Sbaa 3004

SCHOOL OF MANAGEMENT STUDIES
UNIT – I – FUNDAMENTALS OF FINANCIAL MANAGEMENT- SBAA3004

Definition
It means planning organizing, directing and controlling the financial activities such as
procurement and effective utilization of funds to accomplish the objectives of the organization.
Nature of Financial Management

1. Financial management is an integral part of overall management. Acquisition,
maintenance, replacement of assets, sources and costs of different capital, production, marketing,
finance and personal decisions are the activities in a firm.
2. The Central focus of financial management is valuation of firm. That is financial
decisions are directed at optimizing the value of the firm.
3. It involves risk return, trade off. Decisions on investment involve choosing the type of
assets, which generate returns accompanied by risks. Generally higher the risk, returns must be
greater and vice-versa.
4. It affects the survival, growth and vitality of the firm. The amount, type, sources,
conditions and cost of finance influence the functioning of the unit.
5. It is the concern of every concern – small or big, individual or corporate undertakings.
6. It is a sub-system of the business system, which has other sub-systems like production,
marketing etc.
7. The external legal and economic environment influences it. The investor preferences,
stock market conditions etc affect financial decisions of the business.
8. Finance functions are generally centralized, i.e., more decisions are taken at the top level
and ensure unified directions to investment and financing functions.
Finance and related disciplines
Financial management is related to different fields and study such as Economics, accounting,
marketing, production and quantitative methods.
1. Finance and Economics

Business firms operate in macro and micro economic environment.
Macroeconomics deals with money, Banking system, capital markets, monitory and fiscal
policies and ETC. so, there is a need of the financial managers to understand the following.
- Monitory policy and availability of funds.
- Fiscal policy which effect on economy.
- Financial institutions.
- Levels of economic activity and changes in economic policy.
Micro economics deals with the economic decisions of individuals and organization. It involves
- Supply and demand relationship and profit maximization strategies.
- optimal sales and product pricing strategies
- measurement of risk
- The rationale of depreciating assets.
It also discusses on marginal analysis which suggests that decisions should be take based on
marginal cost and marginal reference.
1. Finance and accounting:

Accounting is an input in financial decision making. It is a sub- function of finance. It generates
data relating to activities of the organization. Financial statement such as the balance sheet, the
income statement (P and L), cash flow statements are obtained from accounting. This
information assists the finance managers in assessing the company’s past performance and future
directions of the firm, in meeting legal obligations like taxes, ETC. finance and accounting
activities are within the control of VP finance or CFO
Difference between finance and accounting

-Treatment of fund:
Accounting: Accrual principle (when incurred and not when actually collected are payed)
Finance: cash flows (when actually cash is received are paid
-Decision making:
Purpose of accounting is collection of data and primary focus of financial manager is
planning, controlling and decision making.
3. Finance and other disciplines

Marketing: promotion plans, new product development.
Production: process and capital expenditure.
Quantitative methods: analyze complex financial problems.
Financial management approaches
Traditional Modern
Traditional approach:
Focuses on procurement of funds from investors, financial institutions, and investment
bankers.
Decision making is ignored.
Focus was on long term financial problems, working capital management was not given
important.
Financial management was confined to important events like mergers and acquisitions.
This approach ignores cost and capital, capital structure valuation of firms, etc.
Modern approach:
Modern approach focuses on effective utilization of funds which were raised efficiently. It
discusses on investment decision, financing decision and dividend decision.
Objectives of financial management

Two important objectives of financial management:
Profit / EPS maximization wealth maximization
According to this approach those that increase profit are given atmost importance and those that
decrease profit are to be avoided. Profit is a measurement for economic performance. It leads to
efficient allocation of resources and ensures maximum social welfare.
Drawbacks:
1. Ambiguity:
The term profit is a vague and ambiguous concept. Profit may be short term or long term; it may
be before tax or after tax, may be return on capital employed or total assets or shareholder’s
equity. There is a question as to which profit should a firm consider.
2. Timing of benefit:
It ignores the differences in the time of the benefits received. It does not value the cash flow
highly when received early. In practice benefits received sooner are more valuable than benefits
received later. Receipt of funds immediately should always be preferred to future promise of
funds because these earnings or returns could be reinvested for other projects to provide greater
future earnings.
3. Risk: It ignores risk. Investors are generally risk averters so they expect returns with
minimum risk. It does not consider time, economy and other factors making the returns highly
uncertain. The risk that actually occurs may differ from those expected. A trade-off exists
between return and risk. Return and risk are the key determinants of share price. Higher profit
pushes share price higher, whereas higher risk tends to result in a lower share price because
shareholders will be paid higher return when there is high risk.
Wealth maximization:
The goal of the finance function is to maximise the wealth of the owners for whom the firm is
being carried on. The wealth of corporate owners is measured by the share prices of the stock,
which is turn is based on the timing of return, cash flows and risk. While taking decisions, only
that action that is expected to increase share price should be taken. The market price of shares
(excluding impact of speculation) serves as the standard to judge whether financial decisions
have been taken and implemented efficiently or not. Therefore, maximisation of the
firm’s
market value is considered to be the proper
objective.
Merits
:
1. It is based on the concept and cash flow generated by decision. Thus it avoids
ambiguity.
2. It considers both quality and quantity dimensions of benefits. Amount of return and risk
taken
is analyzed. Time value of money is considered. Cash flow stream is calculated by
discounting.
3. The discount role reflects risk and returns. Higher discount rate means high risk because
it
takes a longer time to get back the
return.
4. It implies maximization of the market price of the shares which means value/ wealth/
NPV
maximizatio
n.
5. It focuses on EVA - economic value
added
6. Focus on stakeholders: Maintaining positive shareholders relationship minimizes conflict
and litigation. So, a firm can better achieve its goal of shareholder’s wealth maximization
with cooperation with stakeholders.
Stakeholders customers, supplier, employees, banks, loan provider, etc.
Demerits
:
1. Shareholder’s
interest:
The goal of maximizing share prices does not imply that managers should seek to improve
the
value of the common stock at the expense of debt/debenture
holders.
2. Agency
problem:
When managers place their personal goals ahead of corporate goals or shareholders goals it
is called as wealth maximization.
Agency problems are prevented by
following:
Shareholders participation: voting rights can replace underperforming management
with competent management.
Hostile takeover: Acquisition of the firm by another firm that is not supported
by management is possible. So due to this threat of takeover managers are motivated
to act on corporate goals.
3. Social
responsibility:
As economic agents whose actions have considerable impact on the society, business firms
must
take into account the implications of their policies and actions on society as a whole. The
expectations of workers, consumers and various interest groups create a greater influence that
must be respected to achieve long run wealth maximization and also for their survival.
Finance function/ decisions in financial management

1. The investment decision:
Selection of assets in which the fund is invested
Long term assets Short term

assets
Long term assets Short term assets/Current assets

Return over a period of time Assets which are convertible to cash in the
cause normal course of business
Capital budgeting Working capital management
Selection of an asset or investment, proposal it Management of current assets:
depends on: i) Ensuring a trade – off between profitability
i) Selecting the asset based on alternatives and liquidity.
available. ii) Individual current assets should be efficiently
ii) Analysis of risk and uncertainty managed
iii) Worth of long term project depending on So that funds are not locked up. (cash,
the benefits that is rate of return called as cost receivables and inventory.)
of capital.
2. Financing decision:
It relates to the choice of the proportion of debt and equity sources of financing. It is termed as
capital structure. There are two aspects of financing decision;
i) Theory of capital structure: shows the relationship between the use of debt and returns to the
shareholders which is also termed as financial risk. A capital structure with reasonable
proportion after and equity capital is called as the optimum capital structure.
ii) Capital structure decision: Determination of appropriate capital structure
3. Divided policy decision:

The profit of a firm is distributed to the shareholders in the form of dividends or is retained in the
business. The proportion of net profits distributed to shareholders is termed dividend payout
ratio.
Dividend payout ratio = Total div/net income or Dividend per share/Earnings per share
Roles/ activities of the financial manager
Financial Planning
This is a decision making function. It involves three basic steps namely i) determining short-
term and long-term financial objectives ii) Formulating financial policies and iii) Making
adjustments and readjustments. In setting out the objective, profitability and financial risk
should be considered. Among various objectives profit maximisation and wealth maximisation
are notable. After setting objectives, the following policies are likely to be formulated. i
)policies determining the total amount of capital required ii) policies determining the selection
of source of capital iii) policies determining debt-equity ratio iv) policies guiding the dividend
policy v) credit policy terms and vi) policies determining the investment of funds in fixed assets
and current assets.
Financial Control:
Success of a financial plan depends upon suitably designed control system and measures.
Control is essential for checking actual performance with planned one. For control the
following steps are needed:
1. Developing standards of performance and 2. Comparing actual performance with these
standards. For proper control a system of reports must be established. The function of financial
control should be continuously performed because the working of a firm is continuously
changing.
Financing decisions:
Financing decisions relate to proportion of debt capital and equity capital in total capital
employed. While making this decision, the financial manager aims at securing optimal
financing mix which secure maximum market price per share in the long run. Financing
decisions are concerned with the choice of sources of funds and the amounts to be raised from
the sources. The cost of financing, the nature of commitment and the period of raising funds
govern selection of sources of particular source of finance.
Investment decisions:
Investment decisions involve the decision of allocation of funds to long term assets and current
assets which determines the firm’s risk. Costs of various methods of financing are affected by
this risk. The financial manager is to see that fund on profitable investments. Some special
investments decisions such as merger, acquisitions, reorganization etc. are also are taken by
financial manager.
Management of Income and Dividend Decisions:
Net profits can be allocated either in the form of dividend to share holders or to employees in
profit sharing plans or by retaining them for further expansion of the concern. The financial
manager is to decide to extent to which funds to be allocated for each purpose. Usually, the
amount to be paid to employees under profit sharing plans is statutorily fixed, therefore, there
is problem in them. He has paid considerable attention to the remaining two choices.
Decisions relating to dividend relate Dividend payout ratio, stability of dividends over a period
of time, and dividends in the form of shares. The financial manager has to study the following
to determine the optional dividend payout ratio:
- The preference of investors or current dividends and for capital appreciation.
- The impact of retained earnings on capital structure and the impact of decisions relating
Liquidity Decisions:
Liquidity decisions relate current assets management. It should be managed efficiently

otherwise the firm may become insolvency. Investment in current assets affects firm’s
profitability and liquidity. In order to ensure that insufficient and unnecessary funds are
invested in current assets the executive should develop sound techniques of managing current
assets. He should estimate them and make sure that funds should be made available when
needed.
Deciding upon borrowing policy:
Every organization plans for the expansion of the business for which he requires additional
resources. Personal resources being limited borrowing from banks or by issue of new shares
and new debentures. The financial manager at this juncture will take a decision about the time
when the funds borrowed from outside sources, how long they will be needed and from what
source they will be repaid. He must choose the capital structure keeping various points such as
cost of capital, return expected and financial risks involved etc. into mind.
Checking upon financial performance:
The financial manager is under an obligation to check the financial performance of the funds
invested in the business. It requires retrospective analysis of the operating period to evaluate the
efficiency of financial planning.
The executive functions discussed are interrelated. Therefore, a change in decision with
regard to one of the functions is likely to affect change in decision concerning some or all
others.
Organisation of finance function

Board of directors
MD/chairman
VIP/directors finance
Treasurer Controller
Capital expenditure management Tax manager

Financial planning and fund raising manager corporate accounting management
Cash manager Cost accounting manager
Credit manager Financial Accounting manager
Foreign exchange management
The main roles of treasurer;
1. Obtaining finance.
2. Banking relationship
3. Investor relationship
4. Short term financing
5. Cash management
6. Credit administration
7. Investment
8. Insurance
Functions of controller:
1. Financial accounting
2. Internal audit
3. Taxation
4. Management Accounting and control.
5. Budgeting, planning and control.
6. Economic appraisal.
Financial forecasting
To increase the profitability of the firm, the financial manager must be able to anticipate its
future needs for cash. Financial forecasting allows the financial manager to make educated
guesses about the future financial condition of the firm. From these forecasts he or she can then
plan the financing of the firm and arrange for external sources, such as debt and stock, if they are
needed. The financial manager also develops budgets, which indicate, as time passes, whether
the forecasts are proving to be accurate.
Tools for financial forecasting

- Financial Statements
- Balance Sheet
- Income statements
- Projected balance sheet
- Comparative balance sheet
- Common size balance sheet
Advantages of financial forecasting:
• It indicates to the management the resources, which are needed.

