UNIT- V

CAPITAL

Introduction
Finance is the prerequisite to commence and vary on business. It is rightly said to be the lifeblood of the
business. No growth and expansion of business can take place without sufficient finance. It shows that no
business activity is possible without finance. This is why; every business has to make plans regarding
acquisition and utilization of funds.

However efficient a firm may be in terms of production as well as marketing if it ignores the proper
management of flow of funds it certainly lands in financial crunch and the very survival of the firm would be
at a stake.

Function of finance
According to B. O. Wheeler, Financial Management is concerned with the acquisition and utiliasation of
capital funds in meeting the financial needs and overall objectives of a business enterprise. Thus the primary
function of finance is to acquire capital funds and put them for proper utilization, with which the firm’s
objectives are fulfilled. The firm should be able to procure sufficient funds on reasonable terms and
conditions and should exercise proper control in applying them in order to earn a good rate of return, which
in turn allows the firm to reward the sources of funds reasonably, and leaves the firm with good surplus to
grow further. These activities viz. financing, investing and dividend payment are not sequential they are
performed simultaneously and continuously. Thus, the Financial Management can be broken down in to
three major decisions or functions of finance. They are: (i) the investment decision, (ii) the financing decision
and (iii) the dividend policy decision.

Investment Decision
The investment decision relates to the selection of assets in which funds will be invested by a firm. The
assets as per their duration of benefits can be categorized into two groups: (i) long-term assets which yield a
return over a period of time in future (ii) short-term or current assents which in the normal course of
business are convertible into cash usually within a year. Accordingly, the asset selection decision of a firm is
of two types. The investment in long-term assets is popularly known as capital budgeting and in short-term
assets, working capital management.

1. Capital budgeting: Capital budgeting – the long – term investment decision – is probably the most
crucial financial decision of a firm. It relates to the selection of an assent or investment proposal or
course of action that benefits are likely to be available in future over the lifetime of the project.
The long-term investment may relate to acquisition of new asset or replacement of old assets.
Whether an asset will be accepted or not will depend upon the relative benefits and returns associated
with it. The measurement of the worth of the investment proposals is, therefore, a major element in the
capital budgeting exercise. The second element of the capital budgeting decision is the analysis of risk
and uncertainty as the benefits from the investment proposals in the future, which is uncertain. They
have to be estimated under various assumptions and thus there is an element of risk involved in the

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 exercise. The return from the capital budgeting decision should, therefore, be evaluated in relation to
the risk associated with it.

The third and final element is the ascertainment of a certain norm or standard against which
the benefits are to be judged. The norm is known by different names such as cut-off rate, hurdle rate,
required rate, minimum rate of return and so on. This standard is broadly expressed in terms of the cost
of capital is, thus, another major aspect of the capital; budgeting decision. In brief, the main elements of
the capital budgeting decision are: (i) The total assets and their composition (ii) The business risk
complexion of the firm, and (iii) concept and measurement of the cost of capital.

2. Working Capital Management: Working capital management is concerned with the management of the
current assets. As we know, the short-term survival is a pre-requisite to long-term success. The major
thrust of working capital management is the trade-off between profitability and risk (liquidity), which
are inversely related to each other. If a firm does not have adequate working capital it may not have the
ability to meet its current obligations and thus invite the risk of bankrupt. One the other hand if the
current assets are too large the firm will be loosing the opportunity of making a good return and thus
may not serve the requirements of suppliers of funds. Thus, the profitability and liquidity are the two
major dimensions of working capital management. In addition, the individual current assets should be
efficiently managed so that neither inadequate nor unnecessary funds are locked up.
Finance Decision
The second major decision involved in financial management is the financing decision, which is concerned
with the financing – mix or capital structure of leverage. The term capital structure refers to the
combination of debt (fixed interest sources of financing) and equity capital (variable – dividend
securities/source of funds). The financing decision of a firm relates to the choice of the proportion of these
sources to finance the investment requirements. A higher proportion of debt implies a higher return to the
shareholders and also the higher financial risk and vice versa. A proper balance between debt and equity is a
must to ensure a trade – off between risk and return to the shareholders. A capital structure with a
reasonable proportion of debt and equity capital is called the optimum capital structure.

