Chapter-22 Financial Management - 117.239.72.150117.239.72.150/E3-E4/E3-E4 FINANCE/PDF/E3-E4...

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Chapter-22

Financial Management

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Investment Analysis

Telecom Industry is highly capital intensive. After the telecom services in India were

thrown open to private players, investment in telecom projects has increased

multifold. In line with this industry trend, BSNL and the other public sector

enterprise, MTNL, have been investing very heavily in capital assets to stay ahead of

the competition. The National Telecom Policy‟99 and related government legislations

have imposed clear direction and targets for the telecom companies. Some of the

objectives in NTP‟99 are:

Create a modern & efficient Telecom Infrastructure taking into account

convergence of Information Technology, Media, telecom & consumer

electronic.

Strengthen R&D for world class Manufacturing capabilities

Enable Indian Telecom Players to become truly Global Players

These objectives and the related telecom policy, legislative and licensing initiatives of

the government have spurred capital investment in telecom Industry, by BSNL and

the other telecom sector players. A clear need also has emerged as a consequence, to

ensure that the Capital expenditure (Or CAPEX) decisions taken at various levels of

BSNL are in tune with the best practices in the industry and the return on investment

conforms to, or exceeds, the industry norms.

Nature of capital expenditure decisions:

Capital expenditure Decisions in BSNL or any telecom company are very critical for

its survival and growth because-

CAPEX decisions involve huge investment, in rupee terms and in foreign

currency terms also in many cases

The decisions are either irreversible in Nature or reversible at a huge cost

Their Consequences extend over a long period into the future

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CAPEX decisions are among the most difficult decisions to make, in industry

segments like Telecom, due to the fast changing Technologies, fast changing

customer preferences, severe competition and supply-demand dynamics.

Future costs and benefits of a CAPEX decision are very uncertain.

At present, some the important telecom services on which capital investments are

being made by telecom companies are as below:

Access provision – Fixed, Cellular Mobile, Wireless in Local loop, Cable

Service Provision

Radio paging

Public Mobile Radio Trunk Services

NLD & ILD services

Global Mobile Personal communication by satellite

V-Sat based services

Other Services (IN, WEB, digital Network etc)

These telecom projects have different components – like switching, transmission, and

value added services, apart from usual components of Land, buildings, vehicles etc.

Gestation periods and Payback periods differ from segment to segment and

technology to technology. While wired line services saw phenomenal investments and

growth in earlier decades, the 21st century has started with wireless revolution – with

GSM and CDMA technologies competing for the wireless telecom space. BSNL has

presence in both GSM and CDMA technologies and is using both for purposes for

which they are found suitable in different segments of the network from time to time.

Steps in CAPEX decisions

Every CAPEX decision involves the following fundamental steps:

Identification of Potential Investment opportunities: Potential investment

opportunities are to be identified by carefully screening the following :

New/emerging telecom Technologies; New Uses for existing

technologies/infrastructure; customer needs perceived through Market surveys

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and customer feed back; Need to spread to New locations; new opportunities

indicated by the growth path of competitors, and the regulatory framework and

policies of government.

Preliminary screening of Opportunities: This involves assembling a set of

investment opportunities as above and narrowing the list to preferred

alternatives. At this stage, the criteria typically applied are : compatibility with

the company‟s existing technology, Existing & potential skill sets,

organizational environment; easy availability of technology, equipment and

their potential sources; lead time; reasonableness of costs; associated Risks

(like obsolescence), competition in the segment etc. After considering these

factors, the set of preferred alternatives can be assembled for conducting a

more detailed feasibility study of each.

Feasibility study: Feasibility study involves preparation of a detailed Project

report (approximating to a Project estimate in BSNL) examining the

Marketing, Technical, Financial and Economic feasibility aspects of a project.

The report contains fairly specific estimates of Costs & benefits, means of

raising funds, schedules of implementation, profitability estimates, social

benefits of the project etc. Then, all the projects are listed in the order of

priority based on (i) cost-benefit analysis (ii) company policy and (iii) funds

availability. The approval of competent authority is to be accorded now, in the

order of priority within the available funds. With the disappearance of waiting

lists of customers and emergence of on-demand provision of services and

fierce competition in most parts of the country and in every business segment,

the newer methods described herein can be used for Investment Analysis

Implementation: After approval of specific projects, implementation needs to

be planned with the Preparation of Blue prints, designs, plant engineering,

Equipment selection and procurement, construction, Training, trial run,

commissioning and equipment maintenance planning. The project report must

take into account these factors for successful implementation of the project.