• It enables the management to know how much and how long funds are required.
• It ensures a method of control by which a corrective action can be taken in time.
• It enables the management to gather the necessary information for the formulation of the
plan.
• It enables the management to co-ordinate preliminary performances for sales and
production and to pre-determine stock levels.
• It enables the management evaluate plans in financial terms and facilitates comparison
with the results which have been obtained.
• The data obtained from forecasts provide a basis for the decisions regarding cash
management and investment in marketable securities.
• The commercial banks are favourably impressed by careful financial planning, especially
on the part of small business where such planning is frequently not done.
Sources of finance
(a) Long Term source
Financing means providing money for investment in the form of fixed assets and also in the form
of working capital needed for day to day operations. Funds can be secured from various sources.
While the availability of finance is of vital importance to any firm, securing it from proper
sources is of prime concern to the finance manger.
External sources
1. Preference Shares:
Preference shares have two preferential rights.
i) At the time of payment of dividend.
ii) Repayment of capital at the time of liquidation of the company.
A fixed rate is paid and they do not have voting rights, so they have no say in the management of
company. There are many kinds of preference shares. Investors who do not like to risk their
investment prefer these shares. The preference shares are issued in various types and each of
them having change by its nature. They are Participating preference shares, non- participating
preference shares, and cumulative preference shares. Non-cumulative preference shares,
redeemable preference shares, irredeemable preference shares, convertible preference shares and
non-convertible preference shares.
Merits:
- No voting rights and normally has no control over the policies.
- The property need not be mortgaged for issue of preference shares.
- Finance through preference shares is less costly as compared to the equity shares.
- Common investors and institutional investors may have special attraction for this share
because of fixed and higher of income. It extends the availability of funds in the market.
Demerits:
- Compared to equity capital it is a very expensive source of financing.
- Though there is no legal obligation to pay preference dividends, skipping them can
adversely affect the image of the firm in the capital market.
- Preference shares may lead for insolvency of the company in case where the Directors
continue to pay dividends on them inspite of lower profits to maintain their attractiveness.
2. Equity Shares:
The equity shares are the main sources of finance and the owners of the company contribute it. It
is the source of permanent capital since it does not have a maturity date. The holders of equity
shares have a control over the working of the company. The rate of dividend on them depends
upon the profits of the company. These shares are issued without creating any charge over the
assets of the company.
Merits:
- It does not involve any fixed obligation for payment of dividends.
- The larger the equity base, the higher the ability of the company to detain credit.
- It can be issued without creating any charge on the assets of the company.
- The liability of the firm is limited to the extent of their capital contribution.
- Equity shares are of small face value. Even the small investors can become members of
big organization. This enhances the opportunity to raise the finance from the market.
Demerits:
- The cost of equity capital is high. The rate of return required by equity shareholders is
Generally higher than the rate of return required by other investors.
- The cost of issuing equity share is generally higher than the cost of issuing other types of
securities. Underwriting commission, brokerage cost and other issue expenses are higher
for equity capital.
- Issuing excess equity shares may lead to over capitalization.
- The control of the company can be easily absorbed through cornering of shares by a
group of shareholders for their personal advantage at the cost of company’s interest.
3. Debentures:
Debentures are certificates issued by the company acknowledging the debt due by to its holders
with or without a charge on the assets of the company. It is payable at some specified time
mentioned in the instrument. A fixed interest has to be paid regularly till the principal has been
fully repaid by the company. Debentures provide an opportunity for trading on equity. They do
not entitle to participate in the management of the company. Cautious investors prefer them.
Companies such as transport, electricity etc may get more benefits from debentures.
Merits:
- The Company is able to secure capital without giving any control to the debenture
holders.
- The Company can raise this capital at lesser flotation cost.
- It provides an opportunity to the company to trade on equity and increase the return on
equity and to increase the return on equity capital.
Demerits:
- Raising of funds through debentures is risky, since in the event of failure of the company
to pay interest or the principal installment in time, the debenture holder may go for the
remedy if filing a petition for winding up of the company.
- Debentures are particularly not suitable for companies whose earnings are always
fluctuating.
4. Institutional Assistance:
The Government has set up certain special financial corporation with the object of stimulating
industrial development in the country. These include IFC, SFC, ICICI, IDBI etc. Such
corporations provide both long term and medium term loans on easy installments to big
industrial houses. The assistance of these institutions are help in promotion of new companies,
expansion and developments of existing companies. They exist in direct subscription to company
securities, under writing of shares and meeting the financial requirements of companies during
economic depression.
5. Public Deposits:
Public deposits are the important source for the firms. Companies prefer public deposits because:
- These deposits carry lower rate of interest

- These are unsecured deposits
- These deposits are comparatively for a long period in comparison with the sources of
working capital.
6. Lease Finance:
Lease financing involves the acquisition of the economic use of an asset through a contractual
commitment to make periodic payments called lease rentals to the person who owns the asset.
Thus this is a mode of financing to acquire the use of assets. Through the ownership of the asset
is not with the business enterprise, the right to use the asset is vested with the business unit.
Leasing allows flexibility for the funds in the hands of the business firms and the cost of
obtaining long-term finance is reduced to a large extent.
7. Hire Purchase:
Hire purchase is also a form of acquiring the assets. Assets involving huge amounts if other
sources of long-term finance are too costly may be acquired through hire purchase. The terms of
hire purchase are set out at the time of entering into the contact itself. As per the contractual
agreement, the business firm will pay a hire purchase charge for a fixed duration till the hire
purchase price of the equipment is fully paid. Hire purchase formalities are lesser and are easier
and less costly mode of financing long-term needs.
8. Government Assistance:
Government subsidies and concessions are other modes of financing long-term requirement.
Subject to the government regulations, subsidies and concessions are granted to business
enterprises. This relieves to a large extent to obligations which otherwise the company would
have to incur. Though there are procedural delays in obtaining this form of finance, this is the
cheapest and most beneficial source of long-term finance for the business firms.
9. Mortgage Bonds:
Mortgage bonds are secured by a lien on fixed assets of the company. It is a written promise
given by the company to the investor to repay a specified sum of money at a specified rate of
interest at a specified time. If the company defaults in any of the provisions of bond agreement,
the trustee on behalf of the bond holders has the power to take over and sell it, using the amount
to pay the bond. If the sale proceeds is less than the amount of the issue outstanding the
bondholders become unsecured creditors for the balance amount.
Internal sources
1. Retained Earnings:
A company out of its profits, a certain percentage is retained ad that amount is re-invested into
the business for its development. This is also known ploughing back of profits. According to this
device, a part of total profits is transferred to various reserves. These reserves can help the units
to come over depression. These methods are cheaper and best source of internal financing. This
method adds credit worthiness of the company and increases public confidence in the solvency
of the company. A Company with adequate surplus can follow stable dividend policy. It is an
ideal source of finance for expansion and modernization. By going for this source the firm has
the following advantages.
- It enables business reputation and also increases the capacity of the business to absorb
unexpected and sudden business shocks.
- This method of financing has been found to be useful financing improvements and
expansion.
- As compared to other sources of financing this method of financing is least costly since it
does not involve any flotation cost.
The disadvantages of raising funds by this way of are:
- The management can misuse the retained earnings.
- The shareholders may also object for the continuous use of retained earnings.
2. Depreciation:
Depreciation means decrease in the value of the asset due to wear and tear, lapse of time and
accident. This is also considered as one of the source of financing to business. Depreciation does
not generate funds but it definitely saves funds. The firm can get the benefit of reducing its
income by deducting this non-cash expense in its profit and loss account. So that the income tax
liability for the period is reduced.
(b) Short term finance:

Short-term financing deals with raising of money required for a shorter periods i.e. periods
varying from a few days to one year. There are, however, no rigid rules about the term. It may
sometimes exceed one year but still be called as short-term finance.
1. Trade Credit
Just as a firm grants credit to its customers it can also get credit from the manufacturers or
wholesalers or suppliers. It is known as trade or mercantile credit. The usual duration of this
credit ranges from 30 to 90 days. It is granted to the company or firm on “Open account” without
any security except that of the goodwill and financial standing of the buyer. The willingness of
the supplier to extend credit is also depending upon the following factors:
- The financial resources of the supplier.
- His eagerness to dispose of his stock.
- Degree of competition in the market.
- Credit worthiness of the firm.
2. Consumer Credit or Customer Advance:

Many times the manufacturers or the suppliers insist on, advance by the customers particularly in
case of special orders or big orders. The customer advance forms part of the price of the products
ordered by him. This is an interest free source of finance. The period of such credit depends upon
the time taken to deliver the goods.
3. Accounts Receivable Financing:

Under this method, a financing company purchases the account receivables from the customers
or money is advanced on the security of the accounts receivable. In short, it is a method of
getting credit by pledging book debts. In financial accounting, it is denoted as Sundry Debtors or
Trade Debtors, and this item appears on the asset side of the Balance Sheet.
Time Value of Money
Definition:
Money has different values at different period of time. Worth of rupee received today is different
from the worth of rupee to be received in future.
Reasons for time preference of money:

- Risk: The longer the time period of returns, the greater is the risk. Hence, present value is
preferred.
- Preference for present consumption: People prefer present consumption than future
consumption.
- Inflation: Inflation erodes the value of money.
- Investment opportunities: Most persons and companies prefer present money because of
available opportunities of investment for additional cash flows.
Questions Bank :
(PART-A)
1. Meaning of Financial Management
2. Definition of Financial Management
3. Importance of Financial Management
4. Objectives of Financial Management
5. What is the primary objective of financial management?
6. What do you understand by time value of money?
7. Ms.Banu has deposited Rs. 50,000 in IOB. Interest is compounded at 6% p.a. for 3
years. Compute the amount of maturity.
8. What do you understand by the Time value of Money?
Question (PART-B)
1. What is meant by financial management? State the primary objective of financial

management.
2. Explain, how does proper financial management helps in the growth of business?
3. Give the meaning of Investment and financing decisions of financial management.
4. Explain the concept and the objective of financial management.
5. What is the minimum amount which a person should be ready to accept today from a debtors
who otherwise has to pay a sum of Rs. 10,000, Rs.12,000, Rs.16,000, Rs.18,000, and
Rs.20,000 at the end of year 1,2,3 and4 respectively from today. The rate of interest may be
taken as 14%.
6. Discuss the various methods used for risk factor in capital budgeting decisions.
Reference Books:
 Advanced Financial Management: Kohok, M. A., Everest Publishing House

 Cases & Problems On Financial Management: Rao, A. P., Everest Publishing House
 Cases In Financial Management: Pandey, I/ Bhat, R. TMH
 Financial Management: Inamdar, S. M. Everest
 Financial Management: Kishore, R. M. Taxman Allied Service
 Financial Management: Kuchhal, S. C. Chaitanya
 Financial Management: Kulkarni, M. A. Career
 Financial Management: Pandey, I. M. Vikas
 Financial Management & Policy: Horne, J. C. V. Pearson
 Financial Management & Policy: Global Perspective: Srivastava, R. M. Himalaya
UNIT – II – FUNDAMENTALS OF FINANCIAL MANAGEMENT-SBAA3004

Capital Budgeting
Introduction
Capital Budgeting decision is also known as investment decision or Capital Expenditure
decision. Financial management is concerned with the raising and allocation of funds. The funds
that are raised through different sources of long term will be allocated for long term investments.
The funds when allocating for long term investment the main objective will be to select the
project that yields maximum returns so as to cover risk and also to the cost of various sources of
funds. Rising of funds like Debentures has the cost of interest, Preference shares and Equity
shares have the cost of dividend. Allocation of funds should be done in such a way that it
recovers all these costs. Hence the finance manger has to evaluate available investment options
in terms of risk, returns and uncertainty, only then he can decide whether the project is feasible
or not.
Meaning & Definition of Capital Budgeting

Capital Budgeting is an important tool in the Financial Management that evaluates Capital
expenditure projects. Capital Expenditure project is an expenditure whose benefit is spread over
a long period of time say more than one year. Here the expenditure is incurred at one point of
time for a long term project and the benefit is realized over the years in the future. Thus Capital
Budgeting decision is a process which involves decision making regarding capital expenditure.
Definitions:
According to Prof. I.M Pandey, "Capital Budgeting decisions may be defined as the firm’s
decision to invest its current funds most efficiently in long term activities in anticipation of an
expected flow of future benefits over a series of years.”
According to Charles T Horngen, “Capital budgeting is long term planning for making and
financing proposed capital outlays.”According to R.M. Lynch, “Capital budgeting consists in
planning the employment of available capital for the purpose of maximizing the long term
profitability of the concern.”
According to Richard and Green law “Capital budgeting is concerned with acquiring inputs with
long run returns.”
Nature of Capital Budgeting

