1.5 ADVANCED FINANCIAL MANAGEMENT Objective

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1.5 ADVANCED FINANCIAL MANAGEMENT

Objective:

1. To impart the knowledge in advanced techniques of financial management.

2. To enable the students to apply the techniques in financial decision making.

MODULE – 1: Introduction – Finance Functions – Financing decisions – Capital structure theories – net income

approach, Net operating income approach – The Traditional approach – Modighani – Miller

hypothesis – capital structure planning and policy – elements of capital structure EBIT – EPS

approach, Valuation approach, cash flow approach.

MODULE – 2:

Investment Decisions – Capital Budgeting decisions – Nature – type – Evaluation criteria – DCF –

NPV –IRR – Reinvestment assumption and modified IRR – Varying opportunity cost of capital –

Investment decision under inflation – Investment Analysis under inflation.

Complex investment decisions – projects unit, different project lives, investment timing and duration –

Replacement of an existing asst – Investment decisions under capital rationing.

MODULE – 3: Risk Analysis in Capital Budgeting – Nature of Risk/statistical techniques for Risk analysis – Risk

analysis in practice – sensitively analysis – Scenario analysis simulation analysis - Decision trees for

sequential investment decisions – utility theory and capital budgeting.

MODULE – 4: Corporate Restructuring – Mergers and Acquisitions, Corporate Restructuring – Valuation under

M&A: DCF approach Financing a merger – significance of PE Ratio and EPS analysis – Accounting

for M&As – Leveraged buyouts.

MODULE – 5: Derivatives for managing financial risk, Introduction – Derivatives & Risk hedging – Hedging

instruments – Options, Futures, forwards & swaps – use of derivatives. A Survey of software

packages for Financial Decisions making.

Books for Reference:

1. Dr. M. Muniraju, Advanced Financial Management, HPH.

2. Pawan Jhavak, Advanced Financial Management, HPH

3. Sudrasan Redd, Financial Management, HPH.

4. Weston :& Brigham, Essentials of Managerial Finance, The Dryden Press.

5. James Vanhorne, Fundamentals of Financial Management, Prentice Hall Inc.

6. John Hampton, Financial Decision Making – concepts, problems & cases, Prentice Hall of

India.

7. Schall & Haley, Financial Management, McGraw Hill, New york.

8. Brealey & Myres, Principles of Corporate Finance, McGraw Hill, New York.

9. Prasanna Chandra, Financial Management, Theory and Practice, Tata McGraw Hill.

10. Khan & Jain, Financial Management, Tata McGraw Hill.

11. I.M. Pandey, Financial Management, Viaks Publishing House.

12. S.C. Kuchal, Financial Management, Chaitanya Publishers, Allahabad.

13. Chakraborthy & others, Financial Management and Control, Mcmillan India Ltd.

Advanced financial management – chapter no.1

Swaminath S, Asst. Professor, Bangalore University Page 1

Introduction: Finance is the life blood and nerve center of a business, just as circulation of blood is essential

in the human body for maintaining life; finance is very essential for smooth running of the business. Finance

plays a significant role in all types of businesses whether it is big, medium or small. Without finance one

cannot start up business or survive. In order to setup a business enterprise finance is needed which can be

obtained from various sources such as bank loan, venture capital, own funds, investors funds, etc. Once the

funds are obtained it used for purchasing assets, further finance is required to meet day to day requirements

in terms of managing various costs incurred in routine operations such as payment of rent, salaries, and other

obligations such as expansion of business. Therefore finance is an essential aspect of an enterprise for

running and maintaining the business efficiently and effectively.

Meaning of Finance: Finance is the science and art of managing money and other assets. In the context of

companies finance implies to procuring funds, investing funds and managing the profits or losses. In the

context of personal level, finance is concerned with individual’s decision about how much of their earnings

they spend, how much they save and how they invest their savings. In the context of government, finance

deals with managing income and expenses of the nation and its status.

Classification of Finance:

1. Public Finance: Public finance deals with role of the government in managing financial requirements

of the economy. This includes procuring funds from various resources of the economy in an

appropriate manner; some of the common sources of funds of government include tax and non-tax

revenues. After generation of funds from various sources these funds are used to meet expenditures

such as national defence, public welfare and infrastructure development. Thus funds generation,

funds allocation and expenditure management are the essential components of a public finance.

2. Personal Finance: Personal finance deals with monetary decision and activities of an individual or a

family unit that includes routine income and expenses planning, retirement planning, tax planning,

investment and wealth accumulation goals. Thus, personal financial planning process involves

successfully meeting financial needs of life through proper management of finances. It is a person’s

road map to financial health and sustainable wealth creation.

3. Corporate Finance: Corporate finance also called as Business Finance and its focus is concerned

with planning, raining, investing and monitoring of fiancé in order to achieve the financial objectives

of the company. Thus, business finance deals with financing decisions on how firms raise money

from investors, how firms invest money in an attempt to earn a profit, and how they decide whether

to reinvest profits in the business or distribute them back to investors.

OR

Classification of Finance: Finance can be classified into two types:-

Private finance

Public finance

Private Finance: It deals with requirements receipts and discernment of funds to an

Individual, Business finance & Non-profit organization or corporation firms finance.



Public Finance: It deals with requirement receipts distributions of fund to the government institutions by: -

Local Self Government

State Government

Central Government

Meaning of Business Finance: Business finance is that business activity which is concerned with the

acquisition and conservation of capital funds in meeting financial needs and overall objectives of a business

enterprise. In other words, it refers to the process of raining, providing and administering of money used in a

business concern.

Definition of Business Finance: Wheeler defines business finance as “That business activity, which is

concerned with the acquisition and conservation of capital funds in meeting the financial needs and overall

objectives of business enterprise”.

Business Finance Sub Classified into three types:-

Sole proprietors Finance

Partnership firm Finance

Joint Stock Company

Importance of Finance:

1. Finance is helpful for modernization, diversification expansion and development of a enterprises.

2. Availability of adequate finance increase the credit worthiness (repayment of loan. of the concern in the

high of the supplies, traders and general public.

3. The issue of a large number of securities as provided wide investment opportunities to the investors.

4. By insuring wide distribution of funds finance contribute to balance regional development in the country.

5. Finance if essential for undertaking research activities, market survey publicity, transportation,

communication and for efficient marketing of a product.

6. By contributing to the renovation and modernization of industry finance contribute to the production and

supplies goods at fair prices to the society.

Importance of Finance in the Economy:

Ø Finance is helpful for modernization, diversification, expansion and development of an enterprise.

Ø It is essential for undertaking research, Market Survey, paragraph, publicity and for efficient Marketing of

product.

Ø Availability of sufficient Finance increases the credit worthiness of concern in the eye of the supplier,

traders and in the general public.

Ø The issue of a large number of securities has provided wide investment opportunities to the investors.



Ø By ensuring wide distribution of funds, finance contribute to balanced regional development in the

country.

Ø By contributing to the renovation and modernization of industries, finance contributes to the production

and supply of goods at fair prices to the society.

Meaning of Finance Function: Finance performs an important function in all types of organisations,

whether it is corporate or government organization, small or big organization. The scope of the finance

function depends on the size of the business and its overall organizational structure. In many organisations,

particularly large organisations, the finance functions tasks are centralized. Finance function is integral part

of various functional areas of an organization such as Production, Marketing, Human Resource and Research

& Development. It refers to action performed by a finance department that involves acquiring the utilizing

funds of a business. It refers to rising of funds and their effective utilization. It does not stop only by finding

out sources and rising of funds but it also covers proper utilization of funds.

Objectives of Finance Function:

1. Acquiring sufficient funds: The main objective of financial function is to estimate the financial

needs of the business and then finding out suitable sources for raising them. If funds are required for

long-term investments then long term sources like issue of shares, debentures, long-term loans, etc.

may be preferred. If funds are required for working capital purposes then short-term sources like bank

credit, trade credit, factoring, etc. may be used.

2. Proper utilization of funds: Another important objective of finance function is proper utilization of

funds. The funds must be used in such a way that the maximum benefit is derived from them. The

returns must be more than their expected costs.

3. Increasing Profitability: When funds are used effectively it may lead to increase in profitability. The

finance function must ensure availability of sufficient funds at all times.

4. Maximizing concerns value: Finance function also aims at maximizing the value of the firm.

Usually the value of the firm is determined by its profitability. The value of the firm is also

influenced by other factors such as sources of funds, cost of capital, money market conditions, etc.

Key Areas / Functional Areas of Financial Management:-

1. Production Department: Production management is scientific way of planning, organizing,

directing and controlling the activities involved in production process. It deals with conversion of raw

material into finished goods or products by incorporating the factors of production namely – men,

money, machines, materials, methods and markets to satisfy the wants of the customers. In order to

ensure effective working of production department funds must be properly allocated from finance.

2. Marketing: In today’s world, production has no meaning unless its exchanged for money or money’s

worth and this concept of exchange makes marketing more important than manufacturing. The key

areas of marketing are product development, pricing, place (distribution) and promotion. In order to

ensure success of marketing plans these areas needs to be addressed carefully. For developing the

product, promotion activities, distribution activities of marketing department funds must be properly

allocated from finance department.



3. Human Resource Management: Human resource department is in charge of recruiting, training,

compensation, performance appraisal, man power planning and employee relations in an

organization. The HRM department is responsible for ensuring the department employees are well-

versed in their areas of expertise. Financial decisions are necessary to fulfill the objectives of HRM

whether it is investment in training of employees or incentive schemes and retirement schemes.

4. Research and Development: The department is in charge of creating new product and innovation

which is very important to stay ahead in competition. R&D also carries out the task of improving

existing consumer products and to explore new ways of producing them. R&D also strives in

controlling costs and adopting efficient methods of production to increase profitability of the

company. Financing of R&D and innovative activities are essential to survive in business in a freely

competitive market.

Principles / Aims / Functions / Steps of Finance Function:

1. Procuring Adequate Funds: Before procuring funds, it is necessary for firms to conduct financial

forecasting to know exactly how much money is needed to get operations going. Whether to start a

new business or operating an existing business. One of the greatest challenges for an organization is

how to raise the necessary funds. Though there are various funding sources, getting the funds can be

actually challenging. If a business is not able to get the right help in the form of financing, they may

end up incurring huge debts and finally end up in insolvency position.

2. Effective Mobilization of Funds: Funds should be allocated into profitable ventures so that there is

safety on investment and regular returns is possible. A proper balance should be maintained while

investing in fixed assets and current assets. Fixed assets cannot be easily converted into cash to

satisfy requirement. Current assets produce sort of an income and are important to businesses

because they are used to fund day-to-day operations and pay ongoing expenses.

3. Acceleration of Funds: Profit is important because it is the bottom line of the business. Profit helps

a business to grow and it makes a business become financially stable. Every organization wants to

improve its profitable position but it varies from organization to organization. To achieve

profitability, it is important to ensure funds do not remain idle, thus if funds are used effectively and

efficiently, profitability gets accelerated.

4. Maximize firm’s value: Value of the firm signifies the net worth of the firm and its standing in the

market. Potential investors assess company performance in absolute terms and relative to that of

competitors – such as revenue growth, operating margin and asset efficiency. Thus, the aim of the

value maximization is the heart of corporate finance function an in order to maximize the value of

the firm to have sustainable growth and earnings.

5. Accounting and Analysis: Accounting and analysis includes an assessment of the stability, validity

and profitability of a business. Accounting analysis is used for determining the efficiency of the

company at utilization of its assets as well as measure of its profitability. Carrying out accounting

analysis is helpful in assessing the ability of a company to repay its debt obligations, to assess ability

of a company to earn income, assessing a company’s ability to maintain positive cash flow and in

assessing the company’s ability to sustaining itself in the long run without the existence of

significant losses in the business conduct.



6. Financial Reporting: Financial reporting refers to the periodic production of business financial

statements. These financial statements include the balance sheet, income statement and cash flow

statement. The balance sheet shows a snapshot of a company’s financial health. The financial

statements of a business are the core strength for its share owners and lenders; it must conform to

generally accepted accounting principles. (GAAP).

Sources of Finance: The sources of finance been broadly classified into two ways:-

Long Term Sources:

1. Shares: Most important sources for raising the permanent or long term capital. A company can issue

various types of shares. Ex: Equity, Preference, Deferred Shares. A public company cannot issue

deferred share as per company act. Preference shares carry preference rights and priority at the time

of winding up of a company.

2. Debentures: It is an instrument issued by the company acknowledging its debt on its holder.

Debentures are most popular method of raising long term loans and permanent working capital.

Debenture holders are the creditors of the company. A fixed rate of interest us paid and it is charged

against profit and loss account. They are generally given a floating rate of interest. Debenture

instruments are well suited for cautious investors.

3. Public Deposits: They are fixed deposits accepted by the enterprise from public. It is very popular

instrument for corporate for both short term and long term finance. Initially it was a popular

instrument issued by textiles mills of Ahmadabad and Bombay for a period of 6 months to 1 year. As

of now a long term deposits for 5 to 7 years are accepted. It is very simple and convenient method.

4. Ploughing Back of Profits: It means the reinvestments by concern of its surplus earning in its

business. It is an internal source of finance and most suitable for an established firm for expansion

modernization and replacement. Main advantage of this mode is that, it is cost free. There is no need

to offer any securities and there is no dilution of control. It ensures dividend policy and gains

confidence of the public.

5. Loans from Financial Institutions: Financial institutions like commercial banks, LIC and Industrial

Financial Corporations are providing loans. They provide both short term and medium term and long

term finance. This is useful for medium term demand of working capital. Interest will be changed at a

fixed rate and principle is repayable by way of installments.

Short Term Sources:

1. Indigenous Bankers: They are private moneylenders and other country bankers. They used to charge

very high rate of interest and exploited the customers to the largest extent possible. Nowadays with

the development of commercial banks, they have lost their monopoly. But even today some business

houses have depended upon indigenous bankers for obtaining loans to meet their working capital.

2. Trade Credit: It refers to the credit extended by the suppliers of goods / suppliers in the normal

course of business. According to trade policies, cash is not paid immediately for the purpose but after

an agreed period of time. It is an informal agreement or arrangement between the buyer and the seller

and there is no legal acknowledgement of debt, which is granted on an open account basis.



3. Installment Credit: Here assets are purchased and the possession of goods is taken immediately but

the payment is made in installments over a pre-determined period of time. Here interest I charged on

the unpaid price or it me adjusted in the price.

4. Accruals: The major accrual items are wages and taxes. Accruals are expenses, which have been

incurred but not yet paid. Wages are paid weekly, fortnightly or monthly and income tax are quarterly

and other taxes may be half yearly or yearly. Accruals vary with the level of activity of the firm.

Since no interest is payable upon this they are often called “free sources of financing”.

5. Cash Credit: It is an arrangement by which a bank allows his customers to borrow money up to a

certain limit against some tangible securities. Customers withdraw from his cash credit limit

according to his needs and he can also deposit any surplus amount with him. Here interest is charges

on daily balance and not on the entire amount of the account.

6. Over draft: Over draft means an arrangement with a bank by which a current account holder is

allowed to withdrawn more than the balance to his credit up to a certain limit. There are no

restrictions for operations of overdraft account. The interest is charged on daily overdrawn balances.

Cash credit is allowed for a longer period and quite permanent form of financing of working capital,

where as overdraft is allowed for a shorter period and is temporary accommodation.

7. Loans: When a bank makes an advance lump-sum against security it is called a loan. Here the bank

sanctions a specified amount. The entire amount is either paid in cash / credited to his account. The

borrower is required to pay interest to the entire amount from the date of sanction. Interest is

calculated at quarterly rates on the reduced balances. The loans may be either medium / long term.

8. Purchases / Discount of Bills: A bill arises out of a trade transaction. In which a bank lends without

any collateral security. The seller of goods draws a bill on the purchaser. The bill may be either clean

or documentary. A document bill is supported by a document of title of goods like Railway receipt, a

bill of lading. On acceptance of the bull by the purchaser, the seller offers it to the bank for discount /

purchase. When the bank discounts / purchases the bill it releases the funds to the seller. The bank

presents the bill to the purchaser (Acceptor) of the bill on the due date and gets it payment.

9. Letter of Credit: A letter of credit is an arrangement whereby a bank helps its customers to obtain

credit from his suppliers. When a bank opens a letter of credit in favor of its customer for some

specific purchases – the bank undertakes the responsibility to honor the obligation of its customers,

should the customer fail to do so.

10. Commercial Papers: They represent short term unsecured promissory notes issued by firms which

enjoy a fairly high credit rating; generally large firms with considerable financial strength are able to

issue commercial papers.

Objectives of Financial Management: Financial management is concerned with procurement and use of

funds. Its main aim is to use business funds in such a way that the firm’s value / earnings are maximized.

Financial management provides a frame work for selecting a proper course of action and deciding a viable

commercial strategy. The main objective of a business is to maximize the owner’s economic welfare. This

objective can be achieved by;

1. Specific Objectives: - Profit Maximization & Wealth Maximization

2. Other Objectives: - listed below



A. Profit Maximization: The prime motto of any kind of business activity is earning profit and

therefore profit maximization is probably be the most commonly cited goal of the business. Profit can

be defined as the amount a business earns after subtracting all expenses necessary for its sales. The

term ‘profit maximization’ implies generation of huge amount of profits over the time period, this

includes both short-term and long-term in nature.

Favorable Arguments for Profit Maximization:

1. When profit earning is the main aim of the business then, profit maximization should be its main

objective.

2. Profitability is a barometer for measuring efficiency and economic prosperity of a business enterprise.

3. Profits are the main sources of finance for the growth and development of a business.

4. A business will be able to survive under unfavorable situations like recession, depression, severe

competition, etc. only if it has some past earnings.

5. Profitability is essential for fulfilling social needs also.

6. Profit maximization attracts the investors to invest their savings in securities of the firm.

7. Profit indicates the efficient use of funds of the business concern.

8. The good will of the firm is based on profitability.

Unfavorable Arguments against Profit Maximization:

a) Huge amount of profit may invite government intervention.

b) Profit maximization objective ignores the time value of money and does not consider the magnitude

and timings of earnings. It treats all earnings as equal through they occur in different periods.

c) It does not take into consideration the risk of the prospective earnings stream.

d) Profit maximization encourages corrupt business practices to increase profit.

e) The effect of dividend policy on the market price of shares is also not considered in the objective of

profit maximization.

B. Wealth Maximization: Shareholders are the owners of corporation and they purchase stocks because

they are looking for a financial return. In most cases, shareholders elect directors, who then hire

managers to run the corporation on a day-to-day basis. Since managers are working on behalf of

shareholders, it follows that they should pursue policies that enhance shareholder value. In this

context management’s primary goal is stockholder wealth maximization, which translates into

maximizing the price of the firm’s common stock. Thus, wealth maximization is process of

increasing shareholders wealth by way of maximizing the market value of firm’s common stock.

Favorable Arguments for Wealth Maximization:

a) Wealth maximization considers the concept of time value of money.

b) Wealth maximization takes care of economic welfare of the owner, which is reflected in the market

share of a company.

c) Wealth maximization also takes care of creditors, employees, public and management.

d) Wealth maximization guides the management in formulating realistic dividend policy.



Unfavorable Arguments for Wealth Maximization:

a) Wealth maximization is a perspective idea

b) Leads to Controversy

c) Not socially desirable

d) Ownership and Management conflict

Other Objectives: Besides the above basic objectives the following are the other objectives of financial

management.

a) Ensuring a fair return to a shareholder.

b) Building up resource for growth and expansion.

c) Ensuring maximum operational efficiency by efficient and effective utilization of finances.

d) Ensuring financial discipline in the organization.

e) Achieving market share

f) Increasing productivity

g) Profit maximization

h) Social responsibility

i) Innovation

j) Customer service

k) Ensuring Profit margin

l) Employee retention

m) Increasing sales

n) Focusing on Quality work

o) Relationship Management

p) Achieving daily targets and Employee performance.

Organizational Structure of Finance: The term ‘Organizing’ mean arrangement of activities in a structured

manner. In the context of financial management organization structure of finance indicates established

pattern of relationships among individuals and positions in a finance department of a business enterprise.

Most of the business organizations have an organization structure shown below:-

The CFO may have many sub-ordinates under him to carry out his function, broadly his functions are divided

into two types:-

a) The Treasurer: The treasurer (the chief financial manager) typically manages the firm’s cash,

investing surplus funds when available and securing financing when needed. The treasurer also

oversees a firm’s investment plans and manages critical risks related to movements in foreign

currency values, interest rates and commodity prices.

b) The Controller: The controller (the chief accountant) typically handles the accounting activities,

such as corporate accounting, tax management, financial accounting and cost accounting. The

treasurer’s focus tends to be more external, whereas the controller’s focus is more internal. The

controller’s functions are mainly concerned with internal activities of business whereas treasurer’s

functions are based on external activities of business. In most of the large business organizations

financial responsibilities are jointly carried out by controller, treasurer and chief financial officer.



Introduction to Capital Structure: In order to run and manage a company, funds are needed. Right from

the promotional stage upto end, finance plays an important role in a company’s life. If funds are inadequate,

the business suffers and if the funds are not properly managed, the entire organization suffers. It is,

therefore, necessary that correct estimate of the current and future need of capital be made to have an

optimum capital structure which shall help the organization to run its work smoothly and without any stress.

Meaning of Capital Structure: Capital structure refers to the composition of capital, in other words, the

mix of sources from which the long term funds required by a business are procured. All the items on the right

hand side of the firm’s balance sheet, excluding current liabilities, are part of capital structure. OR Capital

structure is the permanent long term financing that is represented by Long term debt, Preference share

capital, Equity share capital and Retained earnings. If a firm uses only equity capital in its capital structure

and does not use debt capital, in such a situation the firm cannot get the benefits of trading on equity & the

owners of the firm cannot be successful in achieving the objective of maximization of wealth.

Definition of Capital Structure:

Capital structure of a company refers to the composition of its capitalization and it includes all long term

capital sources i.e., loans, reserves, shares and bonds. –Gerestenbeg

According to I.M.Panday – “Capital structure is the permanent financing of the firm, represented by long-

term debt, preferred stock and net worth.”



Concept of Financial Structure, Capital Structure and Assets Structure:-

Financial Structure: - It refers to the way the firm’s assets are financed; it is the entire left hand side of the

balance sheet. It included all long term and short term obligations of the firm. Financial Structure = Long

term Funds + Current Liabilities.

Capital Structure: - It includes long term debt, preference shares and equity share capital. In equity capital

we include ordinary share capital, surplus and reserves and retained earnings. Capital structure = Long

term Funds or Capital Structure = Ordinary Share Capital + Preference Share Capital + Reserves and

Surplus + Long term Debt.

Assets Structure: - This is the total of fixed assets and current assets. Assets Structure = Fixed Asset +

Current Assets + Other Assets.

Pattern of Capital Structure:

Capital structure with equity shares only.

Capital structure with both equity shares and preference shares.

Capital structure with equity shares and debentures.

Capital structure with equity shares, preference shares and debentures.

Determinants of Capital Structure: The key division in capital structure is between debt and equity, the

proportion of debt funding is measured by gearing or leverages. Capital structure of a firm is determined by

various internal and external factors. Following are the main factors which affect the capital structure

decision.

I. Internal Factors: -

1. Nature of business: The nature of an organization’s business directly influences its capital requirements.

For example, manufacturing industries require large investments in plant, machinery, warehouses and others.

While, trading concerns need relatively lesser investment in such assets.

2. Size of firm: Firm size has been empirically found to be strongly positively related to capital structure.

Large business organization requires huge capital on account of high volume of operations further these

firms are diversified with established profit having goodwill, stability and this enables them to access to the

capital market easily as their credit rating is generally good. On the other hand small business firm’s capital

structure generally consists of loans from banks and retained profits.

3. Stability of Earnings: Companies that have a proven business model and either are already profitable or

offer a clear path to sustainable profitability .Stability in earnings is a measure of accuracy in business, stable

earnings are important to a business and features strongly in business planning. If a business organization

does not manage its earnings, it may become one of those businesses that go bankrupt every year because

they could not manage their earning.

4. Freedom of Working: If the founders do not want interference in policy formation and decision making

of the firm. Company further will not issue equity share and debentures will be concentrated.



5. Asset Structure: Capital structure is the way a company finances its assets through a combination of

equity and liabilities, asset structure represents the proportion of capital employed in each type of asset. A

firm that needs more of fixed assets relays on more long-term debt. On the other hand firms with relatively

greater investment in receivables and inventory rather than fixed assets rely heavily on short-term financing.

6. Control Factor: A firm’s capital structure generally comprise of equity and/or debt, if a firm has equity

capital raised by issuing shares to public it may dilute its ownership stake in business. Because equity

investor typically have the right to vote on important company decisions, company management can

potentially lose control of their business if they sell too much of stock. Therefore it is important for the

management to retain management has 51% of stake in equity capital. On the other hand, when funds are

raised through debt capital, there is no effect on the control of the company because the debenture holders

have to control over the affairs of the company.

7. Risk Appetite of Management: Different management risk appetite may bring different changes in

capital structure decisions. Risk appetite refers to the level of risk that a management is willing to undertake

in its normal course of business. It represents a balance between the potential benefits of new actions that a

business organization undertakes and the threats that change inevitably brings. When deciding on its risk

appetite for each category of risk in its capital structure plan, the board of directors should consider the risk

capacity of the company.

8. Growth Stage: A business firm’s capital structure may also depend upon its growth stage, most of the

companies in preliminary stage have more of debt capital in their capital structure, one of the reason for this

is public investors may not subscribe for shares keeping in mind the growth stage of the company. On the

other hand more stable and mature firms typically need less debt to finance growth as its revenues are stable

and proven. These firms also generate cash flow, which can be used to finance projects when they arise.

9. Operating Ratio: If operating ratio is very high than there is less income, then the firm have more burden

of payment of interest and dividend. If the firm achieves more income with less operative ration then the firm

easily distributed interest and dividend to the share holders.

10. Trading on Equity: If the promoter wants to increase the income then they have to solve the problems

of debt financing then they can easily increase the profit of the firm.

II. External Factors: -

1. Corporate Taxes: Capital structure significantly responds to changing tax incentives, lower taxes affects

the capital structure of firms, resulting in increased equity levels and decreased long-term debt levels.