The second aspect of the financing decision is the determination of an appropriate capital structure, which
will result, is maximum return to the shareholders and in turn maximizes the worth of the firm. Thus, the
financing decision covers two inter-related aspects: (a) capital structure theory, and (b) capital structure
decision.

Dividend Policy decision

The third major decision of financial management is relating to dividend policy. The firm has two
alternatives with regard to management of profits of a firm. They can be either distributed to the
shareholder in the form of dividends or they can be retained in the business or even distribute some portion
and retain the remaining. The course of action to be followed is a significant element in the dividend
decision. The dividend pay out ratio i. e. the proportion of net profits to be paid out to the shareholders
should be in tune with the investment opportunities available within the firm. The second major aspect of
the dividend decision is the study of factors determining dividend policy of a firm in practice.

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 CAPITAL BUDGETING
Capital Budgeting: Capital budgeting is the process of making investment decision in long-term assets or courses
of action. Capital expenditure incurred today is expected to bring its benefits over a period of time. These
expenditures are related to the acquisition & improvement of fixes assets.

Capital budgeting is the planning of expenditure and the benefit, which spread over a number of years.
It is the process of deciding whether or not to invest in a particular project, as the investment possibilities may
not be rewarding. The manager has to choose a project, which gives a rate of return, which is more than the cost
of financing the project. For this the manager has to evaluate the worth of the projects in-terms of cost and
benefits. The benefits are the expected cash inflows from the project, which are discounted against a standard,
generally the cost of capital.

Capital Budgeting Process:

The capital budgeting process involves generation of investment, proposal estimation of cash-flows for the
proposals, evaluation of cash-flows, selection of projects based on acceptance criterion and finally the continues
revaluation of investment after their acceptance the steps involved in capital budgeting process are as follows.

1. Project generation
2. Project evaluation
3. Project selection
4. Project execution
1. Project generation: In the project generation, the company has to identify the proposal to be undertaken
depending upon its future plans of activity. After identification of the proposals they can be grouped according
to the following categories:

a. Replacement of equipment: In this case the existing outdated equipment and machinery may
be replaced by purchasing new and modern equipment.
b. Expansion: The Company can go for increasing additional capacity in the existing product line
by purchasing additional equipment.
c. Diversification: The Company can diversify its product line by way of producing various products
and entering into different markets. For this purpose, It has to acquire the fixed assets to enable
producing new products.
d. Research and Development: Where the company can go for installation of research and
development suing by incurring heavy expenditure with a view to innovate new methods of
production new products etc.,
2. Project evaluation: In involves two steps.

a. Estimation of benefits and costs: These must be measured in terms of cash flows. Benefits to be
received are measured in terms of cash flows. Benefits to be received are measured in terms of
cash in flows, and costs to be incurred are measured in terms of cash flows.
b. Selection of an appropriate criterion to judge the desirability of the project.

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3. Project selection: There is no standard administrative procedure for approving the investment decisions. The
screening and selection procedure would differ from firm to firm. Due to lot of importance of capital budgeting
decision, the final approval of the project may generally rest on the top management of the company. However
the proposals are scrutinized at multiple levels. Some times top management may delegate authority to approve
certain types of investment proposals. The top management may do so by limiting the amount of cash out lay.
Prescribing the selection criteria and holding the lower management levels accountable for the results.

4. Project Execution: In the project execution the top management or the project execution committee is
responsible for effective utilization of funds allocated for the projects. It must see that the funds are spent in
accordance with the appropriation made in the capital budgeting plan. The funds for the purpose of the project
execution must be spent only after obtaining the approval of the finance controller. Further to have an effective
cont. It is necessary to prepare monthly budget reports to show clearly the total amount appropriated, amount
spent and to amount unspent.

