake decision regarding structure.Importance toevolutionoffinancialperformance:Costofcapital isoneof the importantdeterminewhich•affectsthecapitalbudgeting,capitalstructureandvalueofthefirm.Hence,ithelpstoevaluatethefinancialperformanceofthefirm.


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Importancetootherfinancialdecisions:Apartfromtheabovepoints,costofcapitalisalsousedinsomeother•areassuchas,marketvalueofshare,earningcapacityofsecuritiesetc.hence,itplaysamajorpartinthefinancialmanagement.

4.2 Cost of Different Sources of FinanceItcanbefurtherclassifiedintobelowmentionedcategories:

4.2.1 Cost of EquityFirms may obtain equity capital in two ways:

Retention of earnings•Issue of equity shares to the public•

The cost of equity or the returns required by the equity shareholders is the same in both the cases shareholders are providingfundstothefirmtofinancefirm'sinvestmentproposals.Retentionofearningsinvolvesanopportunitycost.Shareholders could receive the earnings as dividends and invest the same in alternative investments of comparable risktoearnreturns.So,irrespectiveofwhetherafirmraisesequityfinancebyretainingearningsorissueofadditionalequityshares,thecostofequityissame.Butissueofadditionalequitysharestothepublicinvolvesaflotationcostwhereasthereisnoflotationcostforretainedearnings.

Cost of Retained Earnings (Kre)Retainedearningsarethosepartsofnetearningsthatareretainedbythefirmforinvestingincapitalbudgetingproposals instead of paying them as dividends to shareholders. The opportunity cost of retained earnings is the rate of return the shareholders forgoes by not putting their funds elsewhere, because the management has retained the funds. The opportunity cost can be well computed with the following formulae.

Where, Ke = Cost of equity capital [D ÷P or (E/P) + g]Ti = Marginal tax rate applicable to the individuals concernedTb = Cost of purchase of new securitiesD = Expected dividend per shareNP = Net proceeds of equity shareg= Growth rate (%)

For instance A company paid a dividend of Rs. Per share, market price per share is Rs. 20, income tax rate is 60% and brokerage is expected to be 2%. Compute cost of retained earnings.

Solution:

=

= 0.10 X 0.408 X 100 = 4.1 %

Cost of Issue of Equity Shares (Ke)Thecostofequitycapital(Ke)maybedefinedastheminimumrateofreturnthatafirmmustearnontheequityfinancedportionsofaninvestmentprojectinordertoleaveunchangedthemarketpriceoftheshares.Thecostofequityisnottheout-of-pocketcostofusingequitycapitalastheequityshareholdersarenotpaiddividendatafixedrate every year.

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Itisthemostdifficultandcontroversialcosttomeasurethereisnocommonbasisforcomputation.

4.2.2 Cost of Preference SharesPreference share is one of the types of shares issued by companies to raise funds from public. Preference share is the share that has two preferential rights over equity shares:

Preferenceinpaymentofdividend,fromdistributableprofits•Preference in the payment of capital at the time of liquidation of the company•

Cost of Irredeemable (Perpetual) Preference ShareShare that cannot be paid till liquidation of the company are called as irredeemable preference shares. The cost is measured by the following formulas:

Where, Kp = Cost of preference shareD= Dividend per shareCMP = Current market price per shareNP = Net proceedsCost of irredeemable preference stock (with dividend tax)

Where Dt = Tax on preference dividend

For instance(Kp with dividend tax) : A coy planning to issue 14% irredeemable preference share at the face value of Rs. 250 per share,withanestimatedflotationcostof5%.Whatiscostofpreferencesharewith10%dividendtax.

Solution:

= 16.21 %

Cost of Redeemable Preference ShareSharesthatareissuedforaspecificmaturityperiodorredeemableafteraspecificperiodareknownasredeemablepreference shares. Cost of preference share when the principal amount is repaid in one lump sum amount.

Where, Kp = Cost of preference shareNP=Netsalesproceeds(afterdiscount,flotationcost)D = Dividend on preference sharePn = Repayment of principal amount at the end of ‘n’ years

Short cut formula is :

4.2.3 Cost of DebenturesCompaniesmayraisedebtcapitalthroughissueofdebenturesorraiseloanfromfinancialinstitutionsordepositsfrompublic.Alltheseresourcesinvolveaspecificrateofinterest.Computationofcostofdebentureordebtcapitaldepends on their nature.


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Cost of Irredeemable DebtPerpetualdebtprovidespermanentfundstothefirm,becausethefundswillremaininthefirmtillliquidation.Costof perpetual debt is the rate of return that lender expect. The following formulae used to compute cost of debentures or debt of bond.

Pre-tax cost = •

Post-tax cost = •

Where, Kdi = Pre-tax cost of debentures, I – Interest , P = Principle amount or face vlueP = Net sales proceeds , t = Tax rate

Forinstance:XYZCompanyLtd.,decidestofloatperpetual12%,debenturesofRs.100each.Thetaxrateis50.Calculate cost of debenture (pre and post tax cost)

Solution: Pre-tax cost =

Post-tax cost =

Cost of Redeemable DebtRedeemable debentures are those having a maturity period or repayable after a certain given period of time. These type of debentures are issued by many companies when they require capital for temporary needs. It is calculated by the following formula:

Where, Kd = Cost of debentures, n = Maturity period, NI= Net interest (after tax adjustment)Pn = Principal repayment in the year ‘n’

4.3 Capital Asset Pricing Model Approach (CAPM)CAPM was developed by William F.Sharpe. From cost of capital point of view, CAPM explains the relationship betweentherequiredrateofreturn,andthenon-diversifiableorrelevantrisk,ofthefirmasreflectedinitsindexofnon-diversifiableriskthatisbeta(β).Itshowstherelationshipbetweenriskandreturnforefficientandinefficientportfolios. Symbolically,

Where, Ke = Cost of equity capital, Rf = Rate of return required on a risk free security (%)β=Betacoefficient,Rmf=Requiredrateofreturnonthemarketportfolioofassets, thatcanbeviewedastheaverage rate of return on all assets.

Assumptions of CAPMCAPM approach is based on the following assumptions

Perfect Capital Market: all investors have same information about securitiesThere are no restrictions on investments•Securities of completely divisible•There are no transaction costs•There are no taxes•

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Investors Preference: Investors are risk averseInvestors have homogenous expectations regarding the expected returns, variances and correlation of returns •among all securities.Investors seek to maximise the expected utility of their portfolios over a single period planning horizon•

For instance The capital Ltd. Wishes to calculate its cost of equity capital using the Capital Asset Pricing Model (CAPM) approach. Company’s analyst found that its risk free rate if return equals 12%, beta equals 1.7 and the return on market portfolio equals 14.5 %.Solution:

= 12 + [14.5 – 12]1.7= 12+4.25= 16.25 %

4.4 Weighted Average Cost of Capital (WACC)A company has to employ a combination of creditors and owners funds. The composite cost of capital lies between theleastandmostexpensivefunds.Thisapproachenablesthemaximisationofprofitsandthewealthoftheequityshareholders by investing the funds in projects earning in excess of the overall cost of capital.

Steps involved in computation in WACCDetermination of the source of funds to be raised and their individual share in the total capitalization of the •firmComputationofcostofspecificsourceoffunds•Assignmentofweighttospecificsourceoffunds•Multiply the cost of each source by the appropriate assigned weights•Add individual source weight cost to get cost of capital•

Assignment of Weights Theweightstospecificfundsmaybeassignedbasedonthefollowing:

Book values: Book value weights are based on the values found on the balance sheet. The weight applicable to a •given source of fund is simply the book value of the source of fund divided by the book value of total funds.Capital structure weights: Under this method weights are assigned to the components of capital structure based •onthetargetedcapitalstructure.Dependingontarget,capitalstructureshavesomedifficultiesinusingit.Theyare

Acompanymaynothaveawelldefinedtargetcapitalstructure �Itmaybedifficulttopreciselyestimatethecomponentscapitalcost,ifthetargetcapitalisdifferentfrom �present capital structure.