Nature of capital budgeting can be explained in simple terms as follows:
Capital budgeting involves huge investment in capital expenditure like investment in
fixed assets (Land & Building, Plant & Machine etc.).
Investment in capital expenditure is for a long term and cannot be withdrawn easily.
Capital budgeting decision involves evaluation of future profits from an investment.
Capital budgeting decision involves high risk as future profits are not certain.
Figure Process of Capital Budgeting
1. Project Generation:
The process of capital Budgeting begins with the generation or identification of an investment
proposal. The proposal for an investment can be identified from within the organization or from
outside. Project generation within the firm comes either from the top, middle or lower level
management. Sometimes even the workers provide idea related to their work. Some of the
investment proposals are as follows:
Adding a new product to the product line
Expansion of production capacity in existing product lines
Reduction in the cost of output without changing scale of operation
Replacement of Assets
Modernization projects
Research and Development projects
Employee welfare projects
Education & training projects.
Hence a firm first has to identify the various proposals for investment while making capital
budgeting decisions.
2. Project Evaluation:
Once an investment proposal is identified the next step in capital budgeting process is to evaluate
the various proposals in terms of its profitability. There are two steps in the evaluation as
follows:
Estimate the cost and benefit of a proposal in terms of cash flows
Select an appropriate criterion to judge the desirability of the project.
The benefits and cost from a proposal is estimated by considering the cash inflows and cash
outflows. This depends on the future risk and uncertainty. The risk associated with each project
should be analyzed and provisions should be made to cover all types of risk. There are a number
of criteria to judge the suitability of a project. The selection of criterion should meet the firm’s
objective of maximizing market value. The technique of time value of money can be used as tool
in the evaluation of a proposal.
3. Project Selection:
The next step in the capital budgeting process is screening and selecting the proposal. The
screening and selecting process differ from one firm to another. In reality though the projects are
scientifically screened by the middle level management, they are approved by the top
management.
4. Project Implementation:
Once the project is selected the finance manager makes necessary arrangements to allocate funds
required for the project. He also prepares a capital budget and takes care to reduce the weighted
average cost of capital. The top manager has to ensure that the funds are spent in accordance
with the allocation made in the capital budget. The preparation of periodical reports and
submitting to top management helps in the proper control over capital expenditure.
5. Performance Review or Follow up:
An investment should be reviewed periodically. For this purpose a systematic procedure should
be developed and the performance of a project should be reviewed. The review is done by
comparing actual performance with the budgeted estimates.
Significance of Capital Budgeting

One of the important business decisions made by every business organization is capital
budgeting decision. All types of capital investment decisions are made by firms only after
evaluation of the cost and benefit of such investments. This is because it affects the firm’s
working and profitability for many years in the future. Some of the reasons for the significance
of capital budgeting decisions are as follows:
a) Long term effect:
The capital budgeting decisions will have an effect on the organization for a very long
term, in terms of its profitability and the cost. An appropriate decision leads to a very
high return to the firm where as a wrong decision might put the firm’s survival under
question.
b) More Risky:
Investment in long term assets not only increases the average return of the firm, but also
leads to fluctuations in the earnings. This makes the firm risky. The longer the period of
the project larger will be the risk. Hence it can be said that the Capital budgeting
decisions affects the future of an organization.
c) Huge Investment:
Capital Budgeting decision requires large initial investment or cash outflow for the
acquisition of fixed assets or for the implementation of large projects. Hence it is
essential to carefully estimate and make arrangements from various sources to get these
funds.
d) Irreversible Decisions:
Capital budgeting decisions are investment in long term assets which are not easily
reversible without much loss. The reasons is that it is very difficult to find a market for
such used capital assets and also those assets cannot be used for any other alternative
purpose. Hence firm incurs huge loss if a wrong capital investment decision is made.
e) Effect on Cost Structure:
Based on the capital expenditure decision taken by an organization many associated cost
arises such as supervision charges Irreversible Decisions, insurance, interest to debt
fund and dividend to equity and preference shareholders, rents and salaries etc. If the
investment fails to make expected profits then it affects the firm’s profitability as the firm
as to bear all these costs.
f) Difficult Decision:
Capital budgeting decisions are the most difficult decision every business organization
makes as it involves future uncertainty and expected future cash inflows. The future cash
flows and business environment are highly affected by the economic, political and
technological forces. Hence these decisions are vital and most difficult.
g) Capital Structure Planning:
The capital structure of the firm is also affected by the capital budgeting decision. The
profit from an investment proposal depends upon the type of capital structure.
Investment Evaluation Criteria/ Capital budgeting Techniques:
There are a number of methods for evaluating capital investment proposals is available. In all the
methods the basic focus is on the comparison of the investments with the return expected from it.
Some of the important methods are discussed here. The investment evaluation methods can be
classified as under:
Non-discounted Cash Flow Criteria (Traditional Method):
Under non-discounted Cash Flow method or Traditional Method the time value of money is
ignored.
1. Pay Back Period Method:

Payback period method helps in the calculation of time required by an investment proposal to
return back the initial investment. In other words it is the period in which the project generates
necessary cash to recover the cash out flow from an investment. Here time value of money is not
considered. It takes in to account only initial investment, annual cash inflows, and the economic
life of the project.
Cash inflow refers to profit before depreciation and after taxes.
Merits of Pay Back Period:
It is easy to calculate and simple in understanding.
Very low cost is involved in implementing this method.
Under this method selection and rejection of a project is easy.
The results are more reliable.
In case of tight money conditions, PBP method helps in judging the quick pay back
project which avoids locking up of funds in projects that yields high returns but takes a
longer period of time.
Demerits of Pay Back Period:
This method does not consider the time value of money.
This method does not consider the profitability of economic life of the asset. Earnings
after payback period are ignored.
Total return on investment is also not considered.
There is no standard procedure for setting the payback period. Hence it is difficult to
determine the maximum acceptable payback period.
This method does not consider all the dimensions of profitability.
Decision Rule :( Accept/Reject Rule):
If the payback period calculated for a project is less than the maximum or standard payback
period fixed by the management, it will be accepted. On the other hand if the payback period
calculated for a project is more than the maximum or standard payback period fixed by the
management, it will be rejected.
Accept: Calculated PBP < Maximum PBP

Reject: Calculated PBP > Maximum PBP
a) Formula for PBP when Cash inflows are uniform:
Original investment
Payback period =
Annual Cash Flow
Illustration 1:
A project requires an investment of Rs. 1, 00,000 and the estimated life of the project is 10 years.
The project generates an annual cash inflow of Rs. 20,000. Calculate the payback period of this
project.
Solution:
Original investment
Payback period =
Annual Cash Flow
Original investment = Rs. 100000
Annual Cash flow = Rs. 20000
100000
Payback period =
20000
PBP = 5 years
b) Formula for calculation of Pay Back Period when cash flows are unequal or not
uniform: Under this method cash flow is calculated based on the cumulative cash flows.
PBP = Year before full recovery + (Unrecovered amount of investment / Cash flows during the
next year)
Illustration 2:
Dev Industries is considering the purchase of a machine. Two machines X and Y costing Rs.
60,000 each are available. Cash inflows are expected to be as under. Calculate Payback period.
Year Machine X Machine Y

Rs. Rs.
1 20000 5000
2 30000 10000
3 40000 20000
4 10000 40000
5 5000 80000
Solution:
Calculation of Pay Back period:
Year Machine X Machine Y

PATBD PATBD
(Rs.) Cumulative CFATBD (Rs.) Cumulative CFATBD
1 20000 20000 5000 5000
2 30000 50000 10000 15000
3 40000 90000 20000 35000
4 10000 100000 40000 75000
5 5000 105000 80000 155000
PBP = Year before full recovery + (Unrecovered amount of investment / Cash flows during the
year)
PBP for Machine X = 2 + 10000/40000 = 2.25 years
PBP for Machine Y = 3 + 25000/40000 = 3.625 years
Here machine X is preferred as the payback period of machine Y is 3.625 years and the Machine
X is 2.25 years which is the shortest.
2. Accounting Rate of Return Method

This method is also known as Return on investment method or average rate of return method.
Accounting rate of return method is based on the conventional accounting concepts. Under this
method the total earnings from a project over its economic life is considered. The rate of return is
calculated as a percentage of the earnings from a project.
Merits of Accounting Rate of Return Method:
It is very simple method to understand and easy to calculate.
This method considers all the earnings over the life of the project.
The information required for this method can be easily drawn from the accounting
records.
This method is less costly compared to modern methods, as this can be calculated by an
accountant and does not require any specialist to analysis.
Demerits of Accounting Rate of Return:
This method ignores the concept of time value of money.
This method is based on accounting concepts and not on actual cash flows after taxes in
evaluating the project. But accounting profits also includes non-cash items and
assumptions.
It ignores the fact that the profit can be reinvested.
It does not consider the market value of shares and thereby ignores the objective of
wealth maximization of shareholders.
Decision Rule/ Accept- Reject Rule:
In case of ARR method accept reject rule is based on the comparisons of calculated ARR with
the predetermined cut-off rate.
Accept: Calculated ARR > Predetermined ARR or cut-off rate.

Reject: Calculated PBP < Predetermined ARR or cut-off rate.
Cash flow under this method means the Profit after depreciation and after tax for the entire life of
the project.
There are two methods of calculation of Accounting Rate of Return:
a) When clearly mentioned as Accounting Rate of Return:
Average Annual Profit After Tax and Depreciation
ARR = × 100
Initial Investment
b) When clearly mentioned as Average Rate of Return:

ARR = × 100
Average Investment
Total Profit After Tax and Depreciation
Average Annual Profit After Tax and Depreciation =
Life of the Machine
Average Investment
Original Investment − Scrap Value + (Additional Working Capital + Scrap Value)
=
2
c) When ARR is given in the problem, any one of the above method can be used but
average rate of return method is the ideal one.
Illustration 3:
Calculate the average rate of return for two projects X and Y from the following:
Particulars Project X Project Y
Investments Rs. 10000 Rs. 12000
Life 5 years 4 years
Projected Net Income after interest, depreciation &
taxes
Years Project A Project B
(in Rs) (in Rs)
1 1000 5000
2 2000 2000
3 3000 4000
4 5000 6000
5 4000 -
If the required rate of return is 12% which project should be accepted?

Solution:
ARR = × 100
Average Investment
=
Life of the Machine
Project X:
1000 + 2000 + 3000 + 5000 + 4000
5
= 3000
Average Investment
=
2
Average Investment = 10000/2 = 5000
3000
ARR Project X = × 100
5000
ARR Project X = 60%
Project Y:
5000 + 2000 + 4000 + 6000
4
= 4250
12000
Average Investment = = 6000
2
4250
ARR for Project Y = × 100
6000
ARR for Project Y = 70.83%
As the ARR is highest in project Y (70.83%) compared to Project X (60%), Project Y can be
accepted.
Illustration 4:
A project required an investment of Rs. 4, 00,000 and has a scrap value of Rs 10,000 after five
years. It is expected to yield profit after depreciation and taxes during the five years amounting
to Rs. 30,000, Rs. 50,000, Rs. 60,000, Rs. 40,000 and Rs. 10,000. Calculate the average rate of
return on the investment.
Solution:
ARR = × 100
Average Investment
Total Profit = 30000+50000+60000+40000+10000 =190000

=
Life of the Machine
Rs. 190000
Average Profit = = Rs. 38, 000
5

Average Investment =
2
400000 − 10000
Average Investment = = 195000
2
Average Anuual Profit
Average Rate of Return = × 100
Average Investment
38000
ARR = × 100
195000
ARR = 19.48%
Return per unit of Investment Method: There is a small difference in this method and the
average rate of return method. Under this method the total profit after tax and depreciation is
dividend by the total investment, i.e.
Total Profit (after depreciation and taxes)
Return per unit of Investment = × 100
Net Investment in the Project
Illustration 5:
Taking the same figures as given in the above illustration 4, the return on average investment can
be calculated as under:
Total Profit (after depreciation & taxes) = 190000
Net Investment in the Project = 400000 – 10000 = 390000
190000
Return per unit of Investment = × 100
390000
Return per unit of Investment = 48.72%
Discounted Cash Flow Criteria (Modern Method)

To overcome the disadvantages of Pay Back method and ARR method, discounted cash flow or
time adjusted techniques was developed. This method considers the time value of money. Time
as a factor of investment is fundamental for evaluating the future cash flow from an investment.
According to this method a rupee received today has more value than receiving the same rupee
tomorrow. Some of the discounted cash flow methods are as follows:
1. Net Present Value Method