2. Degree of Competition: In order to survive in the competition a company has to ensure its products are

different and more advanced than its competitors, now in order to do this it should spend huge funds on

R&D. Further in order to gain momentum and to stay ahead in competition firms have to shell out huge

funds on advertisements and promotion.

3. Legal Requirements: The SEBI has issued guidelines for the issues of shares and debentures. According

to the companies act, they have to perform it.



4. Government Policies: Government creates the rules and frameworks in which businesses operate. From

time to time the government will change these rules and frameworks forcing businesses to change the way

they operate. For example, government regulatory bodies such as RBI and SEBI periodically frame

regulations pertaining to issue of debentures, shares, payment of dividends, mergers and acquisitions and rate

of interest etc. Therefore while deciding capital structures the financial managers should take into

consideration these policies.

5. Floatation Cost: This refers to costs incurred by a company in raising the funds from the market,

floatation costs include the cost of printing the certificates, paying the underwriters, government fees, and

registration of the issue, printing of prospectus, advertisement, and payment to the investment banker.

Generally the cost of floating a debt is less than the cost of floating an equity issue.

6. Cost of Capital: The cost incurred in owning or borrowing capital, including interest payments and

dividend obligations. As compared with other securities, the equity shares are more economical because they

have least cost of capital; from the company’s perspective payment of dividends is optional giving the

company the right to make no dividend payments during challenging trading periods.

7. Conditions of Capital Market: Capital Market conditions have significance influence over capital

structure. During depression interest rates are low and profit potentiality is uncertain and irregular, so in such

a situation debentures are more popular. During inflation profit potentiality is high, therefore demand for

ordinary share rise and in such conditions equity shares are issued.

8. Nature and Type of Investors: Nature and type of investors affects the capital structure. If investors are

ready to take more risk, equity issue is better and if they take less risk, then debentures are more suited.

9. Economic Conditions: Economic condition means the state of the economy that is determined by

numerous macroeconomic and micro economic factors, including monetary and fiscal policy, the state of the

global economy, unemployment levels, productivity, exchange rates, inflation, and business cycles and so on.

Thus, a micro and macroeconomic factor influences capital structure of a business enterprise.

Factors Determining the Capital Structure:

1. Financial Leverage or Trading on Equity: The use of long-term fixed interest bearing debt and

preference share of capital along with equity share capital is called financial leverage or trading on

equity. The use of long-term debt magnifies the earnings per share if the firm yields a return higher

than the cost of debt. The earnings per share also increase with the 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.

2. 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 a cheaper source of finance compared

to preference and equity share capital due to (i) fixed rate of interest on debt; (ii) legal obligations to

pay interest; (iii) repayment of loan & priority in payment at the time of winding up of the company.



3. Risk: There are two types of risk that are to be considered while planning the capital structure of a

firm viz; (i) business risk and (ii) financial risk. Business risk refers to the variability of earnings

before interest and taxes. Business risk can be internal as well as external. Internal risk is caused due

to improper product mix, non-availability of raw materials, incompetence to face competition,

absence of strategic management etc. External business risk arises due to change in operating

conditions caused by conditions thrust upon the firm which are beyond its control e.g., business

cycles, governmental controls, changes in business laws, international market conditions etc.

Financial risk refers to the risk of a firm that may not be able to cover its fixed financial costs.

Financial risk is associated with the capital structure of a company. A company with no debt

financing has no financial risk. The extent of financial risk depends on the leverage of the firm’s

capital structure.

4. Cash Flow Ability to Service Debt: A firm which shall be able to generate larger and stable cash

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.

5. Flexibility: Capital structure of a firm should be flexible, i.e., it should be such as to be capable of

being adjusted according to the needs of the changing conditions. It should be possible to raise

additional funds, whenever the need be, without much of difficulty and delay. A firm should arrange

its capital structure in such a manner that it can substitute one form of financing by another.

6. Nature and Size of a Firm: Nature and size of a firm also influence its capital structure. All public

utility concern has different capital structure as compared to other manufacturing concern. Public

utility concerns may employ more debt because of stability and regularity of their earnings. On the

other hand, a concern which cannot provide stable earnings due to the nature of its business will have

to rely mainly on equity capital; similarly, small companies have to depend mainly upon owned

capital as it is very difficult for them to raise long-term loans on reasonable terms and also cannot

issue equity and preference shares at ease to the public.

7. Control: In case the funds are raised through the issue of equity shares, the control of the existing

shareholders is diluted. Hence, they might raise the additional funds by way of fixed interest bearing

debt and preference share capital. Preference shareholders and debentures holders do not have the

voting right. Hence, from the point of view of control, debt financing is recommended. But,

depending largely upon debt financing may create other problems, such as, too many restrictions

imposed upon by the lenders of suppliers of finance & ultimate bankruptcy of the firm due to heavy

burden of interest & fixed charges.

8. Requirements of Investors: The requirements of investors are another factor that influences the

capital structure of a firm. It is necessary to meet the requirements of both institutional as well as

private investors when debt financing is used. Investors are generally classified under three kinds,

i.e., bold investors, cautious investors and less cautious investors. Bold investors are willing to take

all types of risk, are enterprising in nature, and prefer capital gains & control & hence it is suited.



9. Capital Market Conditions (Timing): The choice of the securities is also influenced by the market

conditions. If the share market is depressed and there are pessimistic business conditions, the

company should not issue equity shares as investors would prefer safety. But in case there is boom

period, it would be advisable to issue equity shares. Proper timing of issue of securities matters.

10. Assets 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.

11. Period of Finance: The period for which the finances are required is also an important factor to be

kept in mind while selecting an appropriate capital mix. If the finances are required for a limited

period of, say, seven years, debentures should be preferred to shares. Redeemable preference shared

may also be used for a limited period finance, if found suitable otherwise. However, in case funds are

needed on permanent basis equity share capital is more appropriate.

12. Legal Requirements: The Government has also issued certain guidelines for the issue of shares and

debentures. The legal requirements are very significant as these lay down a framework within which

capital structure decision has to be made. For example, the controller of capital issues, now SEBI

grants his consent for capital issue when (i) the debt-equity ratio does not exceed 2:1 ( for capital

intensive projects a higher debt equity ratio may be allowed, (ii) the ratio of preference capital to

equity does not exceed 1:3 and (iii) promoters hold at least 25% of the equity capital.

13. 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 not an allowable expense for that purpose.

14. Growth and Stability of Sales: The capital structure of a firm is highly influenced by the growth and

stability of its shares. If the sales of a firm are expected to remain fairly stable, it can raise a higher

level of debt. Stability of sales ensures that the firm will not face any difficulty in meeting its fixed

commitments of interest payment and repayments of debt.

15. Purpose of Financing: If funds are required for a productive purpose, debt financing is suitable and

the company should issue debentures as interest can be paid out of the profits generated from the

investment. However, if the funds are required for unproductive purpose or general development on

permanent basis, we should prefer equity capital.

16. Costs of Floatation: 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 in size of the issue.

17. Personal Consideration: The personal considerations and abilities of the management will have the

final say on the capital structure of a firm. Management which are experienced and are very

enterprising do not hesitate to use more of debt in their financing as compared to the less experienced

and conservative management.



Concept of Capitalization: Capitalization means amount of capital invested in a business. The capital of the

company may comprise various types of securities such as common and preferred stock, debentures, bonds

and long term loans which are summed up in the capital account on a balance sheet.

Meaning of Capitalization: Capitalization refers to the combination of different types of securities of a

business of a business concern.

Definition of Capitalization: According to Guthman and Dougall,”Capitalization is the sum of the par

value of stocks and bonds outstanding.”

Broader

sense Capitalization =

Equity Shares + Preference shares + Debentures + Bonds +

Long term loans + Surplus not meant for distribution.

Narrow

sense Capitalization =

Shares

Equity

Preference

+

Long Term Debts

Debentures, Bonds

Long term loans

Capitalization, Capital Structure and Financial Structure:

The terms, capitalization, capital structure and financial structure, do not mean the same; while capitalization

is a quantitative aspect of the financial planning of an enterprise. Capitalization refers to the total amount of

securities issued by a company while capital structure refers to the kinds of securities and the proportionate

amounts that make up capitalization. For raising long-term finances, a company can issue three types of

securities viz. Equity shares, Preference shares and Debentures. A decision about the proportion among

these types of securities refers to the capital structure of an enterprise. Categories of capitalization are as

follows:-

A. Over Capitalization:

Over Capitalization is situation when the company raises more capital than required for its level of business

activity and requirements. Over capitalization occurs if total of owned and borrowed capital exceeds its fixed

and current assets i.e., more capital used than actually required and the funds are not properly used, the

excess capital is not used to its fullest and the only solution is to either expand the company or reduce the

share capital. In the words of Hoagland, ”Whenever the aggregate of the par values of stocks and bonds

outstanding exceed the truth value of fixed assets of the corporation, it is said to be over capitalized”.

Causes of Over Capitalization:

High amount of idle funds at bank or in the form of low return investments.

Borrowing large amount of capital at a higher rate of interest.

Acquisition of assets when prices were high & inadequate provision for depreciation.

Over valuation in tangible assets like goodwill, patents etc.

Liberal payment of dividends to the shareholders resulting in inadequate retained profits.

High rate of taxation resulting in lower earnings.

High promotional expenditure and the actual returns are not adequate.



Effects of Over Capitalization:

Decline in market value of shares due of low profitability.

Reduce the rate of earning capacity of the shares due to lower profits.

As a result of low profitability, reputation of company is reduced.

Affects the credibility of the company as it is not able to pay its creditors on time.

Difficulties in obtaining necessary capital.

Remedies for Over Capitalization: Over capitalization by reduced by undertaking following initiatives:

By maintaining satisfactory relationship between proprietor’s funds and net profit.

Allocating the funds wisely and in the areas profitably avenue of business.

Fair valuation of assets to their proper values & Reduction of debt burden.

Negotiation with term lending institutions for reduction in interest obligation.

Redemption of preference share through a scheme of capital reduction.

B. Under Capitalization:

The concept of Undercapitalization is just the opposite to over capitalization. Under capitalization is situation

when the company does not have sufficient capital to conduct normal business operations and pay creditors.

In other words, an undercapitalized company lacks adequate cash to carry out its functions and usually fails

qualify for loans from financial institutions due to its unacceptably high Debt-to-equity ratio. Under

capitalization defined by Gerestenbeg,” A corporation may be undercapitalized when the rate of profit is

exceptionally high in the same industry”.

Causes of Under Capitalization:

Under estimation of initial and future earnings.

Desire of control and trading on equity.

Under estimation of total funds requirements.

Procurement of assets at exceptionally low prices during recession.

Use of low capitalized rate & conservative dividend policy.

Following very high efficiency in production of goods and services.

Effects of Under Capitalization:

Under capitalization have evils consequences from the point of view of the company, the society and the

shareholders, they are listed below:

Increase in the rate of profits of the company leading to higher rate of dividend.

Wide inconsistency in the prices of shares and this increases speculative activities.

Increase in the tax burden of the company and attracts Government interference

Consumers feel that they are exploited by the company.

Increase in opportunities for manipulation by management and leads to high competition.



Remedies of Under Capitalization: Under capitalization can be remedied by reduced by undertaking

following initiatives:

By issuing fresh shares under capitalization can be compensated.

Splitting up at the shares in order to reduce the dividend per share.

Issue of bonus shares can reduce both the dividend per share and earnings per share.

Increasing the par value of share may help to reduce under capitalization.

Optimal Capital Structure: The optimum capital structure may be defined as “that capital structure or

combination of debt and equity that leads to the maximum value of the firm. “The following considerations

should be kept in mind while maximizing the value of the firm in achieving the goal of optimum capital

structure:

• If the return on investment is higher than the fixed cost of funds, the company should prefer to raise

funds having a fixed cost, such as debentures, loans and preference share capital. It will increase

earnings per share and market value of the firm. Thus, a company should, make maximum possible use

of leverage.

• 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

reduces, called tax leverage. A company should, therefore, take advantage of tax leverage.

• 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.

• The capital structure should be flexible.

Essential Features of a Sound / Optimal Capital Mix:

1. Maximum possible use of leverage.

2. The capital structure should be flexible so that it can be easily altered.

3. To avoid undue financial/business risk with the increase of debt.

4. The use of debt should be within the capacity of a firm. The firm should be in a position to meet its

obligations in paying the loan and interest charges as and when due.

5. It should involve minimum possible risk of loss of control.

6. It must avoid undue restrictions in agreement of debt.

7. It should be easy to understand and simple to operate to the extent possible.

8. It should minimize the cost of financing and maximize earnings per share.

Capital Gearing Ratio: The term ‘capital gearing’ refers to the relationship between equity capital (equity

shares plus reserves) and long-term debt. It may be planned or historical, the latter describing a state of

affairs where the capital structure has evolved over a period of time, but not necessarily in the most

advantageous way. Capital gearing means the ratio between the various types of securities in the capital

structure of the company. A company is said to be in high-gear, when it has a proportionately higher/large

issue of debentures and preference shares for raising the long-term resources, whereas low-gear stands for a

proportionately large issue of equity shares.



Changes in Capitalization or Capital Structure: The following are the main reason necessitating change

in capitalization:

1. To Restore Balance in the Financial Plan: If the financial structure of a company has become top

heavy with fixed cost bearing securities resulting into a great strain on the financial position of the

company, the company may readjust its capital structure by redeeming the preference shares or

debentures out of the proceeds of new issue of equity shares. This will lead to easing out the tension

or reduce the strain and restore the balance in the financial plan.

2. To Simplify the Capital Structure: When a company has issued a variety of securities at different

points of time to raise funds at difficult terms, it may need to consolidate such securities to simplify

the financial plan as and when the market conditions are favorable.

3. To Suit Investor’s Needs: A company may have a change capitalization to suit the needs of its

investors. The companies, often, resort to split up of its shares to make these more attractive

especially when the market activity in the company’s shares is limited due to high face value and

wide fluctuations in its market prices.

4. To Fund Current Liabilities: Sometimes, the companies feel that they need working capital on

permanent basis. In such circumstances, the companies would prefer to convert their short-term

obligations into long-term by taking advantage of favorable market conditions.

5. To Clear Default on Fixed Cost Securities: When a company is not is a position to pay interest on

debentures or repay the debentures on their maturity; it may be forced to offer them certain securities

(Equity Shares, Preference Shares or New Debentures) to clear the default resulting into a change in

the capitalization of the company.

6. To Write off the Deficit: In case a company has not been doing well and book value of its assets is

over-valued as compared to their real worth or when there are accumulated losses, it is better for the

company to reorganize its capital by reducing book value of its liabilities and assets to their real

values. Such reorganization is also necessitated, because, otherwise the company cannot legally pay

dividends to its shareholders even in future when it makes profits without writing off the losses.

7. To Capitalize Retained Earnings: Changes in capitalization may take place due to capitalization

retained earnings by the issue of bonus shares. To avoid over-capitalization, maintain a balance

between preference shares and equity shares, and equity shares and debentures; a company may

prefer to issue bonus shares out of its accumulated profits and resources without affecting their

liquidity.

8. To Fund Accumulated Dividend: If a company has not been able to pay fixed dividends to its

preference shareholders and the same have been accumulating or when preference shares are due for

redemption and the company does not have necessary funds to pay for the same, the company may

prefer to issue new shares in lieu thereof resulting in a change in its capitalization.



9. To Meet Legal Requirements: Changes in capitalization may also be necessitated to meet the

changes in various legal requirements as and when those take place.

10. To Facilitate Merger and Expansion: In the same manner, to a facilitate merger and expansion; the

intending companies may be required to readjust capital structure. Such a change is generally

required to equate the shares of different companies.

Capital Structure Theories: Capital structure is the major part of the firm’s financial decision which affects

the value of the firm and it leads to change EBIT and market value of the shares. There is a relationship

among the capital structure, cost of capital and value of the firm. The aim of effective capital structure is to

maximize the value of the firm and to reduce the cost of capital. There are two major theories explaining the

relationship between capital structure, cost of capital and value of the firm.

1. Traditional Approach: It is the mix of Net Income approach and Net Operating Income approach. Hence,

it is also called as intermediate approach. According to the traditional approach, mix of debt and equity

capital can increase the value of the firm by reducing overall cost of capital up to certain level of debt.

Traditional approach states that the Ko decreases only within the responsible limit of financial leverage and

when reaching the minimum level, it starts increasing with financial leverage. Assumptions: Capital

structure theories are based on certain assumption to analysis in a single and convenient manner:

- There are only two sources of funds used by a firm; debt and shares.

- The firm pays 100% of its earning as dividend.

- The total assets are given and do not change.

- The total finance remains constant.

- The operating profits (EBIT) are not expected to grow.

- The business risk remains constant.

- The firm has a perpetual life.

- The investors behave rationally.

Net Income Approach (NI): Net income approach suggested by the Durand. According to this approach, the

capital structure decision is relevant to the valuation of the firm. In other words, a change in the capital

structure leads to a corresponding change in the overall cost of capital as well as the total value of the firm.

According to this approach, use more debt finance to reduce the overall cost of capital and increase the value

of firm. Net income approach is based on the following three important Assumptions:

1. There are no corporate taxes.

2. The cost debt is less than the cost of equity.

3. The use of debt does not change the risk perception of the investor.

Where: -

V = S+B, V = Value of firm, S = Market value of equity, B = Market value of debt

Market value of the equity can be ascertained by the following formula:



Where: -

NI = Earnings available to equity shareholder

= Cost of equity/equity capitalization rate

Format for calculating value of the firm on the basis of NI approach are as follows:-

Net Operating Income Approach (NOI): Another modern theory of capital structure, suggested by Durand.

This is just the opposite of the Net Income approach. According to this approach, Capital Structure decision

is irrelevant to the valuation of the firm. The market value of the firm is not at all affected by the capital

structure changes. According to this approach, the change in capital structure will not lead to any change in

the total value of the firm and market price of shares as well as the overall cost of capital.

NI approach is based on the following important assumptions;

- The overall cost of capital remains constant;

- There are no corporate taxes;

- The market capitalizes the value of the firm as a whole;

- Value of the firm (V) can be calculated with the help of the following formula

Modigliani and Miller Approach: Modigliani and Miller approach states that the financing decision of a

firm does not affect the market value of a firm in a perfect capital market. In other words MM approach

maintains that the average cost of capital does not change with change in the debt weighted equity mix or

capital structures of the firm. Modigliani and Miller approach is based on the following important

assumptions:

- There is a perfect capital market.

- There are no retained earnings, there are no corporate taxes.

- The investors act rationally, the dividend payout ratio is 100%.

- The business consists of the same level of business risk.



Value of the firm can be calculated with the help of the following formula:

1. Explain Net Income Approach?

According to this approach, a firm can minimize the weighted average cost of capital and increase the value

of the firm as well as price of equity shares by using debt financing to the maximum possible extent. The

theory propounds that a company can increase its value and decrease the overall cost of capital by increasing

the proportion of debt in its capital structure. This approach is based upon the following assumptions.

1. The cost of debt is less than the cost of equity

2. There are no taxes.

3. The risk perception of the investors is not changed by the use of debt.



The line of argument in favor of net income approach is that as the proportion of debt financing in capital

structure increase, the proportion of a less expensive source of funds increases. This results in the decrease in

overall (weighted average) cost of capital leading to an increase in the value of the firm. The reason for

assuming cost of debt to be less than the cost of equity are that interest rates are usually lower than dividend

rates due to element of risk and the benefit of tax as the interest is a deductible expenses.

On the other hand, if the proportion of debt financing in the capital structure is reduced or say when the

financial leverage is reduced, the weighted average cost of capital of the firm will increase and the total value

of the firm will decrease. The Net Income (NI) Approach showing the effect of the leverage on overall cost

of capital has been presented in the following figure.

The total market value of the firm on the basis of Net Income Approach can be ascertained as follows:

- V = S + D

V = Total Market Value of the Firm

S = Market value of Equity Shares

i.e., Earnings Available to Equity Shareholders (NI)

Equity Capitalisation Rate

Ko = Overall Cost of Capital or Weighted Average Cost of Capital can be calculated as:

Ko = EBIT

V

2. Explain Net Operating Income Approach?

This theory suggested by Durand is another extreme of the effect of leverage on the value of the firm. It is

diametrically opposite to the net income approach. According to this approach, change in the capital structure

of a company does not affect the market value of the firm and the overall cost of capital remains constant

irrespective of the method of financing. It implies that the overall cost of capital remains the same whether

the debt-equity mix is 50:50 or 20:80 or 0:100. Thus, there is nothing as an optimal capital structure and

every capital structure is the optimum capital structure. This theory presumes that:

1. The market capitalizes the value of the firm as a whole;

2. The business risk remains constant at every level of debt equity mix;

3. There are no corporate taxes.



The reasons propounded for such assumptions are that the increased use of the debt increases the financial

risk of the equity shareholders and hence the cost of equity increases. On the other hand, the cost of debt

remains constant with the increasing proportion of debt as the financial risk of the lenders is not affected.

Thus the advantage of using the cheaper sources of funds, i.e. debt is exactly offset by the increased cost of

equity.

According to Net Operating Income Approach (NOI), the financing mix is irrelevant and it does not affect

the value of the firm. The NOI approach showing the effect of leverage on the overall cost of capital has been

presented in the following figure:-

The value of a firm on the basis of Net Operating Income Approach can be determined as below:

V = EBIT

Ko

Where,


Ko = Overall Cost of Capital or Weighted Average Cost of Capital

EBIT = Earnings before Interest and Taxes / Net Operating Income

The market value of the equity, according to this approach is the residual value which is determined by

deducting the market value of debentures from the total market value of the firm.

Where,

S = V – D

S = Market Value of Equity Shares


D = Market Value of Debt

The Cost of equity or equity capitalisation rate can be calculated as below:-

Cost of Equity or Equity Capitalisation Rate (Ke) = Earnings after Interest and Before Taxes

Market Value of the Firm – Market Value of Debt

Ke = EBIT – I

V – D

3. Explain Traditional Approach?

The traditional approach, also known as Intermediate approach, is a compromise between the two extremes

of net income approach and net operating income approach. According to this theory, the value of the firm

can be increased initially or the cost of capital can be decreased by using more debt as the debt is a cheaper

source of fund than equity. Thus, optimum capital structure can be reached by a proper debt-equity mix.

Beyond a particular point, the cost of equity increases because increased bet increase the financial risk of

equity shareholders. The advantage of cheaper debt at this point of capital structure is offset by the increased

cost of equity. After this there comes a stage, when the increased cost of equity cannot offset by the

advantage of low-cost debt. Thus, overall cost of capital, according to this theory, decreases upto certain

point, remains more or less unchanged for moderate increase in debt thereafter; and increase or rises beyond

a certain point. Even the cost of debt may increase at this stage due to increased financial risk.



4. Explain Modigliani and Miller Approach?

M&M hypothesis is identical with the Net Operating Income Approach if taxes are ignored. However, when

corporate taxes are assumed to exists, their hypothesis is similar to the Net Income Approach.

a) In the absence of taxes (Theory of Irrelevance): The theory proves that the cost of capital is not

affected by changes in the capital structure or say that the debt-equity mix is irrelevant in the

determination of the total value of the firm, the reason argued is that through debt is cheaper to

equity, with increased use of debt as a sources of finance, the cost of equity increases. This increase

in cost of equity offsets the advantage of the low cost of debt. Thus, although the financial leverage

affects the cost of equity, the overall cost of capital remains constant. The theory emphasizes the fact

that a firm’s operating income is determinant of its total value. The theory further propounds that

beyond a certain limit of debt, the cost of debt increases (due to increased financial risk) but the cost

of equity falls there by again balancing the two costs. In the opinion of M&M, two identical firms in



all respects except their capital structure cannot have different market values or cost of capital

because of arbitrage process. In case two identical firms except for their capital structure have

different market values or cost of capital, arbitrage will take place and the investors will engage in

‘personal leverage’ (they will buy equity of the other company in preference to the company having

lesser value) as against the ‘corporate leverage’; and this will again render the two firms to have the

same total value.

The M&M approach is based upon the following assumptions:-

1. There are no Corporate Taxes.

2. There is a perfect market.

3. Investors act rationally.

4. The expected earnings of all the firms have identical risk characteristics.

5. The cut-off point of investment in a firm is capitalisation rate.

6. Risk to investors depends upon the random fluctuations of expected earnings and the possibility that

the actual value of the variables may turn out to be different from their best estimates.

7. All earnings are distributed to the shareholders.

MM approach in the absence of corporate taxes, i.e. the theory of irrelevance of financing mix has been

presented in the following figure.

b) When the corporate taxes are assumes to exist. (Theory of Relevance): M&M, in their article of

1963 have recognized that the value of the firm will increase or the cost of capital will decrease with

the use of debt on account of deductibility of interest charges for tax purposes. Thus, the optimal

capital structure can be achieved by maximising the debt mix in the equity of a firm.



According to the M&M approach, the value of the firm unlevered can be calculated as follows:-

Value of the Unlevered Firm (Vu) = Earnings before Interest & Tax

Overall Cost of Capital

Vu = EBIT (1 – t)

Ko

Value of the Levered Firm (VL) = Vu + tD

Where Vu is value of the unlevered firm and tD is the discounted present value of the tax savings resulting

from the tax deductibility of the interest charges, t is the rate of tax and D the quantum of debt used in the

mix.

Problems:

Prob 1: - ABC Ltd., needs Rs. 30,00,000 for the installation of a new factory. The new factory expects to

yield annual earnings before interest and tax (EBIT) of Rs.5,00,000. In choosing a financial plan, ABC Ltd.,

has an objective of maximizing earnings per share (EPS). The company proposes to issuing ordinary shares

and raising debit of Rs. 3,00,000 and Rs. 10,00,000 of Rs. 15,00,000. The current market price per share is

Rs. 250 and is expected to drop to Rs. 200 if the funds are borrowed in excess of Rs. 12,00,000. Funds can be

raised at the following rates.

–up to Rs. 3,00,000 at 8%

–over Rs. 3,00,000 to Rs. 15,000,00 at 10%

–over Rs. 15,00,000 at 15%

Assuming a tax rate of 50% advise the company.

Prob 2: - Compute the market value of the firm, value of shares and the average cost of capital from the

following information.

Net operating income Rs. 1,00,000

Total investment Rs. 5,00,000

Equity capitalization Rate:

(a) If the firm uses no debt 10%

(b) If the firm uses Rs. 25,000 debentures 11%

(c) If the firm uses Rs. 4,00,000 debentures 13%

Assume that Rs. 5,00,000 debentures can be raised at 6% rate of interest whereas Rs. 4,00,000 debentures

can be raised at 7% rate of interest.

Prob 3: - (a) A Company expects a net income of Rs. 1,00,000. It has Rs. 2,50,000, 8% debentures. The

equality capitalization rate of the company is 10%. Calculate the value of the firm and overall capitalization

rate according to the net income approach (ignoring income tax). (b) If the debenture debts are increased to

Rs. 4,00,000. What shall be the value of the firm and the overall capitalization rate?



Prob 4: - XYZ expects a net operating income of Rs. 2,00,000. It has 8,00,000, 6% debentures. The overall

capitalization rate is 10%. Calculate the value of the firm and the equity capitalization rate (Cost of Equity)

according to the net operating income approach. If the debentures debt is increased to Rs. 10,00,000. What

will be the effect on volume of the firm and the equity capitalization rate?

Prob 5: - Abinaya company Ltd. expresses a net operating income of Rs. 2,00,000. It has Rs. 8,00,000 to 7%

debentures. The overall capitalization rate is 10%. (a) Calculate the value of the firm and the equity

captialization rate (or) cost of equity according to the net operating income approach. (b) If the debenture

debt is increasesd to Rs. 12,00,000. What will be the effect on the value of the firm, the equity capitalization

rate?

Prob 6: - There are two firms ‘A’ and ‘B’ which are exactly identical except that A does not use any debt in

its financing, while B has Rs. 2,50,000 , 6% Debentures in its financing. Both the firms have earnings before

interest and tax of Rs. 75,000 and the equity capitalization rate is 10%. Assuming the corporation tax is 50%,

calculate the value of the firm.

Prob 7: - The following data regarding the two companies ‘X’ and ‘Y’ belonging to the same equivalent

class:

All profits after paying debenture interest are distributed as dividends. You are required to explain how under

Modigliani and Miller approach, an investor holding 10% of shares in company ‘X’ will be better off in

switching his holding to company ‘Y’.

Prob 8: - Paramount Products Ltd. wants to raise Rs. 100 lakh for diversification project. Current estimates

of EBIT from the new project is Rs. 22 lakh p.a. Cost of debt will be 15% for amounts up to and including

Rs. 40 lakh, 16% for additional amounts up to and including Rs. 50 lakh and 18% for additional amounts

above Rs. 50 lakh. The equity shares (face value of Rs. 10) of the company have a current market value of

Rs. 40. This is expected to fall to Rs. 32 if debts exceeding Rs. 50 lakh are raised. The following options are

under consideration of the company.

Determine EPS for each option and state which option should the Company adopt. Tax rate is 50%.



Prob 9: - The following is the data regarding two Companies’. X and Y belonging to the same risk class.

All profits after interest are distributed as dividend. Explain how under Modigliani & Miller Approach an

investor holding 10% of shares in Company X will be better off in switching his holding to Company Y.

Prob 10: - Gentry Motors Ltd., a producer of turbine generators, is in this situation; EBIT = Rs. 40 lac. rate

=35%, dept. outstanding = D = Rs. 20 lac., rate of Interest =10%, Ke = 15%, shares of stock outstanding =

No. = Rs. 6,00,000 and book value per share = Rs. 10. Since Gentry’s product market is stable and the

Company expects no growth, all earnings are paid out as dividends. The debt consists of perpetual bonds.

What are the Gentry’s EBS and its price per share, Po?

Financial Decisions: 3 major financial decisions are as follows:-

i. Investment Decision: This decision relates to careful selection of assets in which funds will be invested by

the firms. A firm has many options to invest their funds but firm has to select the most appropriate

investment which will bring maximum benefit for the firm and deciding or selecting most appropriate

proposal is investment decision. The firm invests its funds in acquiring fixed assets as well as current assets.

When decision regarding fixed assets is taken it is also called capital budgeting decision. Factors Affecting

Investment/Capital Budgeting Decisions:-

1. Cash Flow of the Project: Whenever a company is investing huge funds in an investment proposal it

expects some regular amount of cash flow to meet day to day requirement. The amount of cash flow an

investment proposal will be able to generate must be assessed properly before investing in the proposal.

2. Return on Investment: The most important criteria to decide the investment proposal is rate of return it

will be able to bring back for the company in the form of income for, e.g., if project A is bringing 10% return

and project В is bringing 15% return then we should prefer project B.

3. Risk Involved: With every investment proposal, there is some degree of risk is also involved. The

company must try to calculate the risk involved in every proposal and should prefer the investment proposal

with moderate degree of risk only.

4. Investment Criteria: Along with return, risk, cash flow there are various other criteria which help in

selecting an investment proposal such as availability of labour, technologies, input, machinery, etc. The

finance manager must compare all the available alternatives very carefully and then only decide where to

invest the most scarce resources of the firm, i.e., finance.



Capital Budgeting Decisions: Capital budgeting decisions can turn the fortune of a company. The capital

budgeting decisions are considered very important because of the following reasons:

1. Long Term Growth: The capital budgeting decisions affect the long term growth of the company. As

funds invested in long term assets bring return in future and future prospects and growth of the company

depends upon these decisions only.

2. Large Amount of Funds Involved: Investment in long term projects or buying of fixed assets involves

huge amount of funds and if wrong proposal is selected it may result in wastage of huge amount of funds that

is why capital budgeting decisions are taken after considering various factors and planning.

3. Risk Involved: The fixed capital decisions involve huge funds and also big risk because the return comes

in long run and company has to bear the risk for a long period of time till the returns start coming.

4. Irreversible Decision: Capital budgeting decisions cannot be reversed or changed overnight. As these

decisions involve huge funds and heavy cost and going back or reversing the decision may result in heavy

loss and wastage of funds. So these decisions must be taken after careful planning and evaluation of all the

effects of that decision because adverse consequences may be very heavy.

ii. Financial Decision: The second important decision which finance manager has to take is deciding source

of finance. A company can raise finance from various sources such as by issue of shares, debentures or by

taking loan and advances. Deciding how much to rise from which source is concern of financing decision.

Mainly sources of finance can be divided into two categories:

1. Owners fund. 2. Borrowed fund.

Share capital and retained earnings constitute owners’ fund and debentures, loans, bonds, etc. constitute

borrowed fund. The main concern of finance manager is to decide how much to raise from owners’ fund and

how much to rise from borrowed fund. While taking this decision the finance manager compares the

advantages and disadvantages of different sources of finance. The borrowed funds have to be paid back and

involve some degree of risk whereas in owners’ fund there is no fix commitment of repayment and there is

no risk involved. But finance manager prefers a mix of both types. Under financing decision finance manager

fixes a ratio of owner fund and borrowed fund in the capital structure of the company. While taking financing

decisions the finance manager keeps in mind the following factors:

1. Cost: The cost of raising finance from various sources is different and finance managers always prefer the

source with minimum cost.

2. Risk: More risk is associated with borrowed fund as compared to owner’s fund securities. Finance

manager compares the risk with the cost involved and prefers securities with moderate risk factor.

3. Cash Flow Position: The cash flow position of the company also helps in selecting the securities. With

smooth and steady cash flow companies can easily afford borrowed fund securities but when companies have

shortage of cash flow, then they must go for owner’s fund securities only.



4. Control Considerations: If existing shareholders want to retain the complete control of business then

they prefer borrowed fund securities to raise further fund. On the other hand if they do not mind to lose the

control then they may go for owner’s fund securities.

5. Floatation Cost: It refers to cost involved in issue of securities such as broker’s commission, underwriters

fees, expenses on prospectus, etc. Firm prefers securities which involve least floatation cost.

6. Fixed Operating Cost: If a company is having high fixed operating cost then they must prefer owner’s

fund because due to high fixed operational cost, the company may not be able to pay interest on debt

securities which can cause serious troubles for company.

7. State of Capital Market: The conditions in capital market also help in deciding the type of securities to

be raised. During boom period it is easy to sell equity shares as people are ready to take risk whereas during

depression period there is more demand for debt securities in capital market.

iii. Dividend Decision: This decision is concerned with distribution of surplus funds. The profit of the firm is

distributed among various parties such as creditors, employees, debenture holders, shareholders, etc.

Payment of interest to creditors, debenture holders, etc. is a fixed liability of the company, so what company

or finance manager has to decide is what to do with the residual or left over profit of the company.

The surplus profit is either distributed to equity shareholders in the form of dividend or kept aside in the form

of retained earnings. Under dividend decision the finance manager decides how much to be distributed in the

form of dividend and how much to keep aside as retained earnings. To take this decision finance manager

keeps in mind the growth plans and investment opportunities. If more investment opportunities are available

and company has growth plans then more is kept aside as retained earnings and less is given in the form of

dividend, but if company wants to satisfy its shareholders and has less growth plans, then more is given in

the form of dividend and less is kept aside as retained earnings.

This decision is also called residual decision because it is concerned with distribution of residual or left over

income. Generally new and upcoming companies keep aside more of retain earning and distribute fewer

dividends whereas established companies prefer to give more dividend and keep aside less profit. The

finance manager analyses following factors before dividing the net earnings between dividend and retained

earnings:

1. Earning: Dividends are paid out of current and previous year’s earnings. If there are more earnings then

company declares high rate of dividend whereas during low earning period the rate of dividend is also low.

2. Stability of Earnings: Companies having stable or smooth earnings prefer to give high rate of dividend

whereas companies with unstable earnings prefer to give low rate of earnings.

3. Cash Flow Position: Paying dividend means outflow of cash. Companies declare high rate of dividend

only when they have surplus cash. In situation of shortage of cash companies declare no or very low

dividend.



4. Growth Opportunities: If a company has a number of investment plans then it should reinvest the

earnings of the company. As to invest in investment projects, company has two options: one to raise

additional capital or invest its retained earnings. The retained earnings are cheaper source as they do not

involve floatation cost and any legal formalities. If companies have no investment or growth plans then it

would be better to distribute more in the form of dividend. Generally mature companies declare more

dividends whereas growing companies keep aside more retained earnings.

5. Stability of Dividend: Some companies follow a stable dividend policy as it has better impact on

shareholder and improves the reputation of company in the share market. The stable dividend policy satisfies

the investor. Even big companies and financial institutions prefer to invest in a company with regular and

stable dividend policy. There are three types of stable dividend policies which a company may follow:

(i) Constant dividend per share: In this case, the company decides a fixed rate of dividend and declares the

same rate every year, e.g., 10% dividend on investment.

(ii) Constant payout ratio: Under this system the company fixes up a fixed percentage of dividends on

profit and not on investment, e.g., 10% on profit so dividend keeps on changing with change in profit rate.

(iii) Constant dividend per share and extra dividend: Under this scheme a fixed rate of dividend on

investment is given and if profit or earnings increase then some extra dividend in the form of bonus or

interim dividend is also given.

6. Preference of Shareholders: Another important factor affecting dividend policy is expectation and

preference of shareholders as their expectations cannot be ignored by the company. Generally it is observed

that retired shareholders expect regular and stable amount of dividend whereas young shareholders prefer

capital gain by reinvesting the income of the company. They are ready to sacrifice present day income of

dividend for future gain which they will get with growth and expansion of the company. Secondly poor and

middle class investors also prefer regular and stable amount of dividend whereas wealthy and rich class

prefers capital gains. So if a company is having large number of retired and middle class shareholders then it

will declare more dividend and keep aside less in the form of retained earnings whereas if company is having

large number of young and wealthy shareholders then it will prefer to keep aside more in the form of retained

earnings and declare low rate of dividend.

7. Taxation Policy: The rate of dividend also depends upon the taxation policy of government. Under

present taxation system dividend income is tax free income for shareholders whereas company has to pay tax

on dividend given to shareholders. If tax rate is higher, then company prefers to pay less in the form of

dividend whereas if tax rate is low then company may declare higher dividend.

8. Access to Capital Market Consideration: Whenever company requires more capital it can either arrange

it by issue of shares or debentures in the stock market or by using its retained earnings. Rising of funds from

the capital market depends upon the reputation of the company.



If capital market can easily be accessed or approached and there is enough demand for securities of the

company then company can give more dividend and raise capital by approaching capital market, but if it is

difficult for company to approach and access capital market then companies declare low rate of dividend and

use reserves or retained earnings for reinvestment.

9. Legal Restrictions: Companies’ Act has given certain provisions regarding the payment of dividends that

can be paid only out of current year profit or past year profit after providing depreciation fund. In case

company is not earning profit then it cannot declare dividend. Apart from the Companies’ Act there are

certain internal provisions of the company that is whether the company has enough flow of cash to pay

dividend. The payment of dividend should not affect the liquidity of the company.

10. Contractual Constraints: When companies take long term loan then financier may put some restrictions

or constraints on distribution of dividend and companies have to abide by these constraints.

11. Stock Market Reaction: The declaration of dividend has impact on stock market as increase in dividend

is taken as a good news in the stock market and prices of security rise. Whereas a decrease in dividend may

have negative impact on the share price in the stock market. So possible impact of dividend policy in the

equity share price also affects dividend decision.

CAPITAL STRUCTURE – PLANNING & POLICY- INTRODUCTION:

Capital structure refers to the mix of long-term sources of funds, such as debentures, long-term debt,

preference share capital and equity share capital including reserves and surpluses (i.e. retained earnings).

Some companies do not plan their capital structure, and it develops as a result of the financial decisions taken

by the financial manager without any formal planning. These companies may prosper in the short-run, but

ultimately they may face considerable difficulties in raising funds to finance their activities. With unplanned

capital structure, these companies may also fail to economize the use of their funds. Consequently, it is being

increasingly realized that a company should plan its capital structure to maximize the use of the funds and to

be able to adapt more easily to the changing conditions. Theoretically, the financial manager should plan an

optimum capital structure for his company. The optimum capital structure is obtained when the market value

per share is maximum. In practice, the determination of an optimum capital structure is a formidable task,

and one has to go beyond the theory. There are significant variations among industries and among individual

companies within an industry in terms of capital structure. Since a number of factors influence the capital

structure decision of a company, the judgment of the person making the capital structure decision plays a

crucial part. Two similar companies can have different capital structures if the decision makers differ in their

judgment of the significance of various factors. A totally theoretical model perhaps cannot adequately handle

all those factors which affect the capital structure decision. These factors are highly psychological, complex

and qualitative and do not always follow accepted theory, since capital markets are not perfect and the

decision has to be taken under imperfect knowledge and risk. The capital structure should be planned

generally keeping in view the interests of the equity shareholders and the financial requirements of a

company. However, the interests of other groups, such as employees, customers, creditors, society and

government, should also be given reasonable consideration.



A sound or appropriate capital structure should have the following features:

Return: The capital structure of the company should be most advantageous. Subject to other

considerations, it should generate maximum returns to the shareholders without adding additional

cost to them.

Risk: The use of excessive debt threatens the solvency of the company. To the point debt does not

add significant risk it should be sued, otherwise its use should be avoided.

Flexibility: The capital structure should be flexible. It should be possible for a company to adapt its

capital structure with a minimum cost and delay if warranted by a changed situation. It should also be

possible for the company to provide funds whenever needed to finance its profitable activities.

Capacity: The capital structure should be determined within the debt capacity of the company and

this capacity should not be exceeded. The debt capacity of a company depends on its ability to

generate future cash flows. It should have enough cash to pay creditors’ fixed charges and principal

sum.

Control: The capital structure should involve minimum risk of loss of control of the company. The

owners of closely-held companies are particularly concerned about dilution of control.

Approaches to establish appropriate Capital Structure: The capital structure will be planned initially

when a company is incorporated. The initial capital structure should be designed very carefully. The

management of the company should set a target capital structure and the subsequent financing decisions

should be made with a view to achieve the target capital structure. The financial manager has also to deal

with an existing capital structure. The company needs funds to finance its activities continuously. Every time

when funds have to be procured, the financial manager weighs the pros and cons of various sources of

finance and selects the most advantageous sources keeping in view the target capital structure. Thus, the

capital structure decision is a continuous one and has to be taken whenever a firm needs additional finances.

The following are the three most common approaches to decide about a firm’s capital structure:

A. EBIT-EPS approach for analyzing the impact of debt on EPS

B. Valuation approach for determining the impact of debt on the shareholders’ value

C. Cash flow approach for analyzing the firm’s ability to service debt

A. EBIT-EPS Approach: The use of fixed cost sources of finance, such as debt and preference share

capital to finance the assets of the company, is known as financial leverage or trading on equity. If the

assets financed with the use of debt yield a return greater than the cost of debt, the earning per share

also increases without an increase in the owners’ investment. The earnings per share also increase

when the preference share capital is used to acquire assets. But the leverage impact is more

pronounced in case of debt because (i) the cost of debits usually lower than the cost of preference

share capital and (ii) the interest paid on debt is tax deductible. Because of its effect on the earnings

per share, financial leverage is an important consideration in planning the capital structure of a

company. The companies with high level of the earnings before interest and taxes (EBIT) can make

profitable use of the high degree of leverage to increase return on the shareholders’ equity. One

common method of examining the impact of leverage is to analyze the relationship between EPS and

various possible levels of EBIT under alternative methods of financing.



Illustration: Suppose that a firm has an all equity capital structure consisting of 100,000 ordinary shares of

Rs.10 per share. The firm wants to raise Rs.250,000 to finance its investments and is considering three

alternative methods of financing – (i) to issue 25,000 ordinary shares at Rs.10 each, (ii) to borrow

Rs.2,50,000 at 8 per cent rate of interest, (iii) to issue 2,500 preference shares of Rs.100 each at an 8 per cent

rate of dividend. If the firm’s earnings before interest and taxes after additional investment are Rs.3,12,500

and the tax rate is 50 per cent, the effect on the earnings per share under the three financing alternatives will

be as follows:

Table: EPS under alternative financing favorable EBIT:

Particulars Equity Financing

Rs.

Debt

Financing

Rs.

Preference

Financing

Rs.

EBIT

Less: Interest

PBT

Less: Taxes

PAT

Less: Preference

dividend

Earnings available to

ordinary shareholders

Shares outstanding

EPS

3,12,500

0

3,12,500

1,56,250

1,56,250

0

1,56,250

1,25,000

1.25

3,12,550

20,000

2,92,500

1,46,250

1,46,250

0

1,46,250

1,00,000

1.46

3,12,550

0

3,12,500

1,56,250

1,56,250

20,000

1,36,250

1,00,000

1.36

The firm is able to maximize the earnings per share when it uses debt financing. Though the rate of

preference dividend is equal to the rate of interest, EPS is high in case of debt financing because interest

charges are tax deductible while preference dividends are not. With increasing levels of EBIT, EPS will

increase at a faster rate with a high degree of leverage. However , if a company is not able to earn a rate of

return on its assets higher than the interest rate (or the preference dividend rate), debt (or preference

financing) will have an adverse impact on EPS. Suppose the firm in illustration above has an EBIT of

Rs.75,000/- EPS under different methods will be as follows:

Table: EPS under alternative financing methods: Unfavorable EBIT:

Particulars Equity Financing

Rs.

Debt

Financing

Rs.

Preference

Financing

Rs.

EBIT

Less: Interest

PBT

Less: Taxes

PAT

Less: Preference

dividend

Earnings available to

ordinary shareholders

Shares outstanding

EPS

75,000

0

75,000

37,000

37,500

0

1,56,250

1,25,000

0.30

75,000

20,000

55,000

27,500

1,46,250

0

27,500

1,00,000

0.27

75,000

0

75,000

37,500

1,56,250

20,000

17,500

1,00,000

0.17



It is obvious that under Unfavorable conditions, i.e. when the rate of return on the total assets is less than the

cost of debt, the earnings per share will fall with the degree of leverage.

Limitations of EPS as a Financing decision Criterion: EPS is one of the most widely used measures of the

company’s performance in practice. As a result of this, in choosing between debt and equity in practice,

sometimes too much attention is paid on EPS, which however, has some serious limitations as a financing-

decision criterion. The major shortcoming of the EPS as a financing-decision criterion is that it does not

consider risk; it ignores the variability about the expected value of EPS. The belief that investors would be

just concerned with the expected EPS is not well founded. Investors in valuing the shares of the company

consider both expected value and variability.

B. Cost of Capital and Valuation Approach: The cost of source of finance is the minimum return

expected by its suppliers. The expected return depends on the degree of risk assumed by investors. A

high degree of risk is assumed by shareholders than debt-holders. In the case of debt-holders, the rate

of interest is fixed and the company is legally bound to pay interest whether it makes profits or not.

For ordinary shareholders, the rate of dividends is not fixed and the board of directors has no legal

obligation to pay dividends even if the profits are made by the company. The loan of debt-holders is

returned within a prescribed period, while shareholders will have to share the residue only when the

company is wound up. This leads one to conclude that debt is a cheaper source of funds than equity.

This is generally the case even when taxes are not considered; the tax deductibility of interest charges

further reduces the cost of debt. The preference share capital is also cheaper than equity capital, but

not as cheap as debt. Thus, using the component, or specific, cost of capital as a criterion for

financing decisions and ignoring risk, a firm would always like to employ debt since it is the cheapest

source of funds.

C. Cash Flow Approach: One of the features of a sound capital structure is conservatism. Conservation

does not mean employing no debt or small amount of debt. Conservatism is related to the fixed

charges created by the use of debt or preference capital in the capital structure and the firm’s ability tp

generate cash to meet these fixed charges. In practice, the question of the optimum (appropriate) debt-

equity mix boils down to the firm’s ability to service debt without any threat of insolvency and

operating inflexibility. A firm is considered prudently financed if it is able to service its fixed charges

under any reasonably predictable adverse conditions. One important ratio which should be examined

at the time of planning the capital structure is the ratio of net cash inflows to fixed charges (debt-

servicing ratio). It indicates the number of times the fixed financial obligations are covered by the net

cash inflows generated by the company. The greater the coverage, the greater is the amount of debt a

company can use. However, a company with a small coverage can also employ a large amount of

debt if there are not significant yearly variance in its cash inflows and a small probability of the cash

inflows being considerably less to meet fixed charges in a given period. Thus, it is not the average

cash inflows but the yearly cash inflows which are important to determine the debt capacity of a

company. Fixed financial obligations must be met when due, not on an average or in most years but,

always. This requires a full cash flow analysis.



Components of Cash Flows: The cash flows should be analyzed over a long period of time, which can

cover the various adverse phases, for determining the firm’s debt policy. The cash flow analysis can be

carried out by preparing proforma cash flow statements to show the firm’s financial conditions under adverse

conditions such as a recession. The expected cash flows can be categorized into three groups.

A. Operating cash flows

B. Non-operating cash flows

C. Financial flows

Practical considerations in determining Capital Structure:

1. Control

2. Widely-held companies

3. Closely-held companies

4. Flexibility

5. Loan covenants

6. Early repay ability

7. Reserve capacity

8. Marketability

9. Market conditions

10. Flotation costs

11. Capacity of raising funds

12. Agency costs

In practice, it may not be possible for a company to borrow whenever it wants./ lenders may analyze a

number of characteristics of the borrower before they decide to lend. What factors do borrowers think are

considered by lenders? Borrowing firms’ managers perceive the following factors in order of importance

being considered by lenders:

(i) Profitability

(ii) Quality of management

(iii) Security

(iv) Liquidity

(v) Existing debt-equity ratio

(vi) Sales growth

(vii) Net worth

(viii) Reserve position

(ix) Fluctuations in profits

Elements of Capital Structure:

A. Capital mix firms have to secede about the mix of debt and equity capital. Debt capital can be

mobilized from a variety of sources. How heavily does the company depend on debt? What is the mix

of debt instruments? Given the company’s risks is the reliance on the level and instruments of debt

reasonable? Does the firm’s debt policy allow it flexibility to undertake strategic investments in

adverse financial conditions? The firms and analysts use debt ratios. Debt-service coverage ratios and

the funds flow statement to analyze the capital mix.



B. Maturity and priority the maturity of securities used in the capital mix may differ. Equity is the

most permanent capital. Within debt, commercial paper has the shortest maturity and public debt

longest. Similarly, the priorities of securities also differ. Capitalized debt like lease or hire purchase

finance is quite safe from the lender point of view and the value of assets backing the debt provides

the protection to the lender.

C. Terms and conditions firms have choices with regard to the basis of interest payments. They may

obtain loans either at fixed or floating rates of interest. In case of equity, the firm may like to return

income either in the form of large dividends or large capital gains. What is the firm preference with

regard to the cases of payments of interest and dividend? How do the firm’s interest and dividend

payment match with its earnings and operating cash flow? The firm’s choke of the basis of payment

indicates the management assessment about the future interstates and the fluctuations? The financial

manager can protect the firm against interstates fluctuations through the interest rates derivatives.

D. Currency firms in a number of countries have the choice of raising funds from the overseas markets.

Overseas financial markets proviso opportunities to raise lathe amounts of finds accessing capital

internationally also help company to globalize its operations fast. Because international financial

markets may mot perfect and may not he fully integrated, firms may be able to issue capital overseas

at lower costs them in the domestic markets.

E. Financial innovations firms may raise capital either through the issues of simple securities or

through the issues innovative securities. Financial innovations are intended to make the security issue

attractive to investors and reduce cost of capital. For example, a company may issue convertible

debentures at a lower interest rate rather than non-convertible debentures at a relatively higher interest

rate. A further innovation could be that the company offer. Higher simple interest rate on debentures

and offer to convert interest amount into equity.

F. Financial market segments there are several segments of financial markets from where the firm can

tap capital. For example, a firm can tap the private or the public debt market for raising long-term

debt. The firm can raise short-term debt either from banks or by issuing commercial papers of

certificate deposits in the money market. The firm also has the alternative of raising shear-term funds

but public deposits.

***************************************************************************************



Complex Investment Decisions: The simple accept-or-reject investment decisions with conventional cash

flows may not be quite common in practice. Generally a firm faces complex investments situations and has to

choose among alternatives. The use of the NPV rule can be extended to handle complicated investment

decisions. The choice between mutually exclusive projects is a simple example of project interaction.

Project with Different Lives: The correct way of choosing between mutually exclusive projects with the

same lives is to compare their NPV‟s, and choose the project with a higher NPV. The two mutually exclusive

projects being compared, however, may have different lives. The use of the NPV rule without accounting for

the differences in the projects lives may fail to indicate correct choice. Thus, the use of NPV rule would give

incorrect answers in case of projects with different lives. The correct procedure is to compare NPV‟s of the

project having equal periods of time. Project unit refers to an arrangement made by the company to establish

new unit by investing certain amount of capital either for expansion or diversification purpose. In other words

it‟s an idea generated by pooling funds from different sources and achieving the expected target by the

company. Here NPV with same project lives will be selected based on highest NPV value among proposed

projects. Project with different lives refers to projects having different estimated period of time / life, which

are used for productive purposes in premises. Here NPV rule will not going to give us an accurate choice and

the projects can be selected based on cost comparison. (Adding cash flows)

Investment Decision under Capital Rationing: A firm should accept all investment projects with positive

NPV in order to maximize the wealth of shareholders. The NPV rule tells us to spend funds in the projects

until the NPV of the last (marginal) project is zero. Capital rationing refers to a situation where the firm is

constrained for external or self-imposed, reasons to obtain necessary funds to invest in all the investments

projects with positive NPV. Under capital rationing, the management has not simply to determine the

profitable investment opportunities. But it has also to decide to obtain that combination of the profitable

projects which yields highest NPV within the available funds. Capital rationing may arise due to external

factors or internal constraints imposed by the management. There are two types of capital rationing:

1) External Capital Rationing: it mainly occurs on account of the imperfections in capital markets.

Imperfections may be caused by deficiencies in market information, or by rigidities of attitude that hamper the

free flow of capital. The NPV rule will not work if shareholders do not have access to the capital markets.

Imperfections in capital markets alone do not invalidate use of the NPV rule. In reality, we will have very few

situations where capital markets do not exist for shareholders.

2) Internal Capital Rationing: it is caused by self-imposed restrictions by the management. Various types of

constraints may be imposed. For example, it may be decided not to obtain additional funds by incurring debt.

This may be a part of other firm‟s conservative financial policy. Management may fix an arbitrary limit to the

amount of funds to be invested by the divisional managers. Sometimes management may resort to capital

rationing by requiring a minimum rate of return higher than the cost of capital. It is quite difficult sometimes

to justify the internal capital rationing. But generally it is used as a means of financial control. In a divisional

set-up, the divisional managers may overstate their investment requirements.

The capital budgeting procedure under the simple situation of capital rationing may be summarized as

follows: The NPV rule should be modified while choosing among projects under capital constraint. The

objective should be to maximize NPV per rupee of capital rather than to maximize NPV. Projects should be

ranked by their profitability index, and top-ranked projects should be undertaken until funds are exhausted.



Limitations of Profitability Index: 1) Multi-period capital constraints. 2) Project Indivisibility.

Replacement of an Existing Asset: Replacement decisions should be governed by the economics and

necessity considerations. An equipment or asset should be replaced whenever a more economical alternative

is available. A number of companies follow the practice of approving a new machine only when the existing

one can no longer perform its job. These companies follow a simple policy of replacement. Replacement is

necessary when the machine is beyond repair. They do not decide when to replace, the machine decides for

them. This is one of the most expensive wrong policies, which a company could follow. Such a policy erodes

the company‟s profitability by protecting high operating costs. If the competitors follow cost-reduction

policies by following a systematic replacement policy and are able to reduce prices in the future, the high cost

company will be squeezed out of the market sooner or later.

Management should follow a replacement policy based on economic considerations and decide when to

replace. An economic analysis may indicate to replace machine when it is, say, 5 years old with an improved

alternative. If the replacement actually takes place when the machine is, say 20 years old when it is beyond

any repair, the company has been incurring extra costs and losing extra profits for 15 years.

Investment Timing and Duration: A firm evaluates a number of investment projects every year. In the

absence of a capital constraint, it will undertake all those projects, which have positive NPV‟s and reject

those, which have negative NPV‟s, further analysis may also indicate that some of the projects may be more

valuable (that is, they may have higher NPV‟s) if undertaken in future. It may also reveal that some of the

unprofitable projects may yield positive NPV‟s if they are accepted later on. These categories of investment

projects may have different degrees of postponability; some of them may be postponed at the most to one or

two years. Those projects, which are postponable, involve two mutually exclusive alternatives: undertake

investment now or later. The firm should determine the optimum timing of investment.

The timing of investment may be a crucial factor in each of those invests project which occur once in a while

and those which are of strategic important to firm. Postponement also creates uncertainty.

Capital Budgeting under Inflation: The business decision are made by taking all the economic factors into

consideration, that is supply of money, inflation, deflation, interest rate, productivity, consumption level etc.,

inflation is such one factor will have a direct effect on capital budgeting decisions. Since India is a developing

nation, inflation is a constant ad permanent feature of the country. The fluctuation in the real value of rupee or

purchasing power of currency, availability of goods and services are the symptoms of inflation. In order to get

the accurate results of the investment decision, inflation has to be readjusted both to the cost as well as

revenue of the company.

Generally impact of inflation is found both as revenue and expenditure equally (similar fashion), but in certain

situation the inflation is overloaded. They are: 1) Depreciation based on historical costs, therefore the tax

benefits enjoyed on the depreciation does not keep pace with inflation. 2) The cost of capital used for project

appraisal contains a premium for anticipated inflation.

Depreciation and Historical Cost: The cost inflows are calculated by taking into account the significant

impact of inflation since both cost and the revenue both are influenced by inflation but the depreciation

charges and tax conversions are not influenced by inflation because the depreciation charged is on the basis of

historical cost. Therefore the project manager has to reduce the real rate of return.



Investment Decision – Introduction: The study on financial decisions primarily revolves around four

important decisions; (1) Financing decisions (2) Investment decisions (3) Dividend decisions (4) Working

capital decisions. Financing decisions are primarily concerned with identification, selection and arrangement

of funds needed for existence and functioning of business enterprises. Investment decisions involves

commitment of funds to some course of action, usually funds procured are invested in long term assets so as

to get maximum returns in future. Dividend decision is concerned with deciding whether to distribute all the

profits to the shareholders or retain all the profits or distribute part of the profits to the shareholder and retain

the other part in the business and finally working capital decision is also known as liquidity decision, is

concerned with maintaining a balance between profitability and liquidity and most importantly avoiding

insolvency, managing cash, inventories, and short term borrowing and lending (such as the terms on credit

extended to customers).

Meaning and Concept: Investment refers to process of investing money in financial or real assets for profit

or material result. Investment made in buying financial instruments such as new shares, bonds, securities, etc.

is considered as a Financial Investment. Investment made in plant and equipment, land and building and other

infrastructure facilities is considered as Real Investment. Thus, Investment decisions refer to application of

funds on long term assets in anticipation of future benefits and maximization of long term profitability.

Returns: The prime objective of any investment activity is to earn monetary reward; it is a vital decision in

financial management and purely based on the returns. If the investment is unprofitable in the long run, it is

unwise to invest in it. Since the future is uncertain there are difficulties in calculation of unexpected return

(cash flows).

Risk: The risk in general refers to the possibility of suffering a loss due to occurrence of an event. The term

risk is always associated with the loss aspects since the word itself has the association of DANGER OF

LOSS. In the context of investment decisions risk means uncertainty in generating profits from funds invested

in long term assets or the risk of inability to recover back the amount invested in assets.

Capital Budgeting: The decision on investing in long term assets has significant impact on the future of the

company. Since the future in uncertain it is difficult to predict expected return and risk factors associated with

the investment, therefore risk and return are two important considerations of investment decision. Investment

proposals should be evaluated both for their expected return and for their risk to the company. Capital

Budgeting is a financial tool to evaluate the value of a long term project.

Meaning, Definition & Concept: Capital refers to long term assets used in production, while a budget is a

plan that outlines projected expenditures during some future period. Thus, the capital budget is a summary of

planned investments in long term assets, and capital budgeting is the whole process of analyzing projects and

deciding which ones to include in the capital budget. According to Richards & Greenlaw” The capital

budgeting generally refers to acquiring inputs with long term returns”. Thus, Capita; Budgeting primarily

involves making investment decisions in capital expenditure. Usually in business there are two types of

expenditure and they are:-

1. Revenue Expenditure: Revenue Expenditure is amount spent on generating sales revenue and maintaining

a revenue generating asset. The benefits of this expenditure are exhausted within a year, thus revenue

expenses will be taken to the profit and loss account. The following are some of the examples of revenue

expenses:



Expenses incurred for the ordinary administration and carrying on the business.

Expenses for repairs, renewals and expenses on replacement of assets.

Loss from sale of fixed assets.

Interest on loans borrowed for business.

Expenses for the manufacture and distribution of the finished goods.

2. Capital Expenditure: (CAPEX) Capital expenditures is amount spent to maintain or increase the scope of

their operations. The benefits of capital expenditure are greater than a year. Thus CAPEX is the money spent

on physical assets such as equipment, property, or industrial buildings. All capital expenditures are taken to

the Balance Sheet. Funds spend on procuring & renewing fixed assets are capital expenditures, but not all

capital expenditures are classified as fixed assets.

Types of Capital Expenditure Proposals: The capital expenditure proposals can be in the form of revenue

generating proposal or cost reducing proposal, in general capital expenditure proposals are as follows:-

1. Expansion: Capital expenditure in the form of expansion is meant to increase output of existing products

or to expand retail outlets or distribution facilities in markets.

2. Diversification: Diversification in the context of capital budgeting expenditure implies to extension of

business activities into disparate fields. Companies may become diversified by entering into new business on

its own, by merging with another company or by acquiring a company operating in another field or service

sector. Often diversification proposals involve substantial risks, huge capital investment and require

considerable managerial effort and attention.

3. Replacement and Modernization: Replacement proposal includes expenditures to replace machinery and

equipment‟s to lower costs or to produce profitable products. Replacement expenditures substitute for

expansion programmes. On the other hand the modernization proposals are aimed at improving current

business to meet organizational objectives.

4. Research and Development: Research and Development (R & D) is another form of capital expenditure

proposal important for growing and improving business. Now, more than ever, businesses need to invest in

research and development to help differentiate them from the competition and retain their market share.

Innovations can result in greater profits and lower costs.

5. Miscellaneous: This is a mix of all categories that includes projects like developing employee recreation

facilities, education and training facilities, executive aircrafts, and landscaped gardens and so on in order to

create favorable image among public. There is no standard approach for evaluating these projects and

decisions regarding them are based on personal preferences of top management.

Significance and Features of Capital Budgeting:

1. Investment in Capital Expenditure: Capital budgeting involves investment in capital expenditures that

are consistent with the firm‟s goal of maximizing shareholders wealth. Firms typically make a variety of long

term investments, but the most common is in fixed assets, which include development of projects, launching a

new product, improvisation, modernization, expansion, replacement of fixed assets, expansion of production

capacity, procurement of intellectual property, developing R & D facility etc. These activities often referred to

as earning assets; generally provide the basis for the firm‟s earning power and value.



2. Long Term Commitment of Funds: A business makes long term investments in many different operating

assets such as land and buildings, machinery and equipment, furniture, fixtures, tools, computers, vehicles,

and so on. A business also may make long term investment in intangible assets - patents and copyrights,

customer lists, computer software, established brand names and trademarks developed by other companies,

and so on. The capital invested in long term business operating assets is gradually recovered and converted

back into cash over three to five years. The major source through which business enterprises can recover the

amount invested on long term assets is through sales.

3. Associated with Risk and Uncertainty: Capital budgeting decisions are related to future which is

uncertain. Uncertainties can exist when the outcome of an event is not known for certain. Investment

proposals necessarily involve risk, because future benefits are uncertain. Consequently, Investment proposals

should be evaluated both for their expected return and for their risk to the company. The major risk factor in

capital budgeting decision is the recovery of capital and return on capital invested (profits), which is received

in form of sales revenue also referred as cash inflows.

4. Strategic and Expensive: Capital budgeting decisions are strategic in nature, means policies that have a

long term impact on a business. For instance, launching a new product, improvisation, modernization,

expansion, replacement of fixed assets, expansion of production capacity, procurement of intellectual

property, R & D facility etc. equips an organization‟s capabilities to face threats and utilize business

opportunities arising on account of ever-changing environment.

5. Irreversible Decision: Capital budgeting is primarily concerned with sizable investments in long term

assets. These assets may be tangible or intangible assets. It is difficult to find a market for such assets. For

instance let us assume a car manufacturer sets up a new plant for expansion of production capacity of a

specific model which is steeply declines due to huge competition. Now from the perspective of the company it

is very difficult to take back this decision of setting the new plant, as result of this the company may find it

difficult sell this plant established to manufacture only a specific model of car.

Need and Objectives of Capital Budgeting:

1. Appraisal of Capital Expenditure: The term appraisal means estimating or judging the value of

something. The purpose of capital budgeting is to provide an estimation of returns and risk associated with

capital expenditure. This involves constructing a forecast model on how to investment on capital asset which

might help the organization to perform financially accurate.

2. Prioritizing Investment Proposals: Sometimes an organization has many capital expenditure or

investment proposals that could potentially be financially rewarding. With the help of capital budget

techniques it is possible to recognize and understand the scale of problems, quantify and communicate their

financial impact and prioritize the investment proposals.

3. Maximize Profitability & Minimize Risk: Capital budgeting not only assess risk and return of an

investment proposal but also aims at creating a clear and simple picture of the benefits and costs associated

with a possible business investment in both the short term and the long term. The capital budgeting process

identifies how much money will be needed from each source and the costs associated with using that funding

method and thereby allocates funds in invest proposal that are less risk and more profitable and also consistent

with the firm‟s goal of maximizing owners‟ wealth in the long run.



4. Control over Capital Expenditure: The term control in cost of capital budgeting implies to actual

performance of investment proposal with the actual expectation and to take the corrective action in case of

any difference so that deviation from standards are minimized and stated goals of the organization are

achieved in a desired manner.

5. Facilitates Co-ordination of Inter-Departmental Project: An organization has various departments such

as Production, Marketing, Human resource, R & D, etc. All departments need capital investments to carry

smooth operations. For example Production department may need huge fund to buy machines to expand

production capacity, etc. All the proposals are carefully reviewed and prioritized based upon commonly used

criteria such risks, costs and profitability.

Capital Budgeting Process: The capital budgeting process consists of five distinct but interrelated steps:

1. Determine Investment Proposals: The primary step in capital budgeting is to compile investment

proposals that may originate at different levels within a firm. The proposal may arise from top management or

even from operating level management. These proposals for new investment projects are received at all levels

within a business organization and are reviewed by finance department.

2. Screening Investment Proposals: Once the proposals are received from all level organization, the finance

dept. examine of screens with the possibility or intention of instituting the proposal if necessary. The various

proposals received are critically reviewed in term of costs of capital, expected returns from alternative

investment opportunities and the assets life using different capital budgeting techniques.

3. Assessment of Investment Proposals: Once investment proposal which passes through the preliminary

screening stage they are now assessed in financially terms to determine if they maximize the profits of the

firm in long term. The following are the key considerations on which an investment proposal is assessed:

The benefit impact of an investment decision in the long run.

The cost impact of an investment decision over time.

The risk factors associated with an investment both immediately and in the future.

Using criterion the finance department assess these parameters and reserves it decision based on firm‟s

objective of maximizing its market value.

4. Prioritizing Investment Proposals: After thorough assessment of investment proposal on various

parameters, the finance department in this step prioritizes investment proposals by ranking them, The rank is

based on profit or economic consideration, Investment proposal with less risk and more returns with long term

benefits are given high priority for acceptance. Sometimes the proposals are very expensive it may not be

suitable for the concern‟s financial condition in situation like these proposals are rejected.

5. Decision Making: The next step in capital budgeting process is taking a final call on acceptance or

rejection of investment proposal. The decision should be rational and based certain techniques, such as

Payback period (PBP), Accounting rate of return (ARR), Net present value (NPV) and Internal rate of return

(IRR). All these methods have some criteria that help to create a set of decision rules that can categorize

which projects are acceptable and which projects are unacceptable.



6. Implementation: Following the decision, expenditures are made and projects implemented. Expenditures

for a large project often occur in phases depending up nature of proposal. One of the important factors that

need to be carefully evaluated in implementation phase is management of funds and it should be spent in

accordance with appropriations made in the capital budget.

7. Review: The final phase of capital budgeting is comparing actual results with the standard results. If any

deviation is found corrective measures are taken into consideration.

Kinds of Capital Budgeting Decisions: Capital budgeting is a tool which helps in analyzing and evaluating

the projects from different perspectives such as predicting the outcome of accepting the project. A firm may

face several investment proposals for consideration. It may adopt one of them, some of them or all of them

depending upon whether they are independent or dependent or mutually exclusive. Capital budgeting

proposals are classified as follows:

1. Accept or Reject Decisions: Accept or reject investment decisions are also referred as independent

projects. Independent investments serve different purposes and do not complete with each other‟s. In other

words the cash flows of these projects are unrelated or independent of one another, the acceptance of one

project does not eliminate the others from further consideration, a firm may accept an investment proposals if

the expected return is more than the cut-off rate fixed by the management. The cut-off rate is usually the cost

of capital of the firm, therefore all the investment decisions which give more return than the cost of capital

they are acceptable while the investment decisions which give less return than the cost of capital they are

rejected.

2. Mutually Exclusive Decisions: It is quite opposite to independent projects. In mutually exclusive

decisions, investment proposals compete with each other‟s, which mean that, the acceptance of one

automatically rejects the other decisions. For example, a firm in need of increased production capacity and

could obtain it by expanding its plant or by acquiring another company or by outsourcing with another

company for production. Clearly accepting any one option eliminates others.

3. Capital Rationing Decisions: Some organizations may have various profitability investment proposals but

may not have sufficient funds. In situation like this a firm has only an option to rank them as per their

profitability and then accept them. Therefore capital rationing is a process of allocating capital resources in

favor of desired proposals based on availability of funds and importance of investment proposals.

Information required for Capital Budgeting: The capital budget is a summary of planned investment in

long term assets and it is a process of analyzing projects and deciding which one to include in the capital

budgeting. The following information required to be initiated to make capital budgeting decisions:

A: Cash flows: Cash flows in a broader perspective means movement of money in and out of the business, it

signifies incomings (cash inflow) and outgoing (cash outflow) of money from the operating activities of an

organization. Cash comes in from sales, loans proceeds, investments and the sale of assets and goes out to pay

for operating and direct expenses, principal debt services, and the purchase of assets.

In the context of capital budgeting cash flows refers to the revenue generated from the investment proposal

after deducting relevant expenses, All investments proposals in capital assets are expected to earn a return,

which is evaluated by comparing the project‟s forecasted cash outflows to cash inflows.



1. Initial Investment or Cash outlay or Cash outflow: These are the costs that are needed to implement an

investment proposal such as purchase of capital assets, to start a new project etc. Initial Investment is

generally a negative because the investment proposals often require a large initial capital by an organization

that will generate positive cash flow over time. The components are as follows:

(a) Cost of New Assets: This signifies amount spent of procuring the assets, the assets can be fixed assets or

capital assets. Further the cost involved in procurement of assets to installation of assets will also be added.

For an example costs associated with buying the assets (including installation, insurance, transportation and

financing costs) can be added to the carrying value of the fixed assets on the balance sheet.

(b) Opportunity Cost: This refers to the loss of potential gain from other alternative investment proposals

when one alternative proposal is chosen. In other words the benefits of an organization could have received by

taking an alternative action. For an example let assume after completing your graduation you are considering

either taking up post-graduation or to work. The opportunity cost of doing post-graduation is the money you

would have earned if you worked instead. On the one hand, you lose two years of salary while getting your

post-graduation degree; on the other hand, you hope to earn more during your career, thanks to post

graduation education, to offset the lost salary.

(c)Additional Working Capital: Working capital is the amount by which current assets exceed current

liabilities. This means companies either borrow short term loans or use internals cash accruals to procure raw

materials and to meet day to day requirements. These loans are paid once the cash is received from customers.

This process is termed as the working capital cycle (operating cycle) of a firm.

STEPS IN CALCULATION OF INVESTMENT OR CASH OUTLAY:

Particulars Amount

Cost of the Asset XXXX

Add: Installation, Insurance, Transportation, Duties and Financing Costs XX

Add: Opportunity cost (if any) XX

Add: Additional working capital XX

Total XXXX

Less: Scrap value (only in the case of Replacement Decisions).

Note: Treatment of salvage varies according to different methods of capital

budgeting.

XX

Initial Investment or Cash outlay XXXX

2. Net Annual Cash Inflows or Operating Cash flows: Net annual cash inflows denote benefits received in

the form of revenue from the investment proposal every year. Thus Cash inflow is the money flowing inside

the business on account of investment made in a proposal within a given period of time. These cash inflows

can be similar every year (even) or it may differ every year (uneven). It is important to note that accounting

profit is different from annual cash inflows:

Steps in Calculation of Net Cash Inflow:



A. FOR REVENUE INCREASING INVESTMENT PROPOSALS:

Particulars Amount

Sales revenue -----

Less: Expenses(Fixed and Variable) -----

Cash flow before Depreciation and Tax (CFBDI) / (PBDI) -----

Less: Depreciation -----

Cash flow after Depreciation and before Tax -----

Less: Tax -----

Cash flow after Depreciation and Tax (CFADT) / (PADT) -----

Add: Depreciation -----

Net Cash flow (NCF) or Cash flow before Depreciation after Tax (CFBDAT) -----

Therefore, NCF= Sales – Exp – Dep – Tax + Dep (CFBDAT) / (PBDAT)

Notes:

The logic behind deducting depreciation and again adding it back is, firstly deducting depreciation

would lower the tax burden and secondly it should be added back as it is a non-cash based transactions

Instead of the term Cash Inflow Profit can also be used.

B. TERMINAL CASH FLOWS: Terminal cash flow refers to the amount generated from the

investment proposal at the end of its life in addition to annual cash flow. Terminal cash flows can be in

the following forms:

i. Scrap or Residual Value: It is the estimated value that an asset will realize upon its sale at the

end of its useful life.

ii. Working Capital: Some assets require additional working capital to operate (taken into

account at the beginning of the project when calculating the initial investment).

C. FOR COST REDUCTION INVESTMENT PROPOSALS:

Particulars Amount

I. Estimated Savings: -----

Savings on account of decrease in wages

Savings from sale of scrap

-----

(A)Total Savings -----

II. Estimated Additional Costs: -----

Additional cost of maintenance

Additional cost of supervision

Additional depreciation

Cost of indirect material

-----

(B) Total Additional Costs -----

Net Savings Before Tax (A-B) -----

Less: Income Tax -----

Net Savings After Tax -----

Add: Additional Depreciation -----

Net Savings After Tax or Cash Flows -----



METHODS OF CAPITAL BUDGETING / TECHNIQUES OF EVALUATION INVESTMENT

PROPOSALS:

Traditional

Methods

Pay-back Period Method (PBP), Pay Out / Pay off Method

Post pay-back Method (PPBP)

Accounting Rate of Return (ARR) / Rate of Return Method of

Accounting method

Modern Methods

Net present Value Method (NPV)

Internal Rate of Return Method (IRR)

Profitability Index Method (PI)

The major difference between Modern methods and traditional method is time value of money factor. Capital

budgeting decisions involves decisions related to long term capital expenditure and the amount invested is

capital expenditure is recovered gradually in the form of revenue (cash flow) over a period of time. Since the

revenue is received in the future, it is important to determine present value of it. Present value of money

means current worth of future revenue of an investment proposal or stream of cash flows given a specified

rate of return. Let now discuss each method of capital budgeting elaborately.

1. PAY BACK PERIOD: Payback period refers to duration required to recover amount spent in an

investment proposal. Payback period is a traditional and the most simple method of capital budgeting.

The basic essence of this method is to determine the amount of time that is required to recover the

funds spent on the investment proposal.

Procedure for calculating Pay-Back Period: Pay-back period calculation is based on cash flows generated

from the investment proposals and amount spent on investment proposal. Therefore we need initial investment

and cash flow to calculate pay-back period. The procedure of calculating initial investment is already

discussed. However it is important to note that series of cash flows generated from investment proposal can be

same (even) throughout the life of the investment proposal or it may vary year on year (uneven). Therefore

based on the series of cash flow the procedure to calculate pay-back period also slightly varies:

Situation 1: Even Cash Flows: When the cash flows generated from the investment proposal are same

throughout its life, the following equation is used to determine pay-back period.

Pay-Back Period = Initial Investment

Annual Cash Flows

Initial Investment = Cost of asset + Opportunity Cost + Additional Working Capital

Annual Cash flows = Cash flow before Depreciation after Tax (CFBDAT) / (PBDAT)

Situation 2: Uneven Cash Flows: When the cash flows generated from the investment proposal vary

throughout its life, the following steps should be followed.

1. Write down the years and cash flows from the investment proposal parallel.

2. Calculate cumulative cash flows, this can be done by continuous adding the cash flows generated from

the invest proposal year after year till we reach initial investment.

3. In case if the cumulative cash flows exceeds initial investment, then following formula can be used to

determine exact pay-back period:



PBP = Year before recover + Cash Flow required to recover Initial Investment

Actual Cash Flow received

OR

PBP = Completed Year + (Investment – Cumulative Cash Flow of Completed Year)

Actual Cash Flow of next year

Acceptance & Rejection Criteria: In case of independent investment proposals we have to compare the pay-

back period of the proposal with the expectation of management (also called standard or cut-off rate). If the

PBP is less than or equal to cut-off rate proposals should be selected or else rejected. In case of mutually

exclusive proposals, we have to compare pay-back period of all the proposals and whichever proposal has a

lesser PBP should be accepted. However, if cut-off rate is given and if it is a mutually exclusive proposal then

all the proposals should be evaluated keeping in mind the expectation of the management.

Evaluation of Pay-Back Period Method: As discussed earlier in Pay-Back method of capital budgeting

decision to invest in capital expenditure is based on the number of years required to recover the amount

invested in the capital expenditure proposal.

Merits of Pay-Back Method:

1. Easy to calculate and simple to understand.

2. Emphasis on early return of amount invested (liquidity).

3. Risk can be minimized by setting a lower payback period.

4. Cost effective in terms of calculation.

Limitations of Pay-Back Method:

1. Ignores Time Value of Money.

2. Ignores the annual cash inflows after the pay-back period.

3. Emphasis on liquidity and ignores Profitability.

4. Overlooks the cost of capital; i.e., Interest factor if the investment is made from borrowed funds.

5. It does not consider magnitude and timing of cash inflows.

6. It does not take into account salvage value of assets.

2. POST PAY-BACK METHOD: Post Pay back method is an improvement of payback period method.

One of the major drawbacks of payback period is that it does not consider the cash flows earned after

payback period and as a result of this the true profitability of the investment proposal cannot be

judged. Therefore in post payback method the cash flows or returns earned after receiving initial

investment is taken as criteria for accepting and rejecting investment proposal.

Procedure for Calculating Post Pay-Back Period:

Post Pay-Back Profit = Total of sum total of Cash Inflows – Initial Investment.

Cash Flow means Cash Flow before Depreciation after Tax (CFBDAT)

Acceptance and Rejection Criteria: In case of Independent proposal; if the proposal generates profits after

recovering initial investment during its economic life it should be selected, if not rejected. In case of mutually

exclusive proposals after making comparison whichever yields high profits post recovery of initial invest

should be selected, if not rejected.



Evaluation of Post Pay-Back Period Method: Post Payback profit method is simple and to understand and

compute. Further it gives more importance on profitability for making decision about the investment

proposals. Despite of its merits, just like payback period method, it ignored the time value of money. Further

the post pay-back method focuses on short term profitability and an attractive proposal could be overlooked if

the profitability is the only consideration.

3. ACCOUNTING RATE OF RETURN: In this method the profits earned on the amount of

investment proposal is expressed in terms of percentage. Hence, this method is also called Return on

Investment Method. It divides the average profit by the average investment in order to get the ratio or

return that can be expected. This allows enterprise to easily compare the profit potential of investment

proposals.

Procedures for Calculating Accounting Rate of Return:

ARR = Average Annual Cash Flows or Average Return * 100

Average Investment

1. Average Annual Cash Flows here indicates cash flows earned from the investment proposal during its

economic life divided by period of cash flow generation. The cash flows are averaged to ensure that balance

between variations in cash flows. Therefore Average Annual Cash Flow = Sum of Cash Inflows during the

Economic Life of the investment proposal after depreciation and tax /Period of Cash Flow Generation.

Cash Flow means – Cash flow after Depreciation after Tax (CFADAT). The method is based on

conventional accounting concept as it takes into consideration of accounting profits as cash flows.

(Depreciation is not added back)

2. The Average Investment is calculated by using any of the following equation.

1. Average Investment = Initial Investment / 2

OR

2. Average Investment = Initial Investment – Scrap Value / 2

OR

3. Average Investment = Initial Investment – Scrap Value / 2 + [Scrap value + Additional

Working Capital]

Note: In case, if working capital is not given, it is advisable to use equation 1 or 2 depending on the

availability of information in the problem. In case, if working capital is given, it is advisable to use equation 3.

Acceptance and Rejection Criteria: In case of Independent Investment proposals, we have to compare ARR

of the proposal with the expectation of management (also called standard or cut-off rate). If the ARR is more

than or equal to cut off rate, proposal should be selected, if not rejected. In case of mutually exclusive

proposals, we have to compare ARR of all the proposals and whichever proposal has a higher ARR should be

accepted.

Evaluation of Average Rate of Return Method: The Accounting Rate of Return Method is one of the most

widely used techniques for investment appraisals and capital budgeting decisions. The accounting rate of

return calculation is based on the return of the investment proposal and divides the average profit by the

average investment in order to get the ratio or return that can be expected.



Merits of Accounting Rate of Return Method:

1. Simple and straightforward to compute.

2. Based on Accounting Information and Special Reports are not required.

3. Recognizes the Profitability factor of investment.

4. Offers a certain degree of comparability between projects.

Demerits of Accounting Rate of Return Method:

1. Time value of money is not considered.

2. It can be calculated in different ways. Thus there is problem of consistency.

3. It ignores the reinvestment potential of a project.

4. The accounting rate of return does not remain constant over useful life for many projects. A project

may, therefore, look desirable in one period but undesirable in another period.

4. NET PRESEENT VALUE METHOD: This method is used by large companies to evaluate

investment projects. One of the important features of Net Present Value method is that it takes into

account of Time value of money. The concept of time value of money advocates that money available

at the present time is worth more than the same amount in the future due to its potential earning

capacity. The concept behind the NPV method is simple. When firms make investments, they are

spending money that they obtained in one form or another. The money can be obtained from investors

or financial institution or from retained profits.

The NPV method takes into account the time value of investor‟s money and firm retained earnings. It

discounts the firm‟s cash flows at the firm‟s Cost of Capital (COC). Cost of Capital here indicates the

minimum return that must be earned from an investment proposal to satisfy the firm‟s investors.

Investment proposal with higher returns will increase the firm value and vice versa.

Thus, Net Present Value of an investment proposal, where the total of present value of the cash

inflows will be deducted from the total present value of the cash outflows.

The NPV is found by subtracting a project‟s Initial Investment from the total present value of its cash

inflows discounted at a rate equal to the firm‟s cost of capital.

NPV ∑

OR

We will try to figure out the value of cash inflow at the end of every year by dividing it with discount

factor also referred as cost of capital. We calculate the worth of Re. 1 at the end of every year by using

discount factor. The present value of Re. 1 is computed using the following equation:

PV = 1

Acceptance and Rejection Criteria: In case of independent investment proposals, if the NPV > 0,

then accept; if the NPV < 0, then reject. If the NPV = 0, then depending on the requirement & strategy

of the management decision can be taken. In case of mutually exclusive project after making a

comparison, Investment proposal with a higher NPV (NPV>0) should be accepted.



Merits of Net Present Value Method:

1. NPV method considers the time value of money.

2. It considers the cash flows generated throughout the expected life of investment.

3. Profitability and Risk of the projects are given high priority.

4. NPV helps in maximizing the Firm‟s Value.

5. NPV method more credible in comparing investment proposals.

Demerits of Net Present Value Method:

1. NPV requires the company to perform more complex calculations.

2. NPV is based on future cash flows and the discount rate, both of which are hard to estimate with

100% accuracy.

3. PV does not provide an overall picture of the gain (or loss) of executing a certain project.

4. Correct decision may not be possible in NPV, when the projects are of unequal life.

5. PROFITABILITY INDEX METHOD: Profitability Index Method is an extension of NPV

method. NPV Method presents the value in absolute measure as it gives the total rupee figure for

an Investment Proposal, whereas, the profitability index is a relative measure as it gives as the

figure as a ratio. In other words, Profitability Index represents the costs and benefits of

investing in a particular investment proposal in the form of a ratio. The ratio is calculated by

comparing the present value of future cash flows with initial investment.

Procedure for Calculating Profitability Index:

PI = Sum of present value of Cash Inflow

Initial Investment or Present value of Cash Outlay

Acceptance and Rejection Criteria: Profitability index is also referred as benefit-cost ratio. It is also useful

in capital rationing since it helps in ranking projects based on their return. In case of independent investment

proposals, if the PI > 1, then accept the project. If the PI < 1, then reject the project. In case of mutually

exclusive project after making a comparison, investment proposal with a higher PI (PI > 1) should be

accepted.

Merits of Profitability Index Method:

1. The time value of money is taken into account.

2. Considers cash flows generated from investment proposal throughout its life.

3. Indicates whether investment proposal increases or decreases the firm‟s value.

4. Considers the risk involved in future cash flows with the help of cost of capital.

5. Ascertains the exact rate of return of the investment proposal.

Demerits of Profitability Index Method:

1. Decisions made out of profitability index do not show which of the mutually exclusive proposal has a

shorter return duration.

2. It is difficult to understand and accurately estimate cost of capital discount rate.



6. INTERNAL RATE OF RETURN METHOD: Like net present value method, internal rate of return

method also takes into account the time value of money. The internal rate of return (IRR) is the rate of

return promised by an investment proposal over its useful life. It is also referred to simply as yield on

investment proposal. Thus, internal rate of return is the rate that equates the present value of cash

outflows or investment with the present value of cash inflows. In other words internal rate of return is

the rate at which total present value of cash inflows will be equal to cash outflows or Initial

Investment.

Procedure for Calculating Internal Rate of Return: One of the key differences in NPV and IRR is the way

the rate of discount factor/Cost of capital is determined. In case of NPV method, the discount factor is based

on assumption, whereas in IRR method it is identified by the trial and error method. The following are the

basic steps involved in calculation of IRR.

1. Determine IRR Factor: It is computed by dividing the investment required for the project by net annual

cash inflow to be generated by the project. The formula is given below:

IRR Factor = Initial Investment / Average Annual Cash Flows

Average Annual Cash Flow = Sum of cash inflows during the economic life of the investment proposal

after depreciation and tax / period of cash flow generation.

1. Locating discount rate in “present value table Rs. 1 received annually for n years”

2. Computing discount rate and determine PV of cash inflows: In some cases, further it may not be

possible to locate accurate discount rate based on IRR factor. Therefore we must pick up two discount rates. A

higher discount rate and lower rate. After identifying lower and higher discount rate, we must find out present

value of cash flows using higher and lower discount rates, then the following formula is applied to calculate

internal rate of return:

IRR = LDR + TPVCF of LDR – Initial Investment X (HDR – LDR)

TPVCF of LDR – TPVCE of HDR

Note 1: Cash flows means Cash flow before Depreciation after Tax (CFBDAT)

Note 2: The total Present Value of Cash flows at lower discount should be positive. Incase if don‟t get a

positive value the discount factor should be modified, so that we arrive at a Positive total of Present Value of

Cash flows.

Acceptance and Rejection Criteria:

If the IRR of an independent investment proposal is greater than or equal to the proposal‟s discount rate (cost

of capital), accept the investment. However, if the IRR is less than the proposal‟s (cost of capital), reject the

investment. In case of mutually exclusive proposals, accept the proposal with greater IRR provided it is

greater than the discount rate. The logic of IRR is that never undertake an investment proposal that gives less

returns than the money needs to be paid to investors/money lenders (cost of capital).



Merits of Net Internal Rate of Return Method:

1. Takes into account time value of money.

2. Simple to interpret the result after the IRR is calculation.

3. Considers cash flows generated throughout the life of investment proposal.

4. IRR considers higher than its cut off rate. It gives maximum profitability to shareholder.

5. Ranking can be done easily for different prospective proposal and the project with the highest IRR

would be considered the best.

6. The IRR method is considered more popular and straightforward than the NPV approach.

Demerits of Internal Rate of Return Method:

1. Difficult to understand as it requires the company to perform more complex calculations due to trial

and error method.

2. IRR does not account for the project size when comparing projects. Cash flows are simply compared

to the amount of capital outlay generating those cash flows.

3. Ignores the potential future costs that may affect profit.

4. Correct decision may not be possible in NPV, when the projects are of unequal life.

CALCULATION OF CASH FLOWS AND TERMINOLOGIES:

SI.

No. Cash Flow Terminology

Capital Budgeting

Method

Treatment (How to

arrive at correct

Cash Flows)

1

Cash flows after depreciation before tax

OR Cash flows before tax after

depreciation

PBP, NPV, IRR Less: Tax, Add: Dep

2 Cash flows before depreciation and tax OR

Cash flow before depreciation & before tax PBP, NPV, IRR

Less: Dep, Less: Tax,

Add: Dep

3

Cash flows after tax OR Cash flows after

depreciation and tax OR Cash flows after

depreciation & after tax

PBP, NPV, IRR Add: Dep

4 Cash flows before depreciation after tax PBP, NPV, IRR Do nothing

5

Cash flows after depreciation before tax

OR Cash flows before tax after

depreciation

ARR Less: Tax

FACTORS AFFECTING CAPITAL BUDGETING DECISIONS:

1. Cash Flows of Investment Proposal: In the context of capital budgeting Cash flows refers to the

revenue generated from the investment proposal after deducting relevant expenses. All investment

proposals in capital assets are expected to earn a return, which is evaluated by comparing the project‟s

forecasted cash outflows to cash inflows. The success of capital budgeting decisions depending on

potential of Cash inflows.

2. Working Capital: Most capital budgeting decisions involve management of working capital and

forecasting the requirement of the same. In capital budgeting working capital comes as part of initial

outlay. Changes in working capital are added or subtracted, and are considered part of cash inflow.



3. Rate of Return: It is the minimum required percentage of return earned by an investment proposal

that will motivate a company to invest money into a particular asset or project. A firm may accept an

investment proposal if the expected return is more than the cut-off rate fixed by the management. The

cut-off rate is usually the cost of capital of the firm; therefore all the investment alternatives which

give more than the cost of capital are acceptable while the investment alternatives which give less

return than the cost of capital are rejected.

4. Amount of Investment: It signifies cost or outflow i.e., the cost associated with investment proposal.

Capital budgeting involves investment in capital expenditure that is consistent with the firm‟s goal of

maximizing shareholders wealth. Firms typically make a variety of long term investments, but the

most common problem faced in this context is the availability of funds. If a firm has abundant

financial resources it can consider investing in variety on proposals keeping in mind rate of return,

however if the financial resources are limited a firm may opt for capital rationing decisions.

5. Investment Criteria: The decision on investing in long term assets has significant impact on the

future of the company. Risk and return are the two important considerations of investment decision.

Since the future is uncertain it is difficult to predict the risk and return associated with the investment

proposals. The concept of risk and return can be evaluated using various techniques such as PBP,

NPV, IRR, PI, Sensitivity analysis, Decision Tree, etc.

6. Salvage: It is an estimated value that an investment proposal will realize upon its sale at the end of its

useful life. Salvage value is subtracted from the cost of fixed assets to determine the amount of the

asset cost that will be depreciated. Thus, salvage value is used as a component of the depreciation

calculation.

7. Tax effects: Tax deductible expenses decrease the company‟s net taxable income of the company. Net

cash flows are the projected after tax cash flows with the deduction of charges for interest and

principal on loan payments.

LIMITATIONS OF CAPITAL BUDGETING:

1. Based on Estimates: Capital budgeting decisions involved investment of huge funds and this

investment decision is taken on the basis forecasted profits from investment proposals. It is very

difficult to ensure accuracy because they relate to future which is uncertain. Any deviation arising in

the plan may result in sudden loss to business and this will influence the return.

2. Complex Process: In order prepare a capital expenditure various inputs are needed such as cost of

capital, estimated rate of return, etc. Further a firm decision to invest in a new proposal should be

made according to the feasibility of shareholders. Therefore it is very difficult to comply with all the

expectations.

3. Hidden Costs: Certain investment proposal is subject to unpredictable expenses that may arise during

the economic life of the proposal. These hidden cost arises when the investment proposal Starks

functioning. Sometimes huge cost may arise due to changes taking in environment of business. Direct

costs can be hard to price. Indirect costs arise from monitoring, treating, and waste disposal. Hidden

costs can originate from compliance with regulations.

4. Irreversible nature: Capital budgeting involves huge amount of funds to be invested carefully.

Capital budgeting decisions are quite often irreversible, if it is reverted, there occurs a huge loss.

5. Subject to high risk: Capital budgeting decisions are exposed various risk factors. The effects of

inflation need to be considered in estimating cash flows as well. The other risk factors are political

risks, monetary risk, economic instability etc.



INVESTMENT DECISION:

MEANING AND NATURE OF CAPITAL BUDGETING: Capital budgeting is the process of making

investment decisions in capital expenditures. A capital expenditure may be defined as an expenditure the

benefits of which are expected to be received over period of time exceeding one year. The main characteristic

of a capital expenditure is that the expenditure is incurred at one point of time whereas benefits of the

expenditure are realized at different points of time in future. The following are some of the examples of

capital expenditure:

Cost of acquisition of permanent assets as land and building, plant and machinery, goodwill, etc.

Cost of addition, expansion, improvement or alteration in the fixed assets.

Cost of replacement of permanent assets.

Research and development project cost, etc.

According to G.C. Philippatos “Capital budgeting is concerned with the allocation of the firm‟s scarce

financial resources among the available market opportunities; The consideration of investment opportunities

involves the comparison of the expected future streams of earnings from a project with the immediate and

subsequent streams of earning from a project, with the immediate and subsequent streams of expenditures for

it”.

FEATURES OF CAPITAL BUDGETING:

(1) Capital budgeting decisions involve the exchange of current funds for the benefits to be achieved in

future;

(2) The future benefits are expected to be realized over a series of years;

(3) The funds are invested in non-flexible and long term activities;

(4) They have a long term and significant effect on the profitability of the concern;

(5) They involve, generally, huge funds;

(6) They are irreversible decisions;

(7) They have the effect of increasing the Capacity, Efficiency or Economy of operation of existing fixed

assets.

NEED AND IMPORTANCE OF CAPITAL BUDGETING:

(1) Large Investment: Capital budgeting decisions, generally, involve large investment of funds. But the

funds available with the firm are always limited and the demand for exceeds the resources. Hence, it

is very important for a firm to plan and control its capital expenditure.

(2) Long-term Commitment of Funds: Capital expenditure involves not only large amount of funds but

also funds for long-term or more or less on permanent basis. The long-term commitment of funds

increases the financial risk involved in the investment decision. Greater the risk involved, greater is the

need for careful planning of capital expenditure, i.e. capital budgeting.

(3) Irreversible Nature: The capital expenditure decisions are of irreversible nature. Once the decision

for acquiring a permanent asset is taken, it becomes very difficult to dispose of these assets without

incurring heavy losses.

(4) Long-term effect on Profitability: Capital budgeting decisions have a long-term and significant

effect on the profitability of a concern. Not only the present earnings of the firm are affected by the

investment in capital assets but also the future growth and profitability of the firm depends upon the

investment decision taken today.



(5) Difficulties of Investment Decisions: The long term investment decisions are difficult to be taken

because (i) decision extends to a series of years beyond the current accounting period, (ii) uncertainties

of future and (iii) higher degree of risk.

(6) National Importance: Investment decision though taken by individual concern is of national

importance because it determines employment, economic activities and economic growth.

PHASES OF INVESTMENT DECISION / PROCESS:

I. Finding Investment Opportunities: Since the long term profitability of most companies depends on

the nature and quality of their capital investments, locating appropriate projects us particularly

important. Certain capital expenditures can result from the strategic planning process. Employees are

another source of ideas and they should be encouraged to submit proposals.

II. Collect Information about Opportunities: The expected cash flows from project must be estimated

and the total outlay necessary to place the investment in operative form must be determined. In

addition, a plan for implementing the opportunity must be developed and other non-financial

information must be assembled.

III. Select Discount Rate: Before the cash flows can be evaluated, the discounted rate must be

established.

IV. Financial Analysis of Cash Flows: In this phase, the techniques of capital budgeting are applied to

the estimated cash flows developed in the second phase.

V. Decision: Before making up of final decision, one has to look into many factors which influence the

flow of funds in future such as social aspects of the company operations and long term goals, the

timing of the cash flows, the availability of funds for investment purpose and the impact of investment

opportunity on capital structure of the company.

VI. Project Implementation: Once the decision has been made to invest funds more detained plans for

making the project operational are developed. The time involved in implementing the project naturally

varies. For major expansions. Where additional facilities must be constructed, it may take several

years, whereas some equipment replacements can be made in a matter of days.

VII. Project Evaluation and Appraisal: An important but omitted phase of capital budgeting is an

assessment of how effective the investment actually is? The evaluation may be in the form of

continuous monitoring of the project so that corrective action can be taken.

FACTORS INFLUENCING INVESTMENT DECISION:

a) Technological Change: In modern times, one often finds fast obsolescence of technology. New

technology, which is relatively more efficient, takes the place of old technology. However, in taking a

decision of this type the management has to consider the cost of new equipment and its proficiencies

as well as old equipment‟s.

b) Competitors Strategy: Many a time an investment is taken to maintain competitive strength of a firm.

If the competitors are installing new equipment to expand output or to improve quality of their

products, the firm under consideration will have no alternative but to follow suit, else it will perish.

c) Demand Forecast: The long run forecast of demand is one of the determinant of investment decision.

If it is sound that there is a market potential for the product in long run, the dynamic firm will have to

take decisions for capital expansion.

d) Non-Economic Factors: Sometimes, non-economic factors also influence investment decisions, such

as reduction in absenteeism will improve the productivity leads to better performance.



e) Fiscal Policy: Various tax policies of the government such as rebate on new investment, method of

allowing depreciation, tax concessions on investment income etc., also have favorable influence on

capital investment.

f) Cash Flows: Every firm makes a cash flow budget, with its help, the firm plans the funds for

acquiring the capital asset. The budget also shows the timing of availability of cash flows for

alternative investment proposal.

g) Types of Management: The capital investment decisions are also influenced by the type of

management, if the management is modern and progressive in its outlook, the innovations will be

encouraged.

h) Returns Expected from the Investment: In most of the cases, investment decisions are made in

anticipation of future returns. While evaluating investment proposals, it is essential for the firm to

estimate future returns.

KEY POINTS:

1. To accept any proposal from the list of proposals consider the following:-

Method Recommended

PBP The project which has LESS payback period.

Discounted PBP The project which has LESS discounted payback period

ARR The project which has HIGH ARR

NPV The project which has HIGH Positive NPV

IRR The project which has HIGH IRR

PI The project which has HIGH PI

2. Except for ARR & for all other methods Cash Flows must be after tax and before depreciation.

3. To calculate discount factor use the following formula

PV = 1 /

4. To calculate IRR we need one positive value of NPV & one negative NPV i.e., nearest to Original

Investment, to get positive NPV choose lesser discounting percentage & to get negative NPV increase

the discounting percentage.

5. With the absence of information with respect to the CF before tax or after tax, it is always considered

to be after tax.

6. If the cash flow for the given project is same for the entire life of the project then use the Present

Value Annuity table to calculate the Total Present Value.

Reinvestment Assumption and Modified IRR: Internal rate of return (IRR) has never had a good academic

press. Compared with net present value (NPV), IRR has many drawbacks: it is only a relative measure of

value creation, it can have multiple answers, it‟s difficult to calculate, and it appears to make a reinvestment

assumption that is unrealistic. But financial managers like it. IRR expresses itself as a percentage measure of

project performance; it also provides a useful tool to measure „headroom‟ when negotiating with suppliers of

funds. The question we will try to answer is whether there is an even better measure which keeps the benefits

of IRR without the drawbacks. IRR is the discount rate which delivers a zero NPV on a given project.

Discounting, like compounding cash flows, assumes that not only the initial investment, but also the net cash

produced by a project, is reinvested within the project as it proceeds. Thus, the IRR is also the

investment/reinvestment rate which a project generates over its lifetime – and hence IRR is also known as the

„economic yield‟ on an investment.



To some extent, the selection of the discount rate is dependent on the use to which it will be put. If the intent

is simply to determine whether a project will add value to the company, using the firm's weighted average

cost of capital may be appropriate. If trying to decide between alternative investments in order to maximize

the value of the firm, the corporate reinvestment rate would probably be a better choice.

NPV Reinvestment Assumption: The rate used to discount future cash flows to the present value is a key

variable of this process. A firm's weighted average cost of capital (after tax) is often used, but many people

believe that it is appropriate to use higher discount rates to adjust for risk or other factors. A variable discount

rate with higher rates applied to cash flows occurring further along the time span might be used to reflect the

yield curve premium for long-term debt. Another approach to choosing the discount rate factor is to decide the

rate that the capital needed for the project could return if invested in an alternative venture. Related to this

concept is to use the firm's reinvestment rate. Reinvestment rate can be defined as the rate of return for the

firm's investments on average. When analyzing projects in a capital constrained environment, it may be

appropriate to use the reinvestment rate, rather than the firm's weighted average cost of capital as the discount

factor. It reflects opportunity cost of investment, rather than the possibly lower cost of capital.

PI Reinvestment Assumption: Profitability index assumes that the cash flow calculated does not include the

investment made in the project, which means PI reinvestment at the discount rate as NPV method. A

profitability index of 1 indicates break even. Any value lower than one would indicate that the project's PV is

less than the initial investment. As the value of the profitability index increases, so does the financial

attractiveness of the proposed project.

IRR Reinvestment Assumption: As an investment decision tool, the calculated IRR should not be used to

rate mutually exclusive projects but only to decide whether a single project is worth the investment. In cases

where one project has a higher initial investment than a second mutually exclusive project, the first project

may have a lower IRR (expected return) but a higher NPV (increase in shareholders' wealth) and, thus, should

be accepted over the second project (assuming no capital constraints). IRR assumes reinvestment of interim

cash flows in projects with equal rates of return (the reinvestment can be the same project or a different

project). Therefore, IRR overstates the annual equivalent rate of return for a project that has interim cash

flows which are reinvested at a rate lower than the calculated IRR. This presents a problem, especially for

high IRR projects, since there is frequently not another project available in the interim that can earn the same

rate of return as the first project. When the calculated IRR is higher than the true reinvestment rate for interim

cash flows, the measure will overestimate–sometimes very significantly–the annual equivalent return from the

project. This makes IRR a suitable (and popular) choice for analyzing venture capital and other private equity

investments, as these strategies usually require several cash investments throughout the project, but only see

one cash outflow at the end of the project (e.g., via IPO or M&A). When a project has multiple IRRs, it may

be more convenient to compute the IRR of the project with the benefits reinvested. Accordingly, MIRR is

used, which has an assumed reinvestment rate, usually equal to the project's cost of capital.



Using the formula, MIRR is quicker to calculate than IRR. MIRR is invariably lower than IRR and some

would argue that it makes a more realistic assumption about the reinvestment rate. However, there is much

confusion about what the reinvestment rate implies. Both the NPV and the IRR techniques assume the cash

flows generated by a project are reinvested within the project. This is not always the case; as many books

suggest, they are often reinvested elsewhere within the firm and it is not a necessary assumption that the firm

is capable of generating that IRR on its other business. Indeed, one implication of the MIRR is that the project

is not capable of generating cash flows as predicted and that the project‟s NPV is overstated. The only

significant advantages of the MIRR technique are that it is relatively quicker to calculate and does not give the

multiple answers that can sometimes arise with the conventional IRR. That may be a very small gain

compared with the loss of financial significance that the MIRR implies.

Investment Analysis and Decision under Inflation: When it comes to inflation, the question on many

investors' minds is: "How will it affect my investments?" This is an especially important issue for people

living on a fixed income, such as retirees.

The impact of inflation on your portfolio depends on the type of securities you hold. If you invest only in

stocks, worrying about inflation shouldn't keep you up at night. Over the long run, a company's revenue and

earnings should increase at the same pace as inflation. The exception to this is stagflation. The combination of

a bad economy with an increase in costs is bad for stocks. Also, a company is in the same situation as a

normal consumer - the more cash it carries, the more its purchasing power decreases with increases in

inflation. The main problem with stocks and inflation is that a company's returns tend to be overstated. In

times of high inflation, a company may look like it's prospering, when really inflation is the reason behind the

growth. When analyzing financial statements, it's also important to remember that inflation can wreak havoc

on earnings depending on what technique the company is using to value inventory.

Fixed-income investors are the hardest hit by inflation. Suppose that a year ago you invested $1,000 in a

Treasury bill with a 10% yield. Now that you are about to collect the $1,100 owed to you, is your $100 (10%)

return real? Of course not! Assuming inflation was positive for the year; your purchasing power has fallen

and, therefore, so has your real return. We have to take into account the chunk inflation has taken out of your

return. If inflation was 4%, then your return is really 6%. This example highlights the difference between

nominal interest rates and real interest rates. The nominal interest rate is the growth rate of your money, while

the real interest rate is the growth of your purchasing power. In other words, the real rate of interest is the

nominal rate reduced by the rate of inflation. In our example, the nominal rate is 10% and the real rate is 6%

(10% - 4% = 6%). As an investor, you must look at your real rate of return. Unfortunately, investors often

look only at the nominal return and forget about their purchasing power altogether.

Inflation-Indexed Bonds - There are securities that offer investors the guarantee that returns will not be eaten

up by inflation. Treasury inflation-protected securities (TIPS), are a special type of Treasury note or bond.

TIPS are like any other Treasury, except that the principal and coupon payments are tied to the CPI and

increase to compensate for any inflation. This may sound like a good thing, but the running joke on Wall

Street is that it's easier to sell an air conditioner in the dead of winter than it is to convince investors they need

protection from inflation. Inflation has been so low in recent years that it hasn't been much of an issue.

Because these securities are so safe, they offer an extremely low rate of return. For most investors, inflation-

indexed securities simply don't make sense.



OR

Inflation, an economic concept, is an economy-wide sustained trend of increasing prices from one year to the

next. The rate of inflation is important as it represents the rate at which the real value of an investment is

eroded and the loss in spending power over time. Inflation also tells investors exactly how much of a return

(%) their investments need to make for them to maintain their standard of living.

The easiest way to illustrate inflation is through an example. Suppose you can buy a burger for $2 this year

and yearly inflation is 10%. Theoretically, 10% inflation means that next year the same burger will cost 10%

more, or $2.20. So, if your income doesn't increase by at least the same rate of inflation, you will not be able

to buy as many burgers. However, a one-time jump in the price level caused by a jump in the price of oil or

the introduction of a new sales tax is not true inflation, unless it causes wages and other costs to increase into

a wage-price spiral. Likewise, a rise in the price of only one product is not in itself inflation, but may just be a

relative price change reflecting a decrease in supply for that product. Inflation is ultimately about money

growth, and it is a reflection of too much money chasing too few products.

With this idea in mind, investors should try to buy investment products with returns that are equal to or

greater than inflation. For example, if ABC stock returned 4% and inflation was 5%, then the real return on

investment would be minus 1% (5%-4%). So, you can protect your purchasing power and investment returns

(over the long run) by investing in a number of inflation-protected securities such as inflation-indexed bonds

or Treasury inflation-protected securities (TIPS). These types of investments move with inflation and

therefore are immune to inflation risk.

Varying Opportunity Cost of Capital: The difference in return between an investment one makes and

another that one chose not to make. This may occur in securities trading or in other decisions. For example, if

a person has $10,000 to invest and must choose between Stock A and Stock B, the opportunity cost is the

difference in their returns. If that person invested $10,000 in Stock A and received a 5% return while Stock B

makes a 7% return, the opportunity cost is 2%. One way of conceptualizing opportunity cost is as the amount

of money one could have made by making a different investment decision. Importantly, opportunity cost is

not a type of risk because there is not a chance of actual loss.

OR

Evaluation investments we have made a simple assumption that the opportunity cost of capital remains

consistent over times. This may not be true in reality. If the opportunity cost of capital varies over time, the

use of the internal rate of return (IRR) rule creates problems, as there is not a unique benchmark opportunity

cost of capital to compare with internal rate of return (IRR). There is no problem in using net present value

(NPV) method when the opportunity cost of capital various over time. Each cash flow can be discounted by

the relevant opportunity cost of capital. It is clear that for each period there is a different opportunity cost of

capital. With which of the several opportunity costs do we compare the IRR to accept or reject an investment

project? We cannot compare internal rate of return (IRR) with any of these costs. To get a comparable

opportunity cost of capital, we will have to, in fact, compute a weighted average of these opportunity costs,

which is a tedious job. It is, however, much easier to calculate the net present value (NPV) with several

opportunity costs.

***********************************************************************************



Risk Analysis in Capital Budgeting – Introduction:

Any investment decision depends upon the decision rule that is applied under circumstances. However, the

decision rule itself considers following inputs.

The effectiveness of the decision rule depends on how these three factors have been properly assessed.

Estimation of cash flows require immense understanding of the project before it is implemented; particularly

macro and micro view of the economy, polity and the company. Project life is very important; otherwise it

will change the entire perspective of the project. So, great care is required to be observed for estimating the

project life. Cost of capital is being considered as discounting factor which has undergone a change over the

years. Cost of capital has different connotations in different economic philosophies. Particularly, India has

undergone a change in its economic ideology from a closed economy to open-economy. Hence determination

of cost of capital would carry greatest impact on the investment evaluation.

Capital budgeting is used to ascertain the requirements of the long-term investments of a company. Examples

of long-term investments are those required for replacement of equipment‟s and machinery, purchase of new

equipment‟s and machinery, new products, and new business premises or factory buildings, as well as those

required for R&D plans.

Capital Budgeting Techniques under Uncertainty – Nature of Risk:

Risk can be defined as the chance that the actual outcome will differ from the expected outcome. Uncertainty

relates to the situation where a range of differing outcome is possible, but it is not possible to assign

probabilities to this range of outcomes. The two terms are generally used interchangeably in finance literature.

In investment appraisal, managers are concerned with evaluating the riskiness of a project‟s future cash flows.

Here, they evaluate the chance that the cash flows will differ from expected cash flows, NPV will be negative

or the IRR will be less than the cost of capital. In the context of risk assessment, the decision-maker does not

know exactly what the outcome will be but it is possible to assign probability weightage to the various

potential outcomes. The most common measures of risk are standard deviation and coefficient of variations.

There are three different types of project risk to be considered.

A. Stand-alone risk: This is the risk of the project itself as measured in isolation from any effect it may

have on the firm‟s overall corporate risk.

B. Corporate or within-firm risk: This is the total or overall risk of the firm when it is viewed as a

collection or portfolio of investment projects.

C. Market or systematic risk: This defines the view taken from a well-diversified shareholders and

investors. Market risk is essentially the stock market‟s assessment of a firm‟s risk, its beta, and this

will affect its share price.



Due to practical difficulties of measuring corporate and market risk, the stand-alone risk has been accepted as

a suitable substitute for corporate and market risk. There are following techniques one can use to deal with

risk in investment appraisal.

Statistical Techniques for Risk Analysis:

1. Probability Assignment: The concept of probability is fundamental to the use of the risk analysis

techniques. It may be defined as the likelihood of occurrence of an event. If an event is certain to

occur, the probability of its occurrence is one but if an event is certain not to occur, the probability of

its occurrence is zero. Thus, probability of all events to occur lies between zero and one. The classical

view of probability holds that one can talk about probability in a very large number of times under

independent identical conditions. Thus, the probability estimate, which is based on a large number of

observations, is known as an objective probability. But this is of little use in analyzing investment

decisions because these decisions are non-repetitive in nature and hardly made under independent

identical conditions over time. The another view of probability holds that it makes a great deal of

sense to talk about the probability of a single event without reference to the repeatability long run

frequency concept. Therefore, it is perfectly valid to talk about the probability of sales growth will

reach to 4%, the probability of rain tomorrow or fifteen days hence. Such probability assignments that

reflect the state of belief of a person rather than the objective evidence of a large number of trials are

called personal or subjective probabilities.

2. Expected Net Present Value: Once the probability assignments have been made to the future cash

flows, the next step is to find out the expected net present value. It can be found out by multiplying the

monetary values of the possible events by their probabilities. The following equation describes the

expected net present value.

3. Standard Deviation: The assignment of probabilities and the calculation of the expected net present

value include risk into the investment decision, but a better insight into the risk analysis of capital

budgeting decision is possible by calculating standard deviation and coefficient of variation. Standard

deviation (σ) is an absolute measure of risk analysis and it can be used when projects under

consideration are having same cash outlay. Statically, standard deviation is the square root of variance

and variance measures the deviation about expected cash flow of each of the possible cash flows. The

formula for calculating standard deviation will be as follows:



Thus, it is the square root of the mean of the squared deviation, where deviation is the difference

between an outcome and the expected mean value of all outcomes and the weights to the square of

each deviation is provided by its probability of occurrence.

4. Coefficient of Variation: If the projects to be compared involve different outlays/different expected

value, the coefficient of variation is the correct choice, being a relative measure. It can be calculated

using following formula:

5. Probability Distribution Approach: The researcher has discussed the concept of probability for

incorporating risk in capital budgeting proposals. The concept of probability for incorporating risk in

evaluating capital budgeting proposals. The probability distribution of cash flows over time provides

valuable information about the expected value of return and the dispersion of the probability

distribution of possible returns which helps in taking accept-reject decision of the investment decision.

The application of this theory in analyzing risk in capital budgeting depends upon the behavior of the

cash flows, being (i) independent, or (ii) dependent. The assumption that cash flows are independent

over time signifies that future cash flows are not affected by the cash flows in the preceding or

following years. When the cash flows in one period depend upon the cash flows in previous periods,

they are referred to as dependent cash flows.

(i) Independent Cash Flows over Time: The mathematical formulation to determine the expected

values of the probability distribution of NPV for any project is as follows:



(ii) Dependent Cash Flows: If cash flows are perfectly correlated, the behavior of cash flows in all

periods is alike. This means that if the actual cash flow in one year is α standard deviations to the left

of its expected value, cash flows in other years will also be α standard deviations to the left of their

respective expected values. In other words, cash flows of all years are linearly related to one another.

The expected value and the standard deviation of the net present value, when cash flows are perfectly

correlated, are as follows:



6. Risk Adjusted Discount Rate Method: The economic theorists have assumed that to allow for risk,

the businessmen required a premium over and above an alternative which is risk free. It is proposed

that risk premium be incorporated into the capital budgeting analysis through the discount rate. i.e. If

the time preference for the money is to be recognized by discounting estimated future cash flows, at

some risk free rate, to their present value, then, to allow for the riskiness of the future cash flow a risk

premium rate may be added to risk free discount rate. Such a composite discount would account for

both time preference and risk preference.

Decision Rule:

1. The risk adjusted approach can be used for both NPV & IRR.

2. If NPV method is used for evaluation, the NPV would be calculated using risk adjusted rate. If

NPV is positive, the proposal would qualify for acceptance, if it is negative, the proposal

would be rejected.

3. In case of IRR, the IRR would be compared with the risk adjusted required rate of return. If the

„r‟ exceeds risk adjusted rate, the proposal would be accepted, otherwise not.

Merits:

- It is simple to calculate and easy to understand and It incorporates an attitude towards

uncertainty. It has a great deal of intuitive appeal for risk-averse businessman.

Demerits:

a. The determination of appropriate discount rates keeping in view the differing degrees of

risk is arbitrary and does not give objective results.

b. Conceptually this method is incorrect since it adjusts the required rate of return. As a

matter fact it is the future cash flows which are subject to risk.

c. This method results in compounding of risk over time, thus it assumes that risk necessarily

increases with time which may not be correct in all cases.

d. The method presumes that investors are averse to risk, which is true in most cases.

However, there are risk seeker investors and are prepared to pay premium for taking risk

and for them discount rate should be reduced rather than increased with increase in risk.



7. Certainty Equivalent Approach: This approach to incorporate risk in evaluating investment projects,

overcomes weaknesses of the RADR approach. Under this approach riskiness of project is taken into

consideration by adjusting the expected cash flows and not discount rate. This method eliminates the

problem arising out of the inclusion of risk premium in the discounting process. The certainty

equivalent coefficient (α) can be determined as a relationship between the certain cash flows and the

uncertain cash flows.

Decision Rule:

1. If NPV method is used, the proposal would be accepted if NPV of CE cash flows is

positive, otherwise it is rejected.

2. If IRR is used, the internal rate of return which equates the present value of CE cash

inflows with the present value of the cash outflows would be compared with risk free

discount rate. If IRR is greater than the risk free rate, the investment project would be

accepted otherwise it would be rejected.

Merits:

1. It is simple to calculate. It is conceptually superior to time-adjusted discount rate approach

because it incorporates risk by modifying the cash flows which are subject to risk.

Demerits:

1. This method explicitly recognizes risk, but the procedure for reducing the forecast of cash

flows is implicit and likely to be inconsistent from one investment to another.

2. The forecaster expecting reduction that will be made in his forecast, may inflate them in

anticipation. This will no longer give forecasts according to “best estimate”.

3. If forecast have to pass through several layers of management, the effect may be to greatly

exaggerate the original forecast or to make it ultra conservative.

4. By focusing explicit attention only on the gloomy outcomes, chances are increased for

passing by some good investments.



8. Sensitivity Analysis: While evaluating any capital budgeting project, there is a need to forecast cash

flows. The forecasting of cash flows depends on sales forecast and costs. The Sales revenue is a

function of sales volume and unit selling price. Sales volume will depend on the market size and the

firm‟s market share. The NPV and IRR of a project are determined by analyzing the after-tax cash

flows arrived at by combining various variables of project cash flows, project life and discount rate.

The behaviors of all these variables are very much uncertain. The sensitivity analysis helps in

identifying how sensitive are the various estimated variables of the project. It shows how sensitive is a

project‟s NPV or IRR for a given change in particular variables. The more sensitive the NPV, the more

critical is the variables.

Steps: The following three steps are involved in the use of sensitivity analysis.

1. Identify the variables which can influence the project‟s NPV or IRR.

2. Define the underlying relationship between the variables.

3. Analyze the impact of the change in each of the variables on the project‟s NPV or IRR.

The Project’s NPV or IRR can be computed under following three assumptions in

sensitivity analysis.

1. Pessimistic (i.e. the worst),

2. Expected (i.e. the most likely)

3. Optimistic (i.e. the best)

Merits:

• It compels the decision maker to identify the variables affecting the cash flow forecasts

which helps in understanding the investment project in totality.

• It identifies the critical variables for which special actions can be taken.

• It guides the decision maker to concentrate on relevant variables for the project.

Demerits:

• The range of values suggested by the technique may not be consistent. The terms „optimistic‟

and „pessimistic‟ could mean different things to different people.

• It fails to focus on the interrelationship between variables. The study of variability of one

factor at a time, keeping other variables constant may not much sense. For example, sales

volume may be related to price and cost. One cannot study the effect of change in price

keeping quantity constant.

9. Scenario Analysis: In sensitivity analysis, typically one variable is varied at a time. If variables are

interrelated, as they are most likely to be, it is helpful to look at some plausible scenarios, each

scenario representing a consistent combination of variables.

Procedure: The steps involved in scenario analysis are as follows:

1. Select the factor around which scenarios will be built. The factor chosen must be the largest

source of uncertainty for the success of the project. It may be the state of the economy or

interest rate or technological development or response of the market.

2. Estimate the values of each of the variables in investment analysis (investment outlay,

revenues, costs, project life, and so on) for each scenario.

3. Calculate the net present value and/or internal rate of return under each scenario.



Evaluation:

A. Scenario analysis may be regarded as an improvement over sensitively analysis because it considers

variations in several variables together.

B. It is based on the assumption that there are few well-delineated scenarios. This may not be true in

many cases. For example, the economy does not necessarily lie in three discrete states, viz., recession,

stability, and boom. It can in fact be anywhere on the continuum between the extremes. When a

continuum is converted into three discrete states some information is lost.

C. Scenario analysis expands the concept of estimating the expected values. Thus in a case where

there are 10 inputs the analyst has to estimate 30 expected values (3 x 10) to do the scenario analysis.

10. Simulation Analysis: Sensitivity analysis and Scenario analysis are quite useful to understand the

uncertainty of the investment projects. But both the methods do not consider the interactions between

variables and also, they do not reflect on the probability of the change in variables. The power of the

computer can help to incorporate risk into capital budgeting through a technique called Monte Carlo

simulation. The term “Monte Carlo” implies that the approach involves the use of numbers drawn

randomly from probability distributions. It is statistically based approach which makes use of random

numbers and reassigned probabilities to simulate a project‟s outcome or return. It requires a

sophisticated computing package to operate effectively. It differs from sensitivity analysis in the sense

that instead of estimating a specific value for a key variable, a distribution of possible values for each

variable is used.

The simulation model building process begins with the computer calculating a random value

simultaneously for each variable identified for the model like market size, market growth rate, sales

price, sales volume, variable costs, residual asset values, project life etc. From this set of random

values a new series of cash flows is created and a new NPV is calculated. This process is repeated

numerous times, perhaps as many as 1000 times or even more for very large projects, allowing a

decision-maker to develop a probability distribution of project NPVs. From the distribution model, a

mean (expected) NPV will be calculated and its associated standard deviation will be used to gauge

the project‟s level of risk. The distribution of possible outcome enables the decision-maker to view a

continuum of possible outcomes rather than a single estimate.

Merits:

a. It facilitates the analysis and appraisal of highly complex, multivariate investment proposals

with the help of sophisticated computer packages.

b. It can cope up with both independence and dependence amongst variables. It forces decision-

makers to examine the relationship between variables.

Demits:

i. The model requires accurate probability assessments of the key variables. For example, it may

be known that there is a correlation between sales price and volume sold, but specifying with

mathematical accuracy the nature of the relationship for model purposes may be difficult.

ii. Simulation is not always appropriate or feasible for risk evaluation.

iii. Constructing simulated financial models can be time-consuming, costly and requires

specialized skills, therefore. It is likely to be used to analyze very important, complex, and

large-scale projects.



iv. It focuses on a project‟s standalone risk. It ignores the impact of diversification, i.e., how a

project‟s stand-alone risk will correlate with that of other projects within the firm and affect the

firm‟s overall corporate risk.

v. Simulation is inherently imprecise. It provides a rough approximation of the probability

distribution of net present value (or any other criterion of merit) Due to its imprecision; the

simulated probability distribution may be misleading when a tail of the distribution is critical.

vi. A realistic simulation model, likely to be complex, would most probably be constructed by a

management scientist, not the decision maker. The decision maker, lacking understanding of

the model, may not use it.

vii. To determine the net present value in a simulation run the risk-free discount rate is used. This

is done to avoid prejudging risk which is supposed to be reflected in the dispersion of the

distribution of net present value. Thus the measure of net present value takes a meaning, very

different from its usual one, which is difficult to interpret.

11. Decision-tree Approach: Sometimes cash flow is estimated under different managerial options with

the help of decision-tree approach. A decision tree is a graphic presentation of the present decision

with future events and decisions. The sequence of events is shown in a format that resembles the

branches of a tree. Steps in constructing decision tree:

A. The first step in constructing a decision tree is to define a proposal. It may be concerning

either a new product or an old product entering a new market. It may also be an abandonment

option or a continuation option, expansion option or no-expansion option, etc.

B. Second step is identifying various alternatives. For example, if a firm is launching a new

product, it must chalk out the demand possibilities and on that basis it identifies different

alternatives-whether to have a large factory or a medium-size or only a small plant. Each of the

alternatives will have varying consequences on the cash flow.

C. The third step is to lay out the decision tree showing the different alternatives through

different branches. And finally, the estimates of cash flow with probabilities in each branch are

made. The results of the different branches are calculated that show desirability of a particular

alternative over the others.

Merits:

1. Decision tree analysis gives the clarity of sequential investment decisions.

2. It gives a decision maker to visualize assumptions and alternatives in graphic form which is

easier to understand than the analytical form. It helps in eliminating the unprofitable branches

and determines optimum decision at various decision points.

Demerits:

1. The decision tree becomes more and more complicated if he includes more and more alternatives.

It becomes more complicated if the analysis includes interdependent variables which are

dependent on one another.

2. It becomes very difficult to construct decision tree if the number of years expected life of the

project and the number of possible outcomes for each year are large.



OR

In the modern business world, putting the investments are become more complex and taking decisions in the

risky situations. So, the decision tree analysis helpful for taking risky and complex decisions, because it

considers all the possible events and each possible event are assigned with the probability. Construction of

Decision Tree is as follows:

1. Defined the problem

2. Evaluate the different alternatives

3. Indicating the decision points

4. Assign the probabilities of the monetary values

5. Analysis the alternatives.

Accept / Reject criteria: If the net present values are in positive the project may be accepted otherwise it is

rejected.

A decision tree is a flowchart-like structure in which each internal node represents a "test" on an attribute (e.g.

whether a coin flip comes up heads or tails), each branch represents the outcome of the test and each leaf node

represents a class label (decision taken after computing all attributes). The paths from root to leaf represent

classification rules. In decision analysis a decision tree and the closely related influence diagram are used as a

visual and analytical decision support tool, where the expected values (or expected utility) of competing

alternatives are calculated.

A decision tree consists of 3 types of nodes:

1. Decision nodes - commonly represented by squares

2. Chance nodes - represented by circles

3. End nodes - represented by triangles

Decision trees are commonly used in operations research and operations management. If in practice decisions

have to be taken online with no recall under incomplete knowledge, a decision tree should be paralleled by a

probability model as a best choice model or online selection model algorithm. Another use of decision trees is

as a descriptive means for calculating conditional probabilities. Decision trees, influence diagrams, utility

functions, and other decision analysis tools and methods are taught to undergraduate students in schools of

business, health economics, and public health, and are examples of operations research or management

science methods.

Utility Theory and Capital Budgeting: Economics concept that although it is impossible to measure the

utility derived from a good or service, it is usually possible to rank the alternatives in their order of preference

to the consumer. Since this choice is constrained by the price and the income of the consumer, the rational

consumer will not spend money on an additional unit of good or service unless its marginal utility is at least

equal to or greater than that of a unit of another good or service. Therefore, the price of a good or service is

related to its marginal utility and the consumer will rank his or preferences accordingly. OR In economics,

utility is a measure of preferences over some set of goods and services. The concept is an important

underpinning of rational choice theory. Utility is an important concept in economics and game theory, because

it represents satisfaction experienced by the consumer of a good.

https://en.wikipedia.org/wiki/Flowchart

https://en.wikipedia.org/wiki/Decision_analysis

https://en.wikipedia.org/wiki/Influence_diagram

https://en.wikipedia.org/wiki/Expected_value

https://en.wikipedia.org/wiki/Expected_utility

https://en.wikipedia.org/wiki/Operations_research

https://en.wikipedia.org/wiki/Operations_management

https://en.wikipedia.org/wiki/Probability

https://en.wikipedia.org/wiki/Algorithm

https://en.wikipedia.org/wiki/Conditional_probability

https://en.wikipedia.org/wiki/Influence_diagrams

https://en.wikipedia.org/wiki/Utility_function

https://en.wikipedia.org/wiki/Utility_function

https://en.wikipedia.org/wiki/Decision_analysis

https://en.wikipedia.org/wiki/Management_science

https://en.wikipedia.org/wiki/Management_science



DECISION TREE USING FLOWCHART SYMBOLS:

DECISION TREE FOR SEQUENTIAL INVESTMENT DECISIONS:

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Corporate Restructuring - Introduction:

Corporate restructuring refers to the changes in ownership, business mix, assets mix and alliances with a view to

enhance the shareholder’s value. Hence, corporate restructuring may involve ownership restructuring, business

restructuring and assets restructuring.

A company can affect ownership restructuring through mergers and acquisitions, leverages buy-outs, buy back of

shares, spin-offs, joint ventures and strategic alliances. Business restructuring involves the reorganizations of

business units or divisions. It includes diversification into new businesses, out sourcing, divestment, brand

acquisitions etc. Asset restructuring involves the acquisitions or sale of assets and their ownership structure. The

examples of asset restructuring are sale and leaseback of assets, securitization of debt, receivable factoring etc.

The basic purpose of corporate restructuring is to enhance the shareholder value. A company should

continuously evaluate its portfolio of businesses, capital mix and ownership and assets arrangements to find

opportunities for increasing the shareholder’s value. It should focus on assets utilization and profitable or loss

making businesses. The company can also enhance value through capital restructuring; it can design innovative

securities that help to reduce cost of capital.

Types of Business Combination:

There is a great deal of confusion and disagreement regarding the precise meaning of terms relating to the

business combination; - mergers, acquisitions, takeover and amalgamation and consolidation.

Mergers and Amalgamation: A merger is said to occur when two or more companies combine into one

company. One or more companies may merge with an existing company or they may merge to form a new

company. In merger, there is complete amalgamation of the assets and liabilities as well as shareholders’

interests and businesses of the merging companies. There is yet another way of merger. Here one company may

purchase another company without giving proportionate ownership to the shareholders of the acquired company

or without continuing the business of the acquired company.

Merger or Amalgamation may take two forms: 1) Merger through absorption. 2) Consolidation

Absorption: It’s a combination of two or more companies into an existing company. All companies except one

lose their identity in a merger through absorption. Ex: Tata Fertilizers Ltd (TFL) (A Seller / an acquired

company) by Tata Chemicals Ltd (TCL) (A buyer / an acquiring company).

Consolidation: Consolidation is a combination of two or more companies into a new company. In this form of

merger, all companies are legally dissolved and a new entity is created. In a consolidation, the acquired company

transfers its assets, liabilities and shares to the new company for cash or exchange of shares. Ex: Hindustan

Computers Ltd., Hindustan Instruments Ltd., Indian Software Company Ltd., and Indian Reprographics Ltd. In

1986 to an entirely new company called HCL Ltd.

Acquisition: It’s defined as an act of acquiring effective control over assets or management of a company by

other company without any combination of businesses or companies. A substantial acquisition occurs when an

acquiring company acquires substantial quantity of shares or voting rights of the target company. Thus, in an

acquisition, two or more companies may remain independent, separate legal entity, but there may be change in

control of companies.



Takeover: It means acquisitions. A takeover occurs when the acquiring firm takes over the control of the target

firm. A company can have effective control over another company by holding minority ownership.

Holding company & Subsidiary company: A company can obtain the status of a holding company by

acquiring shares of other companies. A holding company is a company that holds more than half of the nominal

value of the equity capital of another company, called a subsidiary company.

Forms of Merger:

1) Horizontal Merger: This is a combination of two or more firms in similar type of production, distribution or

area of business. Ex: Two publishers combined to gain dominant market share.

2) Vertical Merger: This is a combination of two or more firms involved in different stages of production or

distribution. Ex: TV manufacturing company and a TV marketing company merging to get more share in the

market.

3) Conglomerate Merger: This is a combination of firms engaged in unrelated lines of business activity. Ex:

merging of manufacturing of cement, fertilizers, insurance into one entity.

Types of Takeover:

1) Friendly Takeover: In a friendly Takeover the acquirer will purchase the controlling of shares after

negotiating with the seller. This form of purchase is called consent purchase.

2) Hostile Takeover: A person seeking control over the company by purchasing the required number of shares

in open market. This type of takeover is called as violent takeover.

3) Bailout Takeover: This form of takeover allows the company for the rehabilitation or restructuring as per the

scheme approved by final institution here they give more importance to bidding. The final institution will

evaluate the bidder and keep the track record of both the companies.

Motives / Benefits of Mergers and Acquisitions:

1) Limit competition.

2) Utilize the under-utilized market power and utilized resources.

3) Overcome the problem of slow growth and profitability in one’s own industry.

4) Achieve Diversification.

5) Gain economies of scale and increase income with proportionately less investment.

6) Establish a transnational bridgehead without excessive start-up costs to gain access to a foreign

market.

7) Utilize the under-utilized resources – human and physical and managerial skills.

8) Displace existing management.

9) Circumvent government regulations.

10) Reap Speculative gains attendant upon new security issue or change in P/E ratio.

11) Create an image of aggressiveness and strategic opportunism, empire building and to amass vast

economic powers of the company.



Advantages of Mergers:

1) Maintaining or accelerating the company’s growth particularly when the internal growth is constrained

due to shortage of resources. (To expand the market share and expanding existing markets)

2) Enhancing the profitability through cost reduction resulting from economies of scale, operating

economies and synergy.

Economies of scale arise when increase in the volume of production leads to a reproduction in the cost of

production per unit. Operating economies is in addition to economies of scale, a combination of two or

more firms may result into cost reduction due to operating economies. In a vertical merger, a firm may

either combine with its suppliers of input (backward integration) or with its customers (forward

integration).

Synergy implies a situation where the combined firm is more valuable than the sum of the individual

combining firms. It is defined as ‘two plus two equal to five’ phenomenon. Synergy refers to the benefits

other than those related to economies of scale.

3) Diversification implies growth through the combination of firms in unrelated businesses. Such mergers

are called conglomerate mergers.

4) Reducing the tax liability because provision of setting off accumulation losses and depreciation against

the profit of another company.

5) Limiting the competition by increasing the company’s market share.

Valuation Under Value approach through Mergers and Acquisitions:

Merger will create an economic advantage when the combined present value of the merged firms is greater than

the sum of their individual present values as separate entities. Ex: if firm P and firm Q merge, and they are

separately worth Vp and Vq, and total net worth will be Vpq and the economic advantage will occur if:

Vpq > (Vp+Vq) & the Economic Advantage is equal to EA: Vpq – (Vp+Vq)

Acquisition involves costs. Suppose that firm P acquires firm Q. P will gain a present value of Q and in return P

will pay money in the form of cash. Thus cost of merging to P is: Cash paid-Vq.

Net economic advantage = Economic advantage – cost of merger.

NEA= [Vpq-(Vp+Vq)]-(cash paid-Vq)

The economic advantage represents the benefits resulting from operating efficiencies and synergy when two

firms merge. If the acquiring company pays cash equal to the value of the acquired firm, that is cash paid – Vq

=0, than the entire advantage of merger accrue to the shareholders of the acquiring firm.

MEGA MERGER: On the afternoon of 9th

March, 1993 Tata Oils Mills Company Limited (TOMCO) informed

Bombay Stock Exchange about its intention to merge with the Hindustan Lever Ltd (LEVERS). The board of

directors of the two companies approved that merger on 19th

March, 1993. Tomco is a Rs. 4,460 million turnover

(1992) company and Lever a Rs. 20,000 Million.



Valuation under Mergers and Acquisitions (DCF Approach):

In a merger or acquisition, the acquiring firm is buying the business of the target firm, rather than a specific

asset. Thus, merger is a special type of capital budgeting decision. What is the value of the target firm to the

acquiring firm? This value should include the effect of operating efficiencies and synergy. The acquiring

company should appraise merger as a capital budgeting decision, following the discounted cash flow (DCF)

approach. The merger will be advantageous to the acquiring company if the present value of the target company

is greater than the cost of acquisition. In order to apply DCF technique, the following information is required:

1) Estimation of free cash flows over the Horizon period.

2) Estimation of the value of cash flows beyond the horizon period.

3) Discount rate

Earnings are the basis for estimating free cash flows. As discussed in previous chapters, free cash flows include

adjustments for depreciation, capital expenditure and working capital. The appropriate discount rate depends on

the risk of the expected cash flows of the target company. The following steps are involved in the valuations of a

merger or acquisitions.

Identify growth and profitability assumptions.

Estimate cash flows and terminal value

Estimate the cost of capital

Compute present value of cash flows.

Decide if the acquisition is attractive on the basis of present value.

Decide if the acquisition should be financed through cash or exchange of shares.

Evaluate the impact of merger on EPS and Price Earnings ratio.

Financing a Merger / Acquistion:

Cash Offer: A cash offer is a straightforward means of financing a merger. It does not cause any dilution in the

earnings per share and the ownership of the existing shareholders of the acquiring company. It is also unlikely to

cause wide fluctuations in the share prices of the merging companies. The shareholders of the target company get

cash for selling their shares to the acquiring company. This may involve tax liability for them.

Share Exchange: A share exchange offer will result into the sharing of the ownership of the acquiring company

between its existing shareholders and new shareholders. (Shareholders of acquired company). The earnings and

benefits would also be shared between these two groups of shareholders. The precise extent of net benefits that

accrue to each group depends on the exchange ratio in terms of the market prices of the shares of the acquiring

company and its acquired companies. SER= Share price of the acquired firm / Share price of the acquiring firm

Significance of P/E Ratio and EPS: In practice, investors attach a lot of importance to the earnings per share

(EPS) and the price-earnings (P/E) ratio. The product of EPS and P/E ratio is the market price per share. In an

efficient capital market, the market price of a share should be equal to the value arrived by the DCF technique.

This ratio is calculated by dividing the market price of the stock by earnings per share. The P/E ratio indicates

the expectation of equity investors about the earning of the company. The P/E ratio is used as the going concern

method of valuing the stock. As long as company is variable (Business Entity), its real value is reflected in the

profits.



The Investors expectation is reflected in the market price. The P/E ratio is one of the most widely used measures

of final analysis. The price earnings ratio is always greater than 0, hence it is sometimes called as price earnings

multiple. The investors expect high return will going to pay high price for the shares. The investors can

determine the future market value of the stock of the company with help of EPS. This ratio can be used to

measure the capitalization rate or yield. The reciprocal of P/E ratio is EPS/MP and this gives total capitalization

or the yield. The EPS can be calculated: EAT-Pref. Dividend / No. of shares.

Tender Offer and Hostile Takeover: A tender offer is a formal offer to purchase a given number of a

company’s shares at a specific price. The acquiring company asks the shareholders of the target company to

tender their shares in exchange for a specific price. The price is generally quoted at a premium in order to induce

the shareholders to tender their shares. Tender offer can be used in two situations. The acquiring company may

directly approach the target company for its takeover. If the target company does not agree, then the acquiring

company may directly contact the shareholders by means of tender offer / the tender offer may be used without

any negotiations and it may be tantamount to a hostile takeover and their reactions are exclusively depends on

their attitude and sentiment and the difference between the market price and the offered price.

Corporate Strategy and Acquisitions: A merger or acquisition might be considered successful if it includes the

shareholder value. Thought it is quite difficult to say how the firm would have performed without merger, but

the post-merger poor performance would be attributed as a failure of merger or acquisition.

There are several reasons responsible for the failure of a merger or acquisition.

Excessive Premium: An acquirer may pay high premium for acquiring to its target company. This

happens when the acquirer becomes too eager to acquire the target for prestige or increasing the size of

its empire.

Faulty Evaluation: They make a wrong assessment of the benefits from the acquisition and land up

paying a higher price.

Lack of research: Acquisition requires gathering a lot of data and information and analyzing it. It requires

extensive research.

Failure to manage post-merger integration: Many times acquires are unable to integrate the acquired

companies in their business. They overlook the organizational and cultural issues.

To avoid there problem, there are four important steps involved in a decision regarding merger or acquisition.

(Planning, Search & Screening, Financial Evaluation, Integration).

Accounting for Mergers and Acquisitions: Mergers and acquisitions involve complex accounting treatment. A

merger, defined as amalgamation in India, involves the absorption of the target company by the acquiring

company, which results in the uniting of the interests of two companies. The merger should be structured as

pooling of interest, where the acquiring company purchases the shares of the target company, the acquisition

should be structured as a purchase.

A. Pooling of Interest Method: In this method of accounting, the balance sheet items and the profit and

loss items of the merged firms are combined without recording the effects of merger; this implies that

assets, liabilities and other items of the acquiring company and the acquired firms are simply added at the

book values without making any adjustments. Thus, there is no revaluation of assets or creation of

goodwill.



B. Purchase Method: Under this the assets and liabilities of the acquiring company after the acquisition of

the target firm may be stated at their exiting carrying amounts or at the amounts adjusted for the purchase

price paid to the target company. The assets and liabilities after merger are generally revalued under the

purchase method. If the acquirer pays a price greater than the fair market value of assets and liabilities,

the excess amount is shown as goodwill in the acquiring company’s books. On the contrary, if the fair

value of assets and liabilities is less than the purchase price paid, then this difference is recorded as

capital reserve.

Leveraged Buy-Outs: A (LBO) is an acquisition of a company in which the acquisition is substantially finances

through debt. When the managers buy their company from its owners employing debt, the leveraged buy-out is

called management buy-out (MBO). Debt typically forms 70-90 percent of the purchase price and it may have a

low credit rating. LBO’s generally involve payment by cash to the seller. LBO’s are very popular in USA. The

main motivation in LBO’s is to increase wealth rapidly in a short time. A buyer would typically go public after

four or five years, and make substantial capital gains. Which companies are targets for the leveraged buy-outs?

The following firms are generally the targets for LBO’s:

1) High Growth, High market share firms

2) High profit Potential firms

3) High Liquidity and High Debt capacity firms

4) Low operating risk firms

The term leveraged buyout (LBO) describes an acquisition or purchase of a company financed through

substantial use of borrowed funds or debt. In fact, in a typical LBO, up to 90 percent of the purchase price may

be funded with debt. During the 1980s, LBOs became very common and increased substantially in size, so that

they normally occurred in large companies with more than $100 million in annual revenues. But many of these

deals subsequently failed due to the low quality of debt used, and thus the movement in the 1990s was toward

smaller deals (featuring small- to medium-sized companies, with about $20 million in annual revenues) using

less leverage. Thanks to low stock prices, looser regulatory restrictions, and a rally in high-yield bonds, Barron's

predicted that 2001 would be the biggest year since the 1980s for LBOs. The most common leveraged buyout

arrangement among small businesses is for management to buy up all the outstanding shares of the company's

stock, using company assets as collateral for a loan to fund the purchase. The loan is later repaid through the

company's future cash flow or the sale of company assets. A management-led LBO is sometimes referred to as

"going private," because in contrast to "going public"—or selling shares of stock to the public—LBOs involve

gathering all the outstanding shares into private hands. Subsequently, once the debt is paid down, the organizers

of the buyout may attempt to take the firm public again. Many management-led, small business LBOs also

include employees of the company in the purchase, which may help increase productivity and increase employee

commitment to the company's goals. In other cases, LBOs are orchestrated by individual or institutional

investors, or by another company. A transaction used to take a public corporation private that is financed through

debt such as bank loans and bonds. Because of the large amount of debt relative to equity in the new corporation,

the bonds are typically rated below investment-grade, properly referred to as high-yield bonds or junk bonds.

Investors can participate in an LBO through either the purchase of the debt (i.e., purchase of the bonds or

participation in the bank loan) or the purchase of equity through an LBO fund that specializes in such

investments.

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Advanced Financial Management - MODULE - 5

Swaminath S, Faculty, Bangalore University Page 1

Derivatives for Managing Financial Risk: A firm faces several kinds of risks. Its profitability fluctuates due

to unanticipated changes in demand, selling price, costs, taxes, interest rates, technology, exchange rate and

other factors. Managers may not be able to fully control these risks, but to some degree they can avoid the

impact through entering into Financial Contracts.

Major events that shaped Derivative Markets:

Rice futures in China 6000 years ago-ancient Sumer baked clay tokens in the shape of sheep or goat. Forward

agreement related to rice markets in 17th century in Japan. Merchants stored rice tickets against the stored rice.

The first exchange for trading in derivatives appeared to be the Royal Exchange in London, which permitted

forward contracting. The first “future” contracts are generally traced to the Yodoya rice market in Osaka, Japan

around 1650. These were evidently standardized contracts, which made them much like today‟s futures.

The history of futures markets are concerned was the creation of the Chicago Board of Trade in 1848. Due to its

prime location on Lake Michigan, Chicago was developing as a major center for the storage, sale and

distribution of Midwestern grain. A group of traders created the “to-arrive” contract, which permitted farmers to

lock in the price and deliver the grain later. This allowed the farmer to store the grain either on the farm or at a

storage facility nearby and deliver it to Chicago months later, because of Chicago‟s Storage facilities are not

sufficient to hold enormous supply that occurred during the harvest timings. These to-arrive contract proved

useful as a device for hedging and speculating on price changes. Farmers are also understood that transfer of

price risk associated with the grain is important than sale and delivery. These contracts were eventually

standardized around 1865, and in 1925 the first futures clearing house was formed.

Interestingly, futures/options/derivatives trading were banned numerous times in Europe and Japan and even in

the U.S. in 1867, though the law was quickly repealed. In 1874 the Chicago Mercantile Exchange‟s

predecessor, the Chicago Produce Exchange, was formed. The early 20th century was a dark period of

derivatives trading as bucket shops were rampant. Bucket shops are small operators in options and securities

that typically lure customers into transactions and then flee with the money, setting up shop elsewhere. In 1922

the federal government made its effort to regulate the futures market with the Grain Futures Act. In 1936

options on futures were banned in the US. All the while options, futures and various derivatives continued to be

banned from time to time in other countries. In 1972 the Chicago Mercantile exchange, responding to the now-

freely floating international currencies, created the International Monetary Market, which allowed trading in

currency futures. These were the first futures contracts that were not on physical commodities. In 1975 the

Chicago Board of Trade created the first interest rate futures contract, one based on Ginnie Mae (GNMA)

mortgages. In 1982, the Kansas City Board of Trade launched the first stock index futures, a contract on the

Value Line Index. The CME quickly followed with their highly successful contract on the S&P 500 index.

History of Derivatives in India:

The history of organized commodity derivatives in India goes back to the nineteenth century when the Cotton

Trade Association started futures trading in 1875, barely about a decade after the commodity derivatives started

in Chicago. Over time the derivatives market developed in several other commodities in India. Following

cotton, derivatives trading started in oilseeds in Bombay (1900), raw jute and jute goods in Calcutta (1912),

wheat in Hapur (1913) and in Bullion in Bombay (1920).



However, many feared that derivatives fuelled unnecessary speculation in essential commodities, and were

detrimental to the healthy functioning of the markets for the underlying commodities, and hence to the farmers.

With a view to restricting speculative activity in cotton market, the Government of Bombay prohibited options

business in cotton in 1939. Later in 1943, forward trading was prohibited in oilseeds and some other

commodities including food-grains, spices, vegetable oils, sugar and cloth.

After Independence, the Parliament passed Forward Contracts (Regulation) Act, 1952 which regulated forward

contracts in commodities all over India. The Act applies to goods, which are defined as any movable property

other than security, currency and actionable claims. The Act prohibited options trading in goods along with cash

settlements of forward trades, rendering a crushing blow to the commodity derivatives market. Under the Act,

only those associations/exchanges, which are granted recognition by the Government, are allowed to organize

forward trading in regulated commodities. The Act envisages three-tier regulation: (i) The Exchange which

organizes forward trading in commodities can regulate trading on a day-to-day basis; (ii) the Forward Markets

Commission provides regulatory oversight under the powers delegated to it by the central Government, and (iii)

the Central Government - Department of Consumer Affairs, Ministry of Consumer Affairs, Food and Public

Distribution - is the ultimate regulatory authority. The already shaken commodity derivatives market got a

crushing blow when in 1960s, following several years of severe draughts that forced many farmers to default on

forward contracts (and even caused some suicides), forward trading was banned in many commodities

considered primary or essential. As a result, commodities derivative markets dismantled and went underground

where to some extent they continued as OTC contracts at negligible volumes. Much later, in 1970s and 1980s

the Government relaxed forward trading rules for some commodities, but the market could never regain the lost

volumes.

After the Indian economy embarked upon the process of liberalization and globalization in 1990, the

Government set up a Committee in 1993 to examine the role of futures trading in india and the Committee

(headed by Prof. K.N. Kabra) recommended allowing futures trading in 17 commodity groups. It also

recommended strengthening of the Forward Markets Commission, and certain amendments to Forward

Contracts (Regulation) Act 1952, particularly allowing options trading in goods and registration of brokers with

Forward Markets Commission. The Government accepted most of these recommendations and futures‟ trading

was permitted in all recommended commodities. Commodity futures trading in India remained in a state of

hibernation for nearly four decades, mainly due to doubts about the benefits of derivatives. Finally a realization

that derivatives do perform a role in risk management led the government to change its stance. The policy

changes favoring commodity derivatives were also facilitated by the enhanced role assigned to free market

forces under the new liberalization policy of the Government. Indeed, it was a timely decision too, since

internationally the commodity cycle is on the upswing and the next decade is being touted as the decade of

commodities. The first step towards introduction of derivatives trading in India was the promulgation (new law

or idea) of the securities laws (Amendment) ordinances, 1995, which withdrew the prohibition on options in

securities. The market for derivatives, however did not take off, as there was no regulatory framework to govern

trading of derivatives. SEBI set up a 24- member committee under the chairmanship of Dr. L. C. Gupta on Nov

18, 1996 to develop appropriate regulatory framework for derivatives trading in India. The committee

recommended that derivatives should be declared as “securities” so that regulatory framework applicable to

trading of „securities‟ could also govern trading of derivatives.



The SCRA was amended in December 1999 to include derivatives within the ambit of „securities‟ and the

regulatory were developed for governing derivatives trading. The act also makes it clear that derivatives shall be

legal and valid only if contract are traded on a recognized stock exchange, thus precluding OTC derivatives.

The government also restricted in March 2000, the three-decade old notification, which prohibited forward

trading in securities. Derivatives trading commenced in India in June 2000, after SEBI granted the final

approval to this effect in may 2000, SEBI permitted the derivatives segments of two stock exchanges BSE &

NSE and their clearing house / corporation to commence trading and settlement in approved derivatives

contract. To begin with, SEBI approved trading in index futures contracts based on S&P CNX Nifty and BSE-

30 Index (Sensex) this was followed by approval for trading in options which commenced in June 2001 and

trading in options on individual securities commenced on July 2001.

Future contracts on individual stocks were launched in Nov 2001; futures and options contracts on individual

securities are available on more than 200 securities. Trading and settlement in derivative contracts is done in

accordance with the rules, byelaws and regulations of the respective exchanges and their clearing

house/corporation duly approved by SEBI.

Derivative: A derivative is an instrument whose value is derived from the value of underlying asset, which may

be commodities, foreign exchange, bonds, stocks, stock indices, etc. for ex: in case of a wheat derivative, say

„wheat futures‟ the underlying asset is wheat, which is a commodity. The value of the „wheat futures‟ will be

derived from the current price of wheat. Similarly, in the case of „index future‟, say BSE Index Futures, the

BSE index (the Sensex) is the underlying asset.

Definition of Derivative: In the Indian context the Securities Contracts (Regulation) Act, 1956 (SCRA) defines

“Derivative” as follows: - “A security derived from a debt instrument, share, loan whether secured or

unsecured, risk instrument or contract for differences or any other form of security”. Trading of securities is

governed by the regulatory framework under the SCRA. Derivative contracts include forwards, futures, options

and swaps broadly.

Functions of Derivative Markets: (Economic Functions)

It performs the price discovery function (Future and Current Price). Price in an organized derivatives

reflect the perception of market participants about the future and lead the prices of underlying assets to

the perceived future level. The prices of the derivatives will match or converge with the prices of the

underlying asset at the expiration of the derivative instrument.

Derivatives market helps to transfers the risks from those who have them but may not like them, to those

who have an appetite for them. (Risk seeker V/s Risk averse). Transfer of risk enables market

participants to expand their volume of activity.

Derivatives due to their inherent nature are linked to the underlying cash markets. Owing to presence of

derivatives market, the cash market witness‟s higher trading volumes.

Speculative trades shift to a more controlled environment of the derivatives market. Margining,

monitoring and surveillance of the activities of various participants become extremely difficult in these

kinds of mixed markets.

Derivative act as a catalyst for new entrepreneurial activity.

Derivatives markets help increase savings and investment in the long run.



Features of Derivatives:

Derivatives are traded globally having strong popularity in financial markets.

Derivatives maintain a close relationship between their values and the values of underlying assets; the

change in values of underlying assets will have effect on values of derivatives based on them.

Derivatives traded on exchanges are liquid and involves the lowest possible transaction costs.

Derivatives can be closely matched with specific portfolio requirements.

The margin requirements for exchange traded derivatives are relatively low, reflecting the relatively low

level of credit risk associated with the derivatives.

It is comfortable to take a short position in derivatives than in other assets. An investor is said to have a

short position in a derivatives product, if he is obliged to deliver the underlying asset in specified future

date.

Risk Associated with Derivatives:

Market Risk: Price sensitivity to fluctuations in interest rates and foreign exchange rates.

Liquidity Risk: Most derivatives are customized instruments, hence may exhibit substantial liquidity

risk.

Credit Risk: Derivatives trades not traded on the exchange are traded in the Over the Counter exchange

(OTC) markets. OTC contracts are subject to counter party defaults.

Hedging Risk: Derivatives are used as hedges to reduce specific risks. If the anticipated risks do not

develop, the hedge may limit the fund‟s total return.

Regulatory Risk: Owing to the high characteristic inherent in the derivatives market, the regulatory

controls are sometimes too oppressive for market participants.

Commonly used Derivative Products:

Forwards: A forward contract is a customized contract between two entities, where settlement takes

place on a specific date in the future at today‟s contracted specific price; forward contract is not traded

on an exchange.

Future: A futures contract is an agreement between two parties to buy or sell a specified quantity and

quality of an asset at a certain time in the future at a certain price. Futures contract are standardized

exchange-traded contracts. Such contracts were originally protection against price volatility by buyers

and sellers of commodities such as grain, oil and precious metals.

Options: An option is a contract which gives the right, but not the obligation, to buy or sell the

underlying asset at a specific price for a specified time. Stocks are traded on BSE or Bombay Online

Trading (BOLT) system and options are traded on Derivatives Trading and Settlement System (DTSS)

Calls n Puts are 2 types of options.

Call Option: A call option is a contractual agreement which gives the owner (holder) of the option the

right but on the obligation to purchase a stated quantity of the underlying asset (commodities, shares,

indices, etc.) at a specific price (called the strike price), on the expiry date.

Put Option: A put option is a contractual agreement which gives the owner (holder) of the option the

right but on the obligation to sell a stated quantity of the underlying asset (commodities, shares, indices,

etc.) at a specific price (called the strike price), on the expiry date.

Swaps: Swaps are private arrangements between two parties to exchange cash flows in the future

according to a prearranged formula. Swaps can be of interest rate swaps and currency swaps.



Uses of Derivatives:

Using these products can help you to reduce the cost of an underlying asset.

Earn money on shares that are lying idle.

Benefit from arbitrage (Buying low in one market and selling high in other market)

Protection of securities against price fluctuations.

The most important use of these derivatives is the transfer of market risk from risk-averse investors to

those with an appetite for risk.

The objective of firms using derivatives is to reduce the cash flow volatility and thus to diminish the

financial distress costs.

Some firms use derivatives not for the purpose of hedging risk but to speculate about future prices.

One lesson is clear that derivatives may not serve their purpose of hedging risk; rather they may enhance the

risk if they are not used judiciously. Should firm continue using derivatives? Of course, companies must use

derivatives to hedge risk, but with great care and caution. They must use derivatives just for reducing the risk

and not for speculation. They may make money sometimes while speculating in derivatives, but one day it may

so happen that they may lose everything.

Participants of Derivative Markets:

A. Hedgers: Hedgers face risk associated with the price of an asset. They use futures or options markets to

reduce/eliminate this risk.

B. Speculators: Speculators who wish to bet on future movements in the price of an asset. Future and

options contracts can give them an extra leverage, that is, they can increase both the potential gains and

potential losses in a speculative venture.

C. Arbitrageurs: Arbitragers are interested in locking in a minimum risk profit by simultaneously entering

into transactions in two or more markets. If the price of the same asset is different in two markets, there

will be operators who will buy in the market where the asset sells cheap and sell in the market where it

is costly.

Hedging: The practice of offsetting the price risk inherent in any cash market position by taking the opposite

position in the futures market; hedgers use the market to protect their businesses from adverse price changes.

Ex: A Tyre Manufacturer will need to buy additional rubber from its supplier in 4 months to produce tyres that

it is already offering in its catalogue at a published price. An increase in the cost of rubber could reduce or wipe

out any profit margin. To minimize this risk, the manufacturer buys futures contracts for delivery of rubber in

four months at a price of Rs.11,650 per Qntl. (NMCE Feb 2010 futures contract). If, six months later, the cash

market price of rubber has risen to Rs.12,000, the manufacturer will have to pay that amount to its supplier to

acquire rubber. But the Rs.350 per Qntl price increase will be offset by a Rs.350 per Qntl profit if the futures

contract bought at a price of Rs.11,650 is sold for Rs.12,000. The hedge, in affect, provided protection against

an increase in the cost of rubber. It locked in a cost of Rs.11,650, regardless of what happened to the cash

market price. Had the price of rubber declined, the hedger would have incurred a loss on the futures position,

but this would have been offset by the lower cost of acquiring rubber in the cash market.



Importance of Hedging:

By buying or selling commodity contracts traders and businesses seek to achieve what amounts to

insurance against adverse price changes.

Hedgers ensure well-guarded movement of futures prices.

Hedging complements the process of Price discovery which brings stability in the futures market.

Hedgers provide much needed equilibrium between demand and supply dynamics.

Hedge Terminologies:

Long Hedge: When you hedge by going long in futures market.

Short hedge: When you hedge by going short in futures market.

Cross hedge: When a future contract is not available on an asset, one can hedge ones position in cash

market on this asset by going long or short on the futures for another asset whose price are closely

associated with that of your underlying asset.

Hedge contract Month: Maturity month of the contract through which hedge is accomplished.

Hedge Ratio: Number of future contracts required to hedge the position.

Hedging Participants:

Exporters / Importers

Processors

Traders: (Wholesalers & Retailers)

Farmers

Any person having a position in the underlying cash markets.

Opportunities for Hedging:

The futures market provides opportunities for hedging to all participants at different points of time.

It is to be decided by the participant at what time the market may be entered into.

The exchange provides a fair and transparent trading platform for all.

Benefits of Hedging:

Hedging reduces a firm‟s cost of financial distress.

Minimization of impact of adverse price movements.

Optimum utilization of the financial resources (leverage benefit).

Ensure smooth & continuous business operation.

Besides, Hedging has always been a prime tool of financial decision making.

Financial risk management requires managers to hedge against possible movements in interest rates and

exchange rates.

Hedging helps to separate out the effects of fluctuating external factors and good or bad management on

the firm‟s profitability.



Points to be noted while Hedging:

One very important aspect about hedging is that hedging does not necessarily improve the financial

outcomes of any investor, it just reduces the uncertainty.

Hedger expects that hedging will eliminate all the risk associated with the price of the asset.

But the fact is that hedging can only minimize the risk but cannot fully eliminate it.

This means that the loss made during selling of an asset may not always be equal to the profits made by

taking a short futures position.

This is because the value of the underlying asset in cash market and in futures market may differ during

maturity period of the contract. This is known as „Basis Risk‟.

Forwards: A forward contract is a customized contract or an agreement between two entities, where settlement

takes place on a specific date in the future at today‟s contracted specific price; forward contract is not traded on

an exchange and they popular on the Over the Counter (OTC) market. Forward contracts are very useful in

hedging and speculation.

Features of Forward Market:

1. They are bilateral contracts and, hence, exposed to counter party risks.

2. Each contract is customer designed and, hence, is unique in terms of contract size, expiration date and

the asset type and quality.

3. The contract price is generally not available to public domain.

4. On the expiration date, the contract has to be settled by delivery of the asset

5. If a party wishes to reverse the contract, it has to compulsorily go to the same counterparty, which often

results in high price being charged.

Limitations of Forward Contracts:

Lack of centralization of trading & Liquidity. (Non-Tradable)

Counterparty risk. (Default in Payment)

Too much of flexibility and generality.

Ex: Suppose you have been admitted to a post-graduate management programme and to cope up with the

academic workload; you are required to purchase a desktop computer. On 1st of July, when you go to computer

shop, you find that the computer make of your choice is not available for an immediate delivery. The shop

keeper offers to deliver the computer of your choice to you after 15 days for Rs. 30,000. He also states that if

you don‟t accept the offer, and if you want to buy the computer after 15 days, you may end up in paying either

more or less than Rs. 30,000.You agree to the shop keeper‟s offer. As you agree to buy the computer, you are

buying a forward contract. You will be taking delivery of the computer, called deliverable instrument, on the

due date. The shop keeper, by handling over the computer to you, will be making delivery to you. After 15

days, when you take the delivery, you discover that the actual price of the computer, called spot price, is Rs.

31,000. You have gain Rs.1,000 since you shall pay Rs.1,000 less than the current price. Suppose that when you

approach the shopkeeper for buying a computer, he has it for immediate delivery. You will pay cash and take

the delivery. This is a cash transaction where the exchange takes place immediately.



Futures: A futures contract is an agreement between two parties to buy or sell a specified quantity and quality

of an asset at a certain time in the future at a certain price. Futures contract are standardized exchange-traded

contracts. Such contracts were originally protection against price volatility by buyers and sellers of commodities

such as grain, oil and precious metals.

Types of Future Contract:

Commodity Futures: Where the underlying is a commodity or physical asset such as wheat, cotton, etc. such

contracts began trading on Chicago Board of Trade (CBOT) in 1860s.

Financial Futures: Where the underlying is a financial asset such as foreign exchange, interest rates, shares,

Treasury bill or stock index.

Standardized items in a future contract:

Quantity & Quality of the underlying instrument.

The date and month of delivery, Location of settlement or place of delivery.

The Underlying asset or instrument, the type of settlement and last trading date.

The currency in which the futures contract is quoted.

The units of price quotation and minimum price change.

Other details such as the commodity tick, the minimum permissible price fluctuation.

Future Terminologies:

Spot Price: The price at which an instrument/asset trades in the spot market.

Future Price: The price at which the futures contract trade in the future market.

Contract Cycle: The period over which a contract trades. For instance, the index futures contracts

typically have one month, two months and three months expiry cycles that expire on the last Thursday of

the month.

Expiry Date: It is the date specified in the futures contract. (Last Thursday)

Contract Size: The amount of asset that has to be delivered not be less than one contract. For instance,

the contract size of the NSE future market is 200 Niftiest.

Basis: Basis is defined as the futures price minus spot price. There will be a different basis for each

delivery month for each contract. In a normal market, basis will be positive. This reflects that futures

prices normally exceed spot prices.

Cost of Carry: The relationship between futures prices and spot prices can be summarized in terms of

cost of carry. This measures the storage cost plus the interest that is paid to finance the asset, less the

income earned on the asset.

Initial Margin: The amount that must be deposited in the margin account at the time a futures contract

is first entered into is the initial margin.

Marking to Market: In futures market, at the end of each trading day, the margin account is adjusted to

reflect the investor‟s gain or loss depending upon the futures closing price.

Maintenance Margin: This is somewhat lower than the initial margin. This is set to ensure that the

balance in the margin account never becomes negative. If the balance in the margin account falls below

the maintenance margin, the investor receives a margin call and is expected to top up the margin account

to the initial margin level before trading commences on the next day.



Forward contracts are often confused with future contracts. The confusion is primarily because both serve

essentially the same economic functions of allocating risk in the presence of future price uncertainty. However

futures are a significant improvement over the forward contracts as they eliminate counterparty risk and offer

more liquidity.

A future contract is an agreement between two parties to buy or sell an asset at a certain time in the future at a

certain price. Futures contracts are special types of forward contracts in the sense that the former are

standardized exchange-traded contracts.

Ex: Suppose a farmer produces barley and he is expecting to have excellent yield of barley. But he is worried

about the future price of barley and agreed to supply barley to breakfast Cereal Company. Contract has been

made between the two in order to avoid risk and worries by locking the price today. The farmer will deliver

barley to the manufacturer in the future and receive the agreed price, and the manufacturer will take delivery of

barley and pay to the farmer.

In future contract there will be of no money exchange when the contract is entered and contract is binding on

both the parties. Here both the farmer and the manufacturer have hedged risk and both have less risk than

before. The farmer has protected himself against risk by selling barley futures; his action is called a short hedge.

The short hedge is a common occurrence in business and it takes place whenever a firm or an individual is

holding goods or commodities or is expecting to receive goods or commodities. Farmers anticipate receiving

commodities from harvesting agriculture commodities.

In our example, the manufacturer has protected him against risk by purchasing barley futures; his action is

referred to as a long hedge. Generally, long hedge occurs when a person or the firm is committed to buy at a

fixed price.

Like options, one could use futures contracts to hedge risk. But, as with forward contract and option, there is a

difference between these two instruments as well. Unlike options but like forwards contracts, future contracts

are obligations; on the due date the seller (farmer) has to deliver barley to the buyer (miller) and the buyer will

pay the seller the agreed price.

In future contracts, like in the forward contracts, one party would lose and another party will gain. The profit

and loss will depend on the agreed futures price and the actual spot at the time of contract maturity. Suppose the

futures price of barley is Rs. 20000 per metric ton and the market price turns to be Rs.21500 per metric ton on

the due date. The barley farmer will receive 1500 loss and its gain to miller and vice versa. Thus, the seller of

the contract gains when the contracted price is more than the actual market price later on. The buyer of the

contract will gain when the contracted price is less than the actual market price. Both the barley farmer and the

miller are able to hedge their risk. The farmer has locked in the selling price and the miller has locked in the

buying price. Both can concentrate on their operations, instead of worrying about the fluctuations in the barley

price.

Contract Contract size Exchange

Cotton 50,000 lbs New Cotton Exchange (NCT)

Crude Oil 1,000 barrels New York Mercantile Exchange

S&P Index 500 times Index Chicago Mercantile Exchange (CME)



Financial Futures: Futures are traded in a wide variety of commodities: wheat, sugar, gold, silver, copper,

oranges, coco, oil, soybean etc. commodity prices fluctuate far wide. There are firms which do not have

commodity prices exposure but they have significant exposure of interest rates and exchange rates fluctuations.

These firms can hedge their exposure through financial futures. Financial futures, like the commodity futures,

are contracts to buy or sell financial assets at a future date at a specified price. Financial futures, introduced for

the first time in 1972 in USA, have become very popular. Now the trading in financial futures far exceeds

trading in commodity futures.

Objectives and Benefits of Commodity Futures are as follows:

Hedging: Price risk management by risk mitigation.

Speculation: Take advantage of favorable price movements.

Leverage: Pay low margin to enjoy large exposure.

Liquidity: Ease of entry and exit to market.

Price Discovery: For taking farming and business decisions.

Price stabilization along with balancing demand and supply position.

Facilities integrated price structure.

Flexibility, certainty and transparency in purchasing commodities facilitate bank financing.

Facilitates „informed‟ lending by the banks; the primary objectives for any futures exchange are

effective price discovery and efficient price risk management. In commodity futures, it is necessary to

distinguish between investment commodities and consumption commodities. An investment commodity

is generally held for investment purposes whereas consumption commodities are held mainly for

consumption purposes. Gold and silver can be classified as investment commodities whereas oil and

steel can be classified as consumption commodities.

Mechanism in Futures Contracts:

Buy a future to agree to take delivery of a commodity. This will protect against a rise in price in the spot

market as it produces a gain if spot prices rise. Buying a future is said to be going long.

Future Price = Spot Price + Cost of Carrying

Cost of Carrying: Storage, Insurance, Transport cost, Finance costs (Interest)

Sell a future to agree to make delivery of a commodity. This will protect against a rise in price in the

spot market as it produces a gain if spot prices fall. Selling a future is a said to be going short.

Future Trading Functions:

Basic Functions:

- Price Discovery

- Price Risk Management.

Other Functions:

Information dissemination by exchanges.

Improved product standards

Facilities access to credit / financing.



Differences between Futures and Forward Contract:

Delivery: Delivery tendered in case of futures contract should be of a standard quantity and quality as

per contract specification, at designated delivery centers of the exchanges. Delivery in case of forward

contract is carried out at delivery centre specified in customized bilateral agreement.

Trading Place: Futures contract is entered on the centralized trading platform of the exchange; forward

contract is OTC in nature.

Size of the Contract: Futures contract is standardized in terms of quantity and quality as specified by

the exchange. Size of the forward contract is customized as per the terms of agreement between the

buyer and seller.

Transparency in Contract Price: Contract price of futures contract is transparent as it is available on

the centralized trading system of the exchange. Contract price of forward contract is not transparent, as it

is not publicly disclosed.

Liquidity: Futures contract is more liquid as it is traded on the exchange. Forward contract is less liquid

due to its customized nature and mutual trade.

Counter Party Risk: In futures contract the clearing house becomes a counter party to each transaction,

which is called „Novation‟, making counter party risk nil. In forward contract, counter party risk is high

due to decentralized nature of the transaction.

Organized futures Exchange: Forward contracts are contracts between two parties, called the

counterparties and they are not traded in any exchange. Future contracts are traded in the organized

future exchanges. As stated earlier, future contracts are forward contract traded on the futures

exchanges.

Margin: The Buyers and sellers of the future contracts are required to deposit some cash or securities as

margin. This is done to ensure that the buyers and sellers honor the deal.

Settlement: Futures contract can be settled in cash or physical delivery, depending on the commodity

futures contract specification. Forward contract is generally settled by physical delivery.

Valuation of Open position (Mark to Market Position): In case of futures contract, valuation of open

position is calculated as per the official closing price on a daily basis and „mark-to-market‟ margin

requirement exists. In case of forward contract, valuation of open position is not calculated on a daily

basis and there is a no provision of „mark-to-market‟ requirement.

Regulation: Futures contract is regulated by a government regulatory authority and the exchange.

Forward contract, is not regulated by any authority or exchange.

Marked to Market: Consider an example to understand the meaning to M to M concept. Suppose you have a

future contract to deliver 1000 gold coins at $300/each. Assume that price of gold futures next day goes up to

$305. You have a loss on your sales of 1000 gold coins, so 305-300=5*1000=5000 will be debited to your

account by the concerned exchange and u r required to be paid, so after the first day of your contract your loss is

$5 / gold coin and require delivering 1000 at the same rate. This is like buying back your future position each

day and entering into a new futures contract, the buyer of the gold has a reverse position and he makes a profit

of $5 and will be credited to his account by the exchange. On the part of the buyer of gold coins, this is like

selling back the futures position each day and then entering into a new futures contract. This is referred to mark

to market concept. This is nothing but profit and loss on a futures contract are calculated each day, and if there

is profit u will receive from the exchange and if there is a loss u are require to pay to the exchange.



Differences between Futures and Options:

Futures Options

Exchange traded, with novation Same as futures

Exchange defines the product Same as futures

Price is zero, strike price moves Strike price is fixed, price moves

Price is zero Price is always positive

Linear payoff Non linear payoff

Both long and short at risk Only short at risk

Options: An option gives the holder of the option the right to do something. The holder does not have to

exercise this right. The purchase of an option requires an up-front payment. Options are traded on futures. Some

time called futures options. Buyer or holder of the option has the right to buy or sell an underlying asset at a pre

determined strike price or by maturity date. Strike price is the specified futures price at which the future is

traded if the option is exercised.

Ex: How does option help reducing risk of a company – Consider Indian Oil Company (IOC) imports

thousands of barrels of oil, The Company is expecting increase in the price of oil. The company can lock the

price of oil by purchasing an option to buy oil at a predetermined future date at a specified exercise price.

It could acquire 3 month option to buy 3,000 barrels of oil at an exercise price of $50; IOC will have to pay

option premium to the seller of the option. Assume that this premium is $0.60/barrel, by incurring a small cost

(option premium); IOC has bought an insurance against increase in the oil price. Suppose the oil price at the

time of expiry of an option is $52/barrel; since it is higher than exercise price of $50; IOC will gain by exercise

option, where exercise price:- $50, spot price / market price:- $52 and in practice, firms may collect the

differences between the exercise price and oil price. The net pay-off is: - (52-50)*3000 – 0.6*3000, 6000-

1800=4200. The total oil cost: - 50*3000:- 150000-4200 = 145800

On the other hand, if the oil price goes down to $49, IOC will buy from spot market instead of option, here the

exercise price is more than the actual price. Cost will be: - 49*3000 = 147000, +premium (.6*3000) = 1800: -

148800

Conclusion: Option creates an opportunity to guard against risk and benefit from changes in the prices. The cost

of this opportunity is option premium.

Call option: A call option gives the holder (buyer/one who is long call), the right to buy specified quantity of

the underlying asset at the strike price on or before expiration date. The seller (one who is short call) however,

has the obligation to sell the underlying asset if the buyer of the call option decides to exercise his option to buy.

Ex: An investor buys One American call option on silver at the strike price of Rs.10000 at a premium of Rs.

500. If the market price of silver on day of expiry is more than Rs. 10000, the option will be exercised. The

investor will earn profits once the silver price crosses Rs. 10000 (Strike price + premium), suppose the price is

Rs. 12000, the option will be exercised and the investor will buy 1 silver from the seller of the option at 10000

and sell it in the market at Rs. 12000 making a profit of Rs. 2000. (Spot Price – Strike Price (including

Premium))



In other scenario, if at the time of expiry silver price falls below Rs. 10000 say suppose it touches Rs. 8000, the

buyer of the call option will choose not to exercise his option. In this case the investor loses the premium

(Rs.500), paid which shall be the profit earned by the seller of the call option.

Put option: A put option gives the holder (buyer/ one who is long out), the right to sell specified quantity of the

underlying asset at the strike price on or before an expiry date. The seller of the put option (one who is short

put) however, has the obligation to buy the underlying asset at the strike price if the buyer decides to exercise

his option to sell.

Ex: An investor buys one American put option on copper at the strike price of Rs. 10000 at premium of Rs.

500, if the market price of copper. On the day of expiry is less than Rs. 10000, the option can be exercised as it

s „in the money‟. The Investor‟s breakeven point is Rs. 9500 (Strike price – premium paid) i.e. Investor will

earn profits if the market falls below Rs. 9500.

Suppose copper price is 8000, the buyer of the put option immediately buys copper options in the market @ Rs.

8000 & exercises his option selling the copper options at Rs 10000 to the option writer thus making a net profit

of Rs. 2000 {Strike Price (Including Premium – Spot Price }.

In another scenario, if at the time of expiry, market price of copper is Rs. 12000, the buyer of the put option will

choose not to exercise his option to sell as he can sell in the market at a higher rate, in this case the investor

loses the premium paid (i.e. Rs. 500), which shall be the profit earned by the seller of the Put option.

Differences B/W forwards and options:

1) Forward contract, both the buyer and seller are bound by the contract, the buyer must take the delivery and

seller must make the delivery at the agreed price on the specified due date, under option, the buyer has a right to

decide whether or not he/she would exercise the option.

2) Forward contracts are flexible; you can enter into a forward contract for any goods, commodities or assets.

You can choose your delivery date for any qty of goods or commodities, but not in options

3) Option premium required to be paid, where in forward no premium amount is required to be paid.

Options Terminology:

Index Options: These options have the index as the underlying. Some options are European while other

is American.

Stock Options: stock options are options on individual stocks. A contract gives the holder the right to

buy or sell shares at the specified price.

Buyer of an Option: The buyer of an option is the one who by paying the option premium buys the

right not the obligation to exercise his option on the seller/writer.

Options Premium: Option price is the price that the option buyer pays to the option seller. It is also

referred to as the option premium.

Expiration Date: The date specified in the options contract is known as the expiration date, the

exercise date, and the strike date of the maturity.

Strike Price: The price specified in the options contract is known as the strike price or the exercise

price.



In-the Money Option: An in-the money (ITM) option is an option that would lead to a positive cash

flow to the holder if it were exercised immediately. A call option on the index is said to be in-the-money

when the current index stands at a level higher than the strike price. (that is, spot price > strike price)

At-the-Money Option: An at-the money (ATM) option is an option that would lead to zero cash flow if

it were exercised immediately. An option on the index is at-the –money when the current index equals

the strike price (that is, spot price = strike price)

Out-of-the Money Option: An out-of-the-money (OTM) option is an option that would lead to a

negative cash flow if it were exercised immediately. A call option on the index is out-of-the-money

when the current index stands at a level is less than the strike price (that is, spot price < strike price)

Intrinsic value of an option: The intrinsic value of a call is the amount the option is ITM, if it is ITM.

If the call is OTM, it intrinsic value is zero.

Time value of an Option: The time value of an option is the difference between its premium and its

intrinsic value. Both calls and puts have time value.

Swaps:

Swaps are similar to futures and forwards contracts in providing hedge against financial risk. A swap is an

agreement between two parties, called counterparties, to trade cash flows over a period of time. Swaps

arrangements are quite flexible and are useful in many financial situations. The two most popular swaps are

currency swaps and interest rate swaps. These two swaps can be combined when interest on loans in two

currencies are swapped. The interest rate and currency swap markets enable firms to arbitrage the differences

between capital markets.

Currency Swaps: Currency swaps involve an exchange of cash payments in one currency for cash payments in

another currency; most international companies require foreign currency for making investments in abroad.

These firms fin difficulties in entering new markets and raising capital at convenient terms. Currency swap is an

easy alternative for these companies to overcome this problem.

Ex: Suppose Ranbaxy, an Indian company, has a subsidiary company in USA, it wants to expand its operations

in USA which will cost company 50 Million Dollars. The interest rate is 8%p/a. the company is well known in

India; therefore, it is in a much better position to raise rupee loan in India than in US. The financial manager

decides to issue 10% bonds of 600 million to investors. As a result, Ranbaxy will receive cash flow of Rs. 600

Million now and will undertake to pay 60 million interests each year for five years and repay Rs 600 million

after 5 years. The financial manager simultaneously enters into a swap deal with National Bank of India to

exchange its future rupee liability for dollars.

Suppose the spot exchange rate is 1 dollar = Rs. 50. The bank will pay Ranbaxy rupees to service its rupee loan

and the company will make annual payments in dollars to the bank. The cash flow consequences of the deal are

shown in table below:- Ranbaxy receives Rs 600 million in year 0 and will pay Rs 60 million annual interest for

five years and repay Rs. 600 million principal amount after 5 years. The company will trade 600 million for

dollar 50 million at the spot exchange rate with National Bank in year 0. Ranbaxy will receive sufficient rupees

from the bank to service the rupee loan and will undertake to pay the bank US dollars. The net effect of these

transactions is to swap Ranbaxy‟s 10% rupee load into 8 % US dollar loan.



Year Currency Issue rupee loan Swap rupees for dollars Net cash flow on swap

0 Rupees +600 -600 0

Dollars +50 +50

1 Rupees -60 +60 0

Dollars 0-4 -4

2 Rupees -60 +60 0

Dollars -4 -4

3 Rupees -60 +60 0

Dollars -4 -4

4 Rupees -60 +60 0

Dollars -4 -4

5 Rupees -660 +660 0

Dollars -54 -54

Back to Back loan: Currency swaps are a form of back to back loan. For example, an Indian company wants to

invest in Singapore. Suppose the government regulations restrict the purchase of Singapore dollars for investing

abroad but the company is allowed to lend rupees abroad and borrow Singapore dollars. The company could

find a Singapore company that needs Indian rupees to invest in India. The Indian company would borrow

Singapore dollars and simultaneously lend rupees to the Singapore Company. Currency swaps have replaced the

back to back loans. Back to back loans developed in UK when there were restrictions on companies to buy

foreign currency for investing outside the country.

Interest Rate Swaps: The interest rate swap allows a company to borrow capital at fixed (or floating rate) and

exchange its interest payments, with interest payments at floating rate (or fixed rate). Suppose a company X is

AAA-rated Company located in USA. The company has borrowed $10 million floating rate loan to finance a

capital expenditure investment. The five-year floating-rate loan is indexed to LIBOR (London Interest Offer

Rate). LIBOR is the market-determined interest rate for banks to borrow from each other in the Eurodollar

market. When the company issued floating rate loan the interest rates were low. Now the interest rates are

showing great volatility. Under the floating rate loan, the company‟s interest payments will depend on LIBOR

rate. The interest amount each year will be: LIBOR rate * $10 million. Suppose LIBOR rate is either 5.75% or

6.25 %. The company floating rate interest payment will be: -

Particulars LIBOR Rate

5.75% 6.25% 6.75%

Floating-rate loan interest (LIBOR rate * $10 million) 5,75,000 6,25,000 6,75,000

Suppose company X, expected to have a steady flow of revenue from its investment. The company, Instead of

floating rate, could have taken five-year fixed rate loan to finance the capital expenditure. The fixed-rate loan

would have made sense or Company X since it would be using a fixed-rate liability (loan) to finance a fixed-

rate asset (Capital expenditure). Under the floating-rate loan, the company will have to pay higher amount of

interest when the interest rate rises while it is earning a steady income from its investment. With the fixed-rate

loan, the company would pay constant amount of interest and could avoid the interest rate risk associated with a

floating rate loan. What should company X do?



The company can buy back the floating-rate loan and instead take fixed-rate loan. This is a costly alternative.

The company has to incur transaction cost and might suffer trading loss. However, there is a convenient

alternative available to the company. It can enter into an interest rate swap. The company can swap the fixed-

rate loan for the floating-rate loan. It would pay fixed payments for payments indexed to floating interest rates.

If the interest rises, it will increase the company‟s interest amount on the floating-rate loan but, under swap, its

receipts will also increase. Thus, the swap will offset the company‟s exposure.

Company X finds that currently the floating-rate loan based on LIBOR can be exchanges for 6.25 % fixed rate

loan. If the company decides to enter into a swap arrangement, it can agree to pay 6.25% on notional amount of

$10 million to swap dealer and receive for the LIBOR rate on the same amount of the notional capital.


5.75% 6.25% 6.75%


Swap cash receipts (0.0625*$10 million) 6,25,000 6,25,000 6,25,000

Net cash flow on swap +50,000 0 -50,000

The net cash flow consequences of swap agreement and the floating-rate loan for the company under three

different LIBOR rates will be as shown below:-


5.75% 6.25% 6.75%


Net cash flow on Swap (0.0625*LIBOR) $10 million +50,000 0 -50,000

Net payment 6,25,000 6,25,000 6,25,000

You may note that Company X‟s total payment on the floating rate loan with swap is equal to $6,25,000

irrespective of what happens to the LIBOR rate. The company has been able to judge its interest rate risk

without buying back its floating-rate loan and issuing company converted fixed-rate loan. Through the swap

agreement, the company converted the floating-rate loan into 6.25% synthetic fixed-rate loan.

The interest rate swaps can be used by portfolio managers and pension fund managers to convert their bond or

money market portfolios from floating rate (or fixed rate) to synthetic fixed rate (or synthetic floating rate).

There are many other possible applications of the interest rate swaps.

Assignment: - A Survey of Software Packages for Financial Decisions Making – Students are required to

search the information in Google…

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1.5 ADVANCED FINANCIAL MANAGEMENT Objective

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