Market value weights: Under this method, assigned weights to a particular component of capital structure is •equal to the market value of the component of capital dividend by the market value of all components of capital andcapitalemployedbythefirm.

Forinstanceafirmhasthefollowingcapitalstructureasthelateststatement

Source of finance Amount (Rs.) After Tax Cost %Debt Capital 30,00,000 4.0Preference Share Capital 10,00,000 8.5Equity Share Capital 20,00,000 11.5Retained earnings 40,00,000 10.0Total 100,00,000


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Solution:Computation of cost of capital

Source of Finance Weights Specific Cost (%) Weighted CostDebt 0.30* 4.0 1.2Preference share 0.10 8.5 8.5Equity share 0.20 11.5 2.3Retained earnings 0.40 10.0 4.0

1.00 8.35

Note * Debt weight =

4.4.1 Factors Affecting WACCWeighted average cost of capital is affected by a number of factors. They are divided into two categories such as:

Controllable factors (Internal factor)•Uncontrollable factors (External factors)•

Controllable factors (Internal factor): ControllablefactorsarethosefactorsthataffectWACC,butthefirmcancontrol them. They are:

Capital structure policy•Dividend policy•Investment policy•

Uncontrollable factors (External factors): Thefactorsthosearenotpossibletobecontrolledbythefirmandmostly affects the cost of capital. These types of factors are known as external factors.

Tax rates•Level of interest rates•Market risk premium•

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SummaryCost of capital is an integral part of investment decision as it is used to measure the worth of investment proposal •provided by the business concern.Costofcapitalistherateofreturnthatafirmmustearnonitsprojectinvestmentstomaintainitsmarketvalue•and attract funds. Cost of capital is the required rate of return on its investments which belongs to equity, debt and retained •earnings.Computationofcostofcapitalisaveryimportantpartofthefinancialmanagementtodecidethecapitalstructure•of the business concern. Following points illustrates the importance of cost of capital.The cost of equity or the returns required by the equity shareholders is the same in both the cases shareholders •areprovidingfundstothefirmtofinancefirm'sinvestmentproposals.Shareholders could receive the earnings as dividends and invest the same in alternative investments of comparable •risk to earn returns.Retainedearningsarethosepartsofnetearningsthatareretainedbythefirmforinvestingincapitalbudgeting•proposals instead of paying them as dividends to shareholders

ReferencesReddy, G. S., 2008. • Financial Management. Mumbai: Himalaya publications. Paramasivan, C. & Subramanian, T., 2009. • Financial Management. New Age International.Definingthecostofcapital,• [Pdf]Availableat:<http://www.iassa.co.za/articles/002_may1973_02.pdf>[Accessed28 May 2013].The cost of capital• , [Pdf] Available at: <http://www.goldsmithibs.com/resources/free/Cost-of-Capital/notes/Summary%20-%20Cost%20of%20Capital.pdf>[Accessed28May2013].2009. • Introduction to Cost of Capital, [Video online] Available at: <http://www.youtube.com/watch?v=AGaoDQgicVg>[Accessed28May2013].2013. • Cost of Capital Part 1 , [Video online] Available at : <http:/ /www.youtube.com/watch?v=suqQ3huNtrk>[Accessed28May2013].

Recommended ReadingPratt , S. P., 2010. • Cost of Capital: Workbook and Technical Supplement, 4th ed., Wiley.Tennent, J., 2008. • Guide to Financial Management,ProfileBooks/TheEconomist.Avadhani, V.A., 2010.• International Financial Management. Global Media.


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Self Assessment

Existence of perfect capital market is one of the assumptions of ______.1. WACCa. CAPMb. equityc. debenturesd.

Cost of the capital is the ___________ required rate of return expected by investors.2. minimuma. maximumb. higherc. reducedd.

Which of the following statements is false?3. Cost of capital comprises of three componentsa. Cost of capital is the minimum required rate of needed to justifyb. There is no cost for internally generated fundsc. CAPM approach is one of the approaches used in computation of equity capitald.

_______ value weights are based on the values found on the balance sheet4. Booka. Capitalb. Marketc. Weightedd.

CAPM stands for?5. Capital asset price model a. Capital asset pricing model b. Capital asset pricing maturityc. Capital assignment pricing modeld.

The composite cost of capital lies between the least and most _________ funds.6. expensivea. costlyb. low costc. cheapd.

____________debentures are those having a maturity period or repayable after a certain given period of time.7. Redeemablea. Irredeemableb. Capitalc. Assetd.

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Retention of earnings involves an __________ cost8. opportunitya. fixedb. capitalc. explicit d.

Retainedearningsarethosepartsof________earningsthatareretainedbythefirmforinvestingincapital9. budgeting proposals instead of paying them as dividends to shareholders

reduceda. netb. completec. entired.

Cost of preference share when the _______ amount is repaid in one lump sum amount.10. interesta. totalb. principalc. halfd.


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Chapter V

Capital Structure and Leverages

Aim


explain the concept of capital structure•

explicate the features of appropriate capital structure•

elucidatethefactorsthatdetermineafirm'scapitalstructure•

Objective

The objective of the chapter is to:

definecapitalstructure•

enlist the forms of capital structure•

defineleverage•

Learning outcome


undertsand the concept of leverages •

decribe the types of leverages•

identify the objectives of capital structure•

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5.1 Meaning of Capital StructureCapital is the major part of all kinds of business activities, which are decided by the size, and nature of the business concern. Capital may be raised with the help of various sources. If the company maintains proper and adequate level ofcapital,itwillearnhighprofitandtheycanprovidemoredividendstoitsshareholders.

Meaning of capital structureCapital structure refers to the kinds of securities and the proportionate amounts that make up capitalization. It is the mix of different sources of long-term sources such as equity shares, preference shares, debentures, long-term loans and retained earnings. The term capital structure refers to the relationship between the various long-term source financingsuchasequitycapital,preferencesharecapitalanddebtcapital.Decidingthesuitablecapitalstructureistheimportantdecisionofthefinancialmanagementbecauseitiscloselyrelatedtothevalueofthefirm.Capitalstructureisthepermanentfinancingofthecompanyrepresentedprimarilybylong-termdebtandequity.

Definition of capital structureThefollowingdefinitionsclearlyinitiate,themeaningandobjectiveofthecapitalstructures.

AccordingtothedefinitionofGerestenbeg,“CapitalStructureofacompanyreferstothecompositionormakeupofitscapitalizationanditincludesalllong-termcapitalresources”.

AccordingtothedefinitionofJamesC.VanHorne,“Themixofafirm’spermanentlong-termfinancingrepresentedbydebt,preferredstock,andcommonstockequity”.

AccordingtothedefinitionofPresanaChandra,“Thecompositionofafirm’sfinancingconsistsofequity,preference,anddebt”.

AccordingtothedefinitionofR.H.Wessel,“Thelongtermsourcesoffundemployedinabusinessenterprise”.

CapitalStructureisthatpartoffinancialstructure,whichrepresentslong-termsources.Thetermcapitalstructureisgenerallydefinedtoincludeonlylong-termdebtandtotalstockholdersinvestment.

To quote Bogan "Capital structure may consists of a single class of stock, or it may be comprised by several issues of bonds and preferred stock, the characteristics of which may vary considerably". Capital structure is indicated by the following equations:

Capital Structure = Long-term Debt + Preferred Stock + Net worth OR Capital Structure = Total assets – Current Liabilities

Optimum capital structureOptimum capital structure is the capital structure at which the weighted average cost of capital is minimum and therebythevalueofthefirmismaximum.Optimumcapitalstructuremaybedefinedasthecapitalstructureorcombinationofdebtandequity,thatleadstothemaximumvalueofthefirm.

Objectives of capital structureDecision of capital structure aims at the following two important objectives:

Maximizethevalueofthefirm.•Minimize the overall cost of capital•

Forms of capital structureCapitalstructurepatternvariesfromcompanytocompanyandtheavailabilityoffinance.Normallythefollowingforms of capital structure are popular in practice.