Dealing with implementation Delays : This involves locating potential

causes for implementation delays and taking care of them through various

means like PERT (project evaluation research techniques), CPM(Critical path

method) and assigning specific time-bound responsibilities to the nominated

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project managers for different implementation stages in clear terms. PERT is

mainly for R&D projects though some techniques can be used in a few others.

Critical path method involves splitting of a project into its component

operations and ensuring simultaneous completion of various unlinked

operations so that the project can be implemented in the minimum possible

time. A simple example of a project consisting 4 operations, namely, buying

land and machinery, constructing building and installing machinery can be

illustrated. Here, buying land and buying machinery can be done

simultaneously as independent operations. Constructing building depends only

on buying land but not on buying machinery and hence can be planned

accordingly. But, installing machinery requires that all the preceding three

operations are completed, namely buying land and machinery and constructing

building. Standard notations and techniques are used in more formal CPM

drawings.

A Simple CPM Diagram

Performance review: After implementation, the project performance must be

reviewed to see whether it matches the revenue and performance projections

made in the project report and the reasons for variations. Appropriate remedial

action is to be taken based on performance review.

The detailed project report also must contain Market appraisal, Technical appraisal,

financial appraisal and Economic appraisal of the project.

Market appraisal deals with size of market in the area and expected share of the

project in the market. It takes into account past trends, expected future trends, results

STEP.1.B : BUY MACHINERY STEP.3:INSTAL MACHINERY

STEP.1.A.BUY

LAND STEP.2 CONSTRUCT

BLDG

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of market surveys and the assessment of specific customer requirements in the project

area. In the scenario of “on-demand-provision” of services, market appraisal assumes

great significance in the justification of each project.

Technical appraisal examines technical feasibility, required scale of operations,

existing infrastructure of power, land, buildings etc and required technology to

support anticipated customer requirements. This flows from market appraisal and

planned techno commercial choices.

Economic appraisal deals with social cost-benefit analysis especially in respect of

government supported projects and government specified targets, and indicates the

impact of the project on the society it serves in terms of government-specified targets.

For Complying with Universal service obligations and any other government targets,

it is appropriate for telecom companies to keep such details and justification in respect

of VPTs. The financial appraisal looks at risk- return, cash inflows and outflows and

their impact on the viability of the project.

Financial Appraisal:

Before making capital investments on any project, the investment analysis must

estimate the cash outflows (on Investments and working capital outflows) and the

cash inflows (Revenues) and apply standard decision rules to determine whether the

investment satisfies the requisite decision criteria. This is popularly known as

Financial Appraisal of a project. The general principles adopted by Corporate finance

managers in a standard financial appraisal are:

All costs (cash outflows) and benefits (cash Inflows) must be measured.

Net cash flows must be taken – after deducting the applicable rate of corporate

tax. This means that net cash returns must be measured and not the accounting

profit on the project.

Cash flows must be determined in incremental terms. In other words, the

actual additional outflows and inflows resulting from the implementation of

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the project in question must be taken into account and not the average of all

earlier investments plus current investment.

Sunk costs like cost of land already purchased for many other purposes but is

now additionally used for the current project under appraisal must be ignored .

Opportunity costs associated with the resources of the firm must be considered

even though such utilization does not entail explicit cash outflows:

Existing overhead costs need not be shared by the new project in projecting

the cash outflows

In BSNL, the profitability is presently determined with reference to “Annual

Recurring Expenditure (ARE)” and “Anticipated Receipts &Savings (ARS)” of the

project. The other methods of project evaluation (also called investment appraisal)

currently in use in corporate finance are discussed hereunder.

The terms used in these project evaluation / appraisal techniques are explained briefly

hereunder.

Initial Investment = Cost of all new assets procured Minus sale value of old

assets, if any

Cash Flow After Taxes (CFAT) = Profit After Tax + Depreciations and

other amortizations which do not involve cash outgo

Project Life = Period during which the project generates positive Cash Flow

After Taxes

Time value of Money = We know that a rupee we get in future after a few

years is worth much less than a rupee we get today. The Present value (PV) of

a rupee that we get in future depends on (a) an agreed discount rate which in

turn, depends on factors like depreciation, interest on capital, inflation rates etc

and(b) the time lag that the future period involves. The choice of the discount

rate needs to be done by company managements with caution, taking into

account the type of capital used, the quality of assets proposed to be created

and other factors. Standard tables are available now giving the present value of

a rupee, given the discount rate and the future period of accrual of the rupee.