Capital budgeting Techniques:

The capital budgeting appraisal methods are techniques of evaluation of investment proposal will help the
company to decide upon the desirability of an investment proposal depending upon their; relative income
generating capacity and rank them in order of their desirability. These methods provide the company a set of
norms on the basis of which either it has to accept or reject the investment proposal. The most widely accepted
techniques used in estimating the cost-returns of investment projects can be grouped under two categories.

1. Traditional methods
2. Discounted Cash flow methods
1. Traditional methods

These methods are based on the principles to determine the desirability of an investment
project on the basis of its useful life and expected returns. These methods depend upon
the accounting information available from the books of accounts of the company. These
will not take into account the concept of ‘time value of money’, which is a significant factor
to determine the desirability of a project in terms of present value.

A. Pay-back period method: It is the most popular and widely recognized traditional method of evaluating the
investment proposals. It can be defined, as ‘the number of years required to recover the original cash out lay
invested in a project’.

According to Weston & Brigham, “The pay back period is the number of years it takes the firm to
recover its original investment by net returns before depreciation, but after taxes”.

According to James. C. Vanhorne, “The payback period is the number of years required to recover initial
cash investment.

The pay back period is also called payout or payoff period. This period is calculated by dividing the cost
of the project by the annual earnings after tax but before depreciation under this method the projects are
ranked on the basis of the length of the payback period. A project with the shortest payback period will be given

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the highest rank and taken as the best investment. The shorter the payback period, the less risky the investment
is the formula for payback period is

Cash outlay (or) original cost of project

Pay-back period = -------------------------------------------

Annual cash inflow

Merits:

1. It is one of the earliest methods of evaluating the investment projects.

2. It is simple to understand and to compute.

3. It dose not involve any cost for computation of the payback period
4. It is one of the widely used methods in small scale industry sector
5. It can be computed on the basis of accounting information available from the books.
Demerits:

1. This method fails to take into account the cash flows received by the
company after the pay back period.

2. It doesn’t take into account the interest factor involved in an investment

outlay.

3. It doesn’t take into account the interest factor involved in an investment

outlay.

4. It is not consistent with the objective of maximizing the market value of

the company’s share.

5. It fails to consider the pattern of cash inflows i. e., the magnitude and timing of cash in flows.

B. Accounting (or) Average rate of return method (ARR):

It is an accounting method, which uses the accounting information repeated by the financial statements
to measure the probability of an investment proposal. It can be determine by dividing the average income after
taxes by the average investment i.e., the average book value after depreciation.

According to ‘Soloman’, accounting rate of return on an investment can be calculated as the ratio of accounting
net income to the initial investment, i.e.,

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 Average net income after taxes

ARR= ----]--------------------------------- X 100

Average Investment

Total Income after Taxes

Average net income after taxes = -----------------------------

No. Of Years

Total Investment

Average investment = ----------------------

On the basis of this method, the company can select all those projects who’s ARR is higher than the minimum
rate established by the company. It can reject the projects with an ARR lower than the expected rate of return.
This method can also help the management to rank the proposal on the basis of ARR. A highest rank will be
given to a project with highest ARR, where as a lowest rank to a project with lowest ARR.

Merits:

It is very simple to understand and calculate.

1. It can be readily computed with the help of the available accounting data.
2. It uses the entire stream of earning to calculate the ARR.
Demerits:

1. It is not based on cash flows generated by a project.

2. This method does not consider the objective of wealth maximization
3. IT ignores the length of the projects useful life.
4. It does not take into account the fact that the profits can be re-invested.
II: Discounted cash flow methods:

The traditional method does not take into consideration the time value of money. They give equal weight age to
the present and future flow of incomes. The DCF methods are based on the concept that a rupee earned today is
more worth than a rupee earned tomorrow. These methods take into consideration the profitability and also
time value of money.

A. Net present value method (NPV)

The NPV takes into consideration the time value of money. The cash flows of different years and valued
differently and made comparable in terms of present values for this the net cash inflows of various period are
discounted using required rate of return which is predetermined.

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According to Ezra Solomon, “It is a present value of future returns, discounted at the required rate of return
minus the present value of the cost of the investment.”

NPV is the difference between the present value of cash inflows of a project and the initial cost of the project.

According the NPV technique, only one project will be selected whose NPV is positive or above zero. If a
project(s) NPV is less than ‘Zero’. It gives negative NPV hence. It must be rejected. If there are more than one
project with positive NPV’s the project is selected whose NPV is the highest.

The formula for NPV is

NPV= Total Present value of cash inflows – Total Present value of cash outflows.
PV VALUES =1/(1+r)n

Where r= discount rate %

. n = no of years

Merits:

1. It recognizes the time value of money.

2. It is based on the entire cash flows generated during the useful life of the asset.
3. It is consistent with the objective of maximization of wealth of the owners.
4. The ranking of projects is independent of the discount rate used for determining the present value.
Demerits:

1. It is different to understand and use.

2. The NPV is calculated by using the cost of capital as a discount rate. But the concept of cost of capital. If
self is difficult to understood and determine.
3. It does not give solutions when the comparable projects are involved in different amounts of
investment.
4. It does not give correct answer to a question whether alternative projects or limited funds are available
with unequal lines.

B. Internal Rate of Return Method (IRR)

The IRR for an investment proposal is that discount rate which equates the present value of cash inflows with
the present value of cash out flows of an investment. The IRR is also known as cutoff or handle rate. It is usually
the concern’s cost of capital.

According to Weston and Brigham “The internal rate is the interest rate that equates the present value of the
expected future receipts to the cost of the investment outlay.

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When compared the IRR with the required rate of return (RRR), if the IRR is more than RRR then the project is
accepted else rejected. In case of more than one project with IRR more than RRR, the one, which gives the
highest IRR, is selected.

NPV1

IRR = L+ ----------------- X D

NPV1 –NPV2

L- Lower discount rate

NPV1 - Net Present value at lower rate.

NPV2 – Net Present value at higher rate.

D- Difference in Discount rates.

Merits:

1. It consider the time value of money

2. It takes into account the cash flows over the entire useful life of the asset.
3. It has a psychological appear to the user because when the highest rate of return projects are selected,
it satisfies the investors in terms of the rate of return an capital
4. It always suggests accepting to projects with maximum rate of return.
5. It is inconformity with the firm’s objective of maximum owner’s welfare.
Demerits:

1. It is very difficult to understand and use.

2. It involves a very complicated computational work.
3. It may not give unique answer in all situations.
C. Probability Index Method (PI)

The method is also called benefit cost ration. This method is obtained cloth a slight modification of the NPV
method. In case of NPV the present value of cash out flows are profitability index (PI), the present value of cash
inflows are divide by the present value of cash out flows, while NPV is a absolute measure, the PI is a relative
measure.

If the PI is more than one (>1), the proposal is accepted else rejected. If there are more than one investment
proposal with the more than one PI the one with the highest PI will be selected. This method is more useful in
case of projects with different cash outlays cash outlays and hence is superior to the NPV method.

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The formula for PI is

Present Value of Future Cash Inflow

Probability index = ----------------------------------------

Total Present value of cash outflows

Merits:

1. It requires less computational work then IRR method

2. It helps to accept / reject investment proposal on the basis of value of the index.
3. It is useful to rank the proposals on the basis of the highest/lowest value of the index.
4. It is useful to tank the proposals on the basis of the highest/lowest value of the index.
Demerits:

1. It is somewhat difficult to understand

2. Some people may feel no limitation for index number due to several limitation involved in their
competitions
3. It is very difficult to understand the analytical part of the decision on the basis of probability index.

QUESTIONS

1. What do you understand by NPV method of appeasing long-term investment proposal? Explain with the
help of a proposal of your choice.
2. What is ARR and Payback period? Compare and count ran-the two methods.
3. What are the merits & limitations of Pay back period? How does discounting approach overcome the
limitation of payback period?
4. Give various examples of capital budgeting decisions classify them into specific kinds.
5. What is the importance of capital budgeting? Explain the basic steps involved in evaluating capital
budgeting proposals.
6. What is NPV & IRR Compare and contrast the two methods of evaluating capital budgeting proposals.

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