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Equity shares only •Equity and preference shares only•Equity and Debentures only.•Equity shares, preference shares and debentures•

Factors determining capital structure Thefollowingfactorsareconsideredwhiledecidingthecapitalstructureofthefirm.

Leverage:Itisthebasicandimportantfactor,whichaffectthecapitalstructure.Itusesthefixedcostfinancing•such as debt, equity and preference share capital. It is closely related to the overall cost of capital. CostofCapital:Costofcapitalconstitutesthemajorpartfordecidingthecapitalstructureofafirm.Normally•longtermfinancesuchasequityanddebtconsistoffixedcostwhilemobilization.Whenthecostofcapitalincreases,valueofthefirmwillalsodecrease.Hencethefirmmusttakecarefulstepstoreducethecostofcapital.

Nature of the business:Useoffixed interest/dividendbearingfinancedependsupon the nature of the �business. If the business consists of long period of operation, it will apply for equity than debt, and it will reduce the cost of capital. Sizeofthecompany:Italsoaffectsthecapitalstructureofafirm.Ifthefirmbelongstolargescale,itcan �managethefinancialrequirementswiththehelpofinternalsources.Butifitissmallsize,theywillgoforexternalfinance.Itconsistsofhighcostofcapital.Legal requirements: Legal requirements are also one of the considerations while dividing the capital structure �ofafirm.Forexample,bankingcompaniesarerestrictedtoraisefundsfromsomesources.Requirement of investors: In order to collect funds from different type of investors, it will be appropriate �for the companies to issue different sources of securities.

Governmentpolicy:PromotercontributionisfixedbythecompanyAct.Itrestrictstomobilizelarge,longterm•funds from external sources. Hence the company must consider government policy regarding the capital structure

5.2 Features of an Appropriate Capital StructureAn appropriate capital structure should have the following features:

Profitability•Solvency•Flexibility•Conservation•Control•

ConsiderationsFinancial manager has to consider the following while developing optimum capital structure

Return on Investment (ROI) Financialmanagerneedtoraisefixedcostsources)loans,debenture,preferenceshares)offunds,onlywhenROIishigherthatthefixedcostfunds.

Tax benefit Since debt is the cheapest source, because the interest paid on the debt is allowed as a deductible expense in determiningtaxpayment.Hence,abusinessfirmshouldtaketheadvantageoftaxdeduction.

Perceived financial risk Useofmoredebtincapitalstructureleadstoincreaseperceivedfinancialriskinthemindsofequityshareholderswhichreducesthemarketpriceofequityshare,therebyfirm'swealth.Thereforefinancialmanagementshouldnotincrease debt in capital structure when ordinary shareholders perceived an excessive risk.

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5.3 Determination of Capital StructureThe capital structure should be determined keeping in mind the objective of wealth maximisation. Following are the factors affecting the capital structure:

Taxbenefitofdebt•Flexibility•Control•Industry leverage ratios•Seasonal variations•Degree of competition•Industry life-cycle•Timing of public issue•Requirements of investors•

Patterns of capital structureConstruction of optimum capital structure is possible only when there is a appropriate mix of the above sources (debt and equity). The following are the forms of capital structure

Complete equity share capital•Different proportions of equity and preference share capital•Different proportions of equity and debenture (debt) capital and•Different proportions of equity, preference, and debenture (debt) capital•

5.4 Theories of Capital StructureEquityanddebtarethetwoimportantsourcesoflong-termsourcesoffinanceofafirm.Theproportionofdebtandequityinafirm'scapitalstructurehastobeindependentlydecidedcasetocase.Manytheorieshavebeenpropoundedtounderstandtherelationshipbetweenfinancialleverageandfirmvalue.

Assumption of capital structure theoriesThere are only two sources of funds i.e.: debt and equity.•The total assets of the company are given and do no change.•Thetotalfinancingremainsconstant.Thefirmcanchangethedegreeofleverageeitherbysellingtheshares•and retiring debt or by issuing debt and redeeming equity.Operatingprofits(EBIT)arenotexpectedtogrow.•Alltheinvestorsareassumedtohavethesameexpectationaboutthefutureprofits.•Businessriskisconstantovertimeandassumedtobeindependentofitscapitalstructureandfinancialrisk.•Corporate tax does not exit.•Thecompanyhasinfinitelife.•Dividend payout ratio = 100%•

5.4.1 Net Income ApproachAccordingtonetincomeapproachthefirmcanincreaseitsvalueorlowertheoverallcostofcapitalbyincreasingthe proportion of debt in the capital structure.

Assumptions of the Net Income (NI) ApproachTheuseofdebtdoesnotchangetheriskperceptionofinvestors;asaresult,theequitycapitalisationrate,Ke,•and the debt capitalisation rate Kd, remain constant with changes in leverage.The debt capitalisation rate is less than the equity capitalisation rate•The corporate income taxes do not exist.•


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Give below is the graphical representation of the net income approach:

Cost

Ke, Ko Ke,

KoKd

Debt

Kd.

Fig. 5.1 Net income approach

AccordingtoNIapproachboththecostofdebtandthecostofequityareindependentofthecapitalstructure;theyremainconstantregardlessofhowmuchdebtthefirmuses.Asaresult,theoverallcostofcapitaldeclinesandthefirmvalueincreaseswithdebt.Thisapproachhasnobasisinreality;theoptimumcapitalstructurewouldbe100percentdebtfinancingunderNIapproach.

For instance:AssumethatafirmhasanexpectedannualnetoperatingincomeofRs.200,000anequityrate,Ke,of10%andRs.10,00,000 of 6% debt.Solution:ThevalueofthefirmaccordingtoNetIncomeapproach:Net Operating Income NI = 2, 00,000Total cost of debt Interest = KdD (10, 00,000 X 0.6) = 60,000Net Income available to shareholders, NOI-I = Rs.1, 40,000

Therefore: Market Value of Equity (Rs. 140,000/.10) = 14, 00,000Market Value of debt D (Rs. 60,000/.06) = 10, 00,000Total = 24, 00,000The cost of equity and debt are respectively 10% and 6% and are assumed to constant under the Net income approach.Ko = NOI/V = 200,000/24, 00,000 = 0.0833 = 8.33%

5.4.2 Net Operating Income (NOI) ApproachInNetoperatingincomeapproachthemarketvalueofthefirmisnotaffectedbythechangeincapitalstructure,theweighed average cost of capital is said to be constant.

Assumptions of the Net Operating Income (NOI) ApproachThemarket capitalises the value of the firm as awhole.Thus, the split between debt and equity is not•importantThe market uses an overall capitalisation rate Ko to capitalise the net operating income. Ko depends on the •business risk. If the business risk is assumed to remain unchanged, Ko is a constant.The use of less costly debt funds increases the risk to shareholders. This causes the equity capitalisation rate •to increase.

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Give below is the graphical representation of the net operating income approach:

Cost

Ke, Ko Ke,

KoKd

Debt

Kd.

Fig. 5.2 Net operating income approach

AccordingtoNOIapproachthevalueofthefirmandtheweightedaveragecostofcapitalareindependentofthefirm’scapitalstructure.Intheabsenceoftaxes,anindividualholdingallthedebtandequitysecuritieswillreceivethesamecashflowsregardlessofthecapitalstructureandtherefore,valueofthecompanyisthesame.