PV can be calculated for outflows of cash (investments) and inflows

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(revenues) and the net present value (NPV) can be found by deducting the PV

of all outflows from the PV of all inflows. Discount factor can also be

computed without use of tables by using the formula 1/ (1+ k) n where k = cost

of capital; n = year in which the in/outflow takes place. This formula takes

into account only the cost of capital.

Future Value (FV) factor : This is the opposite of the present value factor.

Given the discount rate and the future period, we can calculate the future

worth of today‟s one rupee by using standard tables.

Pay-back method(Pay out or Pay off period): Under this method we calculate the

period taken by the project to recover the investment amount from its future earnings.

Formula: - Pay back period = amount invested

Constant annual earnings

For instance, a project costs Rs.12000 and it is estimated to earn annually Rs.4000net,

then we understand that our investment is recovered over a period of 3 years. The

earnings after this period will constitute profits. This method ascertains the period of

time required for annual earnings of the project to equate with the initial investment.

Here the term „earnings‟ refers to the profits earned by the project (e.g. machine)

before charging the depreciation thereon but after deducting the tax and other

operating expenses. The recovery period is called the pay-back period. The project

which gives the invested capital in the shortest time is the best.

Illustration

ABC Company considers the mechanization of a particular process now carried on by

labour. Two methods are available. The following estimates are made by the experts:

Machine X Machine Y

Working life 5 years 5 years

Cost of machine Rs. 25000 25000

Annual incomes:

I year 7500 3000

II year 10000 6000

III year 15000 11000

IV year 6000 15000

V year 4000 10000

Total 42500 45000

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Calculate the period of time taken by each project to repay the investment amount out

of its earnings

Working

Here the earning of the machine is unevenly spread over the years. So, the general

formula (investment ÷ Constant annual earnings) cannot be used here. We have to

prepare a table as given below:-

Machine X Machine Y

Investment (cost of the machine) 25000 250000

Earnings:

I year 7500 3000

II year 10000 6000

First six months in the III year 7500 -

III year - 11000

First four months in the IV year - 5000

Total 25000 25000

Pay Back period 2 ½ years 3 ½ years

From the above results, we understand that machine „X‟ is preferable to machine „Y‟,

because the former repays the capital earlier.

The pay-back method does not consider the earnings of the post pay-back period.

Decision Rule: - Projects with shorter Payback Period or, those which meet a

management-prescribed Benchmark are to be preferred.

Advantages of the concept:

Simple to understand and Easy to use

Profit or surplus comes only after Payback period.

Used where techno obsolescence is High

Focuses on need for initial higher cash flows

Eliminates / minimizes risk

Comparable to break-even point

Disadvantages of the method are –

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• Stresses only capital recovery (Not profit)

• Nothing about cash flows after PBP

• Non-Comparability of Projects with uneven CFAT

• Ignores Time Value of Money

Discounted Pay Back Period (DPBP)

Determine all Cash outflows (Investment)

Determine all cash Inflows after taxes (revenues) for each year

For each year, the inflows must be netted against outflows. For the net

amount, apply the PV factor from the tables and Compute “Discounted Cash

Flows After Taxes (DCFAT)” by applying the formula: Net CFAT x PV

factor of the year..

Compute the Cumulative DCFAT (CDCFAT)at the end of each year i.e.,

DCFAT till last year + DCFAT of current year

Determine the year in which CDCFAT = INITIAL INVESTMENT

This is the Discounted Pay Back Period (DPBP)

Decision Rule: Accept the Project: If DPBP < Bench mark period fixed by the

company. Else, reject the project. Fixing a proper bench mark in terms of number of

years/months by management for recovery of the initial investment is the essential

first step for applying this method.

EX:- For a particular product “A”, Investment is Rs.36 lakhs. The cash inflows after

taxes for 5 years(in lakhs of Rs) are given. Determine the payback period if the cash

flows are discounted at 12% p.a.

Year 1 2 3 4 5 Total

CFAT(RS) 11.40 11.40 11.40 11.40 11.40 11.40

PV Factor .8929 .7972 .7118 .6355 .5674 3.6048

DCFAT 10.18 9.08 8.11 7.24 6.47 41.08

CUM.DCFAT 10.18 19.26 27.37 34.61 41.08

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So, DPBP = 4 YEARS +[Initial Investment – 4TH YEAR CDFAT] X 100 5TH YEAR DCFAT

= 4 YEARS + [(36 –34.61)/6.47] x 12= 4 yrs 2m

Pay Back Reciprocal (PBR)

Pay back reciprocal (PBR) is computed by the formula: (CFAT P.A. / INITIAL

INVESTMENT) x 100; the formula gives us the approximate internal rate of return

Ex:

(1) Initial investment = Rs.50 Lakhs;

(2) Life of project = 10 years

(3) CFAT = Rs.10 lakhs P.A

(4) PBR = (10 / 50) x 100 = 20%

PBR is generally used if (1) Life of project is at least twice the Payback Period and (2)

Project generates equal amount of annual cash flows

Decision Rule: Accept Projects with highest PBR or those above a Bench mark fixed

Average rate of return method (Accounting rate of return method): Under this

method an attempt is made to calculate the profits of a particular project earned over

its whole working life.

