CAPITAL BUDGETING

DECISIONS
Internal Rate of Return
• The merits of the IRR technique can be summarized as follows :
(i) the time value of money
(ii) analyze a proposal in terms of its percentage return
(iii) consideration of all the cash flows
(iv) based on the cash flows rather than the accounting profit
Internal Rate of Return
• Some drawbacks as follows :
(a) a tedious and complicated trial and error procedure.
(b) an implied assumption that the future cash inflows are reinvested at
IRR.
(c) may give dubious results
 NPV vs. IRR
(a) Superiority of IRR over NPV
(i) IRR gives percentage return while the NPV gives absolute return.
(ii) For IRR, the availability of required rate of return is not a pre-requisite
while for NPV it is must.
(b) Superiority of NPV over IRR
(i) NPV shows expected increase in the wealth of the shareholders.
(ii) NPV gives clear cut accept-reject decision rule, while the IRR may give
multiple results also.
(iii) NPV gives better ranking as compared to the IRR
 NPV vs. IRR
• The following is the relevant information for two mutually exclusive
proposals, X and Y, being evaluated by a firm.
• Evaluate and rank these proposals as per the NPV and the IRR
techniques given that the minimum required rate of return is 10%.
NPV
Year Project (X) Project (Y)

NPV ₹ 2,505.00 ₹ 5,930.00

Decision= Choose Y
IRR
• Using Interpolation to find the IRR

𝑁𝑃𝑉𝐿𝑅
𝐼𝑅𝑅 = 𝐿𝑅 + × 𝐻𝑅 − 𝐿𝑅
𝑁𝑃𝑉𝐿𝑅 − 𝑁𝑃𝑉𝐻𝑅

𝑷𝒓𝒐𝒋𝒆𝒄𝒕 𝑿 𝑰𝑹𝑹 = 24.188%

𝑷𝒓𝒐𝒋𝒆𝒄𝒕 𝒀 𝑰𝑹𝑹 = 21.427%
Decision= Choose X
NPV vs. IRR
• Contradictory ranking
• Conflict- because proposal Y is three times the size of proposal X.
• In view of the objective of maximization of shareholders wealth, the
proposal Y is definitely preferable and should be selected.
COST OF CAPITAL
Cost of Capital- Concept
• Co. needs capital to finance the firm’s investments.
• It procures funds from different group of investors.
• The minimum rate of return that the Co. must earn in order to satisfy the
overall rate of return required by its investors is called the corporation’s
cost of capital
Factors affecting Cost of Capital
1. Risk-free Interest Rate
2. Business Risk
3. Financial Risk:
4. Other Considerations such as liquidity or marketability of the investment
Types of Cost of Capital
1. Specific and Overall Cost of Capital:
• The cost of capital of a firm is calculated as the combined cost of long-
term sources of funds.
• The long-term sources of funds can be broadly categorized into
(i) long term debt and loans
(ii) preference share capital
(iii) equity share capital, and
(iv) the retained earnings.
• The firm has a specific cost of capital for each of these sources and
• On the basis of these specific cost of capital, the overall cost of capital of
the firm can be determined.
Types of Cost of Capital
2. Explicit and Implicit Cost of Capital:
❑Explicit cost of capital
• The interest or dividend that the firm has to pay to the suppliers of funds.
• an explicit flow of return
• E.g. interest on capital, dividend on preference share capital, and on
equity shares.
❑Implicit cost of capital
• the retained earnings of the firm do not involve flow of payment
• The implicit cost of retained earnings is the return which could have
been earned by the investor, had the profit been distributed to them.
Cost of Long Term Debt and bonds
• The cost of debt may be defined as the returns expected by the potential
investors of debt securities of the firm.
❑Factors affecting cost of debt:
(i) The current level of interest rates. High IR, Higher Kd
(ii) The default risk of the firm. High default risk, Higher Kd
(iii) The tax advantages associated with the debt
Cost of Long Term Debt and bonds
• Information needed to find cost of debt:
(a) Net Proceeds from the Issue: This refers to the net cash inflow at the
time of issue of debt. This can be calculated as:
Cost of Long Term Debt and bonds
• For example, a debenture having a face value of Rs.100 is issued at a
discount of 5% and total issue of expenses are estimated at 5%
• The net proceed would be, B0 = Rs.100 – Rs.5 – Rs.5 = Rs.90.
• In case, the debenture is issued at a premium of 10%, then:
• B0 = Rs.100 + 10 – 5.50 = Rs.104.50
• Note: The floatation cost is calculated at face value or the issue price
whichever is higher.
Cost of Long Term Debt and bonds
(b) Periodic Payments of Interest:
• The firm has to pay interest on debt instruments.
• The debt instruments may sometime require regular repayments of the
principal amount also. Both (interest+principal payment) will be
considered as a cash outflow in that case.
• Note: Interest on debt is always payable on the face value irrespective of
the issue price.
• For example, if the company issues 15% debentures at Rs. 100, then the
annual interest charge will be:
• Rs. 100 ×15% = Rs. 15
• Irrespective of the fact whether the net proceeds, B0, was Rs.100 or more
or even less.
Cost of Long Term Debt and bonds
(c) Maturity Payment: The principal amount of the debt or loan (or the
balancing figure after amortization) will be payable by the firm on the
maturity date.
❑Tax Adjustment
• Tax effect
• The interest works as a tax-shield and the tax liability of the firm is
reduced.
• Thus, the effective cost of debt is lower
• The net cost of interest to the firm is the annual interest × (1 – tax rate).
Cost of Long Term Debt and bonds
❑Cost of Capital of Redeemable Debt
• The cost of capital of redeemable debt may be ascertained as follows:

• Equation 5.3 is to be solved for the value of kd.

• This equation is to be solved by trial and error procedure (as the IRR equation)
Example
• ABC Ltd. issues 12.5% debentures of face value of Rs. 100 each,
redeemable at the end of 7 years. The debentures are issued at a discount
of 5% and the flotation cost is estimated to be 1%. Find out the cost of
capital of debentures given that the firm has 40% tax rate.
• Solution: By trial and error and interpolating- Kd=8.68%
Approx method of Cost of debt
• The value of kd, maybe found by approximation :
Approx method of Cost of debt
• ABC Ltd. issues 12.5% debentures of face value of Rs. 100 each,
redeemable at the end of 7 years. The debentures are issued at a discount
of 5% and the flotation cost is estimated to be 1%. Find out the cost of
capital of debentures using approx. method given that the firm has 40%
tax rate.
Example
• ABC Ltd. issues 15% debentures of face value of Rs.1000 each at a flotation
cost of Rs. 50 per debenture. Find out the cost of capital of the debenture
which is to be redeemed in 5 annual instalments of Rs. 200 each starting from
the end of year 1. The tax rate is 30%.
• Ans: The net proceeds = Rs.950.
• As the debenture is to be amortized in 5 instalments of Rs.200 per year, the
interest @ 15% will be payable only on the reduced balances as follows :
Example
• Now use the equation to find kd

• Use trial and error to make LHS and RHS equal

• By interpolation, value of kd comes to 12.71%.
Cost of Preference Share Capital
• How Pref. shares are different from equity share capital:
(i) the preference shares are entitled to receive dividends at fixed rate on
FV in priority over the equity shares
(ii) in case of liquidation of the company, the preference shareholders will
get the capital repayment in priority over the equity shareholders.
• Preference dividend is payable only when the sufficient profit are there
Cost of Capital of Irredeemable Preference Shares
• In this case- dividend at the fixed rate will be payable to the preference
shareholder perpetually.
• The cost of capital of the irredeemable preference shares can be
calculated:
Cost of Capital of Redeemable Preference Shares
• If the preference shares are redeemable at the end of a specific period,
then the cost of capital of preference shares can be calculated by:
Example:
• ABC Ltd. issues 15% Preference shares of the face value of Rs.100 each at a flotation cost of 4%.
Find out the cost of capital of preference share if:
(i) the preference shares are irredeemable
(ii) if the preference shares are redeemable after 10 years at a premium of 10%.
Solution:
(i) If the preference shares are irredeemable
Example: RV = Rs. 110 ; P0 = Rs. 96
(ii) If the preference shares are redeemable at premium of 10%,
Redeemable value would be = Rs. 110
• The cost of capital, Kp, may be calculated by solving the following
equation:

• By trial and error and interpolation, value of Kp comes to 16.31%.

Example: RV = Rs. 96; P0 = Rs. 96
• In the same case, if the premium is not payable at the time of
redemption and the preference share is redeemable, instead, at Rs. 96
only, then the cost of capital will be as follows:

• By trial and error, and interpolation, value of kp comes to 15.63%

• It is same as it was when the preference shares were treated as
irredeemable.
Example: RV = Rs. 100; P0 = Rs. 96
• However, if the preference shares are redeemable at par i.e., Rs. 100
• then the cost of capital will be as follows:

• By trial and error and interpolation, value of 𝑲𝒑 comes to 15.83%

• This increase in cost of capital from 15.63% to 15.83% arises because of
premium of Rs. 4 payable at the time of redemption.
• This premium is a gain to shareholders but reflect a cost to the company
as indicated by the increase in cost of capital.
Approx calculation of Kp
• An approximation to 𝑲𝒑 can be quickly obtained by using the following
formulation:

• In case the preference share is issued at a net proceed of Rs. 96 and is

redeemable at par (Rs. 100) at the end of year 10, then:
Cost of Ordinary Equity Share Capital
• The measurement of 𝑲𝒆 is the most typical
• There is no coupon rate.
• No such starting point is available
• There is no commitment to pay equity dividend and it is the sole
discretion of the Board of Directors
• The return in case of equity shares is available basically, in the form of
dividends from the firm.
• The rate of discount at which the expected dividends are discounted to
determine their present value is known as the cost of equity share capital.
Cost of Ordinary Equity Share Capital
• There can be different assumptions regarding the expected behaviour of
future dividends
• These assumptions and the calculation of Ke have been taken up as
follows:
1. Zero-Growth Dividends
2. Constant Growth Rate in Dividends perpetually
3. Varying Growth Rate in Dividends
1. Zero-Growth Dividends
• dividends will remain constant
• The cost of equity share capital, Ke can be ascertained with the help of
Equation 5.9
2. Constant Growth Rate in Dividends perpetually
• Dividends may be assumed to grow at a constant rate, say, ‘g’ per cent per annum.
• In such a case, the dividend payment in year n can be expressed as :
• Dn = D0(1 + g)n
• And the present market price of the share can be shown as in Equation 5.10

• The only condition before applying Equation 5.10 is that ke > g.

2. Constant Growth Rate in Dividends perpetually
• Equation 5.10 can be further simplified and written as Equation 5.11

• Equation 5.12 shows that the cost of equity share capital, Ke

• It has two components:
1. The first, D1/P0 is called the dividend yield.
2. The second part is referred to as capital gains yield.
3. Varying Growth Rate in Dividends
• Dividends may also be assumed to grow at different rates for different years.
• Equation 5.10 can be modified and the cost of capital maybe calculated with the help of Equation 5.13.

• Equation 5.13 can be solved by trial and error procedure to find out the value of Ke
Example
• ABC Ltd. has just declared and paid a dividend at the rate 15% on the
equity share of Rs. 100 each. The expected future growth rate in
dividends is 12%. Find out the cost of capital of equity shares given that
the present market value of the share is Rs. 168.
• Solution:
• The cost of equity capital = 22%
Example
• The share of ABC Ltd. is presently traded at Rs. 50 and the company is
expected to pay dividends of Rs. 4 per share next year. The growth rate is
expected at 8% per annum. Find out the cost of capital of equity shares.
• Solution:
• The cost of equity capital = 16%
Cost of Equity Share Capital under CAPM
• There are two basic approaches to estimate the cost of equity capital.
1. The first is i.e., dividend growth model (already discussed)
2. Second is known as CAPM model (risk is used explicitly).
Cost of Equity Share Capital under CAPM
• The CAPM as applied to find out the cost of capital of equity shares can be presented as
follows :
Example
• A firm having beta coefficient of 1.8 finds the risk free rate to be 8% and
the market cost of capital at 14%. Find out the cost of capital of equity
shares of the firm.

• ke = 18.8%.
Example
• A firm having beta coefficient of 0.8 finds the risk free rate to be 8% and
the market cost of capital at 14%. Find out the cost of capital of equity
shares of the firm.

• ke = 12.8%
Example
• A firm having beta coefficient of 1 finds the risk free rate to be 8% and
the market cost of capital at 14%. Find out the cost of capital of equity
shares of the firm.

• ke = 14%
Dividend discount model basis of ke vs. the CAPM
based ke
• Dividend discount model does not consider any risk explicitly while the
CAPM considers the risk associated with a security through the beta
factor, β.
• Secondly, the CAPM ignores and is not capable of adjusting itself to any
external variable such as flotation cost or growth in dividends etc.,
whereas the dividend based ke can easily accommodate these variables.
Cost of retained earnings
• Undistributed earnings are called retained earnings which are available for
reinvestment within the firm.
• The retained earnings are often considered as subscription to additional
share capital by existing equity shareholders.
• The cost of retained earnings must be considered as the opportunity cost of
the foregone dividends.
• The cost of retained earnings, kr, is often taken as equal to the cost of equity
share capital, ke, since the retained earnings are viewed as the fresh
subscription to the equity share capital.
• kr = ke
Weighted Average Cost of Capital (WACC)
• The overall cost of capital is the rate of return that must be earned by the
firm in order to satisfy the requirements of different investors.
• It should take care of the relative proportion of different sources in the
capital structure of the firm.
• It has to be calculated as the weighted average rather than simple average
of different specific cost of capital.
Weighted Average Cost of Capital (WACC)
• The weighted average cost of capital (WACC) is defined as the weighted average of
the cost of different sources and may be described as follows :
Example
• Find WACC

• Ans: 8.75%
References
• R.P.Rustagi- Fundamentals of Financial Management, Taxmann’s 14th
Edition
• I.M.Pandey- Financial Management, 11th Edition