For instance:AssumethatafirmannualnetoperatingincomeofRs.2,00,000anaveragecostofcapitalKo,of10%andintialdebt of Rs. 10,00,000 at 6%.Solution: Net operating Income = 2,00,000Therefore,Marketvalueoffirm,V=S+D=2,00,000/0.10=20,00,000Market value of the debt, D = 10,00,000Market value of the equity S= V-D = 10,00,000Ko = NOI/V = 200,000/0.10 = 20,00,000Here, Ke is not constant as that in NI approach. It is computed using the formula:Ke = Ko + (Ko-Kd)D/S= 0.10 + (0.10+0.06)10,00,000/10,00,000= 0.10 + 0.04(1) = 0.14To verify that the weighted average cost of capital is a constant:Ko = Kd(D/V) + Ke(S/V)= 0.06(10, 00,000/20, 00,000) + 0.14(10, 00,000/20, 00,000)= 0.06(0.50) + 0.14(0.5)= 0.03 + 0.07 = 0.10

5.4.3 Traditional ApproachThis is also known as intermediate approach. It is a compromise between the NI and NOI approach. According to thisviewthevalueofthefirmcanbeincreasedorthecostofthecapitalcanbereducedbyajudiciousmixofdentand equity capital.

This approach implies that the cost of capital decreases within the reasonable limit of debt and then increases with the leverage.

This approach has the following propositions as shown in the Fig. below:


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Ke,

KoKdCost

Debt

Fig. 5.3 Traditional approach

kd remains constant until a certain degree of leverage and thereafter rises at an increasing rate•ke remains constant or rises gradually until a certain degree of leverage and thereafter rises very sharply•as a sequence to the above 2 propositions, ko decreases till a certain level, remains constant for moderate •increases in leverage and rises beyond a certain point

5.4.4 Miller and Modigliani ApproachMiller and Modigliani criticise that the cost of equity remains unaffected by leverage up to a reasonable limit and Ko being constant at all degrees of leverage. The assumptions for their analysis are:Perfect Capital MarketsSecurities can be freely traded, there are no hindrances on the borrowing, no presence of transaction costs, securities infinitelydivisible,availabilityofallrequiredinformationatalltimes.

Investors Behave RationallyThey choose that combination of risk and return that is most advantageous to them

Homogeneityof investors risk perception, that is, all investors have the same perception of business risk and returns.

TaxesThere is no corporate or personal income tax

Dividend pay-out is 100%thatis,thefirmsdonotretainearningsforfutureactivities.

Following three propositions can be derived based on the above assumptions:Proposition I: Themarketvalueof thefirmisequal to the totalmarketvalueofequityandtotalmarketvalueofdebtandisindependent of the degree of leverage. Proposition IIThe expected yield on equity is equal to discount rate (capitalisation rate) applicable plus a premium.

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Proposition IIITheaveragecostofcapitalisnotaffectedbythefinancingdecisionsasinvestmentandfinancingdecisionsareindependent.

Criticism of MM PropositionsRisk perceptionThe assumption that risks are similar is wrong and the risk perceptions of investors are personal and corporate leverage is different.

Convenience: Investorsfindpersonalleverageinconvenient.

Transaction Costs: Due to presence of such costs in buying and selling securities, it is necessary to invest a higher amount to earn the same amount of return.

Taxes: When personal taxes are considered along with corporate taxes, the Miller and Modigliani approach fails the fails toexplainthefinancingdecisionandfirm'svalue.

5.5 LeveragesFinancial decision is oneof the integral and important parts offinancialmanagement in anykindof businessconcern.Asoundfinancialdecisionmustconsidertheboardcoverageofthefinancialmix(CapitalStructure),totalamountofcapital(capitalisation)andcostofcapital(Ko).Capitalstructureisoneofthesignificantthingsforthemanagement,sinceitinfluencesthedebtequitymixofthebusinessconcern,whichaffectstheshareholder’sreturnand risk. Hence, deciding the debt-equity mix plays a major role in the part of the value of the company and market value of the shares. The debt equity mix of the company can be examined with the help of leverage. The concept of leverage is discussed in this part. Types and effects of leverage is discussed in the part of EBIT and EPS.

Meaning of leverageThe term leverage refers to an increased means of accomplishing some purpose. Leverage is used to lifting heavy objects,whichmaynotbeotherwisepossible.Inthefinancialpointofview,leveragereferstofurnishtheabilitytousefixedcostassetsorfundstoincreasethereturntoitsshareholders.

Definition of leverageJamesHornehasdefinedleverageas,“theemploymentofanassetorfundforwhichthefirmpaysafixedcostorfixedreturn.TypesofLeverageLeveragecanbeclassifiedintothreemajorheadingsaccordingtothenatureofthefinancemixofthecompany.

Types of LeveragesOperating leverage•Financial leverage•

5.5.1 Operating LeverageOperating leverage is present any time in afirmwhen it hasoperating (fixed) costs regardlessof the level ofproduction.Itcanbedefinedas"Thefirm'sabilitytouseoperatingcoststomagnifytheeffectsofchangesinsaleson its earnings before interest and taxes. The operating costs are categorised into three:

Fixed Costs: which do not vary with the level of production they must be paid regardless of the amount of •revenue availableVariable Costs: raw materials, direct labor, costs and so on that varies directly with the level of production•Semi-variableCost:whichpartlyvaryandpartlyfixed•


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Thedegreeofoperatingleveragemaybedefinedasthechangeinthepercentageofoperatingincome(EBIT),fora given change in % of sales revenue.

When the data is given for one year, then we have to compute operating leverage, by the following formula:

For instance: From the following particulars of ABC Ltd., calculate degree of operating leverage.

Particulars Previous Year 2009 Current Year 2010

Sales revenue 10,00,000 12,50,000

Variable cost 6,00,000 7,50,000

Fixed cost 2,50,000 2,50,000

Solution: Calculation of EBIT on a percentage change

Particulars 2009 2010 % changeSales Revenue

Less: Variable costContributionLess:fixedcost

EBIT

10,00,0006,00,000

12,50,0007,50,000

252525

66.674,00,0002,50,000

5,00,0002,50,000

1,50,000 2,50,000

Operating leverage 2.667 indicates that when there is 25% change in sales, the change in EBIT is 2.66 times.

Application of operating leverageItishelpfultoknowhowoperatingprofitwouldchangewithagivenchangeinunitsproduced.•It will be helpful in measuring business risk.•

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5.5.2 Financial LeverageFinancial manager job is to raise funds for long-term activities with different composition of sources. The required fundsmayberaisedbytwosources:equityanddebt.Theuseoffixedchargesourcesoffundssuchasdebtandpreferencesharecapitalalongwiththeequitysharecapitalincapitalstructureisdescribedasfinancialleverage.AccordingtoLawrence,financialleverageis"theabilityofthefirmtousefixedinterestbearingsecuritiestomagnifythe rate of return as equity shares". It is also known as "trading as equity".

Formulaforcalculatingfinancialleverageisgivenbelow:

OR

For instance Afirmhassalesof1,00,000unitsatRs.10/unit.Variablecostoftheproducedproductsis60%ofthetotalsalesrevenue.FixedcostidRs.2,00,000.ThefirmhasusedadebtofRs.5,00,000at20%interest.Calculatetheoperatingleverageandfinancialleverage.

Solution: Calculation of EBT

Particulars Amount (Rs.)Sales Revenue (1,00,000 units X Rs.10/unit) 10,00,000

6,00,000

Less: Variable cost (10,00,000 X 0.60) 4,00,0002,00,000

Contribution 2,00,0001,00,000

Less: Fixed cost 1,00,000EBITLess: Interest (5,00,000 X 20/100)Earning Before Tax (EBT)

Operating Leverage = Contribution ÷ EBIT = 4, 00,000 ÷ 2, 00,000 = 2timesFinancial Leverage = EBIT÷EBT = 2, 00,000 ÷ 1, 00,000 = 2 times

Application of financial leverageItishelpfultoknowhowEPSwouldchangewithachangeinoperatingprofit.•Itishelpfulformeasuringfinancialrisk.•

5.5.3 Combined LeverageThe operating leverage has its effects on operating risk and is measured by the % change in EBIT due to the % changeinsales.Thefinancingleveragehasitseffectsonfinancialriskandismeasuredbythe%changeinEPSduetothe%changeinEBIT.Since,boththeseleveragesarecloselyrelatedwiththeascertainmentofthefirm'sabilitytocoverfixedcharges,thesumofthemgivesusthetotalleverageorcombinedleverageandtheriskassociatedwith combined leverage is known as total risk.