Net present value method is considered as the best method in evaluating the capital investment
proposal. NPV method takes into account the time value of money. The cash inflows that are to
be received in the future at different periods are discounted at a particular discount rate. Then the
present value of cash inflows is compared with the present value of cash outflows to judge the
best proposal.
Under NPV cash flow refers to Profit after tax and before depreciation.
Merits of NPV Method:
NPV considers the time value of money.
It considers the cash flows of the entire life of the project.
NPV is most preferred in case of mutually exclusive projects.
It takes into account the firm’s objective of wealth maximization of the shareholders.
It considers a discount rate to calculate the present value of cash flow which is equal to
the cost of capital.
Demerits of NPV:
NPV is difficult to understand and calculate when compared to Non-discounted methods.
Calculation of discounting rates is difficult and lengthy and time consuming process.
In case of unequal lives of projects this method is not of much use.
Also in case of different cash outlays this method will not provide exact answer.
Decision Rule (Accept / Reject Criteria):

If the NPV of a project is positive then the project is selected for investment and on the other
hand if the NPV is negative, the project is rejected.
Accept if NPV > Zero
Reject if NPV < Zero
Present Value can be calculated as under:
1
PV =
(1 + i)n
Where i = Discount rate,
n = Number years after which the money is received.
NPV = Present Value of cash inflow – Present Value of cash outflow
Illustration 6:
Find the NPV for a project which require an initial investment of Rs. 15000 and which involves a
net cash inflow of Rs. 5000 each year for 5 years. The cost of funds is 9%. There is no scrap
value. (PV of annuity of Rupee 1 for 5 years at 9% per annum is Rs. 3.890)
Solution:
PV of cash inflow 5000 X 3.890 Rs.19450
Less: Initial investment Rs. 15000
Net Present Value (NPV) Rs. 4450
Illustration 7:
From the following information calculate the net present value of two projects Sun and Moon
and suggest which of the two projects should be accepted @ 10% discount rate. The details are
as follows:
Sun (Rs) Moon (Rs)
Initial Investment 50000 60000
Estimated Life 5 years 5 years
Scrap Value 2000 3000
Profit before depreciation and after tax are as
follows:
Years Sun (Rs) Moon (Rs)
1 20000 10000
2 30000 20000
3 10000 35000
4 5000 15000
5 4000 30000
Total 69000 110000
The present value of Re. 1 @ 10% is as follows:

Years 1 2 3 4 5
PVF @ 0.909 0.826 0.751 0.683 0.621
10%
Solution:
NPV = Present Value of cash inflow – Present Value of cash outflow
Year Project Sun Project Moon

Discount Cash Present Discount Cash Present
factor @ inflow value of factor @ inflow value of
10 % (Rs) cash 10 % (Rs) cash
inflow (Rs) inflow (Rs)
1 0.909 20000 18180 0.909 10000 9090
2 0.826 30000 24780 0.826 20000 16520
3 0.751 10000 7510 0.751 35000 26285
4 0.683 5000 3415 0.683 15000 10245
5 0.621 4000 2484 0.621 30000 18630
5(Scrap Value) 0.621 2000 1242 0.621 3000 1863
Present Value of cash inflow 57611 82633
Less: cash outflow 50000 60000
Net Present Value (NPV) + 7611 + 22633
The NPV is more in case of Project Moon than Project Sun. Hence Project Moon can be
selected.
2. Internal Rate of Return Method

Internal rate of return can be defined as the rate at which the sum of discounted cash inflows will
be equal to sum of discounted cash outflows. IRR is the rate where the Net Present Value of a
will be zero. This method is also known as Trial & Error method, Time adjusted rate of return
method, discounted rate of return and yield method.
Under this method the cash flow from a project is discounted at certain rate through trial method.
The rate which equates the net present value calculated with the initial investment will be
considered as IRR. As this method considers the internally determined rate, it is called as internal
rate of return. At this rate present value of cash inflow will be equal to present value of cash
outflow.
In case of IRR method cash flow refers to Profit after Tax and before Depreciation.
Merits of IRR Method:
IRR method also considers the time value of money.
It considers the profitability of the project for its entire life.
Under IRR calculation of the cost of capital is not a pre-requisite.
It helps in uniform method of ranking all the projects as it calculates the percentage rate
of return.
It supports the firm’s objective of maximizing the shareholders wealth.
Demerits of IRR Method:

It is the most difficult method of understanding.
The evaluation of project under this method is very difficult as it involves lot of
calculations.
IRR method is based on the assumption that the earnings from the project are reinvested
at the internal rate of return, which is not a justified assumption.
The results from NPV method and IRR method differs if the projects differ in their size,
life and the periods of cash flow.
By referring to the present value annuity table for 5 years at PV factor 4 is between 7% (4.1002)
and 8% (3.9927). Hence IRR is 8% approximately.
ii. If the annual cash inflows are unequal: In such cases, IRR is calculated by hit and trial
method where an assumed discount rate is considered to find out the total present value
of cash inflows that equals the total cash outflow. The rate at which the total present
value of cash inflows equals the cash outflows is the internal rate of return.
Illustration 9:
Initial investment Rs. 70000
Life of the Asset 6 years
Expected Net annual cash inflows: Rs
1 Year 22000
2 Year 18000
3 Year 24000
4 Year 38000
5 Year 16000
6 Year 12000
Calculate the Internal Rate of Return.
Solution:
Statement of Present Value of Cash Inflows
Year Cash Discoun PV of Discoun PV of Discoun PV of Discoun PV of

inflo t factor cash t factor cash t factor cash t factor cash
w @ 10% inflow @ 12% inflow @ 15% inflow @ 22% inflow@
@ 10% @ 12% @ 22%
15%
1 22000 0.909 0.893 0.869 0.819

19998 19646 19118 18018
2 18000 0.826 0.797 0.756 0.671
14868 14346 13608 12078
3 24000 0.751 0.712 0.657 0.550
18024 17088 15768 13200
4 38000 0.683 0.635 0.571 0.451
25954 24130 21698 17138
5 16000 0.621 0.567 0.497 0.370
9936 9072 7952 5920
6 12000 0.564 0.507 0.422 0.303
6768 6084 5064 3636
Total 95548
90366 83208 69990
Illustration 10:
A project requires an investment of Rs. 12000 and the expected cash flows are:
Year’s Cash flow (Rs.)
1 8000
2 10000
3 6000
The cost of capital is 10% and the PV factors at 10% are as follows:
1 year 2 year 3 year
0.909 0.826 0.751

Compute the Profitability Index.
Solution:
Present Value of Cash Inflow
Profitability Index =
Present Value of Cash Outflow
Calculation of Present value of cash inflow:

Years Cash Discount PV of cash
Flow Factor @ inflow @
10% 10%
1 8000 0.909 7272
2 10000 0.826 8260
3 6000 0.751 4506
Present value of cash inflow 20038
20038
Profitability Index = = 1.67
12000
Questions
(part-A)
1. Why are the capital investments important?
2. Describe the capital Budgeting.
3. State the feature of capital budgeting.
4. Discuss the importance of capital budgeting.
5. Explain the various stage involved in capital budgeting decisions.
6. Write short note on IRR method.
7. What is mean by risk adjusted discount rate?
8. Give the meaning of profitability Index.
Questions (part-B)
1. What is capital budgeting? What steps are involved in the process of capital budgeting?
2. Describe some measures which are relevant for the successful implementation of a project
in the process of capital budgeting.
3. What is post completion audit in the process of capital budgeting?
4. What is the significance of investment analysis in the capital budgeting process?
5. Explain the various methods of evaluating capital expenditure decisions.
Project cost Rs.50,000 and has a scrap value of Rs.10,000. Its stream of income before
depreciation and taxes during the first five years are Rs.10,000, Rs.12,000,
Rs.14,000, Rs.16,000 and Rs.20,000. Assume a 50% tax rate and depreciation on straight
line basis. Calculate the accounting rate of return.
6. Discuss discounted cash flow techniques useful in capital budgeting decision.
Reference Books:

UNIT – III – FUNDAMENTAL OF FINANCIAL MANAGEMENT-SBAA3004

Leverage
Definition:
It’s the Firm’s ability to use the fixed cost assets or funds to magnify the returns.
Types:
Financial leverage
The use of fixed charges (or interest) bearing sources of funds, such as debt and preference
capital along with the owners’ equity in the capital structure of a company is described as
financial leverage or gearing or trading on equity.
The use of term trading on equity is derived from the fact that the debt is raised on the basis of
the owner’s equity - the equity is traded upon.
The financial leverage is employed by a company only when it is confident of earning
more return on fixed charge funds than their costs. In case the company earns more than
the derived surplus will increase the return on the owner’s equity. In case the company
earns less on the fixed charge funds when compared to their costs, the resultant deficit
will decrease the return on owner’s equity.
If all other things remain same, lower the amount borrowed, lower the interest, lower will
be the profit and greater the amount borrowed, lower the interest, greater will be the
profit.
Financial leverage reflects the amount of debt used in the capital structure of the firm.
Because debt carries a fixed obligation of interest payments, we have the opportunity to
greatly magnify our results at various levels of operations.
The degree of financial leverage is computed as the percentage change in earnings
available to common stockholders associated with a given percentage change in earnings
before interest and taxes.
Thus financial leverage is a commitment to fixed debt charges payment obligation
undertaken by a company.
Measures of financial leverage:

Debt ratio is the ratio of debt to the total available funds of the company, i.e. sum of owner’s
equity and outside debt. The owner’s equity can be measured in terms of either book value or the
market value. In some countries it is also named as leverage ratio. It is defined down traditional
lines as the ratio of external debt to total equity.
Debt equity ratio is the ratio of debt to the total equity. Here too, the equity can be measured in
terms of either book value or the market value. .
Degree of financial leverage: The degree of financial leverage (DFL) is defined as the
percentage change in earnings per share [EPS] that results from a given percentage change in
earnings before interest and taxes (EBIT), and it is calculated as follows:
DFL = Percentage change in EPS / Percentage change in EBIT
Operating leverage:
High fixed costs and low variable costs provide the greater percentage change in profits both
upward and downward. If a high percentage of a firm’s costs are fixed, and hence do not decline
when demand decreases, this increases the company’s business risk. This factor is called
operating leverage.
Operating Leverage = Contribution/EBIT
If a high percentage of a firm’s total costs are fixed, the firm is said to have a high degree of
operating leverage.
The degree of operating leverage (DOL) is defined as the percentage change in operating
income (or EBIT) that results from a given percentage change in sales.
When fixed costs are very large and variable costs consume only a small percentage,
even a slight change in revenue will have a large effect on reported profits.
Operating leverage, refers to the magnified effect on operating earnings (EBIT) given
change in sales.
One of the most dramatic examples of operating leverage is in the airline industry, where
a large portion of total costs are fixed. The higher the proportion of fixed costs to total
costs the higher the operating leverage of the firm. Since a fixed expense is being
compared to an amount which is a function of a fluctuating base (sales), profit-and-loss
results will not bear a proportionate relationship to that base. These results in fact will be
subject to magnification, the degree of which depends on the relative size of fixed costs
vis-a-vis the potential range of sales volume.
Operating leverage refers to the use of fixed costs in the operation of a firm. A firm will
not have operating leverage if its ratio of fixed costs to total costs is nil. For such a firm, a
given change in sales would produce same percentage change in the operating profit or
earnings before interest and taxes.
Higher the fixed cost, higher the variability in EBIT for a given change in sales. Other
things remaining the same, companies with higher operating leverage (because of higher
fixed costs) are most risky. Thus operating leverage increases with fixed costs. Operating
profit of a highly leveraged (operating) firm would increase at a faster rate for any given
increase in sales.
Thus, DOL = (% change in EBIT) / (% change in sales)
Combined effect of operating and financial leverage:

The combined effect of two leverages can be quite significant for the earnings available to
ordinary shareholders. They cause wide fluctuation in earnings per share for a given change in
sales. If a company were to employ a high level of operating and financial leverage, even a very
small change in the level of sales will cause significant effect on the earning per share. Thus the
degrees of operating and financial leverages can be combined to ensure the effect of total
leverage on earning per share due to a very small change in sales. The degree of combined
leverage is expressed in the following manner DCL = (% change in EBIT / % change in sales) x
(% change in EPS / % change in EBIT) DCL = % change in EPS / % change in sales.
EBIT-EPS Analysis
EBIT-EPS analysis is a very strong and important tool in the hands of the finance manager. This
is an alternative technique to measure the impact of financial leverage on the returns available to
equity shareholders. Under EBIT-EPS analysis, an attempt is made to analyse the impact of
change in the capital structure on earnings available to equity shareholders. Thus, EBIT-EPS
analysis shows the relationship between EBIT and EPS at various financing pattern i.e. debt
equity ratio. The financing mix, which yields the maximum EPS to equity shareholders under
assumed EBIT level, is regarded as the best mix or the optimum capital structure.
Particulars Amount (Rs.)