Rate of return = Average annual net profit x 100

Investment

Average annual net profit = all earnings after depreciation

Project‟s economic life

Thus the average rate of return method is an accounting method which represents the

ratio of average annual profits after depreciation and taxes to the investment in

project. A rate of return is fixed keeping in view the cost of capital of the business for

all capital investment projects, and projects which do not give the desired minimum

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rate of return are rejected. Accepted projects are then ranked according to their

respective rates of return.

Illustration

Calculate the average return for projects „X‟ and „Y‟ from the following data:

Project ‘X’ Project ‘Y’

Investment Rs. 20000 30000

Expected life 4 years 5 years

Projected Net income (after depreciation &

taxes)

Year 1 2000 3000

Year 2 1500 3000

Year 3 1500 2000

Year 4 1000 1000

Year 5 1000

6000 10000

If we required rate of return is 6%, which project should be undertaken?

Project ‘X’ Project ‘Y’

Investment

20000 30000

Average annual net profit X =6000 Y =10000

4 5

1500 2000

Average rate of return

X = 1500 x 100 Y =2000 x 100 20000 30000

7.5% 6.67%

Since the rate of return for both the projects is higher than the required rate of return

of 6%, both the projects will be undertaken provided that the two projects are not

mutually exclusive, and that enough financial resources are available. However, if the

two projects are mutually exclusive or enough financial resources are not available,

then Project „X‟ will be preferred, since the rate of return on Project „X‟ is higher than

the rate on Project „Y‟.

Decision Rule: Accept projects with highest ARR or above Benchmark

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Advantages:

• Simple to understand

• Easy to compute

• Income throughout Project Life is considered

Disadvantages:

• Does Not consider CFAT which is more crucial

• Takes rough average of profits of future years & ignores fluctuations in profits

year after year

• Ignores time value of money , which is very important in capital Budgeting

Present value method (Net Present value Method or Net Gain Method): This

method is based upon the concept that a rupee received today is not the same as a

rupee received at the end of the year, because a rupee received today can be invested

so as to earn more money during the year. Under this method, we calculate the present

values of the future earnings spread over a number of years either evenly or

unevenly(using present value table). Then the sum total of these discounted earnings

will be compared with the actual investment to find out the surplus (or otherwise).

But, the problem is what should be discounting rate at which the earnings are brought

down to the present values? This rate is known as he cut-off rate. The rate is based on

the average cost of capital which should be adjusted to allow for the risk element in

each investment project. All cash flows are discounted to present value using the

required rate of return. According to this criterion, the project is accepted if the

present value of cash inflow exceeds the present value of cash outflows. The net

present value method is superior to other methods above, as it takes into account both

the magnitude and the timing of cash flows over the effective life of the asset.

According to this method, the capital project which is quick earning and gives the

returns during early years is considered better than the capital project with the same

total of returns but with longer gestation periods.

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Illustration

Calculate the net present values of Machine „X‟ and machine „Y‟ from the following

data:

Machine ‘X’ Machine ‘Y’

Initial investment Rs. 20000 30000

Expected life 5 years 5 years

Salvage value Rs. 1000 2000

Cash flows

Year

1 5000 20000

2 10000 10000

3 10000 5000

4 3000 3000

5 2000 2000

6 30000 40000

Required Rate of Return

The management determines 10% as the cut-off rate over the proposed investment

project. Discount factors at this rate are given below:

Year 1 2 3 4 5

P.V. .909 .826 .751 .683 .621

Solution:

Machine

„X‟

Machine „Y‟

Value Discount factor

@10%

Presen

t value of

cash

flow

Valu

e

Discou

nt factor

@10%

Present

value of cash

flow

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Cash outflow

Initial

investment

20000

1

20000

3000

0

1

30000

Cash

inflows:

Year

1 5000 .909 4545 2000

0

.909 18180

2 10000 .826 8260 1000

0

.826 8260

3 10000 .751 7510 5000 .751 3755

4 3000 .683 2049 3000 .683 2049

5 2000 .621 1242 2000 .621 1242

5 (salvage) 1000 .621 621 2000 .621 1242

Present

value

24227 34728

Net present

values

(cash inflow-

cash outflow)

4227

4728

The NPV of project „X‟ is Rs.4227 and that of project „Y‟ is Rs.4728. Since the net

cash inflows exceed the net cash outflows for both the projects, both the projects are

acceptable. When the two projects are mutually exclusive so that only one project can

be undertaken, the NPV fails to establish which is a better project, since NPV is

expressed in absolute rather than in relative terms. For making a comparison between

the two projects we will have to calculate the profitability index.