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Thedegreeofcombinedleveragemaybedefinedas the%changeinEPSdue to the%changeinsales.Thuscombined leverage is:

For instance: ABCcorporationhassalesofRs.40lakhs,variablecost70%ofthesalesandfixedcostisRs.8,00,000.ThefirmhasraisedRs.20lakhsfundsbyissueofdebenturesattherateof10%.Computeoperating,financialandcombinedleverages.

Solution: Calculation of EBT or PBT

Particulars Amount (Rs.)

Sales revenue 40,00,00028,00,000Less: Variable cost (40,00,000 X 0.70)

Contribution 12,00,0008,00,000Less: Fixed Cost

EBIT 4,00,0002,00,000

Less: interest (20,00,000 X 0.10)

EBT 2,00,000

Operating leverage = Contribution ÷ EBIT = 12, 00,000 ÷ 4, 00,000 = 3 timesFinancial leverage = EBIT ÷ EBT = 4, 00,000 ÷ 2, 00,000 = 2 timesCombined leverage = OL x FL = 3x2 = 6 times

The combined leverage can work in both directions. It is favorable if sales increase and unfavorable when sales decrease.

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SummaryCapital is the major part of all kinds of business activities, which are decided by the size, and nature of the •business concern.Thetermcapitalstructurereferstotherelationshipbetweenthevariouslong-termsourcefinancingsuchas•equity capital, preference share capital and debt capital.Optimum capital structure is the capital structure at which the weighted average cost of capital is minimum and •therebythevalueofthefirmismaximum.Optimumcapitalstructuremaybedefinedasthecapitalstructureorcombinationofdebtandequity,thatleads•tothemaximumvalueofthefirmThe capital structure should be determined keeping in mind the objective of wealth maximisation.•Construction of optimum capital structure is possible only when there is a appropriate mix of debt and equity.•Equityanddebtarethetwoimportantsourcesoflong-termsourcesoffinanceofafirm.•Inthefinancialpointofview,leveragereferstofurnishtheabilitytousefixedcostassetsorfundstoincrease•the return to its shareholders.

ReferencesParamasivan, C. & Subramanian, T., 2009. • Financial Management. New Age International.Khan, M. Y.., 2004. • Financial Management: Text, Problems And Cases, 2nd ed., Tata McGraw-Hill Education.Capital Structure and Leverage,• [Pdf] Available at: <http://faculty.unlv.edu/msullivan/FIN301%20-%20Chpts%2013%20and%2014%20-%20Capital%20Structure%20and%20Dividends-%20classnotes.pdf>[Accessed 29 May 2013].Capital Structure and Leverage• ,[Pdf]Availableat:<http://www.csun.edu/~dm59084/FIN303/Ch%2013.pdf>[Accessed 29 May 2013].2011. • Capital Structure class I,[Videoonline]Availableat:<http://www.youtube.com/watch?v=lqHuYKGByIQ>[Accessed 29 May 2013].2011. • Capital Structure class II,[Videoonline]Availableat:<http://www.youtube.com/watch?v=6vtuNgGxbso>[Accessed 29 May 2013].

Recommended ReadingBrigham,E. F., 2003.• Fundamentals of Financial Management. 10th ed., South-Western College Pub.Brigham, E. F. & Ehrhardt, M. C., 2008. • Financial management: theory and practice, 12th ed., Cengage Learning.Gitman, 2007. • Principles Of Managerial Finance, 11th ed., Pearson Education India.


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Self Assessment

Optimumcapitalstructuremaybedefinedasthecapitalstructureorcombinationofdebtand__________,that1. leadstothemaximumvalueofthefirm.

liabilitiesa. assetsb. equityc. costd.

Contribution is equal to sales minus _________ cost.2. fixeda. variableb. operatingc. semi-variabled.

Which of the following statements is false?3. Optimumcapitalstructuremaybedefinedasthecapitalstructureorcombinationofdebtandequity,thata. leadstothemaximumvalueofthefirm.Use debt to any extent to maximise EPS.b. Financialleverageismultipliedbyfinancialleveragetogetcombinedleverage.c. Financial leverage is also known as trading on equity.d.

S-V-EBIT =?4. Variable costa. Fixed costb. Operating costc. Profitd.

The use of leverage is essential to maximise ____________.5. profita. lossb. earningsc. contributiond.

Total assets – Current liabilities =?6. Optimal capital structurea. Financial leverageb. Operating leveragec. Capital structured.

_________ofoperatingleverageandhighdegreeoffinancialleverageisidealsituation7. Low degreea. High degreeb. Medium degreec. Optimum degreed.

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Financial leverage is also known as __________.8. indifference pointa. trading on equityb. combined leveragec. capital structured.

Increaseduseofdebt______thefinancialriskofequityshareholders.9. increasesa. decreasesb. constantc. reducesd.

Contribution is divided by EBIT to get ________ leverage10. financiala. operatingb. combinedc. fixedd.


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Chapter VI

Capital Budgeting

Aim


introduce the term capital budgeting•

explicate the methods for evaluating the capital investment proposals•

elucidateprofitabilityindexmethodanditsruleofacceptance•

Objectives

The objectives of this chapter are to:

explain the formula for reciprocal pay-back period•

explicate principles or factors of capital budgeting decisions•

definecapitalbudgeting•

Learning outcome


distinguishbetweentraditionalmethodsanddiscountedcashflowmethod•

understand importance of capital budgeting •

identify capital budgeting process•

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6.1 IntroductionThe term Capital Budgeting refers to the long-term planning for proposed capital outlays or expenditure for the purpose of maximising return on investments. The capital expenditure may be:

Cost of mechanization, automation and replacement.•Costofacquisitionoffixedassets,e.g.,land,buildingandmachineryetc.•Investment on research and development.•Cost of development and expansion of existing and new projects.•

6.2 Definition of Capital BudgetingCapitalBudgetisalsoknownas“InvestmentDecisionMakingorCapitalExpenditureDecisions”or“PlanningCapitalExpenditure”etc.Normallysuchdecisionswhereinvestmentofmoneyandexpectedbenefitsarisingtherefrom are spread over more than one year, it includes both rising of long-term funds as well as their utilisation. CharlesT.Horngnenhasdefinedcapitalbudgetingas“CapitalBudgetingislongtermplanningformakingandfinancingproposedcapitaloutlays.”

Inotherwords,capitalbudgetingisthedecisionmakingprocessbywhichafirmevaluatesthepurchaseofmajorfixedassetsincludingbuilding,machineryandequipment.AccordingtoHamption,John.J.,“Capitalbudgetingisconcernedwiththefirm’sformalprocessfortheacquisitionandinvestmentofcapital.”Fromtheabovedefinitions,it may be concluded that capital budgeting relates to the evaluation of several alternative capital projects for the purpose of assessing those which have the highest rate of return on investment.

6.3 Importance of Capital BudgetingCapital budgeting is important because of the following reasons:

Capitalbudgetingdecisionsinvolvelong-termimplicationforthefirm,andinfluenceitsriskcomplexion.•Capital budgeting involves commitment of large amount of funds.•Capital decisions are required to assessment of future events which are uncertain.•Wrongsaleforecast;mayleadtooverorunderinvestmentofresources.•Inmostcases,capitalbudgetingdecisionsareirreversible.Thisisbecauseitisverydifficulttofindamarket•for the capital goods. The only alternative available is to scrap the asset, and incur heavy loss.Capitalbudgetingensurestheselectionofrightsourceoffinanceattherighttime.•Manyfirmsfail,becausetheyhavetoomuchortoolittlecapitalequipment.•Investment decision taken by individual concern is of national importance because it determines employment, •economic activities and economic growth.