EBIT XXX
Less: Interest XXX
-----------------
EBT XXX
Less:Tax XXX
-------------------
EAT XXX
Less:Preference Dividend XXX
---------------
Earnings Available to Equity Shareholders XXX
Number of Equity Shares XXX
EPS:(Earnings to ESH/ No of Equity Shares) XXX
The EPS will be different for different financing patterns assuming constant level of EBIT. It is
because the interest paid is tax deductible which resulted in tax benefits to equity share holders.
Thus, interest on debt capital can be used to increase the return to equity share holders. However
it should be remembered that interest is a liability i.e. fixed financial charge on the earning of the
company. It increases the risk perception of the investor. So, it’s not possible to keep increasing
the level of debt content in the capital structure of the company. The ratio of debt in capital
structure will depend on various factors like nature of business, market conditions, economic
conditions, earning pattern of the company and cost of the debt. But the two important factors
which determine the level of debt content in the capital structure are rate of interest on debt
capital and rate of return on overall capital. If the rate of interest is higher than the rate of return
to the firm, it is better to use less amount of debt content in the capital structure. In such a case,
equity shareholders will bear a part of cost of debt and EPS will decline. Similarly, when rate of
return on capital exceeds rate of interest on debt, higher amount of debt can be used in the capital
structure which will result in disproportionate increase in the earnings available to equity
shareholders (ESH) and EPS will increase.
PROBLEM:
A company is expecting EBIT of Rs. 5,00,000 per annum on investment of Rs.10,00,000.
Company is in need of Rs. 8,00,000 for its expansion activities. Company can raise this amount
by either equity shares capital or 12% preference share capital or 10%debentures.
The company is considering the following financing patterns:
a.10,00,000 through issue of Equity Shares at par;
b. 5,00,000 by issue of Equity Share Capital and remaining 5,00,000 by issue of Debentures;
c.5,00,000 through Equity Shares and 2,50,000 through 12% Preference Share Capital and
remaining 2,50,000 through 10% Debentures.;
d. 5,00,000 through Debt and 2,50,000 through Equity Shares and remaining 2,50,000through
12% Preference Share Capital. Find out the best financing mix assuming 50% tax rate.
Solution:
Capital Structure Plan I Plan II Plan III Plan IV
Equity Share of 100 each 10,00,000 5,00,000 5,00,000 2,50,000

12% Preference Share ----- ----- 2,50,000 2,50,000
10% Debt ------ 5,00,000 2,50,000 5,00,000
Total Capital Employed 10,00,000 10,00,000 10,00,000 10,00,000
EBIT (ROI 25%) 5,00,000 5,00,000 5,00,000 5,00,000
Less:Interest -------- 50,000 25,000 50,000
--------------------------------------------------------------------------------------------------------------
EBT 5,00,000 4,50,000 4,75,000 4,50,000
Less:Tax(50%) 2,50,000 2,25,000 2,37,500 2,25,000
--------------------------------------------------------------------------------------------------------------
EAT 2,50,000 2,25,000 2,37,500 2,25,000
Less:Preference Dividend --------- --------- 50,000 30,000
Earnings to Equity Shareholder 2,50,000 2,25,000 1,87,500 1,95,000
Number of shares 10,000 5,000 5,000 2,500
EPS= Earnings to Equity Shareholder/ Number of shares

EPS (Rs.) 25 45 41.5 78
In the above example, alternative IV seems to be best alternative with EPS of Rs. 78.The EPS is
Rs. 25 when no debt is used in the capital structure. The EBIT of Rs. 5,00,000 on investment of
RS 10,00,000 turn out to be 50%. After tax ROI will be 25%. But the use of cheaper source of
finance such as debt at 10% cost and preference share at 12%cost will increase earnings per
share. Thus, use of more and more debt or fixed payment capital will lead to increase in EPS to
the shareholders.
PROBLEMS:
1. The following are the details:
Selling price per unit Rs. 20
Variable cost per unit Rs. 12
Actual sales 200 units
Installed capacity 300 units
Calculate operating leverage in each of the following two situations.
(i) When fixed costs are Rs. 1000
(ii) When fixed costs are Rs. 800.
Solution:
Statement showing computation of operating leverage
Sales Rs. 4,000 (Rs. 20*200 units) Rs. 4,000(Rs. 20*200 units)
Less Variables Costs Rs. 2,400 (Rs.12*200 units) Rs. 2,400 (Rs.12*200 units)
Contribution Rs. 1,600 Rs. 1,600

Less – Fixed Costs Rs. 1,000 Rs. 800
Earning Before Tax Rs. 600 Rs. 800
OperatingLeverage= = Rs. 1,600/ Rs. 600 = Rs. 1,600/ Rs. 800

Contribution/EBIT
=2.67 =2
2. A firm has a sale of Rs. 90 lakh, variable cost of 20 lakh, fixed cost of Rs. 5,00,000. The
capital structure of the firm includes 10% debenture of Rs. 20 lakh and equity share capital of
Rs. 40 lakh. Calculate operating, financing and combined leverage.
Solution :
Statement of EBT
Particulars Amount (Rs.)

Sales 90 lakh
Less:Variable Cost 20 lakh
-------------------------
Contribution 70 lakh
Less: fixed Costs 5 lakh
-----------------------------
EBIT 65 lakh
Less:Interest on Debenture 2 lakh
-----------------------------
EBT 63 lakh
-----------------------------
(i)
Operating Leverage
= Contribution/ EBIT= 70 lakh/65 lakh= 1.07 times
(ii)
Financial Leverage
= EBIT /EBT= 65 lakh/ 63 lakh= 1.03 times(iii)
Combined Leverage
= FL×OL= 1.07 × 1.03= 1.10 times.
Problems to solve:
1. Following data of a company is given below: Sales = 90,00,000.
Variable Cost = 50,00,000
Fixed Costs = 10,00,000
Interest Payment = Rs.5,00,000.
Calculate degree of operating leverage and financial leverage. By what percentage will EBIT
increase if there is 10% increase in sales?
2. A company has a sales of Rs. 20,00,000, variable cost of Rs. 14,00,000. Fixed cost of Rs.
4,00,000 and debt of Rs, 10,00,000 at 12% rate of interest. What are the operating and financial
and combined leverages?
3. The finance manager of X ltd expected EBIT is Rs.10,000 for the current year. The firm has
5% debentures aggregating Rs.40, 000, while 10% preference shares for Rs.20, 000. What would
be the EPS assuming EBIT being Rs.6, 000 and Rs.14, 000? The firm has tax rate 35%. The
number of equity shares issued
Capital Structure
Meaning of capital structure
Capital structure is the permanent financing of the company represented primarily by long-
term debt and shareholder’s funds but excluding all short-term credit. The term capital structure
differs from financial structure.
Financial structure refers to the way the firm’s assets are financed. In other words, it includes
both, long-term as well as short-term sourced of funds. Thus a company’s capital structure is
only a part of its financial structure.
Patterns of capital structure

In case of new company, the capital structure may be of any of the following four patterns.
(1) Capital structure with equity shares only.
(2) Capital structure with both equity and preference shares.
(3) Capital structure with equity shares and debentures.
(4) Capital structure with equity shares, preference shares and debentures
Factors affecting capital structure

Capital Structure depends on a number of factors such as,
The nature of the business,

Regularity of earnings,
Conditions of the money market,
Attitude of the investor,
Debt-equity mix:
There is a basic difference between debt and equity. Debt is a liability on which interest has to
be paid irrespective of the company’s profits. While equity consists of shareholders or owners
funds on which payments of dividend depends upon the company’s profits. A high proportion
of the debt content in the capital structure increases the risk and many lead to financial
insolvency of the company in adverse times. However, raising funds through debt is cheaper as
compared to raising funds through shares. This is because interest on debt is allowed as an
expense for tax purpose. Dividend is considered to be an appropriation of profits and so
payment of dividend does not result in any tax benefit to the company. This means if a
company, which is in 50% tax bracket, pays interest at 12% on its debentures, the effective cost
to it comes only to 6%, while if the amount is raised by issue of 12% preference shares, the cost
of raising the amount would be 12%. Thus, raising of funds by borrowing is cheaper resulting
in higher availability of profits for shareholders. This increases the earnings per equity share of
the company, which is the basic objective of a financial manager.
Optimum capital structure

A firm should try to maintain an optimum capital structure with a view to maintain financial
stability. This optimum capital structure is obtained when the market value per equity share is
the maximum.
It may, therefore, be defined as that relationship of debt and equity securities which maximizes
the value of a company’s share in the stock exchange. In case a company borrows and this
borrowing helps in increasing the value of the company’s shares in the stock exchanges, it can
be said that the borrowing has helped the company in moving towards its optimum capital
structure.
In case, the borrowing results in fall in market value of the company equity shares, it can be
said that the borrowing has moved the company away from its optimum capital structure.
The objective of the term should therefore be to select a financing or debt equity mix, which
will lead to maximum value of the firm.
According to EZRA SOLOMAN: “Optimum leverage can be defined as that mix of debt and
equity, which will maximize the market value of a company i.e., the aggregate value of the
claims, and ownership interests represented on the credit interests represented on the credit side
of the balance sheet. Further the advantages of having an optimum, financial structure if such
an optimum does exist, is two-fold; it minimizes the company’s cost of capital which in turn
increases it ability to find new wealth-creating investment opportunities. Also by increasing the
firm’s opportunity to engage in future wealth-creating investment it increases the economy rate
of investment and growth”.
Considerations
The following considerations will be greatly helpful for a finance manager in achieving his goal
of optimum capital structure.
(1) He should take advantage of favourable financial leverage. In other words if the ROI is
higher than the fixed cost of funds, he may prefer raising funds having a fixed cost to increase
the return of equity shareholders.
(2) He should take advantage of the leverage offered by the corporate taxes. A high corporate
income tax also provides some a form of leverage with respect to capital structure
management. The higher cost of equity financing can be avoided by use of debt, which in
effect provides a form of income tax leverage to the equity shareholders.
(3) He should avoid a perceived high risk capital structure. This is because if the equity
shareholders perceive an excessive amount of debt in the capital structure of the company, the
price of the equity shares will drop. The finance manager should not therefore issue
debentures or bonds whether risky or not, if the investors perceive an excessive risk and
therefore it is likely to depress the market prices of equity shares.
Capital structure theories
In order to achieve the goal of identifying an optimum debt-equity mix, it is necessary for the
finance manager to be conversant with the basic theories underlying the capital structure of
corporate enterprises.
There are the four major theories approaches explaining the relationship between capital
structures cost of capital and value of the firm.
1. Net Income (NI) Approach,
2. Net Operating income (NOI)
approach,
3. Modigliani-miller (MM) approach,
4. Traditional approach.
Assumptions
The following are the assumptions in order to present the analysis in a simple and intelligible
manner:
(i) The firm employs only the two types of the capital-debt and equity. There are also no
preference shares.
(ii) There are no corporate taxes. This assumption has been removed later.
(iii) The firm pays 100% of its earning as dividend. Thus, there are no retained earnings.
(iv) The firm’s total assets are given and do not change .In other words the investment
decision are to assumed to be constant.
(v) The firm’s total financing remains constant. The firm can change its capital structure
either by redeeming the debentures by issue of share or by raising more debt and reduce the
equity share capital.
(vi) The Operating Earning (EBIT) are not expected to grow.
(vii) The business risk remains constant and is independent of capital structure and financial
risks.
(viii) All investor have the same subjective probability distribution of the future expected
operating earnings (EBIT) for a given firm.
(ix) The firm has a perpetual life.
1. Net income (NI) approach. (Suggested by Durand)

According to this approach, capital structures decision is relevant to the valuation of the firm.
In other words a change in the capital structure causes a corresponding change in the over all
cost of the capital as well as the total value of the firm.
Higher debt content in the capital structure (i.e. High financial leverage) will result in the
overall or weighted average cost of the capital. This will cause increase in the value of the firm
and consequently increase in the value of equity share of the company. Reverse will happen in a
converse situation.
Assumptions:
(i) There are no corporate taxes.
(ii) The cost of the debt is less than cost of equity or equity capitalization rate.
(iii) The debt content does not change the risk perception of the investors.
2. Net operating income (NOI) approach. (Suggested by Durand)
This is just opposite of the Net income approach. According to this approach the market value
of firm is not at all affected by the capital structure changes .The market value of the firm is
ascertained by the capitalizing the net operating income at the overall cost of capital (k), which
is considered to be constant .The market value of equity is ascertained by deducting the market
value of the debt from the market value of the firm.
Assumptions:
(i) Over cost of capital (k) remains constant for all degrees of debt equity mix or leverage.
(ii) The market capitalizes the value of the firm as a whole and therefore, the split between
debt and equity is not relevant.
(iii) The use of debt having low cost increases the risk of equity shareholders, this, results in
increase in equity capitalization rate. Thus, the advantage of debt is set off exactly by increase
in the equity capitalization rate.
(iv) There are no corporate taxes.
Value of the firm:

According to the NOI approach, the value of a firm can be determined by the following
equation:Optimum capital structure:
According to net operating income (NOI) approach, the total value of the firm remains constant
irrespective of the debt-equity mix or the degree of leverage. The market price of equity shares
will, therefore, also not change on account of change in debt-equity mix. Hence, there is
nothing like optimum capital structure. Any capital structure will be optimum according to this
approach.
In those cases where corporate taxes are presumed, theoretically there will be optimum capital
structure when there is 100% debt content. This is because with every increase in debt content
declines and the value of the firm goes up. However due to legal and other provisions, there has
to be a minimum equity. This means that optimum capital structure will be at a level where
there can be maximum possible debt content in the capital structure.
3. Modigiliani-miller approach
The Modigiliani-Miller approach is similar to the net operating income (NOI) approach. In
other words, according to this approach, the value of a firm is independent of its capital
structure.
However, there is a basic difference between the two. The NOI approach is purely conceptual.
It does not provide operational justification for irrelevance of the capital structure in the
valuation of the firm. While MM approach supports the NOI approach provides justification for
the independence of the total valuation and cost of capital of the firm from its capital structure.
In other words, MM approach maintains that the overall cost of capital does not change in the
debt equity mix or capital structure of the firm.
Basic propositions:
The following are the three basic propositions of the MM approach.
1. The overall cost of capital (k) and the value of the firm (V) are independent of the
capital structure. In other words k and V are constant for all levels of debt-equity mix.
The total market value of the firm is given by capitalizing the expected net operating
income (NOI) by the rate appropriate for that risk class.
2. The cost of equity is equal to capitalization rate of a pure equity stream plus a premium
for the financial risk. The financial risk increases with more debt content in the capital
structure. As a result, ke increases in a manner to off set exactly the use of a less
expensive source of funds represented by debt.3. The cut-off rate for investment
purposes is completely independent of the way in which an investment is financed.
Assumptions:
(i) Capital markets are perfect. This means
(a) Investors are free to buy and sell securities.

(b) The investors can borrow without restriction on the same terms on which the
firm can borrow;
(c) The investors are well informed;
(d) The investors behave rationally; and
(e) There are no transaction costs.
(ii) The firms can be classified into homogeneous risk classes all firms within the same class
will have the same degree of business risk.
(iii) All investors have the same expectation of a firms net operating income (EBIT) with
which to evaluate the value of any firm.
(iv) The dividend payout ratio is 100%. In other words, there are no retained earnings.
(v) There are no corporate taxes. However, this assumption has been removed later.
“MM hypothesis based on the idea that no matter how you divide up the capital structure of a
firm among debt, equity and other claims, there is a conservation of investment value”.
That is, because the total investment value if corporation depends upon its underlying
profitability and risk. It is invariant with respect to relative changes in the firm’s financial
capitalization. So, regardless of the financing mix, the total value of the firm remains the same.
Arbitrage process
The arbitrage process is the operational justification of MM hypothesis. The term “Arbitrage’
refers to an act of buying an asset or security in one market having lower price and selling it in
another market at a higher price. The consequence of such action is that the market price of the
securities of the two firms exactly similar in all respects except in their capital structures cannot
for long remain different in different markets. Thus, arbitrage process restores equilibrium in
value of securities.
Limitations of mm hypothesis:
1. Rates of interest are not the same for the individuals and the firms:
The assumption made under the MM hypothesis that the firms and individual can
borrow and lend at the same rate of interest does not hold good in actual practice. This is
because firms have the higher credit standing as compared to the individuals on account of
firms holding substantial fixed assets.
2. Homemade leverage is not perfect substitute for corporate leverage:

The risk to which an investor is exposed is not identical when the investor is exposed
is not identical when the investor himself borrows. As a matter of fact, the risk exposure to the
investor is greater in the former case as compared to the latter. When the firms borrows, the
liability of the investor is limited only to the extent of his proportionate share holding, in case
the company is forced to go for its liquidation.
3. Transaction costs involved:

Buying and selling of securities involves transaction costs. It would therefore become
necessary for investor to invest a larger amount in the shares of the unlevered / levered firms
than his prevent investment to earn the same return.
4. Institutional restrictions:
The switching option form unlevered to levered firm and vice-versa is not available to
All investors particularly, institutional investors life insurance corporation of India, unit trust
of India, Commercial banks etc. Thus, the institutional restrictions stand in the way of smooth
operation of the arbitrage process.
5. Corporate taxes frustrate MM hypothesis:

On account of corporate taxes, it is a known fact that the cost of borrowing funds to the
firm is less than the contractual rate of interest. As a result, the total return to the shareholders
of an unleveled firm is always less than that of the levered firm,. Thus, the total market value
of levered firm tends to exceed that of the unlevered firm on account of this very reason.
Corporate taxes
The MM hypothesis that the value of a firm and its cost of capital will remain constant with
leverage does not hold good when there are corporate taxes. Since corporate axes do exist, in
1963 MM agreed that the value of the firm will increase or the cost of capital will decline, if
corporate taxes are introduced in the exercise. This is because interest is a deductible
expense for tax purposes and therefore the effective cost if debt is less than the contractual rate
of interest. A levered firm should have, therefore, a greater market value as compared to an
unlevered firm. The value of the levered firm would exceed that of the unlevered firm by an
amount equal to the levered firm’s debt multiplied by the tax rate. This can be put in the form
of the following formula:
VL = Vu + Bi
Where
VL = value of levered firm;
Vu = value of an unlevered firm;
B = amount of debt; and
T = tax rate
The market value of an unlevered firm will be equal to the market value of its shares.
Vu = S
Where
Vu = market value of an unlevered firm S = market value of equity;
S = Profits available for equity shareholders / Equity capitalization rate.

In other words, the value of Vu can be determined by the following equation.
Vu = (1-t) EBT
Ke
Where;
EBT = earnings before tax, T = tax rate.
Ke = equity capitalization rate.
Since in case of unlevered firm there is no debt content, earning before tax (EBT) means earning
before interest and tax (EBIT).
4. Traditional approach
The net income approach and net operating income approach represent two extremes.
According to NI approach the debt content in the capital structure affects both the overall cost
capital and total valuation of the firm while NOI approach suggests that capital structure is
totally irrelevant so far as total valuation of the firm is concerned.
i) The traditional approach is similar to NI approach to the extent that it accepts that the capital
structure or leverage of the firm affects the cost of capital and its valuation. However, it does
not subscribe to the NI approach that the value of the firm will necessarily increase with all
degree of leverages.
ii) It subscribes to NOI approach that beyond a certain degree of leverage, the overall cost of
capital increases resulting in decrease in the total value of the firm. However, it differs from
NOI approach in the sense that the overall cost of capital will not remain constant for all degree
of leverage.
The essence of the traditional approach lies in the fact that a firm through judicious use of debt-
equity mix can increase its total value and thereby reduce its overall cost of capital. This is
because debt is relatively a cheaper source of funds as compared to raising money through
shares because of tax advantage. However, beyond a point raising of funds through debt may
become a financial risk and would result in a higher equity capitalization rate. Thus, up to a
point, the content of debt in the capital structure will favorably affect the value of the firm. At
this level of debt equity mix, the capital structure will be optimum and the overall cost of
capital will be the least.
Optimum capital structure
The optimum capital structure may be defined as “ Capital Structure or combination of debt and
equity that leads to the maximum value of the firm. Optimal capital structure maximizes the
value of the firm and hence the wealth of its owners and minimizes the company’s cost of
capital.
The following considerations should be kept in mind while maximizing the value of the firm in
achieving the goal of optimum capital structure.
(i) It is the return on investment is higher than the fixed cost of funds, the company
should prefer to raise funds having affixed cost, such as debentures, loans and
preference share capital. It will increase earnings per share and market value of the
firm. Thus company should make maximum possible use for leverage.
(ii) When debt is used as a source of finance, the firm saves a considerable amount in
payment of tax as interest is allowed as a deductible expense in computation of tax.
Hence the effective cost of debt is reduced called tax leverage. A company should
take advantage of tax leverage.
(iii) The firm should avoid undue financial risk attached with the use of increased debt
financing. If the shareholders perceive high risk in using further debt-capital, it will
reduce the market price of shares.
(iv) The capital structure should be flexible
Features of an appropriate capital structure

1. Profitability:
The capital structure of the company should be most profitable, the most profitable
capital structure is one that tend sot minimize cost of financing and maximize earning per
equity share.
2. Solvency:
The pattern of capital structure should be so devised as to ensure that the firm does not
run the risk of becoming insolvent. Excess use of debt threatens the solvency of the company.
The debt content should not therefore be such that it increases risk beyond manageable limits.
3. Flexibility:
The capital structure should be such that it can be easily maneuvered to meet the
requirements of changing conditions. Moreover, it should also be possible for the company to
provide funds whenever need to finance its profitable activities.
4. Conservatism:
The capital structure should be conservative in the sense that the debt content in the
total capital structure does not exceed the limit which the company can bear. In other words, it
should be such as is commensurate with the company ability to generate future cash flows.
5. Control:
The capital structure should be so devised that it involves minimum risk of loss of
control of the company.
Factors determining capital structure
1. Financial leverage (or) trading on equity:

The use of long term fixed interest bearing debt and preference share capital along with equity
share capital is called financial leverage or trading on equity. The use of long-term debt
increases magnifies the earnings per share if the firm yields a return higher than the cost of
debt. The earnings per share also increase with use of preference share capital but due to the
fact that interest is allowed to be deducted while computing tax, the leverage impact of debt is
much more. However the leverage can operate adversely also if the rate of interest on long-term
loans is more than the expected rate of earnings of the firm. Therefore it needs caution to plan
the capital structure of a firm.
2. Growth and stability:

The Capital Structure of a firm is highly influenced by the growth and stability of its sale. If the
sales of a firm are expected to remain fairly stable it can raise a higher lever of debt. Stability of
sales ensures that the firm will not face any difficulty in meeting its fixed commitments of
interest repayment of debt. Similarly the rate of growth in sales also affects the capital structure
decision. Usually greater the rate of growth of sales, greater can be the use of debt in the
financing of firm.
3. Cost of capital:
Cost of Capital refers to the minimum return expected by its suppliers. The capital Structure
should provide for the minimum cost of capital. The main sources of finance for a firm are
equity, preference share capital and debt capital. The return expected by the suppliers of capital
depends upon the risk they have to undertake. Usually, debt is cheaper source of finance
compared to preference and equity capital due to I) Fixed rate of interest on debt ii) legal
obligation to pay interest iii) repayment of loan and priority in payment at the time of winding
up of the company.
4. Cash flow ability to service debt:

A Firm shall be able to generate larger and stable cha inflows can employ more debt in its
capital structure as compared to the one, which has unstable and lesser ability to generate cash
inflows. Debt financing implies burden of fixed charge due to the fixed payment of interest and
the principal. Whenever a firm wants to raise additional funds. It should estimate the future cha
inflows to ensure the coverage of fixed charges.
5. Nature of enterprise.
The nature of enterprise also to a great extent affects the capital structure of the company.
Business enterprises which have stability in their earning or which enjoy monopoly regarding
their products may go for debentures or preference shares since they will have adequate profits
to meet the recurring cost of interest/fixed dividend.
6. Size of the company:

Companies, which are of small size, have to rely considerably upon the owner’s funds for
financing. Such companies find it difficult to obtain long-term debt, large companies are
generally considered to be less risky by the investors and therefore they can issue different
types of securities and collect their funds from difficult sources. They are in a better bargaining
position and can get funds form the sources of their choice.
7. Retaining control:
The capital structure of a company is also affected by the extent to which the promoter’s
management of the company desires to maintain control over the affairs of the company. The
preference shareholders and debenture holders have not much say in the management of the
company. It is the equity shareholders who select the team of managerial personnel. It is
necessary for the promoters to own majority of the equity share capital in order to exercise
effective control over the affairs of the company. The promoters or the existing management
are not interested in losing their grip over the affairs of the company and at the same time, they
need extra funds.
8. Purpose of financing:
The purpose of financing also to some extent affects the capital structure of the company. In
case funds are required for some directly productive purposes, for example, purchase of new
machinery, the company can afford to raise the funds by issue of debenture. This is because the
company will have the capacity to pay interest on debentures out of the profits so earned.
9. Requirement of investors:
Different types of securities are to be issued for different classes of investors. Equity shares are
best suited for bold or venturesome investors. Debentures are suited for investors who are very
cautious while preference shares are suitable for investors who are not very cautious. In order to
collect funds form different categories of investors, it will be appropriate for the companies to
issue different categories of securities.
10. Period of finance:

The period for which finance is required also affects the determination of capital structure of
companies. In case, funds are required, say for 3 to 10years, it will be appropriate to raise them
by issue of debentures rather than by issue of shares. This is because in case issue of shares
raises the funds, their repayment after 8 to 10 years will be subject to legal complications.
11. Capital market conditions:

Capital market conditions do not remain the same forever. Sometimes there may be depression
while at other times there may be boom in the market. The choice of the securities is also
influenced by the market conditions. If the share market is depressed the company should not
issue equity shares and investors would prefer the company should not issue equity shares. It is
advisable to issue equity shares in the boom period.
12. Asset structure:

The liquidity and the composition of assets should also be kept in mind while selecting the
capital structure. If fixed assets constitute a major portion of the total assets of the company. It
may be possible for the company to raise more of long-term debts.
13. Costs of floatations:

The Cost of floating a debt is generally less than the cost of floating equity and hence it may
persuade the management to raise debt financing. The costs of floating as a percentage of total
funds decrease with the increase n size of the issue.
14. Government policy:

Government policy is also an important factor in planning the company capital structure. For
example a change in the lending policy of financial institutions may mean a complete change in
the financial pattern. Similarly, by virtue of the capital issues control act, 1947 and the rules
made there under, the controller of capital issues cal also considerably affects the capital issue
policies of various companies.
15. Legal requirements:

The promoters of the company have also to keep in view the legal requirements while deciding
about the capital structure of the company. This is particularly true in case of banking
companies, which are not allowed to issue any other type of security for raising funds except
equity share capital on account of the banking regulation act.
16. Corporate tax rate:

High rate of corporate taxes on profits compel the companies to prefer debt financing, because
interest is allowed to be deducted while computing taxable profits. On the other hand, dividend
on shares is into an allowable expense for that purpose.
Questions (part-A)
1. Write short note on leverage.
2. Explain different types of Leverage.
3. How is the degree of financial leverage measured?
4. From the following information, Calculate operating leverage:
No.of Units produced and sold:60,000
Selling price per unit:30
Variable cost per unit:Rs20
Fixed cost per unit at current level of sales is Rs.3
5. Compare financial leverage with operating leverage.
6. What is meant by capital structure?
7. `What do you mean by optimum capital structure?
Questions (part-B)
1. Describe the arbitrage process under MM approach.

2. What do you mean by operating leverage? Explain its significance.
3. Describe composite leverage. How it is measured?
4. From the following information, Calculate operating leverage:
No.of Units produced and sold:30,000
Selling price per unit:20
Variable cost per unit:Rs10
Fixed cost per unit at current level of sales is Rs.5. What will be the new operating leverage if
the variable cost is Rs.12
5. Explain the Modigliani and Miller approach to capital structure.
6. Discuss the net operating income approach to capital structure.
7. Discuss the factors to be kept in mind while determining the capital structure of a firm.
Reference Books:
 Cases & Problems On Financial Management: Rao, A. P., Everest Publishing
House
 Financial Management & Policy: Global Perspective: Srivastava, R. M.
Himalaya
UNIT – IV – FUNDAMENTALS OF FINANCIAL MANAGEMENT-SBAA3004

Cost of capital
Introduction
The cost of capital is a cornerstone and an important element in Financial Management. The
capital structure of a company is framed on the basis of the concept of cost of capital. Hence it is
essential to understand the cost a firm incurred in raising various types of capital. The cost of
capital is the overall cost incurred by a firm for getting capital. It is the rate of return required by
the suppliers of capital. In other words the cost of capital is the minimum rate of return on
investment expected by the company to satisfy various categories of investors who made
investments in the form of shares, debentures or term loans. Unless the company earns this
minimum rate of return, it will not be in a position to pay interest to debenture holders and
dividend to its share holders. The cost of capital is the weighted average cost various financial
resources that a firm uses in its capital structure.
Definitions
According to I.M. Pandey “It is simply the rate of return the funds should produce to justify their
use within the firm in light of the wealth maximization objective”.
According to Solomon & Pringle “It is the rate of return required by those who supply the
capital”.
Methods of Computing Cost of Capital

As we discussed a firms cost of capital is the combined cost of equity, preference, debt and
retained earnings, to calculate cost of capital we need to calculate cost of different sources of
finance.
1. Cost of Debt
A company’s debt capital may be of short term or long term nature. For the calculation of cost of
debt, the interest on the debt can be considered, but in reality it is not the real cost of debt. The
cost of debt is much lower than the rate of interest the company has to pay. This is because the
interest on debts is tax deductible. Hence while computing the cost of debts adjustments are to
be made for considering tax.
Suppose a firm issues the 12% debentures at a face value of Rs. 1000 each and the tax rate
applicable to the company is 50%. The cost of debenture is not 12%, which is the rate of interest
but it is to be deducted by the tax benefit available. The tax benefit is 50% of 12%. Hence the
cost of debenture is only 6%.
Cost of Equity
Computation of cost of equity is the most difficult and complex exercise as the equity
shareholders do not receive any fixed rate of dividend. The cost of equity capital depends upon
the market value of shares, which in turn depends upon the dividends paid and the rate of
dividend depends on the degree of financial and business risks. The various approaches to the
computation of cost of equity are as follows:
Dividend Price Approach
According to this approach, an investor before investing in equity shares of a company he

expects certain return on investment in the form of dividend. Hence the expected rate of dividend
is the cost of equity.
Earning Price Ratio or Earning Yield Approach

According to this approach an investor invest with the expectation of earning some amount on
his investment from the company either distributed as dividend or not. This method assumes that
the value of invested capital is equal to the market price of shares.
�
�� = × 100
𝑃
Where, E = Earnings per share
P = Market price per share
Dividend Plus Growth Approach

According to this approach when an investor invests in the equity shares of a company he
expects not only payment of dividend but also growth in the dividend rate at a uniform rate
perpetually.
Costs of Retained Earnings

That part of the earnings which is not distributed to shareholders in the form of dividend but
reinvested in the business itself is called as retained earnings. It is argued that retained earnings
do not cost anything to company as there is no formal or implied obligations to pay return on
retained earnings. But retained earnings involve opportunity cost as dividend is forgone by
shareholders and the opportunity to earn returns by investing same outside.
There are three methods of calculating cost of Retained Earnings.
Weighted Average Cost of Capital (WACC)

The weighted average cost of capital is the overall cost of capital. Weighted average cost of
capital is calculated by giving weightage to the cost of each source of funds by assessing the
proportion of each source of funds to the total and the by considering the book value or the
market value of each source of fund.
Illustration 1
ABC Limited has the following capital structure:
Securities Book Value (Rs.) After Tax Cost
(%)
Equity Capital 500000 12
Retained Earnings 200000 10
Preference Capital 300000 14
Debentures 500000 7
1500000
Calculate the weighted average cost of capital of a company.
Solution:
STATEMENT OF WACC
Securities Book Value Proportion After Tax Weighted
(Rs.) Cost (%) Cost (%)
Equity Capital 500000 33.33 12 4

Retained 200000 10
Earnings
13.33 1.33
Preference 300000 14
Capital
20.00 2.8
Debentures 500000 33.33 7 2.33
1500000 100 43 10.47
Weighted Average Cost of Capital ABC Limited is 10.47%.

Illustration 2
A company has the following capital structure. Find out the weighted average cost of capital:
Securities Book Value (Rs.) After Tax Cost

(%)
Equity Capital 300000 13
Retained Earnings 600000 10
Preference Capital 800000 14
Debentures 500000 6
2200000
Solution:
STATEMENT OF WACC
Securities Book Value Proportion After Weighted
(Rs.) Tax Cost (%)
Cost
(%)
Equity Capital 300000 13.64 13 1.77
Retained 600000 27.27 10 2.73

Earnings
Preference 800000 36.36 14 5.09
Capital
Debentures 500000 22.73 6 1.36
2200000 100 43 10.95
Weighted Average Cost of Capital ABC Limited is 10.95%.
Limitations of WACC
Some of the limitations of WACC are as follows:
1. Difficulty in the determination of weights:
While determining the weights for various sources of cost of capital one of the major problems
involved is whether book value weights or the market value weights to be considered. As book
value weights and market value weights are different. The Market value weight gives a higher
value compared to book value weights.
2. Problem with choosing capital structure:
In practice there are three types of capital structure like
Existing/ current capital structure,
Marginal capital structure
Optimal capital structure
Now the question is which capital structure is to be considered. The best one is the optimal
capital structure, but existing capital structure is considered as the optimal capital structure,
which is not always true.
3. Other Limitations:
WACC has limited applicability and not useful during the below said circumstances:
In case of significant changes in the debt policy of the company.
During changes in the dividend policy
Company’s decision to change its growth objective.
Changes in the capital mix.
Considerations in Calculating WACC

The following are the steps to be followed in calculating WACC:
1. Step: Assigning of weights to various sources of funds based on either book value of
funds or on the bases of market value of funds.
2. Step: Multiply the cost of each source of funds by the weight so assigned.
3. Step: Add all the weights so obtained to ascertain WACC.
Questions
(part-A)
1. What do you understand by the cost of capital?

2. Why is the cost of capital important?
3. Describe some aspects of cost of capital.
4. What is cost of debt capital?
5. Write an important condition for the adjustment of the cost of debt.
6. What is the importance of cost of equity capital?
7. What does the cost of equity capital indicate?
Questions (part-B)
1. Explain the concept of average cost of capital with the help of an example?
2. Explain the method of computing cost of preference shares with the help of an example.
3. What is meant by ‘to establish the cost of equity capital’?
4. How many approaches are there for estimating cost of equity?
5. Describe the correct capital structure of a firm for obtaining the weights to work out the
weighted average.
6. What points should be taken into consideration in order to calculate the cost of capital?
7. Describe net capital investment as a component of investment analysis
Reference Books
UNIT – V – FUNDAMENTALS OF FINANCIAL MANAGEMENT-SBAA3004

Dividends
Meaning of dividend
The term dividend refers to that part of the profits of a company, which is distributed amongst
its shareholders. It may be defined as the return that a shareholder gets from the company, out
of its profits, on his shareholdings.
According to the Institute of Chartered accountants of India, dividend is “a distribution to
shareholder out of profits or reserves available for this purpose”.
Dividend policy
The term dividend policy refers o the policy concerning quantum of profits to be distributed as
dividend.
The concept of dividend policy implies that companies through their Board of Directors evolve
a pattern of dividend payments, which has a bearing on future action.
Classification of dividends
Dividends can be classified into different categories depending upon the form in which they
are paid. The various forms of dividends are as follows:
(1)Cash Dividend:
Payment of dividend in cash is called cash dividend and these results in outflow of
funds from the firm.
(2)Bond dividend:
If the company does not have sufficient funds to pay dividend in cash it may issue
bonds for the amount due to the shareholders by way of dividends. The purpose of bond
dividend is to postpone the payment of dividend in cash.
(3)Property Dividend:
In this case, the dividend is paid in the form of assets other than cash. This may be in
the form of assets, which are not required by the company or tin the form of company’s
products.
(4)Stock dividend:
The company issues its own shares to the existing shareholders in lieu or in addition to
cash dividend. Payment of stock dividend is known as “Issue of bonus shares”.
Theories related to dividend policies
1. Modigliani and miller’s approach:

This comes under the Irrelevance concept of dividend. According to them, dividend policy has
no effect on the share prices of a company and therefore, of no consequence. They have
suggested that the price of shares of a firm is determined by its earning potentiality and
investment policy and never by the pattern of income distribution.
For eg., If a company having investment opportunities, distributes all its earnings among its
shareholders, it will have to raise the capital from outside. This will result in increasing the
number of shares resulting in the fall in the future Earning per share. Thus, whatever a
shareholder has gained as a result of increased dividends will be neutralized completely on
account of fall in the value of shares due to decline in the expected earning per share.
Assumptions of MM Hypothesis:
MM hypothesis is based on the following assumptions:

(i) Capital markets are perfect.
(ii) Investors behave rationally. Information is freely available to them and there are no
transaction and floatation costs.
(iii) There are either no taxes or there are no differences in the tax rates applicable to capital
gains and dividends.
(iv) The firm has a fixed investment policy.
(v) Risk or uncertainty does not exist.
According to MM hypothesis, the market value of a share in the beginning of the period is
equal to the present value of dividends paid at the end of the period plus the market price of the
share at the end of the period.
This can be put in the form of the following equation:
Po = (D1 P1)/ (1 Ke)
Where Po = Prevailing market price of a share.