Profitability index = Present value of cash inflows

Present value of cash outflows

Machine „X‟ Machine „Y‟

24227 34728

20000 30000

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=1211 =1157

Irrespective of the fact that the net present value of machine „Y‟ is greater than that of

Machine „X‟, Machine „X‟ is better than machine „Y‟ since the profitability index of

Machine „X‟ is greater than the profitability index of machine „Y‟.

Decision Rule:-Accept if NPV is Positive

Example: - A Firm‟s Investment on a machine = Rs.2 lakhs; Cash Flow after tax &

depreciation = 35,000 p.a. Cost of capital =10%; Its life = 10 years; salvage value

=nil; Calculate Present value, net present value and also profitability Index:

Annuity factor from the tables for 10 years at 10% = 6.1446

So, Discounted cash flows after taxes = present value of 35,000 p.a. paid for 10 years

= 6.1446 x 35,000 = Rs.2,15, 061 (PV)

NPV = DCFAT( - )Initial Investment= Rs.15,061

Formula for Profitability Index (PI) = DCFAT /Initial Investment = 215061 / 200000

=1.075; (see technique.6 below)

Decision: As NPV >0 and PI > 1 the firm should purchase the machinery

Merits of NPV/DCF

Considers Time value, a very important factor

All cash Flows are taken (Unlike Pay Back Period)

Focuses on the basic objective of adding to the Shareholder wealth

Different Projects can be evaluated independently but compared on NPV basis

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Disadvantages

Involves complex calculations

Forecasting Flows & discount rate is difficult

NPV & Ranking of projects differ at different rates, leading to inconsistency in

decision making

Ignores difference in (a) size of investments & (b) the benefits of earlier

inflows enabling the undertaking of more projects later

Discounted cash Flow method or Yield method or Internal rate of return method

or Time adjusted rate of return or Project rate of return: This is used to analyse

cash flows when the approximate cost of capital is not pre-determined, so we do not

know the appropriate discount rate for discounting cash flows to their present value.

The aim of this method is to find out percentage rate of discount that will reduce all

future cash inflows to the same value as the cash invested in the project. The higher

the percentage rate of discounting that is used, the lower will be the present value of

the cash flows. The lower the percentage used, the higher will be the sum of the

present values. By a process of trail and error (using present value table) a percentage

rate can be ascertained that will equate the present value of the future cash flows from

the project with the value of the cash investment. When the rate is found, it will be the

rate of return earned on the funds invested in the project. It allows ranking of

investments according to their internal return.

Illustration

Calculate the internal rates of return for projects A and B from the following data:-

A B

Initial investment Rs. 15000 15000

Effective life (no salvage value) 4 years 4 years

Cash inflow:

Year 1 6000

Year 2 6000

Year 3 6000

Year 4 6000 30000

Solution

Project - A

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There is an annuity of Rs.6000 per year for Project A. So for calculating the internal

rate of return we will use the annuity table. The proportion of annuity of Rs.6000 and

initial investment of Rs.15000 is 6000: 15000 or 1:2.5 So in the annuity table, we

will need the discount rate that will reduce an annuity of Re.1 for 4 years to a present

value factor 2.5 A perusal of the table shows that 2.5 factor lies between the 21% and

22% discount rates.

The approximate internal rate between 21% and 22% shall be determined by

extrapolation as under:

Annuity

(1)

Discount rate

(2)

Discount factor

(3)

Present value

(4) [1 x 3]

6000 21% 2.5404 15,242

22% 2.4936 14,961

1% 281

Internal rate of return = 2 +{15242 minus 15000}

15242 minus 14961

= 21+ 242 =21.89%

281

Project B

For project „B‟ there is a lump sum of Rs.30000 that will be received after the end of

4th year. So, for calculating the internal rate of return, we will use the table that gives

the present value of a rupee due at the end of „n‟ years. The proportion between the

lump sum cash inflow and the initial investment is 30000 : 15000 or 1: .5 So in the

table we will read the discount rate that will reduce a rupee receivable after the end of

4th year to a present value factor of .5 A perusal of the Table shows that .5 factor lies

between 18% and 19% discount rates.

The approximate internal rate between 18% and 19% shall be determined by

extrapolation as under:-

Ump sum

(1)

Discount rate

(2)

Discount factor

(3)

Present value

(4) [1 x 3]

30000 18% .5157 15,471

19% .4286 14,958

1% 513

Internal rate of return = 2 +{15471 minus 15000}

15471 minus 14958

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= 18+ 471 =18.92% 513

Establishing capital priorities

It is essential to establish a system of priorities when the available capital is limited,

so that best use is made of it. The following is a list of such priorities.

1. Projects already in hand: They refer to the projects which are incomplete but

requires additional expenditure for completion They will receive normally

top priority since they are in mid stream.

2. Projects necessitated by law: They refer to the projects which are necessary

to comply with certain legal requirements. Expenditure is necessary, since it

cannot be avoided.

3. Projects to maintain capacity: are meant to keep the productive capacity of

the business intact (e.g.) expenditure on the replacement of a machine.

4. Projects to increase earnings: These are undertaken to reduce costs or to

increase sales of the existing products and are, therefore, naturally looked

upon with favour.

5. Projects to develop New Projects: They refer to the schemes which are

required to improve the profitability of business.

Cost of Financing a Project

In making investment decisions, it is appropriate to have in view the cost of financing

project. This is known as the cost of capital. Common sense tell us that it would be

uneconomical for an individual to borrow money for investment purposes, if he could

not invest these funds at a higher rate. Thus in selecting from among potential

investments, a company should accept only those proposals whose accepted return

would at least exceed the cost of capital to the firm.

Capital expenditure control will have the following features:

1. Constant search: There must be a complete awareness on the part of all

management personnel that long-term expenditure constitutes the basis of

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profits over long periods. This creates constant search for new methods,

processes and products.

2. Comprehensive planning: Budget of an organization incorporates all the

ideas for the future expansion programme. The capital expenditure budget

should be so planned as to ensure balanced development of each part of the

business as well as of the company as a whole.

3. Justification: Having framed the capital budget, it is vital to see that each

project is justified by its forecast profitability. This can be done by using one

or more of the systematic rational methods of ranking investment proposals

such as Pay Back Method, Average Rate of Return Method discounted Cash

Flow Method etc.

4. Authorization: There has to be some routine at every stage request,

authorization, progress and audit. Requests for capital allocation should be

made periodically and they should be reviewed as they pass upward through

managerial level until they reach a committee which shifts these projects and

submits its recommendations to the Board of Directors for final

recommendation.

5. Authentication: As a project is carried out, all expenditure should be

authenticated as being within the previously authorized budget for the

project of the company.

6. Progress: Major capital expenditure projects cannot be accomplished

overnight. They require the preparation of detailed plans and instructions.

The next step consists of issuance of reports during the period in which

project is performed. These reports are aimed at observing that overall

programme remains within limits set by the policy of the company.

Moreover, many unexpected delays may have to be faced. Therefore control

of progress is essential.

7. Post completion audits: This is important phase of the capital expenditure

control. Post-completion audits of projects determine whether their actual

value is in accordance with the one determined at the time of authorization.

It is also possible to detect those areas where action can be taken to improve

future results which may be very valuable n the consideration of future

projects.

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Decision Rule:

If IRR off rate (generally, Cost of capital), ACCEPT

If IRR < Cost of Capital, REJECT

If IRR = Cost of > cut- capital, INDIFFERENT

Ex.: - Calculate IRR of an investment of Rs.2.5 lakhs if CFATs = Rs.45,000 p.a. for

10 years

Annual CFAT for 10 years = 45,000 p.a.

PV interest Annuity Factor DCFAT

10% 6.1446 2,76,507

14% 5.2161 2,34,725

For 4%, difference = 41,782

So, IRR = 10% + [(2,76,507 - 2,50,000) / 41,782] x 4% = 12.54%

Decision Rule: If 12.54% is above cost of capital, Accept; Else Reject;

IRR Advantages:

Takes time Value into account

Takes into account all cash outflows and inflows & time periods

Immediate decision by comparing IRR with cost of capital

Helps to maximize shareholder wealth

Projects with heavy initial years CFAT will have higher IRR. But NPV takes

the timing difference at a suitable discount rate

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Disadvantages:

Tedious to compute for multiple outflows and inflows in each year.

Multiple IRRs leads to difficult interpretation

Conflict with NPV, if in/outflows patterns are different for different proposals

Presumes that all cash inflows are reinvested immediately at the IRR – which

is not practically possible.

Working Capital Management

To create a commercial entity and carrying out commercial activity an investment

called capital is required. This investment may be in the form of cash or other assets.

These assets are used by the company for generating benefits to the company. These

assets are two types: Fixed and Current.

Fixed assets are those assets which are permanent in nature and facilitate business

activity. Examples of fixed assets are land, buildings, machinery, furniture, and long-

term investments. They are not converted as revenue in short term but facilitate

generation of revenue.

Current assets on the other hand are those assets of the entity which are either held in

the form of cash or can be easily converted into cash within a short period, say usually

within a year or an accounting period. Examples of current assets are cash, short-term

investments, sundry debtors or accounts receivable, stock, loans and advances etc.

Liabilities are economic obligations of the company to pay cash or provide goods or

services to outsiders including shareholders. Liabilities may be long-term or current.

Long-term liabilities are those which are repayable over a period greater than the

accounting period like share capital, debentures, long-term loans etc. Current

liabilities on the other hand have to be paid within the accounting period like sundry

debtors or accounts payable, bills payable, outstanding expenses, short-term loans etc.

Working Capital Management means management of current asset and current

liabilities. Traditionally the term working capital is defined in two ways, Gross

Working Capital and Net Working Capital. Gross Working Capital is equal to the

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total of all current assts. Net Working Capital is defined as the difference between

Gross Working Capital and Current liabilities. The basic objective of working capital

is to provide adequate support for the smooth functioning of normal business

operations of a company. The total amount of financial resources at the disposal of a

company is limited. These resources can be put to alternative uses, the larger the

amount of investment in current assets, the smaller will be the amount available for

investment in other profitable avenues available to a company.

Working capital traditionally comprises of cash and bank balances, goods or

inventories, cash equivalents like bills receivables and sundry debtors, etc. As the

business is generally run on credit basis there is a time gap between the transaction

and actual realization of revenue. Similarly there is a lead-time from procurement to

consumption of materials. Hence the balances of sundry debtors and inventories

invariably remain in the books of a business entity. Similarly a business enterprise

takes some time to meet its obligations of payments for services or purchases. But at a

given point of time the business concern must be able to meet its liabilities when

called upon, by converting its current assets into cash. So the working capital

management is basically an issue of liquidity. Thus some part of investment of the

owners is always blocked in holding these current assets and at times the concern is

forced to bring in additional funds from by way of borrowings. The business

concerns have different methods of meeting this working capital requirement; some of

the important methods of raising working capital are discussed below.

Working Capital Management

The problems of Working Capital Management are either not able to assess the actual

requirements of working capital and thereby holding excess current assets like cash

and inventories, or not able to realize the sundry debtors or bill receivable thus

resulting in blocking of funds in working capital. While holding a reasonable level of

working capital is advisable in liquidity point of view and for maintaining optimum

levels of production, sale of goods or services, holding excess working capital in

anyway results in losses to the concern. Let us discuss how the various components

of working capital have an impact on profitability of the business concern.

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The main components of working capital management include

1. Cash management,

2. Receivable management

3. Inventory management.

Cash Management

There is a general tendency to confuse profits with cash. But there is a difference

between profits and cash. Profits can be said to be the excess of income over the

expenditure of the business entity, for a particular accounting period. It includes both

cash incomes (cash sales, interest on investment, etc.) and non-cash incomes (credit

sales, discounts received etc. Similarly both expenses in cash/check (payment of

salaries, wages, interest on term loans, etc.) and non-cash expenses (depreciation,

preliminary expenses incurred during in corporation which are write-off every year,

outstanding expenses like unpaid salaries or rent or insurance) where there is no actual

outflow of cash at the time of accounting are included. „Cash‟ refers to the cash as

well as the bank balances of the company at the end of the accounting period, as

reflected in the Balance Sheet of the company. While profits reflect the earning

capacity of a company, cash reflects its liquidity position.

Why Companies hold cash?

The need for holding cash arises from a variety of reasons which are briefly

summarized below.

Transaction Motive

A company is always entering into transactions with other entities. While some of

these transactions may not result in an immediate inflow/outflow of cash (eg: credit

purchases and sales) other transactions cause immediate cash inflows and outflows.

So firms always keep a certain amount as cash to deal with routine transactions where

immediate cash payments are required.

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Precautions Motive

Contingencies have a habit of cropping up when least expected. A sudden fire may

break out, accidents may happen, employees may go on strike, creditors may present

bills earlier than expected or debtors may make payments later than warranted. The

company has to be prepared to meet these contingencies to minimize its losses. For

this purpose companies generally maintain some amount in the form of cash.

Speculative Motive

Firms also maintain cash balances in order to take advantage of opportunities that do

not take place in the course of routine business activities. For example, there may be

a sudden decrease in the price of raw materials which is not expected to last long or

the firm may want to invest in securities of other companies when the price is just

right. These transactions are of a purely speculative nature for which the firms need

cash.

Objectives of Cash Management

The objective of cash management can be regarded as one of making short-term

forecasts of cash position, finding avenues for financing during periods when cash

deficits are anticipated and arranging for repayment/investment during periods when

cash surpluses are anticipated with a view to minimizing idle cash as far as possible.

Towards this end short-term forecasts of cash receipts and payments are made in the

structured form of cash budgets, information is monitored at appropriate intervals for

the purpose of control and taking suitable measures as warranted by the situation.

Cash Forecasting and Budget

The principal tool of cash management is cash budgeting or short-term cash

forecasting. Usually, the time chosen for making short-term forecast for preparing

cash budgets is taken to one year. For the purpose of better monitoring and control,

however, the year is divided into quarters, quarters into months and months into

weeks. Under critical conditions a week is further divided into days. The efficiency

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of cash management can be enhanced considerably by keeping a close watch and

controlling a few important factors mentioned below:

Prompt Billing and Mailing

A time lag occurs from the date of dispatching goods or providing services to the date

of preparing invoice or bill and mailing the same to the customer. If this time gap can

be minimized, early collections can be expected, otherwise collections get delayed.

Collection of Cheques and Remittances of Cash

Delay in the receipt of cheques and depositing the same in the bank will inevitably

result in delayed cash realization. This delay can be reduced by taking measures for

hastening the process of collection and depositing cheques/cash from customers.

Receivables Management

Introduction

Business firms generally sell goods on credit, to facilitate sales especially from those

customers who cannot borrow from other sources, or find it very expensive or

difficult to do so. Goods or services sold on credit get converted (from the point of

view of the selling firm) into receivables (book debts) which when realized, generate

cash. The average balance in the receivables account would approximately be:

average daily credit sales multiplied by average collection period. For example, if the

average daily credit sales of a firm are Rs. 3,00,000 and the average collection period

is 40 days, the average balance in the receivables account would be Rs. 1,20, 00,000.

Since receivables often account for a significant proportion of the total assets,

management of receivables take up a lot of the Finance Manager‟s time.

Purpose of Receivables Management

The object of receivables management is to promote sales and profits until that point

is reached where the returns that the company get from funding of receivables is less

than the cost that the company has to incur in order to fund these receivables. Hence,

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the purpose of receivables is directly connected with the company‟s objectives of

making credit sales which are:

Increasing total sales as if a company sells goods on credit, it will be in a

position to sell more goods than if it insists on immediate cash payment.

Increasing profits as a result of increase in sales not only in volume, but also

because companies charge a higher margin of profit on credit sales as

compared to cash sales.

In order to meet the increasing competition, the company may have to grant

better credit facilities than those offered by its competitors.

Cost of Maintaining Receivables

Additional fund requirement for the company

When a firm maintains receivables, some of the firm‟s resources remain

blocked in them because there is a time lag between the credit sale to

customer and receipt of cash from them as repayment. To the extent that the

firm‟s resources are blocked in its receivables, it has to arrange additional

finance to meet its own obligations towards its creditors and employee, like

payments for purchases, salaries and other production and administrative

expenses. Whether this additional finance is met from its own resources or

from outside, it involves a cost to the firm in terms of interest (if financed

from outside) or opportunity costs (if internal resources which could have

been put to some other use are taken).

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Administrative costs

When a company maintains receivables, it has to incur additional

administrative expenses in the form of salaries to clerks who maintain

records of debtors, expenses on investigating the creditworthiness of debtors

etc.

Collection costs

These are costs which the firm, has to incur for collection of the amounts at

the appropriate time from the customers.

Defaulting costs

When customers make default in payments, not only is the collection effort to be

increased but the firm may also have to incur losses from bad debts.

Financial Management

1. What is the significance of Investment Analysis in Financial Management ?

2. Discuss about the various steps involved in CAPEX Decisions ?

3. What is meant by Critical Path Method ?

4. Discuss about the various project appraisal techniques ?

5. What is meant by Financial appraisal of a Project ? How it is carried out ?

6. What are the advantages and disadvantages of payback period Method ?

7. What are the merits and demerits of Discounted Cash Flow Methods ?

8. Brief about the working Capital management ?

9. What are the main components of working capital ?

10. What are the motives of holding the cash under cash management system ?