6.4 Objectives of Capital BudgetingThe following are the important objectives of capital budgeting:

Toensuretheselectionofthepossibleprofitablecapitalprojects.•Toensuretheeffectivecontrolofcapitalexpenditureinordertoachievebyforecastingthelong-termfinancial•requirements.Tomakeestimationofcapitalexpenditureduringthebudgetperiodandtoseethatthebenefitsandcostsmay•bemeasuredintermsofcashflow.Determining the required quantum takes place as per authorisation and sanctions.•To facilitate co-ordination of inter-departmental project funds among the competing capital projects.•Toensuremaximisationofprofitbyallocatingtheavailableinvestible.•


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6.5 Principles or Factors of Capital Budgeting DecisionsA decision regarding investment or a capital budgeting decision involves the following principles or factors:

A careful estimate of the amount to be invested.•Creativesearchforprofitableopportunities.•Careful estimates of revenues to be earned and costs to be incurred in future in respect of the project under •consideration.Alistingandconsiderationofnon-monetaryfactorsinfluencingthedecisions.•Evaluation of various proposals in order of priority having regard to the amount available for investment.•Proposals should be controlled in order to avoid costly delays and cost over-runs.•Evaluation of actual results achieved against those budget.•Care should be taken to think all the implication of long range capital investment and working capital •requirements.Itshouldrecognisethefactthatbiggerbenefitsarepreferabletosmalleronesandearlybenefitsarepreferable•tolatterbenefits

6.6 Capital Budgeting ProcessThe following procedure may be considered in the process of capital budgeting decisions:

Identificationofprofitableinvestmentproposals•Screening and selection of right proposals•Evaluationofmeasuresofinvestmentworthonthebasisofprofitabilityanduncertaintyorrisk•Establishingpriorities,i.e.,uneconomicalorunprofitableproposalsmayberejected.•Final approval and preparation of capital expenditure budget•Implementing proposal, i.e., project execution•Review the performance of projects•

6.7 Types of Capital ExpenditureCapital Expenditure can be of two types:

Capital expenditure increases revenue•Capital expenditure reduces costs•

CapitalExpenditure IncreasesRevenue: It is the expenditurewhichbringsmore revenue to thefirmeitherbyexpanding the existing production facilities or development of new production line.

Capital Expenditure Reduces Costs: Such a capital expenditure reduces the cost of present product and thereby increasestheprofitabilityofexistingoperations.Itcanbedonebyreplacementofoldmachinebyanewone.

6.8 Types of Capital Budgeting ProposalsAfirmmayhaveseveralinvestmentproposalsforitsconsideration.Itmayadoptafterconsideringthemeritsanddemeritsofeachoneofthem.Forthispurposecapitalexpenditureproposalsmaybeclassifiedinto:

Independent Proposals•Dependent Proposals or Contingent Proposals•Mutually Exclusive Proposals•

Independent Proposals: These proposals are said be to economically independent which are accepted or rejected on the basis of minimum return on investment required. Independent proposals do not depend upon each other.

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Dependent Proposals or Contingent Proposals: In this case, when the acceptance of one proposal is contingent upon theacceptanceofotherproposals,itiscalledas“DependentorContingentProposals.”Forexample;constructionof new building on account of installation of new plant and machinery describes it.

Mutually Exclusive Proposals: Mutually Exclusive Proposals refer to the acceptance of one proposal results in the automatic rejection of the other proposal. Then the two investments are mutually exclusive. In other words, one can be rejectedandtheothercanbeaccepted.Itiseasierforafirmtotakecapitalbudgetingdecisionsonsuchprojects.

6.9 Methods of Evaluating Capital Investment ProposalsThere are number of appraisal methods which may be recommended for evaluating the capital investment proposals. We shall discuss the most widely accepted methods. These methods can be grouped into the following categories:

Traditional MethodsTraditional methods are grouped in to the following:

Pay-back period method or Payout method•Improvement of Traditional Approach to Pay-back Period Method•

PostPay-backprofitabilityMethod �Discounted Pay-back Period Method �Reciprocal Pay-back Period Method �

Rate of Return Method or Accounting Rate of Return Method•

Time Adjusted Method or Discounted Cash Flow MethodTimeAdjustedMethodfurtherclassifiedinto:

Net Present Value Method•Internal Rate of Return Method•ProfitabilityIndexMethod•

6.9.1 Traditional MethodsPay-backPeriodMethod:Pay-backperiodisalsotermedas“Pay-outperiod”orPay-offperiod.PayoutPeriodMethod is one of the most popular and widely recognised traditional methods of evaluating investment proposals. Itisdefinedasthenumberofyearsrequiredtorecovertheinitialinvestmentinfullwiththehelpofthestreamofannualcashflowsgeneratedbytheproject.CalculationofPay-backPeriod:Pay-backperiodcanbecalculatedintothe following two different situations:

Inthecaseofconstantannualcashinflows.•Inthecaseofunevenorunequalcashinflows.•

Inthecaseofconstantannualcashinflows:IftheprojectgeneratesconstantcashflowthePay-backperiodcanbecomputedbydividingcashoutlays(originalinvestment)byannualcashinflows.Thefollowingformulacanbeused to ascertain pay-back period:

Pay-back Period =

Example 1:AprojectrequiresinitialinvestmentofRs.40,000anditwillgenerateanannualcashinflowofRs.10,000for6years.Youarerequiredtofindoutpay-backperiod.


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Solution:Calculation of Pay-back period:

Pay-back Period =

=

= 4 years

Pay-back period is 4 years, i.e., the investment is fully recovered in 4 years.

Example 2: In the case of Uneven or Unequal Cash InflowsInthecaseofunevenorunequalcashinflows,thePay-backperiodisdeterminedwiththehelpofcumulativecashinflow.Itcanbecalculatedbyaddingupthecashinflowsuntilthetotalisequaltotheinitialinvestment.

From the following information you are required to calculate pay-back period:AprojectrequiresinitialinvestmentofRs.40,000andgeneratescashinflowsofRs.16,000,Rs.14,000,Rs.8,000andRs.6,000inthefirst,second,third,andfourthyearrespectively.

Solution:CalculationPay-backPeriodwiththehelpof“CumulativeCashInflows”

Year Annual Cash InflowsRs.

Cumulative Cash InflowsRs.

1 16,000 16,0002 14,000 30.0003 8,000 38,0004 6,000 44,000

Theabovetableshowsthatattheendof4thyearsthecumulativecashinflowsexceedstheinvestmentofRs.40.000.Thus the pay-back period is as follows:

Pay-back Period = 3 Years+

= 3 Years+

= 3.33 Years

Accept or Reject CriterionInvestmentdecisionsbasedonpay-backperiodareusedbymanyfirmstoacceptorrejectaninvestmentproposal.Among the mutually exclusive or alternative projects whose pay-back periods are lower than the cut off period, the project would be accepted, if not it would be rejected.

Advantages of Pay-back Period MethodIt is an important guide to investment policy.•It is simple to understand and easy to calculate.•Itfacilitatestodeterm.inetheliquidityandsolvencyofafirm.•Ithelpstomeasuretheprofitableinternalinvestmentopportunities.•Itenablesthefirmtoselectaninvestmentwhichyieldsaquickreturnoncashfunds.•

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It used as a method of ranking competitive projects.•It ensures reduction of cost of capital expenditure.•

Disadvantages or Pay-back Period MethodItdoesnotmeasuretheprofitabilityofaproject•It does not value projects of different economic lives•This method does not consider income beyond the pay-back period•Itdoesnotgiveproperweighttotimingofcashflows•Itdoesnotindicatehowtomaximisevalueandignorestherelativeprofitabilityoftheproject•It does not consider cost of capital and interest factor which are very important factors in taking sound investment •decisions.

6.9.2 Improvement of Traditional Approach to Pay-back PeriodThe demerits of the pay-back period method may be eliminated in the following ways:(a) Post Pay-back Profitability MethodOne of the limitations of the pay-back period method is that it ignores the post pay-back returns of project. To rectify thedefect,postpay-backperiodmethodconsiderstheamountofprofitsearnedafterthepay-backperiod.ThismethodisalsoknownasSurplusLifeoverPaybackMethod.Accordingtothismethod,pay-backprofitabilityiscalculatedbyannualcashinflowsineachoftheyear,afterthepay-backperiod.Thiscanbeexpressedinpercentageof investment.

PostPay-backProfitability=AnnualCashInflowx(EstimatedLife-Pay-backPeriod)

Thepostpay-backprofitabilityindexcanbedeterminedbythefollowingequation:

PostPay-backProfitabilityIndex=

(b) Discounted Pay-back MethodThis method is designed to overcome the limitation of the payback period method. When savings are not leveled, it isbettertocalculatethepay-backperiodbytakingintoconsiderationthepresentvalueofcashinflows.Discountedpay-backmethodhelpstomeasurethepresentvalueofallcashinflowsandoutflowsatanappropriatediscountrate.Thetimeperiodatwhichthecumulatedpresentvalueofcashinflowsequalsthepresentvalueofcashoutflowsisknown as discounted pay-back period.

(c) Reciprocal Pay-back Period MethodThis methods helps to measure the expected rate of return of income generated by a project Reciprocal pay-back period method is a close approximation of the Time Adjusted Rate of Return, if the earnings are leveled and the estimated life of the project is somewhat more than twice the pay-back period. This can be calculated by the following formula:

Reciprocal Pay-back Period =

Example 3:The company is considering investment of Rs. 1, 00,000 in a project. The following are the income forecasts, after depreciation and tax, 1st year Rs. l 0,000, 2nd year Rs. 40.000, 3rd year Rs. 60,000, 4th year Rs. 20,000 and 5th year Rs. Nil. From the above information you are required to calculate: (1) Pay-back Period (2) Discounted Pay-back Period at 10% interest factor.

Solution:(1) Calculation of Pay-back Period


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Year Annual Cash InflowsRs.

Cumulative Cash InflowsRs.

1 10,000 10,0002 40,000 50,0003 60.000 1,10,0004 20,000 1,30.0005 -- 1,30,000

Theabovetableshowsthatattheendof3rdyeartheCumulativeCashInflowsexceedstheinvestmentofRs.1,00,000. Thus the Pay-back Period is as follows:

Pay-back Period = 2 Years +

= 2 Years +

= 2 Years + 0.833 = 2.833 Years

(2) Calculation of Discounted Pay-back Period 10% Interest Rate

Year

1

CashInflows

2

Discontinuing Pres-ent Value

Factor at 10%3

Present Value of CashInflows

(Z x3)4

Rs.

Cumulative Value ofCashInflows

Rs.

1 10,000 0.9091 9,091 9.0912 40,000 0.8265 33,060 42,1513 60,000 0.7513 45,078 87,2294 20,000 0.6830 13,660 1,00,8895 -- 0.6209 -- 1,00,889

From the above table, it is observed that up to the 4th year Rs. 1, 00,000 is recovered. Because the Discounting CumulativeCashInflowsexceedstheoriginalcashoutlaysofRs.1,00,000.ThustheDiscountedPay-backPeriodis calculated as follows:

Pay-back Period = 3 Years +

= 3 Years+

= 3 Years + 0.935 == 3.935 Years

6.9.3 Average Rate of Return Method (ARR) or Accounting Rate of Return MethodAverage Rate of Return Method is also termed as Accounting Rate of Return Method. This method focuses on the average net income generated in a project in relation to the project’s average investment outlay. This method involves accountingprofitsnotcashflowsandissimilartothepe1formancemeasureofreturnoncapitalemployed.

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The average rate of return can be determined by the following equation:

Average Rate of Return (ARR) =

=

=

Where,Average investment would be equal to the Original investment plus salvage value divided by 2.

Average Investment = (or)

=

AdvantagesIt considers all the years involved in the life of a project rather than only pay-back years•Itappliesaccountingprofitasacriterionofmeasurementandnotcashflow•

DisadvantagesItappliesprofitasameasureofyardsticknotcashflow•The time value of money is ignored in this method•Yearlyprofitdeterminationmaybeadifficulttask•

6.9.4 Discounted Cash Flow Method (or) Time Adjusted MethodDiscountcashflowisamethodofcapitalinvestmentappraisalwhichtakesintoaccountboththeoverallprofitabilityofprojectsandalsothetimingofreturn.Discountedcashflowmethodhelpstomeasurethecashinflowandoutflowof a project as if they occurred at a single point in time so that they can be compared in an appropriate way. This method recognises that the use of money has a cost, i.e., interest foregone. In this method risk can be incorporated into Discounted Cash Flow computations by adjusting the discount rate or cut off rate.

DisadvantagesThe following are some of the limitations of Discounted Pay-back Period Method:

Theremaybedifficultyinaccuratelyestablishingratesofinterestoverthecashflowperiod.•Lack of adequate expertise in order to properly apply the techniques and interpret results.•Thesetechniquesarebasedoncashflows,whereasreportedearningsarebasedonprofits.•

TheinclusionofDiscountedCashFlowAnalysismaycauseprojectedearningstofluctuateconsiderablyandthushave an adverse on share prices.

6.9.5 Net Present Value Method (NPV)This is one of the Discounted Cash Flow techniques which explicitly recognise the time value of money. In this methodallcashinflowsandoutflowsareconvertedintopresentvalue(i.e.,valueatthepresenttime)applyinganappropriate rate of interest (usually cost of capital).

Inotherwords,NetPresentValueMethoddiscountinflowsandoutflowstotheirpresentvalueattheappropriatecostofcapitalandsetthepresentvalueofcashinflowagainstthepresentvalueofoutflowtocalculateNetPresentValue.Thus,theNetPresentValueisobtainedbysubtractingthepresentvalueofcashoutflowsfromthepresentvalueofcashinflows.


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Advantages of Net Present Value MethodItrecognisesthetimevalueofmoneyandisthusscientificinitsapproach.•Allthecashflowsspreadovertheentirelifeoftheprojectareusedforcalculations.•It is consistent with the objectives of maximising the welfare of the owners as it depicts the positive or otherwise •present value of the proposals.

DisadvantagesThismethodiscomparativelydifficulttounderstandoruse.•When the projects in consideration involve different amounts of investment, the Net Present Value Method •may not give satisfactory results.

6.9.6 Internal Rate of Return Method (IRR)InternalRateofReturnMethodisalsocalledas“TimeAdjustedRateofReturnMethod.”Itisdefinedastheratewhichequatesthepresentvalueofeachcashinflowswiththepresentvalueofcashoutflowsofaninvestment.Inother words, it is the rate at which the net present value of the investment is zero.

HorngrenandFosterdefineInternalRateofReturnastherateofinterestatwhichthepresentvalueofexpectedcashinflowsfromaprojectequalsthepresentvalueofexpectedcashoutflowsoftheproject.TheInternalRateofReturncanbefoundoutbyTrialandErrorMethod.First,computethepresentvalueofthecashflowfromaninvestment, using an arbitrarily selected interest rate, for example 10%. Then compare the present value so obtained with the investment cost.

If the present value is higher than the cost of capital, try a higher interest rate and go through the procedure again. Ontheotherhandifthecalculatedpresentvalueoftheexpectedcashinflowsislowerthanthepresentvalueofcashoutflowsalowerrateshouldbetried.ThisprocesswillberepeateduntilandunlesstheNetPresentValuebecomeszero.TheinterestratethatbringsaboutthisequalityisdefinedastheInternalRateofReturn.

Alternatively,theinternalratecanbeobtainedbyInterpolationMethodwhenwecomeacrosstworates;onewithpositive net present value and other with negative net present value. The IRR is considered as the highest rate of interestwhichabusinessisabletopayonthefundsborrowedtofinancetheprojectoutofcashinflowsgeneratedby the project. The Interpolation formula can be used to measure the Internal Rate of Return as follows:

Lower Interest Rate + × (higher rate – lower rate)

EvaluationApopulardiscountedcashflowmethod,theinternalrateofreturncriterionhasseveralvirtues:

It takes into account the time value of money.•Itconsidersthecashflowsovertheentirelifeoftheproject.•Itmakesmoremeaningfulandacceptabletousersbecauseitsatisfiesthemintermsoftherateofreturnon•capital.

LimitationsTheinternalrateofreturnmaynotbeuniquelydefined.•TheIRRisdifficulttounderstandandinvolvescomplicatedcomputationalproblems.•Theinternalrateofreturnfigurecannotdistinguishbetweenlendingandborrowingsandhencehighinternal•rate of return need not necessarily be a desirable feature.

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6.9.7 Profitability Index MethodProfitabilityIndexisalsoknownasBenefitCostRatio.Itgivesthepresentvalueoffuturebenefits,computedattherequiredrateofreturnontheinitialinvestment.ProfitabilityIndexmayeitherbeGrossProfitabilityIndexorNetProfitabilityIndex.NetProfitabilityIndexistheGrossProfitabilityIndexminusone.TheProfitabilityIndexcanbe calculated by the following equation:

ProfitabilityIndex=

Rule of AcceptanceAspertheBenefitCostRatioorProfitabilityIndexaprojectwithProfitabilityIndexgreaterthanoneshouldbeacceptedasitwillhavePositiveNetPresentValue.LikewiseifProfitabilityIndexislessthanonetheprojectisnotbeneficialandshouldnotbeaccepted.

AdvantagesofProfitabilityIndex:It duly recognises the time value of money.•For calculations when compared with internal rate of return method it requires less time.•It helps in ranking the project for investment decisions.•Asthismethodiscapableofcalculatingincrementalbenefitcostratio,itcanbeusedtochoosebetweenmutually•exclusive projects.


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SummaryThe term Capital Budgeting refers to the long-term planning for proposed capital outlays or expenditure for the •purpose of maximising return on investments.CapitalBudgetisalsoknownas“InvestmentDecisionMakingorCapitalExpenditureDecisions”or“Planning•CapitalExpenditure”etc.According toHamption, John. J., “Capital budgeting is concernedwith thefirm’s formal process for the•acquisitionandinvestmentofcapital.”Capitalbudgetingdecisionsinvolvelong-termimplicationforthefirm,andinfluenceitsriskcomplexion.•Investment decision taken by individual concern is of national importance because it determines employment, •economic activities and economic growth.CapitalExpenditureIncreasesRevenueis theexpenditurewhichbringsmorerevenueto thefirmeitherby•expanding the existing production facilities or development of new production line.Afirmmayhaveseveralinvestmentproposalsforitsconsideration.•There are number of appraisal methods which may be recommended for evaluating the capital investment •proposals.Pay-backperiodisalsotermedas“Pay-outperiod”orPay-offperiod.•One of the limitations of the pay-back period method is that it ignores the post pay-back returns of project.•Discountedpay-backmethodhelpstomeasurethepresentvalueofallcashinflowsandoutflowsatanappropriate•discount rate.Average Rate of Return Method is also termed as Accounting Rate of Return Method.•Discount cashflow is amethodof capital investment appraisalwhich takes into account both the overall•profitabilityofprojectsandalsothetimingofreturn.NetPresentValueisobtainedbysubtractingthepresentvalueofcashoutflowsfromthepresentvalueofcash•inflows.InternalRateofReturnMethodisalsocalledas“TimeAdjustedRateofReturnMethod.•HorngrenandFosterdefineInternalRateofReturnastherateofinterestatwhichthepresentvalueofexpected•cashinflowsfromaprojectequalsthepresentvalueofexpectedcashoutflowsoftheproject.ProfitabilityIndexisalsoknownasBenefitCostRatio.•AspertheBenefitCostRatioorProfitabilityIndexaprojectwithProfitabilityIndexgreaterthanoneshould•be accepted as it will have Positive Net Present Value.

ReferencePeterson, P. P. & Fabozzi, J. F., 2004. • Capital Budgeting: Theory and Practice, John Wiley & Sons.Periasamy, P., 2010. • A TEXTBOOK OF FINANCIAL COST AND MANAGEMENT ACCOUNTING, Global Media.WHAT IS CAPITAL BUDGETING?• [Pdf] Available at: <http://www2.sunysuffolk.edu/rosesr/ACC212/Lessons/CapitalBudget/CapitalBudgetingTraining.pdf>[Accessed16May2013].CHAPTER 29 Capital Budgeting• [Pdf] Available at: <http://mfile.narotama.ac.id/files/Accounting%20&%20Financial/A%20Textbook%20of%20Financial%20Cost%20&%20Management%20Accounting%20(Revised%20Edition)/Chapter%2029%20%20Capital%20Budgeting.pdf>[Accessed16May2013].Irfanullah, A., 2011. • CFA Level I Capital Budgeting Video Lecture by Mr. Arif Irfanullah part 2 [Video online] Availableat:<http://www.youtube.com/watch?v=qfzQwqLdXH0>[Accessed16May2013].Capital Budgeting• [Videoonline]Availableat:<http://www.youtube.com/watch?v=qGgVGUcBqAg>[Accessed16 May 2013].

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Recommended ReadingJacobs & Davina, F., 2006. • A Reviews of Capital Budgeting Practices, International Monetary Fund.Dayananda, D., 2002. • Capital Budgeting: Financial Appraisal of Investment Projects, 2nd ed. Cambridge University Press.Baker, K. H. & English, P., 2011. • Capital Budgeting Valuation: Financial Analysis for Today’s Investment Projects, John Wiley & Sons.


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Self Assessment

___________isconcernedwiththefirm’sformalprocessfortheacquisitionandinvestmentofcapital.1. Investmenta. Capital budgetingb. Capital expenditurec. Planningd.

Which of the following statements is false?2. Capital budgeting involves commitment of small amount of funds.a. Wrongsaleforecast;mayleadtooverorunderinvestmentofresources.b. Manyfirmsfail,becausetheyhavetoomuchortoolittlecapitalequipment.c. Capital decisions are required to assessment of future events which are uncertain.d.

____________ is the expenditurewhichbringsmore revenue to thefirmeither by expanding the existing3. production facilities or development of new production line.

Mutually Exclusive Proposalsa. Independent Proposalsb. Capital Expenditure Increases Revenuec. Capital Expenditure Reduces Costsd.

Whatreducesthecostofpresentproductandtherebyincreasestheprofitabilityofexistingoperations?4. Mutually Exclusive Proposalsa. Independent Proposalsb. Capital Expenditure Increases Revenuec. Capital Expenditure Reduces Costsd.

____________ refer to the acceptance of one proposal results in the automatic rejection of the other proposal.5. Mutually Exclusive Proposalsa. Dependent Proposalsb. Contingent Proposalsc. Independent Proposalsd.

Which proposals are said be to economically independent?6. Mutually Exclusive Proposalsa. Independent Proposalsb. Dependent Proposalsc. Contingent Proposalsd.

WhichofthefollowingformulacalculatesProfitabilityIndex?7.

Average Rate of Return (ARR) = a.

Lower Interest Rate + b. × (higher rate – lower rate)

Reciprocal Pay-back Period = c.

ProfitabilityIndex=d.

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____________isdefinedasthenumberofyearsrequiredtorecovertheinitialinvestmentinfullwiththehelp8. ofthestreamofannualcashflowsgeneratedbytheproject.

ProfitabilityIndexMethoda. Internal Rate of Return Methodb. Pay out Period Methodc. Net Present Value Methodd.

Iftheprojectgeneratesconstantcashflowthepay-backperiodcanbecomputedbydividing__________by9. annualcashinflows.

constantannualcashinflowsa. investment proposalsb. cashinflowsc. cash outlaysd.

____________isamethodofcapitalinvestmentappraisalwhichtakesintoaccountboththeoverallprofitability10. of projects and also the timing of return.

Discountcashflowa. Cashflowb. Net present value methodc. Internal rate of return methodd.

Unit-2

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