Ke = Cost of equity capital.
D1 = Dividend to be received at the end of the period one.
P1 = Market Price of a share at the end of the period one.
From the above equation, the following equation can be derived for determining the value of P1.
P1 = Po (1 + Ke) – D1
Criticism of MM hypothesis:
Tax: MM hypothesis assumes that taxes do not exist, is far from reality.
Floatation costs: A firm has always to pay floatation cost in term of underwriting fee and
broker’s commission whenever it wants to raise funds from outside.
Transaction costs: The shareholder has to pay brokerage fee, etc, when he wants to sell
the shares.
Discount rate: The assumption under MM hypothesis that a single discount rate can be
used for discounting cash inflows at different time periods is not correct. Uncertainty
increases with the length of the time period.
2. Walter’s approach
This comes under the relevance concept of dividend.
Relevance concept:
A firm’s dividend policy has a very strong effect on the firm’s position in the stock
market. Higher dividends increase the value of stock while low dividends decrease their value.
This is because dividends communicate information to the investors about the firm’s
profitability.
According to Prof.James E. Walter’s approach, the dividend policy always affects the
value of the enterprise. The finance manager can, therefore use it to maximize the wealth of
the equity shareholders. Walter has also given a mathematical model to prove this point.
Prof. Walter’s model is based on the relationship between the firm’s
(i) Return on investment or internal rate of return (i.e.)
(ii) Cost of Capital or required rate of return. (i.e., k)
According to Prof.Walter, if r > k, i.e., the firm can earn a higher return than what the
shareholders can earn on their investments, the firm should retain the earnings. Such firms are
known as growth firms, and in their case the optimum dividend policy would be to plough
back the entire earnings. In their case the dividend payment ratio (D/P ratio) would, therefore,
be zero. This would maximize the market value of their shares.
In case of firm, which does not have profitable investment opportunities (i.e., r, k), the
optimum dividend policy would be to distribute the entire earnings as dividend. The
shareholders will stand to gain because they can use the dividends so received by them in
channels, which can give them higher return. Thus, 100% payout ratio in their case would
result in maximizing the value of the equity shares.
In case of firms, where r = k, it does not matter whether the firm retains or distributes earnings.
In their case the value of the firm’s shares would not fluctuate with change in the dividend
rates. There is, therefore, no optimum dividend policy for such firms.
Assumptions:
(i) The firm does the entire financing through retained earnings. It does not use
external source of funds such as debt or new equity capital.
(ii) The firm’s business risk does not change with additional investment. It implies the
firm’s internal rate of return (i.e., r) and cost of capital (i.e., k) remains constant.
(iii) In the beginning earning per share (i.e. E) and dividend (i.e., D) per share remain
constant. It may be noted that the values of ‘E’ and ‘D’ may be changed in the
model for determining the results, but any given values of ‘E’ and ‘D’ are assumed
to remain constant in determining a given value.
(iv) The firm has a very long life.
Mathematical formula:
Prof. Walter has suggested the following formula for determining the market value of a share:
r
D+ (E−D)
K
P=
K
Where,
P = Market Price per share
E = Earnings per share
D = Dividend per share
K = Cost of capital of the firm
r = internal rate of return of the firm.
Criticism:
(i) Walter’s assumption that financial requirements of a firm are met only by retained
earnings and not by external financing is seldom true in real situations.
(ii) The assumption that the firm’s internal rate of return (i.e.,r) will remain constant does not
hold good.
(iii) The assumption that ‘k’ will also remain constant does not hold good.
3. Gordon’s theory on dividend policy:

Gordon’s theory on dividend policy is one of the theories believing in the ‘relevance of dividends’
concept. It is also called as ‘Bird-in-the-hand’ theory that states that the current dividends are important
in determining the value of the firm. Gordon’s model is one of the most popular mathematical models to
calculate the market value of the company using its dividend policy.
Relation of dividend decision and value of a firm:

The Gordon’s theory on dividend policy states that the company’s dividend payout policy and
the relationship between its rate of return (r) and the cost of capital (k) influence the market price
per share of the company.
Relationship between r and k Increase in Dividend Payout
r>k Price per share decreases
r<k Price per share increases
r=k No change in the price per share
Assumptions of gordon’s model:

No debt
No external financing
Constant irr
Constant cost of capital
Perpetual earnings
Corporate taxes are not accounted for in this model.
Constant retention ratio: The model assumes a constant retention ratio (b) once it is
decided by the company. Since the growth rate (g) = b*r, the growth rate is also constant
by this logic.
K>G
Gordon’s model assumes that the cost of capital (k) > growth rate (g). This is important for
obtaining the meaningful value of the company’s share.
Gordon’s formula to calculate the market price per share (P) is P = {EPS * (1-b)} / (k-g)
Where,
P = market price per share
EPS = earnings per share
b= retention ratio of the firm
(1-b) = payout ratio of the firm
k = cost of capital of the firm
g = growth rate of the firm = b*r
Implications of Gordon’s model:

Gordon’s model believes that the dividend policy impacts the company in various scenarios as
follows:
Growth firm
A growth firm’s internal rate of return (r) > cost of capital (k). It benefits the shareholders more
if the company reinvests the dividends rather than distributing it. So, the optimum payout ratio
for growth firms is zero.
Normal firm
A normal firm’s internal rate of return (r) = cost of the capital (k). So, it does not make any
difference if the company reinvested the dividends or distributed to its shareholders. So, there is
no optimum dividend payout ratio for normal firms.
However, Gordon revised this theory later and stated that the dividend policy of the firm impacts
the market value even when r=k. Investors will always prefer a share where more current
dividends are paid.
Declining firm
The internal rate of return (r) < cost of the capital (k) in the declining firms. The shareholders are
benefitted more if the dividends are distributed rather than reinvested. So, the optimum dividend
payout ratio for declining firms is 100%.
Criticism of Gordon’s model:

Gordon’s theory on dividend policy is criticized mainly for the unrealistic assumptions made in
the model.
Constant internal rate of return and cost of capital
The model is inaccurate in assuming that r and k always remain constant. A constant r means that
the wealth of the shareholders is not optimized. A constant k means the business risks are not
accounted for while valuing the firm.
No external financing
Gordon’s belief of all investments being financed by retained earnings is faulty. This reflects
sub-optimum investment and dividend policies.
Factors affecting dividend policy

The factors affecting the dividend policy are both external as well as internal.
External factors
1. General state of economy:
In case of depressions, uncertain economic and business conditions, the management may like
to retain the whole or part of the retained earnings to build up reserves to absorb shocks in the
future. In periods of prosperity the management may not be liberal in dividend payments
though the earning power of a company warrants it because of availability of larger profitable
investment opportunities.
2. State of capital market:

In case a firm has an easy access to the capital markets either because it is financially strong or
because favourable conditions prevail in the market, it can follow a liberal dividend policy.
However, if the firm has no easy access to capital market because either of weak financial
position or because of unfavourable conditions in the capital market, it is likely to adopt a more
conservative dividend policy.
3. Legal restrictions:
A firm may also legally restricted form declaring and paying dividends. For e.g., the
Companies Act, 1956 has put several restrictions regarding payments and declaration of
dividends. Some of these restrictions are as follows:
(i) Dividends can only be paid out of
(a) The current profits of the company,
(b) The past accumulated profits or
(c) Money provided by the Central or State Government for the payment of dividends is
pursuance of the guarantee given by the Government.
(ii) A company is not entitled to pay dividends unless
(a) It has provided for present as well as all arrears of depreciation
(b) A certain p[percentage of net profits of that year as prescribed by the Central
Government not exceeding 10%, has been transferred to the reserves of the company.
(iii) Past accumulated profits can be used for declaration of dividends only as per the rules
framed by the Central Government in this behalf.
Similarly, the Indian Income tax Act also lays down certain restrictions payment of dividends.
The management takes into consideration all the legal restrictions before taking the dividend
decision.
4. Contractual restrictions:
Lenders of the firm generally put restrictions on dividend payments to protect their interests in
periods when the firm is experiencing liquidity or profitability problems. For eg.it may be
provided in a loan agreement that the firm shall not declare any dividend so long the liquidity
ratio is less than 1: 1 or the firm will not pay dividend of more than 12% so long the firm does
not clear the loan.
5. Tax Policy:
The tax policy followed by the Government also affects the dividend policy. For e.g., the
Government may give tax incentives to companies retaining larger share of their earnings. In
such a case the management may be inclined to retain a large amount of the firm’s earnings.
Internal factors:
The following are the internal factors, which affect the dividend policy of the firm:
Desire of the shareholders
Financial needs of the company
Nature of earnings
Desire to control
Liquidity position.Problem:
Example on Walters’s dividend model:
The following information is obtainable in respect of a firm:
Capitalisation Rate (Ke) = 10%
Earning Per Share (E) = Rs. 8
Compute the market price of share under Walter's Model by assuming
Rate of Return
(i) 15% (ii) 10% (iii) 5%
Dividend Payout Ratio
(i) 0% (ii) 25%
Solution:-
Dividend policy and the value of share (walter's model)
1. Assume that there are three firms. Firm A B C.

Particulars Firm A Firm B Firm C
Rate of return (r) 20% 15% 10%
Cost of capital (k) 15% 15% 15%
Earnings per share (EPS) 8/- 8/- 8/-
Assume a payout ratio of 0%, 50%, and Rs.100/.Prove Walter’s model
2. Assume that there are three firms. Firm A B C.

Particulars Firm A Firm B Firm C
Earnings per share (EPS) 12 12 12
Rate of return (r) 20% 15% 10%
Cost of capital (k) 15% 15% 15%
Prove Gordon’s model when retention ratio is 0%, 25% & 50%.
Questions
(part-A)
1. What is dividend? Explain the types of dividend.
2. Explain the approaches of dividend decision.
3. Explain the factors affecting the dividend policy
4. Discuss the various types of dividend policy.
5. Write short note on stable
6. State the criticism of MM approach.
7. What are the assumptions of Walter’s model
Questions (part-B)
1. What are the assumptions and criticisms of Gordon’s model?
2. Explain the irrelevance and relevance dividend theories.
3. Explain the factors affecting the dividend policy
4. Discuss the various types of dividend policy.
Reference Books
 Advanced Financial Management: Kohok, M. A., Everest Publishing House
 Cases & Problems On Financial Management: Rao, A. P., Everest Publishing House
 Cases In Financial Management: Pandey, I/ Bhat, R. TMH
 Financial Management: Inamdar, S. M. Everest
 Financial Management: Kishore, R. M. Taxman Allied Service
 Financial Management: Kuchhal, S. C. Chaitanya
 Financial Management & Policy: Global Perspective: Srivastava, R. M. Himalaya

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SCHOOL OF MANAGEMENT STUDIES

UNIT – I – FUNDAMENTALS OF FINANCIAL MANAGEMENT- SBAA3004

Nature of Financial Management

Finance and related disciplines

1. Finance and Economics

1. Finance and accounting:

Difference between finance and accounting

3. Finance and other disciplines

Financial management approaches

Objectives of financial management

Profit / EPS maximization wealth maximization

Finance function/ decisions in financial management

Long term assets Short term

Long term assets Short term assets/Current assets

3. Divided policy decision:

Roles/ activities of the financial manager

Management of Income and Dividend Decisions:

Liquidity decisions relate current assets management. It should be managed efficiently

Checking upon financial performance:

Organisation of finance function

Capital expenditure management Tax manager

Tools for financial forecasting

Advantages of financial forecasting:

• It indicates to the management the resources, which are needed.

- These deposits carry lower rate of interest

(b) Short term finance:

2. Consumer Credit or Customer Advance:

3. Accounts Receivable Financing:

Time Value of Money

Reasons for time preference of money:

1. What is meant by financial management? State the primary objective of financial

 Advanced Financial Management: Kohok, M. A., Everest Publishing House

UNIT – II – FUNDAMENTALS OF FINANCIAL MANAGEMENT-SBAA3004

Meaning & Definition of Capital Budgeting

Nature of Capital Budgeting

Significance of Capital Budgeting

Investment Evaluation Criteria/ Capital budgeting Techniques:

1. Pay Back Period Method:

Accept: Calculated PBP < Maximum PBP

Year Machine X Machine Y

Year Machine X Machine Y

2. Accounting Rate of Return Method

Decision Rule/ Accept- Reject Rule:

Accept: Calculated ARR > Predetermined ARR or cut-off rate.

b) When clearly mentioned as Average Rate of Return:

If the required rate of return is 12% which project should be accepted?

Average Annual Profit After Tax and Depreciation

Original Investment − Scrap Value + (Additional Working Capital + Scrap Value)

Discounted Cash Flow Criteria (Modern Method)

1. Net Present Value Method

Decision Rule (Accept / Reject Criteria):

NPV = Present Value of cash inflow – Present Value of cash outflow

The present value of Re. 1 @ 10% is as follows:

Year Project Sun Project Moon

2. Internal Rate of Return Method

Demerits of IRR Method:

Year Cash Discoun PV of Discoun PV of Discoun PV of Discoun PV of

1 22000 0.909 0.893 0.869 0.819

0.909 0.826 0.751

Calculation of Present value of cash inflow: